Kainos sales growing but wage inflation is squeezing margins

The need for companies to adopt hybrid working practices has buoyed the digital transformation market, to the extent that even notoriously slow-moving government departments now recognise the need to update their working practices. This is good news for digital transformation business Kainos (KNOS), which generates nearly 40 per cent of its revenue from the public sector.

While the UK and Ireland remain Kainos’s biggest market, with 72 per cent of sales, there has been significant growth in North America and Europe; North American headcount increased by 110 to 249 as sales growth topped 49 per cent. Overall, the company's headcount rose by 41 per cent which, in combination with significant wage inflation, contributed to a 50 per cent rise in operating costs to £74.8m. The increase in costs and working capital explains the 4.7 percentage point fall in gross margin to 47.4 per cent.

However, bookings increased 81 per cent to £187m, which resulted in a 38 per cent increase in contracted backlog, with a lot of this generated by Kainos’s Workday division which saw an increase of 56 per cent. It is the only specialist Workday partner headquartered in the UK.

Management said the NHS’s increased use of technology throughout the pandemic has given the health sector confidence to speed up its digital transformation – a fact backed by committed government spending. For example, in the recent Budget, £5.9bn of capital investment was announced for the NHS to tackle “the backlog of non-emergency procedures and modernise digital technology”.  

House broker Investec has revised down its margin forecast for the full year to 46.7 per cent (from 48.8 per cent). However, because of an increased revenue forecast to £202m from £187m, it is expecting group cash profit to remain flat. The rapid growth of the digitalisation market, and the company’s high customer retention rates, are behind the rich forward PE ratio of 52.8, putting it on a par with other tech-related service companies.

However, shrinking margins and a fall in cash conversion from 123 per cent to 38 per cent, due to increased working capital, along with the large amount of accrued (booked but unbilled) revenue on the balance sheet, is a cause for concern. Sales are likely to grow, but we would like to see these converted much more effectively into cash for Kainos's business model to be fully validated, which is why we are downgrading our long-standing buy recommendation. Hold.

Last IC view: Buy, 1,441p, 24 Mar 2021