K3 Business Technology Update on preliminary results

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1 K3 Business Technology Update on preliminary results Back to business Technology FY12 was a year of integration for K3, digesting the five acquisitions made in H112 and the four in FY11. Despite tough market conditions in several end markets, the company generated operating margins of 16.8% while increasing investment in product development and Managed Services offerings. We expect the company to continue this investment in FY13 while paying down some of the debt incurred in making the acquisitions, before returning to operating margin growth in FY14. Year end Revenue ( m) PBT* ( m) EPS* (p) DPS (p) P/E (x) Yield (%) 06/ / /13e /14e Note: *PBT and EPS are normalised, excluding amortisation of acquired intangibles, sharebased payments and exceptional items. 21 September 2012 Price 149p Market cap 42m Shares in issue 28.5m Free float 49.2% Code KBT Primary exchange AIM Other exchanges N/A Share price performance FY12: Challenging market conditions K3 saw 29% revenue growth in FY12 and 6% growth once FY12 acquisitions are excluded. Operating profits grew 18% y-o-y although fell 4.5% excluding FY12 acquisitions. K3 saw challenging conditions in the UK and Dutch retail markets but surprisingly has seen stronger demand from the manufacturing and distribution sectors in the UK. Focused investment on the Retail AX product and weakness in the process manufacturing AX business reduced margins in the Microsoft UK business from 12.2% to 8.9%. Strong demand in the International business boosted margins to 29%; the SYSPRO and Sage business held margins above 20% despite the higher mix of Sage business. The Managed Services business grew 16% but re-invested all profits in building out its hosting platform to support a wider range of products. FY13: A year of investment and consolidation In FY13 K3 intends to continue investing in Microsoft Dynamics AX for Retail product development and developing the Managed Services business. This will hold back margins in the respective divisions in FY13 but in the longer term should drive growth and profitability. The International division should generate strong growth in FY13, although is likely to achieve lower margins as FY12 contained several one-off amounts. We forecast group revenue growth of 10.1% in FY13 and 3.2% in FY14, with 2% earnings growth in FY13 and 15% growth in FY14. Valuation: Bid premium disappears Since K3 announced it was no longer in a sale process, the share price has fallen 16%. However, on our revised forecasts the company is trading on very depressed multiples: 4.9x FY13e EPS and 4.2x FY14e EPS. Key triggers for share price appreciation would be evidence that debt is being repaid, improving margins in Microsoft UK and customer wins in Managed Services. % 1m 3m 12m Abs (14.0) (13.4) (14.2) Rel (local) (14.7) (17.4) (22.0) 52-week high/low 207.5p 122p Business description K3 provides Microsoft- and Sage-based ERP solutions and managed services to SMEs in the retail, distribution and manufacturing sectors. Next events Interim results March 2013 Analysts Katherine Thompson +44(0) Dan Ridsdale +44(0) tech@edisoninvestmentresearch.co.uk Edison profile page K3 Business Technology is a research client of Edison Investment Research Limited

2 Review of FY12 results Exhibit 1: Summary financials 000s FY12 FY11 Change Revenues 67,961 52, % Normalised operating profit 11,405 9, % Normalised profit before tax 10,096 8, % Normalised net income 8,591 7, % Reported EPS (p) % Normalised EPS (p) % Source: K3 Business Technology Group K3 reported revenue growth of 28.7% in FY12, driven mainly by recent acquisitions, with recurring revenues up to 50% from 46% in FY11. As the group increased product development in the Microsoft UK division and put additional investment into the Managed Services division to widen the range of hosting options, operating profits grew more slowly than revenues. In Exhibit 2, we show the split of revenues and operating profit by division. Exhibit 2: Divisional revenues and profitability Revenues ( m) H111 H211 H112 H212 FY11 FY12 Microsoft UK International SYSPRO and Sage Managed Services Total YoY growth Microsoft UK 13.4% 5.0% 8.9% International 29.1% 47.2% 39.7% SYSPRO and Sage 61.1% 46.8% 54.4% Managed Services 55.4% -6.6% 15.6% Total 35.2% 23.0% 28.7% Adjusted operating profit ( m) Microsoft UK International SYSPRO and Sage Managed Services (0.09) Head Office (0.14) (0.06) (0.14) (0.20) (0.2) (0.3) Total Adjusted operating margin Microsoft UK 14.8% 9.8% 12.6% 5.4% 12.2% 8.9% International 29.9% 23.0% 28.9% 29.1% 25.8% 29.0% SYSPRO and Sage 41.2% 8.4% 29.5% 16.0% 25.8% 23.5% Managed Services 8.9% 12.9% 3.4% -3.2% 11.5% 0.0% Total 25.3% 12.1% 20.8% 12.9% 18.2% 16.8% Source: K3 Business Technology Group 2

3 SYSPRO and Sage (36.7% of FY12 revenues) The division grew revenues 54% y-o-y, the majority of which was driven by the acquisitions of FDS Enterprise and IBS. Excluding acquisitions made in FY12, the division grew 7.7% y-o-y, although this included the benefit of a full year s revenue from parts of the Panacea and FD Systems acquisitions. Recurring revenues made up 59% of FY12 revenues versus 63% in FY11. Operating margins dropped y-o-y as the acquired Sage businesses are lower margin, although the absolute operating profit grew 40% y-o-y. The SYSPRO business won 0.9m of new business in the year versus 0.5m a year ago and the pipeline value is 76% higher than a year ago ( 4.4m versus 2.5m). The Sage business has 922 customers and signed 58 deals worth 2.2m in the year. The division has added Sage X3 to its portfolio and is looking to sell its hosting service to new and existing customers. International (18.6% of FY12 revenues) The International business grew 40% y-o-y, or 13% excluding the Unisoft acquisition, and saw improved operating margins y-o-y. The division saw a high level of activity from the IKEA relationship. At the end of FY12, K3 signed a five-year agreement with Inter IKEA Systems BV (the owner and franchisor of the IKEA concept and the division s largest customer) to support and develop the IKEA Master Version software used by IKEA franchisees. K3 also sold IP relating to the Master Version to IKEA, creating an exceptional gain of 0.76m. The division had a pipeline worth c 3.7m at year-end, excluding potential business from the IKEA agreement. The company expects margins to be lower in FY13 as FY12 included several one-off licenses. Microsoft UK (36.7% of FY12 revenues) The division grew revenues 8.9% y-o-y, although excluding the impact of the acquisitions of Azurri and RSG, revenues were essentially flat. The division also benefited from a full year s revenue from parts of the Panacea business, Sense and Clarita, which were acquired in FY11. Operating margins dropped from 12.2% to 8.9% y-o-y, affected by tough business conditions in the UK retail market combined with increased investment to bring the division s Microsoft Dynamics AX for Retail product up to the same level of functionality as the Microsoft Dynamics NAV solution. The company expects that this investment will continue in FY13 but should be complete by the end of the year. The division received its first major AX for Retail order from Eason Microsoft will be the main contractor with K3 providing the specialist retail modules. Over 50% of the prospect pipeline is focused on the Microsoft AX Multi Channel retail solution. As the process-manufacturing AX business has been particularly weak, the company reduced the cost base by 0.75m on an annualised basis, which should help margin improvement in FY13. Managed Services (8.0% of FY12 revenues) The division grew revenues 15.6% y-o-y but was break-even at the operating profit level. Recurring revenues grew from 56% in FY11 to 66% in FY12. The business increased investment in the year in order to develop hosting platforms for SYSPRO, Sage 200 and Microsoft Dynamics NAV and only really started marketing the services in earnest from the end of H112. By the end of FY12, the business had a run-rate of recurring income of 3.58m (+36% y-o-y). Towards the end of H2, the business deployed its first SYSPRO Canada order and will soon launch hosting for SYSPRO Australia. The prospects pipeline was worth 2.65m at the end of FY12. The division expects to continue investing in hosting platforms in FY13. 3

4 Update on sale process After turning down a bid for the company from its largest shareholder, PJ Claesson, on 26 January, the company entered into a strategic review, and then on 1 March into a formal sale process. Management announced on 18 September that no bidder had submitted an offer at a price that management considered would be acceptable to shareholders (bearing in mind the equity placing in July 2011 at 205p per share) so the process was terminated. Progress with acquisitions The table below shows the acquisitions K3 has made since the beginning of The company has integrated all of the acquisitions made in H112. In FY12, K3 paid 7.1m towards these deals and according to the year-end balance sheet, has 2.5m in deferred and contingent consideration still to pay. We estimate that K3 will pay c 1.5m in FY13 and c 0.5m in FY14. Exhibit 3: K3 acquisitions since 2010 Date Company Initial cash consideration m Deferred/contingent consideration Mar 10 DigiMIS 0.436* Up to 1.09m, plus 75k deferred Mar 10 Pebblestone m over 5 years at 6% coupon Jun 10 Pebblestone IP Up to 0.4m payable CY11 Nov 10 Panacea None Dec 10 FD Systems 1.25 None Mar 11 Sense Enterprise Solutions 1.2 Up to 0.9m over three years Mar 11 Clarita 0.82 None Jul 11 Azurri m retention; up to 0.5m if GM targets reached over next two years Jul 11 FDS Enterprise m deferred; up to 1m in 12 months Dec 11 Unisoft PoS m deferred and up to 1.27m earn-out over three years Dec 11 IBS m retention dependent on renewal of contracts Dec 11 Retail Systems Group 1.13 Plus 0.15m retention one year, up to 0.2m earnout over two years Total Source: K3 Business technology Group and Edison Investment Research. Note: *Plus 0.1m in K3 shares. New estimates As we have been unable to produce forecasts during the sale process, comparison with previous forecasts adds little value. The forecasts below reflect all the acquisitions made since the sale process began and we introduce forecasts for FY14. 4

5 Exhibit 4: Divisional revenue and adjusted operating profit forecasts Revenues H112 H212 H113e H213e H114e H214e FY12 FY13e FY14e Microsoft UK International SYSPRO & Sage Managed Services Total YoY growth Microsoft UK 13.4% 5.0% 5.9% 2.0% 2.0% 2.0% 8.9% 3.9% 2.0% International 29.1% 47.2% 50.0% 5.0% 3.0% 3.0% 39.7% 22.2% 3.0% SYSPRO and Sage 61.1% 46.8% 7.0% 6.0% 2.0% 2.0% 54.4% 6.6% 2.0% Managed Services 55.4% -6.6% 26.4% 27.6% 15.2% 11.1% 15.6% 27.0% 13.0% Total 35.2% 23.0% 14.4% 6.1% 3.3% 3.1% 28.7% 10.1% 3.2% Adjusted operating profit Microsoft UK International SYSPRO and Sage Managed Services 0.09 (0.09) Head Office (0.14) (0.20) (0.18) (0.17) (0.19) (0.19) (0.34) (0.35) (0.38) Total Adjusted operating margin Microsoft UK 12.6% 5.4% 8.2% 14.1% 13.8% 14.2% 8.9% 11.2% 14.0% International 28.9% 29.1% 21.0% 21.2% 22.0% 22.2% 29.0% 21.1% 22.1% SYSPRO and Sage 29.5% 16.0% 25.9% 16.0% 28.0% 14.0% 23.5% 21.5% 21.8% Managed Services 3.4% -3.2% 1.3% 4.7% 5.0% 6.0% 0.0% 3.1% 5.5% Total 20.8% 12.9% 16.4% 14.9% 19.4% 14.6% 16.8% 15.7% 17.1% Source: K3 Business Technology Group and Edison Investment Research Net debt position The company used a revolving credit facility to make recent acquisitions. The debt was originally due to be repaid by December 2012, but the company has recently renegotiated an extension until December 2013 on the same terms, with an additional 2m committed and a further 3m available for acquisitions. We forecast that K3 will generate cash in FY13 and FY14 taking net debt down from 15.7m at the end of FY12 to 10.9m by the end of FY13 and 3.6m by the end of FY14. Valuation Since K3 announced it was no longer in a sale process, the share price has fallen 16%. However, on our revised forecasts the company is trading on very depressed multiples: 4.9x FY13e EPS and 4.2x FY14e EPS. Although investment is likely to dampen margins in FY13 (we forecast operating margins will fall by 110bp in FY13) we expect margins to improve in FY14 as investment reduces, even with modest revenue growth of 3%. We would expect a gradual re-rating of the stock as the company provides evidence that debt is being repaid, Microsoft UK margins are improving and the Managed Services business is winning customers. 5

6 Exhibit 5: Financial summary '000s 2010* e 2014e Year end 30 June IFRS IFRS IFRS IFRS IFRS PROFIT & LOSS Revenue 59,783 52,800 67,961 74,851 77,264 Cost of Sales (22,460) (23,486) (28,491) (31,437) (32,451) Gross Profit 37,323 29,314 39,470 43,413 44,813 EBITDA 10,327 10,574 12,942 13,358 14,923 Operating Profit (before am of acq. Intang. and except.) 9,013 9,633 11,405 11,738 13,183 Amortisation of acquired intangibles (2,892) (2,826) (3,586) (3,800) (3,800) Share-based payments 39 (52) (72) (70) (70) Other 0 (942) (395) 0 0 Operating Profit 6,160 5,813 7,352 7,868 9,313 Net Interest (1,365) (905) (1,309) (900) (650) Profit Before Tax (norm) 7,620 8,728 10,096 10,838 12,533 Profit Before Tax (FRS 3) 4,767 4,908 6,043 6,968 8,663 Tax (1,018) (428) (319) (1,301) (1,629) Profit After Tax (norm) 5,770 7,108 8,591 8,838 10,204 Profit After Tax (FRS 3) 3,749 4,480 5,724 5,668 7,034 Average Number of Shares Outstanding (m) EPS - normalised (p) EPS - normalised fully diluted (p) EPS - FRS 3 (p) Dividend per share (p) Gross Margin (%) EBITDA Margin (%) Operating Margin (before GW and except.) (%) BALANCE SHEET Fixed Assets 48,602 59,457 68,325 66,105 63,365 Intangible Assets 13,176 17,635 21,255 18,555 15,455 Tangible Assets 1,393 1,993 2,722 3,202 3,562 Goodwill 33,467 39,082 43,540 43,540 43,540 Other Current Assets 14,808 23,456 32,418 34,641 37,236 Stocks Debtors 14,439 22,642 30,322 31,786 33,023 Cash ,096 2,855 4,213 Current Liabilities (19,510) (29,300) (48,043) (43,293) (37,043) Creditors (5,491) (7,874) (8,797) (9,497) (9,797) Other Creditors (9,719) (16,628) (21,468) (20,018) (19,468) Short term borrowings (4,300) (4,798) (17,778) (13,778) (7,778) Long Term Liabilities (12,457) (16,371) (5,797) (5,697) (5,597) Long term borrowings (7,051) (11,502) Other long term liabilities (5,406) (4,869) (5,797) (5,697) (5,597) Net Assets 31,443 37,242 46,903 51,756 57,961 CASH FLOW Operating Cash Flow 7,331 5,640 7,284 12,594 13,986 Net Interest (1,303) (947) (839) (900) (650) Tax (1,637) (1,368) (1,312) (2,001) (2,329) Capex (1,638) (2,055) (3,160) (3,200) (2,800) Acquisitions/disposals (2,856) (5,407) (7,132) (1,450) (550) Financing 1, , Dividends (247) (64) (214) (285) (299) Net Cash Flow 1,084 (4,027) (347) 4,759 7,358 Opening net debt/(cash) 13,012 10,982 15,486 15,682 10,923 HP finance leases initiated Other 946 (477) Closing net debt/(cash) 10,982 15,486 15,682 10,923 3,565 Source: K3 Business Technology Group and Edison Investment Research. 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