Daily notes

Daily Notes – XRO, ARB, BBN, MLB

Xero (XRO) – Solid numbers… ARB Corporation (ARB) – Nothing new, more multiple expansion… Baby Bunting (BBN) – Sector consolidation continues… Melbourne IT (MLB) – to ARQ Group

Xero (XRO) – Solid numbers…

Reported full year results showing continued growth of key metrics during FY18. SaaS metrics continued to improve with lifetime value per subscriber increasing 9% to $2,310. This was driven by flat ARPU of $29.13, decreased churn to 1.10% and an improved gross margin percentage to 81%. Total subscriber lifetime value increased to $3.2bn. Total subscribers grew to 1.4m and annualised monthly recurring revenue grew by $121m to $484m.

The company has continued to solidify its market leadership position in ANZ with continued subscriber, revenue and profit growth. This region really shows what the business is capable of at scale, and it’s impressive and really only getting started in terms of building out connected platform services.  

The company added 100k subscribers in the UK (47% growth to 312k) with revenue growth of 60% yoy. The company seem to have established themselves as the leaders in cloud-based accounting and significantly, the UK has now overtaken NZ to become the second largest region for the company behind Australia. US subscriber numbers increased by 43% to 132k and revenue grew by 28%. The US is an under-penetrated cloud accounting market with slow market adoption in the small business accounting segment, but still represents a very large greenfield opportunity.

With $80m in cash left in the bank, the company is still guiding to cash-flow breakeven within its current cash balance. This is looking increasingly believable given positive operating cash flow of $41.2m for FY18, an improvement of $45.6m from $(4.4m) in FY17 and operating and investing cash flows as a % of revenue improved to 9% in FY18. Total operating and investing cash flows was $(36.9m) for FY18, a reduction from $(70.8m) in FY17.  

Overall very solid result – strong growth maintained in mature and developing markets, very strong SaaS metrics and showing signs of real efficiencies as the business scales.

ARB Corporation (ARB) – Nothing new, more multiple expansion…

Update provided to the market. Stock up 6%, showing strength moving out of base set over 2.5 months. Interesting to note given that the update did not provide much in the way of new information. Business still growing steadily, while maintaining high and defensible returns on capital and stable margins.

Whilst EBIT has more than doubled over the last 10 years, the share price is up many times this, due mainly to expansion in the earnings multiple, as shown in the charts below. No judgements, just something interesting to note.

Baby Bunting (BBN) – Sector consolidation continues…

Baby Bounce and Baby Savers have both fallen over. Baby Bounce operated 10 stores across NSW and Queensland; Baby Savings operated 4 stores in Sydney. Baby Bunting’s sales and gross margin performance has been affected by the distressed trading of competitors and the liquidation of stock. FY18 EBITDA now expected to be in the range of $18 and $20 million, a level similar to FY17, albeit achieved with higher sales.

Interesting thing about this business is that they’ve been able to grow their store network and sales over the last 2 years without committing any new capital to the business. Total asset turnover has gone from 1.8x to 2.2x. Problem is that while gross and net margins expanded during FY17, they’re now coming back in. Competitor liquidations of stock and the arrival of Amazon will have that affect.

Sales and gross margin performance has been adversely affected both in the lead up to and since these competitors entered administration. After comparable store sales growth of 4.7% in Q3, comparable store sales have been negative 2.5% in the first 6 weeks of Q4, driven by a higher level of market discounting and reduced transactional volumes as competitors liquidate stock.

So, what caused these competitor failures? Amazon and online ate their lunch, Baby Bunting itself? Either way, what is quite clear is that the smaller operators are having difficulty in the current environment and this is likely to continue.

Smaller operators will fall over, their stock will be liquidated and online and Bunting will move in to fill the void. Margins are likely to be weak for some time as the industry rationalizes and might even stabilise at a lower level due to online competition. It is very difficult to see how this will play out over the medium term and how long the competitive disruption will go on.

With the current level of uncertainty and down trend in both the business fundamentals and investor expectations, this is not something that we would want to be involved in right now. With that said, it will be an interesting one to watch as the industry evolves.

Melbourne IT (MLB) – to ARQ Group…

This business has been transformed over the last 5 years, through a multitude of divestments and acquisitions, and on the face of it the restructure has gone well. Revenue and underlying EBITDA both show consistent growth upwards and to the right. The share price is up 3x.

With all that’s gone on, it’s really difficult to understand what has gone on. Has it been just multiple expansion that’s driven the growth in the share price or has there been any actual organic growth in the underlying business?

The company has added $185m in goodwill to the balance sheet, funded mainly through share issuance ($67m) and debt ($75). Obviously, you spend this much buying new businesses, revenue and profit are going to go up. The key question is whether returns on this additional capital justify the additional capital being committed. Even this question is surprisingly difficult to answer given all the adjustments and the like going through the income statement. The company is now rebranding in order to bring the myriad underlying businesses under a common name. Once the accounts clear up we’ll be able to get a better sense of what’s going on under the hood. For now, this is an IT consultancy business composed of ~10(?) separate businesses, with 800 employees, looking to hire another 270 people this year and unify them under one brand and management team. What could go wrong?

By Danny Sandler

Founder of Ocean Asset Management.