K3 Business Technology

As flagged in the recent trading update, FY13 results were negatively affected by the combination of weak retail markets in the UK and Holland, and increased investment in developing K3’s AX for Retail solution. Recent order intake for both NAV and AX solutions points to a recovery in the Microsoft UK business, while the other business lines look set for a steady performance in FY14. Trading at a discount to peers, we see scope for upside as evidence of sustained revenue and margin recovery emerges.

FY13 results affected by retail market weakness
FY13 revenues declined 6.5% y-o-y as the weak retail market led to a 24% decline in the Microsoft UK division and suppressed growth in the International division. This pushed the Microsoft UK division into a loss-making position and depressed International margins, with adjusted operating profit falling 55% to generate an 8.1% margin (vs 16.8% in FY12). The performance of SYSPRO and Sage held up in the year, and demand for Sage X3 and SYSPRO 7 should drive growth in FY14. Although Managed Services saw 18% revenue growth in FY13, investment in developing hosting platforms (now complete) resulting in an operating loss. Good working capital management resulted in a better than expected year-end net debt.

Recent order intake points to more positive FY14
The strength of Q4 bookings points to a revenue recovery for the Microsoft UK division in FY14, which in turn could drive demand for hosting in the Managed Services division. As Gemstone development is completed and the software is made available to the international sales channel, there is scope for growth to exceed our conservative FY15 forecast. We forecast revenue growth of 15% in FY14 (with 36% growth in Microsoft UK) followed by 3% in FY15. This drives improving profitability, with operating margins of 9.7% in FY14 and 12.1% in FY15. We forecast a reduction in net debt of £1.6m in FY14 and £3.0m in FY15.

Valuation: Evidence of sustained recovery is key
K3’s share price is up 47% since the lows reached after the June trading update but on a P/E of 9.1x FY14e and an EV/sales multiple of 0.8x FY14e, still trades at a material discount to its peers (sub-£200m market cap UK Software P/E 15.6x, EV/sales 1.8x). With operating margins moving towards 10% in FY14 we believe that K3 could trade up to at least 10x FY14e EPS (157p), and with evidence of sustained improvement in the Microsoft UK division and further improvement in margins, could move towards 200p (equivalent to EV/sales of 1x FY14e).

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