“Being extremely early is tantamount to being wrong.”

This quote is attributed to Seth Klarman however it's been paraphrased by many others over the years. I'm not sure I completely agree with the quote, but I do acknowledge the fact that until you are able to look back with the certainty of hindsight, the difference between early and wrong is indistinguishable.

With that in mind, analysis of the PRO FY24 result is whether I am early while the thesis continues playing out or I am wrong and the thesis is busted. In a nutshell, the PRO thesis is that like most other enterprise cloud SaaS businesses it can demonstrate the operating leverage inherent to the business model as revenue grows. The accepting of being early part stemmed from the fact the while PRO was going through a transition from perpetual licence to recurring subscription revenue, that operating leverage would not show up in the headline numbers even as the earnings power of the business was growing in the background.

The chart above best highlights the two segments within PRO and is a testament to the quality of the recurring subscription business model compared to its perpetual licence counterpart. emite began the transition in FY17 and it wasn't until FY21 before the benefits were tangibly seen in the reported numbers. Since then however, the beauty of compounding recurring revenue growth can easily be seen. Snare began the transition FY23, and the last two years have been the muddy period where the business growth is not seen in the numbers. However, the chart below shows FY24 is likely the trough of the transition impact with subscription revenue taking over in FY25:

Note: I am looking ahead to FY25 using PRO’s reported contracted ARR and making a conservative assessment of what I think can be implemented and recognised.

So, the revenue side of the PRO investment thesis is playing out. Group revenue has nearly doubled over the last three years driven by emite and with Snare completing its revenue model transition I expect that trend to continue strongly.

The other side of operating leverage is of course the cost base. Given the marginal cost of distribution can be exceptionally low, we know that software businesses run efficiently at scale are very high margin. But many aren't run efficiently, and despite reporting strong growth they never truly scale as they run to stand still or embed a culture of profligate spending.

This has been the main criticism levelled at PRO over the last few years as we have seen a steady swelling of the cost base. To some degree I'm forgiving of this as there is an investment that is required to put in place the infrastructure to shift from on premise licencing to cloud based subscription.

With that investment largely behind PRO now, you should expect to see a normalisation of cost growth. However, from FY23 to FY24 we saw roughly a $4m increase in the operating cost base. Digging into the notes of the report we can see where the biggest impacts came from:

Pleasingly, employee costs only rose modestly, by about $1m with most of that coming from employment benefits rather than direct salaries and wages. The two biggest impacts came from a swing in foreign exchange from a gain of $600k to a $240k loss, as well as nearly a $2m rise in hosting costs.

The foreign exchange swing should be ignored when assessing the operating business, so for PRO the key to answering the question about whether the cost base side of the operating leverage thesis is intact comes down to whether the sharp increase in hosting costs is a structural issue. We can expect there will be modest increases in hosting costs as revenue grows given PRO hosts their customer environments in the cloud, but the bulk of the hosting costs comes from PRO hosting their own internal product development in the cloud as well. In the past they have spoken about the efficiency gains that comes from this arrangement however based on commentary in the report the higher than expected costs will see a re-architecture for emite to save around $700k per year and over time shift to a shared infrastructure to reduce costs further.

If these measures are successful, then the discipline being shown across the rest of the cost base should allow for operating leverage to emerge and the investment thesis to remain well and truly on track.

To wrap it up, the market (the final arbiter of these questions) has decided that I was definitely too early with an investment in PRO. Am I wrong though? While the headline numbers suggest the answer to that question is also yes, I think teasing apart the numbers shows the thesis is still intact (for now!).

17/11/23 Prophecy Q1 FY24 Business Growth Update

@JPPicardsummed it up well in his straw, this was a poor update from PRO compounded by the fact that management tried to convince us otherwise. One bad quarter is never a problem and should be expected every now and then, but you want to see management acknowledge it, comment on what went wrong and how things are progressing moving forward.

Headline ARR going backwards is not a good look, digging deeper shows Legacy product revenue winding down (previously flagged so not an issue) and a decline in Snare maintenance renewals. That is somewhat expected as the business model shifts to subscription, but the quantum of the fall ($3.4m to $2.5m in one quarter) with only a modest increase in the Snare subscription ARR ($4.2m to $4.6m) was larger than expected. eMite growth was also modest ($14.9m to $15.4m) and couldn't offset the declines in Legacy or Snare maintenance revenues.

Even removing Legacy and Snare maintenance revenues, eMite and Snare subscription revenues only grew 4% quarter on quarter, below historical trends and growth targets of management. Again, quarter to quarter can be lumpy given enterprise deals so no reason to panic, but you would like to see management acknowledge the weakness rather than ignoring it.

There were some positives in the update, the imminent signing of the first non-Genesys or Amazon eMite client is great news and is the first sign PRO can attack the much larger TAM outside of their core platforms. The commentary that they expect to be cashflow positive for the half and full year is interesting and I am keen to find out how that will be achieved. In FY23 there was a big split in 1H and 2H cash collections as large customers are invoiced in the 2H, the point where cashflow was -$3m in the 1H and $2m in the 2H. I would suspect to be positive cashflow there is likely a shift in collections to smooth out the seasonality, because without that a cashflow positive 1H would result in a very strong full year result given the usual strength of the 2H.

PRO is a software provider with two key products: eMite, a cloud based call centre analytics product and Snare, a cyber security monitoring software. @Noddy74 and @Valueinvestor0909 have covered the software in previous Straws so I won't go in-depth here.

FY22 was a foundational year for PRO, winning their largest contracts for both of their products, Humana (US insurer) for eMite and the UK Government for Snare. While the company will likely not be able to match the 70% growth in ARR in FY23, the platform has been set with the business now sustainably established giving management flexibility to further invest in organic growth or perhaps M&A.

2022 was a tough year for tech stocks and the market finally woke up to the various tricks companies can use to make things appear rosier than reality, particularly when the focus was so heavily on ARR and not what was happening beneath that unaudited metric. PRO has been lumped in with these tech peers, but I think it is worth taking a step back and looking at the business and realise that not all software is created equal and the same goes for revenue and cash.

I will focus on eMite with this analysis but most of the points also apply to Snare. eMite is a pure SaaS solution, primarily delivered through channel partner cloud marketplaces Genesys and Amazon Connect. As investors, one of the main reasons software businesses can be so attractive is the fantastic incremental unit economics. However some software products lose a large chunk of this benefit if the software must be heavily customised to individual customers which also comes with long implementation periods. Most companies who suffer from this problem usually disclose contracted ARR to try and show the pipeline of ARR that will come online over time. Further, when software is heavily customised to customers it makes the roll-out of updates and improvements difficult and usually comes with more implementation time.

eMite avoids this problem with an out of the box solution (which can then be highly customisable by the customer themselves) that can be deployed in hours over a customers cloud call centre infrastructure. The lack of a long implementation phase means PRO's ARR is extremely clean. Because the software can be turned on and off so easily, management have also established a disciplined negative working capital model. Management clearly break this out in the annual report (a virtue I wish other software peers would emulate!):

Again, this negative working capital model is another reason why software businesses can be so attractive. However, many software peers have cash collection issues and in 2022 most have been exposed by the market which has focused more closely on cash. The strength of PRO's model can most clearly be seen by FY22 revenue of $16.4m vs $21.5m in cash receipts.

On top of this, management also don't capitalise any R&D so operating cash flow is very clean and the P&L isn't artificially boosted (actually the opposite because some legacy D&A is still rolling off).

The business model gives us clear visibility for FY23, with $18.4m ARR entering the year, another $2-3m in Snare license sales as the business model continues to shift to a subscription service plus further growth through the year. I expect reported revenue to be in the range of $23-24m. Management have flagged a ramp up in costs to chase further growth with the strong tailwinds they have with the shift to cloud based call centre infrastructure and cyber security solutions. I'm not exactly sure how much will be tacked onto the cost base, but given the revenue growth I'd expect the business to be profitable (but definitely cashflow positive given the negative working capital model).