Not a Bulletproof moat

Bulletproof (ASX: BPF) is a cloud services provider in Australia and New Zealand. It has 3 main businesses: private cloud, public cloud and professional services. In a nutshell, the company has previously been growing revenue and Earnings before Interest Taxes, Depreciation and Amortisation (EBITDA) significantly through organic and inorganic growth. However, things have taken a turn for the worse.

BPF revenue
The driver of the fast growth had been the public cloud division, where they are a managed service provider (re-seller) of Amazon Web Services (AWS). It is estimated to be ~40% of BPF’s revenue. The industry trend is attractive, with most organisations moving significant parts of their data to the cloud. Cloud migration is a real cost saver. AWS is leading the charge here, driving down cost and also increasing features to their service suite.

Unfortunately for me, it is an example of a poor business model with a small and declining moat. The revenue growth of the past years have stalled as more and more competition join the fray, reducing their margin to get business and hurting BPF twofold, in winning less work and forcing BPF to reduce their own margins. The recent FY17 report shows visible clues of the declining moat with the high churn rate of 2.5% (against an industry benchmark of around 1.5%).

BPF underlying EBITDA margin

(note: having “underlying EBITDA” as my reference point is already being very optimistic)

The main problem with being (an almost pure) re-seller of AWS and other public cloud services is the continual pressures on its margin. Customers have the option to go direct to AWS and bypass the managed service providers themselves. There are talks in the industry that AWS is indeed pursuing this route for major customers.

The way to differentiate and attract higher margin is to create bespoke and niche solutions through the professional services division. This is the route that Melbourne IT (ASX: MLB) took, and they have proven to be more than capable. Melbourne IT’s Enterprise Services (their comparable division, although it has other significant services such as data & analytics and mobile solution that they cross-sell alongside the cloud solution) has shown significant growth of 41% with higher margin than BPF, and more importantly management expecting for the EBITDA margin to improve to 20% in the next 2 years. BPF’s capabilities in this space are lacking. With a good professional services division, they have the chance to make customers stickier and at the same time increase their revenue. Unfortunately, the private cloud division, where customers migrate their data to a BPF-owned data centre, is also continually getting eroded as the economics and capabilities of public cloud become more and more logical.

The management team is generally known to be competent. This is a firsthand example of Warren Buffett’s quote, “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.” They were opportunistic in that they were at the right place at the right time of the dawn of cloud infrastructure revolution. Now the tide has turned. I did not understand the severity of the business deterioration that resulted in significant number of senior people leaving the business. This was a major red light that I ignored. The notification of legal claim that they mismanaged the Cloud House business is just another bad news. At the minimum, that claim shows how tough the industry is.

I invested in BPF and it was a mistake. I came into the situation believing that FY16’s margin compression was a temporary event due to poor operational planning by the business that can be fixed. However, this was a major oversight on my part and now I believe that the margin compression is a long term trend that can only be fixed by creating a more bespoke and sophisticated cloud solutions, which BPF has not proved to be able to do. I have since sold the majority of my BPF holdings.

Disclosure: I own shares in BPF. Nothing here is advice.

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