Property exchange platform Pexa (ASX: PXA) deserves our attention not because the shares have performed well (they have not), but simply because it is a high margin business with strong competitive advantages. Just because the valuation was arguably too high, does not mean the business is a bad one. In fact, as I will explore below, I think Pexa is quite a good business.
What Does Pexa Group Do?
Pexa has three main segments; Pexa Exchange, which is an electronic conveyancing platform, Pexa Digital Growth which provides consulting and data analysis mostly to government, and Pexa International, which largely consists of a law firm called Optima Legal that specialises in re-mortgage applications, over in the UK. However, the only really important segment is the Pexa Exchange, which contributes the vast majority of the revenue and the entirety of the profit.
When listening to the conference call recently, I couldn’t help wondering if the following Buffett quote could be reversed. While Buffett said, “When a management with a reputation for brilliance tackles a business with a reputation for bad economics, it is the reputation of the business that remains intact,” the more relevant question for Pexa is what happens when management with a reputation for lack of brilliance tackles a business with a reputation for good economics.
Essentially, the Pexa business model seems to be to take the profits from the monopolistic Pexa exchange, and scatter them around randomly in the hope that one of managements’ brain farts generates satisfactory returns.
Since listing, Pexa has announced investments in “AI software leader” Elula, remortgage processing firm Optima Legal, property analytics and technology solution Slate analytics and property tech company Landchecker. These investments were all made from 2021 to 2022, when markets were particularly frothy, so I would expect write downs associated with at least some of the past expenditure, in due course.
While Pexa does spend many millions each year on “growth initiatives”, without any actual growth to show for it, it must be said that its core Pexa exchange is a resilient business that will grow, even if it doesn’t grow every year. Even in the face of an extremely sluggish property market, Pexa Exchange remains outrageously profitable. That said, it did suffer an almost 15% drop in half yearly operating earnings before tax, interest, depreciation and amortisation, in H1 FY 2023.
However, Pexa’s other divisions have very little going for them.
In H1 FY 2023, Pexa Digital saw losses increase around 365%, to about $8m at the EBITDA level, and Pexa International saw losses increase 188% to around $9.1 million. So there can be no doubt that CEO Glenn King has a mandate to lose money di-worse-ifying the revenue base, and he intends to use it.
You can see below how the company spent some $50m investing in M&A during H1 FY 2023.
While I absolutely expect this spending spree will be proven to be wasteful, given the timing of it and lack of articulated strategy, there is of course some possibility it will pay off. H1 FY 2023 only saw about $1.8m in revenue from Optima Legal, which has a revenue run rate of around $20m, so a full period contribution from that acquired business will add some revenue, at the very least.
But even if these acquisitions prove wasteful, this expenditure won’t necessarily damage the core Pexa Exchange business, which still received considerable ongoing investment of $16.5m in the last half, according to the chart above.
During the current financial year, Pexa expects to invest ~20% of revenue in the Pexa exchange, with an additional $45m to $50m invested in international growth, and another $20m on Pexa Digital. As a result of all this, you can’t expect profits or genuine free cash flow any time soon. Core valuation metrics like free cash flow do not appear to be a priority for management, which seems to have a focus on top line growth more suited to 2021 than 2023. You could not accuse these guys of reading the room, and it is no surprise the share price is down about a third from its peak.
But Xero shows how quickly that can change.
Xero had a CEO that did not seem to pay attention to free cashflow and profit, and spent lavishly on absurdly expensive acquisitions that were subsequently written down, or written off completely. Then, the board brought in a new CEO who cut costs and brought the focus back to genuine free cash flow. Hey presto, after her very first set of results, the stock has gained some 60% from the bottom. You can see how this played out for Xero shareholders below.
Now, there is no guarantee that Pexa will ever stop flinging cash at moonshot growth initiatives.
But if there is one thing I learnt from watching Xero’s recent transformation, it is that such a transition can be made very quickly, if the will to change exists. Within 6 months we could see the market perception of the business change wildly. At the moment, we have a management team completely ignoring actual net profit margins, spending shareholder cash on minority investments even while the business groans under almost $300m of debt.
As if to inadvertently emphasise the disconnect between Pexa management and reality, the word debt does not even appear in their H1 FY 2023 investor presentation. Only a fool would invest in a company before considering its balance sheet, but perhaps that is who Pexa hopes to appeal to.
Consensus analyst estimates for FY 2024 suggest Pexa will achieve normalised earnings per share of about 33c, and statutory EPS of about 14c. Even if we accept the normalised number for FY 2024, that would put Pexa on about 40x normalised earnings at the current price of $13.13. It would trade on a statutory PE ratio of above 90; far from cheap.
Having said that, I still think Pexa has a lot of potential as an investment.
The reason I find Pexa so interesting is that the Pexa exchange is a virtual monopoly. For example, in NSW there are only two approved Electronic Lodgment Network Operators, Pexa and Sympli. But as you can see from the chart below, Pexa enjoys almost complete dominance in NSW (along with the other 5 Australian jurisdictions it operates in).
Not only does Pexa dominate its niche, but it also touches the most important transactions most people will make in their lifetimes, a house purchase. Because houses are so expensive, the cost of the eConveyancing platform is hardly a major consideration.
When buying a house for $1m, you simply don’t care much about whether you could save $100 by using Sympli instead of Pexa. That means that incumbency is extremely valuable in this market.
Is The Pexa Share Price Attractive?
As I’ve discussed above, the true value of the Pexa exchange is hidden by the profligate spending of a management team dedicated to building an international empire. There’s simply no way of knowing if control Pexa will ever pass over to management who want to run the business for maximum profit.
However, if we imagine for a moment that Pexa was a private company, you could easily see how it could generate a tonne of free cash flow. Most of the cash generated by Pexa Exchange is going to Pexa International, Pexa Digital, and various private equity style investments.
If the company cut all spending except for ongoing R&D spent on its core Pexa Exchange, it could already generate around $50m in half yearly free cash flow, or more than $100m per year.
Although the core business would naturally have its ups and downs (since more property transactions mean more money for Pexa), the overall growth of the Australian population and market share growth in NT, Tasmania and Queensland and WA, could all ensure that the business does not remain stagnant. As a result, I believe it would easily deserve a solid multiple of current free cash flow levels, since free cash flow should improve as the housing market sees more transactions, even without any product enhancements.
Correction, Sunday, 18 June: Please note, I made an error in my initial calculation of market capitalisation, and published an incorrect figure. I have corrected this in the paragraphs below and apologise for the error.
At the current Pexa share price of $13.13, Pexa has a market capitalisation of around $2.35 billion, or about 23 times the free cash flow I believe it could achieve right now.
However, in order to get a better idea of value, we should also consider the enterprise value.
Since Pexa has net debt of about $260m, its enterprise value is about $2.6b, or around 26 what I think its free cash flow could be, if it was run to maximise returns to shareholders. That doesn’t seem very attractive.
At the end of the day, I think Pexa would look attractive if it was focussed on generating free cash flow, and the share price was a bit lower.
While there is no immediate indication the company will focus on profitability, I think any change in strategy towards immediate profits, and away from speculative M&A, could act as a catalyst for a strong re-rate.
This stage of high investment may continue for a while, but it is unlikely to continue forever unless it actually produces some genuine growth. At some point, surely, the board will realise that it is better for both shareholders and themselves personally if the company introduces some discipline around its various growth initiatives.
Either through cutting back on speculative growth initiatives, or through those initiatives actually succeeding, Pexa could well produce very strong profits in the future. After all, it is a virtual monopoly, earning EBITDA margins over 50%.
With management still behaving like it’s 2021, it might be a bit early to buy Pexa shares right now. However, given the Pexa Exchange is such a top quality business, you could do worse than to buy now and wait for a strategy change.
Having said that, my preferred course of action would be to buy only once signs indicate Pexa will follow the Xero playbook.
Any change in the CEO, or even simply a change of strategy by the current CEO, could well mark the nadir of sentiment around the stock. In my view, if only Pexa would shift its focus to generating free cash flow and net profit after tax, then it would potentially benefit from both profit growth, and sentiment uplift, making it a far more attractive stock to own.
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