The shares have pulled back sharply from their summer highs, but management’s guidance is that the business is trading in line with analyst's full-year profit expectations. In fact, adjust for foreign exchange movements and underlying pre-tax profits shot up by almost two thirds to £3.6m in the first six months of this year. Sterling rose by over 3 per cent against the US Dollar in the period, which wiped £700,000 off reported profits. But sterling has lost all those gains in the past couple of months so the currency back drop is far more benign for the second half.
It’s also clear that KBC’s placing in May, which raised £23m at 115p a share, is enabling the company to target larger, more capital-intensive, higher-margin projects. Executive chairman Ian Godden reports that the second half has started well, buoyed by a number of contract wins. These include a US$5.8m (£3.4m) five-year contract award from a large South American based multinational energy company. The agreement involves KBC expanding the licence of its refinery wide simulation software suite, Petro-SIM™ and the associated SIM-suite™ reactor models, to the client’s refinery business. KBC reported a very healthy order book of £63m at the end of June, having increased first half revenues by 8 per cent to £34.4m.
The equity raise has also enabled KBC to acquire complimentary niche software companies that sell into the upstream sector and whose software integrates effectively into KBC's Petro-SIM™ platform. In July, the company acquired FEESA, a global leader in upstream hydraulics, for £11.2m. As a result the enlarged operation will now be able to offer clients profit improvement programmes across the full hydrocarbon value chain. Adjust for that acquisition post the half-year end and KBC’s current pro-forma net funds of £14.4m account for a quarter of net assets of £61m. It’s reasonable to expect further deals too.
Cash profit growing strongly
It’s also reasonable to expect KBC to lift full-year cash profits from £9.2m to £10m on revenues up from £65m to £70m as analysts at research firm Equity Development predict. The respective forecasts for 2015 are revenues of £74.9m and cash profits of £11m. On an adjusted pre-tax profit basis, Equity Development expect profits to rise from £8.4m in 2013, to £9.2m in 2014 and £10.5m in 2015. House broker Cenkos Securities has identical pre-tax forecasts.
True, EPS are forecast to dip from 9.5p last year to 7.7p this year due to the dilutive effects of the share placing. However, with net cash accounting for a quarter of shareholders funds, and 17 per cent of KBC’s market capitalisation of £84m, I feel that valuing the company on a cash profit to enterprise value (market value less net cash) basis is far more appropriate.
Using this metric for peer group comparison, the company’s equity is being valued on only 7.4 times cash profit estimates for 2014. It’s worth noting that in the absence of further acquisitions Equity Development expect the cash pile to grow to £19.2m by the end of 2015, so the enterprise value falls from £70m to £65m. And with cash profits set to grow 10 per cent to £11m next year, this means that enterprise value is less than six times cash profit estimates for 2015. Based on Cenkos Securities’ net cash forecasts of £20m at the end of 2014 and £24m at the end of 2015, the rating is even lower. To put the current valuation into some perspective, the average multiple for oil services companies is 8.8 times cash profits, and for small cap software companies it’s 11.2 times cash profits.
A fairer valuation
With KBC’s higher margin technology division generating over half the company’s profits, albeit it only accounts for a quarter of revenues, I feel that the equity should be valued somewhere between an oil services and software company. As it is KBC's equity is being valued on a discount to both.
True, KBC’s shares have drifted down from my last recommendation (‘A slick performance’, 16 July 2014), albeit they are up significantly on the level of my first buy recommendation of 69p ('Fuelled for growth', 5 May 2013). But I still feel that my target price of 165p, valuing KBC’s equity at £133m, is a far more appropriate valuation for this type of business. Deduct forecast net cash of £19.2m at the end of 2015, and this implies an enterprise value target of £114m, or 10 times Equity Development’s cash profit estimates. Please note that although Equity Development and Cenkos have identical adjusted pre-tax profit estimates, Equity Development have lower cash profit forecasts due to a different treatment of development costs of around £1.4m a year. I have used these more conservative cash profit forecasts in the above analysis.
Needless to say, offering 60 per cent upside to my target price, I continue to rate KBC's shares a buy on a bid offer spread of 103p to 105p.
■ 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'
