Kelly+Partners (ASX:KPG) - Review of Results

1H2023 Results

• Half Yearly Report and Accounts

• Investor Presentation 1H23 Half Year Results

• Market Release 1H23 Half Year Results

Today, Kelly+Partners reported it’s results to which they were largely quite impressive, but given the recent significant trim I did and it’s stretched valuation (especially relative), it is worthwhile reviewing in depth. First, a quick reminder. In my 2022 Portfolio Letter i stated the following:

“Following the Kelly+Partners results, while I was satisfied with the results but disliked their intention to shift their focus to international markets including the UK/US. Having worked in the business up until December 2022, I don’t think they have the central services capability to handle it personally, and despite what they say, I also don’t think it is all that much better than a normal accounting firm. The higher margins are merely a function of high performing employees, or inversely quite underpaid employees, In this case it is a bit of both. I won’t get into the details however, this is the driver of margins. Gross margins of 60%+ (and coincedently EBITDA margins north of 30%). I was increasingly aware of this so wanted to move on to somewhere that shared their profits a bit more with the people producing the work. In the end, what they are doing is excellent for shareholders though.

Anyway, this discontent along with a lack of portfolio deposits (having increased lifestyle costs after moving in with my fiance’, wedding planning, house savings etc.) led me to wanting to treat my portfolio with a bit more of a traditional lens. The days of me saving up, deploying and repeating are over. From here on out the portfolio will be managed sensibly. So in saying that, I also wanted to focus heavily into my circle of competence, which I ended up defining as professional & financial services broadly. This includes firms, but also any services to those firms such as training, software providers etc.

I ended up trimming my KPG position 75%, replacing with 3 stocks. In addition I sold ZIGExN in preference for something within my circle of competence. Furthermore, I replaced AFL, which was mainly driven by it being a source of capital losses to offset my significant KPG gains, but also in part a recognition of error… a poor one at that. Under Peter’s stewardship it likely improves significantly, although I opted for something a bit more certain.”

From an investment standpoint, I was spooked by an earlier than anticipated intention to expand overseas. I knew this was coming with further investment in the services team along with a potentially dilutive impact on their domestic intiatives and focus.

From an employee standpoint, it’s a fundamental disagreement with a get up early, stay up late work mentality, and I ultimately think that mentality is ripe for competition at least at any level below partner in these firms. The employment offer for anything but partner is not attractive, with highly demanding billables with highly underwhelming salary (A function of high gross margins and relative lack of standardised processes and automation), along with no real incentive scheme for these employees. In saying this, the partnership offer is exceptionally appealing financially, but comes with an equally exceptional committment and lock-in for said partners.

So with all this in mind, I considered a peak weighting of 65% of my portfolio to be highly overkill. I still really think the business is a great one, but there is some things that give me pause so the position size of ~15% it currently is makes a lot more sense to me.

Moving on, we have seen some of the first signs of an investment for expansion with the excess parent expenditure reaching levels which we haven’t seen since 2020 when they invested heavily in their IT capability. In this case we have seen an investment in ‘brand' and ‘digital’ in order for them to support further acquisitions and global expansion. It’s in my view that this could continue for a few years yet as they scale up overseas services teams which would have substantial cost relative to their actual services provided until they reach some reasonable level of scale. So that’s one thing that puts weight on those high value near term cash flows and is given the commentary in the earnings call, is likely to result in a cut to the dividend. Not that this particularly hurts the investment at the current high valuation…

What they do well is acquire, and I do look forward to seeing what that looks like in a US/UK context. Firepower is diluted with a central services cost that is taking what was this year ~3.3% of the group revenue where they typically run around a 10% margin and 60% payout ratio, leaving them <1% in free cash to retain for acquisition. Another potential reason to cut the dividend, or perhaps more interestingly as eluded to in the earnings call is B class listing where Brett perhaps gives up a high % of his ownership in the A class shares in return for cash flow, whilst simultaneously issuing B shares to himself to retain control.

Anyway, some more nuance is that we saw SIGNIFICANTLY less promotion in these releases relative to what we saw last year, evidenced by a 42 page slide deck in comparison to an 80 page deck for the PcP and 51 for the full year. A welcome improvement in my view.

Financially, some cherry picked observations:

• Organic revenue growth was in line with YoY inflation at 7.8%

• Like-for-like firms (not acquired) saw an EBITDA margin of 31.0%, down 7% from 33.3% in the PcP.

• Working capital conversion was strong with lockup days consistent.

• Net Debt/EBITDA increased to 1.61x (on the high end of their target range).

• No Government Grant YoY + acquisition costs + doubled customer list intangibles drove lower statutory NPAT notwithstanding parent overspend.

• A Beacon Lighting (ASX:BLX) like Canberra Property Trust disclosure of the purchase of a $2.2m property and raise beneficiary funds via. operating partners.

• Central services team costs of $1.1m on services team office fitout and PP&E purchases.

All in all, good results I just am taking a conservative stance in regards to my trim. We should get some exciting details in the coming 6-12 months given Brett intends to be ‘hard to contact’ over this time. I.e. around international expansion and capital allocation/dividends.

Thanks for reading