Of course, shares in companies that have been sold off heavily are likely to bounce back strongly if the concerns expressed by investors that led to the share price decline prove unfounded. But as is always the case, any investment decision is all about balancing risk and reward. Personally, I would rather recommend buying shares in a quality small-cap company with a solid and loyal shareholder base and where the share price is unlikely to take a hit if investor risk-aversion rises any further.
High margin, and high growth software play
Bearing this in mind, I have noticed that Aim-traded shares in retail software company K3 Business Technology (KBT:358p), the Salford-based supplier of software to the retail, manufacturing and logistics sectors and provider of managed IT and web-hosting services, have held up remarkably well since the share price hit a 19-year high of 377p last November. The sideways consolidation move, and lack of selling since then, is usually a good sign that the next move will be to the upside. It's a company I know well, having spotted the investment potential when the shares were priced at 220p ('Tapping into retail growth', 16 Sep 2014). I last recommended running profits back in April at the current price ('Hitting target prices', 21 Apr 2016).
Shortly after I published that article the company raised £13.5m in a placing of 4.09m shares at 330p each, which expanded its share capital by 12.8 per cent. The main purpose of the capital raise was to acquire DdD, a Danish provider of proprietary 'point of sale' software/hardware for retailers primarily for the fashion sector. DdD's core 'retail in a box' product is a fully integrated combined hardware/software proposition that provides and integrates a retailer's point-of-sale, back-office system, and head-office system. The suite is designed as an easy-to-install 'plug and play' solution which is delivered via the cloud and licensed to clients on a monthly 'consumption' basis. Its main attraction to retailers lies in its rich customer interface as well as ease of use and rapid installation.
The benefit for K3 is that DdD enhances the company's overall offering to the retail sector and, in particular, increases the number of its own IP-based solutions. Revenues earned from DdD's consumption-based licensing model and a diverse and well established 750-strong customer base across Denmark, Germany, Sweden and Norway also enhances K3's recurring income. There are cross-selling opportunities, too, while access to DdD's cloud technologies boosts K3's product development activities.
It looks a sensibly priced deal as DdD is a growing, profitable and cash-generative cloud consumption-based business with significant proprietary IP and one that generated cash profit of €1.08m (£850,000) and operating profit of €868,000 on revenue of €6.2m in 2015, so the initial cash consideration of £7m equates to seven times cash profit. There is also an earn-out of £900,000 dependent on performance targets being hit, so management is well incentivised.
Strategically, the acquisition makes sense because it would have taken K3 around 18 months to develop and deliver an equivalent pilot product and at a cost of £2.5m. So the company has not only avoided the execution risk and the time it would have taken to deliver an in-house development programme, but has got its hands on a lower-risk developed-IP with profitable cash generative revenue streams. DdD also brings with it a highly experienced team of personnel to add to K3's own pool of talent.
Earnings upgrades
Another point worth noting is that K3's board confirmed at the time of the acquisition eight weeks ago that the pipeline of new deals across the business remains very healthy. The pipeline was valued at £56.5m at the time of the half-year results in March, including potential new orders from channel partners, a chunky amount in relation to analysts' full-year revenue estimates of £89m for the 12 months to the end of June 2016.
The board also noted that it expects cloud-based consumption licensing to be an increasing feature of the revenue mix in the future, together with rising channel partner sales and hosting, and is confident about the potential to exploit K3's own IP. Bearing this in mind, by raising an additional £5.5m of cash in the placing, the company is expected to end the financial year with net debt of only £6m, a sum equating to 8 per cent of forecast shareholders' funds of £71m. This balance sheet strength means that K3's board has the flexibility to "significantly accelerate the development timetable by making additional acquisitions which enhance K3's existing product offering as well as potential disposals of non-core parts of the business". In other words, I wouldn't bet against further bolt on earnings accretive acquisitions being made.
The point being that following earnings upgrades, K3's robust trading prospects are not being priced into the current valuation, and neither is the potential for more bolt-on deals similar to DdD. Analyst Andrew Darley at broker finnCap expects K3 to lift underlying pre-tax profit by over 30 per cent to £9.3m in the 12 months to the end of June 2016, an outcome that drives up EPS from 19.1p to 24.3p. Analyst Katherine Thompson at Edison Investment Research has similar forecasts and expects at least a 10 per cent hike in the dividend to 1.65p a share when the company releases these results in September. Mr Darley is more bullish and predicts a 1.8p a share payout.
Moreover, reflecting the contribution from a strong order book and sales pipeline, and the additional profits from DdD, both finnCap and Edison believe there are decent prospects for another 25 per cent-plus hike in underlying pre-tax profit to £11.7m and £11.9m, respectively, in the financial year to the end of June 2017. On that basis, expect consensus EPS to rise by at least 10 per cent to 26.8p and underpin a 10 per cent dividend hike. This means that K3's shares are only priced on 13 times forward earnings, hardly a punchy rating for a company benefiting from strong sales momentum and rising margins on the back of a higher proportion of sales of its own-IP products, and major contracts for its 'ax|is fashion' solution with major online retailers in Germany, the largest market for fashion in Europe.
Territorial expansion into Europe
These contract awards in Germany are well worth noting. That's because expanding K3's third-party sales network has been a key focus for the company over the past 18-24 months and is a significant part of its growth strategy. It's clearly working because at the end of last year the company won major contracts with one of Germany's major online retailers, K-mail Order GmbH & Co, secured through K3's channel partner in the country, having secured a similar contract with Munich-based TriStyle Mode GmbH, a leading European mail-order fashion retailer, a few months earlier.
In addition, they demonstrate the potential for further territorial expansion into Europe, the US and the Far East, through an expanded channel partner network and one offering additional promotion and sales routes to market. The German contracts also underpin the aforementioned profit forecasts, as does K3's high and growing level of recurring revenue from software licence and support renewals.
The other point worth making is that the current rating may seem appropriate for a Microsoft reseller, but not a provider of its own ax|is IP. K3's core business offering has been historically a Microsoft Dynamics-based range of retail software that provides a single platform for the entire business. It's one of the most powerful ERP systems in the world as it enables businesses to integrate the management of a host of functions including: manufacturing, production, warehousing and distribution, finance, and much more. K3 has been a leading supplier of Microsoft Dynamics in the UK for the last 10 years and regularly tops the sales charts.
It's a good business, and will remain so, but the upside of building out its partner channel for its high-margin own-IP, and selling its managed services and hosting services to a higher percentage of its customer base, is further margin expansion and a higher recurring revenue base. Investors like to see strong visibility of earnings, and potential to enhance margins, and attribute higher value to such revenue streams, creating potential for earnings multiple expansion.
This is something that K3 is achieving. In the first half gross margins rose by almost 5 percentage points to 55.7 per cent, higher-margin own-IP revenue represented 23 per cent of total sales, and recurring revenue accounted for 47 per cent of the total and generated an eye-catching gross profit margin of 70 per cent, up from 64 per cent in the same period in the prior year.
The company is highly cash generative, too: adjusted cash flow generated from operations in the first half of the financial year increased from 109 per cent to 114 per cent of underlying operating profit. In turn, this robust cash generation is enabling the board to continue with its progressive dividend policy and gives the directors financial headroom to both service the contracts it has been winning, and tender for new ones, too. There are very sound reasons to remain positive on the investment case here.
Target price
So, with the company likely to release a pre-close trading update in mid-July ahead of the release of its full-year results in September, and one from my analysis that should make for a very good read, it's hardly surprising that the shares have held up so well in the current sell-off.
Moreover, I feel that irrespective of the outcome of the forthcoming EU referendum that K3's business is set fair to continue its upward momentum, a factor not reflected in a forward PE ratio of 13, an unwarranted 15 per cent discount to the average rating for small-cap software companies in K3's space, especially as K3 is already making a post-tax return on equity of 11 per cent, and rising sharply. A price-to-book value ratio of 1.9 times is modest, too. In my view a valuation closer to 425p is justified to bring the rating into line with peers - Edison has fair value of at least 393p and finnCap has a raised target price of 465p.
The chart set-up is equally supportive of my target price and a move above last autumn's 377p multi-year high would be a major buy signal and one well worth following. Interestingly, the 200-day exponential moving average (EMA) has now caught up with the price during the multi-month consolidation period, the shares are above the rising 50-day EMA, and the moving average convergence divergence (MACD) momentum oscillator is positive and above its signal line. For good measure, the shares are not overbought, either as the 14-day relative strength indicator has a reading around 60.
Offering 19 per cent upside to my 425p upgraded target price, I rate K3's shares a buy on a bid-offer spread of 354p to 358p.
