Hunting for compounders - Kape Technologies

Kape Technologies (LON:KAPE) , it’s fair to say, divides opinion. On the one hand, it’s growing at pace, but on the other it is majority-backed by a colourful billionaire and comes with some pretty hard-to-decipher accounts.

At a recent Mello Bash, I was asked to look into this mid cap technology stock and owner of the CyberGhost VPN brand. Either this is a great investment opportunity in a high growth market, or it could go badly wrong.

My initial view is that Kape Technologies is probably well-placed to grow for many years to come. It will do this via organic investment and acquisitions. Given that, I think it is probably attractively priced at 17.2x forecast earnings and 4.1x forecast sales.

But I qualify my view due to accounting issues which I have so far failed to resolve. And because of that I continue to rule it out as an investment.

There’s no two ways about it: Kape’s accounts are hard to understand. Perhaps Kape holders on the site can give some insights.

As I see it, underlying performance is obscured by:

• The recent shift in strategy and reporting segments,
• Subsequent material acquisitions,
• Adjusted cash flow accounting,
• Adjusted EBITDA measures, and
• Accounting for contracts.

Complicated accounts put me off. It seems I’m not alone - the Mello panel quickly identified these issues and the company was deemed a clear majority ‘Sell’ in the eyes of the c500-strong audience.

It would be great to get some views on this one because if these doubts over the accounting can be legitimately explained, then we are probably looking at a high growth company that is being discounted by the market due to it being in the ‘too difficult’ tray (or worse) for many investors.

Kape: a brief summary

Kape is a digital security software provider that focuses on protecting consumers and their personal data as they go about their daily digital lives. These security products are designed for big, growing global consumer markets.

The group has successfully transitioned to a SaaS model and boasts strong revenue visibility and EBITDA growth. With its focus on customer service, Kape is also achieving strong customer retention of around 80%.

Its operating segments are Digital Privacy and Digital Security.

• The Digital Privacy market is a fast growing area and the COVID pandemic has increased internet usage. The VPN market exceeded $25bn in 2019 and is expected, by Global Market Insight, to reach some $70bn in 2026.
• The Digital Security market is more mature but still very big, with projected market revenues of $170.4bn expected in 2022 (Source: Gartner, Wandera).

Given the above, a forecast PE ratio of 17.2 in the Growth & Value box looks very attractive. But note the vastly different price to free cash flow metric further down.

Admittedly this compares forecast and trailing twelve month data, but it still draws attention to differences between cash flows and earnings figures reported by management, in my view.

The story so far

With its digital marketing background, Kape drives value from acquisitions by stripping out costs and scaling up the amount of leads received by its acquired products. It does this with the customer acquisition-focused tech stack it has developed.

It’s an important part of Kape’s growth strategy, and it seems to have worked well so far.

Kape has completed five acquisitions in around four years, with more on the agenda.

A brief history:

• The group IPOd in 2014 as Crossrider, valued at $250m. Crossrider specialised in digital advertising.
• In 2015 the group reported a drop in adjusted EBITDA and the CEO resigned.
• 2016 was a year of restructuring, and current CEO Ido Erlichman came on board
• In 2017 it was renamed Kape. Kape acquired Cyberghost, where it has since increased revenues from $5m to an anticipated $40m this year. It also made good progress in transitioning towards a pure SaaS model
• The acquisition of Intego in 2018 brought a strong cyber security research team into the fold, which has subsequently been expanded. Zenmate was also acquired.
• In 2019 the group merged with PIA, one of the leaders in the US digital privacy market. So far, 30% of new PIA sales have come from Kape’s user acquisition platform.

Kape has managed to grow subscriptions up to 2.4m in short order. Granted it has done this via a series of acquisitions, but that is testament to the buoyant and growing market this company focuses on.

Accounting quality

Tracking segment performance over the years is hard due to the fact that Kape has only recently begun to report results across Digital Privacy and Digital Security.

So, digging through the accounts, we immediately come up against a lack of comparability.

Depending on which side you fall, this will probably strengthen your existing view of Kape as either a bargepole stock or a high-risk high-reward company in transition.

For what it’s worth, here is the segmental performance I have been able to assemble.

You can see the group’s recent big acquisition of PIA now skews Kape much more towards the fast-growing Digital Privacy segment.

There’s no denying the growth trajectory looks good, but we already have two complications: a recent large acquisition and a lack of historic comparability across accounts.

Accounting issues

And if you dig into the accounts, you find more questions.

Adjusted EBITDA

Reading through management commentary, you will find multiple references to adjusted EBITDA. This measure of profitability has hovered around the $10m mark for much of Kape’s operations so far.

So finding on the Financial Summary that Kape has generated a net loss for every year except 2019, might come as a surprise. This important fact could have been more simply and forthrightly conveyed to shareholders over the years, in my view.

It’s true that the direction of travel in net profit has been on a pretty steady path upwards, but still, the ‘adjusted EBITDA’ figures used by management are a long way from the profits attributable to shareholders.

Here are the adjustments between adjusted EBITDA and operating profit over the reporting periods measured as a percent of total adjusted EBITDA:

There is a constant stream of ‘exceptional and non-recurring costs’ - likely due to Kape’s acquisitions. And increasing depreciation and amortisation charges mean the gap between adjusted EBITDA and operating profit has grown.

It could be that Kape is approaching an inflection point, and that cash flows and operating profits will soon reduce that gap to adjusted EBITDA. But for now it makes me slightly uneasy.

Adjusted cash flow

We also have ‘adjusted cash flow’ after ‘adding back payments that are one off in nature’. Surely cash is cash - it either swaps hands or it doesn’t.

In the FY19 accounts, Kape refers to cash conversion, which is a good measure to follow. But the definition of cash conversion here is ‘adjusted cash flow from operations as a % of adjusted EBITDA’. And these two figures are adjusted in different ways.

And, what’s more, in 2019, even this adjusted cash conversion figure was just 7%. So Kape prefers to use an adjusted adjusted cash flow figure by excluding the ‘increase of deferred contract costs’.

This amounts to some $16.93m and takes FY19 adjusted cash flow of just $0.97m up to $17.9m.

This, of course, gives Kape a much nicer looking cash conversion of 123%. Needless to say it is this heavily adjusted figure that is used as the headline ‘cash conversion’ in the management commentary, often with no qualification as to how it has been calculated.

In fact I’m still not sure the adjusted calculation of cash flow for 2019 even makes sense.

Source: 2019 Annual Report

We start off with $1.357m of CFO in 2019 and a positive $2.331m of exceptional & non-recurring payments. That should make for an adjusted CFO figure of $3.668m, not $0.974m.

The 2018 column adds up on the basis that a positive exceptional and non-recurring payments line is added back to CFO to arrive at adjusted CFO of $5.721m.

Even though management notes that ‘Cash flow from operations was $1.4m’ in 2019, this was in fact an outflow. So negative $1.4m plus positive $2.3m gets to the $0.974m adjusted figure.

If we then head over to the actual cash flow statement in the 2019 accounts, we can confirm that this is a $1.4m outflow.

Everybody makes mistakes, and a forgotten minus sign might not indicate anything sinister, but I would still expect it to be spotted by a management team that cares about its accounts and communication with shareholders.

And then there are the deferred and capitalised contract costs themselves. But, again, I’m running out of time and space.

Suffice to say that there are about $29.34m in assets and $35.31m in associated liabilities on the balance sheet regarding contract costs. For what it’s worth, the independent auditor does say it found no material issues on this matter in its review.

Focusing on Quality

It could well be that Kape’s combination of trading momentum, internal investment, acquisition pipeline, and the wider VPN market growth is just so potent that this company will continue to grow successfully in the years ahead.

But there’s a reason I have never looked at it closely before and that is because of the low Quality Rank and other quality flags on the StockReport.

So it’s nice to see that, after going deeper into the accounts, I do agree with the Stockopedia algorithms. Other issues stand out as well - all falling under the umbrella of the Quality factor.

Low returns on capital

There are a few categories in which management can deploy a firm’s capital. It is worth bearing in mind that acquisitions - and particularly large acquisitions - are often flagged as a potentially value destructive form of capital allocation.

Kape has spent over $159m on its M&A strategy so far, with more to come.

And it is hard to miss Kape’s poor returns on capital. What’s more, the operating margin looks to be heading in the wrong direction, although the lack of data does make it tricky to extrapolate these trends.

While it is still early days in Kape’s strategy of growing quickly into a digital security and privacy firm of substantial scale, these metrics raise questions about the use of capital so far.

That said, big projects can take a while for the related returns to come through. So we could see improving returns in future.

Poor cash generation

The company says it is reaching an inflection point in terms of profits and cash flows, and if it can successfully integrate PIA and make an additional substantial acquisition soon, then historic cash generation will likely be a poor indicator for the future.

Nevertheless, the signs are there in the Financial Summary:

Low F-Score

The Piotroski F-Score is a nine-criteria financial health scoring system developed by financial academic Joseph Piotroski.

Kape scores just three and fails to pass checks regarding increased debt, the recent placing, and faltering margins.

Short screen

Kape qualifies for James Montier’s 'Unholy Trinity' Screen.

This short screen uses the price-to-sales ratio to find companies that appear to be overvalued based on their revenues. It looks for signs of low quality by finding stocks that score less than 3 out of 9 on the Piotroski F-Score of financial health.

Finally, Montier looks for companies where asset growth could be excessive, based on the theory that management teams can be inefficient capital allocators.

Goodwill and intangible assets

On that note, I think the rapidly changing and expanding asset mix is something to keep an eye on. Note how dramatically this has changed, and how intangible assets (in dark blue) have ballooned post-PIA merger.

Conclusion

If you’re still reading, well done.

On the whole, I still think it is likely that Kape will grow rapidly in the years ahead.

The strategy sounds good: buy and develop in-demand, subscription-based digital privacy and security products, strip out duplicated costs, and then use Kape’s user acquisition tech stack and digital marketing expertise to drive a step change in leads and subscriptions.

Internal product development is increasing as profit and cash generation show signs of reaching an inflection point. The group has a strong line up of new product launches including password managers and private browsers.

The forecast market growth is phenomenal, heading towards $70bn by 2026 for VPNs alone. And, at 17.2 times forecast earnings, Kape looks to be attractively priced given its organic and acquisitive growth prospects.

But ultimately I don’t think understanding its accounts should be so hard, and I’ve seen enough to rule this one out for now. Good luck to holders though and counterpoints are very much appreciated.