Alex Milton, Principal and Co-Portfolio Manager
New management initiatives and major business transformation the key catalysts
Melbourne IT is a well known company and one of the high profile IPO’s almost 20 years ago which marked the formation of an ASX listed internet sector.
The company has a long history in providing domain name registration and basic web services (such as hosting) to small businesses. However, these services have been facing strong competition (think small businesses selling from Facebook and other aggregator sites) and experiencing relentless price deflation over many years which has adversely impacted its profitability. This legacy business is experiencing low single digit declines per annum in revenues.
Fast forward to the last few years and Melbourne IT has undertaken a significant transformation which we believe underpins the growth required over the medium term to justify a new a position in our smaller companies fund.
The current CEO, appointed in 2014, has led the implementation of a strategy to diversify the business beyond basic web services, expand its client reach and importantly provide a platform for stronger growth. Put simply expanding from commoditised services with limited to non-existent pricing power to value added services in higher growth markets which attract more defendable revenues.
Since 2013 we have seen revenues grow from just over $100m to $197.8m and underlying earnings before interest tax, depreciation and amortisation grow to $38.6m from less than $6m representing compound annual growth of nearly 18% and 60% respectively.
This strategy has involved acquisitions over the last few years which provide Melbourne IT the capability to offer a larger set of clients an expanded range of contemporary services in high growth markets such as customer centric mobile app development, data analytics, cyber security and cloud based digital solutions.
Melbourne IT operates two major divisions:
- Small and Medium Business
Interacting with some 500,000 small businesses, this division has expanded its offering from facilitating operational functions such as domain registration services and web hosting to now providing more strategic solutions such as website design, online marketing and search engine optimisation. Management estimates this is a $2bn market growing at 10% per annum.
- Enterprise Services
Similarly acquisition and organic growth initiatives in this division have seen it move along the spectrum of services from hosting to designing and implementing contemporary digital solutions including managed cloud services, mobile app development, security and data analytics. While Melbourne IT accounts for 7% market share of a $1.4bn market, this division is growing sales at 3x the market rate so we expect it to become a bigger player in the large company and government services segment over time.
Acquisitions and organic initiatives to expand the range of value added services carries three key benefits for us.
- More in depth client relationships
Melbourne IT is now engaged in projects with a much broader brief which provides the opportunity to grow revenue by forming a much deeper relationship with each client. Just in the Small and Medium Business segment alone average revenue per user has grown 17%.
- More annuity type management services revenue
The company is now positioned to improve its revenue profile by offering ongoing management services thereby creating annuity type revenue streams in addition to improving earnings visibility both of which attract a higher investment rating by the market.
- More valued add equals more valuable revenue
A lot of the work Melbourne IT does for clients requires bespoke type development and therefore we expect will generate better margins over time. Profit margins are expected to settle in the low 20 percent range after a period of growth driven by management initiatives to enhance productivity.
Risks to consider
As always, all the usual key risk factors apply here such as customer retention, competition impacting revenue opportunities and margins and staff departures.
With the above as a given we would highlight the three key risks that we look at specific to Melbourne IT as it continues the substantial transformation program discussed above.
- Balance sheet strength.
While debt sits above $70m this is offset against $20m in cash and we are comfortable that interest cover will not become an issue should our forecasts not be met. However, management have flagged further acquisitions down the track which will require funding so it’s something we will monitor.
- Acquisition what you pay and what you get don’t always stack up
While the appeal of expediting growth through acquisitions is understandable, we’ve all seen otherwise good investment opportunities fail because of acquisition related execution issues. In a people business like Melbourne IT, cultural alignment between the legacy business and the acquired ones, as well as integration and importantly evidence that acquired business are living up to their promise is one of the biggest challenges management teams face. So far so good for Melbourne IT but it is still a key risk for investors in this company.
- Scaling capacity costs up and down in cyclical business
While there are compelling reasons for both large and small clients to stay technologically relevant in a digitally mobile, cloud based world we have often seen what were labelled “mission critical projects” get delayed or down scaled when economic conditions get tough. Part of Melbourne IT’s growth strategy has seen its people count climb significantly over recent years to over 800 with net 530 additional staff just in the last two years. While we’re comfortable this is backed by a growing revenue base we would expect an economic downturn or recession impacting business confidence will present short term challenges to achieving expected earnings as revenues weaken on a substantially higher cost base.