Kainos sacrifices margins for growth

IT services business Kainos (KNOS) is benefiting from strong underlying demand for digital transformation both from the public and private sectors. The company is split between two services. Digital services is a generalised offering, which helps customers digitise their businesses and utilise their data. Then there is the Workday practice, which helps customers deploy and test their Workday software. Workday (US:WDAY) is a separate HR and finance software business that has a partnership with Kainos.

The pandemic accelerated the need for customers to digitise their businesses, which has helped drive top-line growth across all of Kainos’s divisions. Digital service revenue rose 24 per cent to £200mn in the year to 31 March, while the Workday practice grew 41 per cent to £103mn. This was primarily driven by growth in commercial and healthcare revenue, which was up 53 per cent and 41 per cent, respectively. Public sector grew a more modest 5 per cent.

But this strengthening revenue growth has not filtered all the way through to profit and cash flow growth. As well informed investors will know, the labour market in tech is very tight, which is driving up wage costs. Employee retention slipped from 92 per cent to 86 per cent. This means Kainos has had to use more contractors.

Along with increased marketing costs, operating costs have risen 37 per cent and this has pushed the gross margin down 4.1 percentage points to 46.3 per cent. For a tech company this isn’t particularly impressive. While adjusted pre-tax profit was up slightly, the statutory pre-tax figure actually fell 9 per cent.

Less of these profits are also being turned into cash, with the cash conversion rate falling to 83 per cent from 112 per cent last year. This was mainly because of a £23mn increase in trade and other receivables. The company said this increase was because last year had “exceptionally high cash conversion”. This is true, but the direction of travel isn’t ideal and implies that customers aren’t paying as swiftly as they were – a potential bellwether for softening demand.

But decreasing margins can be expected when companies are in growth mode. Last year, Kainos more than doubled its headcount in North America and the 26 per cent backlog of contracted revenue does  suggest demand for its services.

A big drop in value since its last results means Kainos is now trading a forward PE ratio of 31, according to FactSet consensus. This is still fairly pricy and probably reflects the strong top-line growth. However, we would still like to see more of these sales turned into cash. We stick to hold.

Last IC View: Hold, 1,861p, 15 Nov 2021