Monday, May 01, 2006

Earnings Preview for Monday: KNXA

Kenexa (KNXA) reports earnings later today. What follows is a quick recap of the stock's strengths and weaknesses.

What They Do Employee recruitment and management is key to a business's survival -- just ask Kenexa. The human capital management solutions provider just went public last year and is quickly capturing the hearts of savvy investors and analysts alike. 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 that'll continue to grow in leaps and bounds: 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.

What We Like Kenexa's subscription-based (sales as service, or SAS) business model has enjoyed a 90% retention rate. Kenexa's rapid response approach to its customer's personnel-related quandaries 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.

What We Don't Like Application software vendors like to trade at 28x earnings -- at 40x next year's forecasted earnings, shares of KNXA look pricey. 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. 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).

Summary 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. We see shares hitting $40 by the end of the year, a 21% premium to where they are currently trading.

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