As I have pointed out in previous articles this year, the company has been showing encouraging signs of entering an earnings upgrade cycle as the recovery in the business gathers pace. With this in mind, some of the key areas I look for in potential recovery plays are: a business emerging from a restructuring with a much slimmer fixed cost base, and so offers potential for a greater proportion of future revenue to drop straight down to the bottom line; and a return to revenue growth to build on the higher operational gearing. On both counts, KBC is showing the right signs.
In fact, buoyed by a raft of contract wins, revenues in the six months to end-June surged by 15 per cent to £31.7m, of which an eye-catching £9.6m was derived from the higher-margin technology segment and the balance from consultancy work.
Contracts won include five-year agreements with a Japanese refiner worth £1.8m, and a similar deal with a US refiner worth £1.8m. KBC also won a $16m, seven-year contract for the provision of Multiflash™ software, maintenance and support services to a large oil and gas services company, in early May. The contract is an extension to a previous royalty agreement between the client and Infochem, a company that KBC acquired 15 months ago, and will enable the integration of Multiflash™ within all of the client's production software applications, which are used by the majority of oil and gas companies worldwide. These contract wins are in addition to the one with EP Petroecuador (EPP), the integrated state national oil company of Ecuador, worth $100m (£64.5m) over a period of four years. KBC is working with EPP to improve its core work processes and support systems, as well as develop the technical capability of the workforce.
So, with the benefit of a lower cost base, and rising margins on contracts won due to a change in the business mix, this meant that operating margins quadrupled from around 2.6 per cent at this stage last year to 10 per cent. Moreover, the strong trading has continued into the second half and the record pipeline of contract work currently stands at over £84m, including a further £8m of contracts won since July.
As a result, guidance is that full-year profits will be ahead of current analyst forecasts, prompting analysts at house broker Cenkos Securities to upgrade their full-year pre-tax profit estimate from £7m to £7.5m on revenues of £66m, up from £5.5m and £63m, respectively, last year. On this basis, expect full-year EPS of 7.3p. For 2014, the broking house is conservatively maintaining EPS of 8p next year based on a further rise in profits to £8m on revenues of £67m.
So, with the shares currently trading at 85p, the 2014 forward PE ratio is only 10.5 - a massive discount to the UK software and services sector average earnings multiple of 15 for sub-£100m market cap companies.
Dividend to be reinstated
Investors can also expect a reinstatement of the dividend at the time of the final results. Cenkos forecasts a 1.6p a share payout, implying a prospective yield of around 2 per cent. KBC can certainly afford it as the company ended the half year with net cash of £5.15m, or 9p a share, and this was after expensing research & development costs of £1.3m in the period. Strip that sum out from the current share price of 85p, and in effect KBC's is being valued on 9.5 times earnings estimates for next year. The company's market value of £50m is also a modest 40 per cent premium to book value of £35.4m.
Share price poised for further upside
Having taken out the 80p resistance level after I highlighted the investment case three weeks ago ('Buy the break-out', 6 September 2013), the shares are well on their way to an assault on the 91p high from February last year. It also vindicates my decision to advise buying the shares at 69p in early May ('Fuelled for growth', 5 May 2013). Beyond that the next resistance level is 100p.
In my opinion, the combination of potential for further earnings upgrades on the back of additional contract wins, a reinstated dividend, and strong profit growth this year and next continues to make KBC a compelling investment opportunity. As a result, I rate the shares a strong buy on a bid-offer spread of 84p to 85p and have raised my target price to 100p. Cenkos have a discounted cashflow valuation of 100p-plus on the shares. Offering a potential 25 per cent further upside, the shares rate a decent buy and the time-frame for this trade is four months to factor in likely positive news flow from a pre-close trading update in January.
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