Half Yearly Report

KBT

K3 BUSINESS TECHNOLOGY GROUP PLC

("K3" or "the Group" or "the Company")

Unaudited Half-yearly Report -

Six months to 31 December 2012

KEY POINTS

Financial Key Points

·; Results impacted by very weak retail markets, with major contract deferrals, and ongoing investment programme ("Project Gemstone") in new global retail Microsoft AX solution

·; Revenue reduced by 5% to £31.55m (2011: £33.36m)

- recurring income up 3% to £17.6m (2011: £17.1m)

- acquisitions made in prior year contributed £6.08m (2011: £3.83m)

·; Adjusted profit from operations*1 decreased to £2.94m (2011: £6.91m) - £0.76m contribution from acquisitions made in the prior year*2 (2011: £0.51m)

Profit from operations decreased to £0.62m (2011: £4.66m)

·; Project Gemstone investment costs of £2.15m after capitalising £0.57m of development costs

·; Exceptional reorganisation costs of £0.48m, primarily relating to past acquisitions (2011: £0.14m) - to realise operational and financial benefits

·; Adjusted PBT before tax*3 reduced to £2.51m (2011: £6.23m) / PBT of £0.19m (2011: £3.98m)

·; Adjusted basic EPS*4 of 6.5p (2011: 18.1p) / Basic EPS of 0.8p (2011: 12.3p)

·; Operating cash generationstrong at £6.92m (2011: £5.81m)

·; Net debt reduced by 8% to £12.32m (2011: £13.35m, 30 June 2012: £15.68m)

·; No interim dividend (in line with dividend policy) but final dividend expected

Operational Key Points

·; "Project Gemstone" programme underway - to develop an enriched global retail software solution based on Microsoft's new AX technology and incorporating the features of K3's successful NAV multi-channel, fashion and wholesale software products

- aim is to become Microsoft's 'go-to' partner for AX for Retail

·; Major new contract wins totalled £3.1m (2011: £8.6m) - but pipeline is strong

·; Mixed performances across four Divisions:

- SYSPRO and Sage; strongest performance, with high levels of recurring income and cash

- Microsoft UK; weakest performance, impacted by investment in Microsoft AX and weak retail market

- International; sales and margins impacted by slowdown in Dutch retail market

- Managed Services; growing gradually, good pipeline linked to Dynamics UK and worldwide SYSPRO opportunities

·; Board expects the Group to return to growth within the next 12 months

Commenting on the results, Tom Milne, Chairman of K3, said,

"This has been a difficult period for K3 with delays in closing key deals in our UK retail software business combining with a major investment in AX for Retail development and resourcing. Economic difficulties in the UK and European retail markets are leading to deals being deferred. Despite this background our other operations have been holding up well with Syspro performing exceptionally in the first six months. Results were supported by the high levels of recurring income the Group enjoys from annual software licence and support renewals across our customer base. Cash flows were also strong as usual in this period.

K3 is in the process of creating a major new global Retail solution built around Microsoft's latest AX technology. This development project is progressing well and we are encouraged by the growing pipeline of interest. Our aim is to be the 'go-to partner' for Microsoft AX in retail and this should be reflected in deal closures through 2013.

Developing intellectual property and global channels to market, together with Managed Services in the medium term, will help to drive K3's growth and is expected to yield significant returns in the future."

Notes:

*¹ Adjusted profit from operations for the six months ended 31 December 2012 is calculated before amortisation of acquired intangibles of £1.82m (2011: £1.75m), acquisition costs of £0.03m (2011: £0.36m) and reorganisation costs of £0.48m (2011: £0.14m).

*2 Contribution from acquisitions for the six months ended 31 December 2012 is calculated before amortisation of acquired intangibles of £1.07m (2011: £0.08m) and reorganisation costs of £0.13m (2011: £0.02m).

*3 Adjusted profit before tax for the six months ended 31 December 2012 is calculated before amortisation of acquired intangibles of £1.82m (2011: £1.75m), acquisition costs of £0.03m (2011: £0.36m) and reorganisation costs of £0.48m (2011: £0.14m).

*4 Adjusted basic EPS for the six months ended 31 December 2012 is calculated before amortisation of acquired intangibles (net of tax) of £1.22m (2011: £1.19m), acquisition costs (net of tax) of £0.03m (2011: £0.36m) and reorganisation costs (net of tax) of £0.36m (2011: £0.10m).

Enquiries:

OVERVIEW

The six months to 31 December 2012 have been an extremely difficult period for K3 combining challenging trading conditions, especially in the retail sector, and a period of significant investment as we increased resources to create a new global retail solution built around Microsoft's latest AX technology ("Project Gemstone") and continued to develop our Managed Services offering. The Group's retail software activities in particular suffered from customers deferring spending decisions and some expected large deals did not close. This resulted in the deferral of software licence revenue and loss of services revenue for which the cost of the sales and delivery resource had already been committed by K3 and so reduced both like-for-like sales and margins, and increased operating costs. The Group's results reflect these challenges, with revenue decreased to £31.55m against £33.36m in the same six months in 2011 and adjusted profit from operations*1 reduced to £2.94m against £6.91m in 2011. Our investment in our Microsoft AX offering in the first half totalled £2.15m after capitalising £0.57m of development costs and profitability was also adversely affected by exceptional reorganisation costs amounting to £0.48m (2011: £0.14m).

Alongside the headline figures, it is worth noting the robustness of our recurring income (from software licence renewals and support contracts), which increased by 3% year-on-year to £17.60m and the Group's very strong operating cash generation at £6.92m. Net debt has also reduced by 8% to £12.32m against the same point in 2011. The acquisitions we made in the prior year performed in line with our expectations at the time of purchase and contributed £6.08m of income and £0.76m of adjusted profit from operations*2.

Project Gemstone is progressing well and we expect our AX solution to be a very significant driver for growth. Microsoft is investing heavily in AX as its strategic global enterprise business solution and we believe this will create a significant opportunity for K3. We aim to leverage our dominant position as Microsoft's largest retail partner in the UK and extend this internationally through our established independent software vendor distributor channel. As we previously reported, we are encouraged by the growing pipelines for AX. The net cost of the AX resource investment charged to profit from operations in the current period was £2.15m after capitalising £0.57m of development costs.

We continue to invest in Managed Services. Here we have improved our product offering and reduced the price points of various services. Both customer numbers and revenues are growing. However, the increase in costs together with the phased recognition of income (which is recognised over the life of the hosting contract) means that we operated at a small loss in the first half. Nonetheless, the growth opportunity is still exciting with a number of large international prospects now at an advanced stage.

There has been some disruption to the business over the past 12 months resulting from the strategic review and sales process which followed the approach by Mr P J Claesson regarding a possible offer for the Company. As we previously announced, this process ended on 18 September 2012 without a final offer being received that the Board felt able to recommend to shareholders and the Board is now firmly focused on its business investment strategy.

As we have stated previously, developing K3's own intellectual property ("IP"), our global channels to market and our Managed Services offering will help drive medium and long term growth and yield significant returns. The steps we have taken in the first half help support this strategy and, subject to market conditions, we expect to see K3 return to growth within the next 12 months.

FINANCIAL RESULTS

For the six months to 31 December 2012, the Group generated revenues of £31.55m (2011: £33.36m). Recurring revenues from software licence renewals and support contracts in the half year increased to £17.6m (2011: £17.1m), representing 56% of Group income in the first half, and continue to underpin the results of the Group. Software sales decreased to £3.72m (2011: £5.04m) and services revenue was £8.54m (2011: £10.79m) reflecting the shortfall in new software wins.

Adjusted profit from operations*1 for the six month period reduced to £2.94m against the same period last year (2011: £6.91m). The upper tier of our Microsoft UK retail sales has moved rapidly to a focus on the AX software suite which is being developed and we have incurred net costs of £2.15m in building up the resource to manage the deals. Additionally, we have capitalised £0.57m in respect of new Retail AX intellectual property that will benefit future periods. We incurred £0.48m of exceptional reorganisation costs, which related primarily to acquisitions we made in the prior year, with the financial and operational benefits to come through in the second half and beyond. These acquisitions contributed £6.08m to revenues (2011: £3.83m) and £0.76m (2011: £0.51m) to adjusted profit from operations*2. Profit from operations at £0.62m (2011: £4.66m) reflected the factors above plus a small increase in the amortisation of intangibles.

Adjusted profit before tax*3 reduced to £2.51m (2011: £6.23m). Profit before tax was £0.19m (2011: £3.98m). This reflects the shortfall in profit from operations, a £0.06m increase in intangibles amortisation and a £0.25m reduction in finance costs as facility utilisation reduces. Adjusted earnings per share*4 reduced to 6.5p (2011: 18.1p). Basic earnings per share were 0.8p (2011: 12.3p). This is stated after amortisation of acquired intangibles (net of tax) of £1.22m (2011: £1.19m) and acquisition and reorganisation costs (net of tax) of £0.39m (2011: £0.46m). There was a net tax credit for the period of £0.03m (2011: charge of £0.52m), which includes the benefit of a £0.60m credit to deferred tax on acquired intangibles (2011: £0.57m), including the impact of UK tax rates reducing in future years.

Cash flow and banking

Net debt at the period end reduced by 8% year-on-year to £12.32m and is £3.36m lower than at the start of the financial year (2011: £13.35m and 30 June 2012: £15.68m). Operating cash flow in the first half was £6.92m, representing 235% of adjusted profit from operations*1 (2011: £5.81m, representing 84%). This highlights the ability of the Group to generate cash from its recurring income base, with cash generation strongest in the first half of the year, reflecting SYSPRO licence and support contract renewals. Deferred and contingent consideration outstanding relating to acquisitions amounted to £1.04m (2011: £4.48m) and we have drawn down an additional £0.84m on our facilities to fund settlement of this consideration. Finance costs reduced to £0.44m (2011: £0.69m) reflecting lower borrowings and foreign currency gains.

Dividend

In line with the Group's dividend policy, no interim dividend is proposed but the Directors intend to propose a final dividend with results for the full financial year.

Operational Review

The financial results by operating division are summarised in the table below:

Microsoft UK Division

Project Gemstone

Microsoft is investing heavily in AX as its strategic global enterprise business solution. Project Gemstone is our software development project, supported by Microsoft, that will create a world class MS Dynamics AX solution for the retail and wholesale markets.

We are taking our existing market-leading retail and wholesale solutions and incorporating the functionality into a single product, Gemstone. The final product will be CFMD "Certified for Microsoft Dynamics" which means that Microsoft will support its international distribution. The first commercial release will be mid year 2013, with more releases following over the next 12 months.

We expect K3 to become one of Microsoft's leading global software authors for the retail and wholesale sectors as a result of this process. We already have an established reseller channel which we will extend to exploit fully this opportunity. Microsoft is seeking to appoint a single 'Go To Market' partner for AX retail and wholesale and we hope that Project Gemstone will help us to secure this status.

Results

The results of the Microsoft UK Division have been heavily impacted by Project Gemstone, our Microsoft AX for Retail product and the sales, delivery and development resources required for this together with very weak retail markets. It has been difficult to close deals at a time when retailers are struggling in the recession and some expected major deals have not been signed. This in turn has meant that consulting services have been depressed. However, we have attempted to offset this by focusing delivery resource on key software development areas and this is likely to result in an additional £1.0m of accelerated product development in the year (of which 50% has been recognised in the period). Encouragingly, our total Microsoft Dynamics pipeline currently stands at close to £36.0m (2011: £28.6m), with a fundamental switch from NAV to AX deals and this should help to support the Group's return to growth.

Revenues at the Microsoft UK Division reduced by 30% to £8.47m (2011: £12.1m), with recurring income delivering £3.59m (2011: £4.37m) due to the absence of major new deals and loss of a significant account. New order wins for the division totalled £0.6m (2011: £8.6m), with the reduction effectively mirroring the pipeline increase year on year. The reduction in revenues and increased retail AX cost base resulted in an adjusted loss from operations*5 of £1.26m (2011: profit of £1.52m), with retail AX contributing a net £2.15m of losses. Whilst the revenue in the retail AX unit had a combined value of only £0.25m, these contracts are important to the evolution of our AX product as they contain our own new IP that we will be utilising in larger contracts. Project Gemstone also incorporates work with our International Division on a development roadmap for fashion, wholesale and multi-channel retail product based on the successful products we already have running with Microsoft Dynamics NAV.

The smaller units in the Division, which sell a mixture of non-retail NAV, non-retail AX and legacy products, enjoyed an improved operating performance assisted by the rationalisation in the cost base following acquisitions in previous years, and a strong performance from Retail Systems Group Ltd ("RSG") which we acquired in December 2011 (revenue: £0.93m, adjusted profit from operations*6: £0.14m). RSG provides a product offering more suitable for smaller retailers, and its results are benefitting from the marketing of the rest of the Retail Division.

International Division

The International Division, based in The Netherlands and Singapore, saw a mixed performance. Inter IKEA Systems B.V. (the owner and franchisor of the IKEA concept and the largest customer in the Group) continued to perform extremely well with revenue up 16% at £2.0m (2011: £1.72m). The domestic Dutch fashion market, by contrast, slowed considerably with customers reluctant to commit to deals whilst the full impact of Government austerity measures are being absorbed. Our cost base in Holland is geared to a higher level of activity and the severity of the impact on the Dutch market means that margins have reduced. There are however a number of operational changes that will improve this situation as we move into the second half of the year. Revenues increased by 11% year-on-year to £5.39m (2011: £4.84m), mainly reflecting the addition of Unisoft, and recurring income increased to £1.93m (2011: £1.90m). Adjusted profit from operations*7 significantly reduced to £0.47m (2011: £1.40m), reflecting not only market weaknesses and the cost factors referenced above but also the slowdown in licence sales, particularly from our high margin international Pebblestone distribution channel. The Unisoft business that we acquired in December 2011, which provides retail Point of Sale (POS) solutions in Holland and Scandinavia, performed ahead of expectations, contributing sales of £1.43m and a small profit. Its January maintenance billing will contribute £0.6m to second half profit from operations.

We signed 21 significant new contracts in the period, worth a total of £0.53m (2011: nine contracts, £0.50m).

The International and Microsoft UK Divisions are actively working together on Project Gemstone and we expect significant opportunities to flow through the reseller channel as a result.

The prospects pipeline, excluding potential business anticipated in a long term plan with Inter IKEA Systems B.V., currently amounts to £7.1m of orders (2011: £3.3m). The increase in the pipeline reflects deferral of deals and some large pipeline AX deals.

SYSPRO and Sage Division

In the first half, the SYSPRO and Sage Division (which comprises four business units) saw revenues increase by 6% to £14.60m (2011: £13.81m), with recurring income up 13% to £9.97m (2011: £8.79m). Adjusted profit from operations*8 was marginally higher than prior year at £4.11m (2011: £4.07m). Acquisitions made in the prior year contributed £3.30m of revenue (2011: £3.10m) and £0.62m of adjusted profit from operations*9 (2011: £0.31m). In total, the Division signed £2.10m of new orders against £1.9m in the same period in 2011, with SYSPRO sales being exceptionally strong. The pipeline of prospects is increasing steadily with a value of £14.0m (2011: £9.20m). This includes £10.2m of potential Sage business.

The K3 SYSPRO unit, which supplies SYSPRO ERP solutions, performed very strongly, signing software deals with both new and existing customers and contributing adjusted profit from operations*10 of £2.96m (2011; £2.93m). In total, seven new deals were won with a combined value of £1.2m (2011: six deals; £0.60m) and a number of these deals were signed with extended period maintenance agreements. We have a very strong offering for the current market, which is well-priced, rich in functionality and delivered by a highly experienced team. In addition to the new sales, annual SYSPRO software licence fee renewals of approximately £6.0m (2011: £5.90m) were collected between October and December. The October renewal percentage was 98% (2011: 98%) and 85% of the recurring income falls in the first half year.

Our Sage business, representing the merged businesses of Panacea and Fifth Dimension Systems, started the year slowly. This reflected deal slippage at the end of the previous year as well as the fact that sales of Sage 500 and Sage 1000 have slowed as the X3 product was launched as a new product of choice. In total 22 new deals worth £0.84m were signed in the first half (2011: 39 deals worth £1.3m). The X3 product started to get traction from midway through Q2 and we closed three new X3 sales before the period end, with a pipeline of 30 significant potential deals worth £4.0m at the period end. We also closed a number of deals in the complementary business intelligence and CRM product sets, and completed the integration of the two Sage businesses merging the sales, marketing and delivery resources. The cost of the integration is included in exceptional operating costs and is expected to result in an annualised benefit of £0.8m, which will help deliver strong results in the second half year.

The other two business units in this Division supply customers running smaller ERP systems who can be offered upgrade opportunities to our SYSPRO or AX solutions and hosting. These businesses performed well in the period contributing £1.68m (2011: £1.02m) of revenue, substantially all of which is recurring.

Managed Services Division

Revenue rose by 18% to £3.09m (2011: £2.61m), with recurring income delivering £2.09m (2011: £2.04m). As previously reported the profitability of the Division is being adversely affected by the cost of our investment in the second half of the prior year in both resource and operating capability of our hosting operation. We now have a number of large new contracts in the pipeline, the delivery of which has been made possible by this investment. In the current environment, customers usually need the impetus of a "compelling event" in order to make a complete switch to fully hosted ERP solutions from an on-site solution. Nonetheless, we continue to grow the customer base, with 398 customers (2011: 346 customers) now using part of our managed services solution. We have now added platforms for all Sage software including the new X3 product and have created a platform for hosting Dynamics AX as well as low cost platforms for NAV and Pebblestone which can provide cloud functionality to our smaller retail customers.

Divisional overheads have increased to £1.74m (2011: £1.36m), capitalised development was £0.15m (2011: £0.22m) and capital expenditure was £0.28m (2011: £0.25m). Adjusted loss from operations*11, after taking account of the investment being made, was £0.16m (2011: profit of £0.09m).

At 31 December 2012 the run rate of recurring income had increased to c.£4.4m (2011: £4.2m) with the slow rate of increase being attributable to delay in closing deals in Microsoft UK. Currently, the prospects pipeline stands at £4.2m of which £3.3m would be recurring income.

Head Office

Head office costs*12 for the first half were £0.22m (2011: £0.17m).

Outlook

Difficult market conditions and the transitioning of our UK retail offering to Microsoft AX have contributed to fewer major new contract wins than expected, resulting in a year-on-year decrease in sales and profit in the first six months of the financial year.

We believe that the investments we have made and will be making in the second half of the financial year will address many of the issues we are currently facing and expect our new IP enriched AX product, when it is commercially launched mid year 2013, to be a major growth driver for the Group.

In the meantime, the positive combination of high levels of recurring income and strong performance in other product areas will provide core profitability and good cash flows for the Group. We remain confident of prospects and expect K3 to return to growth within the next 12 months.

Tom Milne

Chairman