The company has just won a US$5.8m (£3.4m) five-year contract award from a large South American based multinational energy company. The agreement, which constitutes a renewal, extension and expansion of an existing licence, will see KBC expand the licence of its refinery wide simulation software suite, Petro-SIM™ and the associated SIM-suite™ reactor models, to the client’s refinery business. The latest contract win follows on from a major licence win with another South American national oil company in June, highlighting the relevance of the Petro-SIM engineering simulator to the processing industry.
It also vindicates the company’s decision to undertake a placing in May which raised £24m at 115p a share. The new equity represented around a quarter of the enlarged issued capital of 80.6m shares and means that KBC’s pro-forma net funds are around £31m, or 38p a share. The company's market capitalisation of £99m equates to 1.67 times book value so it is not extended given that net cash represents half of the company’s net asset value and 30 per cent of the current share price.
Importantly, and as can be seen by the two major contract awards in the past month, the new cash is enabling the company to target larger, more capital-intensive, higher-margin projects. The new funding is also enabling KBC to continue investment in sales and marketing with the aim of boosting revenue and earnings growth; expand its technology offering to provide a more comprehensive software package across the full spectrum of wellhead, production, oil and gas processing, refining and petrochemicals; and acquire niche software companies that sell into the upstream sector and whose software integrates effectively into KBC's Petro-SIM™ platform.
In addition, KBC is looking to invest in high-growth markets in China, Middle East, Latin America, Asia and India over the next couple of years. 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.
And as I pointed out when I last updated the investment case (‘A slick fundraise, 23 May 2014), Oslo-listed company Kongsberg Gruppen ASA (NO:KOG) subscribed for 20 per cent of the placing shares to give it an interest in 5 per cent of KBC’s enlarged share capital. The investment strengthens the working relationship between KBC and Kongsberg Gruppen and is worth noting because Kongsberg Gruppen is a global group that supplies high-technology systems to customers in the oil and gas industry, the merchant marine, and the defence and aerospace industries.
Re-rating beckons
In my opinion, the move to higher-margin work, investment in new direct software sales and ongoing contract wins should lead to a higher proportion of recurring revenues. That’s because the higher-margin technology business accounts for a quarter of KBC’s revenues and enjoys operating margins of around 30 per cent. Moreover, recurring revenues from the division account for over 40 per cent of the unit's £17.6m of revenues, having shot up by 20 per cent last year. By contrast, KBC’s larger consultancy division generates operating margins of around 8 to 10 per cent.
Furthermore, recurring revenue is now growing strongly following a raft of contract wins in the past year including a five-year agreement with a Japanese refiner worth £1.8m; a similar deal with a US refiner; and a £10m, seven-year contract 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. By my reckoning, KBC’s pipeline of contract work should now be in excess of £80m, part of which is underpinned by a four-year contract worth $100m (£58m) 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.
It is also clear to me that the dynamics driving the industry are supportive of the investment case and favour even more contract wins from major oil and gas companies. For instance, the global hydrocarbon sector continues to grow strongly and is an important market for KBC’s technologies. The ramp-up in US domestic crude oil and gas production from shale and tight oil is key here and underpins the outlook for hydrocarbon markets in the medium term. In upstream oil production, as oil and gas, 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, then KBC should be a major beneficiary.
Attractive valuation
I also believe that as the contribution from KBC’s software business becomes a greater proportion of the overall operation, then the earnings multiple the shares are rated on should increase too.
That’s because, net of KBC’s pro-forma cash pile of £31m, the company's enterprise value of £68m equates to only 12 times last year's post-tax earnings of £5.5m, a hefty 40 per cent discount to the average multiple enjoyed by Aim small-cap software companies with high recurring revenues. True, a multiple of 12 times earnings for KBC's consultancy division seems fair, but given that the software business is growing revenues sharply then this higher-growth and higher-margin operation surely warrants a higher rating than that.
For instance, valuing KBC's technology operation in line with the UK software and services sector average earnings multiple of 15 for sub-£100m market capitalised companies, this implies that KBC’s equity is being undervalued by around 25 to 30 per cent. So although KBC's shares have surged since I first advised buying at 69p ('Fuelled for growth', 5 May 2013), a re-rating to my target price of 165p still looks reasonable on valuation grounds. From a technical perspective, this target also coincides with a major high dating back 13 years.
If achieved this would give the company a market value of £133m. Strip out net funds and an enterprise value of £102m equates to under nine times this year's cash profit forecasts of £11.7m. Moreover, that's not factoring in any earnings upgrades for higher-margin contract wins. There is a dividend too after the board declared a final payout of 1p a share.
So, ahead of the forthcoming half-year results on Tuesday 23 September, I continue to see significant upside to KBC's shares. On a bid-offer spread of 122p to 125p, and offering 33 per cent upside to my target price, KBC's shares continue to rate a buy.
■ Simon Thompson's new book Stock Picking for Profit can be purchased online at www.ypdbooks.com, or by telephoning YPDBooks on 01904 431 213 and is being sold through no other source. It is priced at £14.99, plus £2.75 postage and packaging. Simon has published an article outlining the content: 'Secrets to successful stock-picking'
