Two microcaps that could double (at least) from here

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Making profits is better than bleeding cash, obviously. But as a microcap investor, Merewether Capital founder Luke Winchester takes a more nuanced view.

For young businesses, profitability doesn't arrive overnight, and astute capital raisings can make them thrive. Investors in the microcap sector need to be able to read through the numbers to understand the fundamentals of a business.

In this video, Winchester relates what moving into profitability can tell you about the state of an enterprise and how to see if capital is being raised for the right reasons.

"Profitability marks a very important inflexion point for a business," he says. "It marks a company moving from being reliant on capital markets to being a self-sustaining business."

Winchester discusses two software microcaps he thinks have what it takes to become multi-baggers.

Edited transcript

Which two microcaps do you think could become multi-baggers? Why?

The first one I'll talk about is a company called 8common (ASX: 8CO). It's a software business servicing the travel and expense management sectors.

A few years ago, management pivoted to focus on government in Australia as a key client and has been quite successful in that pivot.

That culminated back in July when 8CO won a contract for the whole of the Federal Government. And this was a very big contract; a company-making announcement that will progressively roll out over the next two or three years.

 If your model takes into account the Federal Government employees who will come onto that platform as users - and the average revenue those users bring on - the business will go from doing about $3 million annualised recurring revenue today to maybe around $9 to $10 million in that two or three year timeframe.

That's exactly what I'm looking for as an investor. I can, with a pretty good degree of certainty, model the next two or three years.

I can see that growth coming through. Then it's just a matter of the business executing, which I'm comfortable it can.

I've been familiar with the business and the management for a few years now and I think they've executed very well so far. I back them to continue to do that.

It trades at about 10 times annualised recurring revenue today, which is probably not cheap, but a fair price. But it's that underlying growth that can come through.

If I think the business can double or triple its ARR (annual rate of return) over the next couple of years, I think that's where the multi-bagger effect can come from.

The business will most likely swing into profitability in that time as well. It's only slightly loss-making at the minute.

With that additional leverage, you'll see that come from the profits and you'll get that leverage effect. 
If the management team can execute on that opportunity, it could easily be a multibagger over that two or three-year timeframe.

The second company is Xref (ASX: XF1). XF1 is the ticker for that one. It's another software business. These guys do reference-checking software. It's a very simple platform in a sense.

If an Xref subscriber has a new job opening with an applicant, they enable that applicant to log onto the Xref platform, upload their details and upload the details of some referees.

Details get sent to those referees. They're able to log on at their leisure and provide their references.

It's all amalgamated in the one piece of cloud software and is very streamlined and organised. Like a lot of software, it removes the admin burden of phone calls and trying to get people at the right time.

Everyone's able to do it in their own time and at their own pace. Simple software, but it solves a real problem for HR people who don't want to waste their time making unnecessary phone calls.

The business has done really well over the last few years and won some really big blue-chip clients. It has a very good land-and-expand strategy.

But what really excites me about the business is that pre-COVID, like a lot of tech companies, they were spending quite heavily for that growth and burning maybe $4 or $5 million cash a year.

And I think COVID was a bit of a wake-up call to the management team that if you're going to run those cash losses, the market may not always be there as a provider of capital when you need it most. So they swung the business into a sustainable, cash-flow-positive business.

You're really seeing the leverage you would expect to see in a software business come through. They've kept their cost base relatively stable.

I think from here, you'll see some modest cost inflation. But that revenue growth doing triple digits — admittedly coming off some COVID lows — but triple-digit revenue growth is really providing that margin expansion I was referring to before that I always love to see.

Top-Line growth is growing very strongly, but it's coming through in the margins as that leverages over the cost base.

The business is well and truly spitting out cash because their business model means they have a very good working capital cycle where they're getting cash in the door before they even recognise revenue.

So that's one where the multiple you're paying isn't cheap. It's probably around that 10 times recurring revenue. So it's not a cheap multiple.

But again, over the next two or three years, I think the underlying growth of that business will be explosive. And even if it maintains that multiple or potential, it can expand it. You could see a real multi-bagger in that stock as well.

How do companies usually perform after moving into profitability?

I haven't done any research or statistics around it, but it is something I'm looking for as an investor because it marks a very important inflexion point for a business. It marks a company moving from being reliant on capital markets to being a self-sustaining business.

You'll often see businesses where if the market is anticipating a capital raise, the share price becomes quite depressed because the market knows that they're about to be tapped on the shoulder for capital and they want to get as low a price as possible.

So, when the business does make that pivot into profitability, into sustainable cash flows, that weight gets lifted off the business and they're able to grow.

And if they do tap the market for capital or even debt as they grow a bit larger, it means they're doing it for the right reasons. It's not for the survival of the business, it's to chase growth, expand into a new geography, or look to develop a new product.

They are what I would call good reasons, rather than just needing cash in the door to keep the lights on. They're the businesses you really want to avoid.

Looking to invest in microcaps?

The Merewether Capital Inception Fund invests in small and microcap companies listed on the ASX, with the ability to invest in pre-IPO opportunities. It employs a long-only, high conviction strategy (10-25 positions) with a focus on profitable growing companies with skilled and aligned management teams. The Merewether Capital Inception Fund is open to wholesale investors only. Contact Merewether Capital here.

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