Q2 2024 Letter
Dear partners,
Thank you for your continued trust and support; you are the best partners I could ask for. I didn’t receive a single worried call, text, or email despite a rough 2022 so I’m happy to share that we’ve clawed our way out of the hole. We are now neck and neck with the S&P 500 since inception, despite virtually zero attribution from large cap tech. But as I don’t like to dwell on the performance when we’re in a drawdown, I won’t get too excited about things turning around. You can do the math on our year-to-date numbers at the bottom of this letter but as always, the process determines the outcome so that’s what we’ll focus on. We still have a long way to go before I’m anywhere close to satisfied.
One interesting topic I’d like to discuss before highlighting a company is the trade-off between returns on capital and cash flow generation. Customer lifetime value is a great example with software companies. If a customer is worth 10x more to you in two years, it makes great economic sense to spend everything you can on acquiring more customers. So the returns on your outgoing dollars are really good but you’ll likely burn cash in the process. Further, these sorts of calculations are constantly changing and likely can’t capture the real time forces of incoming competition and a changing macro landscape. So maybe the lifetime value of customers is actually shorter than previously calculated and now it doesn’t make sense to burn cash. The tolerance to burn cash also tells you a great deal about the risk tolerance of a management team. Maybe it tells you they are willing to take a really long-term view and forego current profits for more cash later. Or that they’re overly aggressive and don’t actually care about becoming a sustainable enterprise. So what tends to be a less risky business decision is to at least get to free cash flow breakeven and then reinvest the excess dollars that are flowing back to the business if those dollars continue to produce impressive cash returns. If you look at all of the very successful winners (100x+), nearly all of them were at least operating cash flow positive. Yes, some capital light businesses invested through the income statement so they weren’t GAAP profitable but a very high proportion were solidly GAAP profitable.
So, yes, while in theory, returns on capital and free cash flow generation are at odds, because you would surely have negative free cash flow if you owned a money printer that took in one dollar and spit out two in a year; oftentimes, the very best businesses can’t reinvest at high enough rates because they are drowning in cash. It’s typically the uber-competitive industries where companies are undercutting each other on price that you find cash burners. After all, if you could demand a higher price, you would!
I think there is an element of intentional under-maximization with the best companies. What I mean is that if the returns on capital are very high, a prudent management team realizes that things could change so it may not make sense to swing for the fences, only to realize that you have to raise money at a terrible valuation or take on debt. It can actually make more long-term economic sense to not invest absolutely every dollar but maintain a solid growth rate and let the foundation of the company and its culture grow at a more measured pace. With that said, sometimes there are very real advantages to gaining market share and creating a brand like we’ve seen with Uber. The company became such a household name that now it is firmly profitable and Lyft is struggling to compete. Now, I think every situation is unique, especially since Uber was always able to raise capital at fantastic terms so maybe it is the rational decision to burn as much cash as possible if you know that future returns on capital are quite good. That calculus should change if your cost of capital increases substantially.
I used to be far more willing to invest in a free cash flow negative company but after some lessons learned, one thing I’ve noticed is that the industries these companies are in tend to be very competitive and the management teams tend to be quite aggressive. These situations can work out, but finding companies that have firm control of their destinies decreases investment risk exponentially. And this is crucial for a concentrated portfolio.
With that as the intro, early last quarter, we bought a small position in a company called Alarum. Formerly known as Safe-T, this is an Israeli proxy network company that is inflecting on profitability after a decade of losses.
Things really started to turn around in 2019, when Alarum bought a company named NetNut for ~$10 million. At this point, NetNut was doing just over $2 million in sales and its founder, Moshe Kramer, wanted some liquidity. Over the past 4 years, revenue in that business has grown to $31 million. NetNut provides B2B proxy network software that allows customers to scrape data from websites at scale. Over the past year, there has been a tailwind from AI as LLMs need lots of structured data from across the internet. What’s interesting is that investors view proxy networks suspiciously but LLMs use them to scrape training data. It’s all about perception.
In the fall of 2021, Alarum bought Cyberkick, a consumer facing cybersecurity business but has already decided to shutter it. In Q2, the company recognized a $6 million goodwill impairment, which made the GAAP numbers screen very poorly.
NetNut provides a residential proxy network that allows businesses to scrape websites at scale. Whether it be an airline that wants to track competitor pricing or an advertiser that wants to verify email addresses, proxy networks enable this. A proxy network is essentially a software program that allows the scraper to constantly change its IP address to get around scraping protections. NetNut has more than 85 million residential IP addresses that it sources through a partner called DiviNetworks which works with 200 internet service providers. Generally, the more residential proxies a company can obtain, the better its scraping potential.
One thing that is important to note is that retention rates are fairly high in this business because customers need to constantly refresh most of the data they need scraped. The company’s net retention rate has been accelerating and reached 166% last quarter and that is before its new products have really ramped up. That means the large customers are getting an increasing amount of value from NetNut core offering.
Unsurprisingly, e-commerce sites are a large buyer of this type of product. Sophisticated e-commerce sites will scrape pricing data for competitors and change prices in real-time on thousands of different products. This requires fresh data and the ability to get around scraping limitations.
The numbers are pretty if you dig around. Q3 ‘23 was really the first GAAP profitable quarter because Q2 had the goodwill impairment. However, the company has been EBITDA breakeven since Q1 ‘23. What’s really key is that NetNut is far more profitable than the Cyberkick business, which is almost fully wound down.
In the Q1 ‘24 financials, free cash flow margins were nearly 38% and NetNut revenue grew 14% quarter-over-quarter which can be annualized to almost 70% growth. So here we have a company growing about 70% with 38% margins. You certainly don’t see that every day. The company also now has $15 million net cash and should remain profitable from here on out.
The company’s top two competitors do more than $300 million in revenue collectively so it’s safe to say there is plenty of market opportunity left. Management pegs the overall opportunity in the billions as the proxy network provides footholds for other products. For instance, the company recently launched its Search Engine Results Page API that enables better SEO and its highly anticipated AI Data Collector should be launching at the end of Q3 this year.
Most recently, there are estimates that the largest competitor, Bright Data, is doing $190 million in revenue. Further, it’s important to note that customers often use multiple proxy networks to have redundancy. Some providers get blocked from specific sites while others may have success. It all depends on the quality and density of the IP addresses of the proxy networks.
The company’s two main competitors are Bright Data and OxyLabs, both of which are private. And then there are several more including SOAX, IPRoyal, and a newcomer in the AI space called Nimbleway. Bright Data (formerly known as Luminati Networks) was purchased by private equity, EMK Capital, for $160 million in 2017 for about 6x sales. Until recently, Alarum was trading for less than that so I viewed that as a floor valuation-wise. Bright Data is the largest competitor, boasting enterprise clients like Shopee, Microsoft, and McDonalds. The company has also created turnkey datasets that customers can buy separately rather than needing to scrape the data themselves. This is a route that NetNut is trying to monetize as well.
The moat in this space is mainly a scale advantage. Bigger players tend to have access to more IP addresses which enables better scraping. A lot of smaller players will buy data center proxies because they are cheaper but they can also be blocked much more easily. The real value is in residential proxies that are either purchased from internet service providers or actually retrieved through providing a P2P VPN service. Right now, NetNut has 85 million IP addresses, Bright Data has 77 million, and OxyLabs has 102 million. NetNut was able to scale to this as its former CEO, Barak Avitbul, founded a software company that helped ISPs in 2004. His relationships in the industry helped NetNut acquire the strong proxy network to scale as they have done. Unfortunately, Avitbul is no longer with the company as he stepped away in December of 2021.
There is a slight switching cost for large projects if a customer has to set up all of the workflows again. And then brand is very important. One reason Luminati Networks changed their branding is because there have been many lawsuits against the company, both from competitors and customers. Relatedly, Bright Data won a $7.5 million judgment against OxyLabs for patent infringement and NetNut got a case dismissed in late 2021 that Bright Data brought against it. But the point stands that brand matters. OxyLabs and Bright Data are the two names that have the biggest presence but NetNut has a solid position and is viewed quite positively despite what, in my opinion, is a terrible name.
Though NetNut doesn’t necessarily have the widest moat, it has done a good job of delivering a solid product at a reasonable price and the fact that the industry has grown is lifting all boats but there are definitely risks involved with this investment.
First, the company has a long history of losses and they did a poor acquisition of Cyberkick. They bought it in July of 2021 for $12 million and started winding it down about 2 years later because they wanted to get profitable. Now that the company has profits, there are questions about capital allocation. There is clear evidence that NetNut is quite profitable as a standalone business but management may use profits to do another poor acquisition.
Second, and related, management said this in Q2 ‘23, “And this does not account for an additional $2.2 million in non-dilutive financing we have available to us. As such, we are in a great position to continue executing and see no near-term scenario requiring us to raise additional funds.” But then they proceeded to do a $4 million private placement just a couple of months later at a bad price – well, great for the Chairman, CEO and CFO that invested $1 million, collectively. If management says one thing and does another, they have to build back trust. And the fact that the CEO and founder, Shachar Daniel, has been there for 10 years means that he’s overseen everything, especially the history of losses and bad acquisitions. But now he has far more skin in the game so it’s probable that he won’t be as quick to dilute shareholders.
Third, there are potential existential risks about privacy and security. Website content delivery networks like Akamai and Cloudflare have rate limiter products that can curb scraping tools. But proxy networks constantly rotate IP addresses as a workaround. There are third-party IP address blocklists out there that can be used to fight this problem but it’s incredibly difficult to block rotating residential proxies because they are real IP addresses. Since they are real, it’s perfectly legal. But it’s something to keep in mind – it’s possible that rotating proxies can be curbed technologically in the future. Moreover, there are litigious risks concerning privacy. Meta and X recently sued Bright Data for not complying with their terms of service, accusing the company of illegally scraping data. The legality of some of this is somewhat hard to nail down but walled gardens will continue to try to make it harder for proxy companies based on stricter terms of service. However, the judgment from the Meta case was recently in favor of Bright Data, a strong precedent that alleviates much of this risk.
Fourth, since NetNut isn’t the largest company in the space, it doesn’t have the same scale advantages that Bright Data and OxyLabs have. For example, Bright Data has a 60 GB plan that costs $8/GB for residential proxies. Compare this to NetNut which has a 50 GB plan that costs a little over $10/GB. So Bright Data, being more than 5x larger, can price at ~20% less since it can spread the cost of acquiring proxies across a larger swath of customers. Even still, the market is quite large and Bright Data is still growing nicely at its size so there is plenty of room for multiple players. While the industry has seen quite a few price cuts at the lower end of the market, NetNut’s accelerating net retention rate flys in the face of competitive worries for the time being. We are keeping a close eye on these dynamics as the industry is rapidly changing. I do think there is limited pricing power in the industry but the need for data will grow much faster than pricing pressures. This is the broad thesis but it’s still important to watch how competition affects NetNut’s long-term earnings power.
The current CEO, Shachar Daniel, has been with the company since the beginning in 2013. He owns a 4% stake which would be much larger if there hadn’t been so many dilutive raises over the decade. The company has a strange history as it spent the better part of 4 years trying to beta test different cybersecurity products at the beginning. Nothing really stuck so they pivoted to buy a few companies and they struck gold with NetNut. Importantly, the founder of NetNut is still with Alarum as the VP of R&D.
Management doesn’t particularly strike me as incredible but I think the recent focus on profits and the willingness to ignore the sunk costs of Cyberkick so quickly after the acquisition are two strong pieces of evidence that things are turning around.
The share count is 7.8 million ADS’s fully diluted (the ADS ratio is 10:1). On a $41 stock price (our average cost is much lower), the market cap is $320 million. After $15 million in net cash, the enterprise value is around $305 million.
So NetNut is less than 7x forward sales. When we first purchased the stock, it was less than 4x sales so even though the multiple has not quite doubled, the stock has quadrupled since our first purchase. But where things really start to get interesting is if the Q1 ‘24 numbers can be improved upon. The company did $3.2 million in cash from operations, which is very similar to FCF since it’s such a capital light business. And since most customers pay monthly, there isn’t a ton of deferred revenue. Annualizing that, we get about 23x FCF for a SaaS company with big tailwinds and a huge combination of growth and profit potential.
The stock has had quite a run so I’m not expecting a similar trajectory but if we can get to $20 million in FCF next year, a 20x multiple still implies about 30% upside over the next 18 months. If the company can execute on its strategy of moving up the value chain into data insights and foster growth through its new products, 23x forward FCF may still look like a bargain. While there are clear risks with this name, we are holding our shares.
Closing
I’m honored to have you as a partner. Thank you for your trust and support. It enables me to think long-term and will be our own competitive advantage.
The stock market, like life, will have its ups and downs. All we can do is focus on what we can control and work hard to continually raise our standards. Our strategy is simple – hitch a ride to the world’s best entrepreneurs that are running the fastest-growing, highest-quality companies at the most attractive valuations we can find. Here’s to many more years of focusing on the inputs and letting the outputs take care of themselves.
Sincerely,
Ryan Reeves
Performance Appendix
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