K3 Business Technology Group

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1 Gareth Evans,, ACA Bob Liao, CFA Sammer Khatlan BUY KBT : AIM : 217p TARGET PRICE: 290p Inside Executive summary... 3 Valuation and Recommendation... 5 Existing business... 6 Managed Services / Hosting...11 Evaluating the potential...15 Financial summary...19 Investment risks...20 Please note: we are transferring lead coverage of K3 Business Technology Group to Gareth Evans. Technology -- Software -- Software and Services K3 Business Technology Group Delivering the cloud today K3 is still a successful reseller and integrator of software The group has enjoyed a strong period of profitable growth from both the Retail and Manufacturing divisions. We expect the Panacea and FD Systems acquisitions to become material contributors to the group moving forward. but it has now added a material managed services strength K3 has been investing for some time in its managed services/hosted offerings, which are now beginning to bear fruit. This division is already managing and hosting business software platforms for customers, beginning with the software that K3 resells and including K3-developed modules. The service is now extending to other third-party software, as well as desktop, server and security environments. Managed Services value in profits, and also as a signal We believe this Managed Services development is valuable in three ways: 1. the revenues and strong margins will add usefully to group profits, driving organic growth from existing customers; 2. managed services customers will be even less likely to churn away than other ERP software customers; and 3. it demonstrates that K3 is significantly more than a reseller it understands its customers businesses well and materially augments the IP in the software. We remain BUYers despite the recent strong run We believe upside to forecasts is possible as Managed Services takes flight the group has many essentially captive customers and should earn good revenues as these are migrated towards hosted or cloud-based offerings. Equally, within the core business, IKEA looks poised to increase its level of spend on K3 systems. Either of these developments could drive earnings upgrades and multiple expansion may follow. We recommend BUYing the shares ahead of these possible developments. We upgrade our target price from 230p to 290p (based on a P/E of 10 times FY12E EPS). This research note is produced by Canaccord Genuity Limited which is authorized and regulated by the Financial Services Authority (FSA). This is non-independent research and a marketing communication under the FSA F Conduct of Business rules. Please see the Important Disclosures section in the appendix of this note which are an integral part of it or visit Canaccord Genuity s Online Disclosure Database for more information. 6 June

2 2 Company Statistics Price Chart 52-week Range: 112p Avg. Daily Vol. (000s): 32 Market Cap (M): 56 Shares Out (M): 26 Share price data COB 1 June Earnings Summary FYE Jun 2010A 2011E 2012E Revenue (M): EBITA (M): Pre-tax Profit (M): Adj basic EPS: Dividend per Share: Net (Debt)/Cash (M): (11.0) (14.5) (10.3) EV/EBITDA (x): Adj P/E (x): Dividend Yield (%): Company Description K3 is the UK's market-leading supplier of Microsoft-based supply chain management solutions to SMEs. The company is focused on two verticals: Retail Software (some 60% of sales) and Manufacturing Software (the residual 40%). 75% of sales are to the UK and just over 40% of revenues are recurring. K3 Business Technology Group 6 June 2011

3 3 EXECUTIVE SUMMARY Managed Services is key to unlocking the value of K3 s position The K3 investment case is, in our view, moving forward rapidly. The group continues to command leading positions in the UK markets for reselling and integrating accounting and ERP (Enterprise Resource Planning) software. This provides a profitable platform in its own right, and pockets of valuable organic growth. In addition, K3 is monetising its intellectual property and know-how not only through vertically-targeted enhancements to off-the-shelf software, but through horizontallyprovided hosting and managed services. K3 works on behalf of customers to run and maintain software and IT systems, both those based on K3 platforms and others. This enhanced position in the market place is depicted in the diagrams below. Figure 1: Before and after Managed Services ERP Software Platform ERP Software Platform Customer Business Process Knowhow Code Customer Business Process K3 Sector Knowhow Code K3 Business Technology SYSPRO Sage SYSPRO Sage Microsoft Microsoft Source: Canaccord Genuity Limited and K3 Business Technology Group This Managed Services adjunct is useful, in our opinion, in three ways: 1. Managed Services will provide material incremental revenue, at good gross margins and with good recurring revenue potential. 2. By offering such hosting and broader services, K3 will be able to reduce the (already low) levels of churn within its existing software customer base managed services will make existing customer relationships stronger and more enduring. 3. For investors, the advent of Managed Services within the group is a major signal and endorsement of the group s standing with its customer base, and the true value of its incremental in-house IP. Managed Services and hosting could, in theory, be offered by a number of different providers that customers appear willing to entrust this crucial service to K3 almost proves that customers value and respect the group s know-how a proof that previously we have been unable to test. Managed Services, in a sense, validates and confirms the value of the rest of what K3 has been doing for many years. 6 June 2011 K3 Business Technology Group

4 4 Managed Services upside only partly in the numbers In the section Evaluating the potential on page 15, we attempt to measure the financial potential of Managed Services to K3 in P&L terms. We calculate it could add some 3 million of revenue and 0.75 million of adjusted PBT (assuming long-run margins of c.25%). This could, over a number of years, take EPS from 20p to c.30p and beyond. While the company is taking its first steps in the Managed Services journey, we believe it prudent to discount the potential impact and, therefore, have not assumed all this Managed Services upside in our published forecasts, which incorporate revenue growth of around 2 million per annum. For FY11, we assume no major profit upswing as most of the benefits are being ploughed back in terms of additional capacity and sales force. Valuation and recommendation K3 is a relatively complex mix of assets some that mainly resell and support ERP software, others that have significant levels of in-house intellectual property, and lastly Managed Services, which is evolving a cloud-based hosting platform for mid-market users of software of almost all types. Key strengths of the group, in our opinion, include: A strong and consistent vision, well delivered over many years a profitable and cash generative group, with roughly 80% of revenues either contractually recurring, or repeat business from existing customers. A professional management team, capable both of sourcing and acquiring ERP customer bases and of delivering enhanced revenues and margins over time. Strong market position the UK s #1 Microsoft Dynamics partner, and a fastgrowing position in Sage software. In the section below, we present a peer group of UK Software & IT Services stocks. Taking this into account, alongside what we believe to be cautious near- and mediumterm estimates and the group s strong market position, we believe a target P/E of c.10 times our FY12E EPS is appropriate suggesting a target price of 290p. This equates to an EV/EBITDA of c.8 times our FY12 forecasts, which again, given the peer group and the group s position and material opportunities, feels achievable to us. K3 Business Technology Group 6 June 2011

5 5 VALUATION AND RECOMMENDATION In the long term, we expect K3 s valuation to be driven by two factors: 1. the degree to which the group is able both to effectively acquire additional customer bases at reasonable cost, and to migrate portions of these customer bases towards managed services offerings; and 2. the degree to which the group s proximity to customers allows it to derive enhanced margins across a broader swathe of its activities. This ties into our view that hosting and management of software, in particular the granular understanding of customers enterprises required to do this, will become steadily more valuable relative to simply writing the code. Therefore, we will look to evolve a full sum-of-the-parts valuation model for the group, with discrete figures ascribed to in-house IP, reselling of third-party software and to Managed Services. For now, the divisional disclosures are only slowly allowing a detailed analysis of the performance of these different units, and none has the clear track record to allow discrete analysis and valuation. Therefore, we look to overall group metrics to derive our target price and, from that, our recommendation. The UK Software & IT Services peers are shown below. Figure 2: Peer comparison EV/EBITDA EV/Op Profit P/E Software and IT services Rating Price (p) MV C2011E C2012E C2011E C2012E C2011E C2012E 6M Revisions Anite Group plc 1 Buy % Autonomy Corporation plc 1 Sell % Aveva Group plc 1 Hold % Computacenter NR % FFastfill plc 1 Buy % Fidessa 1 Buy % Kofax 1 Buy % Logica 1 Buy % Micro Focus International plc 1 Buy % Misys 1 Buy % Phoenix IT NR % RM NR % Sage 1 Buy % SDL 1 Buy % Median % K3 Business Technology Group Buy % Source: Canaccord Genuity Limited estimates 1, Bloomberg. NR = Not rated. We believe that a reasonable multiple for the group, over the coming 12 months, would be a P/E of c.10 times and an EV/EBITDA of c.8 times. These figures suggest a target price of 290p and would still represent a material discount to the peers shown above. 6 June 2011 K3 Business Technology Group

6 6 EXISTING BUSINESS A brief history K3 was established through the acquisition of a division of Kewill in 2000, which was then reversed into the LSE via RAP Group plc in March The strategy has been fixed with the intention being to build a major, UK-focused solutions provider into the Manufacturing, Distribution and Retail segments. Figure 3 depicts the various major events since 2001, describing for acquisitions the key knowhow or customer set that each brought to the group, along with consideration paid and revenue and EBIT figures where disclosed. Figure 3: Table of acquisitions Date Company Initial Consideration m Sales m Profits m 2000 December Kewill Systems (UK Division) October Alpha Landsteinar June IEG March MBL September Landsteinar Nederland December Index March DigiMIS March Pebblestone June Pebblestone IP November Panacea December Sage March Sense Enterprise March Clarita Solutions Source: Company RNS Total Organic Growth Forecast 2012 performance Augmenting its continual process of adding customer bases and product know-how, the group made, through the acquisition of Digimis in 2010, a significant step towards a faster expansion of its Managed Services business, which we expect to show significant growth in coming years. Management team and focused strategy The group has been delivering against a clear and well-enunciated strategy for several years to acquire (at low cost) ERP software customer bases, to sell new software when practicable, to own material amounts of in-house IP, and to drive strong margins and shareholder value by cross-selling and up-selling to the acquired base. We do not seek to provide a complete ground-up description of the group in this report, so we do not repeat management biographies here, save to note the management team has significant relevant experience for the ERP software segment, and that under its control the group has delivered solid EPS growth over many years. K3 Business Technology Group 6 June 2011

7 7 Software platforms Figure 4 depicts the various software platforms that K3 sells (and customises). The group provides platforms mainly based on Microsoft technology, on SYSPRO (which is itself grounded in Microsoft) and, at the lower-end SME range, Sage. Figure 4: Software platforms MS Dynamics AX EN TERPRISE Customer Scale Retail MS Dynamics NAV Manufacturing SYSPRO MID RANGE Sage SME Source: Canaccord Genuity Limited research K3 s specific market positions (in Retail and Manufacturing) are supported by verticallytailored versions of Dynamics NAV and SYSPRO respectively, as shown in Figure 4 above, and in greater detail in Figure 5 overleaf. Overall current structure The group is, following the various acquisitions described above, and driven by organic customer wins, positioned as shown in Figure 5 below, which depicts the markets addressed, the ownership of software intellectual property, the delivery of services and the underlying relevant software platforms. 6 June 2011 K3 Business Technology Group

8 8 Figure 5: IP and Services Manufacturing Distribution Retail Ax Ax Ax Main software platform Enterprise Fresh Dynamics Feedax Fresh Dynamics Feedax Multi Channel Retail Ax Owned software Index, Sense Enterprise Acquisitions SYSPRO NAV NAV Main software platform Mid-market [in-house] Pebblestone Alpha Landsteinar Multi Channel Retail NAV Owned software Kewill division, IEG, MBL, DigiMIS (Hosting) Pebblestone, Panacea, Clarita Alpha Landsteinar, Landsteinar Nederland Acquisitions Sage Sage Sage Main software platform Entry level Owned software FDS Panacea, FDS FDS Acquisitions Managed Services Remote Desktop Backup / Storage Network Monitoring Hosting Server Management Source: Canaccord Genuity Limited research The next two sub-sections describe the existing sector vertical units Manufacturing, and Distribution & Retail. The sections that follow describe Managed Services in more detail and attempt to quantify the opportunity that the group sees in that segment. MANUFACTURING SYSPRO background SYSPRO is a global software platform, based on Microsoft Dynamics technology, but very much tailored with SYSPRO intellectual property and targeting the manufacturing segment. SYSPRO has strong functionality for areas such as demand and lead time management, product design and production planning, quality control and standards and conformance. SYSPRO has, we understand, some 14,000 customer sites but it is a privately held business, so it is difficult to gain a clear view of which are the more material market segments, but it appears that consumer durables, food & beverage and machinery & equipment are all major sectors. K3 and SYSPRO K3 has become the exclusive SYSPRO distributor into the UK market, through a number of acquisitions since 2005 as shown in Figure 4. K3 enjoys a strong relationship with SYSPRO at a senior level, and the two companies clearly work well together to provide customers with strong software platforms on which to run their businesses. K3 Business Technology Group 6 June 2011

9 9 Recent performance Manufacturing, as a division, had a difficult H1 FY11 (to December). Revenue fell yearon-year from 9.9 million to 9.4 million, and adjusted EBITA also drifted from 3.6 million to 3.3 million. Average contract sizes fell, and even annual recurring revenue fell back compared to the prior year. New business wins were generally smaller in scale ( 100k versus 200k or 250k deal size historically), and were harder to win, with higher bid costs and more protracted processes. Although none of these trends look likely to reverse in the near term, at least margins appear relatively stable, and we would expect the group to benefit as the Manufacturing sector stabilises moving forward. Aside from SYSPRO, Dynamics AX has also seen significant deal slippage, but the pipeline overall is roughly the same size as in the prior year, and the group has managed to obtain a strong reference site in Murray Metals. Hosting potential We discuss the SYSPRO hosting opportunity below. K3 has announced a global deal with SYSPRO, through which K3 will provide hosted solutions to any SYSPRO customer, regardless of geography, in conjunction with SYSPRO and the local integration partner. RETAIL Software platforms and divisional history K3 mainly sells MS NAV (historically Navision). The group s Retail business has evolved over a number of years, with the original acquisition (in 2004) of Alpha Landsteinar, the purchase and subsequent disposal of Elucid, and the 2007 acquisition of Landsteinar Netherlands, which brought with it the IKEA IP and contract saw the acquisition of Pebblestone (which owns IP for fashion distribution). The retail unit, which includes Distribution (described separately below), has a strong multi-channel offering, giving retailers a full suite of software platforms for the three main aspects of most businesses: in-store merchandising management, management information (MIS) and logistics; mail order, warehouse management and catalogue information systems; and online ecommerce offerings, website database population and links to logistics Recent performance The Retail business has, like the Manufacturing segment, been suffering from difficult end markets in recent periods H1 FY11 sales were some 12.6 million, down from 13.3 million in the prior year. Margins, however, have expanded as the group has migrated mix of sales towards owned IP. IKEA and Managed Services potential There are, in our opinion, two key positives to the K3 retail presence, other than simply the opportunity to grow revenues over the long term by reselling (and owning some) software relevant to the segment. 1. The IKEA contract is a major opportunity the group provides the software that is mandated for use by IKEA s franchisees in every country where IKEA operates an 6 June 2011 K3 Business Technology Group

10 10 indirect franchise model. The potential here is two-fold: firstly, as IKEA adds additional geographies, this is likely to increase K3 s market opportunity; and secondly, there is always an outside chance that IKEA could start to use K3 s solution (or parts of it) in countries where it operates directly. We understand K3 s product compares well with IKEA s own in-house platform, so this potential is not entirely blue-sky. 2. Retail customers operate (generally) a large number of sites with relatively limited IT resource on each site, and with significant requirements of their group-wide ERP systems to report sales information, manage inventory levels, support efficient distribution and so on. Retail customers, therefore, rely heavily on their ERP integration partner (K3) and have a large number of low-it-resource sites: they are, in our view, prime candidates for Managed Services cross-sell. DISTRIBUTION History and where it fits in the group The distribution know-how within K3 has been built up over a number of years and in a number of ways: most retail operations have some degree of distribution or warehousing component, so the Retail division has evolved a distribution knowledge simply as part of doing business. The specific areas of distribution know-how are as follows: Pebblestone, acquired in June 2010, owns software IP in wholesale fashion distribution, based on MS Dynamics NAV. Panacea, acquired in November 2010, was a reseller of MS Dynamics NAV with a number of distribution customers (although Sage and managed services also figured strongly in Panacea s sales). Sense, acquired in March 2011, added a number of MS Dynamics AX high-end distribution customers. Clarita, acquired in March 2011, like Panacea, resold MS Dynamics NAV but historically was also a reseller of the Pebblestone IP (which is already owned by K3). Despite these multiple instances of acquired distribution knowledge and IP, distribution has not historically been a separate unit within K3 distribution-related elements have been, generally, found within the Retail division. Going forward, however, the unit plans to have a specific and clear focus on the Distribution opportunity. Given that most distribution businesses relate to some kind of retail operation (either directly as part of a retailer, or as a standalone distribution company with many retail customers), it is logical that Distribution remains within the Retail unit, but it will now be managed as a business unit in its own right. Like other areas of the group, the core strategy for evolution of the Distribution customer base is clear: the group can acquire large numbers of customers relatively cheaply through acquisition (and has done so already), and there will be value in the provision of Managed Services into this base. K3 Business Technology Group 6 June 2011

11 11 MANAGED SERVICES / HOSTING K3 has, in our opinion, a major opportunity to grow and develop a material business in the provision of Managed Services and hosting. Importantly, this hosting is not primarily the hosting of websites for internet traffic (web hosting) but rather the upkeep and management of in-house IT platforms and systems that can then be accessed by users (both internal and external to an organisation) as if they were being run by the in-house IT department. K3 refers to Managed Services as on-customer-site control of a platform or solution by K3 remotely, and Hosted as a server in one of the K3 data centres running a software platform for access by a customer or other third party. We discuss the Managed Services potential at K3 with regard to the ERP packages (Microsoft Dynamics, SYSPRO and Sage), and with regard to K3 s own specialised intellectual property elements developed alongside (above or around) the ERP systems. We also consider other (non-erp) platforms where K3 s customer relationship may allow it to manage and/or host various third-party systems and services even if these are relatively remote from the core K3 ERP centre of gravity. ERP PLATFORMS SYSPRO SYSPRO is an ERP platform written in Microsoft technology, but which is specifically designed for a manufacturing environment. SYSPRO, globally, has some 14,000 customer sites across 60 countries, and K3 is the UK distribution partner for SYSPRO. As announced in February 2011, K3 is SYSPRO s chosen partner for global managed services / hosting implementation. The deal, which technically is to deliver SYSPRO Business Live, is for a three-year term and is a worldwide exclusive deal. Following this announcement, any of SYSPRO s customers, anywhere in the world, requesting a hosted implementation of the platform, will be offered a K3-hosted environment. We would anticipate the most material opportunities arising in the US, Canada and Australia. We see this as a major development for two reasons: firstly, there will be material and ongoing financial implications for K3; and secondly because (like the more general managed services dynamic from the K3 customer base) it is a major demonstration of belief in the K3 intellectual property and know-how. We discuss the financial implications of the SYSPRO relationship in the next section Evaluating the Potential. For now, suffice to say, we believe the potential could be several million pounds of revenues, with high gross and operating margins. Microsoft Dynamics K3 has also rolled out a hosting platform from the managed services delivery of Microsoft Dynamics. Dynamics NAV is being hosted for a small number of pilot customers prior to general release. Such hosted platforms are particularly attractive to new or fast-growing companies the group has signed Boux Avenue, a new online and high-street retailer that was attracted by the low upfront cost, predictable pricing that scales with the customer, and ease of use of the hosted offering. In this way, the group is not only harvesting its existing 6 June 2011 K3 Business Technology Group

12 12 customer base for Dynamics hosting potential it is also using its hosting credentials to win new Dynamics customers outright. Sage The group has announced that it intends to host Sage products, but rather than adopting the Sage strategy of selling NEW hosted systems (such as Sage X3), K3 will instead focus on the hosted delivery of EXISTING (and incumbent) Sage platforms. The acquisitions of FDS and Panacea brought good numbers of Line 200 and Line 500 Sage customers into the group, and there will, we believe, be a good opportunity to offer managed services to this customer base in due course. K3-developed intellectual property In addition to the third-party software from Microsoft, SYSPRO and Sage, K3 has developed a sector-specific implementation code for a number of its areas of expertise, such as the Fresh Dynamics platform for food producers. The group is, as one would expect, hosting these systems alongside (and as part of ) the main ERP implementations. K3 is also hosting an Epicor platform (which it did not sell) for one customer where this was part of a broader requirement. We believe this again demonstrates that the group is credible not just in hosting products it has sold, but also more broadly. NON-ERP SYSTEMS & PLATFORMS Outside of the hosting of ERP software platforms (and the associated K3- or SYSPROdeveloped intellectual property), there is clearly an opportunity for K3 to earn additional revenues through the hosting and managed service delivery of other areas of customers IT needs. This area of the business should be considered in two stages: 1. Why should K3 have any divine right to be the provider of services in areas apparently unrelated to ERP software provision? 2. Which areas are most likely to be susceptible to this type of up-sell or cross-sell? We leave discussion of the financial potential of this additional hosting opportunity (and its potential timeline) to the next section, where it naturally fits with the core managed ERP hosting financial analysis. 1. Why should K3 have any credibility in hosting non-erp systems? Figure 6 below, in our view, holds the key to this: K3 is, for many of its mid-sized corporate customers, the only external party that is likely to have had any material interaction in terms of the detail of a customer s business model, its foibles, way of doing business, and (most critically) exposure to its senior decision-makers, both inside and outside the IT department. K3 Business Technology Group 6 June 2011

13 13 Figure 6: K3 is almost the only integrator in the frame for a Managed Services deal Integrated K3 Customer Sector Specific Software Off-the-shelf software Server Management & Hosting Desktop Management Network Management & Hosting Phone System & Data Comms ERP MS Outlook Databases MS Exchange CAD/CAM MS Office Process Control Web Filtering Antivirus Source: Canaccord Genuity Limited research The group is already hosting the types of systems and platforms shown below, for active customers in production environments. We see the rapid move to this position as a major achievement, and look forward to continued growth at (we expect) good ongoing margins. Microsoft Exchange, SQL Server Anti-virus and web filtering platforms Desktop and server support Storage / mirroring Disaster recovery with online backup & restore Local / Wide area networks (LAN / WAN) Granted, other providers may already be offering (or providing) desktop support, hardware break-fix or telephone systems (VoIP or other) but few of these systems will have required major tailoring to the customer s requirements for their initial implementation. This means that, in our view, the customer proximity to K3 is significantly greater than that of any of the other obvious aspirants to the prime outsource role in the delivery of managed services. Outside the realm of current providers (i.e. those shown in Figure 6), there is a raft of other parties who would in some ways like to be seen as capable of delivering a full outsource. Microsoft, IBM, HP (EDS), Google and Amazon are all making major moves towards hosted offerings, cloud platforms or other managed service portfolios. We contend that these global giants would face major difficulties in providing such services to small and mid-market customers, for a number of reasons: 1. They lack the ability to address small customers cost effectively, unless via a channel (of people like K3) - when did you last think of calling Microsoft s helpline to assist you with a query in MS Word, and how much support is a 25-person company from Dagenham likely to receive from HP? 6 June 2011 K3 Business Technology Group

14 14 2. They tend to provide one-size-fits-all products and rely on local partners to localise and tailor them, both for different geographies and different vertical markets. 3. US organisations, in particular, may be subject to Patriot Act issues requiring them to hand over third-party information to the US government under certain circumstances regardless of the customer s global location this may be unpalatable to UK or European businesses. 4. Most of these players are aiming to offer some but not all the services required by a typical SME and SMEs, like larger groups, are keen to reduce the number of suppliers with which they deal. We therefore believe that K3 has at least a fighting chance of becoming the provider of a number of non-erp managed services. 2. Which areas are most likely to be successful in this regard? At this stage, we think it is difficult to determine which areas are most likely to be offered up by customers as part of the menu of managed services uptake. We suggest the points below might give some indication, based on the type of service, the likely propensity for customers to outsource (based on cost savings, business benefit and security), and the ability of K3 to credibly offer such products or services. 1) ERP system 2) WAN for helping ERP implementation 3) LAN as customer end of the WAN 4) Storage and servers as major components of the LAN 5) Desktop, MS Exchange, web filtering and anti-virus etc The group has, to date, found that the ERP system is normally the first element, or the catalyst, for a conversation, and other elements in the list above tend to migrate towards K3 as their existing provision contracts reach a renewal or renegotiation date. K3 Business Technology Group 6 June 2011

15 15 EVALUATING THE POTENTIAL We are naturally cautious of the timelines surrounding uptake of managed services and hosted offerings: therefore, we consider aspects of the timing first, and only then run the numbers in terms of potential upside for K3. Our caution on the timings, naturally, drives what we believe to be a prudent level of uptake assumed over time. REASONS WHY NOW MIGHT ACTUALLY BE THE TIME Businesses have been vaunting the prospect of Managed Services for many years, under a variety of different names, and delivered in a number of different ways remember the client/server model and Application Service Provision? In some ways, these technologies have been available, in subtly different forms, for a long time in other ways, they are really only now coming of age for four specific reasons. 1. Data connectivity it is only in the last few years that most businesses have been able to obtain, cheaply, significant and reliable bandwidth on a broad enough basis to allow widespread adoption of services that require an always-on internet connection. 2. Software and hardware configuration partly as a result of the connectivity improvements, and partly through natural evolution, there have been major steps forward in the implementation of hardware solutions and software platforms for delivery to remote customer sites the server developments from VMWare, and the data centre aspirations of players such as HP and Cisco for hardware, and Microsoft and Google for software have all helped in this regard. 3. Psychology probably the most important of the four, as we believe there is a fundamental shift currently underway in corporate managements thinking. Webmanaged platforms are reliable in the home (think Hotmail, Facebook, itunes, shared web-based photo albums, etc), so why is all office-based computing confined to local programs and files stored on shared network servers? Further, there is a growing acceptance that, in the absence of web and connectivity, a business cannot function realistically anyway. 4. Hosted CRM C is here is hosted ERP next? Hosting of customer relationship management (CRM) solutions has become the de facto standard with salesforce.com arguably blazing the trail and transforming the market segment; Netsuite is proof perhaps that salesforce.com was not a one off. Sales force automation was, with hindsight, an obvious early-adopter of cloud delivery, given the importance of seamless information flow, the mobile nature of the workforce and the relatively low level of integration needed with other platforms. ERP head office and production systems are naturally arriving later to the party, but they will arrive eventually, driven by cost and flexibility. 6 June 2011 K3 Business Technology Group

16 16 RUNNING THE NUMBERS SYSPRO HOSTING Figure 7 shows the potential scale of the SYSPRO opportunity, both in the UK and overseas. UK We consider K3 s UK customer base, where the group has been, of its own accord, pushing to manage and host customers existing SYSPRO systems. Figure 7 suggests that, if 3% of the UK base migrates each year, then 1 million of new (recurring) revenue could be generated each year. This UK expectation appears realistic given the Current position, which we highlight in the right-most column. Around 5% of K3 s UK SYSPRO customers has migrated to the hosted platform over the last two years or so and this group is contributing, today, some 1.6 million of revenue per annum. We would anticipate the rate of addition of customers, and their average spend, to increase over time as the group targets larger customers and has a broader range of services on offer. Global hosting The Global hosting section illustrates the potential for K3 if other SYSPRO resellers in other geographies take up K3 s offer to host the existing software platform essentially the overseas analogue of the UK existing position. In Figure 7, we assume only 1% of the globally roughly 7,000 sites migrate per year again adding around 1 million per year of new and then recurring revenue. Global SYSPRO Business Live This section of Figure 7 relates to the recently-announced new software platform from SYSPRO, which will be a hosted-only solution, and will be managed and hosted by K3 for new SYSPRO customers globally. This new offering is targeting incremental customer wins for SYSPRO, although we model it only cannibalising the existing SYSPRO base. Given that K3 will be responsible for all hosting of this product, any material success on SYSPRO s part should drive significant revenue for K3. Overall we believe that between the UK and international hosting opportunity for the existing SYSPRO range, and the new Business Live initiative, there is potential for a realistic 3 million per annum increase in K3 s revenue. For the avoidance of doubt, this figure is not fully reflected in our published forecasts, which assume just around 2 million of revenue uplift from managed services between 2012 and K3 Business Technology Group 6 June 2011

17 17 Figure 7: SYSPRO managed services revenue potential Total Potential annual increment Current UK - hosting K3 customers % 5.4% Customers taking Managed Services Revenue per customer per annum (all K3) Total UK customer revenue ( k) 1,084 1,610 Global - hosting Total customer sites 7, % Customers taking Managed Service 70 - Revenue per customer per annum 50 K3 share 33% K3 revenue per customer per annum 17 Total ex-uk K3 revenue ( k) 1,155 - Global - SYSPRO Business Live (Software as a Service) Potential customer uptake (from SYSPRO customer list) 1.0% Customers taking new SaaS platform - Business Live 70 K3 hosting fee per annum 10 Total SaaS K3 revenue ( k) 700 Total SYSPRO Potential incremental revenue growth ( k) 2,939 per annum Source: Canaccord Genuity Limited estimates Figure 8 shows some revenue sensitivities to demonstrate the variance in revenue resulting from actual performance deviating from our base assumptions. Figure 8: Sensitivity analysis revenue impact k revenue impact UK For every 1% more/less uptake pa 361 For every 10k revenue per customer pa 127 Global - hosting For every 0.5% more/less uptake pa 577 For every 10% K3 share of revenue 231 For every 10k revenue per customer pa 350 Global - SaaS For every 0.5% more/less uptake pa 350 Source: Canaccord Genuity Limited estimates, company information Figure 9 depicts three different scenarios: Scenario A which corresponds to the assumptions in Figure 7 Scenario B which has more optimistic assumptions for UK and global hosting uptake Scenario C which assumes half the base level of assumed uptake, and at lower revenues per customer, which still suggests a 1.3 million revenue increase per annum 6 June 2011 K3 Business Technology Group

18 18 These scenarios again suggest to us that our forecasts for Managed Services, and the group as a whole, should be cautious. Figure 9: Scenario analysis Scenario A B C UK customer uptake pa 3.0% 4.0% 1.5% UK revenue per customer pa ( k) Global hosting customer uptake pa 1.0% 2.0% 0.5% Revenue per customer pa ( k) K3 share 33% 33% 33% SaaS platform customer uptake 1.0% 2.0% 0.5% K3 hosting fee ( k) K3 revenue uplift per annum ( k) 2,939 5,155 1,258 Source: Canaccord Genuity Limited estimates, company information Retail and Sage currently excluded from our forecasts Our SYSPRO numbers include nothing for the Retail or Sage customer bases, which could also supply material revenue upside. We will analyse and model these opportunities once the group has more of a developed track record in delivering managed services around these platforms, and when more detailed financial metrics are available. While the UK SYSPRO customer base provides a major source of potential managed services customers, we believe the Retail customer base is also highly susceptible to the managed services approach. We think Retail customers are likely to value a hosted or remote solution (given their normally large number of locations with relatively low IT skills at each site), but the flipside is that Retail customers are, relatively, less demanding in terms of customisation and bespoke hosting delivery than their Manufacturing sector counterparts. So it may be that Manufacturing customers are slower to outsource, but tend to stick close to their ERP provider (in this case K3) for the delivery of managed services. Retail customers may be more likely to consider other providers (given their lower level of ERP customisation) but are also more likely to enjoy the benefits of outsourcing in the first place. Summary of Managed Services upside potential for K3 1. We believe UK hosting of SYSPRO (existing software) alone could generate a revenue increase of 1 million per annum revenue that recurs annually as long as the customer is using the software. 2. International opportunities (hosting existing systems and the new Business Live platform) could add another 2 million per year of growth in recurring revenue. 3. The potential for providing managed services or hosting in relation to MS Dynamics (AX or NAV), or Sage, could add materially to this already significant potential over time. 4. We have assumed only growth of c. 2 million between FY12 and FY13 in our published forecasts for the group. We believe these forecasts will, in time, prove cautious and that there could be scope for upgrades. K3 Business Technology Group 6 June 2011

19 19 FINANCIAL SUMMARY Figure 10: Financial summary Y/E June. m, except per share data E 2012E 2013E PROFIT & LOSS Sales Gross Profit EBITDA Depcn & Amort of capitalised development (0.5) (1.0) (1.4) (1.7) (1.9) Adjusted EBITA Other income etc Interest income / (expense) (1.4) (0.8) (0.9) (0.7) (0.6) Adjusted PBT Amortisation of acquired intangibles (2.0) (2.6) (2.5) (2.5) (2.5) Other non-operating 0.0 (0.1) (0.5) Taxation (1.0) (1.0) (1.3) (1.8) (2.1) Net Profit Adjusted EPS (fully diluted) (p) DPS (p) BALANCE SHEET Tangible fixed assets Intangible fixed assets Total fixed assets (inc other) Stock Trade debtors Cash (3.2) Other current assets Total current assets Trade creditors (10.8) (3.3) (4.0) (4.7) (4.5) Loans and overdrafts (current and long-term) (13.5) (11.4) (11.4) (11.4) (11.4) Other liabilities (3.1) (17.3) (15.7) (15.2) (14.8) Total liabilities (27.4) (32.0) (31.0) (31.3) (30.7) Net Assets Invested Capital Net (Debt) ( / Cash (13.5) (11.0) (14.5) (10.3) (4.8) Net trade working capital (1.3) CASH FLOW Operating profit Add back : depreciation & amortisation Working capital movements 0.2 (1.5) (3.7) (3.0) (2.7) Other operating items 0.1 (0.1) (1.5) (1.0) (1.0) Operating cash flow Financing (1.2) (1.0) (1.1) (0.9) (0.8) Tax (1.6) (1.1) (1.9) (2.3) (2.5) Capital Expenditure (1.2) (1.0) (0.8) (0.8) (0.8) Dividends paid 0.0 (0.2) (0.2) (0.2) (0.2) Trading cash flow Acquisitions / disposals etc 0.3 (2.8) (5.0) Shares issued / bought back Increase (decrease) in net cash (3.6) Source: Company reports, Canaccord Genuity Limited estimates 6 June 2011 K3 Business Technology Group

20 20 INVESTMENT RISKS As with any equity investment, especially one in a relative small and niche-focused UK technology stock, there are a number of risks. We highlight the four that we consider to be most material for the Managed Services story either in terms of likelihood or potential impact and also summarise the key risks we see in the existing business. Uptake rate There could be a disappointingly slow rate of adoption. Although it seems Software-as-a- Service and Managed Services are becoming more generally accepted, and that customers are keen to explore such remote delivery models, it is always possible that the early adopters have already adopted, and that the rate of increased penetration into the remainder of the customer base is slow. Uptake total We see an additional danger that, even if those willing to adopt managed services do so relatively quickly, they may be relatively few in number, with most customers not migrating to managed services in even the long term. Microsoft/other software owner reaction It is possible that, in the face of a number of services players earning good margins and strong degrees of recurring revenue from the hosting and management of software platforms, the software intellectual property owners attempt to (or succeed in their attempts to) control and deliver the managed services themselves. Such a move would be a major departure from existing trends, but cannot be ruled out entirely. Other entrants into Managed Services on back of data centre investments As with the third risk (software players moving more into managed services), there is also a risk that other groups those with material data centre assets, for example could look to learn about the vertical markets in which K3 attempts to offer managed services, and offer a hosted platform to a customer base without either owning the software IP or having a history in the market segment. Again, this would be a bold move, but given the scale of a number of industry players (Amazon, Google, HP etc) it also should not be entirely ignored. Risks outside Managed Services The business is subject to changes in fortune in the broader economy, and there exists specific risk with regard to key customers and partners. To date, we believe these relationships are strong and likely to persist, but they must be acknowledged as risks in the longer term. K3 Business Technology Group 6 June 2011

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22 22 K3 Business Technology Group 6 June 2011

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24 24 APPENDIX: IMPORTANT DISCLOSURES Analyst Certification: Each authoring analyst of Canaccord Genuity Limited whose name appears on the front page of this investment research hereby certifies that (i) the recommendations and opinions expressed in this investment research accurately reflect the authoring analyst s personal, independent and objective views about any and all of the designated investments or relevant issuers discussed herein that are within such authoring analyst s coverage universe and (ii) no part of the authoring analyst s compensation was, is, or will be, directly or indirectly, related to the specific recommendations or views expressed by the authoring analyst in the investment research. Site Visit: An analyst has visited the issuer's material operations in the UK. No payment or reimbursement was received from the issuer for the related travel costs. Price Chart:* Distribution of Ratings: Global Stock Ratings (as of 3 May 2011) Canaccord Ratings System: Coverage Universe IB Clients Rating # % % Buy % 36.7% Speculative Buy % 62.7% Hold % 17.5% Sell % 11.1% % BUY: The stock is expected to generate risk-adjusted returns of over 10% during the next 12 months. HOLD: The stock is expected to generate risk-adjusted returns of 0-10% during the next 12 months. SELL: The stock is expected to generate negative risk-adjusted returns during the next 12 months. NOT RATED: Canaccord Genuity does not provide research coverage of the relevant issuer. Risk-adjusted return refers to the expected return in relation to the amount of risk associated with the designated investment or the relevant issuer. Risk Qualifier: SPECULATIVE: Stocks bear significantly higher risk that typically cannot be valued by normal fundamental criteria. Investments in the stock may result in material loss. K3 Business Technology Group 6 June 2011

25 25 Canaccord Research Disclosures as of 6 June 2011 Company Disclosure K3 Business Technology Group 1A, 2, 4, 5 1 The relevant issuer currently is, or in the past 12 months was, a client of Canaccord Genuity or its affiliated companies. During this period, Canaccord Genuity or its affiliated companies provided the following services to the relevant issuer: A. investment banking services. B. non-investment banking securities-related services. C. non-securities related services. 2 In the past 12 months, Canaccord Genuity or its affiliated companies have received compensation for Corporate Finance/Investment Banking services from the relevant issuer. 3 In the past 12 months, Canaccord Genuity or any of its affiliated companies have been lead manager, co-lead manager or co-manager of a public offering of securities of the relevant issuer or any publicly disclosed offer of securities of the relevant issuer or in any related derivatives. 4 Canaccord Genuity acts as corporate broker for the relevant issuer and/or Canaccord Genuity or any of its affiliated companies may have an agreement with the relevant issuer relating to the provision of Corporate Finance/Investment Banking services. 5 Canaccord Genuity or any of its affiliated companies is a market maker or liquidity provider in the securities of the relevant issuer or in any related derivatives. 6 In the past 12 months, Canaccord Genuity, its partners, affiliated companies, officers or directors, or any authoring analyst involved in the preparation of this research has provided services to the relevant issuer for remuneration, other than normal course investment advisory or trade execution services. 7 Canaccord Genuity intends to seek or expects to receive compensation for Corporate Finance/Investment Banking services from the relevant issuer in the next six months. 8 The authoring analyst, a member of the authoring analyst s household, or any individual directly involved in the preparation of this research, has a long position in the shares or derivatives, or has any other financial interest in the relevant issuer, the value of which increases as the value of the underlying equity increases. 9 The authoring analyst, a member of the authoring analyst s household, or any individual directly involved in the preparation of this research, has a short position in the shares or derivatives, or has any other financial interest in the relevant issuer, the value of which increases as the value of the underlying equity decreases. 10 Those persons identified as the author(s) of this research, or any individual involved in the preparation of this research, have purchased/received shares in the relevant issuer prior to a public offering of those shares, and such person s name and details are disclosed above. 11 A partner, director, officer, employee or agent of Canaccord Genuity and its affiliated companies, or a member of his/her household, is an officer, or director, or serves as an advisor or board member of the relevant issuer and/or one of its subsidiaries, and such person s name is disclosed above. 12 As of the month end immediately preceding the date of publication of this research, or the prior month end if publication is within 10 days following a month end, Canaccord Genuity or its affiliate companies, in the aggregate, beneficially owned 1% or more of any class of the total issued share capital or other common equity securities of the relevant issuer or held any other financial interests in the relevant issuer which are significant in relation to the research (as disclosed above). 13 As of the month end immediately preceding the date of publication of this research, or the prior month end if publication is within 10 days following a month end, the relevant issuer owned 1% or more of any class of the total issued share capital in Canaccord Genuity or any of its affiliated companies. 14 Other specific disclosures as described above. Canaccord Genuity is the business name used by certain subsidiaries of Canaccord Financial Inc., including Canaccord Genuity Inc., Canaccord Genuity Limited, and Canaccord Genuity Corp. The authoring analysts who are responsible for the preparation of this research are employed by Canaccord Genuity Limited, which is authorised and regulated by the Financial Services Authority (FSA). In the event that this is compendium research (covering six or more relevant issuers), Canaccord Genuity and its affiliated companies may choose to provide specific disclosures of the subject companies by reference, as well as its policies and procedures regarding the dissemination of research. To access this material or for more information, please refer to The authoring analysts who are responsible for the preparation of this research have received (or will receive) compensation based upon (among other factors) the Corporate Finance/Investment Banking revenues and general profits of Canaccord Genuity. However, such authoring analysts have not received, and will not receive, compensation that is directly based upon or linked to one or more specific Corporate Finance/Investment Banking activities, or to recommendations contained in the research. Canaccord Genuity Limited and its affiliated companies may have a Corporate Finance/Investment Banking 6 June 2011 K3 Business Technology Group