The Kainos (LSE: KNOS) share price had a difficult start to the trading week yesterday. The shares crashed over 10% at one point, which was the worst performance across the FTSE 250 index.
Let’s take a closer look at why the shares fell, and if it’s presented me with a buying opportunity.
The business
Before I dig into the interim results, it’s worth recapping what the business does.
Kainos provides information technology services, operating across two divisions. Digital Services is the largest of these, offering full development of digital solutions for government and commercial clients. The second division is Workday Practice. Here, Kainos is a full-service partner of Workday and provides expertise on how to tailor the platform to its clients’ needs.
Interim results
The release of the results yesterday covered the six-month period to the end of September. And they looked pretty good, at least on the top line. Revenue grew a bumper 33%, reaching £142.3m. Its software as a service division grew an impressive 118%, and bookings rose by 81%.
The outlook statement was promising too, anticipating that demand will remain high for all of the company’s services. The pandemic has generally been disruptive for businesses, but Kainos say it has accelerated the move towards digitalisation, which is good for the company.
But it was the profit generation that was the weak spot in the results. Although revenue grew significantly, profit before tax only rose 3% (or 12% on an adjusted basis). The weaker growth in profit implies that margins have been squeezed. It’s a pattern I’ve been seeing across a lot of company results recently. Volex was another example I wrote about last week.
Management guided that margins were constrained due to salary increases and elevated use of contract staff. The reversal of non-recurring cost savings from the equivalent period 12 months ago also impacted profit. Some of these factors should ease in the months ahead, but looking forward, it’s unlikely last year’s heightened profit margins will be maintained.
A record high
Yesterday’s share price fall should be viewed in the context of the stellar run the shares have been on. Before this week, the share price had risen 66% over one year, and a lofty 47% over the past six months. In fact, the price was at an all-time high just as recently as last week.
So I think there was some profit-taking yesterday after the good run in the share price.
I do have a concern over the valuation though. On a forward price-to-earnings (P/E) basis, the shares are on a steep 55 multiple. I consider this richly valued when profit is only growing 3%. The full-year consensus forecast for earnings per share growth is 2%, so it doesn’t make me want to buy the shares at this valuation either.
All things considered, I think there’s a good business here. I agree with management when it says the pandemic has accelerated the trend towards digitalisation, which should support further growth for Kainos. But the valuation puts me off buying the shares, especially when margins are being squeezed and profits are suffering.
For now, it’s one for my watchlist.
