Kainos Group plc (KNOS) Earnings Call Transcript & Summary

Good morning, everyone, and welcome to the presentation for our results for the 6 months to the end of September 2024. While this is still a virtual meeting, you'll see that we're actually in our Belfast office today rather than in our home offices, which perhaps at this stage are too recognizable. So starting tomorrow, Richard and myself will be in London for some in-person investor meetings. So hopefully, the weather will be kind. I'm going to start the presentation just in a minute. A couple of housekeeping points. Presentation will take about 40 minutes. During the presentation, your connection will be muted. And at the end of the presentation, FTI will moderate the Q&A. We are recording this broadcast in Teams and it will be subtitled and we'll publish a recording on our website later on today. So firstly, a quick safe harbor statement, which I'll not read out, but I'll assume you'll all skim through. So in terms of what we're doing today, well, we've taken the opportunity to update some of the images that we use in our slides. This photograph is from our early careers development program with some of our colleagues in Belfast. So it's always good to see some smiles there as well. We've got a slight change to the running order from previous running orders. Richard is going to cover the financial performance a little earlier in the presentation. So just a quick business overview. We have 3 divisions that over the last 5 years that have delivered strong growth with strong margins and strong future opportunities. While the current trading conditions in digital services and Workday services market is currently softer, I would also say that we hold great positions in each of these markets. Collectively, the markets represent GBP 5.8 billion of opportunity. So it's always good to look at some of our customers as well and highlight that we do some great work, and we take great pride in the work we do with them. Our customer cohort is now over 1,000 ambitious organizations, some very well-known names. We got 30 on the screen. There is an emphasis on the international as 41% of our revenue is now derived internationally. So each time we do the results, we update a few of the logos. It is not a test. And this time around have added ING in the third row, I'll be talking about later. We've also added in Fidelity and Bupa, we've just taken on Smart test. So looking at the highlights. Overall, in H1, we've seen mixed performance with excellent Workday products and Healthcare growth, offset by subdued digital services, public and commercial sector, along with our Workday services markets. It's pleasing to see the discipline remain in the business in a softer market where there's continued uncertain macroeconomic backdrop and now political change added into the mix. We've continued to be disciplined in our execution. Our adjusted profit margin is now 21%. But we've continued with proactive cost management, firstly, in H1, and that's been extended into H2 as well. So our contractor numbers have remained low, and our average employee salaries actually decreased by 2%, and that's due to the investment in our entry-level model. So as part of our business mix and our agile model for staff, we've been able to move people around the business, and we've moved 83 people from our services business into our product business. And this is the advantage of allowing us to continue to invest for the future. So for our Workday products, ARR, annual recurring revenue has continued to grow strongly, and we're now up to GBP 65 million, which is up 18%. So actually, in constant currency, it is 24%, and it's more aligned to previous growth rates. So Workday products is now 19% of group revenue and really thinking ourselves more as a services rather than a software business. In terms of bookings, it largely mirrors the comments about revenue, products and health care is pleasing, lower levels in public sector and the Workday services and the commercial sector. We have strong levels of backlog as at GBP 354 million at the half year despite the tougher services conditions, but it does underpin our future outlook as we continue to navigate a period of caution. And our cash balance is now at GBP 152 million, and that's on the back of another good cash collection period. On the 31st of October, we announced our intention to launch our first share buyback program. And this morning, we shared more details including the level of GBP 30 million. Richard is going to speak a little bit more about that in the accounts review. For our customers, each of these charts tells a different and important story about our business and about our fabulous customers. The value we deliver to our customers, the excellent levels of customer satisfaction generates repeat business from our existing customer base. And as we add new customers, that unlocks future revenue streams. Our customers are not immune to economic or political conditions, and we've seen a drop-off in the revenue from our existing customers. But overall, we have a well-balanced business. We have over 50% of our revenues now generated from commercial sector clients. That's mainly from a Workday business, and we're very pleased with the balance across our sectors. I've already mentioned the product revenue growth, and that's 19%. So that is also into the mix here as well. And I have mentioned about our international business, and it does bear repeating. So today, 41% of our revenues are generated in international markets. So our focus is really about building a global company. So our people are the driving force in our business, and it's their energy and expertise and experience that really drives us on. So over the first half, our headcount has increased by 34 people. So it's broadly flat. But that doesn't really tell the full story. There's also been this continued focus on the operational excellence. I've mentioned about being able to move people around. So 83 people have moved from our Workday services and digital services into product. We have maintained a low contractor headcount. And in real interest in this, our entry-level model around graduate placements and school leavers, where this year, we'll see another 127 people enter the business at that level. So that also is a benefit of rebalancing our cost base. So the recruitment market has cooled generally. We're also being cautious about new senior hires, and we're taking the opportunity to promote from within where we have some capacity at junior levels. Our employee engagement remains a focus. So our talent market has cooled, like I mentioned, it means that there's less job switching, a bit more caution around that, but our employee retention remains at a very high level at 93%. So we made positive progress in our best places to work. We're now up to #39. So as we think about ourselves as a responsible company, our activities are still based around the United Nations Sustainable Development Goals. So in terms of climate action, our financial year '24 carbon footprint was independently verified and showed that we were close to achieving our science-based near-term net zero targets. That's 2 years earlier than we expected. Deadline for achieving these was financial year '26. So we have more scope to do on Scope 3 emissions. So that's about supply chain and business travel, but we're making good progress. So for gender equality, we know that the technology sector is a significant issue around gender imbalance. We continue to focus on developing and retaining the talent of women already working in Kainos. The percentage of work of women is now up to 36%. That's up from 35% when we previously reported. And the image that you see there in the middle of the screen is Ruth McGuinness. So this was an award when I refer to one of the Microsoft Power Women Tech Awards. She's one of 19 people globally to be recognized. We're very pleased about that and about the work that Ruth has undertaken leading our AI and data activities. The quality education is also important for us. We continue to invest in our on-the-job development and coaching, short courses, technical learning and our talent programs as well. Our technical outreach programs continue. We have engaged over 1,000 young people over the last 6 months through work placements and technical programs. That's an increase of 20% over the same period last year. So with that, I'm going to hand over to Richard to talk about the financial performance.

Thanks, Russell. So we'll start with the group income statement, and I'll start by talking about revenue in Digital Services, which overall was a disappointing performance. Revenue was down 11% compared to H1 last year. Within the 3 parts of that, public sector revenue was down 15%. And we've talked about the issues in commercial sector following excellent growth in FY '23, that declined by 27% compared to H1 last year. To put that in some context, this is still just over 11% of the division's total revenue. Healthcare was by far the best performer growth at 16%, now that the COVID comparators have flushed through that part of the business. I mentioned previously that Digital Services has had pauses in revenue growth before. In FY '17, revenue growth was only 2%. The following year, it was only 8%. But after that, revenue growth has been 150% since we went ex-growth in FY '18. Gross margin actually ticked up by 0.7%, partially as a result of effective rate ticking up, partially by further reducing contractor numbers that Russell referred to earlier. Contractor numbers are now down 84% from the peak 2 years ago. Contribution fell broadly in line with revenue. In terms of Workday Services, revenue also fell by 10% against H1 last year, but we had previously flagged exiting the Blackline business. Excluding that -- adjusting for that, we would have had a 5% reduction in revenue. Gross margin in Workday Services fell by just under 1%, which was a decent performance in the circumstances. Effective rate remained broadly flat. And as Russell mentioned, salary inflation was limited. Contribution fell from 23% to 20% in this part of the business as direct expenses fell more slowly than revenue. Overall, the services business reminds me of the lurks of one of those country songs by Kenny Rogers, you picked a fine time to call a general election and come into government without a plan for getting projects running quickly or you picked a fine time to introduce new Workday services partners during an economic downturn. I get the point that neither of those scan as well as the bit about [indiscernible] hungry children like crop in the field, but you get the idea. Moving on to Workday Products. You get a much more Taylor Swift vibe than country music. Revenue grew by 28% year-on-year. Most of the revenue in this part of the business is denominated in dollars. So looking at this on a constant currency basis, growth would have been 31%. Gross margin actually ticked up by a couple of percent. That's an excellent performance given that employee document management as a product is still early in its life cycle. Direct expenses grew 15%, partially driven by the built on Workday costs. The cost for the period was GBP 1.2 million. This is fully expensed as with all our product development costs, and it will be treated as a sales and marketing expense. We had very little additional product development or sales and marketing costs incurred during the period for internal costs related to built on Workday, but that will increase in H2. The percentage contribution increased substantially in this part of the business compared to H1 last year from 25% of revenue up to 32% of revenue. That will reverse in H2 with the full built on Workday Payments to Workday Inc. and the internal Kainos costs coming through. We've always said we'd be happy to invest in this part of the business dependent on finding good products to invest in. Central overheads increased by 3% compared to H1 last year, we've tried to control costs given the current economic climate. This was more than offset by the growth in interest income as a result of higher interest rates than last year and higher cash balances. In terms of adjusting items, we continue to be consistent in our treatment of adding back share-based payments and acquisition costs. This led to an adjusted PBT of GBP 38.2 million for the first half, which was up 1% on H1 last year. The taxation rate for the period was 26%. This is 2% lower than last year, which had nondeductible acquisition costs. We consider 26% to be a reasonable maintainable level. It's probably worth noting that the changes to U.K. employers NIC will cost us just under GBP 3 million next year. Moving on to the balance sheet. Our fixed assets fell from September because we completed a part sale of the office site in Belfast. That was offset to some extent by capitalizing new leases. Goodwill and intangibles moved slightly, but that was largely due to exchange rate fluctuations. Trade receivables and WIP remained steady at 62 days combined. Historically, that's a low level for our business, and we're happy at that level. In terms of liabilities, deferred income fell as normal in this time of the year. There is a seasonality associated with our deferred income based on our sales and renewals of the Workday Products business being higher in H2. Therefore, deferred income is higher at the 31st of March than at the 30th of September. In terms of other liabilities, we also see seasonality with higher dividends payable at the 30th of September, but lower bonuses payable at that point. In terms of cash flow, cash conversion, as Russell mentioned earlier, has also been historically good for us. 75% in H1 is a good figure. We're happy with that level. We move on then to the capital allocation strategy for the business. We wanted to talk more broadly about the principles we apply and then talk about the share buyback very briefly. The key thing for us is to have the capital available to grow the business primarily organically, but also through targeted acquisitions, if necessary. Both the services business and the products business are cash generative. We've always been able to grow products from cash flow of that business. The bigger constraint has actually been staff rather than capital. We would be prepared to invest cash if necessary and if the right opportunities were available. We have done targeted acquisitions in the past, and we would consider those in the future, but historically, those have not been large amounts of money. In terms of working capital, our estimate is approximately GBP 25 million of a cushion for working capital. Clearly, we're way above that level. We've always said we wanted to have a progressive dividend. We'll maintain that this year as well. We did pause technically in the early days of COVID. But apart from that, we've always had a growing dividend. Within these principles, therefore, we believe that we have the ability to return value to shareholders, and we're doing that through a share buyback that Russell mentioned earlier of GBP 30 million. The level of that is set largely by what we believe is possible given the liquidity within the stock.

Okay. Getting into the individual divisional performance. I'll start off with Workday products. And as a reminder, Workday is a comprehensive SaaS platform, but it does not address every customer requirement nor does Workday have the capacity to do that. So we've developed our own software products that are complementary to the platform and enable customers to further increase the benefit that they get from Workday. So performance has been super, but you look at revenue, ARR, backlog, they're all registering excellent increases. The sales team are working well after a change in leadership. We're seeing the evolution of what we expect to be more predictability in the sales execution as well as continued growth. We also continue to evolve our customer value propositions and our sales processes. H1 has been our most successful sales half for the first half of the year, and that's on top of our previous best in financial year '24. Our smart portfolio has now been off to a great start for the year. We now have over 500 customers and each product has grown strongly. We launched EDM, employee document management in general release just over a year ago, and it continues to be our most successful product launch so far. Perhaps we've learned from the previous 3 products. So as a reminder, EDM addresses 2 requirements. It's around legal compliance. That's about employee document retention and about saving money by streamlining the creation and generation of employee-related documents such as offer letters, salary updates. We're excited by the EDM success, possibly even more so than when I first spoke about it a year ago. So we've refreshed the picture about the market opportunity and our revised estimates are -- now the total addressable market for EDM is GBP 800 million. That's up from GBP 400 million. And that's really been driven by the increased subscriptions and a slightly bigger market size as we've read out our market sizing exercise. We continue to invest in our products. R&D has shown a strong increase of another 31%. And just to reemphasize, we do expense the full GBP 14 million of investment through the P&L, and we'll continue to sensibly scale the increase in sales and marketing. Now I'd like to get into the build on Workday partnership in a little bit more detail. So in June 2024, Workday announced a new build on Workday program as part of their marketplace for partners to develop, sell and deploy products to enhance or augment core Workday functionality. As already mentioned, we already had a thriving software business, and we were delighted that we were able to agree the first multiyear strategic partnership with Workday that further enables our long-term growth. So under the standard term of built on Workday, partners pay a 20% commission on all sales to Workday, but we just play a flat fee each year. So as a result of this partnership, we've increased our ARR ambitions from the GBP 100 million by 2026 to GBP 200 million by 2030. There's 3 important aspects of the agreement that I want to highlight and also our progress against them. So the new strategic partnership with Workday incentivizes Workday's worldwide sales teams to introduce and co-sell our products as well as future products. So like a sales quota retirement for doing that. So our initial focus has been enabling the Workday sales team through a series of launch and learns, regional sales calls, individual calls. We are where we expected to be at this stage, and the first series of opportunities are now making their way into our sales pipeline with now an extra GBP 3.5 million added to the pipeline. The picture that you see on the left side of the screen is Damien Taylor, who's our product CTO. And this is Damien presenting at the keynote at Rising. So he presented in front of 9,000 people in the room and 25,000 people were viewing online. So this is part of our -- about how we market ourselves within that Workday ecosystem. About 2 hours after Damien spoke, I met with Carl Eschenbach, who's the Workday CEO. And his opening comment was your guys smashed it. This is the first time a partner has presented our innovation keynote. And we're there for the next 2 years as well, which is just great exposure. We're also actively talking to the Workday development team about new product ideas or opportunities. So things that they've been asked to do, but they're too small as maybe impact a subset of the Workday users. We have 4 now that are in Stage 2 of our new incubation team assessment, and we have another 25 that are in Stage 1 and earlier stage in the process. Many of these opportunities or ideas will address regulations or compliance obligations. So product growth is exciting. We're super pleased about our built on Workday strategic partnership, and that is why we've extended that ambition out to GBP 200 million by 2030. The GBP 100 million target by 2026 hasn't been forgotten, and we're still confident of reaching that. So just as a quick case study, ING Bank. They were a smart test customer, and they're introduced to the concept of our EDM employee document management back in 2022 as we were building that out. So initially, document management wasn't considered by ING as part of their Workday go-live, and this caused many challenges downstream. The organization knew that there was going to be a huge opportunity for efficiencies. In Phase 1, 80% of document creation in the first 3 countries were now fully automated. The initial savings are to be seen across the organization, ING Bank will be making savings of 20 FTEs for automating employee contracts alone. I think of a scale that out into the other functional areas. ING Bank has over 2,000 requests every year for access to documents. At present, employees have to send a request to the HR team. The HR teams have to retrieve from various legacy systems and then manually upload them from employees. These will now be available in Workday and it's a much better working -- way of working for the HR team, and it's a much better employee experience. Workday Services, we've seen the reduction in our Workday Services business in H1. So this is rather than familiar exceptional growth stories that we can tell in the past. Yes, we did have the Blackline revenues in financial year '24, which Richard has already mentioned. Excluding Blackline, we have seen a more modest reduction of 5%, but it's still a reduction. We've seen fewer deals come into the Workday partner ecosystem, and there's an increased number of services partners. So that means there's increased competition is putting pressure on rates and is lower deal sizes. There's no doubt that the general economic conditions we're seeing are having an impact. We continue to see CFOs being careful about spend, about deferring projects or additional modules, but there's also a structural change with the increased number of partners. So to get back to growth here, our response is in 2 parts. Firstly is around further global expansion. We already operate in 20 countries, Workday themselves see the main growth market outside of the U.S. We're following Workday in the Asia Pacific as a growth area. We're starting in Australia, and the first date was already signed in October with 15 more deals in the active pipeline. We're just at the start of the journey, but it is moving at pace. And the second area is around adjacent services. We will look to solve additional customer problems around the Workday platform that we use and extend our own data skills, our automation work and we'll draw on skills from other parts of the business. This may also include other partnerships like our new partnership with Pulsora to use Workday data to generate ESG reports. So by way of example, RaceTrac is a Georgia-headquartered company operating a chain of gasoline service stations across the southern part of the United States. In 2023, it was the 18th largest private company in the U.S. with annual revenue of over $19 billion. In December '23, RaceTrac acquired Gulf Oil, including 1,100 branded sites in the U.S. and Puerto Rico. And the company needed to convert its newly acquired business into new use of Workday Financial Management. So we brought the new post-acquisition RaceTrac organization live within 6 months, and that finished in August 2024. So it's an incredible time scale to realize value quickly by getting up to speed really quickly while limiting risk. And this is the interesting part of the story. For further Kainos build-out, RaceTrac is now a smart test customer. We signed an additional 3 years of professional services to help with the merger in 2024 and beyond, and we're now exploring and selling the other products all under RaceTrac. In Digital Services, the decline in the revenue figures overall for digital services has been a combination of economic and the political environment in the U.K. Each of the 3 sectors has different characteristics. In H1, we saw the early election being called in the U.K., which resulted in a slower ramp-up in projects and some delays in decision-making, which has impacted our public sector business. In our previous experience of 4 U.K. election cycles, growth has returned quickly as new ministers have taken their posts. This time around, we underestimated the impact and there's been more pronounced. That's caused us to give the trade an update on the 31st of October. We're taking a cautious outlook for H2 and into financial year '26. There is a spend review in the springtime that will span multiple years. That should give more clarity in the longer-term priorities and stimulate more action. I'd be delighted if we saw an earlier uptick. So I would emphasize these are delays rather than cancellations. Our win rate hasn't changed. The message from the government is a driver for digital transformation. It's around efficiency, use of technology, around using data and AI. But also as a reminder, the business of government hasn't stopped. There's still opportunities coming out of procurement. And actually, our top 8 opportunities in the pipeline have a maximum contract value of GBP 270 million, and that's due to have results sometime between January 2025 and July 2025. The biggest concern at the moment for our sales team in the public sector is the capacity to staff bids for everything we think we have a chance of winning. So it's always a good problem to have. We're just being cautious around the timing of decision-making, and it's very much a question of when rather than if. So I'm really pleased to talk about the strong growth in our health care business as a result of a lot of hard work from the team over the last 12 to 18 months, diversifying our health care business in a post-COVID health care world, where the merger between the NHS England and NHS Digital is now bedded in. So an example of a project we've won recently is around urgent and emergency care with a total contract value of GBP 36 million over 4 years. That covers services like the 999 service or the NHS 111 service. Commercial sector has seen further headwinds as we expected. We've seen a continuation of delays in the decision-making, but I don't want to overstate this. It's about 6% of our overall group revenue. So a quick case study for Digital Services, Our Future Health. U.K.'s biggest health research program, which aims to revolutionize disease prevention, early detection and treatment to improve the health and well-being of millions of people across the U.K. So think about common diseases and conditions such as cancer, Alzheimer's or heart disease. So our solution is around secure data platform with a simple and accessible registration service for volunteers to capture health, lifestyle information and enable participants to make clinical appointments to provide blood samples. It's all integrated with the CRM solution to record all the volunteer interactions. It also encompasses a digital application that helps clinical staff to manage appointments with up to 5 million volunteers, this is a huge challenge. It is expected that this data may hold to key to hundreds of discoveries leading to new or improved screening or prevention programs and earlier treatment. I want to talk a little bit about AI before I finish up as well. We set an exciting AI vision. We're inspiring, guiding and enabling responsible AI adoption to drive real business value for our customers. In H1, we invested and we scaled our teams to help our customers adopt AI quickly, responsibly and with purpose. We've invested in a dedicated AI catalyst team to amplify our brand to create leads and develop proofs of concept for customers under 5 days. Ultimately, it's to drive sales. Since its launch, we've delivered at least one proof of value per week. That includes things like an AI-assisted underwriting tool for insurance brokers or AI note taking for local authorities. So it is about responsible AI and responsible adoption. We're supporting secure and ethical AI adoption through our repeatable AI adoption framework. But ultimately, it's also about the excellence in delivery. We continue to pride ourselves and the delivery excellence with over 200 AI and data professionals delivering transformative projects for over 30 of our AI customers. We have now 500 colleagues who are trained in generative AI and over 50% of projects are using copilots to assist in accelerating our development pace. To give you an example of a project that's actually made it through into the live environment with DVSA, the Driver and Vehicle Standards Agency who look after vehicle inspections. So we developed an MOT Assistant. The MOT testers also often have a difficulty in determining the severity of vehicle defaults accurately. And over the course of 2018 to 2023, 4.9 million vehicles had incorrect, missed or misrecorded defects in MOT certificates. This is particularly difficult for people who've got issues around accessibility. It might be things like dyslexia. So in our solution, we've developed the MOT Assistant. It's an AI-powered pocket assistant designed to assist MOT testers to accurately classify vehicle defects. It records, transcribes verbal prompts, displays relevant issues and it is based on a systematic approach to provide criteria and content for decision-making. It's already live. It's been rolled out to up to 24,000 garages now across the U.K. with 80,000 mechanics. It's going to be a reduced time to test. DVSA have estimated that it will save garages up to GBP 14 million per year upon full rollout. It will also make for reduced training time for new employees and it supports natural language translation to support a more inclusive engineer engagement. So as we look ahead, so thinking about across all 3 of our divisions, we continue to see significant long-term opportunity in our core markets despite the current services softness. In digital services, we continue to be the leading partner in digital transformation in U.K. public sector. Despite the current hiatus in decision-making at the new government, the stated ambition for digital transformation from labor is there and the long-term drivers for efficiency and better citizens saving services tend not to go out of fashion. Our health care business is growing, and we're well placed across a diversified customer base. And the business cycle will change for our commercial sector. And our response will help us to capitalize in the medium term. We want -- we've talked about what we're doing in the U.K., but we also want to continue to grow digital services internationally. We see a path for future growth in the public sector in Canada and across our Workday services clients in North America. The numbers are currently not reported separately. It's still less than GBP 10 million per year, but the growth rate is over 50% over the last year. So that's definitely one to note for the future. Workday Services, while our Workday Consulting is in a changing market for us, with exciting opportunities to expand geographically. Australia is exciting before thinking about any other countries. And then there's the other adjacent services. So it's really putting customer challenges and their use of the Workday platform at the center for us to expand the services that we deliver. We will continue to be innovative. We've previously been called out by Workday as our most innovative partner. And then finally, for our Workday products, we're really at GBP 65 million of ARR with great momentum due to the sales success in all of our products. We're excited for the future as we get closer to our ambitious GBP 200 million ARR target and of course, not forgetting that GBP 100 million target by 2026. We've built Workday partnership, which again is just super exciting. We now have a new level of recognition within the Workday ecosystem and within the Workday organization. And in addition to our existing products with over 500 customers, we look forward to expanding our product portfolio and reporting back on progress. So I'm going to bring the presentation to a close, and I'm going to repeat the current trading has mixed performance, but there's still a lot to be pleased about and we remain both excited and confident about our opportunities ahead. I'm going to stop sharing my screen. I'm going to pass over to the FTI to host the Q&A session.

Thank you, Russell, and good morning all. As mentioned, we'll now turn to the Q&A portion of the analyst presentation. [Audio Gap]