Description

OVERVIEW:

Rhipe Limited is an aggregator and wholesaler of cloud-enabled software (and more recently, infrastructure - more on that later). In practice, software is consumed by a large number of corporate enterprises who often need help understanding, implementing, and configuring the software they use. This help typically comes from the very large and fragmented universe of IT service providers. As a distributor, Rhipe takes software from giant multinational vendors like Microsoft, VMWare, and Citrix and makes it available to IT service providers who then set it up for their end customers. This model allows companies like Microsoft the ability to work with 10-20 key partners, as opposed to hundreds of thousands of IT service providers, or millions of corporate enterprises. Vendors count on wholesalers like Rhipe to build their sales channel, educate and train the channel, and provide customer service and billing (95% of Microsoft's revenue comes from Channel Partners). All of the software that Rhipe distributes / licenses is cloud based and is paid for on a monthly subscription basis or pay-per-consumption. In other words, nearly all of Rhipe's revenues are recurring on a monthly basis.

HISTORY:

NewLease was established in 2003 by Doug Tutus and Dawn Edmonds with the vision of becoming the next generation software channel. “Born in the Cloud”, NewLease’s specialization in subscription licensing was underpinned by the rise of cloud computing and offered customers increased flexibility and lower initial capital outlay than traditional models of software consumption (perpetual license agreements + hardware investment). On December 3, 2013 NewLease agreed to be acquired (Doug would retain 40% ownership and Dawn 5%). Mike Hill led the transaction which involved taking the company public via a controlled shell company, FRR Corporation. Leading up to its acquisition NewLease had $51m AUD in revenue and had grown revenue at a 47% CAGR over the prior 5 years. In February of 2014, Doug Tutus tragically and unexpectedly died on a business trip to Canada. Over the next 5 months, Dawn Edmonds served as interim CEO, before Dominic O’Hanlon was appointed as the new CEO on July 30 2014. Dominic has served in prior roles as Chief Strategy Officer for MYOB (sold to Bain Capital in 2011 for $1.2B), Senior Vice President of Oracle Corporation, and President and CEO of Haley Limited (sold to Oracle in 2009). Whilst at MYOB, Dominic built an instrumental partnership with Microsoft in order to deploy MYOB AccountRight Live on Microsoft’s Azure cloud platform. In August of 2014, the company changed its name to Rhipe Limited.

BUSINESS:

Rhipe Limited partners with 2,500+ resellers to drive cloud based licensing across the Asia Pacific region. Its key vendors include Microsoft, VMWare, RedHat, Citirix, TrendMicro, Veeam, Zimbra, Datacore, and Symantec. As of June 2018, 96% of Rhipe’s revenue consisted of cloud licensing while the remaining 4% consisted of cloud solutions (support people and professional services to help service providers with technical needs). Additionally, 70% of Rhipe’s revenue came from Australia and New Zealand while 30% came from South East Asia.

It is easiest to think about Rhipe’s licensing business in 3 different segments: (1) Microsoft SPLA Licensing, (2) Microsoft CSP Licensing, and (3) Other Licensing. Microsoft currently accounts for 72% of revenue and is likely to continue to become and even bigger portion of Rhipe’s business. The Microsoft Service Provider License Agreement (SPLA) provides the license rights to host specific Microsoft Products. With SPLA, IT Service Providers can license eligible Microsoft products through Rhipe on a monthly basis to provide software services and applications to end users. The key item to not here is that SPLA licensing is for software that is NOT hosted by Microsoft.  Up until 2016 Microsoft SPLA Licensing and Licensing from other vendors accounted for all of Rhipe’s revenue.

CSP LISCENSING:

The core of my investment thesis centers on Rhipe's key position as a Microsoft Cloud Solutions Provider, or CSP. The Microsoft CSP program was launched in 2015 and is Microsoft's way to distribute Office 365, Enterprise Mobility + Security, Windows 10, Microsoft Dynamics 365 and more. Importantly, the CSP program is for licensing software that IS hosted by Microsoft. Rhipe is one of only 11 Globally Managed CSP Licensing Partners, and currently has the #1 position and 40% market share of the CSP Indirect model in the APAC ex-Japan region. There is an enormous amount of compute shifting to Public Cloud with a limited number of dominant global providers like Amazon, Microsoft, and Google. And as a CSP Distributor, Rhipe will be one of the few global partners that is acting as the enabler of this structural transition for Microsoft in the APAC ex-Japan region. There are two models within the Microsoft CSP Program, (1) The Direct Model, and (2) The Two-Tier or Indirect Model. According to Microsoft, the vast majority of its partner channel will be serviced within the two tier model, and while Rhipe has the ability to operate under the Direct Model, their DNA is “Channel First” and driving value for their reseller partners.

In 2017, Rhipe commissioned a study by Acuitas Consulting to estimate the size of the Microsoft CSP Indirect opportunity in the APAC region and needless to say, the results were very encouraging. Here are a few of the key takeaways.

While currently small compared to total revenue, Rhipe's CSP business is growing at incredible rates (O365 seat count up ~100% in the last 12 months). As of September 10th 2108 Rhipe has 300K O365 seats which generate $39m in annual recurring revenue, compared to a total revenue of $197m AUD. Currently there are 10 Microsoft CSP providers in South East Asia and 8 in Australia. One risk to this business is that IT service providers have the ability to switch Microsoft CSP Wholesalers. For instance they could switch from Rhipe to Ingram Micro, and Rhipe would then lose the recurring revenue from the end consumer that the specific service provider represents. However, it is my understanding that the customer churn is incredibly low. There are no technical barriers to exit, but Rhipe's job is to add value to their IT service provider customers by helping them grow their business and by making them look good in front of their end users. End customer lead generation, Marketing as a Service, technical enablement and training, tech nights and workshops, 24/7 customer support and service, and Rhipe's first class Platform for Recurring Subscription Management (PRISM) are a few of the key elements that drive customer loyalty and retention. Rhipe generally targets small IT service providers that don't have their own in-house software for managing and provisioning accounts, and who also get a lot of benefit from the technical training a support provided by Rhipe. In addition to this, most reseller have only hundreds or thousands of users, which makes cost only one factor when considering their CSP wholesaler. Finally, Rhipe's customer base of IT Service Providers is massively fragmented and with every passing month it continues to become more diverse (increase of signed CPS tier-2 resellers by 50% over the past 12 months).

While the CSP program will inevitably have some negative impact on the performance of Rhipe's traditional SPLA business (currently ~57% of revenue), I believe the SPLA business will continue to grow albeit at slower rates as many end users seek a hybrid cloud solution compared to a pure public cloud solution. In fact in the most recent quarterly conference call, management noted that the legacy SPLA business grew 12% in aggregate and 42% in South East Asia for the fiscal year and they see no reason for it to stop. Here are the rough numbers based on the information given in the annual report, call transcripts, and IR presentation.

CSP LISCENSING – PART 2:

I believe Rhipe would still be a compelling opportunity if software distribution through the CSP program was the only element fueling their growth. However, there’s an even larger unappreciated opportunity, distribution of Infrastructure-as-a-Service. Azure distribution through the Microsoft CSP Program began in earnest two years after the distribution of O365. As of September 2018 Rhipe had $9m AUD in annual recurring revenue from Azure, a 300% increase from June of 2107. In 2017, IaaS represented 17% of public cloud revenue but is forecasted to grow at faster rates that SaaS over the next 5 years. According to forecasts by Gartner, global IaaS spend is forecast to double over the next 3 years reaching $80+ billion.

I believe over time distribution of IaaS will become an even bigger business for Rhipe than SaaS. Cloud migration is a difficult process, and Rhipe’s technical expertise and focus on adding value to their IT Service Provider network gives them a big advantage here. In addition, Microsoft has exceled in the SaaS space with O365 but on IaaS they have a lot of work to do to catch up with AWS.  They are making a concerted effort now to drive Azure growth in the form of higher margins for their CSP partners and promotional offers to end users. They also have continued to make their traditional on premise business more expensive, further encouraging customers to move to the cloud.

Finally, Rhipe can continue to expand its business by being awarded new geographies by Microsoft. Last year they were awarded South Korea, and this Year New Zealand. The most logical next geography would be Japan, which would be an enormous market and drastically increase the potential end customer base for Rhipe.

PRISM PORTAL:

A key element to Rhipe’s intellectual property is their subscription management platform called PRISM. Through PRISM Rhipe’s 2,500+ reseller partners can, provision, bill, and manage the software consumed by their end clients all from a single platform.

In addition, while many CSP cloud distributors send their partners one bill for each customer tenant created, Rhipe offers its partners a single invoice each month regardless of the number they have. This dramatically simplifies the user experience for the IT Service Providers driving further adoption of the PRISM platform.

VALUATION:

If Rhipe’s legacy business continues to grow at even modest rates, and the CSP business continues to grow at half the present rate, there is tremendous upside potential from the operating leverage in the business. Nearly all of Rhipe’s costs ex vendor payments are personnel and investments in new teams to open up new regions (e.g. South Korea in FY 2018). Rhipe has shown that they can be diligent on cost control and expect to see operating leverage play out as the business continues to grow and investments in new geographies bear fruit.

As an example, from FY 2015 through FY 2017 total expenses increased $4.5m AUD while revenues increased $53m AUD and gross profit increased $8.1m AUD. Today Rhipe has 138m shares outstanding on a diluted basis and $23m AUD in cash and zero debt. Here is a simplified model of what the economics could conservatively look like over the next three years.

Under the assumptions above (which I believe are still on the conservative side), if Rhipe’s share price remains unchanged it will be trading at sub 10x EV to Free Cash Flow within the next 2-3 years growing underlying cash flow at 35%+ YoY with 100% recurring revenues.  It’s hard to know exactly what the business is worth, but reaching a 10% free cash flow yield in 2 years for a business growing north of 30% seems obviously mispriced to me. Depending on one’s assumptions for the runway of growth ahead for O365 and Azure, this business could be many multiples the size of today in 10 years’ time. I believe a fair price range would be $2.0 AUD to $2.6 AUD per share or a 70% to 125% premium to today’s trading range. A 125% premium would result in the business trading at 10x EV to FCF  in 6 years’ time and a 70% premium would result in the business trading at a 10x EV to FCF in 4 years’ time.

RISKS:

• Customers switch away from Rhipe in favor of another CSP 2-Tier Distributor.
  • I believe this risk is mitigated by the fact that Rhipe focuses on adding value to their reseller partners, and as they grow, their scale will allow them to do even more for their partners in a cost effective manner. Additionally, this is an enormous end market. There is plenty of room for Rhipe, Ingram Micro, and a few others to all do well together.
• Competitor poach Rhipe’s employees.
  • This is very possible. Ingram Micro is the other player with significant scale that is very active in the APAC region, but their focus is not on small IT service providers. At the end of the day, it will be very important for Rhipe to keep their employees happy and motivated.
• Microsoft controls product pricing. Therefore when they lower prices of Azure and O365, it impacts Rhipe’s top line.
  • Microsoft generates 95% of their revenue through their partner channel. It is in their best interest to act in a way that is mutually beneficial. For instance many of their current initiatives are focused on driving growth in the CSP program by offering attractive margins to distributors like Rhipe and promotions to end users.  

• Global Trend Shift back toward on premise compute.
  • It is hard to imagine this occurring, but it is a tail risk.
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Catalyst

Continued Cash Flow Growth