Business brokerage and financial services group K3 Capital (LON:K3C) shares dropped today as it released a trading update trimming its expectations for full year profits. The share price tanked 20% on open, but this does not tell the full story:
As we can see from the chart, the share price has been tanking for some time. The latest update was in January, and since then the share price has dropped almost by half on no public news. The obvious inference is that there must be advance knowledge of this, and unfortunately retail shareholders are the ones holding the dud.
Prior to this, K3 had been a rather decent success story. Raising £17.3m on IPO in 2017 and has successfully grown revenues and share price in the following year, and the share price was approaching 400p. Cited as one of the growing stars in the small-cap space, we can easily see that this business might be one of the few that are counter-cyclical, as any downturn may lead to small businesses either becoming distressed or divesting/merging.
The warning comes in a trading update:
The Company confirms that a number of the significant transactions within its KBS Corporate Finance Division mentioned within the trading update released on 11 December 2018 continue to progress through the due diligence processes and are in advanced stages of commercial negotiation. Due to the increasingly difficult backdrop of UK’s economic and political environment in the run up to Brexit, these transactions continue to experience challenges and take longer to complete than anticipated and consequently may not close within the current financial year. As a result, the Board expects to report EBITDA between £4.5m and £5.0m.
Unlike many other firms where Brexit is a convenient excuse, it may be possible to see how it could affect K3’s business. I would envisage that disruption would disproportionately affect small-caps more, and one of the troubles about key contracts is that any delay has an affect on the figures.
We need to go to Research Tree to find out the profit metrics: in January adjusted EBITDA was estimated at £7.1m, so this is a rather large miss.
As predicted, the flipside of uncertainty is no bad thing for K3:
The Company’s KBS Corporate and Knightsbridge brands have continued to perform well in the second half of the Period and the Board is encouraged to see the ongoing trend of these divisions contributing an increasingly greater proportion of the Group’s revenue and profit than in previous years. This growth within the ‘volume driven’ brands is combined with continuing improvement in the main KPIs across the Group with record ever numbers of sellers coming to market and record buyer numbers being recorded. This is leading to year on year growth in the number of completed sales.
K3 will enter the new financial year with a strong pipeline across the Group and consequently the Board remains confident of the Group’s future prospects and makes no change to its outlook for FY20.
In some ways, this is an additional miss as well. FY20 was estimated at £7.5m EBITDA, but profits from the delayed contracts should drop into this period as well.
It seems that the most recent period are really the first blips on K3’s copybook. Since IPO, it has almost always traded at quite a premium valuation, up until the last 6 months or so. Now, there seems to be the possibility of a growth share not delivering growth, and the market dislikes this. At current prices it could be argued that all growth has been priced out.
There can be no doubt that the last year was a successful one for K3 – turnover and profits jumped on the back of increased spend. The figures are clean, with adjusted EBITDA lying very close to operating profit, which means few adjustments. The business is also very capex light, with minimum amount of costs capitalised.
This has led to a good cash conversion: although dividends are costly, requiring £3m in the last year and £3.5m in the interims. This has led to a slight decrease in cash from a high of £7.5m to £5.9m. However, the company carries no debt at all, and the balance sheet shows a strong position, with other liabilities covered.
One bugbear may be the amount paid out on wages and salaries. K3’s work is more labour intensive than anything else, as their business cannot operate without people providing the service. In the past year there has been a large uptick in the number of staff:
Here, we see that wages and salaries have gone up hugely; from an average of £38k to £55k. There can be many reasons for this, perhaps rewarding existing employees post-IPO could be behind it. Aside from this, it appears to be a decently run ship.
Whether you think this is good value depends on your opinion on the growth. Certainly the board are bullish about the prospects, and so are its analysts – FinnCap reiterates its 375p target price, and make a good point about the accounting policy booking revenue only when received – a potential banana skin for these type of firms, which could give an upside surprise in the next year. But going beyond this they too do not envisage explosive growth.
One easier thing about the business is that there are not many moving parts, or a lot of profit tied up in not very liquid assets. Adjusted EBITDA therefore can be taken to be very close to real profit. The market cap has now dropped to only a little bit above what it was at IPO, and on a multiples valuation whilst still not in bargain territory it offers plainly quite good value as opposed to the ‘jam tomorrow’ outlook of the likes of Begbies Traynor.
One of the main bear points is that there may not be much of a moat, here or in the future. What K3 do could be replicated by others, should they acquire the correct people, although whether they could do it better may be another thing – it is not quite a commodity service.
Another is implicit in the profit warning itself. Income is going to be heavily skewed between big deals completing, which seems logical enough considering that a commission would not be paid on a failed deal. But buyers (or sellers) could walk away at any time. So a case of ‘jam tomorrow’ could exist here indefinitely, with the big profits always around the corner.
A solid 3/5 for me here, I quite like how it has been run but don’t feel able to really judge what might happen in future.