The headline numbers made for a pleasant read: underlying full-year pre-tax profits increased 13 per cent to £9.5m (above analysts' expectations) on revenues ahead 17 per cent to £76m; the company's higher-margin technology business had a record year; and the pipeline of new work is at an all-time high of £88m, up almost £10m year on year. In turn, shareholders were rewarded with a 10 per cent hike in the dividend to 1.1p a share. So, how did the company manage to turn in such a strong operational performance in the face of a savage downturn in the oil and gas industry?
An operational efficiency and profit improvement service
The explanation lies in the fact that KBC is not being impacted directly by the US domestic oil exploration downturn since a large proportion of its business is in the downstream part of that market which is less adversely affected. In fact, around 90 per cent of its revenues are generated from downstream petrochemical plants, which has insulated the company from the widespread industry belt-tightening in the upstream sector. So, although chairman Ian Godden predicts "a scenario of low oil prices for at least 18 months and some further belt-tightening by our clients", there are definite positives underpinning the business case.
For example, more of KBC's clients need to optimise their existing assets in this pricing environment; the company's technology solutions are helping clients optimise production rates at lower energy costs; as oil companies reduce their work forces, they will need consultants to fill the gaps; downstream refining profitability is returning to higher margins than have been seen for several years; and upstream operators are looking to drive more efficient production. Indeed, included in the year-end order book is a $48.6m (£33m) two-year contract extension with an existing South American client, the third-largest contract in the history of the 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. The company also won a notable upstream software deal worth £3.3m.
Smart acquisitions
In addition, KBC has been expanding aggressively through acquisition and successfully too. Last summer, the company acquired FEESA, a global leader in upstream hydraulics, for £11.2m. As a result, the enlarged operation is able to offer clients profit improvement programmes across the full hydrocarbon value chain. The business has been targeting larger, more capital-intensive, higher-margin projects, having raised £23m in a placing at 115p a share last May to strengthen its balance sheet.
Net funds ended the year at £11m, but working capital requirements have peaked and net cash has since increased to £15m in the past couple of months. That's a significant sum in relation to KBC's market capitalisation of £70m, and its net asset value of £66m. It also means that the company has the firepower to seek out further complementary acquisitions, and seek out more contracts, while comfortably meeting its working capital needs. In fact, I understand that the company's technology business won a major European contract from a rival in the final quarter of last year, highlighting the value in this higher-margin proprietary software business and one accounting for 70 per cent of full-year profits.
A positive earnings outlook
Following the earnings beat yesterday, and factoring in the robust order pipeline, analysts at broker Cenkos Securities and research firm Equity Development predict that KBC should be able to increase underlying pre-tax profits by 10 per cent to £10.5m this year. On this basis, Cenkos expects adjusted EPS to rise by around 5 per cent to 9.8p. This means that once you adjust for the latest net cash figure of £15m, or 18p a share, KBC's shares are being rated on just eight times last year's post-tax earnings, or half the average rating of the small-cap software sector.
That's a harsh valuation in my view and one that justifies maintaining my long-term buy recommendation on the shares when I initiated coverage at 69p ('Fuelled for growth', 5 May 2013). I last updated the investment case at around the current level ('Energising growth', 8 Dec 2014). In fact, I still believe that a fair value is nearer 165p, or almost double the current share price. That's because, based on a further increase in net cash to £19m, as both Cenkos and Equity Development predict, the shares would still only be rated on a cash-adjusted PE ratio of 14 for fiscal 2015 if the share price was to double. Trading on a bid-offer spread of 85p to 87p, I continue to rate the shares a buy.
K3 Business profits set to take off
Shares in Aim-traded retail software company K3 Business Technology (KBT: 227p), the Salford-based supplier of software to the retail, manufacturing and logistics sectors and provider of managed IT and web hosting services, have yet to hit my 275p target price, but there is no doubting the company is moving in the right direction.
There were several key takes for me in yesterday's half-year results including the 11 per cent growth in K3's recurring revenues (to account for almost half of turnover) underpinned by licence fee renewals, support contracts and hosting income; an increasing focus on K3's own IP, which is driving margins higher and boosting recurring revenues from a base of over 3,100 customers; and a raft of major contract wins. In fact, no fewer than 81 new customers were added in the six-month trading period.
Headquartered in Didcot, Oxfordshire, K3′s core business offers customers a Microsoft Dynamics-based range of retail software to provide a single platform for the entire business. The benefits for retailers is three-fold: the technology removes the need to purchase different software solutions for a customer's head office, store and EPOS till systems; avoids the requirement of integrating multiple databases; and leads to faster delivery of meaningful data, and fewer integration challenges.
Retail driving earnings
K3 is now not only Microsoft's largest Dynamics Retail reseller in the UK, but the software giant's preferred partner for the fashion retail sector: customers here include Agent Provocateur, Charles Tyrwhitt, and The White Company. K3's retail segment increased half-year revenues by a third to £19.6m, driven by sales of its flagship new Microsoft Dynamics AX solution, "ax | is". In turn, the division more than doubled its profit contribution to £1.06m, easily outpacing K3's manufacturing and distribution business.
The core offering here is a Microsoft-based business solution aimed at small- and medium-sized manufacturers, and developed by SYSPRO, one of the longest standing independent, international vendors of ERP business software solutions and services. K3 primarily sells SYSPRO solutions to manufacturing customers and is the exclusive distributor in the UK. The manufacturing business posted half year operating profit of £3.4m on revenues up 11 per cent to £22m, but investment in personnel to support future growth meant profits were down slightly, albeit recurring revenue remains high at 59 per cent of the total and chairman Lars-Olof Norell describes prospects as "encouraging".
He has a point as new products have been introduced including a cloud-based SYSPRO product, new channel partners have been signed up in three countries in Europe for SYSPRO, and the company should get a lift from an upgrade to its Microsoft Dynamics NAV distribution product, K3 Advantage. In fact, the pipeline of business for K3's manufacturing and distribution activities has increased by over 20 per cent to £29m year on year, reflecting these three initiatives.
Attractive valuation
As a result, head of equity research Andrew Darley at broker finnCap predicts that K3's revenues will increase from £72m to £80m in the financial year to the end of June 2015 to drive adjusted pre-tax profits up 13 per cent to £7.5m, in line with the profit growth rate reported in the first half. True, this is slightly down on the £8m profit estimate when I initiated coverage six months ago when the shares were 220p ('Tapping into retail growth', 16 Sep 2014), but it mainly reflects a higher non-cash amortisation charge.
In any case, pre-tax profits are still growing at a double-digit rate which makes a forward PE ratio of 11 - based on adjusted EPS estimates of 19.5p in the 12 months to June 2015 - too low in my book. Moreover, as the benefits of investment in broadening sales channels and territories comes through as 2015 progresses, expect a ramp up in profits driven by higher-margin license sales.
This helps explain why Mr Darley predicts pre-tax profits will jump by almost 30 per cent from £7.5m to £9.7m based on a 10 per cent increase in revenues to £88m in the fiscal year to the end of June 2016. On this basis, the shares are being priced on just nine times underlying EPS of 24.6p, a massive 40 per cent discount to the small-cap software sector average. They are only priced on 1.3 times book value, too, a rating out of sync with a company generating a double-digit post-tax return on equity and one with a lowly geared balance sheet: net debt of £12m equates to only 22 per cent of shareholders' funds.
That's an anomalous valuation in my view and, with K3's pipeline of new work underpinning earnings forecasts, I feel a return to the April 2014 all-time high of 240p, and beyond, is still warranted. So, offering 21 per cent upside to my target price of 275p - below finnCap's target of 330p, upgraded from 300p post yesterday's results - I continue to rate K3's shares a value buy on a bid-offer spread of 225p to 227p.
Making some very fair points
Fairpoint (FRP: 123p), a leading provider of consumer professional services including debt solutions and legal services, posted a modest earnings beat in yesterday's bumper set of fiscal 2014 results. As flagged up in a pre-close trading update revenues surged by almost £10m to £38.3m on the back of some well-timed and well-priced acquisitions.
The board had already given notice of a raft of one-offs charges associated with those acquisitions and refinancing its credit lines, but strip these items out and underlying pre-tax profits jumped by 15 per cent to £9.3m, slightly better than analysts had predicted. The IFRS reported pre-tax profit figures were £2.5m lighter, but this reflects genuine one-off transaction costs associated with the acquisitions, restructuring of businesses acquired and a £480,000 charge for entering a new five-year bank facility of £20m with AIB in May. On an underlying basis, EPS of 17.2p was 17 per cent higher than a year earlier.
Cash generation of the business stood out for me, with net cash generated from operating activities around £5.7m. This is important because Fairpoint has a progressive dividend policy and the board declared another hike in its payout to 6.4p a share, the £2.8m cash cost of which is comfortably covered twice over by that net cash inflow. That leaves a similar sum available for investment in diversifying the business, something the board have proved adept at doing through last summer's acquisitions of Simpson Millar LLP Solicitors, a consumer legal services business, and Fosters & Partners, a Bristol-based law practice specialising in all aspects of family law.
Legal eagles flying
The legal services segment accounted for £11.9m revenue in the second half of 2014 (49 per cent of the group total in the six-month period) and contributed pre-tax profits of £1.6m which means that on an annualised basis it's as profitable, if not more, as Fairpoint's declining IVA services business which reported profits of £3.4m, down from £4.1m in 2013. The IVA market continues to suffer from tough market conditions as old cases come off the books and newer ones are smaller and less profitable, but representing just over a third of the overall business, its importance is diminishing too as Fairpoint diversifies into new areas.
The other key take for me was the growth in the company's debt management plan (DMP) operation. Driven by three acquisitions including Bournemouth-based Debt Line, a debt solutions provider with over 9,000 plans under its management, the division ended the year with 25,462 cases under management, up from 15,688 cases at the start of 2014, and delivered pre-tax profits of £3.3m on revenues of £8.3m. I can certainly see Fairpoint acquiring more DMP back books this year as well as seeking out complimentary acquisitions by tapping around £8m of headroom on the AIB facility, and recycling internal cash flow.
Another year of growth ahead
But even without further bolt-on debt-funded deals analysts expect another year of earnings growth underpinned by a full 12 months contribution from the legal services and DMP acquisitions made in 2014. Research house Equity Development predict Fairpoint's pre-tax profits and EPS will rise to £10m and 18p, respectively, in 2015 to support a further hike in the payout to 6.8p a share. The risk here looks to the upside. On this basis, the prospective yield is 5.5 per cent and the forward PE ratio is less than seven. As an aside, analyst Gilbert Ellacombe at Equity Development notes that there is hidden value in Fairpoint's balance sheet as the company's last set of accounts reveals that the estimated value of previous acquisitions is £20m more than the goodwill attributed to them in the notes to the accounts. To put that sum into some perspective, the latest reported net asset value of 105p could be far closer to 150p.
So, no matter which way I look at this, Fairpoint's Aim-traded shares are grossly undervalued which is why I rate them a decent income buy offering substantial upside to my target price of 190p. Even at that level they would still only be rated on little over 10 times this year's likely earnings. Please note that I first advised buying them at 98.25p in my 2013 Bargain Shares Portfolio and last commented on the investment case when the share price was 119p ('Valuable points to make', 4 Feb 2015).
MORE FROM SIMON THOMPSON...
Please note that since the start of March I have written articles on a total of 30 companies, all of which are available on my IC homepage... and are detailed in chronological below with the relevant web links for ease of reference.
■ Non-Standard Finance: Buy at 103p ('A non-standard investment', 2 Mar 2015)
■ WH Ireland: Buy at 92p, target 140p ('A non-standard investment', 2 Mar 2015)
■ Software Radio Technology: Buy at 31.25p, target range 40p to 43p ('On the radar', 3 Mar 2015)
■ Vislink: Buy at 48.5p, target 60p ('Tapping into e-commerce profits', 4 Mar 2015)
■ Sanderson: Buy at 68p, target 80p to 85p ('Tapping into e-commerce profits', 4 Mar 2015)
■ Town Centre Securities: Run profits at 292p ('To bank profits or not?', 5 Mar 2015)
■ Sutton Harbour: Buy at 36.5p ('To bank profits or not?', 5 Mar 2015)
■ Housebuilders: Run profits on Persimmon, Bellway, Barratt Developments, Taylor Wimpey, Berkeley Group. Bank profits on Crest Nicholson, Bovis Homes, Galliford Try and Redrow. Buy Inland at 64p) ('Housebuilders: trading gains', 9 Mar 2015)
■ Walker Crips: Buy at 47p; Henry Boot: Buy at 232p; H&T: Buy at 179.5p; Nationwide Accident Repair Services: Buy at 85p; Communisis: Buy at 56p; Global Energy Development: Speculative buy at 44p ('Six-shooter of small-cap buys', 10 Mar 2015)
■ Stadium: Run profits at 123p; Pure Wafer: Hold at 42p ('Electrifying shares', 11 Mar 2015)
■ CareTech: Buy at 230p, target 300p ('Time to take care', 16 Mar 2015)
■ LMS Capital: Buy at 77.5p; Globo: Run profits at 55.5p; Trifast: Buy at 99p, target 140p ('Exploiting currency moves', 17 March 2015)
■ Simon Thompson's 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 stockpicking'
