A Post-Mortem - Chasing the Re-Rate on ARR Multiples…On the two-year anniversary of the biggest bubble in small cap tech since 2000 I thought it would be good to reflect on a few things…
This one is tough to write up because I have entirely, utterly and in all respects lost everything and completely blew up my portfolio combined between this area of the market and AdTech to the point of utter wreckage and beyond repair to an unrecoverable level. When running a concentrated book goes against you it gets ugly fast… funny how history only remembers the winners with a massive survivorship bias.
Let’s set the scene, a late 2020 into early 2021 into an utter melt up a bubble cresting that second week of February. With complete trash down market cap just gapping higher 20-30% higher every day. The worse the company the higher it went. Let’s just highlight a couple;
Virtual Armour VAI.CN – Got into the 0.50’s from <0.05/share only to go private at 0.07/share within 12 months…
VSBLTY Group VSBY.CN – Highs of 1.89/share to close today at 0.175/share to never turn a profit heck, to be selling product at NEGATIVE GROSS MARGIN…
TrackX TKX.V – My personal favourite, was churning massive volume doing millions of shares a day for weeks on end to hit a high as high as 0.14/share to only turn around and be all but a ZERO here…
Why do I bring these up, there was a massive appetite for anything growth/tech with a ARR revenue stream and a story. With private raising rounds going for >100x ARR and public index basket of stocks that even got as high as 30x ARR in aggregate.
Then you got little ole’ Tall Craig, sitting >50% cash going into 2021 watching names run away with value and actual fundamentals names not moving without that liquidity impulse. Next thing you know you get forced to chase as the end goal (A property in Southwest Ontario fleets further into the abyss if you don’t keep up) put simply, FOMO to only end up once the dust settles further away then ever.
The plan was simple, to go down further on market cap where they haven’t moved as much at a discount to larger cap peers to play for a re-rate on a liquidity impulse. With the availability in hindsight that was the worst possible thing to do at the worst time so lets go through a post-mortem of
the Good, the Bad & the Ugly. Lets Dig in; The Ugly – Martello Technologies Group MTLO.V Entry Point – Low 0.20s/share
Current Price – 0.025/share
Performance – DOWN a smooth 90% The Story – A play on Microsoft Teams growth through DEM backend monitoring/performance with a legacy Mitel support business that was funding the growth of the MSFT365 growth on the back of the shift from work from home.
The balance sheet was an absolute mess but in a bull market and big financiers behind the story that didn’t matter as they would be able to refi on a re-rating of the business as the mix shift went to more of a pure growth model.
It was a pureplay SaaS name that was able to reach EBITDA profitability with 90% gross margins in the midst of COVID trading at a 2-3x EV/ARR multiple at the entry point where peers were trading 8-10x EV/ARR as the business shift mix was shifting to more and more of a high growth DEM business model where the cash cow Mitel business was still stable to growing mid single digits.
When it Cracked - June 28
th, 2021 on the announcement of Fiscal Q4 numbers. (0.15/share)
That should have been the point to pull the rip cord and sell everything, they turned back on the spending spigot to the point where they were burning >1M/quarter an yet they were seeing negative QoQ growth in their growth engine of their MSFT365 DEM product and the Legacy Service Analytics/Mitel business started to fall off a cliff.
The MSFT growth rate was suppose to make up for the decline in the legacy business and reach a pivot by the end of that fiscal year. Which did not even come close to happening. At the same time they were changing how the measured/counted users if I recall which in hindsight was a red flag.
At that point, it should have been blown out, but you were looking at a point in time where it was getting below 1x ARR… (If you believed if the ARR growth was going to go back to the guided figure) So what did I do, I kept plowing more and more money into it throwing good money after bad. Especially with the doom loop of the balance sheet weighs around the neck of this thing like an anvil it just kept getting worse and they refused to cut spending even as incremental spend was not driving any ARR growth.
I just sat there adding, thinking that on a strategic asset value it was worth more then the enterprise value of the business, but as the egregious spending and lack of discipline by management on the cost side led to a decaying asset and has since just turned it into a credit story being kept alive by a single investor.
Where are we Now – I sold everything I could for tax purposes.
Its exactly where we started… still sitting there at 2x EV/ARR but between ARR declines and the massive cash burn it has increased the enterprise value as they keep plowing more debt & equity onto this thing.
Just a complete mess.
Lessons Learned – Add into fundamental execution & reduce into fundamental performance (Completely did the opposite here)
On these strategic asset plays, if it is not default alive as in cashflow positive the natural decay of the financial position of the business is going to kill you. It is like you are holding an option and there is THETA decay just eating away at your upside optionality.
Just pull back the chart kid, if a group of people in software have not been able to create shareholder value in the SaaS space in the greatest run ever for SaaS in the 2010s why would it change and they start making good decisions. It was always down and to the right.
Sacrificing business quality for a valuation discount at the entry point is never going to work, especially when the cash burn is that high. Operating cash burn when the balance sheet was already stretched is a recipe for disaster especially when the market sentiment turns.
It was always a bet they could turn the business around from a revenue mix shift basis before they ran out of balance sheet runway and they unequivocally failed.
The Bad – Route 1 Group ROI.V Entry Point – Low 0.60s/share
Current Price – 0.085/share
Performance – DOWN a sultry 85% The Story – A play on cyber security with a growth business within the US government agencies selling a hardware with a backend ARR model with a growth division in MoBiKey.
The balance sheet wasn’t great because management took on such a stupid legal dispute jeopardizing the financial stability of the business with a patent claim.
I am a sucker for these hardware up front subscription in the back ARR models especially with the sticky client base they had with the room for product expansion across many lines of business.
At the time I want to say it was around 2-3x EV/ARR again but with a very discipline management team when it came to OpEx management which resulted then driving solid EBITDA margins and cashflow and I loved how they targeted gross profit dollars over revenue generation.
When it Cracked - November 22
th, 2021 on the announcement of Fiscal Q3 numbers. (0.40/share)
ARR growth went negative the fiscal Q2 of that year on a QoQ basis but was still up on a YoY basis and they were able to do a great job maintain the profitability of the business through cost discipline.
By the time that the business decline happened the stock has already been cut in half and someone new something about the deterioration in the core business.
At that point, it was still a profitable business doing call it 10M ARR with no indication and no guidance of continued deterioration in ARR growth on a go forward basis.
Instead, management install a buyback and was excited about the launch of their aLPR that was going to re-accelerate ARR growth. Well… since that point ARR has been cut in half in a year… Well done team.
Should be noted they utilized a stock newsletter promoter with a following that was completely price insensitive in Small Cap Discoveries which was able to raise capital through its West Coast Broker network with the promise of rolling up verticals which turned out to be completely false and just used the money to pay off the lawsuit and deliver no growth and then you have all this hot money behind a stock promoter that just dumped the stock. I am not saying this is right or wrong it just leads to such misaligned incentives between time horizons…
For example, they raised $3M at 0.85/share Dec 2020 which is equal pretty much to the entire market cap of the company today!!! (With an equal amount of EBITDA generation none the less on a run rate basis…) Where are we Now – Took my tax loss but added back some.
This one is a little different as they have been able to keep the business EBITDA profitable through this entire mess. As a result, the enterprise value hasn’t ballooned even with the stock price decline and it stays in a default alive position.
I should note this is disgusting that management didn’t buy a single share of the company all the way down then awarded >5% of the company to themselves on long term incentive grants. Makes me sick.
I still remember on one of the calls Tony had the gall to say that the business is so misprice down here at 0.40/share and he was going to take it private down here if it stayed down there. Then the stock proceeded to get cut in half, then cut in half, THEN GET CUT IN HALF AGAIN. And what did Tony do…. NOT BUY A SINGLE SHARE OF THE COMPANY.
Actions speak louder than words my friend… They have been able to hold onto aprox. 2M in EBITDA (<2x EBITDA) even as ARR declined but the decline in ARR is not slowing down. If they could just get that to stabilize it would really start to change the outlook.
So <1x ARR and <1x Gross Profit I think there is upside option value here but it is not an investment it is a trade at this point.
Lessons Learned – I don’t think I have seen a guy Over promise and Under deliver worse than this guy. He oversaw the ARR of the business get cut in half on an ARR basis but yet talking about growth the entire time. How does that happen???
Stay away from names that are raising capital through a known stock promoter like in this case Small Cap Discoveries. Their business model is not the same as retail. You are the product. There is nothing wrong with it but just realize the misaligned incentives. (Especially when you look at Small Cap Discoveries founder public HoldCo and he & his boardmates are all paying themselves $200K a year or 10% of AUM to managed a basket of all non-arm’s length businesses including board members that do nothing – As a little guy, I’ll stand up and say that that is no okay) I think it’s alright if there is overlap in names that you are looking at but when there is a capital raise involved (especially with warrants attached) they are playing a different game. Raise, Churn, and burn and hold that warrant.
When the bottom falls out and sentiment turns there is no bottom in price no matter the valuation when management is this two faced.
Finally, if a microcap company is suing a multibillion company and is blaming the judge and the multibillion-dollar company just doesn’t buy the microcap to make the problem go away. – RUN, RUN FAR AWAY. The Good – AirIQ IQ.V Entry Point – Low 0.20s/share
Current Price – 0.26/share
Performance – UP 30% The Story – Real simple here, a telematics business with a hardware & recurring software subscription model for telematics for road assets and logistics benefiting from increased asset monitoring from ELD regulatory compliance to high value asset tracking/monitoring.
Balance sheet immaculate with 25% of its market cap in cash no debt and a buyback program active.
At the time I want to say it was <2x EV/ARR again with an asset light model and even at that time with strong mid-high teen operating margin and EV/Cash EPS <10x with a mid-high single digit growth in ARR.
When it Cracked - February -March 2021 (Mid 0.30s/share down to mid 0.20s/share)
Nothing really changed in the fundamental story the core ARR growth continued to tick higher at a mid-high single digit clip the only thing that changed was the pace of hardware sales.
With that quarter being the first quarter in many years with <$100K revenue in hardware sales. But given the minimal churn in the business it did not affect the run rate or pace at of future ARR growth.
This is when we were near peak supply chain problems but the big thing here I think was just multiple compression and investor interest. There is no sex appeal to a <$10M market cap that is churning out mid-high single digit ARR growth.
It just became a fund flow problem at that point where was the incremental buyer going to come from… part of the reason why I wish they would hammer on the buyback a little harder.
Where are we Now – Just Keep Adding…
This one of my larger holdings now, what I didn’t do on MTLO I learned my lesson and just kept adding on fundamental execution here.
The TTM ARR growth rate has accelerated to 14% from the previous mid-high single digit pace they were putting up at the same time they have been able to hold onto that 20% Cash operating margin. With a conservative management team guiding to a targeting turning this sleepy little company into a Rule of 40 growth name.
You back out the cash it is trading 1.5x EV/ARR with a faster growth rate now then when I entered the name generating close to 50% more in Cash operating earnings.
Lessons Learned – Keep it simple add on execution. Boring is sexy.
You pull back the chart here back a decade. This was a 0.04-0.05/share a stock. With the same management team, no drama just compounding capital for shareholders. Must pull back that chart and look for names that are lower left to upper right on longer time horizon.
Not breaking news here but a clean balance sheet is a hell of an asset, not only from a financial point of view but from a psychological point of view. It prevents management hand being forced to make just bonehead decisions and guidance more based in myth than truth to goose the stock price higher in the short run. It allows management to think a little longer term.
Great little business wish I owned 20 of these.
Moving Forward I continue to bet big on concentration, but buying businesses at trough valuations with expanding margin profiles and growth rates. That way you get the multiplier effect from all three, top line growth, margin expansion & multiple expansion.
1) Premier Health of America Inc. – PHA.V (See Attached for Take)
https://stockhouse.com/companies/bullboard?symbol=v.pha&postid=35188947 2) Spark Power Group Inc. – SPG.TO (See Attached for Take)
https://stockhouse.com/companies/bullboard?symbol=t.spg&postid=35215084 3) Sabio Holding Inc. - $SBIO.V (See Attached for Take)
https://stockhouse.com/companies/bullboard?symbol=v.sbio&postid=35247066 In Conclusion So there it is, my post mortem how I went from 50% cash position to ALL IN to blowing up my portfolio in under 12 months from overweight in two industries chasing ARR growth re-ratings instead of the liquidity impulse that was working in B2B Tech & Hyper Growth AdTech that was boosted by uneconomic spending from venture backed names at nosebleed valuations with no concern to CAC paid to grow at all costs.
Thesis drift especially on growth is a hell of a death trap. Blew me up beyond repair, especially when its compounded by multiple compression. It wasn’t the initial investment that killed me, it was the compounding of errors by continuing to average down.
Multiple Compression when you were playing for expansion can really add torque to those losses faster then you can re-evaluate you positioning.
In hindsight, the play should have been to chase the liquidity impulse in the junk that was ripping because when it rolled over you would have no fundamental attachment to it to blow it out. Playing for the extra torque on these balance sheet that were not in great shapes to begin with and shady management team was the death nail.
As I sit here hunched over a keyboard a skew looking for answers under a dim light. For tonight, I have no answers only reflections lay here of a portfolio gone awry with losses taken that short trip to the stocks Gods to never return. A cautionary tale, once again that is Tall Craig over the cliff of market folly enduring the same fate of the lemmings he thought he was better than. In the end… it was a bull market and a poor stock picker