Included in the notice of Extraordinary General Meeting (held 30 April in Sydney) released today is an independent opinion by Titan Partners of the deal which was that it was “not fair but reasonable”. It was not fair due to the controlling interest acquired but reasonable due to the 39% premium offered.

The analysis of the business which starts from page 30 and well worth reading for those interested in the business – I picked up a few new things.

Including about Mr Baxter, I hadn’t realised he was the guy from Shark Tank Australia:

Mr Baxter is an Australian venture capital investor and entrepreneur, with a focus on innovation and technology. He was previously featured on Shark Tank Australia from 2015 to 2019 and has founded and exited a number of companies. He founded TEN13, a tech startup investing platform as well as Beaten Zone Venture Partners, a venture capital fund dedicated to investments in Australian sovereign legal defence technology.

https://en.wikipedia.org/wiki/Steve_Baxter_(entrepreneur)

The valuation is a regulated (RG111) formulaic academic piece of garbage (capitalisation of revenue methodology for Enterprise and Net Asset for Entertainment) you expect from an independent valuation with no consideration to the growth of the Operator XR (Enterprise) business, which holds almost all the value.

Total Value: $21.9 - $27.1m (3.84 to 4.74 cents per share) sum of parts approach.

Enterprise based on revenue between $3.6m (the ARR) and annualised reported revenue of $4.3m times a multiple of between 4.2 and 4.8 times based on the average of spurious comparable transactions of a wide range to get a value of $15.1m to $20.3m

Entertainment net assets of $15.3m attributable to the Entertainment business alone.

Adjusted for net cash/debt of -$8.5m

The only interesting part of the valuation is the net asset value of the Entertainment business. If they could realise that into cash that would be a game changer. The FREAK business is almost none of that, it’s all iFly, which isn’t up for sale as yet – sooner the better in my books.

Disc: I own RL+SM

Announcement from XRG that it’s $4.6m debt with Causway Asset Management (due to mature Sep25) has been renegotiated to a $5m facility maturing in Mar27 with a possible $1m addition subject to conditions. Interest payable quarterly (same as prior arrangement) but also 5m XRG warrants issued at a 20% premium to the 30 day VWAP at initial drawdown, 3 year expiry.

This concludes the debt restructuring for XRG near term, assuming the 30 April EGM to approve the capitalisation of the Birkdale Holding $4.6m debt at $0.05 per share (which I would bet on).

Having moved the Debt issue from a red flag to orange on the Birkdale announcement my view is it is now no longer an issue (white flag?) at least for another 2 years. The business is generating positive cash and they now have a bit more capital to accelerate Operator XR development and sales growth.

The next major announcement in the works is what they are doing with the FREAK business, hopefully some extra cash on disposal, but we will have to wait and see.

Disc: I own RL+SM

Results for the half just released – things look in order.

Key points:

·        Loss of -$992k, improvement on -$1,501k PcP due to GM up $1,096k, grant income up $437k offset by higher Op cost of $995k.

·        Sales up 30% v PcP, Entertainment -10% (to $3.8m) and Operator XR +565% (to $2.1m), fall in Entertainment put down to professional user sale in November, bringing forward cash but delaying revenue (don’t see that as valid, but thesis is not about Entertainment business).

·        Revenue includes $1,183k in Grants Vs $1,068 PcP for R&D rebates and also includes $313k for revaluation of inventory (Hmmm, would like more info on this).

·        Operator XR customers now at 51, was 29 at the end of FY24. Includes 30 US federal agencies, state and city police and sheriff departments.

·        Operator XR launched OP-2 in November which added “Scenario Creator Suite” and combines OP-1 (Military) and OP-1LE (Law Enforcement) systems to streamline development.

·        Formal engagement of Distributors in Europe and Asia occurred in the half.

·        $1.7m cash at the end of the half, FCF at break even now -$23k Vs -$1.2m PcP.

·        Deferred revenue now at $5.8m, of which $3.6m is current. I am looking for $8m in Deferred revenue by year end, it’s up $2.0m in the half so tracking ok and they now report a break out between businesses which is good.

·        Plan to exit FREAK in FY25 and the first indication that iFly is also under review as they turn their total focus on Operator XR.

·        Debt Refinance: engaged with debt provider, watch this space.

·        Ash Crick, globally recognised AI expert has joined CRG as Chief AI Advisor.

Operator XR revenue is running of a very low base, so % change is not relevant. Nominal increase in customers is what I am tracking and had assumed 60 by the end of FY25 for my initial modelling. The are at 51 in February, having added 22 since 30Jun24 with 9 of those since 31Dec24, so look like they could pass this, but low numbers and sales cycle time lines could through the number around, but they are tracking well ahead of 60.

P&L results were better than I anticipated but only due to the Grant income (was ultra conservative), GM was very close but Sales and Marketing expenses much higher by $496k and Dep & Amt by $311k. I expect a lot of variance at this point – a lot of moving parts and I am still firming up my model. However cash flow and customers are heading in the right direction and these are the key indicators for me at this stage. The P&L is going to jump around a lot, but cash flows will show the directional trend with sales following. Operating expense growth is going to be a wild card for a while.

So, it looks like we may get some info on debt sometime soon, the Causeway $4.25m matures in September, so they are getting in early which is good to see.

Other than that mostly old information, good to get a financial update, but that looks backwards and forwards is where the value lies so I am looking forward to progress reports on customer growth and sales wins of Operator XR.

Disc: I own RL+SM

Strong positive Operating Cash Flow (+1.5m Vs +0.5m Q1) and for the first time since Q2FY22 positive Free Cash Flow (+416k Vs -423k Q1) as I expected. Receipts from Entertainment were $2.5m at the top end of where I was thinking given it’s normally a strong quarter, but Enterprise (Operator XR) was $2.7m, up from $2.1m in Q1 but I thought it would be at least $3m.

Product Manufacturing and Op Costs were $734k, down from $1,004k in Q1 which is a bit unexpected. I am yet to get an understanding of their supply chain, but would expect that these costs are a lead indicator for sales growth, so I would like to see them go up. However, it is early days and they may just be lumpy and nothing of concern, or Q1 spike was associated with inventory build for the new Op-2 system released mid Q2.

Intellectual Property spend of $1,105k up from $958k is generally a good thing if they can afford it (which it looks like they can), but they have now spent just under what was indicated for the full year. Again, it may drop off in later quarters given they have just released OP-2 the new version or indicate new promising opportunities – a question for Wayne.

ARR and TCV both growing well as per below and 7 new customers added in the quarter for Operator XR which is around the run rate I am looking for and they have been tracking at.

The sales pipeline remains very health at 216 leads or $27.3m (190 & $27.2m in Q1)

The only other point of interest is that they expect the OP-2 system which consolidates the previously separate OP-1 (Military) and OP- LE (Law Enforcement) also adding a new “Scenario Creator Suite”. This may make the product more attractive to customers and streamline development and maintenance costs, we will see.

So nothing to change my view at this point and I will be looking forward to H1 results and hopefully a SM interview to flesh out some details and see how things went at Shot Show.

Disc: I own RL+SM

A notice today for the issue of 1m options to an NED is interesting for the fact that the exercise price is $0.065 and the expire is 23/1/26. I am not sure which director this is for but given today’s close of $0.043 and a 52-week high of $0.067, this shows some confidence or bravado on the price over the next 12 months. 

I don’t think I have ever seen options issues where the share price needs to go up more than 50% in 12 months for them to be in the money at the time of issue…

That said, I wouldn’t be at all surprised if there well in the money by then!

Disc: I own RL+SM

This valuation is totally focused on the Operator XR product and Enterprise part of the business.

XRG is breaking new ground when it comes to training for PD’s and Special Forces, so the market potential is staggering compared to the current small but still impressive sell in. So I am starting a BASIC valuation on the grounds the sell in continues at a modestly increased pace, but way short of the opportunity just in the US (note Europe being approached via distributors).

Due to the cash up front sales model, cash flows are very favourable compared to profit in the current growth phase, which has only just started. Hence, I have used a mix of value methods based on price multiples, a DCF is a bit wild given the high growth rate, up front and pulsing cash flow pattern and picking suitable terminal value assumptions is a wild guess.

The multiples used are based on high growth (20%+) and high margin factors, but are totally up for debate and challenge. The result is a ballpark market cap of a bit over $100m in 3 years which at a 15% discount rate is about $61m now (taking an average of 2-4 year results) or about $0.097 per share on a fully diluted basis (628.9m shares+options).

I do not accept this valuation as in any way accurate and neither should anyone else – I just wanted to get a feel for if it may be worth well above the current value based what I consider low ball assumptions, as well as see how the P&L and FCF’s may play out based on unit economics.

Key Assumptions:

·        Entertainment business is static (ie ignore benefit of sale of FREAK or iFly growth)

·        The DoD & Aus Gov contracts don’t expand and stays at $3m/$270k per year

·        New customers generate A$250k revenue on average (low end of US$150-200k)

·        Net New customers in FY25 of 30, 40 in FY26 then 50 each year after.

·        Entertainment margins 80% and Enterprise 70%

Enterprise Sales, Cash Receipts & Unearned Income

XRG is adding customers rapidly at an average deal value of US$150-200k for a 3-year upfront payment, so mapping the cash flows and revenue requires also forecasting the Unearned Income balance sheet movements. So, I have used customer additions to calculate receipts and recognised this revenue over 3 years. Noting that the customer number are net of any discontinuations, so you also have renewals of customers first added 3 years earlier.

Below are my workings, customer numbers in green drive the cash receipts in orange which are then split between immediately recognised 0.5yr (1/6), current assets 1yr (1/3) and non-current assets (1/2). With current assets being released to the P&L as revenue in the following year and a potion of non-current assets moving to current each year.

I have included the DoD contract as an addition, which has cash receipts and revenue recognition aligned as they pay by the month for the 20-month contract (Sep24 start). I then assume this continues at the same rate per year going forward. However, it should be noted this is a development project, which will if successful open effectively a whole new business opportunity in Augmented Reality (current is VR).

The Australian Government contract was added separately just due to it’s size. I have just assumed this roles at the end of 3 years as a year by year contract.

The yellow line shows the cash receipts total, which as you will see is well ahead of revenue recognised in the P&L. Due to the 3-year renewal or re-contract approach, you will notice receipts have big increase in FY27 then only a small increase in FY28 as the renewal cycle pulses cash receipts. This is clearer if graphed out a few more years as below.

Gross Margin (total company)

Based on flat sales for Entertainment and 80%/70% margins for Entertainment/Enterprise we get the below gross margin break out into Immediately recognised sales and those from deferred release of Unearned Income. Note that Entertainment has prepaid gift cards but the balance on these is relatively stable, so Unearned Income movements are Enterprise driven.

Note also that I am basing the 70% Enterprise margin on a comment by Wayne that it was 70-75% margins. I suspect that they are moving around a lot as the product/customer mix is evolving, so I have taken the low end as a starting point but would expect scale and maturity to provide improvements on this figure.

P&L Forecast (total company)

Given a relatively steady state growth rate that is assumed I am running with a 10% S&M growth and 5% for Admin. Noting the freeze on Entertainment, these changes are all Enterprise business related. Add a few tweaks for Grant income and Finance cost dropping off and for the period cumulative tax losses of $23.7m from FY24 should mean no tax is payable in the forecast period (acknowledging this doesn’t mean no tax expense on the P&L, but a benefit exists).

Under the assumptions the company is profitable by H2 of FY26. High gross margins enable operating leverage, but depend on controlled Operating Expenses of which Sales and Marketing is the bulk but shouldn’t need to grow at anywhere near the rate sales do. If additional sales teams are added and associated costs, we would also expect much higher sales.

FCF: Receipts Vs Revenue

The Enterprise business is capital light, with negative working capital requirements, hence cashflows run ahead of profits when they grow. This is unlike most businesses which can run out of cash in a growth spurt due to increased working capital needs.

I have assumed growing PPE (capitalised development costs), which goes beyond just maintaining the VR product, it is also to keep them ahead of the competition and continue to innovative.

A DCF on these figures gives a $57m value with a 15% discount and 5% terminal growth (above system because growth is still high in termal year). This is close to the other values but I don’t think this calculation is appropriate based on forward assumptions, just interesting its close.

The current debt should be paid off by the end of FY27, but acquisitions or expanding the business with Augmented Reality products and new markets will radically change this (noting they have the ability to raise 25% of their listed capital ready to fire if needed). Hence, I would only expect a capital raise to fund an acquisition or significant investment to fund a new product line.

The fact they have acquired a company and built from the ground up a world leading VR and weapons integration system from what I can gather is well under A$10m tells me they can do a lot with a little. So, I am not expecting the company to burn shareholder value on empire building, but it is always a risk and particularly if they move heavily into Defence contracts or if they move into capital intensive areas (like iFly where they started).

Conclusion

The Operator XR product is the investment thesis and the companies opportunity to generate very high cash flows. XRG is a highly agile and innovative company that embodies it’s special forces heritage in how it plans, operates and executes. 

Part of the problem with forecasting and valuing is the fact that Operator XR is a new product in a new market so standard operating procedures are still being defined and the business model is evolving. None the less, it is clear there is a value opportunity, it is significant, the market is going to struggle to see and price it, but the cash flows will start speaking for themselves very soon to show value.

As always constructive feedback sought, please poke holes in the valuation and calc’s so I can continue to improve them.

Disc: I own RL+SM and looking to buy more for both.

Hope this works for everyone:

xReality Group_Alan Kohler 17Jan25.pdf

XRG has exactly what I am looking for in an investment, an imminent and evident unrecognised pivot in performance (well until today maybe). The type of thing that stopped quality SAAS business being recognised in the early days is in play, namely a delayed and hidden profitability from growth investment, high margins and sticky revenue commitments.

Interview of CEO Wayne Jones by Alan Kohler provides a lot of insight (I will try and get a print copy for those who don’t have access): xReality Group: All Geared Up - Intelligent Investor (released Friday so weekend listeners were buying today it seems)

Forbes article for a bit of history: xReality Group going from SAS to SaaS

The business has been investing the profits and cash flows of it’s core business into a new business that is now achieving strong commercial success to the point that it should generate more income than the core business by the end of FY25. The core Entertainment business has performed reasonably well over the last 2 years but the costs to develop the new Enterprise business (6m+) have made XRG unprofitable and unattractive to investors.

In addition, debt has been built up and dilution from capital raises has been needed to fund the development of the Enterprise business. This I expect to see change in the next 4C due to the working capital positive nature of the Enterprise business and quite frankly astonishing growth rate from market acceptance in the US.

Operator XR is the Enterprise product and investment case for XRG. The equipment, licence and systems are sold on a 3 year agreement with payment up front in most cases. So in the first year 1/6^th of revenue is recognised, 1/3^rd in the next two and 1/6^th in the final year on average, but the current high growth rate will sku this as the weight of new contracts in a year occur later. 

To measure success we can look at Revenue Vs Revenue + change in Deferred Revenue as graphed below, which shows a leading indicator for how revenue will move. Looking at FY25 based on YTD information (DoD contract + customer additions), the lead indicator is streaking ahead of revenue as the Enterprise business scales and goes from a rounding error Vs the Entertainment business to the dominant business by the end of FY25.

The DoD contract: US$5.6m over 20 months Development of augmented reality (Vs VR), which is not the final product but XRG will own all the IP at the end of the project.

The upside opportunity is exceptional given it is currently only a $20m cap (EV $28m) company and my expectations that operating cash flows likely to be well over $4m for FY25 (FCF of $2m+) however NPAT is unlikely to be positive due to delayed revenue recognition and cost build to support growth. Profitability I would expect H1 FY26.

LA SWAT is using their equipment + 40 other PD’s

70-75% GM for Enterprise

US$150-200k current deal size average for customers

Expectations for 4C Q2 FY25: I expect positive Operating CF to exceed IP costs to provide positive FCF due to Q2 usually being a strong quarter for Entertainment (Est 2-2.5m up from under 2m) but increasing Enterprise contributions (Est 3-4m up from 2.3m) driving total receipts in the range of 5-6.5m. 

As such I believe Wayne Jones statement in the interview with Alan Kohler that additional capital raise is not likely due to expecting positive CF in Q2 and the additional 500k debt facility to allow for inventory build to provide any required buffer on the $1.5m closing balance from Q1.

I have a lot more analysis to finalise and add, so will publish as complete, but my general conclusion that this is an asymmetric investment with massive upside and clear evidence of likely success is basically locked in!

Disc: I own as of today and looking to buy more.