BUY Target: 215p YOUR HOST: K3. From value to growth stock. Raising price target to 215p

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1 UK Daily Letter 1 K3 Business Technology Group KBT : AIM : 138.5p BUY Target: 215p Bob Liao, CFA bliao@canaccordgenuity.com Kevin Ashton kashton@canaccordgenuity.com COMPANY STATISTICS: 52-week Range: Avg. Daily Vol. (000s): 23 Market Cap (M): 35 Shares Out (M): 26 EARNINGS SUMMARY: FYE Jun 2011E 2012E Revenue (M): EBITA (M): Net (Debt)/Cash (M): (8.4) (5.5) EPS: adj. FD EPS: Dividend per Share: EV/Revenue (x): EV/EBITA (x): P/E (x): adj. FD P/E (x): Dividend Yield %: SHARE PRICE PERFORMANCE: /09/10 Technology -- Software -- Software and Services YOUR HOST: K3 From value to growth stock Since we initiated in January 2010, K3 has been perceived as a value stock with modest growth prospects. We believe the move into hosting alongside the potential growth from the existing Microsoft based franchise means the market should start to expect meaningful growth from K3 and value it accordingly. K3 s installed base perfect for hosting cross-sell Hosted solutions are preferred when software solutions are complex (e.g. mid-market, verticalised solutions) and the organisation does not have the resources to run complex IT systems. This is typical of K3 s installed base. Hosting could be transformational for K3 K3 has seen strong hosting momentum post the DigiMIS acquisition. With customers spending an incremental 3.4 times maintenance revenues on hosting, the hosting opportunity in the installed base is possibly worth 10 million on conservative assumptions. These revenues are primarily recurring (3-5 year contracts) and high margin (25%) S O N D J F M A M J J A S K3 BUSINESS TECH.GP. (~ ) FTSE ALL SHARE - PRICE INDEX (~ ) Source: Thomson Datastream COMPANY SUMMARY: 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. Raising price target to 215p Despite a strong performance the stock remains cheap on practically any measure, especially P/E (6.8 times debt-adjusted FY11E earnings and FCF yield (10% of FY11E FCF). As the market appreciates the higher than expected growth opportunities, we expect K3 to rerate to at least a P/E of 10 times FY11E debt-adjusted earnings and raise our price target to 215p accordingly (previously 180p). All amounts in p unless otherwise noted. Share price data COB 22 September This research note is produced by Canaccord Genuity Limited which is authorized and regulated ed by the Financial Services Authority (FSA). This is non-independent research and a marketing communication under the FSA 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.

2 UK Daily Letter 2 RAISING PRICE TARGET TO 215p We believe it is time to start looking at K3 as a growth stock rather than a value play. K3 could generate significant, high margin, recurring revenues from the hosting opportunity. Our revised price target (explained later in this note) targets a debt-adjusted P/E of 10 times FY11E earnings compared to the current multiple of 6.8 times. In truth, 10 times is still not really a growth multiple but it still gets us to a price target of 215p and we raise our price target accordingly. STRATEGIC MOVE INTO HOSTING K3 described FY10 (ended 30 June) as strategically significant for several reasons. Key amongst these was the March 2010 acquisition of DigiMIS, which is a UK-based hosting and managed services business. DigiMIS has allowed K3 to offer cloud computing and Software as a Service (SaaS). It has been merged with K3 s existing network infrastructure services business to create the new (separately reported) Managed Services division. While K3 has moved into hosting only recently it seems its customers are crying out for its hosted solutions. Indeed K3 s clients base is, in our opinion, amongst the most likely to adopt a hosted solution. Hosted solutions are preferred when software solutions are complex (mid-market, verticalised solutions can certainly be that) and where the organisation does not have the resources to run complex IT systems. With the broader trend towards hosted solutions and especially cloud computing, we suspect mid-market companies will be even more compelled to examine the K3 solution. Managed Services is the fastest growing part of K3 s business, one that achieves strong margins (some 25%) and one that comprises almost entirely of recurring revenues that are usually on contracts of between three to five years. After generating revenues of just 0.6 million in FY09 the Managed Services division saw revenues double to 1.2 million in FY10. However, with the pace of activity rising towards the end of the year as DigiMIS was taken over by K3 the run rate has risen to 2.3 million. On top of this the order book now stands at 2.1 million. With the lead time in closing contracts as short as six weeks the division looks set to continue its rapid growth trajectory. MEANINGFUL, HIGH MARGIN, RECURRING REVENUES K3 has a substantial opportunity from its existing installed base of 1,500 customers. Perhaps the best way to analyse this is to look at the hosting revenues that existing clients have generated compared to the recurring maintenance revenues they pay to K3. K3 has given the example of three clients who have taken the hosted solution. While they were generating recurring maintenance on existing products of some 315k per annum they are now paying 1.1 million per annum for hosting services. K3 provides much more than simply hosting the system which it has sold them (in these three cases SYSPRO but Managed Services also hosts for K3 s retail customers). K3 also hosts MS Dynamics, MSOffice, , Web, BI, CRM, Firewall etc. This is at least part of the reason for the higher income stream.

3 UK Daily Letter 3 In this model then a stream of 315k is supplemented by a stream of 1.08 million when the companies move to a hosted solution (for a combined total of 1.4 million). That is a multiple of 4.4 times. Looking at the individual companies the ratio varies from 3.3 to 5 times. In total, K3 currently generates maintenance revenues of 17 million. Now if we take the lower end of the multiples (3.3 times), if all the installed base were to move to hosted solutions this would generate an incremental 40 million of revenues (double the level achieved in FY10). It is hard to know what the exact take-up of hosting services would be in K3 s existing client base (and it will of course not happen overnight), but we do believe, as stated above, that K3 s client base has an ideal profile for hosting. Assuming 25% would be a potential target, this would be an incremental 10 million of revenues from the installed base alone, which is again material in the context of 40 million of revenues. With a current pipeline of 2 million after a short period of ownership we are confident that 10 million is a conservative assessment of the near-term potential from the installed base. STRONG MOMENTUM FROM CORE BUSINESS TOO While we are excited about prospects for the hosting business, it is worth reviewing the recovery that has commenced in K3 s core retail and manufacturing software businesses. Retail Software (62% of sales, 47% of profits) As anticipated, the retail business is providing the engine of growth for K3 s business. This is partly due to market recovery but perhaps more to the success of K3 s online multichannel offerings. Major new business wins were up 75% yoy in the year ended 30 June 2010, reaching 7.7 million. 80% of the retail business comes from the UK and Ireland with the residual mostly from Holland. The UK business is currently the strongest and showed sales up 24% (all organic) in FY10. This is a substantial pick-up given the decline in revenues in calendar 2008 and modest growth in calendar K3 achieved some excellent wins in the period including substantial orders from Dublin Airport Authority, White Stuff, DNA Lingerie and Buy as you View. We understand Dublin Airport Authority was the replacement of an SAP system. K3 describes the UK pipeline as healthy and points to several deals that are at an advanced stage of negotiation. The Dutch business saw organic growth of some 9% in the period (adjusted for the Pebblestone acquisition and the stronger euro). K3 changed the senior management team in mid-2009 and invested in sales, delivery resource and IP and these measures have clearly been a success. During the period key client, IKEA (perhaps 30-40% of Dutch revenues), slowed down its investment schedule as it considered whether to standardise on one system. In the end IKEA decided to continue to use its in-house system as well as K3 s system. Towards the end of the period IKEA started spending again and K3 expects this spending to continue this year. A significant event for the Dutch business was the acquisition of Pebblestone NL and Pebblestone IP, market leader in software solutions for the fashion industry. This has doubled the size of the Dutch operations and added an international sales network of some 33 distributors across 20 countries.

4 UK Daily Letter 4 Manufacturing Software (36% of sales, 51% of profits) The manufacturing division was hit hard by the downturn but has now been in recovery mode since In the period to 30 June 2010 total revenues grew by 9%. The principal growth driver is now the AX business, which saw revenues rise 53% to 2.5 million in the period. It is our belief that this business will continue to be an area of strong growth. K3 refers to an improving lead intake and a growing pipeline of new business for AX. Microsoft Dynamics AX is Microsoft s most scaleable product-orientated offering (more so than NAV, GP or SL). It offers more extensive functionality than SYSPRO with all the traditional ERP areas (e.g. manufacturing, sales and marketing, finance, HR etc.) as well as BI, CRM, project management, collaboration etc. In a June 2009 report on the Mid-market and Tier 2-Oriented Product-Centric Companies, Gartner described AX as the only one offering that qualifies as a leader. K3 has developed add-on modules for AX in the areas of fresh food and steel. The largest, cash cow, division SCS (the SYSPRO business) saw revenues rise just 3% in FY10 and we do not anticipate rapid growth here. However, contributing three quarters of divisional profits this business is a lynch pin of the manufacturing division. Similarly, the small systems division (Walton) is currently seeing flat revenues and may experience some attrition going forward as customers upgrade from legacy systems to the likes of SYSPRO or NAV. BIGGER PICTURE MICROSOFT PLAY Q: What is the most disruptive event in the ERP/business applications market this decade? A: Microsoft s entry into the SME business applications market at the turn of the decade. Having come from a background of offering operating systems (Windows) and personal productivity tools (Office), Microsoft entered the world of enterprise applications with the late 2000 acquisition of Great Plains, which itself had just acquired competitor Solomon. The desire to be a leading player in the SME business applications market was left in no doubt with the subsequent acquisition of the Danish company Navision in Navision had merged with its Danish neighbour, Damgard in Thus, over the space of a couple of years Microsoft went from no presence in the market to having four solutions: Great Plains, Solomon, Navision Financials and Damgard Axapta. Today, a decade later, the four solutions are all called Microsoft Dynamics, with each one being distinguished by the initial after the name (respectively GP, SL, NAV and AX). Microsoft started out with some heady projections. While Great Plains and Navision had combined sales of US$550 million in Microsoft s fiscal 2003 year, it was projecting sales of US$10 billion by For some time it has been apparent that this target was way too high. We believe Dynamics is likely to generate sales of approximately US$1.3 billion in FY10. This represents, however, organic growth in the mid teens since the acquisition and around 20% per annum over 2007 and By contrast, Sage has seen low to mid-single digit organic growth over the period depending on how this is measured (Sage often excludes divisions it is sunsetting to arrive at organic growth rates, which are then higher). Ignoring for a minute the initial hyperbole, it strikes us that Microsoft has been gaining market share since it made the acquisitions and we would expect this to continue. Figure 1 shows reported growth rates of Microsoft Dynamics as reported by Microsoft (i.e. not currency adjusted).

5 UK Daily Letter 5 Figure 1: Microsoft Dynamics yoy organic growth 25% 20% 15% 10% 5% 0% -5% -10% Q110 Q210 Q310 Q410 Source: Microsoft Dynamics has clearly been hit by the downturn, as might be expected (this continued in its September 2009 quarter, with Dynamics sales down 6%). However, we think that the midto high teens growth being registered before the downturn will return as the global economies regain momentum. While we do not know the exact amounts, Microsoft continues to invest substantially in developing Dynamics. We believe the division broke even on sales of about US$1 billion in The typical level of R&D investment of a mature company in this area might be 12%. The typical margin of such a mature company should lie at least between 20-30% (quite possibly higher). This suggests that Microsoft was spending between US$ million per annum on R&D on the division, which is probably in the region of US$ million today. By contrast, Sage spends approximately US$ million per annum (on substantially higher sales). The roadmap for Microsoft s NAV stretches out to 2017, providing considerable visibility for Microsoft s partners and most importantly for their customers. This is a ball that appears Microsoft does not intend to drop. Microsoft s specific commitment to the retail area was shown recently by its purchase of the LS Retail solution for Dynamics AX. K3 has been the exclusive reseller for the LS Retail solution for Dynamics NAV for some years, and is one of the largest LS Retail resellers globally. We expect to see significant demand for LS Retail Dynamics AX for which K3 is the 'Microsoft Go To Market Partner' for the UK. As discussed elsewhere, the Microsoft model is to work as far as possible through partners (indeed the slower growth seen in Dynamics in 2005 was a result of Microsoft farming more services work out to partners in that year). As the largest Dynamics reseller in the UK, K3 is an important route to market for all this investment.

6 UK Daily Letter 6 RAISING PRICE TARGET TO 215p Figure 2: K3 Key Valuation Metrics E Price (p) E SII (m) Mkt Cap ( m) Net debt ( m) Rolling EV ( m) EV/sales 103% 95% 86% EV/EBITA (x) EV/FCF (x) Adj/ P/E (x) Debt adj P/E (x) Yield 0% 0% 0% FCF Yield 11% 10% 10% Source: Company reports, Canaccord Genuity Limited estimates Although K3 has seen a 55% increase in its share price since early 2010 it remains cheap on practically any measure, most notably on P/E and FCF yield. While K3 has historically been seen as a value play with modest growth prospects we believe the move into hosting coupled with the existing traction from the return to growth for the Microsoft products will generate material revenue and earnings growth (which we have not yet factored into our numbers). K3 should then increasingly be perceived as a growth stock and one that is operating in a very hot area (hosted SaaS solutions). As such, we believe the stock should rerate at the very least to 10 times FY11E debtadjusted P/E. This corresponds to a value of 215p and we lift our price target accordingly. Investment risks Spending in K3's software solutions is, to a large degree, a function of the economic health of the UK retail and manufacturing verticals. K3 has debt facilities through to August 2012 and needs to repay 3.5 million annually to pay this off. K3 resells software from Microsoft, Landsteinar and SYSPRO. All three relationships contribute materially to K3's profits and need to be maintained.

7 UK Daily Letter 7 Figure 3: K3 Key Financials FYE Jun ( M) 2009A 2010A 2011E 2012E P&L Retail Software Manufacturing software Managed Services Total revenues Retail Software Manufacturing software Managed Services Central costs Adj. operating profit Adj. operating profit margin 18.0% 17.1% 18.8% 18.7% Amortisation of acquired intangibles SBP EBIT Net Financials Adj PBT PBT Tax expense Net Profit WA SII Basic EPS (p) Adj.FD EPS (p) Yoy Chg 39% 10% 2% Dividend (p) Cash Flow CF from Operations B4 chg in NWC Chg in NWC CFO Interest and Tax Capex Other Investing activities Financing Other Chg in net debt Cash flow/bs Metrics Memo - FCF FCF(CFO-Capex)/Sales 13% 11% 9% 8% Cash conversion 103% 82% 79% 80% Net Debt Source: Company reports, Canaccord Genuity Limited estimates

8 UK Daily Letter 8 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 1 September 2010) Canaccord Ratings System: Coverage Universe IB Clients Rating # % % Buy % 37.4% Speculative Buy % 61.5% Hold % 20.9% Sell % 0.0% % 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. Canaccord Research Disclosures as of Company Disclosure K3 Business Technology Group 1A, 2, 4, 5

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