June 14, 2023
The Fairlight investment strategy avoids investing in early-stage technology companies given the large range of outcomes when forecasting future cash flows. This approach may appear overly rigid, especially in the current environment when almost any company that mentions artificial intelligence, or ‘AI’, on an earnings call is experiencing a sharp increase in its share price. However, it has been our experience that investors can still benefit from technological innovation while reducing risk by focussing on companies that provide the ‘picks and shovels’ (i.e. related tools and services), rather than the innovative products. Testament to this is the Fund’s 30% exposure to the Technology sector spread across IT distribution, niche services and software.
While the technology companies we invest in are less likely to become the next tech giant, they are also unlikely to face risks related to product specific obsolescence due to the advent of even newer technologies. Our technology companies are all well-established, highly profitable leaders in their respective markets. Often these companies support innovation while remaining agnostic to which type of technology will eventually prevail. Reply, an IT consultancy focused solely on ‘new generation’ technology, is a Fund holding that exemplifies this well.
Reply, a trusted IT partner
Mario Rizzante started Reply in 1996 to help large Italian corporations embrace new technologies. Since then, as technology progressed, so did Reply’s expertise. This ability to keep up with progress has earned the company the reputation of a trusted partner that clients can rely upon throughout their digitalisation journey.
While in the 1990’s Reply was focused on helping clients roll out their first websites and e-commerce strategies, today the focus is instead on cloud computing, data analytics, cybersecurity, the ‘Internet of Things’ and artificial intelligence. As technology continues to evolve, new products will be released and old products will fade into obsolescence. However, corporations will always need a trusted partner with broad, product-agnostic expertise to help them navigate the increasingly complex environment.
Reply as the leading player in Italy is well placed to benefit from this constant change, and we believe that, as the rate of technological change within businesses continues to accelerate, its growing scale and unique culture of mental flexibility and agility will be crucial in deepening its partnerships with clients.
Diversified and scaled service provider
Despite its Italian centric roots, Reply has become an increasingly international and diversified business. Italy now accounts for less than half of sales, with Germany, the UK, France and the US making up the balance. As it has grown, Reply has also diversified across customers and industries, with no client accounting for more than 10% of sales in any given year. The company is also increasingly product-agnostic with enduring relationships across all major vendors such as Microsoft, AWS, Google, Adobe and Salesforce, to mention a few.
Importantly, this process of geographic, industry, customer, and product diversification is ongoing as Reply opens new offices to better service its clients across the globe. The company also has a successful track record of acquiring smaller boutiques as a low-risk way to enter new markets or add new services to its offering. As a result, since 2005 Reply has been able to grow sales at an impressive annual rate of 16% and has maintained consistent, strong profitability with an operating margin of at least 10% (Figure 1).
Distinctive decentralised model and culture
Growing industries attract competition and the IT services one is no different, especially as there is no significant upfront investment required to start a new consultancy. However, we believe that Reply’s decentralised organisational structure, centred around more than 150 independent but collaborating boutiques, will allow it to consolidate its leadership. In fact, this atypical structure should continue to foster agility and fight the common pitfalls that labour-intensive businesses experience as their headcount grows, such as excessive bureaucracy and loss of accountability.
Conservatively managed with a long-term focus
Finally, Reply’s management take a prudent and conservative approach to growth. While the industry is booming, Reply targets a yearly organic growth rate of around 10%, much lower than what many of its peers aspire to achieve. Having experienced first-hand the 2001 tech wreck, management see over-hiring as a key risk. Focus is instead on maintaining the quality of employees and protecting its unique culture.
Management has historically run Reply with no debt, with its low-risk tuck in acquisition strategy financed with operating cash flows. These acquisitions have generated substantial value as evidenced by the stable 18% cash return on cash invested (CROCI ) over the past two decades (Figure 2). Given the founder and the broader Rizzante family still own half of the business, we would expect this conservative, long-term focussed approach to persist.
The Fairlight View
The Fairlight investment team is cognisant of the rapid pace of technological change and the impact it will have on corporations globally; however our quality hurdles and focus on capital preservation mean early-stage, unprofitable technology businesses without demonstrable track records do not meet our investment criteria. Instead, when investing in the sector we prefer to reduce risk by focussing on businesses with long track records of successfully evolving with technological change and maintaining strong profitability over several economic cycles.