Thursday, April 20, 2006

How To Play the Employee Management Boom

It doesn't matter what business you're in -- if you can't manage the people who work for you, you won't stay in business for long. Employee recruitment and management is key to a business's survival -- just ask Kenexa (KNXA). The human capital management solutions provider just went public last year and is quickly capturing the hearts of savvy investors and analysts alike.

Overview Briefly, Kenexa enables enterprises to optimize employee recruitment & retention via its on demand software. The firm has approximately 2,000 customers (to which KNXA sells directly) and almost 1/5 of the Fortune 500 is already using KNXA's productivity-enhancing tools. This is a market ready to blast off: according to the Bureau of Economic Analysis, more than half of US GDP is spent on human capital. The human capital management market is expected to grow rapidly for the next few years as older, technologically obsolete modules & systems are replaced by up-to-date, automated hiring process platforms. IDC thinks this category could grow at a CAGR of 25% over the next 5 years -- we're thrilled, as are Kenexa's shareholders: shares have more than doubled from $14 in just a matter of months.

Kenexa's subscription-based (sales as service, or SAS) business model has enjoyed a 90% retention rate. IDC's figures are once again revealing: they think the SAS market could hit over $10 billion by 2008. Kenexa's rapid response approach to its customer's personnel-related quandaries has thus far served the firm very well (sales hit $65M in 2005, a 50% jump from 2004 revenues) -- and we think they're poised for further growth ahead. Only 1/4 of KNXA's top 100 customers use more than one or two of its products, which means there's plenty of room for upselling. Another growth opportunity lies on the international front: because most of Kenexa's sales are here in the US, international expansion will be key to their growth strategy. Right now, Kenexa is fleshing out operations in India and London, as well as hiring more salespeople. With $43M in cash (or $2.50 a share) and negligible debt, Kenexa has the resources to grow.

Valuation We'd love to pick up shares of Kenexa now, but we think we'll wait -- application software vendors like to trade at 28x earnings and at 40x next year's forecasted earnings, shares of KNXA look pricey. Because we believe Kenexa is a budding business and a stock Wall Street hasn't really woken up to, we eagerly await a pullback. As Kenexa's revenues grow, so will the number of analysts that cover the stock. Last September, only 4 analysts followed it; today, there are 11 analysts serenading Kenexa's management.

Risks The biggest risk to our thesis is that the competition KNXA faces is fierce. There are much larger players on the field (Oracle and SAP, to name a few) that could easily step all over KNXA if they suddenly decided to hone in on the HCM niche. On the flip side, the sheer size of these rivals could retard them from moving in on customers with the quickness that nimbler players like KNXA can exploit. Other risks include: subscriber attrition; a slowdown in the IT spending cycle; and share price volatility (KNXA's tiny 12 million float is not for the faint of heart). It doesn't help that insiders have been doing some unloading lately, either. Since Kenexa is a newly publicly traded company, we're not pushing the panic button just yet. Insiders have mortgages, too.

Summary Wake up and smell your co-worker, Mr. Manager. We're in the middle of a paradigm shift in which employees are no longer just seen as a cost, but as rather as a significant value driver. HR departments will need talent acquisition solutions and they'll need them fast. On demand software providers such as Kenexa are already capitalizing on this opportunity and ballooning the size of their operations. For investors, a renewed focus on employees could mean a very rewarding summer for your portfolio. Our advice: pick up Kenexa before more analysts do. We know we will.

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