Tapping into prodigious free cash flow generators

First-half results from cyber security software provider Kape Technologies (KAPE: 285p) not only delivered strong organic revenue and profit growth, but also bumper operational cash flow. This is enabling the group to pay down borrowings following last December’s $936mn (£807mn) acquisition of ExpressVPN, a leading provider in the digital privacy space with more than 3mn active users across 180 countries.

On a pro-forma basis, first-half revenue increased 19 per cent to $302mn, of which 88 per cent was recurring in nature, to lift adjusted cash profit by 17 per cent to $88.9mn. The group’s subscriber base rose 6 per cent to almost 7mn customers, and the retention rate improved a smidgeon to 82 per cent. The key driver was growth in digital privacy revenues, up almost a fifth to $253mn on a pro-forma basis, a reflection of the strong underlying market for cyber security software (which protects data security and privacy against piracy and phishing attacks), and virtual private network (VPN) solutions (which encrypt and secure internet connections). Kape’s average customer is aged 20 to 45, based in the US or Europe (45 per cent and 30 per cent, respectively, of the subscriber base), is tech-savvy and has multiple devices to protect.

The acquisition of ExpressVPN not only added scale to Kape’s existing cyber security product suite (Cyberghost and Private Internet Access are two of its leading brands), but it provides a notable opportunity to cross and up-sell Kape’s privacy products across a larger customer base and wider geographic footprint. Importantly, management is on target to deliver $30mn annualised cost synergies next year as planned, and reiterated 2022 guidance for pro-forma revenue of $610mn-$624mn and cash profit of $166mn-$172mn. 

Moreover, the first-half cash conversion rate of 101 per cent of cash profit enabled net debt to be slashed from $457mn to $392mn, and house broker Shore Capital expects closing net borrowings of $322mn based on full-year free cash flow of $147mn (42c a share), thus transferring more of the economic interest in Kape from debt to equity holders. In addition, a $110mn to $200mn placing and retail offer through PrimaryBid was announced the day after the results, to provide funding to accelerate growth through acquisitions.

Prospects for ongoing organic and acquisitive growth are simply not being priced in as the shares trade on bumper forecast free cash flow yields of 12.6 per cent (2022) and 14.6 per cent (2023), forward price/earnings (PE) ratios of 8.1 (2022) and 7.1 (2023) and prospective cash profit multiples of 8.8 (2022) and 7.7 (2023) to enterprise valuation, the latter being a 45 per cent discount to the average rating over the past five years. Furthermore, slower-growing rival Avast was recently acquired by NortonLifeLock on 19 times annual cash profit to enterprise valuation, and an exit PE ratio of 24.

Since I covered the annual results, Kape has been de-rated by 30 per cent, a decline that is completely at odds with the ongoing strong operational performance and maintained guidance (‘Profit from cyber security’, IC, 22 March 2022). I first suggested buying the shares, at 47.9p, in my in 2017 Bargain Shares Portfolio, and offering 75 per cent share price upside to reach my 500p fair valuation, the mis-pricing is a strong buying opportunity. Buy.

Arcontech’s compelling value opportunity

• Operating profit beats forecasts by 8 per cent
• Net cash up 12 per cent to £6mn (45p a share)
• Annual dividend realised 18 per cent to 3.25p a share

Aim-traded financial software provider Arcontech (ARC:82p) beat house broker FinnCap’s operating profit forecasts by 8 per cent, albeit they had been downgraded last autumn after one customer decided to scale back its market data spend, and another decided not to renew its contract because it is switching to a solution in a legacy, bundled contract.

Adjusted operating profit of £0.87mn was still a fifth below the prior year result on 9 per cent lower revenue of £2.76mn, but the fact that the board lifted the dividend 18 per cent to 3.25p a share and issued an upbeat trading outlook is well worth noting. That’s because several years of inactivity during the Covid-19 pandemic (at many of the company’s clients and prospects) has created pent-up demand and a robust pipeline of contract opportunities.

Although conditions remain uncertain, as economies globally face well-documented challenges, Arcontech’s directors are “confident that some of the current interest will be converted to firm orders and start to build back the revenue lost during the pandemic”. Also, as rivals push through price increases, Arcontech is well-placed to capitalise by offering its expanding range of solutions at attractive prices. 

So, although FinnCap conservatively pencils in current-year revenue of £2.65mn to factor in a full 12-month impact from last autumn’s contract losses, analysts at the brokerage “see substantial upside” to their forecasts and note that Arcontech’s operational leverage means that it could drive double-digit growth to operating profit estimates of £0.65mn. Furthermore, the company is a prodigious cash generator, delivering £0.97mn of free cash flow in the 2021-22 financial year, implying a free cash flow yield of 8.8 per cent, and boosting net cash to £6mn (45p a share), a sum equating to more than half its £11mn market capitalisation.

The bumper cash flow performance enabled the board to raise the payout per share by 18 per cent to 3.25p, declared from adjusted earnings per share (EPS) of 6.5p. On this basis, the shares are priced on a cash-adjusted PE ratio of six and offer a dividend yield of 3.9 per cent. FinnCap believes that the dividend could be hiked to 3.6p a share in the current financial year without making a dent in the cash pile. This is based on an ultra-conservative EPS estimate of 4.9p, implying the shares offer a prospective dividend yield of 4.4 per cent and are priced on a cash-adjusted forward PE ratio of 7.5.

Arcontech’s shares have risen 11 per cent since my last buy call (‘On the results and M&A beat, IC, 24 January 2022), and with real prospects for contract awards and earnings upgrades, I maintain that advice. Buy.

This article was first published at 4.40pm on Monday, 12 September 2022 and updated on Tuesday, 13 September 2022 to incorporate Kape Technologies' proposed share placing.

■ Simon Thompson's latest book Successful Stock Picking Strategies and his previous book Stock Picking for Profit can be purchased online at www.ypdbooks.com at £16.95 each plus postage and packaging. Details of the content can be viewed on www.ypdbooks.com.

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