K3 Business Technology — Update 22 March 2016

K3 is a software developer and value-added channel partner; the company designs, resells and implements ERP and related business software solutions for the retail, distribution and manufacturing sectors. The group has a well-balanced business model of predictable, recurring licence income in the manufacturing software sector combined with higher growth opportunities in retail software, and offers managed services across all divisions. K3 is focused on developing its own software to enhance margins and create specialist solutions in target verticals.

K3 reported 1.5% revenue growth in H116, with the weaker euro having a negative impact. The company made good progress selling own-IP product and won several major contracts through its international partner channel. Gross margins improved year-on-year, as higher margin own-IP and hosting revenues made up a greater proportion of the total. In addition, measures to reduce the cost of implementation have started to have a positive impact. Adjusted operating profit increased 25% y-o-y, with margins expanding from 9.9% to 12.1%. Reflecting increasing customer demand for consumption-based pricing, which reduces short-term revenues and cash inflows, we have reduced our revenue, operating profit and EPS forecasts and increased our net debt forecasts for FY16 and FY17.

The stock has undergone a significant re-rating, with a 53% gain in the share price over the last 12 months. The stock now trades on a P/E multiple of 15.0x FY16e EPS and 13.6x FY17e EPS compared to sub-£500m market cap UK software and IT services stocks trading on an average 21x current year and 16x next year EPS. K3 continues to invest in developing and supporting its own-IP solutions and building out its partner channel. Combined with a focus on selling hosting services to a larger proportion of customers, the company has the potential to grow the business on a multi-year basis. The company may also consider accelerating growth through acquisition, specifically to build out the product range. We would expect upside triggers to include evidence of more “ax│is” contract wins, continued progress with the international partner channel, further debt reduction, and the managed services business winning customers. We believe that the stock could trade up to at least 15x FY17e EPS (384p per share).

The main sensitivities or risks to our forecasts are: 1) the macro environment; 2) organic growth, which depends on the ability to hire and retain skilled staff; 3) technology – the managed services business uses third-party data centres and could be negatively affected by service disruptions; 4) the timing and outcome of product development is uncertain; and 5) K3 is dependent on the technology roadmaps of the software vendors that it resells.

K3 is a software developer and value-added channel partner; the company designs, resells and implements ERP and related business software solutions for the retail, distribution and manufacturing sectors. The group has a well-balanced business model of predictable, recurring licence income in the manufacturing software sector combined with higher growth opportunities in retail software and offers managed services across all divisions. K3 is focused on developing its own software to enhance margins and create specialist solutions in target verticals.

K3 started life in 2000 as the result of a buyout of the UK manufacturing Enterprise Resource Planning (ERP) business of Kewill Systems, comprising two business units and c 1,500 customers with a high proportion of recurring revenues. In 2001, K3 joined AIM through a reverse acquisition. Since then the company has broadened its offering with a series of acquisitions. These have expanded the company’s ERP and business solution offerings in the manufacturing, retail and distribution sectors and added a managed services offering.

The group supplies ERP products based on Microsoft and Sage technology and business intelligence solutions from Microsoft and QlikView (see Exhibit 2).

Group strategy has been to focus on adding internal IP to the Microsoft-based product range. As a straight reseller of Microsoft products, K3 would achieve a gross margin of c 30-55% on software sold, depending on the product. By adding its own proprietary software to customise products for more specific requirements, K3 is able to retain a higher percentage of the software licence fee.

In H116, 25% of licence revenues was generated from own IP products (H115: 23%). Exhibit 3 shows how the development of proprietary IP is contributing to revenue and margin growth. K3 is organised into two divisions and reports financials on this basis. For each division, the table shows the value of software sold that is based on K3’s IP and any related services, recurring revenue or hardware sales flowing directly from this licence sale. In H116, own-IP related revenues generated a gross margin of 65.6% compared to a group gross margin of 55.6%; excluding own-IP related revenues, remaining revenues generated a gross margin of 52.7% (up from 47.0% a year ago).

In H116, the company shifted product development staff out of their respective business areas to create one core IP development team. This should allow the team to share expertise, particularly as products are developed for Microsoft AX and NAV solutions in both divisions. It should also allow developers to focus on building strategic K3 solutions rather than being allocated to work on customer-specific contracts.

The company has also stated that it would consider making acquisitions to bolster its product range – we would expect this is more likely to be focused on the Retail division.

With the development of the ax│is fashion solution in the Retail division, the company started to develop its reseller channel to increase the addressable market outside of K3’s traditional UK and Dutch markets. In the Retail division, K3 is working with a number of global system integrators to take its software into the rest of Europe and the US. In Manufacturing & Distribution, K3 is working in building out its SYSPRO reseller channel.

K3 has developed its managed services business through a combination of in-house development and acquisition. In addition to offering outsourced IT support to its customer base, K3 offers application hosting to its 3,000-strong customer base, with the ability to host all products sold including own-IP solutions. K3 is focused on selling managed services across its customer base; for example, all SYSPRO contracts are sent out with a hosting option. K3 has an agreement with SYSPRO to provide hosting services to the wider 15,000-strong global SYSPRO customer base, providing an additional source of hosting customers. In H116, managed services and hosting made up 13% of group revenues.

Since buying Willow Starcom (a Wigan-based hosting and managed services business) in April 2015, the company has rebranded its entire hosting and managed services business as Starcom, and has integrated the three existing managed services business into one. While focused on growing the proportion of K3 customers using its hosting services, Starcom also provides hosting services to companies that are not K3 software customers.

K3 was recently certified by Microsoft as an Azure Tier 1 CSP (cloud service provider). This allows K3 to sell and manage Azure hosting services alongside its own hosting service.

David Bolton stepped up to the CEO role in January 2014 from his role as CFO, having worked with the previous CEO since the formation of K3. Brian Davis moved into the CFO role at the same time; he had been head of finance since 2007. The company’s group operations director, Andrew Hodges, previously held commercial and operations director roles in K3’s Microsoft UK division.

This division develops and sells Microsoft Dynamics AX and Microsoft Dynamics NAV-based solutions for the retail market. Operations are based in the UK and Holland, with three satellite offices to support overseas customers. The core offering is based around K3’s “ax│is” technology, which is based on and enhances Microsoft AX for Retail. K3 started developing the IP for this solution in FY13. In FY14, it released version one of the solution, named “ax│is fashion”, and later that year won nine major contracts worth £12.6m for the solution. While the initial focus is on the fashion segment of the retail market (the second largest after food retail), the company expects to use the core “ax│is” technology to develop other retail vertical solutions such as for “big-ticket” items. In addition to the flagship AX-based solution, K3 previously developed a retail-specific solution based on Microsoft NAV, which is targeted at small and mid-sized retailers. The company also offers complementary products such as business information, channel and point-of-sale software. All products are available for hosted or on-premise delivery. In July 2015, K3 was awarded “Inner Circle” status by Microsoft – this is only awarded to less than 60 of Microsoft’s fastest growing partners.

A longstanding customer for this division is Inter IKEA Systems, which signed an exclusive five-year agreement at the end of FY12 for K3 to support the IKEA Master Version software used by franchisees outside the IKEA group; this contract has since been extended until 2020 (including a multi-year enhancement licence). There are 14 franchises based in Europe, the Middle East, the Far East and Australia. Existing franchisees are encouraged to open up new stores in existing and new countries, and IKEA expects them to use K3’s solution when they do so.

We believe that the ax│is fashion solution is one of only a few in the market that has been specifically developed for AX for Retail and therefore K3 has an opportunity now to exploit its head start on a global basis. While in the UK K3 typically sells direct and implements its own projects, in order to maximise potential sales outside of the UK, K3 is looking to build out its partner channel. The appeal for system integrators is that K3 provides vertical-specific software that is not available directly from Microsoft, and having access to this provides a competitive advantage when selling to global retailers. This is particularly attractive to Microsoft-focused system integrators such as Avanade, Microsoft’s largest AX partner.

In September, the company announced it had signed an ax│is contract with TriStyle (a European mail order fashion retailer) in Germany via a global system integrator (GSI) – its largest contract to date through this channel and its first contract win in Germany. Since then, it has signed two more contracts via channel partners, one of which was with KLiNGEL, Germany’s largest online retailer.

For divisional performance data, refer to Exhibit 5 on page 9. The retail division received major orders worth £6.6m compared to £6.8m a year ago and added 51 new customers (H115: 33). The division saw total revenue growth of 0.5% y-o-y. Software licence revenues were up 10% y-o-y, service revenues were effectively flat, while recurring revenues were 9% lower (the division experienced a lower level of renewals, particularly for multi-year enhancement deals). With exposure to the euro via its Dutch business, revenues were negatively affected by the weaker euro versus sterling, although this had a smaller impact at the adjusted operating profit level. The company noted that it sold its first major cloud-based subscription contract for Microsoft Dynamics NAV in Q216.

Divisional gross margins expanded to 52.0% from 43.6% a year ago, helped by several factors. Higher-margin own IP-related revenues grew by 10% y-o-y to make up 39% of divisional revenues (H115: 35%). Services gross margins improved to 30.5% from 20.6% in H115 as measures taken by management to reduce the cost of implementation took effect. Operating expenses increased 3% y-o-y, resulting in an adjusted operating margin of 12.7%, up from 5.4% a year ago. The majority of H116 exceptional costs were incurred in this division resulting from the restructuring of divisional management and work to tackle performance issues in the Dutch business. Management estimates that the restructuring could lead to annualised cost savings of £1.4m.

The retail division had a pipeline worth £26.3m at the end of H116 (H115: £28.7m), including for both ax│is and other more established solutions. Management noted that it is well advanced with initial work on a contract for a large global fashion retailer – this could result in significant multi-year revenues.

The company has noted that customers are shifting towards consumption-based pricing structures. This means that in addition to K3 selling perpetual licences with an upfront licence fee that is paid for and recognised when the contract is signed, customers are also signing up to use software on a subscription basis. In this case, companies pay one fee for the software licence, enhancements, support and hosting, driving up the level of recurring revenues. Management estimates that while this leads to lower revenues in the short term, it could lead to higher customer lifetime values than the perpetual licence model. The company is also signing contracts where the licence fee is paid for over a number of years. The impact on reported financials will be to reduce the cash received in the initial period when the contract is signed, but will result in cash receipts over multiple periods. Licence revenue recognition will depend on the terms of the licence, the delivery schedule and the credit status of the customer.

Microsoft has very recently launched Microsoft Dynamics AX7 – initially it will only be available hosted on Azure. K3’s ax│is solution is already available for this and would also be hosted on Azure. In time, it is expected that Microsoft will launch an on-premise version of AX7.

This division supplies SYSPRO, Sage and Microsoft Dynamics AX and NAV solutions to c 1,000 manufacturing customers and c 700 distribution customers. As in the retail division, K3 develops its own IP to enhance the SYSPRO and Microsoft Dynamics functionality. Own-IP products include advanced planning and scheduling, warehouse management, pallet management, data integration and payroll/HR. The division offers hosting and managed services for all solutions and, as described on page 4, has launched a cloud service for SYSPRO.

K3 is SYSPRO’s exclusive partner in the UK and Europe. SYSPRO is a Microsoft.NET-based ERP solution developed for the manufacturing sector. This business generates a high level of licence and support renewals in the second half of each calendar year (ie K3’s H1). The business has recently updated some of its own IP SYSPRO products, including Dataswitch Connectivity, Equator Payroll and Orchard Warehouse Management.

K3 is one of Sage’s largest partners in the UK, and is the largest reseller of Sage X3. Sage X3 is Sage’s most advanced ERP offering and is targeted at mid-market companies.

All hosting and managed services results are reported in this division, although we note that a proportion of revenues are generated from Retail customers.

Divisional revenues were up 2.4% y-o-y (see Exhibit 5 on page 9). Taking into account the £1.5m of revenues contributed by the Starcom acquisition, revenues declined 4.4% y-o-y. New orders worth £4.7m were received in the period (H115: £5.5m) – management noted that several large software deals shifted into H216 – and 60 new customers added (H115: 48). The SYSPRO business performed in line with management expectations, maintaining the renewal rate at 98% and making its first sales through channel partners. The Sage business saw lower licensing and related service revenues, although the company has seen a pick-up in demand since the period end. The Dynamics NAV and AX business was weaker than expected, but closed the period with a strong pipeline, which has since started to convert. Hosting and managed services contributed recurring revenues of £3.79m (28% of divisional recurring revenues and up 39% y-o-y) and at the end of H116 had an £8.22m contracted run rate of subscription income, up 29% y-o-y and 3% h-o-h.

The divisional gross margin increased from 56.9% in H115 to 58.8% in H116 – each revenue stream increased margins, through a combination of better efficiency in delivery and a higher proportion of hosting services. Operating expenses increased by 12% y-o-y as Willow Starcom was integrated into the business and the full impact of additional heads hired in H215 took effect.

The division had a pipeline worth £30.2m at the end of H116 (H115: £28.0m). Management is focused on growing the cloud hosting business.

The main factors influencing our forecasts and the share price are:

Group revenues grew 1.5% y-o-y; normalising for the effect of the weaker euro, constant currency growth reached 4% y-o-y. Recurring revenues made up 47% of the total, similar to a year ago. Gross margin improved from 50.7% a year ago to 55.6%, with margin improvements from the success of the company’s programme to reduce implementation resourcing costs, the higher proportion of own-IP business, and the increased contribution from hosting and managed services (as the Starcom acquisition was integrated). Operating expenses increased 8.3%, with a large proportion of the increase accounted for by the integration of Starcom. Overall, this resulted in a 24% increase in normalised operating profit (as in Exhibit 4), with the margin increasing from 9.9% to 12.1% year-on-year. On a constant currency basis, normalised operating profit increased 36% to £4.84m. The effective tax rate of 19% was in line with our expectations, resulting in normalised EPS growth of 44.6% y-o-y.

Net debt reduced from £12.1m at the end of both H115 and FY15 to £10.5m at the end of H116. The largest element of debt is a secured loan repayable in August 2017 (at a rate of Libor +2.95%), of which £11.9m is outstanding. The company also has access to a £7.5m revolving credit facility, which is currently unused.

We have revised our forecasts to reflect the weaker euro as well as the effect of increased demand from customers for consumption licensing. This results in a reduction in our revenue forecasts of 2.6% in FY16 and 4.2% in FY17. Reflecting the gross margins achieved in H116, we have raised our gross margin assumptions for both years, particularly in Retail. This results in a 1.0% cut to our adjusted operating profit forecast in FY16 and an 8.4% cut in FY17, and reduces normalised EPS by 1.5% in FY16 and 9.8% in FY17. We have increased our capex forecasts by £420k in FY16 and £320k in FY17 to take account of slightly higher investment in product development and hosting assets. Combined with lower profitability and the shift towards consumption-based licensing (which has an impact on working capital) we have increase our net debt forecast in both years although we continue to forecast a reduction in the absolute amount each year.

K3’s share price has gained 53% over the last 12 months, as the company has shown good progress selling its new ax│is solution, developing its partner channel, improving profitability and reducing debt. The stock now trades on a P/E multiple of 15.0x FY16e EPS and 13.6x FY17e EPS. Sub-£500m market cap UK software stocks are trading on 22.3x current year and 17.3x next year EPS and UK IT service companies are trading on 18.6x current year and 15.3x next year EPS. K3 continues to invest in developing and supporting its own-IP solutions and building out its partner channel. Combined with a focus on selling hosting services to a larger proportion of customers, the company has the potential to grow the business on a multi-year basis. The company may also consider accelerating growth through acquisition, specifically to build out the product range.

We would expect triggers for further upside in the stock to include evidence of more “ax│is” contract wins, continued progress with the international partner channel, further debt reduction, and the managed services business winning customers. We believe that the stock could trade up to at least 15x FY17e EPS (384p per share), equivalent to an EV/sales multiple of 1.5x FY17e. K3 pays a small dividend, equivalent to a forecast yield of 0.5%.