Consensus community valuation
“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!).
Sneak peak on how Emite works
Don't worry as I know how it feels.
I had to clone a system on OCI and it failed. I'm still chasing up via the cumbersome OSS if we will still be billed as the VM was still up for 5 days for purpose of troubleshooting even though it showed failed, was "flaky" and running nothing.
But back to this, if using MS licensing then I'm not sure how you can rearchitect to reduce license fees without reducing your compute footprint.
I wanted to avoid posting on Prophecy and I know this will be a very unpopular low vote post and damage my ranking.
But I can't help myself again!
These slides just screams "Buy Oracle" even if it is $100+ USD and you need to fill in that WB form to receive the quarterly dividends to ensure you are not taxed too much.
There is also a partnership fee when joining the Oracle Partner Network. I know as the company I work for is part of the OPN.
On top of that, there are ongoing certification fees and certification expires after 2 years. - but of course you have a choice to do it once and not do it again.
Then of course there's commissions etc... to Oracle for being a partner which cuts into the margins.
On the move to Oracle Cloud I have a feel this will cost quite a bit and need new hires to maintain emite and Snare on Oracle Clloud Infrastructure. Hence the mention about the hosting cost. Hopefully for shareholders the containers before the move were running latest versions so it would be less labour intensive. Prophecy had no choice because it is obvious that some of their government and NGO clients are making the move to Oracle Cloud. This is why it makes more sense to buy Oracle shares instead.
I could get into more detail on Virtual container image maintenance etc.. on OCI but that will be beyond the scope of this post and will just confuse everyone more. You can do a google search on Patch Hypervisor or Host and Virtualbox for a basic primer of what this could involve but I can assure it is a pain when you patch your Linux system only to find your little Virtual machines and docker stuff suddenly don't work.
Having said that, I think the cycle of moving off deprecated systems in OCI on average is about about 2-3 years.
You are probably aware from the last Sydney meetup about my background in Oracle Cloud so feel free to probe me a bit more on this.
AEF Building their position.
Could be due to the company's impressive 26% ARR growth, a stable bottom line, a substantial $12M cash reserve, and zero debt.
Seems like a decent proposition to me.
Disclosure: I hold.
FY23 updates highlight
In first half, operationally they were outflow of $2.8m ( which means for full year operational cash outflow will be ~$0.8m)
I think management set expectations of full year cash flow neutral or positive in past few presentations.
Although, the thesis is working nicely ( However, I like management not to set high expectation). Since last five years, ARR has grown significantly and now it is at inflection point of achieving cashflow positive in near future.
ARR Growth:
FY18 : $4m
FY19 : $5.9m
FY20 : $7.8m
FY21: $10.7m
FY22: $18.3m
FY23 : $23.1m
Prophecy has delivered a substantial turn around in cashflow in Q3, with a $3.0m increase in its cash position since the end of 2022. That compares to a $3.2m outflow in the first half. Larger subscriptions were flagged as being weighted to H2 and management had indicated that cashflow would be positive for the full year. This was evidenced by invoicing, which was almost as high in Q3 as it was for all of 1H.
Annual Recurring Revenue continues to grind higher, up $0.7m to $21.3 since they last reported, although government agencies are continuing to opt for perpetual licenses. The combined sales pipeline for eMite and Snare is roughly equivalent to their last report. Management expect cashflow to remain positive for the remainder of FY23.
At an EV of about $28 million the valuation doesn't look stretched for a company that is growing at the rate it is and can pay it's own way. However the market reaction has been 'meh'. Like many of the companies I own the buy/sell spread is daunting.
[Holding]
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).
Prophecy International has been absolutely smashing it of late - up almost 3x in the past couple of months, which is pretty extraordinary for a business that was established in 1979 and listed in 1997.
They are a B2B software solutions provider in two major verticals. They have three products but you can pretty much discount eFoundation, which they are not developing and running down. The other two are:
eMite
Which is an analytics solution for contact centres (on premise or cloud). It does number crunching, visualisations, KPI management and reporting. As at mid-Oct it was generating $10.5m in ARR, up almost 40% since Jun 21. This was partly on the back of their largest ever signing (Humana in the U.S) but it has grown steadily and strongly over the past few years.
SNARE
This is Cybersecurity and compliance tool. Up until now I believe this has been offered on a perpetual license basis but was recently rolled out as a subscription offering. This has been a little slower to get going but is growing and has been growing faster of late.
Clearly there's no shortage of competition in the space but they must be doing something right given the growth they're experiencing. Having said that they've been investing to get the growth and haven't been profitable since FY17. Despite the top line growth I'm not sure they will be in FY22 either but we'll see.
Insider ownership is healthy with the non-exec Chairman (joined as GM in 1987) being the largest holder with 12.2%.
Congratulations to ValueInvestor who is its only Strawman investor. You must of been turning over a lot of rocks to find it as it hasn't looked like much on many measures until very recently. Wini has been spruking it of late also so props to him too.
One cautionary note - it's worth reading ValueInvestor's ##Not so honest communication post here.
Psychologically it's hard to look at a company that has recently gone 3x and not think that you've missed it. Having said that the market cap is still only just above $100m and it's not unreasonable to think ARR could end FY22 at $20m. An ARR multiple of 5x? Pro-Medicus holders might like to have Prophecy's ticker symbol but I'm pretty sure they're content with PME's multiple...
[Not held]