One additional internal blog on this company
Friday, 23 February 2024 at 12:50:27 PM
So I have been reading more about Alletec. And there are some pretty obvious good things. Actually it is very difficult to find a company which is so small in terms of market cap and where the promoter is clean. And where we have very good growth and a huge total addressable market. Such situations make you wonder that am I not seeing something which the rest of the market is seeing. But let me just first speak a bit more about the promoter. I focus too much on the promoter because he is the one who is the biggest moat of the company right now. This is true for all companies. But the quality of the promoter matters a lot more in small companies. Small companies do not yet have the checks and balances of a big company. And hence the promoter has a lot of leeway to badly run the company. At the same time, the promoter has a lot of leeway to run the company well without organisational constraints slowing him down.
In this case our promoter clearly has mindset to build a company which will outlive him. One example of this is ESOPs. This company created an ESOP pool in 2009. They were such a small company at that time. And even then the founder was thinking about how to create a feeling of ownership amongst the employees of the company. At least amongst his top management. When the company went for IPO, out of a total of 48 crores being raised, 4 crores was an offer for sale. Do you know who sold? Not our promoter, instead the employees holding ESOPs sold some of their stock. Even in concalls the promoter makes sure that his top 5 team members attend the concall along with him. And then he also directs some questions to them. The glassdoor rating is 4.1. I would say that is pretty good. The attrition rate is 22%. Now this seems high. But for employees who have spent more than 1 year at the company, this attrition rate drops to 6%. Basically during year 1 people make a decision. And the ones who stick, stick with the company for long. For a company like this, employees are the biggest input. After all, they do not have any plant and machinery. So on this count I don’t have a lot of worry. And they don’t pamper employees too. For example if you look at the annual report you will see that the average salary hike is less than 10%. So the promoter and the management are maintaining a fine balance between keeping employees happy and not breaking the bank. Actually this also is a good way to figure out an opportunity to enter the company’s scrip. Usually what happens is that the company tries to figure out what kind of business they can expect to generate over the next one year or so. And basis that they figure out how many additional employees they would need, how much attrition would happen and how much would be the training time to achieve productivity with the new set of employees. Now at best this is an estimate. It is bound to go wrong somehow. Sometimes you will generate too much business and your current employee strength would be too low. Other times you will have too many employees but not enough work for them. Actually this is the thing with Human Resources. You sometimes need a workforce which would have to be expressed in a fraction. Suppose you get a project where you would need 1 full time employee. Now you commit a deadline to the customer. Now this employee has to take a two week leave because someone in his family is unwell. What would you do now? Would you push the delivery deadline for the client? Usually clients dont like that. After all they expect reliability from a service provider. So to avoid this situation you would hire a back up human resource. And that Human Resource would step in and make sure the project is delivered on time. So the next time a similar project comes to you, you will learn from your mistake and decide that this time I am going to make sure that I put two people on the project. One would be the person doing everything and the other person would be his back up. Now this time you will improve your reliability because you now have a back up. But you will now get hit on your cost competitiveness. Now from the same project you need to make enough money that you are able to pay the salary of the two Human Resources as well as get some of your own profitability. And then after doing this for a while you would realise that most of the time, the backup is just sitting idle. So now again you start thinking. Why am I paying this guy his full salary and then he is just sitting idle. To get better utilisation from this 2nd person you would may be take on another project and then again you would hire a backup for this 2nd project. So now you have 2 projects and 3 employees. And so on. Then you realise over a period of time that actually you need 1.3 employees per project. And once this equation sort of becomes clear you then start taking on more projects and hiring more people such that you always have 1.3 people available to work on the project. And as you gain more scale this 1.3 would come down to 1.2 and so forth. And you would also use more software to increase productivity of your employees. And then you would also figure out a few freelancers or staffing agencies which can help you out when suddenly you have too much demand and too few employees despite all your meticulous planning. The point of all this is that sometimes we will realise that in a quarter or 2 the margins of the company would really take a hit. This would be because the company overhired in anticipation of demand and then they could not generate enough work for the employees that they have. At this time, the stock may correct a bit and give us an opportunity to enter. This would be especially true when the market is giving a big PE to the company. One bad quarter where margins get hit will mean that suddenly the market would overreact and that would be a good window to buy.
Ok let’s talk about a risk to the company. And that is the vision of the founder. I think the founder gets scared when he thinks about hyper growth. He is trying to build a resilient company where concentration of revenue from top 10 customers is not too much. But he is giving up growth because of that. One example is the kind of projects the company would bid for. Will the company bid for a 20 million USD project if the opportunity comes? In the latest concall the founder said no. And he mentioned how he is more comfortable bidding projects for 1 to 2 million because that way the concentration of top customers does not become substantial. So he is not saying that he does not have the tech expertise to carry out a 20 million project. But instead he is saying that he does not want the volatility that comes from trying to grow too fast. And this conservatism reflects in multiple places. For example not experimenting enough with other platforms except Microsoft. I love thinking about the innovators dilemma. People who are currently winning usually refuse to tinker with their winning combination. Why fix something which isn’t broken? And that is where the opportunity of the challenger is. The challenger is focusing on what really is the pain point of the customer. And the challenger is doing a lot of experiments irrespective of the outrageousness of it to fulfil that need of the customer. Whereas the current winner would want to stick to the current way of doing things. Sooner or later he would be forced to adapt to what the competitor has figured out. So right now the founder in this company claims that Microsoft has the best tech stack to serve the needs of businesses. I agree to that. What I do not agree to is the complete failure of the company to keep experimenting with other tech stacks for fulfilling the same kind of customer requirement. They do try out other tech stacks only when Microsoft tech stack is really bad at something. For example for digital commerce they are trying out Shopify and Magento. I just hope that somehow the founder realises that this is the time when he should spend may be 5% of his annual budget on wild experiments. Both to boost his options for servicing current client needs, as well as to figure out new levers to scale and get a much bigger market share globally.
Now let’s talk about the strategy to grow inorganically. I was sceptical whether the company can actually acquire growing companies with the limited cash reserves available to the company. However now I think there is a way out. And that is earnout. An ‘earnest’ arrangement at the time of acquisition is basically an agreement with the seller where a part of the company’s price will be given to the seller upfront. But the remaining part will be given to the seller only when the acquired business continues to perform well over the next few years and generates cash which would be then paid to the seller. Let us take an example. Suppose our promoter finalises a deal to buy a company for 10 million USD. Now instead of paying 10 million immediately, our promoter will pay 5 million. And let’s say the business which is being acquired generates 1 million USD of free cash every year today. Now the seller will get the remaining 5 million dollars over the next 5 years. So after five years our promoter would have complete control over the company and also would have paid off the seller completely without impacting our company’s balance sheet. Such an arrangement ensures that the seller is not being completely dishonest with us upfront. Now this is like the ideal scenario that I have listed right now. Our promoter wants to buy a company in North America which would give him the brand name in that geography. Why is a brand name so important? Well basically when you are building business applications, you get new business basis your reputation and experience in a particular industry. Now let’s take another example. Suppose there is a university in the US which wants to implement the ERP solution from Microsoft. Now Alletec will put in a bid from India and in that bid Alletec will highlight all the good work that we have done with the education industry. But almost all our examples will be from outside the US. And now let’s say we have a competitor in USA who makes the same pitch to the client. Assume that he has only worked with 3 universities in the US till now. So obviously he is coming in with an inferior body of work. Yet, I think the client would choose the American company. And that is how reputation plays a role in this business. The client knows nothing about ERP implementation. They are basically going to play it safe and go with the service provider who has worked in their exact same context earlier. Also, the client would be able to do a few reference checks easily for the company based in the US versus for Alletec. And I think that is why it makes sense for Alletec to keep acquiring companies as we go ahead. Inorganic growth would be a key component of the Alletec overall growth story going ahead. Let’s see how they fund such acquisitions. I would be very happy if they raise debt to fund at least part of the acquisition. And if this debt is raised in the same currency in which they need to pay the seller.
One more interesting growth driver for the company going ahead is data engineering. Let me explain. Consider a steel manufacturer in India. Now 15 years back he did not have an ERP. May be he ran a small operation with a few employees and the overall revenue was not much. But then the steel manufacturer started scaling. And then he started facing problems which could only solved with the help of an ERP. For example earlier it took a lot of time to raise an invoice. It was all manual. We don’t even know how much time it took. Because no one was measuring earlier how much time it took to raise an invoice after a request for the same is made. So to solve this challenge of everything being on paper he decided to implement an ERP. Let us assume that Alletec helped him setup the ERP. Now that improved his ability to scale. Now let’s assume that the manufacturer setup more factories and also started serving more number of customers. Now Alletec helped him implement a CRM which would keep track of all engagements with the customer. So now within a few years his business has been scaling and thanks to his ERP and CRM he can go back and figure out exactly what happened with any particular customer or with any particular order. Now let’s assume that till now there was no cloud. All his data was saved in his own servers. And someone in his accounts department remembered to back up the data once a week. But then the accountant had to be on leave during covid and back up was not taken for 20 days. And suddenly one day the server crashed for some reason. And only a few days data could be backed up. This time Alletec helped this manufacturer to move his ERP and CRM to the cloud. So now Alletec has made three interventions in the life of this steel manufacturer over ten years. And now I think we are poised for the fourth big intervention. And that is data engineering and AI. Somewhere in the future, this steel manufacturer will realise that he can substitute one raw material with another depending on the spot price of those raw materials. But to do this, someone has to manually keep track of what is the spot price of raw material 1 and raw material 2 and then manually place an order keeping in mind the delivery date of the final product. But why do we need a human being to keep track of this? Why can’t AI make this recommendation to the manager of the plant and then the manager will just click a button and automatically all systems get updated such that the raw material substitution happens. Let’s say the company increased its profitability by 0.2% due to this intervention. And this is what data engineering and AI is going to enable. This I see as a big growth driver for Alletec. If they can start showing that AI is not just a gimmick but it actually making money for businesses via analytics, that is when they will gain that business from their existing clients and new clients too. I believe this data engineering capability is also what they are looking for in a possible acquisition target.
So I am pretty positive on this company. As we go ahead I will be tracking how much is their overall EBITDA margin. It has grown from 10% to 22%. I would see if it keeps inching up with each passing year. It should because the company is launching more and more software products of its own. Over the next few years those should start contributing more than 50% to the overall revenue of the company. If that happens then our overall EBITDA margin should go to at least mid 30s. Also, the company should start taking up more data engineering work going ahead which should again be higher margin. The only thing which I think won’t change is how conservative the management is. Unless the promoter’s son comes back to take charge of the company and he starts growing the company aggressively. This company has an opportunity to grow 50-60% per year for many years to come. But the founder and the top team seem to be happy with 25-30%. That is my only complaint. And sorry one more complaint. They need to work on their branding and marketing and sales. They have recently hired a head of marketing. Let us see whether she starts making meaningful changes to this aspect too.