Kainos (KNOS)

Hi,

I’m happy to post some notes on this company if anyone is interested?

Having a small position, I looked further into it when the share price dropped on half-year results earlier this week, and came to the conclusion the company may have a lot of room to grow.

Regards,

Ben

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I’d be interested in your take. I’ve been invested since 2018, at a price around £4, and have enjoyed its growth. In the early days, I could see that it must be making a difference to UK gov, simply because of the massive improvements in various departmental websites and processes - courts, passports, transport. It just seems so much easier to tax your vehicle online than it used to be. But my worry was that it might be getting too reliant on UK Gov and that it was struggling to get new customers and diversify overseas. I haven’t yet looked at the latest report so it would be great to have another point of view

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By popular demand, please find said notes below!

I will continue to hold because I think it may bag again, but for anyone who reads this, please don’t follow my advice - I’ve made some spectacular mistakes in the past. Also, it’s pretty fully valued, as described…

KNOS – Kainos Group Limited

‘Kainos’ meaning in Greek – ‘Fresh’/’New’/’Novel’

Full listing on the LSE, Market cap £2.3bn, Enterprise value £2.24bn, 2024 employees, 1811 pence per share today (16th Nov 21), pe 50.6 /TTM pe50.6. 546 customers. £234m turnover.

w: www.kainos.com

wiki: Kainos - Wikipedia

Purpose of the Company

IT Services, consulting, and software solutions as follows:

69%, digital services – i.e. solves business problems through technology. Both public and commercial sector. The idea is to save the client money – for example a digital transaction is 50x cheaper than a face-to-face transaction. 24% 5-year compound annual growth rate (cagr)

21% Workday Services – i.e. consulting, project management, integration and post-deployment services relating to Workday Inc enterprise resource planning software (erp software). 49% 5-year cagr.

10% SMART proprietary software – workday customers test their workday configuration is effective (SaaS offering). E.g. ensuring it is Sarbanes-Oxley compliant and the like. 51% 5-year cagr.

Clearly the success of the SMART offering is a function of the success of the Workday Services division.

A Brief History

1986 – company founded. Joint venture between Fujitsu and The Queens University of Belfast business incubation unit (QUBIS Ltd). One of Northern Ireland’s first campus companies. Frank Graham ceo.

2001- Document management system spun off. Frank Graham left to be CEO of this company, Meridio. Current CEO, Brendan Mooney appointed as Kainos CEO.

Originally pursued software in the financial and telecoms sector which dried up in the great financial crisis.

Then supplied data management systems (EVOLVE).

2011- Appointed as an implementation partner to Workday Inc.

2015 -Admitted to the main LSE stock market.

Company Operations

Turnover: 75% UK+Ireland, 16% North America, 8% Europe, 1% rest of world.

Turnover: 45% public, 35% Commercial, 20% Healthcare

What about Workday Inc, if 31% of the revenue is derived from this US company?

Workday Inc was co-founded by US tech entrepreneur, David Duffield. It is one of those US tech companies with amazing gross margin but which spends all of it’s money expanding leaving not much net profit i.e. a land-grab, Amazon style.

Mr Druffield originally founded Peoplesoft, an erp software enterprise taken over by Oracle in a hostile takeover during 2005 for $10.8 billion.

Mr Druffield and his director of planning from Peoplesoft, subsequently co-started Workday Inc and the share structure is such that they control 67% of the voting rights, presumably to avoid another hostile takeover in the future! Mr Druffield is 81 years old now, but co-CEO Mr Bhusri is 55, so should continue working with the same strategies, for a decade or so, hopefully.

David Duffield - Wikipedia

Aneel Bhusri - Wikipedia

Who are Workday’s competitors?

Competitors of Workday include SAP Successfactors, Ceridian and Oracle.

Some would argue SAP and Oracle are originally based on 1970’s technology whereas Workday was orignally based on 2005 technology and so more flexible and current. If you have ever used SAP or Oracle you will know how clunky and unfriendly they are (personal opinion).

An interesting point for me was since 2017 Workday Inc allowed Workday to be a platform for developers, so clients could develop their own reports which I would guess is a source of additional revenue for Kainos. Also, Workday can work on a module basis rather than having to purchase the whole suite. It is sold as SaaS.

Is Workday Inc trading well and solvent?

Yes.

NASDAQ_WDAY


Kainos Fundamentals

ROE 61.9% (+4.6% p.a. over past 5 years)

ROOCE 66.2% (+3.1% p.a. over the past 5 years)

ROIC 59.6% (+3.2% p.a. over the past 5 years)

CROIC 74.4% (+16.5% p.a. over the past 5 years)

Gross margin 50% (approximately the same as 5 years ago)

Operating margin 22.3% (but flattered y-e Mar 21 due to Covid. Usually around 14%)

Debt to market cap 0.2% (net borrowing -£59m)

Pension deficit? No

Material director shareholdings? Yes, as described below

Reported eps increase over 5 yrs ago : +202%/+24% annualised.

FCF increase over 5 yrs ago: +549%/43.8% annualised

F-score: 7/9 up from 5/9 five yrs ago (shares issued + asset turnover marginally down)

Turnover +166% over 5 years, 5 yr cagr +26% p.a.

Eps (reported) +202% over 5 years, 5 year cagr +24.8%

Operating cashflow 5 yr change +442%, 5 year cagr +40%

Share dilution: 105% of 5 year ago share count

Book Value per share: +27% p.a. (past 5 yrs, annualised)

Cash conversion 125%, 3 year average 94.9%

R&D tends to be covered by R&D credits and government grants.

Drivers for Growth/Qualities of the company:

  • Any company report which uses the work ‘growth’ 70 times(as Kainos did in it’s y-e 2021 annual report) is probably worth further investigation!
  • Good area to operate in. Other companies succeeding in cloud based tech, albeit slightly different areas, include SoftCat and CCC.
  • Transitioning into an international organisation.
    • Started in EU in 2015 with an office in Amsterdam, now there are staff in 13 EU countries.
    • Started in the US in 2018, now with 142 employees in the US.
    • An interesting thing about the Workday ecosystem is that the different territories seem to be able to compete with each-other.
  • Whereas SAP and Oracle have thousands of distributers, Workday Inc only has 40 or so partners. An opportunity and a threat, should Workday change their policy.
  • The ERP market is increasing at 8% p.a., so the cake is getting larger. Kainos is growing at 16% p.a. (their figures, so probably needs verifying).
  • The culture of the company seems to be such that the staff are all pulling in the same direction. Glassdoor approval rating of 86%.
  • Kainos is developing a post-deployment annuity type revenue stream (£49m in year-ending 2021).
  • As well as Workday Inc, Kainos is a partner to Amazon Web Services and Microsoft.
  • Capital light business model and, it says, pursuing organic growth.
  • The company is trying to avoid having few customers and actively pursues smaller companies to keep it’s customer base diverse.
  • Investing in artificial intelligence and data analytics, so forward looking?

Risks for the company

  • Reliant on Workday Inc. As mentioned, Mr Duffield of Workday Inc is 81 years old, however his co-founder is in his fifties. I hope current policies continue. They don’t appear to want to sell out from the voting share structure.
  • Has any UK company ever successfully transitioned into an international organisation?!

Balance Sheet:

Great overall.

At 30 Sept 21:

No debt, £80m cash.

Current assets £154m vs Current liabilities £94m

Total assets £194m vs Total liabilities £99m

Net Asset Value £95m.

Net Assets less intangibles £78m.

Trade payables have increased by 80% to £38m, but Trade Receivables have also increased by 100% to £43m - seems to be a pattern during the pandemic with other companies also.

Intangible Assets:

Total NBV, £17m, made up of:

£13.9m goodwill

Goodwill of £13.9m, up £10m from prior year due to a couple of acquisitions. (£1.9m Argentina + £9m Nordics), in-line with international ambitions.

Goodwill impairment review annually, upwards only. 11%-12% discount rate for 3 years and 2% thereafter. No impairment due.

£3.1m other intangibles = customer relationships upon business combinations. Written off over 10 years, straight line.

Profit and Loss

Accrued income - £28m at 30 Sept 21

‘Revenue Revenue is recognised to depict the transfer of promised services to customers in an amount that reflects the consideration to which the entity expects to be entitled in exchange for those services. The Group has adopted the five-step approach to the timing of revenue recognition based on performance obligations in customer contracts. This involves identifying the contract with customers, identifying the performance obligations, determining the transaction price, allocating the price to the performance obligations within the contract and recognising revenue when the performance obligations are satisfied. Revenue from the Group’s activities is recognised as detailed below. The Group recognises a contract asset (accrued income) when the value of the satisfied performance obligations is in excess of the payment due to the Group or a contract liability (deferred income) when the amount of unconditional consideration is in excess of the value of satisfied performance obligations. Once a right to receive consideration is unconditional, that amount is recognised as a receivable.’

Dividend – 1.2% (21.5p for y-e 2021). Seems to be increasing.

Operating expenses – £42.2m vs revenue of £142m and direct costs of £75m for the 6 months to Sept 21. An increase on the prior year (£32m), but the prior year had a lot of long-term costs excluded (training etc) due to the pandemic. Seems a little high, though.

Share price history

Usual 10% fall after floatation (from July 15 until June 16), but has increased at a staggering rate subsequently.
LSE_KNOS (1)

Valuation

TTM pe=50.6 and price to turnover is 10.8x with a free cash flow yield of 2.2%. Is this company over-valued?

Based on Earnings Power Value (EPV) with a 15% required return (so assuming profits are constant and don’t grow) Kainos is 85% overvalued. Some would say 50% is their limit on this metric.

However;

  • To get to a 10% fcf yield:

    • At 50% increase in fcf p.a. this would take 4 years
    • At 40% increase in fcf p.a. this would take 5 years
    • At 30% increase in fcf p.a. this would take 6 years.
  • Fcf has historically been growing at between 36% and 62% over the past 5 years.

  • The current share price would be supported at a fcf growth rate of sustainable increase of 12.5% p.a.(at a 15% discount rate), which should be more than achievable.

  • Comparing to the other companies within it’s subsector, possibly Bytes (BYIT) is better value but then you have the recent float risk.

Management

People and policies (kainos.com)

Chairman (non-exec) – Tom Burnet, who co-incidentally is non-exec Chairman of the Baillie Gifford US Growth Trust (previously accesso technology).

CEO – Brendan Mooney

CFO – Richard McCann

Ownership

11.5% Brendan Mooney (CEO)

10.5% Standard Life

10.16% Qubis (referenced earlier – Queens University of Belfast)

7.45% Liontrust

5.8% Paul Gannon (ex-exec director, 2015 to 2021)

3.75% Richard McCann (CF0)

3.5% Brian Cannon

So, 15.25% owned by the CEO and CFO

Recent news-flow:

  • 15/11/21- Results for 6 months to Sept21 Shares hammered on margin decrease due to post-pandemic admin costs. Revenue increased 33%, though. Bookings up 81%, SaaS bookings up 118% and order backlog up 38%. Although the share price has decreased by 14%, this only takes the share price back to it’s early October 2021 value. Happy to hold and see what happens.
  • 23/09/21 – All resolutions passed at AGM
  • 08/09/21 – CFO’s wife sells £640k
  • 01/09/21 – UNE Consulting in Argentina purchased . 5th purchase by Kainos in the Workday partner ecosystem.
  • 01/09/21 – Trading update – ahead of current forecasts
  • 25/08/21 – CFO’s wife sells £942k
  • 10/08/21 – change of auditor
  • 01/06/21 – Purchase of Cloudator (Workday partner in the Nordics)
  • 24/05/21 – full year results to 31/03/21. Turnover+31%,Stat profit before tax +117%
  • 21/05/21exec director Paul Gannon to leave the board, but still working for Kainos and non-exec Chris Cannon to leave also (after 6 years)
  • 16/04/21 – trading statement – upper end of market expectations.
  • 22/01/21 – trading statement – ahead of market expectations.

I hope the above was helpful to people and it’s probably good as a primer if you haven’t investigated Kainos before. Please let me know if I have missed any risks!

Regards,

Ben

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Thanks, it’s really useful to see all the data in one place. As you say, it is very fully valued but it has been ever since I first bought in. I am very tempted to buy the current dip. The need for good IT and work flow in UK official systems is massive - have you had occasion to try to complete a passenger locator form to get past UK border control?

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Hi Graeme,

I’ve not had the pleasure with UK border control, yet! It’s been difficult to get abroad with children. Hopefully in the next year or so, assuming we don’t have a Waterloo with Macron before next Spring’s French election…

Kainos seems to be a quality company with good staff culture. I wouldn’t bet against them.

I am going to look into Bytes before investing further, though. Sanford Deland Free Spirit think Bytes have grown 20% p.a. fairly consistently since 2004 or so (ref Capital Employed podcast).

I’ll post it on here if I have time to do so.

Regards

Ben

Hi Ben

Terrific write-up!

Arguably the likes of GSK and Unilever have made a reasonable international transition, but I take your point :slight_smile:

Another risk could be befalling the fate of Logica (LOG), CMG, Sema and other IT project developers/consultants.

Old hands will remember such stocks were market darlings during the late 90s, but suffered badly when all the Y2K, Euro-conversion and telecoms work dried up post-2000.

All of a sudden they found themselves with lower income and lots of expensive IT employees with not a lot to do.

For KNOS and LOG as types of bespoke project-contractor/consulting businesses, revenue per employee is important.

For example, LOG’s accounts show revenue per employee was £69k for 1997, £77k for 1998, £80k for 1999 and £104k for 2000, then declining to £95k to 2001 and back to £101k for 2002:

So around 2000, employee ‘productivity’ peaked at LOG and in hindsight we now know the rapid growth phase of the 90s was over.

Looking at the options small print, the share price had rallied from 40p to £26 during the 90s:

I think the peak P/E must have been at least 153x.

Ok, so KNOS is not as madly valued as LOG was, but the risk may be the same: keep an eye on revenue per employee, as the employee IT skills are essentially what KNOS clients are paying for. If that ratio starts to falter, then maybe the growth phase may be ending.

SharePad shows this chart for KNOS revenue per employee:

KNOS rev per employee

Maynard

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Thanks, Maynard.

Thanks Maynard, that was very interesting, not least because it reminded me of frustrations dealing with Logica in a Telco between 1998 and 2001. My perception was that they were bureaucratic and really inefficient, staffed by people who weren’t very good. The suggestion of following turnover per employee is really good because that is where any change in the culture will show up

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