The Business

Kainos Group PLC is a Belfast based company that helps organisations with digital transformation. They offer consulting, tech solutions, and platform services, focusing on cloud systems, AI, and enterprise IT. They’re well-known for their work with government and healthcare sectors in particular, and are a top partner for Workday Incorporated, a popular US-listed, cloud-based HR and finance SaaS platform. Their services include modernising digital systems, agile software development, and creating smart solutions to make businesses run more efficiently. The company has three core departments: Digital Services, Workday Services, and Workday Products.

The company was founded in 1986 (which makes them slightly younger than me) and listed on the FTSE 250 Index in July 2015. In one of the more curious origin stories it was borne out of a joint venture between Fujitsu and Queens University Belfast’s Business Incubation Unit (QUBIS Ltd). It’s fair to say that Kainos Group’s share price performance has had some difficulties in the past few years, including a near 24% drop since a trading update earlier in the month was met with a distinct lack of enthusiasm. But was this reaction warranted? And if not, has a compelling business opportunity presented itself?

Key Figures & Performance

Market Cap: £1,082.25M	P/E: 22.64	Return Since Inception CAGR: 20.87%
Net Profit Margin: 12.7%	ROIC 5Y Avg: 52.78%	Levered FCF Growth 5Y CAGR: 31.27%
Net Income 5Y CAGR: 23.53%	Debt / Equity: 0.04	Dividend Yield: 3.12%

How I Found Kainos Group

If you’ve read any of my previous posts, you’ll know I generally screen for companies meeting certain metrics. These metrics act as a guideline for growth & performance, stability and quality of management within a business. Ordinarily I’d be looking for the following key figures, (though I will admit I have been tinkering with this recently):

• A return since inception greater than 15% (does the company have the ability to compound returns for investors)
• A 5 year CAGR of 15% or more on net income (has the company demonstrated high and sustained growth in income)
• Levered free cash flow growth of 15% CAGR over the past five years (does the company have the ability to generate and grow free cash for reinvestment into the business, acquisitions or share repurchases)
• A 5 year return on invested capital of greater than 15% (can the company generate good returns on the free cash reinvested into the business)
• A debt to equity ratio of 0.5 or lower (does the company operate consistently with little to no debt)

As you can see from the above table, Kainos Group PLC hits all these metrics, quite comfortably.

The Share Price

Let us first address the elephant in the room, the share price. As you can see from the chart above, the share price has fallen from a peak of £20.84 on 11th November 2021 to a price around £8.65 today. It won’t take a maths whizz to recognise that it has fallen by more than 50%, and has generally been trending down from that peak ever since.

Around November ’21, the valuation of Kainos looked very different. For example, the price-earnings ratio sat at 57.4 (current: 22.6), the earnings yield was 1.6% (current: 4.6%), the free cash flow yield was 1.3% (current: 6%) and the price-to-book was 26 (current: 7).

It appears to me that the company’s share price was run up to an unsustainable level, with a multiple expansion far in excess of its growth in financial performance, which whilst excellent, could not match this share price increase. It’s a familiar story of a growth stock being bid up to unsustainable heights, who are then in a situation where expectations are so high that any sign of underperformance is met with drastic price action response.

The Trading Update (02/09/24)

Which leads us on to their most recent trading update earlier this month, which you can read here. This release provided information from April 1st to date, and included an update to guidance for FY2025. Was it doom and gloom? Far from it. The most horrifying sentence came in the second paragraph:

“For the year ending 31 March 2025, the Board expects to deliver adjusted PBT in line with current market consensus forecasts, but due to the tougher trading environment in services in the financial year to date, expects only a small increase in overall revenues, which will be below current market consensus forecasts”

A dramatic decline in revenues? No. Loss of key customers? Nope. Any sort of scandal at all? No. Decrease in any projection of income or profitability? Nada. Since that release the share price has fallen by a further 11.7%, and for the life of me I cannot see why. Ok, the previous full year’s results disappointed, with single-digit growth compared to the double digits everyone had been accustomed to, but is this not a bit of an overreaction? Or is it a sign of things to come.

Now, reading further into the update we can get a better picture of the situation. The Digital Services division, which accounts for approximately 56% of revenues, has experienced a mixed bag in terms of progress. Healthcare has continued to grow, however other public sector and commercial areas have experienced delays over client caution around new project implementation. Irrespective of this, the company end on an upbeat note:

“Overall, there has been a subdued start to the year but expect to see revenue growth over the remainder of this year.”

The second division, Workday Services (~29% of revenues), is updated along a similar vein. Contract wins and values have been lower, and pricing has been more aggressive amongst partners. But again, they end on a positive note:

“…we expect a return to growth in the second half of the year.”

Lastly, the Workday Products division, accounting for around 15% of group revenues, is far more exciting. A new enhanced strategic partnership with Workday announced in July has proved a significant catalyst, leading to the group increasing expectations on annual recurring revenues by 100%, from £100m to £200m. The expectation is that this update will increase the proportion of revenue generated by Workday Products from the 15% reported in their last full-year results.

What I Like

From a financial and metric standpoint there’s a lot to like. The company has a proven track history, has managed to compound growth in revenues and income consistently over the past ten years, exceeding the average annual return of the FTSE All-Share Index. Management clearly have an aptitude for deploying excess cash effectively, generating consistently solid ROIC.

Kainos Group have built strong relationships with public sector and government departments, along with some absolutely massive corporations, including Netflix, Match.com, and Tripadvisor. Their client base is broadly split 50/50 between public sector/healthcare and commercial, with approximately 39% of customers based internationally. Customers are consistently happy with the service they receive, leading to Kainos having an average Net Promoter Score of 58 (generally anything above 50 is considered ‘excellent’).

As mentioned above, the latest trading update increasing their ARR target to £200m in the Workday Products section of the business has the potential to meaningfully improve the profitability of the company. 18 months ago the ARR was £49m for the same department, highlighting the strong growth it’s creating. With last FY revenues of £382.4m, a £200m ARR would result in FY revenues of £525m, a 37.3% increase. This assuming the Digital Services and Workday Services didn’t grow at all.

What I Don’t

The most obvious concern relating to Kainos is it’s reliance on another company, Workday, Inc. Workday are a publicly listed US based organisation, founded in 2005, with a market cap of $67.46B. Accounting for 44% of revenue, Kainos relies heavily upon their Workday Services and Products arms, and is therefore reliant on the continued success of the larger company in its business operations. Having looked at Workday, however, my concerns are somewhat assuaged. It appears to be well-run, with little to no debt, consistent free cash flow generation and evidence that heavy investment in R&D is bearing fruit for the business. If one were to look at the valuation of the company, one might argue it is overvalued at present, however this bears little direct correlation to the success of the business itself. It is also firmly established, with a large customer base of corporate, medical and state clients.

The other pervasive issue dominating my newsfeed on a daily basis is the disruptive potential of A.I, and what the impact of an adoption of generative A.I. will have on service and software based companies. I am by no means well versed in the intricacies of this debate, however one thing I feel reasonably confident about is that those businesses that will succeed will be the ones curating and nurturing GenAI into their working practices, using it to add additional value and growth. Reading Kainos’ H2 ’24 update, a separate segment is given to the £10m investment they have made into GenAI, reflecting on the statistic that over 30% of their projects are using some sort of A.I. co-pilot. They were also Microsoft’s first UK Services Partner award winner in 2023, and are a Premier tier AWS partner. Suffice it to say, they are taking A.I. seriously.

Discounted Cash Flow Valuation

No write-up is complete without a look at the potential intrinsic value of the company, and its relationship to the current share price. As you may now be aware, I like to conduct a discounted cash flow valuation exercise on every business I look at, and use similar inputs each time. If you’d like to read about this methodology in more detail, I’d suggest reading my previous article here.

1. An average of the last five years free cash flow generation. For Kainos, this is £47.22m
2. A calculation of the compound annual growth rate in net income over the past five years. Kainos has compounded at 27.2% a year.
3. An expectation that growth can continue at this pace for the next ten years, falling to a terminal growth rate of 3%.
4. I use a discount rate encompassing the 10 year Gilt yield, currently 3.8%, PLUS an equity risk premium of 7%, equivalent to the long term return on the FTSE 100 index. This brings the discount rate to 10.8%

Conclusion

Putting these calculations together, I arrive at an intrinsic per share value of £31.49. Compared to the current market price of £8.74, this represents a healthy discount to perceived true value, equating to a 21% annualised share price return. I will, as I always do, caveat this to say that it is purely my interpretation. Amendments to any one figure would change the output, and that you must do your own research. I don’t use the DCF to give me an exact per share value, nor do I expect it to meet said value. What I do use it for is to ascertain whether there is an appropriate margin of safety in any potential investment.

In this case, I think there is, and I’m buying.

I’d love any feedback or comments on my interpretation of the business. Leave a comment below, or find me on X @X.com/britishinvestor or Bluesky @britishinvestor.bsky.social. If you enjoyed this post, please consider sharing it on the platforms above.

Happy investing!

Chriss

P.S. I’m a recent convert to Finchat.io, an A.I. assisted financial screening and share database. Take a look via my referral link here.