Kape Equity Research Report

Today I would like to tell you about Kape, a UK listed midcap I hold which, due to operating in the fast growing sector of digital security, is a clear beneficiary of Covid. The COVID-19 pandemic has increased the requirement for staff to work remotely, dramatically accelerating the digital transformations for many companies and industries. I expect many of these changes to become permanent and demand for VPN subscriptions, which allow employees to connect safely to their work networks, is expected to grow three-fold to US$70bn by 2026.

This material is not investment research in accordance with the legal requirements designed to promote investment research independence and is also not subject to any prohibition on dealing ahead of the dissemination of investment research; and as such is considered to be a marketing communication.

Kape operates in an attractive sector where growth has been materially boosted by the pandemic, but the shares trade on a forecast 2022 PE ratio of just under 13x. This looks very attractive but the shares are not without risk as I detail below.


Source: Stockopedia

Past performance is not an indication of future results.

Company Description

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 profit growth. In addition, earnings visibility is quite high as Kape is also achieving strong customer retention of around 83%.

Its operating segments are Digital Privacy and Digital Security:

  • The Digital Privacy market is a fast growing area and the COVID pandemic has increased its profile and according to the company made it “mass market”. The VPN market exceeded $25bn in 2019 and is expected, by Global Market Insight, to reach some $70bn in 2026. This is increasingly Kape’s dominant focus and 53% of the business is from the US
  • The Digital Security market is more mature but still very big, with projected market revenues of $170.4bn expected in 2022 (Source: Gartner, Wandera)

There are good reasons why this growth is likely to continue:

Source: Kape

Source: Kape

Background

Acquisitions are an important part of Kape’s growth strategy, and it seems to have worked well so far. With its digital marketing background, Kape has grown partly by acquisition, driving value by stripping out costs and scaling up the number of leads received by its acquired products. It does this with the customer acquisition-focused tech stack it has developed. Kape has completed six acquisitions in around four years, with more no doubt 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.

At this point, Kape had managed to grow customer subscriptions up to 2.5m. Granted it has done this via a series of acquisitions which is a higher risk strategy, but this doesn’t take away from the company’s successful implementation nor its attractive exposure to a buoyant and growing sector. The group’s big acquisition of PIA further skews Kape’s business towards the faster-growing Digital Privacy segment:


Source: Kape

Recent Launch of Privacy Suite

In Q3 2020, Kape launched a new product, the CyberGhost 8 Privacy Suite, which the CEO says gave the business a noticeable lift. This is a comprehensive security suite and 25% of users wanting VPN opt for it. Rather than just being an upsell, CEO Erlichman notes that it also boosts lifetime values and reduces churn. With Kape therefore increasingly throwing its marketing dollar at growing VPN sales over security product sales, the Digital Security segment fell 5% to US$16.7m. In the most recent results, we heard that 10% of new sales of Cyberghost took the suite solution which should give an immediate uplift in revenue per consumer. The combined group now has 2.5m subscribers and 83% customer retention (up from 81%) which they contend is very high compared to industry benchmarks.


Source: Kape

Investment Case

The Surprise Acquisition of Webselenese

During February, Kape announced a hugely oversubscribed placing of shares to raise US$115m at 150p, setting the stage for another big deal. Subsequently, the Kape share price soared 27 per cent following its US$149m earnings accretive acquisition of Webselenese, an independent digital platform that provides 8.5m users with unbiased insight driven content focused on cyber security and privacy trends that attracts all the major software vendors in the space (McAfee, NortonLifeLock, Dashlane and Kape).

Source: Kape

Webselenese is a very important strategic acquisition for Kape. It attracts over 105 million users interested in improving their digital security and privacy. Webselenese has achieved this through very strong bi tech enabling them to analyse and improve user journey as well as through very strong and high quality localised content (29 languages). In addition, Kape and Webselenese have known and worked together since 2017 (after the CyberGhost acquisition).


Source: Kape

Kape’s rationale was that they wanted to add organic traffic flow to their digital properties and by buying Webselenese, they are adding one of the strongest and best proven marketing platforms in the industry which should provide a meaningful competitive advantage going forward. The company estimates that this acquisition will reduce their customer acquisition costs by (conservatively at least) 16% and that is without assuming any uplift in the combined organic sales of the digital security divisions as a direct result of this combination.

Source: Kape
Past performance is not an indication of future results.

Like Kape, Webselenese is fast growing and hugely profitable: cash profit tripled to US$30.7m on 91 per cent higher revenue of US$64.5m in 2020, with both financial metrics increasing more than 10-fold in the past three years. Its owners will receive 12.1m Kape shares worth US$32.5m in part consideration to give them a 5.44 per cent stake in the software group. That’s important as Kape will benefit from their extensive expertise in growing the business. Kape part funded the US$116m cash element from its own cash resources and an US$85m bridging loan provided by its majority shareholder which will be refinanced in due course.

I feel on balance we have every reason to be hopeful that the acquisition of Webselenese will prove a game changer for Kape. What gives comfort is Kape’s successful record in integrating acquisitions and delivering on synergies (as demonstrated by the large acquisition of PIA – see below) as well as the fact that the two companies know each other and have worked together in the past few years.

When we look at what happened after the acquisition of PIA now it’s well into its second year, we can see the business has grown strongly and integrated well and 97% of the core PIA team have stayed and taken key positions in the combined group. According to the company, PIA has shown month-on-month growth every month at an even better rate than expectations. They add that they couldn’t be happier with the integration of systems and personnel of PIA and synergies that have been achieved are bigger than expected.

Source: Kape
Past performance is not an indication of future results.

Recent Results

Kape’s trading update yesterday for the first half of its current financial year confirms that the Group continues to show strong growth in line with management’s expectations for the full year. Importantly, the integration of Webselenese is ‘progressing well’ and has already realised a reduction in average customer acquisition costs for the Group. Revenue for H1 2021E is expected to be c. $95.7 million, up 60%, or 27% on a proforma basis. The adjusted EBITDA margin increased to 30.1% versus 27.8% in H1 2020. The Group’s core privacy division has seen 17% growth in revenues in H1 2021E while the digital security segment also returned to growth with a 9% increase in revenues over H1 2020.

Management also detailed a new content provision agreement that Private Internet Access (PIA) has concluded with 3 Hong Kong, a subsidiary of the Hutchinson Group, which added another string to Kape’s bow. This is the first agreement of its kind for Kape (and the first co-operation between Kape and a telecom operator), which will see its VPN offered to postpaid and prepaid customers of 3 Hong Kong, a subsidiary of the Hutchinson Group with 3 million customers.

The recent 2020 final results statement from Kape showed very strong growth, with revenues up 85% at $122.2m and adjusted pre-tax profits up more than 146% at $26.1m ($10.6m). Earnings more than doubled from 6.5c to 13.5c per share. Brokers’ estimates, for this current year and next, show $200m of sales for 2021, then $250m for 2022. Profits could more than double to $64m this year and move up to $84m next year, worth 25.5c, then 33c in earnings per share.

Revenue was driven by a 31% increase in organic growth in the digital privacy segment and full year contribution of Private Internet Access, the company said. “We have successfully completed the integration of PIA realising cost savings which were 50% higher than we anticipated, alongside strong traction in new users in Q4,” it added. Subscribers rose to 2.52 million at 31 December 2020 from 2.31 million last year. Visibility on revenues from existing users increased to $110.5 million, up from $98.8 million. The US at 53% of sales is now by far the largest market.

What was important in these results was the cash generation. In the past, this has been the Achilles heel of the business (the fact that they struggled to generate cash given their breakneck growth speed). 2020 results showed a very cash generative business (£20.4m operational cashflow versus £1 in 2019) and cash conversion of 112% excluding investments. The business now also has a cash balance of £50m on the balance sheet. The company contends that the very positive cashflow picture is mainly because they started the year with a much bigger subscriber base (means lower investment in user acquisition given high retention rates).

In terms of reliability, the proportion of renewable user revenue has increased significantly and user acquisition costs as a proportion of revenues has dropped markedly by 12% in the period. The company does have debt however. Debt financing was raised at very good rates – 1.8-2.2 percentage points over LIBOR. Current leverage is 1.6x but given cash flows the intention is to get below 1x already in this financial year and to be debt free in 2022.

Source: Kape
Past performance is not an indication of future results.

Looking ahead: the management remains very optimistic about growth prospects

Looking ahead, the company said at their recent AGM that trading in the first quarter of 2021 has remained strong with solid traction for Kape’s solutions:

We are on-track to deliver on our guidance of revenues of between $197-202 million (a c. 65% expected increase) and adjusted EBITDA of between $73-76 million (a c. 90% expected increase) for the full year 2021. Kape now supports c. 2.61 million paying subscribers globally. Since the beginning of the year, we have been adding c. 25,000 new customers a month, on a net basis, in our digital privacy division, and we expect this to accelerate.

Webselenese is proving to be an excellent addition to the Kape family. In May 2021, we launched our Privacy First Anti-Virus for PC, which will initially be Intego branded, and in the coming months will be rolled-out to both CyberGhost and Private Internet Access users as part of a wider Company initiative. We believe we are well positioned to become the one-stop shop of choice for our customers’ digital privacy and security needs through our product suite and go-to market capabilities.

Prior to the acquisition, Kape was expected to deliver 2021 cash profit of US$41.5m, so profit estimates have doubled. However, the share count only rises 5.8%, so even after factoring in higher interest costs, earnings per share (EPS) will soar.

Kape believes that the perceived need for VPN is going mass market as ordinary people understand the risks more clearly. If Kape just kept their (albeit small) market share of the VPN market, there is every possibility for the business to more than double given the underlying sector’s expected growth. Global Insights (GI) published a report about 12 months ago specifically on the size and future of the VPN market. Globally GI expected the market to grow from c.$30bn today to c.$70bn by 2026. It expected 16% to be consumer-driven, not heavyweight commercial stuff. So $4.8bn growing to about $11bn. Kape’s current revenues are a fraction of this. All in all, this group is building up fast and I would suggest that higher earnings estimates will soon follow.

Source: Kape
Past performance is not an indication of future results.

What’s not to like

I think the key risks to be aware of are that:

  • Kape operates in a very competitive sector

  • The Webselenese acquisition is large and decisive in terms of prospects

  • The company’s record on cash generation has not been the best (albeit this year’s results are very encouraging on that score).

In my opinion these concerns are the very reasons we can pick up such a high growth stock at these low valuations.

Some analysts contend that c. 80% retention rate is not that fantastic and that Kape clearly operates in a competitive market, getting more so over time. They worry that unless the retention rate goes up or the cost of client acquisition goes down then cash generation will remain elusive. To be fair, it is a big ask to be throwing off cash at the same time as investing for the future. Nevertheless, cash conversion to profit was only 65% last year given new subscribers require upfront marketing investment. However, as renewals start to kick in, Kape looks capable of delivering a tidal wave of cash. In my opinion, delivering better on cashflow will help alleviate many of these concerns and result in a higher rating for the company. Meanwhile it is very likely that Kape will continue on its high growth trajectory anyway, therefore even without a higher PE multiple, there is strong upside.

One other thing to note about the company is that insiders hold more than 60% of the stock. Normally, this would be seen positively as showing that their interests are aligned with us as shareholders but in this case, the CEO is a colourful albeit well-connected character who certainly divides opinion! More generally, I would say many market participants seem to distrust Israeli tech stocks and I definitely remember a few dodgy ones in the 80s/90s but there have been numerous success stories in the more recent past amongst companies I know well and have invested in.

I think people also worry that the Webselenese acquisition is simply too good to be true. On the face of things, the acquisition is both earnings accretive (it will boost Kape’s earnings this year) and a strategically smart play. Firstly, let’s look at some excerpts to understand just what a change in business it would be for Webselenese going from being an unbiased information platform to being owned by one supplier:

Webselenese’s mission is to provide honest and unbiased information via its well-regarded websites that have received thousands of positive user-generated reviews. Webselenese was founded with the goal to provide best-in-class consumer-focused privacy and security related news and product information to users across the globe. Its team of researchers extensively research and test every product before reviewing and recommending it

So, Webselenese is essentially an independent comparison tool, which through its various websites such as vpnMentor provides unbiased and honest reviews of consumer cyber security technologies. Kape is a provider of cyber security software through its solutions such as Zenmate and Cyberghost, which are aimed at personal consumer security. For many years, Kape was a client of Webselenese, advertising as a vendor on its web platforms.

As the above description from Kape alludes, the deal makes economic sense. Webselenese grew revenues by 91% in 2020. It is also a very profitable company, with a growing customer base and good EBITDA margins (roughly 50%) — it will be immediately accretive to Kape’s earnings profile and therefore the huge rise in Kape’s share price on the announcement of the deal is justified.

However, we need to be aware just what a sea change this acquisition is: this acquisition would be akin to Hilton or Intercontinental Hotels purchasing the likes of Tripadvisor. The competitive advantage that Kape is discussing above is equivalent to the competitive advantage that the Hilton Corporation could leverage by analysing all of the customer data from Tripadvisor and using this information to boost its own ‘independent’ ratings! In this sense, Kape’s decision to acquire the independent, unbiased, review platform sounds like a fantastic strategic move. However, it is clear that challenges present themselves. The most obvious challenge is of Webselenese retaining credibility as an independent and trusted authority by its user base when it has been acquired by one of its key vendors. Webselenese are clearly aware of this conflict of interest as they have posted the following statement on their website post the acquisition announcement:

vpnMentor is proudly unbiased; the information here is unaffected by the commissions we get when a purchase is made using some of our links. We take pride in the fact that, although Cyberghost, Zenmate and Private Internet Access are owned by our parent company, we nevertheless, examine all our products according to the same strict evaluation standards

In summary, there are risks but it seems more likely that this acquisition will be very beneficial to Kape and its shareholders.

Conclusion

At 300p and a forward PE of 13x, Kape is very attractively valued for a business with such high growth potential and I believe the balance of mid-term opportunity vs. risk is materially in our favour as investors. Backing this view is a record of strong strategic execution to date (both organic and M&A) and the exciting prospects for the enlarged Group following on from the Webselenese acquisition. With high recurring revenues, a large and growing customer base and a markedly increased earnings outlook, Kape looks well set for the year ahead and beyond.

The 85 per cent EPS upgrade to 32.5¢ (23.5p) for 2022 is even greater as Kape will benefit from a full 12-month contribution from Webselenese, as well as ongoing organic growth across all its businesses. Moreover, because free cash flow is set to surge by more than half to US$31.3m in 2021, and could almost treble to US$81m in 2022, with Kape set to pay down all debt by the end of 2022. As demonstrated by the new growth avenue provided by the new 3 Hong Kong agreement, the risk to 2021 and 2022 earnings estimates remains heavily skewed to the upside, a factor not reflected in valuation metrics.

This material is not investment research in accordance with the legal requirements designed to promote investment research independence and is also not subject to any prohibition on dealing ahead of the dissemination of investment research; and as such is considered to be a marketing communication.

All investments have the potential for profit and loss and your capital may be at risk. Past performance is not indicative of future results.

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Very exciting news this morning from Kape. The new proposed acquisition of cyber security specialist Express VPN is transformative for the group, with 28% increase in accretive EPS forecasts and adding an established cash generative business. The acquisition will be funded by cash and shares. Here is the write up from the firm’s broker Shore Capital:

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