The case for Nuix - right company, wrong price?

Hiall,

Firstly,wishing holders good luck for Monday and the week ahead.

Nuixis looking interesting at $6.06 (only a 14% premium to the original IPO price)and I’m thinking of taking a position. Over the last two days I’ve read throughmost of the major threads here on HC. I’m reading a lot of handwringing onvarious threads here due to Friday’s action. Some of it is understandable butit seems like there’s a lot of unwarranted market panic going on.

Ican’t help but wonder how many of you would be feeling different over theweekend if you’d read the results then immediately lost your internetconnection for all of Friday and not seen the market’s response. Aside from theSP hemorrhage, has the company really changed that much? Has your outlookchanged because of a small revenue miss and general bond-induced panic on theNASDAQ? I hope not. There’s still a lot to love, it appears.

Myhigh-level view goes as follows… (starting with the negative to get it out ofthe way):

Negative:Crazy post-IPO SP shenanigans

Thecompany listed in December 2020 priced at $5.31 but after the first day oftrading closed at $8.01. That in itself suggests too much hype to me, unlessMacquarie erred hugely in their valuation (a possibility I suppose, but they’vebeen in the company since 2011). But a 51% SP increase in a single day… wowza. Howeverfor it to hit a further high of $11.86 on January 22 had to have alarm bellsringing. A 220% price rise in little more than 49 days? I am reminded of theGraham/Buffett view of chasing ‘hot stocks’ and the mantra “the quicker theyrise, the quicker they fall”. If I’d bought in at the IPO, or thereabouts,I would be happy with a 50% annual increase. When people say “marketdarling” I think they mean “everyone else has cottoned on to your goodidea and made it far too expensive”.

Asan aside on IPO’s more generally, in Benjamin Graham’s ‘The IntelligentInvestor’, he spends some time in Chapter 6 discussing “common-stock flotations”(IPO’s in our modern parlance) and how, on the whole, historically they endbadly for most individual [retail] investors. Considering this section wasfirst written in 1959 (and updated, only a little, in 1965) it still makes forvery accurate reading. Then in the commentary to chapter six, Jason Zweigwrites the below (which is sometimes wrongly attributed to Graham himself) – andthese thoughts may ring true for many post-IPO buyers of Nuix so I thought itwas worth sharing here:

“Unfortunately,for every IPO like Microsoft that turns out to be a big winner, there arethousands of losers. The psychologists Daniel Kahnerman and Amos Tversky haveshown when humans estimate the likelihood or frequency of an event, we makethat judgment based not on how often the event has actually occurred, but onhow vivid the past examples are. We all want to buy “the nextMicrosoft”—precisely because we know we missed buying the first Microsoft. Butwe conveniently overlook the fact that most other IPOs were terribleinvestments. You could have earned that $533 decillion gain only if you nevermissed a single one of the IPO market’s rare winners—a practical impossibility.Finally, most of the high returns on IPOs are captured by members of an exclusiveprivate club—the big investment banks and fund houses that get shares at theinitial (or “underwriting”) price, before the stock begins public trading. Thebiggest “run-ups” often occur in stocks so small that even many big investorscan’t get any shares; there just aren’t enough to go around.”

Zweigfinishes the commentary on Chapter 6 by saying:

“Weighingthe evidence objectively, the intelligent investor should conclude that IPOdoes not only stand for “initial public offering”. More accurately, it is also shorthandfor:

It’sProbably Overpriced

ImaginaryProfits Only

Insiders’Private Opportunity

Idiotic,Preposterous, and Outrageous.”

Notall of these apply here (Nuix has a strong underlying business IMO), but Ithink #2 and #4 may have an element of truth in this situation?

PS:I fully understand that as I write this up, that there will be a strong elementof hindsight bias – that’s almost unavoidable. None of this is intended as “Itold you so” (I didn’t tell anyone anything) and it’s worth noting that likeprobably most investors I’ve fallen into the “bought the hype” trap – in mycase, it was Avita Medical, and my timing was so perfectly atrocious it’s almostfunny (entry in early 2020, when Covid-19 was starting to pop up but markets,including me, were not taking it seriously enough). I bought so close to the topit was snowing. So that’s my fairdisclosure, I’ve been here before too (albeit not on an IPO) and yes, I’m stillunderwater on Avita… I didn’t just stick it in the bottom draw, I’ve buried itin a bunker under my house).

Negative:The “Sheehy case”

Theother worrying thing, which I’m sure everyone is sick of hearing of, but I haveto flag to myself in my DD, is the Sheehy issue. I’m still reading up on thisbut it strikes me as odd that while all other shareholders and option holderssaw their holdings up x50, Sheehy’s holdings were the only ones that satoutside this. I know technically/allegedly they expired, but still trying toget my head around how this will stand up in court. I’m not sure of thetimelines of any legal action – anyone else know? The major risk, as an AFRarticle from 1^st December 2020 points out, is if the share pricetakes off (which it did) and then falls back (which it has). If Sheehy wins hiscase, he will no doubt be looking to “claim damages based on the peak shareprice, because he was unable to trade” (quoting above noted article). His453,273 options, if multiplied by the x50 factor would be 22.7 million shares.Taking the peak share price of $11.855 less the IPO of $5.31 leaves us at$6.545. Multiplied by his no. of (potential) shares is $148,571,500 in“damages”. That’s not pocket change – it’s almost 85% of FY20 revenue, andmultiples of EBITDA.

Update:Funnily enough, after writing this earlier this morning (Sunday), I see thatRear Window in the AFR have pointed out this very risk today as well.

OKenough of the bad stuff. Onto the opportunity, which I think is veryimpressive indeed. I split this in two parts while reading up, given from anASX-listing perspective this isn’t even a toddler yet.

Positive:The back-looking story

· ~15years of R&D into their platform, critical for the software space where thecompetitive edge is speed and ease of processing and ability to handle morecomplex + less structured + higher volumes data sets. Never overlook theimportant of the R&D spend (more below).

· Proven,documented success stories in major analytic areas i.e. the Panama Papers (11.5million documents processed), the Banking Royal Commission in Australia

· Over1,000 customers and counting, including large and sophisticated corporationslike AIG, Airbus, Amazon, American Express, Barclays, Big 4 accountants, CBA(I’m only up to the first three letters of the alphabet, wow…) not to mention policeand government agencies round the globe (including the SEC and DOJ – quite anendorsement) and closer to home with the ATO, AFP, ASIC. Whilst theseheadliners are great, it’s pleasing to see lots of small and medium businessestoo – you don’t want an Appen situation where disproportionate amount ofrevenue comes from a handful of big customers; all it takes for one of these toscale back and you have some serious issues (FYI I’m a holder of Appen,although in the $21 range so not panicking just yet).

· Moreon the customer base – not only are the numbers strong, but the spread across alarge variety of industries is a real plus point for me; unlike an Appen (forexample), whose customers are almost exclusively in the tech space by virtue ofthe fact the underlying product/service is AI related, Nuix on the other handhave customers across multiple industries, many of which are non-correlated. Inmy view this gives them a much better ability to weather a storm verses a peermore exposed to one, two or three key industry types. By way of illustration, let’sjust take a look at some of the corporations featured on their website. This iswhat we get, remembering this is just a fraction of their actual customers, anddoesn’t include some industries mentioned in the prospectus, like oil and gas:

o Accountancy& Consulting (BDO, Kroll)

o Aviation(Airbus)

o Automotive(Jaguar)

o Banking(Barclays, CBA, Deutsche, HSBC)

o Communications(WPP)

o ConsumerGoods (Samsung, Unilever, Vodafone)

o Engineering(B&P)

o Insurance(AIG)

o Legal(Bilzin Sumberg, BCLP, Consilio, Covington & Burling, DLA Piper, Dorsey, etc)

o Payments(American Express)

o Technology(Amazon, Fronteo)

· Lowcustomer churn, strong base of renewable SaaS revenue, fairly strong barriersto swapping to a competitor, meaning the sort of product that allows them toput their price up without losing market share (the Coca-Cola effect that Mr.Buffett loves to quote). The strong ‘swap’ barrier hasn’t seemed to hurt Nuixin return, given their customer base and the big names on their register, andthe recent +49 reported new customers in H1 FY21.

Positive:The forward-looking story:

· Sixpatents thatdon’t expire until between 2031 and 2035 – strong competitive moat on analready large customer base in a large addressable market.

· Ongoingstrong focus on R&D– 26% of revenue from the 1H FY21 spent on product enhancements (in thesoftware space it’s critical this remains high – if I was a shareholder I wouldNOT want to see a dividend payment. I was surprised to see a poster call this “anothernon-divo dog” or words to that effect. If you want a dividend – suggest youdon’t come to tech, there’s lots of nice, safe, boring yield plays out therei.e. CBA, SOL, etc)

· $103million cash on hand,noting they’re a profitable tech player. I agree with many comments on herethat they’re far more of a true tech company than Appen or Altium, which to mymind aren’t tech companies per se, they simply provide a service (APX) or aproduct (ALU) for companies in the tech space.

· Sizeand scope of data collection in private/corporate/government only going one way in the coming years, even inthe face of growing privacy concerns. This is the big one for me. I work in fora large global corporate in the financial services sector, and the degree ofcompliance/regulation/data collection etc is only increasing. The biggest issueright now is the spillover of this type of work into areas like mine – anincoming-generating role, but I’m spending more and more time doingnon-income-generating work to keep the compliance/regulatory powers happy. Yesit’s all necessary, but when your income/sales staff are not focused on theirprimary role, you’re going to run into issues down the track. That point aside,there are many other applications of this I see just in my own industry, someof which Nuix appear to be in, others in which they might be looking to expand.One that jumps out is the M&A space. The problem with M&A’s in thebanking/insurance sector is the immense amount of data that the acquiringcompany has to sift through in their DD. There are some recent (and many historical)examples of overpriced acquisitions because the level of DD didn’t or simplycouldn’t dig deep enough. However I suspect the real problem for M&A teamsis not how deep they dig, but what they do with what they find: making sense ofthe data. Back in the day the approach for the company being acquired would beto come into the war room with the bare minimum in information for the biddersto look through – drop off the manila folder and wait for the competingacquirers to ask for more (assuming they know what to ask for!). These days itseems the opposite would apply – dump so much information on theacquirer that they get data overload and simply can’t sift the wheat from thechaff. If I was on an M&A team, responsible for making a call on abillion-dollar acquisition, I would want Nuix working away in the background,even just as a backup, if not as a primary reviewer. (As an aside, think aboutthe head start Nuix has when considering their own acquisition targets – they couldtheoretically run any data dump straight through their own system).

Icould go on about the forward-looking stuff but this is getting too long…

Confusion:Last Friday’s announcement/result

Finally,in terms of the recent result – given the slowdown in spending on discretionarycontracts across the tech space (and elsewhere) a 5-8% revenue miss is hardlysurprising to me, and they were down 4% verses prior year. The prospectus (page74) highlighted the Covid-19 risks to revenue via “a lengthening in thesales cycle for some prospective and existing customers, and delays in thedelivery of professional services and training to some customers.”

Ihaven’t yet had time to listen to the investor call, but the AFR summary noted“a number of contracts the business was expecting to win in the first half werepushed back, but were closed in January […] Although the first half was soft,Nuix already has visibility over more than $100 million of revenue for thesecond half, thanks to its high recurring revenue base and low customer churn.It said it was also targeting $15 million of new business in the second half.”

A32% drop in the SP because of a relatively small miss from an unavoidableglobal pandemic that has hit all companies in all industries in all countriesaround the world? To me, this speaks volumes about the market’s frothy approachto this company, and a lot less about the operation of the company itself. Ifyou’re a holder with a long-term view that perhaps got in somewhere around the$8’s then a little level-headed calm will go a long way, and mynon-professional gut feel is that in 3-5 years’ time you might be quite happy.Selling now only turns your paper losses into real losses. I think if youbought in the $10’s to $11’s then, unfortunately, IMO you were likely buyinginto the market hype, not the company’s prospects – because the long-termprospects were already fully priced in (for reference, this was me with Avita…)

Onthat latter point, I saw a few comments here and there about Nuix “becomingthe next ALU or APX” (or words to that effect) and the share price goinginto the same realm as those companies enjoyed at their hype (i.e. the $30 to$40 range). Sorry to state the obvious but this is baloney to me. NLX has 2.4xand 2.6x the number of shares on issue verses ALU and APX respectively. So ifwe take their 52-week highs, this is what we get:

ALU:131,228,194.00 shares issued @ 52WH: $40.21 equals MC of $5,276,685,680

APX:123,014,132.00 shares issued @ 52WH: $43.66 equals MC of $5,370,797,003

But,

NXL:317,304,794.00 shares issued @ HCH*: $30 equals MC of $9,519,143,820

NXL:317,304,794.00 shares issued @ HCH*: $40 equals MC of $12,692,191,760

*HCH= Hot Copper Hopeful

There’sa big problem here (if you are taking these three as peers, as some appeared tobe).

Mysummary then is that this is a solid company with a strong history of achievingresults and, more recently, profit. Lots to love about it, once the tech-hypeis stripped away, which Friday just did for us, and the NASDAQ / bond marketmay continue doing in the coming week or so (perhaps longer).

Sofor me this one is looking very interesting indeed, currently sitting just 14%above the IPO price (but I’m cautious of even that, thanks to Messiers Grahamand Zweig as noted at the start of the article).

Myleftover questions…

Iguess with all of that said and done, I’m genuinely interested in having mypoints raised above put to the test – I always like to hear the bear case toeven out my research and avoid confirmation bias (as much as is possible).

Asidefrom the SP collapse, which I think is (partly) understandable for the reasonsnoted above, what’s the major downsides to this company? What don’t peoplelike? If you’re into the tech sector, why are you watching this one, but givingthis one a pass? (especially at $6.06).

Thanksand look forward to people’s views.

mondy

(Disclaimer:this was all written for the purpose of summarizing my own research thus far.I’m not an investment professional and this does not constitute financialadvice. It’s my opinion only. Do your own research and act in line with yourown financial situation. Thanks)