This share price progress has been fully warranted too as the recovery in the business gathers pace. The 45 per cent surge in adjusted pre-tax profits to £8.4m last year may have grabbed the headlines in this week's results release, but for me the key take was the margin enhancement. At just shy of 13 per cent, profit margins have risen to their highest level for five years as the company emerged from a restructuring with a much slimmer fixed cost base, evidence of which was a near £2m reduction in staff costs. At around £32.4m this overhead accounted for half of revenues and with other operating costs slashed by almost £2m to £11.6m, the keen focus on cost control has underpinned the sharp rise in profits. Measures taken by KBC’s management team include closing or downsizing oversized offices in more mature regions; adding smaller offices in growth regions; increasing consulting utilisation rates; and introducing performance targeting and more focused sales and marketing.
Technology division the key to a higher rating
But this has not been at the expense of product development as investment in new direct software sales is expected to boost software sales in future years. That’s another key take for me because for KBC’s share price to enjoy a higher rating more inline with small cap software companies then growth needs to be driven by its higher margin technology business, accounting for 27 per cent of last year’s revenues of £65.1m. This unit enjoys operating margins around 30 per cent, whereas the consultancy division makes around 8 to 10 per cent. It’s therefore worth noting that recurring revenues from the technology business shot up 20 per cent to £7.6m last year. Revenue here consists of royalty, maintenance and support fees, and income earned from client upgrades.
Importantly, KBC’s recurring revenue stream is likely to grow significantly in the coming years following a raft of contract wins in the past 12 months. These include a five-year agreement with a Japanese refiner worth £1.8m; a similar deal with a US refiner; and a seven-year contract, worth £10m, for the provision of its Multiflash™ software, maintenance and support services to a large oil and gas services company. KBC’s Multiflash™ software is being integrated within all of these client's production software applications, which are used by the majority of oil and gas companies worldwide.
The main point for me is that if KBC can grow both the recurring revenue stream from its software business, and boost the segment’s overall contribution to the company’s total profits, then there is a strong case to be made that the earnings multiple the shares trade on should be much higher than at present. Net of a cash pile of £6.9m, worth 11.7p a share, the company is being rated on a very modest cash adjusted PE ratio of 11.3 times, based on underlying EPS of 9.5p last year. To put that into some perspective, the average PE ratio for Aim small cap software companies with high recurring revenues is around 21, according to research carried out by analysts Andy Bryant and Jason Holden at brokerage Cenkos Securities.
True, KBC’s consultancy division looks correctly priced on a multiple of around 12 times earnings. But it seems anomalous to me to value the software part of the business on the same multiple given it enjoys margins three times higher at around 30 per cent and an increasing amount of more valuable recurring revenue. In addition, the software business has grown revenues by 38 per cent in the past three years, so there is top-line growth coming through too.
Furthermore, even if you were to take a conservative approach and rate KBC’s technology operation in line with the UK software and services sector average earnings multiple of 15 for sub-£100m market cap companies, then this part of the business is still being undervalued by around 30 per cent.
Strong industry drivers
The case for a much higher valuation is made even stronger by a £78m pipeline of contract work. That is close to an all-time high and offers further visibility that the recovery in the business is on track. KBC’s revenues are also well underpinned by a four-year contract worth $100m with EP Petroecuador (EPP), the integrated state national oil company of Ecuador. The company is working with EPP to improve its core work processes and support systems, as well as develop the technical capability of the workforce.
The dynamics driving the industry are also very supportive of the investment case and favour more contract wins for the company from major oil and gas companies. For instance, the global hydrocarbon sector continues to grow strongly and remains an important marketplace for KBC. The ramp up in US domestic crude oil and gas production from shale and tight oil is clearly a major factor and underpins the positive outlook for hydrocarbon markets in the medium term. In addition, large offshore gas discoveries are generating significant LNG investment in East Africa and Australia.
KBC is not only capitalising on its traditional markets of downstream refineries and petrochemicals, but also on more recently targeted upstream production and midstream marketplaces. In upstream oil production, it’s reasonable to expect major new market opportunities for KBC in the coming years as oil and gas companies and oilfield service companies make greater use of sophisticated software to cut capital expenditure and to implement profit improvement techniques more typical for downstream assets. Admittedly, upstream exploration is showing some signs of a cyclical slowdown in spending, especially for deep water exploration projects, but this segment is of less direct relevance to KBC.
In downstream activity, the major investment and new capacity are mainly in the Former Soviet Union (FSU), Middle East, India and Asia, all target growth markets for KBC. In the FSU, there is a major 10-year programme in place to upgrade refinery assets which KBC is well positioned to support. In the Middle East, new world-scale refinery and petrochemical facilities are being built which will need a large number of skilled workforces, requiring services in organisational and skill enhancements suited to KBC's offerings. All these industry drivers are supportive of further profit growth for the company in the coming years.
Lowly valued relative to peers
Post the full-year results, house broker Cenkos Securities is forecasting a rise in revenues from £65.1m to £67.1m in the current year to end December, to lift pre-tax profits by around £500,000 to £8.9m. The respective forecasts are for revenues of £69.1m and pre-tax profits of £9.5m in 2015. On this basis, expect the reinstated final dividend of 1p a share announced alongside these results to be lifted by 10 per cent this year and the same next. It could be more given that operating cash flow is expected to be in excess of £9m this year and £11m in 2015, making the £600,000 cost of this year’s payout easily affordable.
In terms of valuation, not only are KBC’s shares modestly rated on an historic cash adjusted PE ratio of 11.2, but a multiple of six times cash profits to enterprise value (market capitalisation less net cash) is hardly an exacting valuation either. So, given the positive trading update, and potential for earnings upgrades this year on the back of further contract wins, I have decided to upgrade my fair value estimate on the shares to 165p which neatly coincides with a major high in August 2001. A move through January's 131p high would be a bullish sign indeed as it would signal a break-out on the point and figure chart.
If my new target price is hit the shares would be priced on a far more reasonable 16 times earnings net of cash. My time-frame to achieve this target is six months and encompasses a likely trading update alongside the AGM on 4 June, a pre-close trading update in July and the interim results on 23 September.
Please note that I have taken into consideration news that finance director Caroline Brown, who was appointed in 2012 to assist with KBC's drive to improve commercial and financial performance, will be leaving the company next month having substantially completed her objectives. Ahead of the appointment of a replacement, director Andrew Hebb will act as interim chief financial officer, a position he has held previously at a number of companies in both the professional services and software markets.
Finally, I am working my way through a number of announcements from companies on my watchlist including today's results from Moss Bros (MOSB), IQE (IQE) and GLI Finance (GLI).
