Kainos pauses after stunning run

Kainos made millionaires of staff when it floated the tech business in July at 139p. They'd have doubled their money again if they'd held on a little longer, with the shares topping out at almost 300p earlier this month.

However, with the chancellor's Spending Review due on Wednesday, and with government decisions having already hit gross margin at the core digital services division during the first-half, investors are trousering profits.

Set up in 1986 as a joint venture between ICL (now Fujitsu) and Queen's University of Belfast, Kainos makes its money as a specialist in digital technology, software design, third-party software integration and implementation, and tech support. It's been hugely successful in winning government contracts, and pre-tax profit excluding IPO costs jumped by a fifth in the six months ended 30 September to £6.8 million.

Revenue grew by 29% to £37.2 million, and sales bookings (the value of contracts signed excluding taxes) leapt by 55% to £34.8 million. And Kainos, which typically wins 25-30 new contracts every year, added 30 new customers in just the first six months of this year. Admittedly, some of that is due to sales of cheaper services, particularly the Smart automated testing tool, but this is a clear boost nonetheless.

Being picked by Apple as a partner is a significant boost, too - the American colossus clearly wants to sell more iPads to businesses, and Kainos is one of a dozen new partners chosen to help target the medical industry. The firm's Evolve software is already used by the NHS to digitise patient records.

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However, despite an 18% increase in revenue at the digital services unit to £24.4 million, gross margin for the division dropped 9% to 46%. That meant profit fell by £0.3 million to £11.1 million, due to changes in some government contracts, including cuts on a big deal with rural agency Defra. Kainos chief executive Brendan Mooney tells Interactive Investor that most of this has now washed through and margin should improve in the second half.

The government's Spending Review midweek is also likely keeping investors on the sidelines. It's expected to make grim reading for government departments, with massive cuts across the board. Still, Kainos is embedded in nine different departments, and cost cuts will mean they'll have to digitise more work.

"It's good for us," says Mooney, "but it will take time to get there for Kainos". It will be mid-February before we see clear plans from departments about which projects will get priority, he thinks. 

Clearly, there is great potential here, but Investec Securities also believes Kainos shares will "pause for breath as it consolidates post its exceptional run". It's why the broker cuts its rating from 'buy' to 'hold' and repeats its 250p price target.

Even at that level, Kainos would trade on 27 times earnings per share (EPS) estimates for March 2016 of 9.4p. Investec adds: "It is prudent not to upgrade our forecasts now, but wait until the impact of the CSR [comprehensive spending review] is clear."

This article is for information and discussion purposes only and does not form a recommendation to invest or otherwise. The value of an investment may fall. The investments referred to in this article may not be suitable for all investors, and if in doubt, an investor should seek advice from a qualified investment adviser.