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OPINION

Small-cap value plays

Small-cap value plays
September 23, 2015
Small-cap value plays

In the first half of this year, the company's pre-tax profits edged up 3 per cent to £4.2m on a 5 per cent rise in revenues to £36.2m, a rare performance indeed for a business operating in an industry that has seen a savage downturn in the past 12 months. True, cost cutting has played its part as KBC's board took the decision to take overheads out of the business to align the cost base given the challenging market environment. Headcount was cut by 10 per cent in the half-year, including the closure of the company's New Jersey office, at a cost of £800,000. These measures are expected to generate annual cost savings of £3.5m, the full benefit of which will be seen in the second half.

But this is far more than a cost-cutting story as 85 per cent of KBC's revenues are derived from oil refiners, the part of the industry that has been doing remarkably well, whereas it has been the upstream segment that has seen the savage cost-cutting and project deferrals. Indeed, the combination of a plunging oil price and rising output has sent US Gulf Coast crack spreads to five-year highs, a sign of refiners' profitability, which has enabled KBC to increase its own pricing on some contracts. Moreover, given that KBC's smart software and consultancy activities optimise performance and profitability for cost-conscious clients, demand is well underpinned.

In fact, the order book was up 17 per cent to £74m in the six-month period and since then KBC has won two important contracts, a three-year award worth $8.5m (£5.5m) with a Middle Eastern client for margin improvement and workforce capability development across three refineries, and its largest award ever in the Former Soviet Union.

It's worth noting that half the order book results from a four-year contract worth $100m (£64.5m) with Ecuador national oil company EP Petroecuador. This alone accounted for £13m of KBC's first-half revenue of £36m and offers solid visibility on future revenues. It also explains why trade receivables spiked from £30m to £43m year on year. However, I understand that all the December receivables from EP Petroecuador and other clients have been collected, in addition to a further £6m of receivables since the June half-year-end. As a result, KBC's net funds of £10.6m are set to rise to somewhere between £13.2m and £14.7m by the year-end, according to finance director Eric Dodd. That's important as running a strong balance sheet is enabling KBC to tender for further multi-million-dollar contracts without stretching its finances.

The bottom line is that KBC is bang on track to deliver the 10 per cent rise in pre-tax profits to £10.5m as predicted by analysts and reward shareholders with a 9 per cent hike in the dividend per share to 1.2p. So after stripping out net funds from its market value of £91m, in effect the equity is being valued on around seven times underlying operating profit estimates. That's hardly a punchy valuation for a company with a high-margin technology business that makes around £7.4m of operating profit on turnover of £21m and could be easily worth £60m on a standalone basis.

So having advised buying KBC's shares at 69p ('Fuelled for growth', 5 May 2013), reiterated the investment case at 110p (‘Riding an earnings upgrade cycle’, 18 June 2015) and at 123p (‘Fuelled for strong growth’, 12 August 2015), I believe a return to the 142p highs dating back to June 2014 is a reasonable target. On a bid-offer spread of 111p-112p, I rate KBC's shares a buy.

 

K3 on a roll

Aim-traded retail software company K3 Business Technology (KBT: 298p), the Salford-based supplier of software to the retail, manufacturing and logistics sectors and provider of managed IT and web hosting services, has smashed my 275p target price. I initiated coverage exactly a year ago when the price was 220p ('Tapping into retail growth', 16 Sep 2014), and last advised running profits at 275p (‘Hitting the right numbers’, 30 July 2015).

It's easy to understand why investors are warming to a company that is not only generating decent profit growth - adjusted pre-tax profit rose by 9 per cent to £7.2m on revenues up 16 per cent to £83m in the 12 months to end June 2015 - but prospects are increasingly positive. Revenue from K3's own IP software is growing strongly, the company has been recognised by Microsoft as a leading partner for the fashion retail sector, and K3 has recently become a member of Microsoft's inner circle of Dynamics partners. This should provide a step change in licence sales and size as Oxfordshire-based K3's core business offering is a Microsoft Dynamics-based range of retail software that provides a single platform for the entire business. Last year, K3's sales of Microsoft Dynamics-based software products rose by more than half to £7.4m, representing 9 per cent of its revenues.

Furthermore, the company has just announced a major contract win for its "ax l is fashion" solution with Munich-based TriStyle Mode GmbH, a leading European mail-order fashion retailer. The order has been secured through K3's channel partner in Germany and is its first order though a global systems integrator, the largest order secured to date through K3's channel partner network, and is the first win in Germany, the largest market for fashion in Europe. The expansion of K3's third-party sales network has been a key focus for the company over the past 12-18 months and is a significant part of the growth strategy.

It's worth flagging up that sales and profit growth is also being underpinned by licence fee renewals, support contracts and hosting income; an increasing focus on K3's own IP, which is boosting higher-margin recurring revenues; and a focus on growing the SYSPRO and Sage businesses and selling hosting services to a larger proportion of its customers. This strategy is clearly working as the retail business had a pipeline worth £32m at the end of June and the manufacturing and distribution software business had just shy of £30m-worth of new deals in the pipeline.

It's also the reason why analysts at broking house FinnCap expect revenues to rise by around 8 per cent to £90m in the 12 months to end-June 2016 to drive up both pre-tax profits and EPS by a third to £9.7m and 25.3p, respectively. This means that K3's shares are trading on 12 times fiscal 2016 earnings estimates, a three-point rating discount to the average earnings multiple for the small-cap UK software and IT service sector. Importantly, the company is well funded to achieve the step change in sales as year-end net debt of £12.1m, better than analysts had expected, represents less than a quarter of shareholders' funds. In turn, the combination of rising profits and falling debt offers scope for another double-digit increase in the dividend following the 20 per cent hike to 1.5p a share in the full-year results.

In the circumstances, I would run your healthy profits as there is a decent chance the shares could run up to analysts' upgraded target prices. Edison Investment Research has fair value of 355p (up from 289p previously), and FinnCap raised its target price from 330p to 380p. Run profits.

 

Cenkos' bumper cash returns

Aim-traded corporate broker Cenkos Securities (CNKS: 177p) has announced yet another hefty cash return to shareholders on the back of a solid set of half-year results.

The company now has net funds of £48.2m, or 80p a share, and net trading investments worth £6.5m, or 11p a share on its balance sheet, reflecting a net cash inflow of £15.3m in the first six months of this year during which Cenkos made pre-tax profits of £18.5m. That cash position is calculated after factoring in the £10.8m spent on buying back 5.7m shares through a tender offer at 188p in January and the £5.6m cost of a final dividend of 10p a share. So with cash generation robust, the board has declared a held interim dividend of 7p at a cost of £3.9m and will be returning a further £8m through another tender offer. Combined, that's the equivalent of 12 per cent of Cenkos' market capitalisation of £98m.

Importantly, the trading outlook is promising as chief executive Jim Durkin notes that his company has made a "good start to the second half of the year, our current pipeline is encouraging and there continues to be institutional demand to fund high-quality companies and ideas". Cenkos is certainly gaining a reputation for large fundraisings having acted as lead manager and broker to a £1bn placing for BCA Marketplace (BCA: 173p), an operator of one of Europe's largest used vehicle marketplaces. This deal accounted for half of the funds raised for the broking house's client base of 125 companies.

True, operating profits were down a fifth in the first half, but this was only because in the same period in 2014 Cenkos reaped a huge windfall from the IPO of AA (AA.:303p). More relevant is the fact that the £18.6m interim profit figure exceeded that for the whole of 2013 and 2012 combined, highlighting the progress made in recent years. In my view, this is yet to be factored in to the valuation as the shares are still only trading on less than six times 12-month rolling earnings. On a bid-offer spread of 174p-177p, I continue to rate Cenkos' high-yielding shares a buy.

Please note that I last updated the investment case when the price was 197p (‘Small-cap updates’, 31 March 2015) having initiated coverage at 159p ('Broking for success', 20 May 2014). Buy.

 

Game on for Netplay's acquisition spree

The demise of online gaming companies in the post-remote-gaming-tax regime has failed to materialise. Half-year results from Netplay TV (NPT: 10p), a constituent of my 2015 Bargain Shares portfolio at 8.35p, highlighted that the company's operations remain very profitable, albeit in light of a £1.83m charge for betting and gaming duties following the introduction of the UK point of consumption tax at the end of last year.

By cutting back marketing spend from £7.1m to £4.5m, and targeting new customer acquisitions more effectively, the company managed to report adjusted pre-tax profits of £1.1m in the first half of this year, in line with its performance in the second half of 2014 before the new tax became effective. A focus on customer retention is also helping, with 62 per cent of revenue generated from customers holding accounts for 12 months or longer.

Fortunately, Netplay is in the enviable position of having a cash-rich balance sheet - net funds of £13.9m at the end of June equate to half its market capitalisation - which it can use for earnings-accretive acquisitions. Post the June period-end, Netplay acquired Otherside, an online marketing, product development and technology business, for £2.7m with a further £500,000 payable 12 months after completion. This company specialises in online marketing, display media and affiliation marketing and reported cash profits of £600,000 on revenues of £2.6m in the 12 months to end-May 2015. I would expect further deals to follow as house broker Shore Capital calculates that Netplay will still have net funds of £11.9m at the year-end.

True, the full-year dividend of 0.55p a share is only covered 1.3 times by forecast EPS of 0.7p, but that forecast doesn't factor in any contribution from Otherside, so has scope for an earnings beat even without the benefit of further acquisitions. Offering a prospective dividend yield of 5.6 per cent, and rated on seven times cash adjusted earnings estimates, I continue to see value in Netplay's shares. Buy.

Please note that my next column will appear at 12pm online on Tuesday, 29 September.