I didn’t become an accountant because I’m good with numbers.
Despite the stereotype, my mental math is terrible. I need Excel to do basic arithmetic.
I gravitated towards accounting because I love the money side of business.
I love uncovering how much profit a business makes. What the margins are. How minted the owners are. What kind of house they live in.
I’m a financial voyeurist – if there was an Onlyfans for finances, I’d be a premium subscriber.
I’ve analysed hundreds of financial statements over my career. It surprises me how profitable the most unassuming businesses are. Small, family-owned businesses that you’ve never heard of, servicing a niche, and cash flowing millions of dollars.
These businesses typically operate in what most people consider boring industries: plumbing, HVAC, manufacturing. There’s often no secret sauce or proprietary technology to their success. They simply provide a common service, uncommonly well.
Forget the blue ocean strategy and disruptive startups – boring businesses are where the riches are at.
Accounting firms are a wonderful example of a beautifully boring business model.
Here’s what I love about accounting firms:
✔️Recurring revenue
✔️Great margins (Gross margins 50%+, EBITDA 20%+)
✔️Sticky clients
✔️Large Total Addressable Market (TAM)
✔️Low working capital/CAPEX requirements
✔️Not easily disrupted (because of their trusted advisor status)
As an owner of an accounting business, I’m always seeking to benchmark my firm’s financial performance against others.
Industry publications and ‘Top 100’ lists are one way of getting this data.
The problem is these stats are often questionable . A circle-jerking amongst Tier 2 operators. The best operators don’t care to reveal their metrics to the market or participate in ‘Rich Lists’. They’re busy executing.
That leaves us with the next-best option, which is to analyse the publicly listed company version of your business.
One of the companies I obsess over is accounting firm Kelly and Partners ($KPG).
$KPG is an interesting business to me for many reasons. I have pages and pages of notes and memos on my analysis of $KPG.
In this financial teardown, I’ll share the gems with you.
About Kelly and Partners ($KPG)
$KPG is a small cap stock listed on the ASX. Led by CEO Brett Kelly, the firm is an aggregator of accounting firms. It acquires a controlling interest in cottage accounting firms and integrates them into the KPG operating business model.
M&A is the primary growth strategy, because organic growth in professional services businesses is hard.
Scaling a professional services business is hard for a few reasons:
- Key person risk: The Partners/Principals of these firms maintain the relationships with clients. If that person resigns, the clients generally follow.
- Organic growth is challenging: Due to the high trust, sticky nature of accounting clients, organic client acquisition/growth is slow. It’s typically built on relationships. Firms growing organically of > 10% p.a is considered “above benchmark”. This is why most high-growth firms pursue inorganic growth strategies.
When I say “inorganic growth”, I mean growth by acquisition.
How roll-ups work
A roll-up is an inorganic growth strategy where a head company acquires many smaller businesses within a vertical. The acquired businesses are merged into a single brand and several functions are centralised.
The end result, if successful, is a single large enterprise with professional management, a unified strategy, efficient cost structure, and better offerings for its customers.
Just about every industry you can think of has either been rolled up, or attempted to be rolled-up. From vets, pharmacies, dental practices, HVAC services and many more – you name the industry, and someone has tried to roll it up.
In theory (or in a spreadsheet), roll-ups make sense and look great . Group a bunch of smaller businesses. Streamline all costs to a centralised back office. Standardise business processes across the group to provide consistency, efficiency and best practice.
If executed well, the overall value is greater than the sum of its parts. In other words, 1+1 = 3.
Multiple arbitrage
Small, private businesses typically transact at lower profit multiples and valuations compared to their listed counterparts. This is due to 2 main factors:
- Size; and
- Illiquidity
A small business doing $2M in revenue has more risk than a comparable business doing $50M in revenue. Smaller businesses (especially service businesses) have high key person risk. Larger businesses have infrastructure which reduces this risk.
Small businesses are also illiquid. They have limited access to capital. The company’s shares are usually very difficult to buy or sell. This depresses the earnings multiple that the company can expect to receive from investors. For these reasons, small businesses typically are valued anywhere between 2x to 5x profit.
A roll-up helps to solve these issues. When a few small companies are rolled up into a bigger company, the bigger company’s shares become attractive to more investors. This expands the company’s access to capital and its liquidity. Increased liquidity translates into a higher earnings multiple and greater valuation. This is a reason why public company shares trade at higher multiples than private company ones.
The net net? The bigger company can create financial value by consolidating small companies with low earnings multiples into the larger company that has a higher earnings multiple.
This is what finance dorks term “‘multiple arbitrage’’ – where a company effectively uses its valuation to buy businesses on a lower valuation.
Let’s use $KPG as an example.
As of today, $KPG has an enterprise valuation of ~$275M. Based on the FY22 financial results, the company generated EBITDA of $23M, meaning it’s trading at ~12x earnings.
Contrast this to the typical small business accounting firm which is valued at 4x earnings.
Let’s say KPG acquires a small accounting firm with $1M of earnings for $4M (4x profit). The value of KPG, in theory, should increase by $13M to $288M (12x the now $24M of earnings).
In other words, $KPG paid $4M to “create” $13M of financial value. Pretty good, huh?
In the short-term, investors can make large financial returns.
However, the long-term financial results are mixed. This is where the failures with the model can occur. Here are some of the reasons why rollups fail.
Overestimating synergies
Integrating a pool of small businesses is hard. Employees have their own way of doing things – their own processes and systems. Then you have to deal with change management. Cultural integration is equally, if not more important, than system integration. Compound that with the bureaucracy of larger organisations, and you can have a recipe for disaster.
Overpaying for acquisitions
As the acquirer gets more and more hungry to scale the business and meet investor’s expectations, so do the sellers. Good businesses are rare to buy. Sales price expectations increase too. It’s not uncommon for companies to lose price discipline at scale.
Overleveraged
Many roll-ups use debt to finance their acquisitions. Debt is an amazing instrument to maximise return on equity, but too much of it can put stress on the business and make it fragile.
Has this been done before?
There’s a graveyard of once publicly listed professional services businesses that have torched capital in their roll-up strategy.
The most notable example is Slater and Gordon – the first law firm in the world to be listed on a stock exchange. But with a few poor acquisitions and a failed integration strategy, it’s now a shell of its former self. At its peak, Slater and Gordon was worth over $2.7Bn. Today, its market cap is $74M.
Another less publicised example is one closer to home – Crowe Horwath (formerly WHK Group). Crowe Horwath was a roll-up of accounting firms. The playbook was similar to Slater and Gordon: To acquire small-to-medium-sized accounting firms, and then streamline and standardise the brand and back-office operations. Realise “synergies”.
As a former comrade, I witnessed first-hand the challenges with the strategy.
The main challenge was solving the good old Principal-Agent problem. As the Partners of the accounting firms sold their firms to Crowe, few had the desire to grow the consolidated company. They were fat and happy. There were also integration issues between the firms – not many synergies were realised, from what I understand.
Shareholder and market pressure to grow enterprise value, paired with unmotivated operators, led to poor performance. The business was eventually taken private by a financial planning group. I left shortly after.
So how is KPG different?
KPG’s strategy is same-same but different, according to its well documented and insightful Owners Manual (a hat tip to Kelly’s idol Warren Buffet).
Skin in the game
$KPG considers itself an aggregator rather than a roll-up. The business model is based on a ‘Partner-Owner-Driver’ model, whereby the accounting firm operators retain a 49% stake in their operating business.
The masterstroke here is ensuring the operating Partners still have significant skin in the game. The Principals and Agents are aligned in their mission to grow enterprise value for investors, and more importantly, themselves. I will also note that the CEO Brett Kelly also owns a significant amount of shares in the listed vehicle himself – close to 50%, which I think is up there as the highest amount of shares owned by a public company CEO, globally.
A “superior” operating system
$KPG claims to be a better operator of accounting firms than typical owners – which translates to above-benchmark economics.
As an insider, I’m the first to admit that many accountants don’t make good business operators (they love the craft of tax/accounting, not so much the actual running of the business).
However, I would also challenge the idea that $KPG has better systems and infrastructure compared to boutique and technology first competitors. The barriers to entry are low.
Furthermore, professional services business models don’t have scale economies. Accountants are the COGS (literally and figuratively speaking) – their wages don’t go down just because you have more of them. In fact, you could argue the opposite. Being a listed company adds to bloat, rather than trimming it.
Network effects
‘Network effects’ refers to the concept that the value of a product or service increases when the number of people who use that product or service increases. The more people that use it, the more valuable the service. Facebook is the most referenced example – if you have no users , it’s pretty much worthless.
TBH, I don’t see any network effects in accounting businesses. Changing an accounting firm doesn’t become harder just because the firm is bigger. (I’m open to being challenged on this.)
Programmatic acquisition strategy
Whilst there is no shortage of accounting firms in the market, $KPG’s big bet is the demographic shift of boomers seeking to exit/retire in the next three to five years – AKA the Silver Tsunami.
Let’s take a look at some of the acquisitions $KPG made, based on the FY22 financials.
$KPG’s acquisitions are mostly sub $3M revenue accounting firms in New South Wales. The average profit multiple paid (assuming earn-outs are achieved) is 4.4x, with the median 3.6x – spot-on with what you would expect to pay for a professional services business.
The financial teardown
Okay, so let’s unpack the financials.
The table below shows $KPG’s key financial metrics since the IPO in FY17.
Revenue Growth
- Revenue has more than doubled in 5 years, representing a 16.5% CAGR.
- The table below outlines the organic vs inorganic growth – a key metric to consider in aggregator strategy.
- $KPG states the organic growth rate target is 5% per annum – a modest yet representative growth rate of an accounting business model.
- The majority of revenue growth is derived from acquisitions (inorganic).
Gross Margins and EBITDA
- Gross margins (calculated as revenue less Accountants COGS) are ~60% over the analysis period.
- EBITDA margins are ~30%, a strong operating margin for a services business.
- These are both healthy, and metrics you would expect for a high-performing professional services business, based on the “rule of thirds”.
Side note: One of the most common questions I get asked by service business owners – whether that be accounting, digital agencies or IT managed services – is ‘What profit margin should I be aiming for?’
For service-based business models, we refer to the rule of thirds, a back-of-the-envelope measure of performance. The rule goes like this: For every one unit of revenue you have, 1/3 should be your direct wages cost, 1/3 should be your overheads, and 1/3 should be your profit. You learn more about the rule of thirds here.
Free Cash flow
- A common trait with services businesses is capital efficiency and cash flow compounding power. $KPG is no different, with strong working capital management, resulting in almost 100% of profit trickling down to free cash flow.
In summary, $KPG’s fundamentals are strong. The key risks I’d be concerned about are:
- Its mid-to-long-term ability to execute on the programmatic acquisition strategy;
- Key person risk and client retention with the accounting firm partners eventually retiring; and
- Managing debt.
Debt management
$KPG buys businesses with debt, which is one of the reasons why its total Return on Equity is awesome – 40%+!! Compare this to financial returns of, say, the S&P 500 of 7% to 8%, and you can understand why buying small businesses can be an uncommon, yet lucrative, wealth strategy.
Let’s unpack how debt – AKA leverage – can be used to generate awesome financial returns.
Let’s say an accounting firm does $4M revenue and $1M EBITDA, valuing it at $4M enterprise value.
$KPG has 2 options:
- Buy the business with cash
- Buy the business with cash and debt
Banks will typically lend ~50% of the purchase price for small business acquisitions. If the bank underwrites $2M, $KPG needs to stump up $2M of cash equity.
Assuming a bank loan is 10 years at a 5% interest rate, that equates to an annual interest and principal repayment of $253k per annum. Because the business is already cash flowing $1M of profit every year, the net cash flow after debt repayments is $747k.
Divide that $747k by the $2M of cash equity that was paid, and that’s 37% of Return on Invested Capital (ROIC).
Pretty awesome, hey? And this is assuming earnings don’t grow. If you can grow profit through sales and marketing/cost efficiency programs – like $KPG is doing – then you can further grow that ROIC.
Debt is a tool commonly used by private equity investors to maximise return on equity.
But beware – leverage can amplify returns, and losses. Too much debt can make a company fragile, especially in a recessionary environment where profit may shrink and interest rates increase. The worst case is in default/bankruptcy. This is why it’s prudent to manage debt wisely.
In FY22, $KPG had $31.4M of Net Debt and had a Net Debt to EBITDA gearing ratio of 1.36x – essentially meaning it can pay off all debt with 1.36 years of cash flow. Their internal target is less than 2x.
Whilst it’s not uncommon for businesses to use debt, it does pose a risk factor in an environment of a potential recession and rising interest rates.
In summary
Overall, I have enormous respect for what Brett Kelly is building. The annual reports and shareholder letters are insightful and interesting reads for Warren Buffet and Mark Leonard-worshipping, capital compounding dorks such as myself.
I would probably break my “index fund investing strategy” and buy shares in $KPG if I wasn’t already an owner of an accounting business.
They make boring businesses – and that’s what’s wonderful about them.
