A recurring investment theme

Global economic forecasts remain mixed, uncertainty still pervades and the spectre of a double-dip recession looms over the UK economy. Against this backdrop, for small technology companies in particular, many threats to earnings exist. Clients, on the roster today or those being targeted by sales and marketing teams, are likely to defer project and investment spending as they pull in their horns. Alternatively, they may choose to place their business with lower-cost competition, as they implement a bout of belt tightening.

One canny way to insulate your portfolio from this earnings fog is to invest in well-managed technology and software companies that have placed strategic emphasis on growing their repeat revenue bases.

Thankfully, amid London’s quoted small-cap ranks, there are a number of attractive investment situations on offer – high-quality companies that trade on undemanding valuations, despite locking in reassuring and rising levels of repeat revenues.

K3: current valuation looks compelling
Despite strong pipelines of new business in both its divisions and the delivery of creditable 2009 numbers, AIM-quoted K3 Business Technology trades on a miserly multiple and is well worth a look at current levels.

Guided by livewire CEO Andy Makeham, K3 delivers Microsoft-based business software to retailers and manufacturers. During a tough 12 months to December, with K3 returning to growth in the latter half, sales grew by a creditable 5 per cent to £39.5 million, with pre-tax profits edging up from £5.9 million to £6 million. With cash generation strong at £8.92 million, net debt was pared 60 per cent to below £5.4 million.

Significantly, K3 continued to build earnings visibility, with recurring income and account management revenues increasing from 76 per cent to 79 per cent of the top line. ‘As the recession goes on, we are farming our customers better,’ the affable Makeham informed Growth Company Investor.

And despite the downturn, major new order wins were up 77 per cent year-on-year at £11.3 million (2008: £6.4 million). In manufacturing, where K3 boasts more than 1,000 clients and average deal sizes are increasing, operating profits rose 17 per cent to £4.26 million and the new deals pipeline is healthy. Recent profits progression in retail was temporarily interrupted, due to tough trading in Holland and delayed orders resulting in lower than expected services revenues, though a flurry of second-half wins, including GIVe and Dublin Airport Authority, leave the retail arm well placed.

K3 has also just completed two sensibly priced, profitable acquisitions, boosting its managed services abilities via the takeover of DigiMIS and acquiring Pebblestone Netherlands for up to e2 million (£1.79 million) in a move extending its fashion retail footprint.

Forecast to make £7.6 million pre-tax on £58.2 million sales for the 18-month period to June, giving 22.1p of earnings, the dividend-paying shares trade on a lowly five times earnings. That valuation looks inexplicably ungenerous.

Kewill: clinching new business
With handsome earnings visibility stemming from its strong recurring revenue base, Kewill, a counter with a Full List quote, is growing profits by providing software and solutions that simplify global trade.

Despite international downturn, Kewill, guided by enthusiastic CEO Paul Nichols and whose technological solutions deliver clear investment returns by simplifying supply chains, continues to clinch new business.

Its products are employed by more than 40,000 users worldwide, with customers ranging from Procter & Gamble and Nike to TNT and Vodafone, while recent business has been bagged with stellar names including Nokia, Lockheed Martin and warehousing group Steinweg. In a solid half to last September, Kewill grew sales 11 per cent to £27.2 million, despite a 20 per cent licence sales dip caused by customers delaying spending.

Underpinning the robust performance, however, was burgeoning recurring revenue, which Kewill derives from software-as-a-service (SaaS), hosting and maintenance and which rose strongly to £17.1 million (2008: £14.3 million) to account for a reassuring 63 per cent of turnover. Operating profits grew 25 per cent to £3.5 million, benefiting from management’s ongoing efficiency initiative, while the cash-generative concern upped the interim dividend 17 per cent to 0.35p.

A sure-fire beneficiary of a return to growth in global trade, Kewill can count on its repeat revenue base and also boasts something of a war chest – £7.2 million was raised at 92p in November – which it intends to use for acquisitions to capitalise on growing legislation in the area of international trade.

With analysts forecasting growth in pre-tax profits to £8.2 million (2009: £7.5 million) and in earnings to 9.5p (2009: 9.3p) this year, the shares, trading on an undemanding p/e of 10.4, are a strong buy.

StatPro: strength in SaaS
Another AIM counter with improving revenue visibility is StatPro, the Wimbledon-based provider of analytics and data to asset managers across Europe, South Africa and North America. By renting out its SaaS-based technology platform, StatPro, ably bossed by CEO Justin Wheatley, helps clients analyse their portfolio performance, risk and Global Investment Performance Standards (GIPS) compliance.

Calendar year 2009 financials beat forecasts, with pre-tax profits powering ahead 48 per cent to £6.9 million, benefiting from decisive cost cutting in 2008. Yet another strong cash performance – the firm has kept on paying dividends throughout the downturn – underpinned meaningful debt reduction and a 20 per cent dividend hike to 2.1p.

Turnover grew 13 per cent to £31.6 million, driven by healthy growth in software licences and data fees, though professional services revenues were weaker due to factors including pricing pressure. Significantly for investors, total recurring revenue rose 19 per cent to £29.4 million, swelling as a proportion of sales to a bumper and highly reassuring 93 per cent (2008: 89 per cent ) and further improving already excellent sales visibility, especially since average contract lengths span some 20 months.

Wheatley plots further expansion of this formidable repeat business base, with good growth expected from the newly launched StatPro Seven product this year and the forthcoming StatPro Revolution service set to boost the financials in 2011.

Broker Cenkos sees further profits progression to £7.6 million this year on £33 million sales, giving 9.5p of earnings and a likely dividend of 2.4p, with upgrades a distinct possibility. For 2011, investors might expect £8.8 million pre-tax, EPS of 10.1p and a 2.6p payout. Selling for 13 times prospective earnings, a multiple that falls to 12.2 next year, the shares should have much further to go.

Profitable moves from smartFOCUS
Less of a sure-fire bet, but worth a punt, is Bristol-based multi-channel marketing software counter smartFOCUS, which swung into profit in 2009. Sales moved 15 per cent higher to £11.9 million last year and smartFOCUS converted losses of £1.2 million into £500,000 of pre-tax profit, with one-off costs added back, a positive swing of £1.7 million. The company closed the year with a healthy £2.4 million in net cash.

Last year, the AIM-quoted venture experienced strong demand for its SaaS offering, driving ongoing development of the repeat revenue base. Specifically, recurring revenue grew 50 per cent to represent 66 per cent (2008: 50 per cent) of total sales, with performance underpinned by the retention of recurring revenue at more than 90 per cent.

Europe proved a geographic bright spot, with demand from new customers for email campaigns particularly strong, while further inroads were made into the US and other international markets, assisted by ongoing development of the group’s network of partners.

Dividend free and not particularly cheap – they sell for 19 times 2010 estimated earnings – smartFOCUS shares, up from last year’s 3.13p nadir at 12p, nevertheless offer good improvement potential.

Just the Tikit for upturn

Pre-tax profits at legal and accountancy software specialist Tikit may have declined by 29 per cent last year to £2.5 million, but the AIM-quoted concern has a good overall growth track record and says it has had an encouraging start to 2010.

Tikit, which supplies major UK, European and US law firms and accountancy practices, saw turnover slide 11.5 per cent to £25.2 million in the year to December. Chairman Mike McGoun blamed this on the deferral of capital projects by clients in the uncertain economic climate and on a switch to ‘subscription-based’ pricing for some of Tikit’s products.

Pre-tax profit was down significantly year-on-year at £2.5 million (2008: £3.5 million), though pointedly, this bottom-line performance was still ahead of downgraded forecasts. Having generated £3.5 million cash, Tikit, ended the period with £1.6 million net cash in the coffers and was able to maintain the annual dividend at 6p.

Despite pressure on profitability levels last year, McGoun believes the business put up a creditable performance awash with a number of positives. What should please investors is that recurring support and outsourcing revenues grew 10.2 per cent to £13.7 million to account for more than half of the business – 55 per cent of the total top line, up from 44 per cent a year earlier. Moreover, McGoun insisted that there had been a ‘positive customer response’ to Tikit-developed software.

Furthermore, a bout of timely restructuring removed some £1 million of annualised costs and, alongside a better product mix, drove a strong second-half improvement in operating margins from 9.1 per cent to 15.1 per cent.

Tikit, a one-time Growth Company Investor recommendation, is now much fitter, is strongly positioned for economic recovery and has the financial firepower to move on acquisitions. Based on forecast profits of £3.3 million and EPS of 17p, the income-generating shares look decent value, selling for less than ten times likely earnings. If you are already invested, then sit tight for recovery. If you have faith in the fundamentals, you might consider buying for a return to growth.