The institutional placing of 20.8m shares raised £24m at 115p a share to account for just over 25 per cent of the enlarged capital of 80.6m shares and means that pro-forma net funds are around £31m, or 38p a share. The company's market capitalisation of £100m after the placing equates to 1.67 times book value so it is not extended given that net cash accounts for half of net asset value and 30 per cent of the current share price.
More importantly, the new cash will enable the company to target larger, more capital-intensive, higher-margin projects; continue investment in sales and marketing with the aim of boosting revenue and earnings growth; expand KBC's technology offering to provide a more comprehensive software package across the full spectrum of wellhead, production, oil and gas processing, refining and petrochemicals; and selectively acquire niche software companies that sell into the upstream sector and whose software integrates effectively into KBC's Petro-SIM™ platform.
In addition, KBC will deploy some of the new capital to invest in high-growth markets in China, Middle East, Latin America, Asia and India over the next couple of years. That's a very sensible use of funds. 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. The company is also well positioned to support a major 10-year programme in place to upgrade refinery assets in the former Soviet Union, too.
Interestingly, Kongsberg Gruppen ASA (NO:KOG), an Oslo-listed company, has subscribed for 20 per cent of the placing shares to give it a beneficial interest in 5 per cent of the enlarged share capital. 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. The investment will further strengthen the working relationship between KBC and Kongsberg Gruppen, so the benefits go way beyond the fresh capital raised.
Technology division to drive re-rating
It’s my firm view that the targeted move to higher-margin work and investment in new direct software sales will not only enhance KBC's software sales in the coming years, but should also lead to a higher proportion of recurring revenues. The higher-margin technology business accounted for just over a quarter of the company's revenues of £65.1m in 2013, but it's worth pointing out that recurring revenues from the division surged by 20 per cent in the same period to account for £7.6m of the unit's £17.6m of revenues. This business enjoys operating margins around 30 per cent, whereas KBC’s consultancy division makes around 8 to 10 per cent.
It's worth noting too that recurring revenue is set 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 £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.
Another key take for me in last week's fundraising, and clearly for the financial institutions backing the company, is that if KBC can boost the contribution from its software business, then there is a strong case to be made that the earnings multiple the shares trade on should be much higher than at present. Let me explain why.
Net of the 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 massive 40 per cent discount to the average multiple enjoyed by Aim small-cap software companies with high recurring revenues. Admittedly, a multiple of around 12 times earnings for KBC's consultancy division looks about right, but given the software business has grown revenues by 38 per cent in the past three years then to value this higher-growth and higher-margin operation on the same multiple seems harsh to say the least.
Even taking a conservative approach and rating KBC's technology operation in line with the UK software and services sector average earnings multiple of 15 for sub-£100m market capitalised companies, then KBC is still being undervalued by around 25 to 30 per cent.
Understanding the industry drivers
The fund managers backing the placing will have also noted that KBC’s pipeline of contract work was worth £78m at the time of the last trading update a couple of months ago, thus offering good visibility. KBC's revenues are well underpinned by a four-year contract worth $100m (£60m) 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.
I also believe that the dynamics driving the industry are highly supportive of the investment case and favour more contract wins from major oil and gas companies. For example, 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 a key factor and underpins the outlook for hydrocarbon markets in the medium term. In addition, large offshore gas discoveries are generating significant LNG investment in East Africa and Australia.
In upstream oil production, 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, but this is of less direct relevance to KBC.
Re-rating far from over
Although KBC's shares have moved up sharply since I first advised buying at 69p ('Fuelled for growth', 5 May 2013), the re-rating is far from over in my view. Indeed, even if the shares hit my target price of 165p to give the company a market value of £133m, then the enterprise value of £102m would still only equate to less than nine times this year's cash profit forecasts of £11.7m. Moreover, that's not factoring in any upgrades for higher-margin contract wins. There is also a small dividend after the board declared a final dividend of 1p a share.
So, ahead of likely trading updates at the annual meeting on Wednesday 4 June, a pre-close update in July and the half-year results on Tuesday 23 September, I continue to see significant upside to KBC's shares. So do analysts at Cenkos Secutires who "can envisage a scenario where the shares are worth in excess of 200p as the technology business becomes a significantly greater proportion of KBC's revenues". On a bid-offer spread of 121p to 123p, and offering 33 per cent potential upside to my target price of 165p on a six-month basis, KBC's shares rate a buy.
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