Description

(Note: Consensus above is FY with a July 31 FYE, we are using GBp conventions for Share px) 

Idea Summary

There's lots one could say here (business in transition, underlying business trends vs headline as a result, mislabeling due to history, ongoing woes of UK small cap, etc) but, at the core, this is bumpitrage in an already competitive situation (i.e. we expect a topping bid). The idea is this: Kin and Carta (KCT LN) has a an offer out from BC Partners at 130p. Prior to that, Apax had already bid for KCT at 110p (that bid was accepted, prior to the topping bid from BC). The stock trades at 135p at time of writing. At YE23, Apax said its prior 'Increased and Final Offer' is no longer quite so final and that "Apax is considering its options and a further announcement will be made when appropriate." Both PE shops have active, deployed strategies around consolidating assets in this space and we believe that the value is fairly clear here for Apax to increase its bid a further 20%, if not substantially more. In the event that they do not offer a topping bid, we judge ~4% downside to be attractive and manageable given that the BC offer at 130p is highly likely to go through barring a higher bid from Apax. 

Business Overview

Kin and Carta plc ('KCT' here, or 'Kin + Carta' to use their trendier new trade name) may be formerly known to some longstanding UK-watchers as St Ives plc, a provider of print marketing services and book printing (including 'Harry Potter' and 'Twilight'). Understandably, the company traded as a melting ice cube for years as it took the cash flow and attempted to build something new and future-oriented (changing its name in the process to break with history). Despite all odds, they appear to have succeeded and the KCT of today is now a pure-play 'Digital Transformation' IT consulting business.

'Digital Transformation' (aka 'DX') is a famously opaque descriptor, but generally it can be thought of as higher-end, more skills-intensive and more modern IT services. Generalizing here, but that work often tends to be stickier as well (e.g. maintaining an app or function for a larger company's code base). Their 'Kin + Carta Create' segment represents 65% of their net revenue and they describe that business function as 'Modern Cloud Engineering and [an] Emerging Tech Studio for our CIO Buyer'. Examples of their work include automating lead qualification for Berkshire Hathaway, implementing the Google Marketing Platform suite across Europe for Lexus and building an app for Corteva's agronomists to use in the field.

The customer base is genuinely very impressive considering KCT's small size:

And they have added blue chip logos consistently over time:

As of 2021 CMD, it was heavily indexed towards financial services players (Discover in particular):

Emphasizing their technological bonafides, they regularly get recognition for things like "2023 Google Cloud Industry Solution Services Partner of the Year Award for Retail Digital Growth’, and ‘Sustainability Changemaker 2023 Microsoft US Partner of the Year Award." They were a launch partner for Google's generative AI platform, an early access partner to Microsoft's version of the same and appear to be a strong partner to Amazon as well. Bottom line, we think there's some evidence that they may be uncommonly well-regarded for their size and they clearly come with a deep, sticky book of business among marquee customers and partners:

More tangibly, this is now a 192mn GBP business on a revenue basis. Frequent M&A along the way makes clear conclusions difficult, but we think KCT's DX business was growing mid-teens organically pre-Covid and can continue to grow in-line with or better than other DX peers going forward (HSD or better). For example, their 'Data & AI' service line is growing 55% YoY.

Their active push for more near-shoring is likely going to depress headline growth in the near-term - the whole value proposition of overseas work is that they charge less per unit of work - but should improve margins and competitiveness over time. Unlike most DX businesses, KCT is still shockingly American and British (as opposed to Indian and, to a less extent, Eastern European and Latin American).

70% of revenue is in the Americas (mostly the US) and financial services, retail and Ag/Industrials predominate as clients:

There's an open question about how much credit you are willing to give their adjustments however, on paper, this business already has very solid Adj EBITDA margins even prior to its near-shoring journey. As e.g. LatAm headcount grew by 44% in FY23, we think it's plausible that KCT could converge on the 15%+ margins of EPAM et. al., especially if merged into another, more-scaled entity.

Situation Overview

That dovetails nicely with the situation today. BC is attempting to acquire KCT through its Valtech (IT consulting) unit and Apax has similar exposure to this category via, for example, its continued controlling stake in Thoughtworks (TWKS). In fact, TWKS is a busted IPO and Apax hinted at its continued enthusiasm for the category by considering a take-private at a 50%+ higher price to today as recently as 8 month ago!

https://www.bloomberg.com/news/articles/2023-05-02/apax-said-to-weigh-buyout-of-2-billion-it-provider-thoughtworks

We think Apax, BC and others clearly and correctly view DX as a pretty good category and one that lends itself nicely to platform-style M&A. We further think it is in that framing that KCT was approached by both bidders in October and December, respectively.

Risk/Reward

So, what might Apax (or others) be willing to pay? Even after the second bid, KCT trades at or near the bottom of the range of multiples (the relevant framing, we think, given the active M&A). Thoughtworks is among the worst-performing DX assets (esp in terms of growth) but, if we were to value KCT at a TWKS multiple despite KCT's better performance, we would see upside of 25% (using fwd EBITDA multiples) to 40% (using fwd P/E). Apax appears to have been willing to consider buying in TWKS at 50%+ higher prices, which may suggest their WTP above current market levels for TWKS. If you are willing to start comparing KCT to top-of-the-category players (e.g. EPAM), the comps math suggests that this could be a double or more (although we are by no means underwriting to that!).

Because of KCT's relatively small size at <2% of EPAM's market cap (EPAM has a $16bn cap even after the Russian invasion!), the company is attractively bite-sized. We think that plus its customer quality, 'unoptimized' geographic footprint and strong reputation make paying up a bit more palatable. 

Meanwhile, we consider the deal risk with BC to be small so the risk/reward seems highly skewed given that KCT is only trading a few points through the deal price.  

Catalyst

* Apax topping bid

* 'Kiss' from BC to prevent said topping bid

* Additional bidder comes in (we have no view here)