Xref: Not as Bad as it Seems
I believe the recent fall into unprofitability from Xref provides us with an opportunity to buy a great business at a reasonable price. While the recent result is obviously concerning, when we zoom out I believe many of the issues they're facing on the cost side to be clearly short term. In the meantime the long term plan for the business seems to be intact and we're presented with an opportunity to purchase a borderline profitable, rapid grower with a fantastic product and a long runway for growth.
The Business
Xref's core business revolves around doing automated reference checks for employers looking to hire. The company’s cash timing is incredibly favourable as customers purchase credits for cash, before later using those credits for checks (which is when revenue is recognised). This product is incredibly popular (with very high reviews from every source) and serves a variety of customers from small businesses to blue chips such as Coles, Mcdonalds and the Salvation Army. Management has taken this product (which is operationally profitable), and is in the process of using it to build out a full digital HR offering. Through a combination of R&D and acquisitions the company has released id and graduate verification, exit surveys and employee engagement services to cover every segment of the employment process. The company has also been in the process of converting this to a subscription service in order to make the revenue more consistent.
The Short Term Thesis
Following the release of their most recent half year report Xref's stock has crashed 30% due to rising expenses and a slip into unprofitability. While revenue (ex crypto) has continued to exhibit fantastic growth, many investors were expecting this growth to continue to be profitable, and for the company to exhibit some level of operating leverage. While I was equally concerned when initially reading the report, upon breaking down the expenses and considering the macro context I don't believe the report to be as concerning as the rest of the market, and I believe the long term thesis is still firmly intact. Looking at the expenses growth, $1.9m out of the $2.6m of the change came from some form of employee expenses (employee expenses+stock comp+admin expenses). I believe that upward pressure in employee expenses should significantly ease over the next year. At the core of this belief is Australian wage growth, and my belief that wage growth will stabilise as the job market loosens. We have already seen this at the blue collar level, as rising immigration has significantly eased the pressure in the job market in industries such as hospitality and retail. I know this because I live it, with the majority of my friends and associates working in these kinds of industries. People who could pick their hours and employers a year ago are now taking what they can get.
Furthermore, the RBA continues to raise rates to try and tame inflation rates, which have continued to run hot in Australia. It should be noted that the Australian consumer is very heavily impacted by rate hikes with huge mortgage debt levels made up of mainly variable rate mortgages. While an economic slowdown would obviously impact Xref’s growth, I believe in the strength of their core product which provides companies with an important and helpful service at very low cost. My belief is that labour looseness will slowly trickle up to white collar industries, spearheaded by skilled worker immigration and an economic slowdown caused by rate hikes. If this thesis plays out then the business should begin to exhibit operating leverage as their expenses growth slows significantly.
Long Term Thesis
The other element of expenses growth for Xref is R&D and growth spend. With the acquisition of Voice Project, the transition of their product to a subscription service and the general integration of all their products R&D has been significantly increased. The key thing to highlight here is that this R&D expenditure isn't maintenance expenditure, it's reinvestment into the core drivers of the long term business plan. Furthermore, management has flagged that much of this increase is temporary as they finalise product development and integrate all their offerings into the subscription platform. This seems to me like a classic case of profitability being masked by growth expenditure. Their core reference checking service is beloved by customers and provides them with both an entry point and a strong reputation to help promote their other products. If these other products are anywhere near the margins of their reference checking software then a lot of the new revenue will likely be heading straight to the bottom line once R&D starts to stabilise. I believe that we are close to an inflection point, and that revenue growth over the long term will be met with significant operating leverage.
The Finances
The first thing to note is Xref’s revenue growth. Xref has compounded revenue at almost 40% over the past 4 years. While this year’s revenue growth has slowed, it’s impacted by a decline in the ID segment that serves crypto, however this should be fairly negligible from here onwards. The company is currently trading at a 16 run rate price/gross profit (a metric I prefer to price/sales) off 20% gross profit growth. I believe this is a very reasonable valuation for a company that should be able to compound revenue at double digits over the long term with significant operating leverage. Xref has demonstrated an ability to grow profitably in the past, with net income margins increasing from -100% to 4% from 2019 to 2022. Going forward after this year I expect these margin improvements to continue. Finally, Xref’s balance sheet is solid. Due to their credit sales they are well capitalised as the working capital cycle works in their favour. Currently their debt position sits at around $5m leaving them with plenty of flexibility.
Key Risks
The first key risk is around the Australian and American jobs markets. It's likely we'll have a slowdown in both economies which will ease the tightness in employment. It's hard to say what the impact of this will be on Xref. On one hand there will likely be less jobs available and therefore less hiring. However, the other side is that open jobs will have more people competing for the roles, increasing the need for their product in order to better differentiate between candidates. Obviously a big recession would likely significantly impact their business, however my belief is that the US and Australian economies are resilient and while we will probably have a slowdown it won't be drastic. Furthermore, I believe the strength of the product offering and the consumer love for the product would provide a level of resilience in an economic downturn.
The second key risk is almost the opposite. Obviously much of the short term thesis revolves around wage expenditure slowing while revenue continues to grow. Inflation in Australia has so far continued to run hot while white collar industries continue to experience job tightness. While the RBA continues to aggressively raise rates, if we get an extended period of wage growth this would invalidate the short term element of the thesis. While this would obviously impact the value proposition here, it doesn't really impact the long term thesis and I believe the company could still be a good investment regardless.
A third key risk is around valuation. While I’m fairly confident in the company’s ability to run profitably in the long term, whether they can grow into their valuation is another question. Due to their lack of profitability it’s difficult to make an accurate forecast of cash flows. I am very confident in their ability to grow revenue, but the big question is whether they can demonstrate operating leverage, or whether we continue to see expenses creep to fund growth. This will be a core factor I watch long term and I will sell if it continues to be an issue.
To sum up, I believe that we have an opportunity to buy a high quality and beloved company at an inflection point dealing with some short term headwinds. While there are some risks with regards to both revenue and expenses, I am optimistic regarding the long term vision for the business.