Every so often, an analyst note becomes the talk of the City.

Over the last couple of weeks, Charles Stanley scribe Michael Donnelly, has been in back-to-back meetings with fund managers wanting to find out about his contrarian take on energy consultancy Utilitywise (UTW:AIM).

It has been a darling of the stock market since listing in 2012, gaining nearly 200% in 2013 and a further 10% last year in a flat year for the FTSE All-Share. It is one of the few small caps to feature in star fund manager Neil Woodford’s portfolio at CF Woodford Equity Income (GB00BLRZQ737).

But it has sold off by 27% since the start of the year, a run which accelerated on 21 January when Donnelly published his research, titled ‘Unto the camp, and profits will accrue’, a quote from Shakespeare’s Henry V.

In Shares’ view any fears look overdone and the weakness in the share price represents a potential opportunity but it is worth examining Donnelly’s concerns in detail.

He says Utilitywise has been booking accruals - mainly non-cash profits - at a rate far faster than its sector peers. He says unwinding these assets and liabilities via cash-settled transactions will be tricky and the outcome ‘will not be pretty’.

Broad-based concerns

The analyst also cites a range of other risks which he says puts a question mark over the sustainability of growth at the company:

• Operating margins have not expanded since listing despite extra scale;

• Customer concentration risk has increased;

• Planned expansion into France and Germany increases risk profile.

Accruals are a natural part of Utilitywise’s accounts because of its business model. It provides energy consulting and brokerage services on behalf of corporate and small and medium sized enterprises (SMEs). Utilitywise is paid after providing services on most of its contracts, and before providing services by a smaller number of customers. These types of payment arrangements are fairly typical among all commercial enterprises and give rise to accounting ‘accruals’.

Donnelly says that while he accepts these accruals are to be expected in a small and growing business, Utilitywise’s far outstrip any of its peers. These include Inspired Energy (INSE:AIM), Energy Assets (EAS:AIM) and Smart Metering Solutions (SMS:AIM).

Using a measure known as the ‘aggregate accruals ratio’ (see table), Donnelly shows Utilitywise’s balance sheet (excluding cash and debt) relative to net debt increased by an average of 70% a year between 2010 and 2014. That compares with a peer group median of 13%.

(Click on table to enlarge)

Digging further into the financials, Donnelly calculates ‘cash sales’. Revenue in the income statement includes both cash sales to customers and sales which have been invoiced but not yet settled. This, again, is a standard arrangement used by all companies on the stock market. When cash sales are generally equal to income statement revenues, earnings quality is said to be high. When cash sales start to undershoot, it can be a red flag.

Donnelly shows cash sales consistently run lower than reported revenues at Utilitywise (see chart), which he attributes to the SME division.

(Click on charts to enlarge)

Questioning the growth

Operating margin is another area which concerns Donnelly. He says a key part of the initial public offering story at Utilitywise was its capacity to increase revenues over a relatively fixed operating cost base. Over time, this should lead to margin expansion and allow profit to grow faster than revenues. But that has not been the case.

Margins have been high but stubbornly flat since Utilitywise listed and this leads to question marks over the sustainability of growth at the company. If Utilitywise has to rely on revenue growth rather than margin expansion to deliver increasing profitability, it has to hire consultants (new staff) exponentially into the future just to keep its growth story intact.

‘Not everyone in the UK can work for Utilitywise,’ Donnelly says. ‘Incremental sales growth can only take you so far before you reach saturation.’

Foreign expansion is one way Utilitywise may seek to mitigate a tightening UK market. Management has signalled foreign ventures could be the way forward and bought Tegaz, a division of energy giant Total (FP:EPA), in 2013 to break into the French market. Donnelly says he can think of barely any British companies that have delivered a successful ‘pick-up-and-drop’ strategy in Europe.

Customer concentration also looks like it is increasing. In its financial year to end-July 2014, Utilitywise reported that its biggest customer contributed 36% of its total sales, compared to just 18% a year earlier. This, Utilitywise management say, is because several separate contracts were consolidated under supply arrangements with a single customer.

Overall, Donnelly sounds more bearish on Utilitywise than the ‘hold’ recommendation he has on the stock would suggest. He downgraded the stock from ‘buy’ to ‘hold’ after researching the ballooning accruals on its balance sheet and cut the target price to 244p, down from 350p.

In the note, Donnelly hedges his bets slightly.

‘What if we’re wrong and the shares are still a ‘buy’?,’ he writes.

‘After falling 18% since reporting results for the year to July 2014 in October 2014, the shares trade on [a price to earnings ratio of] only 13 times, a discount to the wider market for a company with almost £10 million of net cash and 30% margins.

‘Fast-growing companies generally create fast-growing accruals and accelerated hiring in the SME business would generate further consensus upgrades. Finally, we still believe regulation in Utilitywise’s markets to be at least two years distant.’

He says fund managers he has spoken to over the past couple of weeks now recognise the accruals issue is something to be watched. The opportunity to short the stock is limited, he says, because of a lack of available shares to borrow.

A spokesperson for Utilitywise said its management team were unable to comment for this story as they are preparing a trading statement.

Accruals at Utilitywise should certainly be watched but as Donnelly concedes, small companies that grow quickly tend to generate larger-than-average accruals. The business generated around £8 million of free cash flow last year which is not indicative of a business with significant liquidity constraints. At 196p the recent sell-off puts Utilitywise on a price-to-earnings ratio of 11 times next year’s earnings which looks undemanding to us.