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TIVP064: Kelly Partners Group: The Constellation Software of Accounting? w/ Daniel Mahncke & Shawn O’Malley
01:17:05
Daniel and Shawn take a deep dive into Kelly Partners — a fast-growing Australian chartered accounting network.
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Transcript61 lines
- [00:01]
Daniel Munka
In the last couple of weeks, I've been looking at companies that could be the next 10, 20 or even 50 beggar. Kelly Partners is a company that's early in its journey and for the first time in years, attractively valued.
- [00:12]
Sean O'Malley
It's another serial acquirer, a business model that has been highly successful in the last few decades. But many of its most prominent representatives are in huge drawdowns right now, including Kelly Partners.
- [00:24]
Daniel Munka
The good news is that it's focused on text businesses, so no software involved. The bad news is that the market doesn't care. AI can also come for tax advisors. However, I think Kelly Partners has a unique value proposition.
- [00:41]
Podcast Narrator
You're listening to the Intrinsic Value Podcast by the Investors podcast network. Since 2014, with over 180 million downloads, we've learned directly from the world's best investors. Now we're applying those lessons to analyze businesses and investment opportunities every week, helping you uncover intrinsic value. And now here are your hosts, Sean o' Malley and Daniel Munka.
- [01:13]
Sean O'Malley
By now you might say that we have a new favorite category of stock to look at. And today we'll be looking at Kelly Partners Group, another programmatic acquirer that is in the very early innings and thus promises to have a long Runway of high return compounding in front of it, hopefully. And so we have looked at programmatic acquirers in a few different sectors now we covered Transdigm in the aerospace industry and Constellation Software and Chapters Group, which are both in the vertical market software space. And so Kelly Partners does follow a similar playbook. However, it is more focused on acquiring accounting and tax businesses specifically. That's their niche. And so I think it's a name that most people are probably not familiar with. That's partly because it's an Australian company, but also I will say that people who are active in the small and mid cap space may know the name. It was really popular on Fintwit a few years ago and so the CEO is also a popular guy as well. And the business has performed very, very well in recent years. So that definitely attracts a lot of attention in investing circles.
- [02:17]
Daniel Munka
I gotta say, I still have a couple of companies with the M and A model on my list, but after we look at those, I'm finally done with it. You know, the performance of Kelly Partners has been impressive over the last five years. The stock compounded at a cake of 24% and that's after the massive 50% drop that we have seen since the highs in early 2025. And I first heard about the stock, I think about a year and a half ago. But I didn't look into it much at the time and I regretted that a little later after the stock had doubled. But Mr. Market gave me a second chance. Kelly Partners is now even cheaper than when I first heard about the company on or, well, at least the stock trades lower. And I guess we will have to figure out whether that means the stock is actually trading cheaper.
- [02:57]
Sean O'Malley
So the setup looks promising, right? I mean, the Stock has dropped 50%. Revenue has continued to compound at a CAGR of 25%. But before we do get into the weeds of the financials, I mean, how about you tell us more about the business and perhaps this founder of the company who is so noteworthy.
- [03:14]
Daniel Munka
The company was founded by Brad Kelly, who is a pretty remarkable guy. I'm quite confident, actually, that we will have him as a speaker in our intrinsic value community soon, which of course does not mean that we're biased. In today's pitch, I actually always try to reach out to people I consider experts on the companies that we cover to just get better information and somewhat of a deeper understanding of both the company and the industry. And that can include the management team of a company, as well as clients or former employees. Obviously you would like to speak with people from both sides, so that means someone who gives you a bullish perspective and someone who gives you a bearish perspective. Brett has also his own podcast, so to some extent, I would say you could say that we are peers. His podcast is called Be Better off show, and he basically interviews all kinds of highly successful people. So that could be entrepreneurs, business experts, as well as successful coaches or athletes. I mean, he had people on like Shaquille o' Neal or Wayne Gretzky, but also Jordan Peterson, William Thorndike or Lawrence Cunningham. And Lawrence Cunningham is actually the vice chairman of Constellation and, and also by now a non executive independent director of kpg, in short, for Kelly Partners Group. So the essence of the show is about succeeding a business, but it certainly includes a whole lot of general life lessons as well.
- [04:28]
Sean O'Malley
If there's one thing we've learned over time, especially since we started covering companies here on the show, it's the importance of management teams and culture. And if you don't have the right people steering the wheel, it's just very difficult to turn a company into a success. We see that over and over again. And so Brett Kelly is by far the biggest shareholder in the company, owning close to 50% of the business. And that might be maybe the largest ownership stake we've seen yet in any CEO or founder in the show. So, you know, it's in part, I think that's because you just tend to get diluted over time as a founder. And KPG really is in the early innings of its journey. So some of that dilution hasn't come, or maybe it won't come at all.
- [05:10]
Daniel Munka
Just to get some perspective on how early this company is in its life cycle, at least when we assume it keeps growing successfully. Constellation's revenue when it went public was about $200 million. Kelley Partner's revenue today is about half of that. So technically, CSU wasn't even a public company when it was the same stage that Kelly is today. And Kelly partners actually IPO'd in 2017. So Brad Kelly decided to take this company public very early on in his journey, and he's certainly highly aligned with the shareholder base, you know, as you said, almost owning 50% of the company. And I would say he basically sees himself as a partner of both the other shareholders, but also a partner to other business people that he brings in by basically acquiring businesses through M A. So again, KPG follows what Brad calls the partner owner driver model. So each of their accounting firms is owned and operated by partners who have an equity stake in that specific firm still. But perhaps I should go one step back first. So just we're all on the same page here. KPG is essentially a network of chartered accountancy firms, mainly in Australia, but also expanding into the UK and the US now. And Kelly Partners is basically the parent company behind it all. So comparisons should sometimes be treated with caution. But a quick explanation of what KPG does is to say that it is the Constellation software of the accounting world. And there are some major differences as well, and pretty sure we'll get to them. But it's kind of a helpful mental model to think about what KPG does
- [06:36]
Sean O'Malley
that might also be the reason why the stock sold off, right? I mean, while tax and accounting firms are not the same as vms, there is certainly an argument to make here that AI will be disruptive here too. And generally the entire programmatic acquirer model is just facing a ton of selling pressure in markets these past few months.
- [06:54]
Daniel Munka
It hasn't been the best time for them. That's true. There's certainly an argument to make, you know, that taxes and accounting will be tackled by AI as well. And I'm sure we'll get into the details of that. But truly understand why I still believe that Kelly Partners has at least a good shot at succeeding despite AI is for me to fully understand their business model and the approach they're following. So there are two ways that Brad Kelly implemented this partner owner driver model. The first is focused on the main market in Australia and it's basically the standard playbook that they use. So how it works is that KPG acquires a 51% controlling stake and directly in the target accounting firm, and then the existing partners retain 49% and basically continue to run the business as so called partner owner drivers. And the main purpose of this model is to ensure that the people running the firms are not just employees, but actually co owners who still have significant skin in the game and also an interest in running the operations as successfully as possible.
- [07:53]
Sean O'Malley
Incentives are everything in these acquirer businesses. You know, every time we cover an acquirer, we talk about incentives and you just have to, with the wrong incentives, you're buying a business that now is going to potentially be significantly worth less because the original owner or key employees could just step away or they're going to be less motivated to work as hard after they're getting some big payday. Right? That's the challenge of coming in as a third party and, you know, buying out a business, but also wanting to keep it running the same. And so you have to be really careful with how you structure it. And, you know, the example I might use is if you buy a local plumbing business and pay them out in cash, and then the seller will go on their way and just retire. And now you've assumed the burden of running a plumbing business without having any plumbing skills. And so clearly, if you're going to routinely make these kinds of acquisitions as part of a business model, you have to have a structure that leaves the current business intact as much as possible. And to do that, you have to properly incentivize key people to stay and work hard. And yeah, you know, we've seen lots of different variations of how to approach this, but they all involve trying to keep the people who ran the business previously in place, for the most part, with as much skin involved as possible, as much skin in the game as they can get, even if the ownership structure has changed. This is a pattern we see across most serial acquirers of keeping the same managers of the business in place with incentives in line.
- [09:16]
Daniel Munka
The other advantage of this model is that it keeps decision making local, which is something that we've seen with all the great acquirers too. So one difference though is that Brett Kelly is, I would say, still much more involved than, for example, Mark Leonard was with CSI's acquisitions. And in part that's simply due to size. But KPG has also not shown the same obsession yet with decentralizing everything to the extent Mark Leonard has done early on, at least not in terms of allocating capital apart from KPG size. It's also more difficult to decentralize as much when you have this partner culture, right? I mean, Mark Leonard likely didn't even know all the people who make capital allocation decisions down the line at csi. Brett Kelly though, has to not only choose the right business but but also the right business partners. And for that you need to be much more hands on and get a feeling for the people that you go into business with. On the other hand though, by getting the right people involved, you also have high quality people working with you who can take on these tasks themselves with full trust and confidence in the future.
- [10:16]
Sean O'Malley
Well, speaking about size, what market caps are we talking about here for Kelley Partners and what is the profile of their acquisition targets?
- [10:23]
Daniel Munka
Typically, Kelly Partners has a market cap of a little less than 300 million Australian dollars and that's about 200 million US dollars. So we are talking about a company that's just really early in their stage of expanding. And it's probably the earliest company that we talked about or covered here on the show. And basically so far it has been highly successful. The revenue CAGR has been over 30% since IPO and actually accelerated recently. And I would say the overall plan that also Brett Kelly talks about is to double the company or the business every three years. And in the last few years the company has averaged between five and six acquisitions per year. Most of them are in the ballpark of, you know, two to five million dollars. And for Kelly, you know, a large acquisition would mean going after a company with, let's say, $5 million or more in revenue. And by the way, most of the numbers in today's episode are in Australian dollars. If that's not the case, I'll let you know. Acquisitions are usually financed using cash flow and debt. So just like Constellation, KPG does not usually issue any shares to fund acquisitions. And there's been some slight share issuance over the last years, but it has really been minimal. And when you zoom out, the share count today is the same as the share count has been at the ipo. KPG also usually doesn't load the acquisition debt onto the whole group. Instead it places the debt in the operating businesses where it then gets repaid over four to five years using those businesses profits. And this only works if the firm that is bought is really bought at a cheap enough price. Which is why KPG focuses so much on the multiple that it pays for these acquisitions. So they typically aim to buy, you know, at mid single digit earnings multiples. So the cash earnings can realistically cover both the seller payment and also the debt repayment. And they also don't pay the seller everything up front. So what that means is that the payout is basically staged. So one third of that payout is paid in year one and the remaining two thirds after year two. And that way the seller has for one a reason to stay engaged. And also KPG reduces the risk of overpaying if the earnings drop after the deal. Although acquired companies usually sign long term contracts anyway. So I mean we're talking about 10 years and some of them in the range of five to eight years. So keeping them engaged, I would say is probably a secondary reason.
- [12:34]
Sean O'Malley
There's also a fee of 9% of revenues that the acquired business has to pay to KPG after being acquired. And I don't know, when I hear all of this right now, I mean, giving up half your business and maybe slightly more, actually paying a 9% fee and then also taking on debt from the acquisition, you gotta wonder why this is such an attractive opportunity for the acquired company. I mean, why would I want to sell my firm to KPG in the first place? That's like the big question ringing in my head.
- [13:03]
Daniel Munka
Well, it sounds weird, but to some extent that's kind of the point. Brett Kelly talks about having negative filters to avoid partnering with the wrong companies. And up to this point, every partnership that Kelly has entered into has worked out, at least to him. And that's also what we see with the success if you look at margins and the general top line of the company growing. So to a large extent that's because Kelly makes it deliberately difficult for companies to join the group. And part of that is paying the 9% fee that you just mentioned. And technically those are two separate fees. So there's 6.5% that you pay as somewhat of a service fee, which is paid to cover things like marketing costs, HR compliance stuff and certain back office solutions. And the remaining 2.5% are so called IP license fees. And that fee mostly covers software development costs and just the cost of building and maintaining the Kelly Partners ip. So what does that mean? It means KPG owned systems and documented processes that subsidiaries can now use and benefit from when they're part of the group. So KPG is not just taking that fee and essentially adding 100% margin income stream. In fact, when you look at their Financials, KPG tends to invest even more than the 9% fee they receive in those systems and processes to make sure that subsidiaries can get the maximum benefit from joining Kelly Partners in the first place.
- [14:23]
Sean O'Malley
I assume one of the biggest advantages for the partner firms of KPG of not having to worry about marketing, HR and all that back office stuff anymore, is the time they suddenly have to either provide more advisory services to existing clients or just to reach out to and onboard new clients. And it reminds me a lot of a company we covered way back in the day on this podcast many, many months ago. We covered comfort systems and it was the same sort of thing. You had these small H Vac businesses that didn't want to have to worry about payroll and admin and legal and all this stuff. And they just wanted to do their job, go and, you know, do mechanical and electrical work. That was really their specialty. And you know, you think about it as a business owner, you sign up thinking that you're starting a plumbing business and really you inherit all of this other, you know, tax responsibility, legal responsibility, paperwork that you have to be on top of. And so to some extent this is sort of an exit valve to say, hey, we'll take these problems off your hands and, and you can just focus on your life's work or what you love doing. And now, as you mentioned in the beginning, this is a supply constrained market. And so there's a lot of demand and too few companies to go after it. So if you have more time, you know, freed up by not having to do this admin stuff, that incremental time can immediately be used in the most effective way possible. And that's growing the business.
- [15:46]
Daniel Munka
Absolutely. I mean, that's even more important than the money you can save. According to KPG, paying this fee allows partners to spend about 40% more time with clients on the actual high margin advisory work that you mentioned, or even just onboarding new clients. And that's also sort of the dual engine of kpg, you know, pulling to increase the margins of the businesses that it acquires. And that basically happens by bringing down the costs, spending more time on high margin business segments and of course, onboarding new high value clients. And the industry's average EBITDA margin is about 18 to 19%. KPG targets an EBITDA margin of 35% for all of its subsidiaries. And as you can see on the graph that we currently have on screen, Kelly does a pretty good job of achieving that EBITDA margin. Total EBITDA margins are already at 31% on average. And that includes the group of newly onboarded businesses that obviously still improving their margins. And of course KPG's margins as a parent will also be slightly lower than those of the operating businesses because you handle all of these back office costs that are only accounted for at the parent company level. And last but not least, many companies that sell to KPG, or to be more precise, become a partner of KPG are running into succession problems. So maybe the founder wants to retire or at least reduce work time and thus enters into a partnership with kpg.
- [17:07]
Sean O'Malley
How exactly though is KPG helping with that? It's something I asked myself while looking at the partnership model here. And since the current management team of the acquired business, which I'd guess is only the founder most of the time, considering the size of the businesses, is keeping a 49% share and is supposed to stay in the business, they can't really target businesses where the founder wants to leave, right? Or does KPG have its own people who take over the company? How do they balance that?
- [17:36]
Daniel Munka
Most of the time it's actually someone from the inside of the acquired business who takes over. So let's imagine there are junior employees who know the business well and also have a trusted relationship with the clients and are also willing to take over the practice. But they lack the capital to buy out the founder or the CEO. And then KPG kind of enters the picture, buys the controlling stack of the company, solves the payout for the existing partner, and then creates a structure where the next generation can basically buy into the operating business over time and become the leader of it. And that has been the process in some of the acquisitions over the last couple of years. And you know, that's a great way to source new investment opportunities for KPG. And again, some founders or CEOs, they don't even want to leave immediately. They don't want to go into retirement as soon as they sell to Kelly Partners. Because as you just said, part of the idea is also to become a partner. And you know, if you sell into KPG with the idea of becoming a partner and you immediately retire, the that's not really what KPG is looking for. So most of them, you know, they just want to continue working. But not for 60 hours a week. Right. Which is something that KPG can help them with too.
- [18:40]
Sean O'Malley
You pointed this out before. Whenever I hear about tax or accounting firms, it just seems like they're always working at 100% capacity and maybe more so and just still cannot meet demand. And it's actually an issue I've rushed up against a few times personally trying to get tax out. But you know, that fact alone makes me Quite bullish on KPG's overall growth, growth outlook. And so my question for you is, where do you think are the biggest growth drivers going forward?
- [19:05]
Daniel Munka
Yeah, we actually talked a bit before this call about our own tax stories. So there's certainly a problem finding the right people for your taxes. And I actually spoke to one of our community members recently. His good friend works as a forensic accountant in San Francisco and he has a successful firm. He earns seven figures and as you just said, doesn't even come close to meeting demand. And he doesn't want to retire yet, but he does want to reduce his workload. And this is one of the businesses that in theory would be perfect for kpg. It's highly profitable, the founder wants to slow down a bit, and there's so much demand left that you could technically expand the business with KPG's resources and make it bigger and more profitable almost overnight after joining the structure. So this example shows I would say, two tailwinds. First, a founder who is slowly stepping down and is looking for a way out and a highly profitable business that can be expanded as soon as KPG joins as a partner. I would say it's not just, you know, cherry picking. An example here. In KPG's home market, Australia, almost 60% of accounting business owners who plan to retire are doing so in less than five years. So that's about 20,000 businesses left with a potential succession problem. And if you would add the US and the uk, the two markets that KPG is expanding into, that number actually goes up to almost 90,000 businesses. So point being, there seems to be no shortage of acquisition targets for kpg.
- [20:27]
Sean O'Malley
Well, that makes sense. How do you see the industry evolving though? I mean, we have to talk about AI in every episode, it feels like, so you won't be surprised when I bring it up here. But of course, the question for me is whether this market is generally going to be growing or declining in the future because of the impact of AI. And right now, yes, demand is so high that the practitioners can't meet it. But taxes and accounting seem to very much be areas where LLMs are already pretty good and getting better quickly. So is this something that you expect to change, I mean, will in five years time a personalized AI agent on your computer file all your taxes for you and just have all your financial information and do it automatically?
- [21:07]
Daniel Munka
Yeah, I would say. Let's first answer where the market, not accounting for the AI impact, is generally growing or declining. So where it's going, you might have heard about the recent headlines in the Netherlands where the government has now implemented a 36% tax on unrealized gains, which is a scandal if you ask me. But I wouldn't be surprised at the same time if we see more of this in other European countries. The point being, on average, I expect taxes to go up and to get more complex. And, you know, it's what we've seen over the last few decades. And I've heard few people who believe this will change. Debt for countries is going up and you will need a way to finance that. And higher taxes are one of the first that come to mind. And if you add to that that in all countries KPG operates in, there's actually a shrinking base of taxpayers simply due to demographics. That's just another reason to increase taxes over time for the people who are still working so basically for the middle class of those countries. And Brett Kelly actually mentioned something that immediately reminded me of Mark Leonard. While Brad was an expert accountant before starting KPG and worked in the field for over 10 years, he's read thousands of books and studied hundreds of businesses, but also industries. So he could have settled for all kinds of industries to establish a serial acquiring business in, but he settled for taxes. And then you ask why? Well, in his words, there are two things that are certain death and taxes. And it's kind of similar to the idea that Mark Leonard had, which is basically, and I'm convinced Mark Leonard is simply an exceptional investor, which means he would have been successful in all kinds of fields. But he chose VMS because he believes that's a highly predictable business that will exist for, quote, unquote, forever. And in many ways, taxes are similar, but even more durable. And, you know, there's just an important distinction that I have to make. I think we'll come back to that later. And I think that's probably the one thing that gets Me paused about KPG's M&A pipeline and therefore also their way to grow, but staying with taxes just for a second here, since the 1950s, the tax law volume has actually grown by 14 times. And while the UK still performs quite well in terms of how easy it is to file your taxes, which kind of came as a surprise to me after also talking to some UK members in our community who I think wouldn't agree with this statistic, Australia and the US are even further down the list. So holding the 25th and the 36th place, respectively. And by the way, I just looked it up because I was interested in it. I'm not surprised to see Germany even further down the list in place 48. And when taxes go up and become more complex, that's obviously bullish for tax advisors and accountants, and it's probably the biggest tailwind in today's story. We just got to figure out and that's kind of what you alluded to, whether firms like KPG will be the main beneficiaries of that, or whether AI will take most of the workload. And some might remember my episode on S and P Global a while ago and one of the reasons their businesses are relatively shielded from AI, at least in my perspective, besides the data mode, is the regulatory environment. In the age of AI, you want to own companies that operate in markets where regulation is complex. Personally, I ask ChatGPT or Gemini questions about my tech situation all the time, but in the end I do have a tax advisor who handles everything. And my tech situation isn't complex as we talked about before. Actually, ChatGPT could handle pretty much everything that I need. However, your tax advisor is the one actually talking to the tax authorities, and while he doesn't take on full responsibility for everything, there are still many things for which you just need an official tax advisor. And S and P Global, that's what I said in this episode, has kind of the stamp of approval on ratings, so ChatGPT just can't provide the same. And people like me have a tax advisor who more or less gives his stamp of approval for my taxes. As you know, my co host Sean and I are obsessed with analyzing companies. But you probably have noticed from personal experience that talking stocks is not everyone's favorite hobby. And I'm reminded of that every time I bring up investing at dinner or when I'm out with friends, they tolerate it for about 10 minutes. But then I get this look, the one that says we get it. You love stocks, but this is not the place. So Sean and I thought, why not build that place? And we did it. It's called the Intrinsic Value Community. Our members range from pilots and firefighters to lawyers and engineers, but also hedge fund managers, actual rocket scientists, and CEOs. And despite those different backgrounds, what connects all of us is the passion for value investing and continuous learning. And each week we host live calls covering everything from vetting the group's best stock pitches to analyzing portfolios, investing case studies, and conversations with expert guest speakers who are either prominent portfolio managers, CEOs, or authors. And the best thing is that if you ever miss a call, we have a library of recordings for watching back every single call we've ever hosted. And if you prefer reading over watching, well, then we have dedicated spaces in the community to share write ups, discuss investing ideas, or just your thoughts on the general market. 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- [26:42]
Sean O'Malley
I'm still looking at that chart, actually. It says that Japan is the hardest country to pay taxes in, so I guess we should both be fortunate that we're not there. But yeah, you know, this past year I went through the process of setting up an llc, an S corp, and those aren't like hugely complicated things to do by any means. But as I started working with ChatGPT to try and do it myself, I just realized that I'm not the type of person who wants to take on the risk and uncertainty that you might be doing things wrong or not fully optimally, because you don't know what you don't know honestly. And you're also creating a lot of extra work for yourself when there's the possibility to just pay an expert a fair price and they'll tell you, yeah, you should do this, don't do this. Pretty straightforward, I'll handle it for you. That peace of mind is still valuable in the age of AI. And I went into this year thinking that I could do it all on my own with AI. And honestly, I came out happier than ever to pay for professional help than I would have in the past. In the past, it used to kind of annoy me that I had to pay for tax prep help. And now I'm like, send me that invoice. I'm more than happy to pay, you know, as long as you have a good relationship with your accountant. And to me it seems like a pretty worthwhile expense. And I think I probably, if I really wanted to, of course, anything's possible. I'm sure I could have figured it out with AI. And I know for a fact there are people who are more resourceful than me and who are more motivated than me to try and figure it out for themselves. But still, I want to talk about these risks that AI poses and how KPG might benefit from it. Because the number of people who are able to use AI to figure out their taxes, maybe not me, is definitely growing. And you have to see that as some sort of challenge to the business.
- [28:26]
Daniel Munka
I think you point out one of the most underappreciated facts about the entire AI discussion, which is it's possible to do things with AI yourself, but most of the time it just ends up not being more efficient than just hiring an expert with enough experience and expertise to help you with that problem effectively and hopefully for the right price. And that has been true for almost all technical innovations in the last few decades. And it's why so often you say that certain industries will die, but in the end they only become even more important. And it's something that we talked about, for example, in the Constellation episode. But anyway, I mean, the two main bear cases are that clients are handling more tasks by themselves using LLMs. And you know that a good chunk of the work that accountants are doing will be commoditized. Think of stuff like simple bookkeeping, standardized reports and all such things, basically what my tax accountant would be doing for me. And that's a good chunk of billed hours by accounting firms. And if this is commoditized, prices on those billed hours would fall and margins would obviously compress. And I think that's a risk personally, you know, that Kelly Partners can shield against relatively easily. I mean, the main question is, which customer are you serving? If I'm your customer, your job is certainly in danger. Again, my taxes are so easy to file that, you know, with some more improvement on the AI side, I could fire them myself and feel comfortable doing so. Especially when you think about AI agents that are even more hands on than, you know, your usual LLMs. But if your client base consists of these small and medium sized Enterprises, so called SMEs, well then things just get much more difficult. I mean, there's a reason why 90% of SMEs use professional help. And at that point, the true value add comes from the advisory service, not just filings and reports and things like business structures, trust anti decisions. Those kind of things are where the actual value is lying. And while this can be technically done by AI too, we're now entering the territory where the stamp of approval that I talked about earlier becomes way more important. When you set up a complex corporate structure to save on taxes, then suddenly the tax office Calls to get a detailed explanation of what's going on. I know I would much rather call my tax Advisor than ask ChatGPT to explain it to me so I can go back to the tax office. And this stuff is just highly personalized and sensitive to. So that doesn't necessarily matter for you and me if we file our own taxes. But if you hire a tax office, they can't just use ChatGPT, Gemini or Claude and feed your data into those LLMs. It's kind of similar to what you talked about with Doximity and the HIPAA AI models. You know, that increases the chance for tax offices to apply their own AI tools, which gives them the option to work more efficiently and shield themselves from these horizontal AI competitors like the big techs that we always talk about. And you're technically tax advisories or accountants don't have a huge moat. But once you trust your tax accountant and you feel like you pay a good price and he's actually helping you, you tend to stay with them. And that's something that we've seen over decades now.
- [31:21]
Sean O'Malley
So it sounds like you agree with KPG's opinion that AI will mostly handle these routine compliance SaaS and calculations. Well, the advisory part of the business becomes more important and that's also where the margin is right. I mean, even if build hours from routine tasks are getting squeezed or priced lower, the strategy and advisory part of the business is where the pricing power is. And you know, we're talking a lot about how AI will take jobs and there's all these bear cases out there, but this is sort of the opposite of that. There's a really compelling argument to make that by leveraging AI, tax professionals will have significantly more time to actually advise their customers. And considering that demand does outpace supply so significantly in terms of the number of people who need help with better optimizing their taxes, this does seem like it could translate into a significant business expansion opportunity. By onboarding more clients of people who know they need tax help but never felt motivated to do it or couldn't find the right accountant. Or helping people realize that they need tax help who never understood. I mean, there's probably a lot of customer acquisition that they can do as they have more time to focus on advisory instead of the more routine stuff,
- [32:38]
Daniel Munka
I would say it definitely makes sense to me how KPG can balance, you know, some of those lost build hours with higher margin advisory services. And yes, it also makes sense to me why SMEs would not choose an AI agent over professional tax Experts, at least not public ones. However, I'm also humble enough to admit I don't know, I don't know how things will play out. I think the improvements in AI are still incredible. And just when you think it has stopped, Claude comes around the corner and just overshadows ChatGPT and Gemini completely. We just started using Claude here on tip and we just got to say, well, we were blown away by how much better these models are compared to ChatGPT or Gemini. So this is kind of making you think about how far this can still go. But there are also some potential positive impacts of AI for businesses like KPG on the acquisition engine. For example, Brad Kelly expects M and A to be possible at even lower prices right now and probably also in the next, let's say four to five years. ASP firms or private equity firms that bought many accounting and tax businesses over the last few years and are selling them amid the overall market sell off because they fear they can't hit their short term targets anymore and, and basically want to get their money out to invest it elsewhere. So for example, what we also see in public markets, taking your money out of, let's say software and putting it into, you know, semiconductors, memory chips, basically all of those sectors that benefit from the AI trade. And that offers Kelly partners an opportunity to take over some of those businesses at even better prices than they have done so in the past. And the same goes for, you know, founders of such businesses. I would say in the grand scheme of things, we often forget that all of these are little businesses run by individuals. When you're in your 50s or 60s, you might no longer be on the leading edge of tech. I mean, some of those founders might rather sell their companies since they fear they can't compete in a world of AI. I mean, you'll laugh, but my grandfather owned a plumbing business many decades ago and it was performing really well. But then computers came. Yep, that's the time we're talking about here. And he just didn't want to use them. So he ended up retiring before he would kill the business by insisting on not using computers. I tell that story just to let listeners know that these things exist. Small factors that no one talks about in finance class or in big corporations. Anyway, I think if you believe Brad Kelly, the acquisition engine will benefit a lot from the AI shift.
- [35:01]
Sean O'Malley
Somebody who lives on a computer for their work. I think he made the right decision. I get tired of staring at the screen, but yeah, no, it's funny. I mean, I think he's right. But, you know, talking about Brett Kelly, but for all the doom and gloom, I haven't really seen any CEOs who are publicly saying that they'll be negatively impacted by AI. Everybody at least has some kind of story of how they will benefit, and we'll just have to wait and see how true that ends up being. But obviously, not everybody can be a winner. But the age point that you made is also interesting to me since Brett actually makes the argument that KPG's age structure will help them adjust to new developments better. Apparently 75% of the company is in the 25 to 49 range, and more than half of the company is 34 or younger.
- [35:50]
Daniel Munka
Yeah, that will certainly help in integrating AI and adapting changes in how people work. Again, this might sound like a weak point to many, but changing how you work off the decades in the business is just not an easy thing to do. Right. And to compare KPG's average age to the industry, I mean, the average age of partnership firms in the accounting and tax industry is typically around 60. And to go full circle, since these are the companies, you know, eventually acquired by kpg, you can also imagine how the margin expansion potential and the efficiency gains from acquisitions in the next five to 10 years could be even better than in the past, considering that KPG will take advantage of all the automation and AI, and a lot of firms that it will acquire will not have done the same. But as you said, and I think that's quite a good point, I haven't yet heard of a CEO who said AI will kill them. I guess Mark Leonard was probably the only CEO who I heard publicly saying that he doesn't know whether this will be something that can actually disrupt the business. All of the CEOs are very confident in telling you that they will be the beneficiaries and that AI will increase their margins. And no business will be touched by AI.
- [36:57]
Sean O'Malley
So just talk about the companies that they like to acquire. And besides the regions that they look in and the fact that KPG often acquires companies with succession problems, what are the more detailed acquisition criteria they look for? You know, what other things do they need to check the box on to make a deal?
- [37:17]
Daniel Munka
So KPG applies five filters when assessing potential partnerships. And the first one is about the mission, the values, and the vision. And I think this always sounds a bit wonky, and it's hard to pinpoint what exactly that means. But, you know, Brad Kelly is a very smart man and highly motivated man, and I think that's also what he expects from his partner. So he wouldn't want to partner with someone who is in it only for the payout or to reduce the risk of his operation. He wants people who buy into the mission of kpg, which is basically growing accounting businesses, especially in Australia, but also just helping these small and medium companies by giving them the best service possible. And I think that also aligns with the second filter, you know, which is the acquired partners should want to be part of the KPG team.
- [38:02]
Sean O'Malley
Honestly, it reminds me a lot of tip, which is the acronym for our company that we work for, the Investors podcast. We're a small company of maybe 20 or so people, but it's a special place because I think we all take a lot of ownership and pride over our work. And as a company, we're also big fans of the author Jim Collins, who talks a lot about how the best businesses have the right people on the bus. So I know you know that, Daniel, what that means is basically it doesn't matter where the bus is going, but with the right people on the bus, things will work out. And I would probably augment that to say that you don't just need really high quality people who understand business to be on the bus, but you also need to incentivize them correctly. That's equally important if your employees KPI is to reduce R and D as a percentage of revenue. Rather than pushing them to think about how technology can be used to grow the top line of the business, you might actually just be encouraging them to slash the company's R and D budget, damaging the business over time by underinvesting in technology. And so, point being, you need great people and you need them thinking about what's best for the company long term in terms of shareholder value creation. So the CEO of our company, Sig Brodersen, he often talks about wanting to find people who are on the same journey too. And it's like, okay, what does that mean? Well, to me, that's not just about finding great talent and incentivizing them properly, but it also means getting the timing right. You know, if you had just had a baby and are starting a family, it's probably not the right time to take on a ton of financial risk and start a company. I mean, people do it, but it's, you know, for most people, it's probably not the thing they're most interested in doing at that time, with the idea being there are moments in time when the stars align and an opportunity is a win, win, win. And there are times where with the same person Maybe even going after the same opportunity, things just don't work out. And it sounds very vague, but I relate to it on a personal level. Like it makes a lot of sense to me of, you know, there's just these random moments in life where you could have gone either direction and, you know, it works out for better or worse. And so there are moments when it just makes sense for people's journeys to sync up. But most of the time the timing is probably not right. That's kind of the mindset you have to have. And at least that's the mindset we have here at TIP of we're very, very selective about bringing new people in. And then once you're in, you're really part of the family. And to some extent it's because we're looking for high quality people. And to some extent it's making, wanting to make sure we can bring them into a situation where the incentives are aligned. But also it's looking for, hey, are you the right person in the right place at the right time? Do all these things line up for this really to make sense for us to work together? And if it doesn't, we'll keep the door open to working together down the road. And that was like a super rambling way to say we do try to live by these philosophies ourselves and we are, in a sense, always hiring that. We're always looking for people who can bring that special talent and trying to assess where they are in their journey to see if it syncs up with where we're at as a company.
- [41:08]
Daniel Munka
I certainly have found a new appreciation for the right cultural fit after joining tip. Before that, I likely wouldn't have been very skeptical about culture and talking so much about the perfect fit and the right time because I felt like, you know, if there's a business that's perfectly run, you should buy that business if you're a kpg. But especially considering how close you work together with this 51%, 49% stake, you actually have to find the right people in place. And also if you think about decentralizing the business later on, you want the right people at the right spot to make decisions for getting your business ahead. And something that I can't emphasize enough is the fact that clients in the tax and accounting industry are very loyal to their personal advisor. So technically, KPG could acquire a company, then the founder leaves, opens up another shop, and then reaches out to old clients again. I'm sure there are ways to prevent this through certain contracts, but as you know, I mean, bad actors don't really care about that. And in KPG's position, you want to prevent this stuff basically from the get go. So trust is just a very important factor for the business. So they want to be a permanent home for their partners and their businesses. And that includes acquiring the companies with as little disruption as possible. So the 5149 structure is also implemented here because the client relationships matter so much in the business. For Constellation Software, I don't know, Transdigm, for example, this structure wouldn't have made as much sense as it does for Kelly Partners. And the third layer, you know, in the process is that KPG only wants to buy companies where it can own all of the offices. In accounting, there are many of these so called networks that basically look big on paper, but they are in reality just independent firms kind of sharing the same name or maybe a loose service agreement. It's sort of an affiliate model. And in that case KPG just couldn't run their usual playbook. The whole model depends on plugging firms into these centralized systems. So we're talking about the tech stack, we're talking about the reporting, the back office stuff, all the processes and the brand standards. And you know, if half of the offices are independent affiliates, you can't force them to adopt the KPG standards. And if they go out on their own but remain affiliated with KPG to some extent that also adds significant risk.
- [43:18]
Sean O'Malley
And looking at the graphics on screen, it looks like the last two filters are what we already discussed. And the core business must be accounting and tax services for small to medium enterprises. And then the acquired company should have around 2 to $10 million in revenue.
- [43:33]
Daniel Munka
Yeah, I think the only thing I would emphasize again is how important it is that these are SMEs so these small and medium sized businesses. Because again, earlier I talked about how my personal taxes are relatively easy to handle with the AI and maybe an agent. But the advisory part is really where you have, you know, customer lock in comments you play in. Obviously KPG knows that and that's why they focus so much on these small and medium enterprises. And this isn't new either. I mean there have been hundreds of software solutions for taxes and accounting in the last 20 years that have tested tax advisory modes or at least competitive advantages before. And it's kind of similar to how Constellation software was tested by the SaaS model and also didn't get disrupted. But to emphasize again, we decided against owning Constellation because we don't own underestimate the threat of AI programmatic acquirers do not have a natural moat like, I don't know, companies like Airbnb, Uber, or DoorDash. They succeed if they have the right structure, if they have the right incentive system, and if they are operationally better than the other companies trying to do the same. And AI is now testing at least this part of operational superiority. And it is incredibly difficult to figure out exactly how it will impact businesses. And the ones that survive are most likely those that are heavily regulated. You know, taxes and accounting are certainly sectors where that's the case. And I do think that gives me some peace of mind thinking about the future for the industry.
- [44:56]
Sean O'Malley
Whenever we talk about acquirers, it's not as straightforward to talk about competitors. And when we talk about Airbnb, you know, it's relatively obvious that booking.com is a direct competitor. And for Netflix, there's a bunch of companies you can mention, Disney plus, Amazon Prime. And you could also make the argument that really, any medium, any screen that attracts people away from Netflix is a competitor. Any time not spent on Netflix, in theory, is, you know, a competitive challenge to Netflix. But in this case, I guess you could imagine Maybe the big four like Deloitte, PwC, EY and KPMG, even if they don't compete in the same sense of acquiring other companies, they do compete on attracting talent and clients. But are there any companies that actually follow the same playbook as KPG that are, you know, literally a direct competitor in the purest sense on the public side?
- [45:51]
Daniel Munka
I would say the closest competitor is probably cebis. I mean, Brad also talks about CBIZ as one of the closest comparisons for KPG as a company, and it's US focused and also based on acquisitions in the financial services sector. But I don't consider them to be, you know, as much of a competitor as, for example, Booking is to Airbnb, because cbiz has so many other different units as well. So they are having, you know, this benefits and insurance business, which is a huge part of it. So it's such a large market, too, that I would say there's space for kpgs or Kelly Partners, for cbiz, and many other companies to exist and to compound. And actually, when it's the case that they would actually hunt for the same companies, I think that's a good sign because it would be showing you that both companies compounded wonderfully. And that's something that I would take as a shareholder, especially looking out at all these potential targets that are in the market, I don't see how they will hunt for the same companies and let's say the next five, 10, even 15 years, more serious competition for KPG, at least in my mind, are private equity companies or just private businesses doing M and A in the space. So in the past, PE drove up prices by entering the market and basically bidding up the price that they are willing to pay for companies. And I say in the past because the AI sell off had one positive effect on companies like Constellation or also Kelly Partners. And that's less private equity competition. Private equity, you know, they look for companies that they don't hold forever as kpg, for example, does. They buy them to sell them for more money. That's basically what they do. So when public comparables fall and strategic buyers get more cautious, the obvious exit at a higher multiple than what you paid becomes just harder to underwrite. And if the exit multiple is uncertain, you know, private equity tends to get out of the space because suddenly you just can't justify paying the old entry prices. And then the second problem for BE companies is actually the leverage that they use to achieve the return hurdles. And this is a higher risk approach. So you know, when the outcome is less certain, this approach is even more risky than usual. And most of the time they tend to get into different spaces. So for example, as I mentioned before, they might look for opportunities in the AI space rather than KPGs, accounting businesses or maybe software. If you talk about BMS, there's also
- [48:03]
Sean O'Malley
a second order effect where PE can end up creating sellers. If a PE backed accounting firm was built on the assumption of an easy exit, a valuation reset can lead to stalled sales processes, recapitalization, discussions or pressure to de risk portfolios. And that doesn't mean that private equity leaves the space, but it does mean the most aggressive bidding behavior kind of cools down in some PE owned assets, may eventually look for a more long term home. But how about we talk some more about Brett Kelly, Primarily his stake in the company and his compensation, and also the key man risk that comes with all this and his clout over the business and importance to it. We talked about key man risk for companies like Berkshire and Constellation, but in this case with a company that's only worth a couple hundred million dollars, it's even more important, right, because you don't have nearly as many second lieutenants lined up like you probably do at Berkshire. And so with the departure of Buffett or Mark Leonard at Constellation, the main question has been really whether the market is still willing to pay a Buffett or Leonard premium. When valuing Berkshire and Constellation but with kpg, it's about how the company is run and truly the operational side of the business. This business is far from having that same unshakable culture as Berkshire and it's not yet close to having constellations decentralization. So what do you think of Brett Kelly and his role in the stock success and the key man risk here?
- [49:40]
Daniel Munka
Kelly Partners is certainly highly dependent on Brad Kelly right now. And he still makes all, you know, the capital allocation decisions, although they have about 12 so called scouts who are working for them and basically figure out or looking for companies digging into the market and kind of seeing where the good opportunities are that you could go after. He also has over 25 years of experience in commercial and professional accounting. So he's not just the type of CEO who is good at storytelling and motivating people, although he certainly is great at both. He also has a ton of knowledge on this sector and on the industry. And whenever you hear him talk, it's also very clear that KPG is somewhat of his baby and that he wants to lead it to become much bigger, much more successful of a company. And he's probably said that he wants to stay for at least another 25 years. Now the future is unpredictable and we never know what will happen. But I think it certainly isn't planned for him to go anywhere again. He owns close to 50% of the shares, so he's also highly aligned with the shareholders. He did say though, and that's interesting, that he wants to bring his stake in Kelly Partners down to about 35% over time. And he also tried to take the key man risk fear by saying that they have a detailed succession plan in place if anything should happen to him at any time and that they are highly capable partners in place who could take over. And I'm sure that's true. Yet if there's a departure of Brett Kelly, that would certainly be a huge hit to the company.
- [51:09]
Sean O'Malley
And what's the explanation for why he wants to reduce his stake in the company? I mean, I don't know if it's concerning, given that he still would own more than a third of the company, but it is a sizable reduction that deserves an explanation.
- [51:21]
Daniel Munka
I think it's mostly about gaining some more liquidity. We can't forget that while he's very wealthy on paper, he never got paid any additional stock options or grants that he could sell. And he didn't earn any outsized salaries either. So up until now he basically has made most of his money from KPG's dividends in fact, I'm actually quite sure that the main reason for the dividends has been to pay him. Most likely that's also why the dividends were eventually paid out monthly instead of quarterly. And to be fair, those were not huge dividends. We are talking about reasonable dividend yields of about 3 to 4% on average, including special dividends. So it's not like the dividends have halted the businesses operations because there wasn't enough capital or money to reinvest. But besides Brad Kelly's personal finances, I think another reason for reducing his stake is a potential listing in the US because if he owns 50% of the company, that would also mean that there's limited float for the stock. And bringing his stake down means again, there's more shares that can be traded publicly. And he actually even moved from Australia to the US to personally oversee the expansion in the US Which I think means that he really wants to double down on this market.
- [52:32]
Sean O'Malley
How is the expansion going? I don't think there's a US listing yet. Is that right?
- [52:39]
Daniel Munka
By now, I mean 15% revenue comes from the US for comparison, that's five times the size of the UK business. KPG currently owns about six businesses in the US so there's plenty of room to grow. One of the latest acquisitions has been Maki, an office in California that generates about $5 million in revenue. Another company KPG partnered with is actually a big partner of McDonald's. I think they serve about 700 McDonald's franchises, which is, as far as I know, about 5% of the entire McDonald's footprint in the U.S. and while that's great, I think they do have to build a customer base that is not in connection with McDonald's and that entire bubble. I'm pretty sure they will be able to do that in terms of a US listing. There's already an OTC ticker, so the stock is also quoted in US dollars, but there's no major exchange listing yet. And I wouldn't expect that to happen anytime soon. But that's just a gut feeling. And also if you look at how much money that would cost KPG also on an ongoing basis, I think it's not the best decision for them right now. There's not much information about whether there are any concrete plans right now for listing in the future, but it's not necessarily something that I would be excited about seeing.
- [53:47]
Sean O'Malley
Well, this is the fun part, and by fun part, the not so fun part of trying to look at these acquirer businesses because they're not straightforward to Value, right? I mean, it's easy to look at one company and their financials and get an idea of what you might think a fair price is. We're talking about an acquirer. You're looking at all of these different businesses that they own, and then trying to see how that's reflected in the parent company. And it gets messy quick. But let's get into the nitty gritty a little bit. I mean, what are the metrics that play a role for this company? And I got to admit, when I just quickly glanced at their financial statements, it's confusing. It is like, it's messy.
- [54:26]
Daniel Munka
It is a bit tricky to fully understand what's going on. And unfortunately, that's often the case, as you just said, with these types of businesses. And whenever I do look at their financials, I think my main objective is to find the main metrics, you know, the most important ones that I have to monitor and kind of understand to then understand the entire company. Usually that's cash flows, but depending on the reporting, it can make sense to make certain adjustments. So for Constellation, there was this number called free cash flow to shareholders. For Kelly Partners, that number is called npata, which stands for net profit after tax before amortization. And you need to add back amortization because KPG capitalizes the client relationships. If it buys a company and those are counted as intangible assets on the balance sheet, and then they are getting amortized over time. And that amortization is a real historical cost, but it's not a recurring cash drag on the business. So adding it back kind of gives you a metric that's the closest proxy to what actually flows to shareholders. You might call it owner's earnings. If you were to use a normal PE on a serial acquirer like this, it would make it look just perpetually expensive because the amortization line only grows as you acquire more. And that basically says nothing about the quality of the underlying cash generation. On the other hand, though, you can also not just look at their income statement and know what's going on, because they have to report 100% of the revenues and the profits made because of the GAAP measures, although they own only 51% of those businesses. So that also means they own only 51% of the revenues that you see, and they own only 51% of the profits you see. So in terms of revenue, you do have a similar picture to Constellation. Again, I mean, relatively low organic growth, about 4 to 5% per year, and the inorganic growth is the main driver of the business. So that's basically purely a function of capital deployment. So how many firms KPG buys and at what size and at what multiple. And part of what you're betting on when you invest in KPG is basically that Brett Kelly can keep finding these fragmented accounting firms to buy at, you know, three, four, five times EBITDA and then fold them into a platform that trades at 20 or even 30 times earnings. And that spread between, you know, three and five times EBITDA or 20 or 30 times that spread between is what, you know, the market values those earnings at. And it's a big part of where the return is coming from. An even bigger part though, is the margin story. So again, we talked about it before buying businesses that are an 18% EBITDA margin and basically doubling that to far over 30%. That's another huge driver.
- [57:02]
Sean O'Malley
KPG margins, they look impressive overall, especially when you compare it to the competition. KPG's gross margin is consistently in the mid to high 50s, while C business gross margin is what, like 15%? So just to quote Brett Kelly, I really like this. High gross margins are the most important single factor in long run performance. The resilience of gross margins pegs companies to a level of performance. And that really resonates with me. We see this in all kinds of businesses. Gross margins kind of set the ceiling for how well a business can do. And high quality companies tend to have high gross margins. If you can't price your products or services attractively in the beginning or have to overpay on the cost of delivering them, then it's very unlikely that you can make up for that later on by reducing some of your costs. Further down on the income statement, the gross margin is the most raw form of profit. We're just literally subtracting out the cost of goods sold. So if you're a coffee shop, it's just accounting for subtracting the cost of the coffee beans and you know, maybe the water and what, whatever, but it's not like the full overhead is being accounted for. And so the only caveat I would say is I'm not sure I entirely agree with the point because the idea does seem to overlook these businesses that lean into scaled economies shared like Costco and Amazon. You know, Amazon has very low gross margins, but excluding those, I very much do see the point on how gross margins set the ceiling of profitability. And, and yeah, if you start out with a business or looking at a business that has poor gross margins, the room for error is a whole lot narrower and it's also interesting to me that C business margins though are so much lower than KPGs. I mean, is there any good explanation other than just KPG is fabulous and very well run? I mean, is there a good reason for why there's such a gap?
- [58:59]
Daniel Munka
I think the main reason is actually a structural one. So CBIZ again is a large US Professional services conglomerate. And revenue includes also advisory consulting, but also insurance and benefits administration work, all of that stuff. And many of those are services that require expensive specialist staff with high billing costs relative to the fees that they can charge. So large enterprise clients also have more negotiating power, which, you know, then compresses the fee to cost ratio. So CBIS is effectively operating like a staffing intensive business where most of the revenue that comes in is immediately flows out as compensation to the professionals delivering it. And then you have KPG on the other hand, which is basically generating 95% of its revenue from these tax and accounting services to again, small and medium sized private businesses. So KPG clients are largely price taking and relationship driven. They have been with their accountant for years, again often decades, and they're just unlikely to leave unless the relationship breaks. So they're not as price sensitive as these larger corporations are. And that's basically the dynamic that gives KPG pricing power that CBIZ simply does not have. And also this partner owner driver model kind of reinforces this dynamic further because the equity partner running each office is not just a salaried employee, which would be the case for cbis. They own a stake in the business, which means by nature they are incentivized to then manage costs and just protect margins. And as we mentioned before, KPG's partner firms, they don't simply join because of the money. So that's something that, you know, Brad Kelly talks about. KPG doesn't have to compete on offering the best salaries in the market. That's not what they do. One interesting thing that we also see in the chart is when we compare the margins, you will see a third company, and that third company is called Telenorm. And Telenorm is a Finnish accounting firm that uses software automation for bookkeeping and all these basic accounting services. And their gross margins are roughly 40%. So that's significantly above Seabis but also well below Kelly Partners. And the most likely reason that I see is that Telenorm's automation models reduce, you know, some of the direct labor costs that CBIZ has, but they also compete on price in a relatively commoditized segment and they carry more technology and infrastructure costs in the end, it's just a different band. You know, these lower cost delivery through technology rather than these higher value relationships. And the gross margin is basically reflecting that at. If you ask me, that model is most likely to be disrupted by AI, even if they have a first mover advantage in implementing it. And we only talk about these different models and kind of look at the gross margins because it gives you an idea of how important this SME part of the business is. If you tackle these large corporations, you don't really have pricing power. But if you automate these very small bookkeeping tasks, then it's very likely that AI will actually come for your business. And you can kind of see that in the gross margins that the higher quality business you have and KPG is the highest quality here, the least likely. It also is that you get disrupted by things like AI in the future.
- [62:01]
Sean O'Malley
I think we've probably used Constellation as a comparison today maybe a dozen times, but to do it once more. One thing we've seen with Constellation is a lack of share issuances to fund acquisitions. And looking at KPG share count, which is almost entirely flat, it suggests that they do the same. And given that, then how does the balance sheet look? Right, because they're not issuing equity and they probably can't entirely fund acquisitions with their own cash flow. Clearly they're taking on debt. So how much debt are we talking here?
- [62:37]
Daniel Munka
We touched on it briefly, but I think it's worth understanding exactly where the debt sits because the structure is also not trivial if you just look at the filings and the presentation. So KPG reports its debt in two buckets, and that's for one, the parent entity. So you know, the listed holding company KPG and then the operating businesses, which are the 51% owned subsidiaries running the actual accounting practices. Historically, the vast majority of debt was in the operating businesses, since again, each acquisition is funded at the subsidiary level with the acquired firm's own annuity cash flows. And those are then used to repay the term debt over 45 years. So basically, how do you fund the acquisitions? A mix of the cash flows of the company plus debt. In 2024 though, for example, the operating businesses carried about $36 million of the $45 million in net debt, while the parent company, so KPG only had $9 million. That changed though, with the US expansion. I mean, the parent's debt basically surged from 9 million in 2024 to 29 million by December 2025, as again KPG began funding the US expansion, or at least some larger acquisition activity directly at the holding company level, rather than just pushing all the debt down into the subsidiaries. And generally, KPG targets a net debt to EBITDA ratio of around one and a half. And basically two would be what they would call their ceiling. In practice, the ratio has ranged from 0.8 to 1.9 since the IPO, depending on just the number of deals completed in any given year. And right now, for example, it sits at 1.8, which is on the higher end mainly because of an increase in acquisitions and also the aforementioned US expansion. This is a lot of numbers. It seems kind of complex. Long story short, debt seems to be quite well managed. And we also shouldn't Forget that roughly 95% of KPG's revenue is annuity based. So we are talking recurring fees for, you know, tax returns, compliance and accounting services that these SME is also legally required to obtain every single year. So they don't cancel, they don't delay. They're just not sensitive to economic cycles in a way that say, you know, a construction or retail business is. So for example, during COVID KPG's revenue barely moved. I mean, the annuity character of that cash flow means that lenders and investors can really treat the debt repayment as highly predictable. Especially considering that also for the customers, the retention rate is about 93%.
- [65:05]
Sean O'Malley
All right, how about valuation time? I think KPG has been a rather expensive stock for a long time, but after coming down 50% in this broader market, sell off for all companies that might even remotely be touched by AI. I wonder if this has changed in your eyes. I mean, is this a company that is looking attractively valued or is it one that manages to still be expensively priced even after dropping 50%?
- [65:32]
Daniel Munka
I think it's fair to say that it's somewhere in the middle. We tend to think a large drawdown automatically means that the stock is cheap, but that's obviously not the case. The problem with valuing Kelly Partners in particular is that it's in such an early stage. With Constellation or with Transdigm, you just have a better idea of how many acquisitions you can actually expect from that company, or at least what their impact will be on the overall financials. And in Kelly's case, that's a lot harder to pinpoint. If you look at the latest half year report, the price to earnings is about 25. And earnings in this case again means NPATA, net profit after taxes before amortization. However, Kelly Partners gives guidance for the year. Actually, they kind of give two guidances for the year, a low case scenario and a high case scenario. And in the low case, KPG still expect almost 14 million in profits, which would translate to an earnings multiple closer to 20. In the high case, earnings would be slightly higher and the multiple would be closer to 17. And if anything, I think this shows us how much uncertainty there is in the current valuation. We're not even talking about five years out, we're just talking about six months out. Right. And in my model, I project revenue growing at about 25% annually for the next two years, so 2026 to 2028 and then moderating to about 20% for, you know, 2028 to 2030 as the base grows larger. And this is more or less in line with the historic growth rate of KPG. You know, KPG itself targets $500 million in revenue by fiscal year 31, which implies a similar trajectory if you just calculate that back. That said, I think the 25% near term growth rate does assume continued active deal flow of about six to eight acquisitions per year, broadly in line again with what we've seen in recent years. And if you combine that with, you know, 4 to 5% organic growth, that's kind of the baseline that you have for these multiple cycles. And the deceleration of 20% in the back half of the forecast simply reflects the reality that if the base is growing, it will get significantly harder to deploy capital at the same rate. And it's not enough anymore to acquire six businesses. You would need to acquire 12 businesses to get the same growth rate. And since KPG is picky in regard to who they work with, it might get more difficult to keep today's growth rates up. If that requires not only 10 companies a year, but 15, 20, 25 companies on that trajectory. With parent earnings margin recovering modestly from, you know, six and a half percent back towards the seven and a half percent range as US Overhead scales against the larger revenue base. I think the model arrives at a 2030 EPS of roughly 65 cents. And that would be a five year CAGR of approximately 25% from the base that we currently have. And that's in line with long historical averages. And then quickly to the end, if we apply a 22 times multiple discounted cash flows at this time, 10% just due to the higher uncertainty involved here. And at a margin of safety of 30%, you would get a fair intrinsic value estimate of $6.40. And mind you, all of these numbers are in Australian dollars and at the current price of $6. In my model, that would imply an 18% estimate annualized return.
- [68:39]
Sean O'Malley
The modeling looks attractive, but I think it's fair to say the range of possible outcomes is a lot wider here for a small company like this in terms of, you know, what does it mean when I say range of possible outcomes? Well, in terms of how much the intrinsic value could swing in the coming years than is the case with our other portfolio bets like Alphabet and Netflix and Amazon and so on. This is comparatively a shot in the dark. And honestly, I think there's probably very little value at all in relying on a model for a company at this stage. Modeling is helpful to the extent that it pushes your thinking further to imagine different scenarios. And it can definitely be more valuable with mature companies or you have a little bit more predictive power about the future, a little more certainty. But this at the end of the day is just about trusting management. Do you trust Brett Kelly to be the stewards of our capital? And so we know the strategy generally works and has been working for kpg. And so like I said, now it's do we trust the folks running the ship with our money?
- [69:47]
Daniel Munka
One more thing I think it's worth mentioning. It's kind of what probably stops me from investing in KPG right now is to figure out how many companies they can actually acquire. It's really one thing to say that there are, you know, tens of thousands of companies that are potential targets, but how many actually clean the five step filtering process? If there are 50,000 potential targets, but only 100 of them are actually of the quality and culture that KPG wants to onboard, you run into problems in a couple of years from now. I've talked to Ryan recently who is really one of our savviest members in the intrinsic value community, and he made the point perfectly. He said to me, you know, the reason why VMS acquirers work so well is that software is spawning. So there's more and more of it and it basically never stops. There was almost an infinite amount of potential targets. And even a company like Transarm or Haiku, you kind of see similar effects. So sure, an airplane, you know, doesn't spawn like software does, but every new plane comes with thousands of new parts. And if you combine that with the life cycle of a plane, which is 20 years or longer, and then you kind of see how long the Runway is that you can keep going. For these companies, taxes and accounting doesn't really work the same way. Yes, you will always need it, but it doesn't spawn. There's no compounding effect to the Same extent in terms of new offices opening up. And I would say you could almost compare it to lvmh. So there's an infinite number of luxury brands that Bernard Arnault could acquire. However, in that case, they can at least spawn more products. So a brand might start with handbags, then you manufacture coats, then you go to dresses, then shoes, and, you know, go from there. To me, this is my main concern with the company because you need to acquire a lot of businesses for this to become, you know, a 10, a 20 or even a hundred bagger. It might not be enough to acquire 10 businesses a year for the next three years, but then it needs to be 15, 25, 30. At some point you need 50 to 100 businesses per year. And that's a time frame that we're talking, which is like 15, 20 years.
- [71:44]
Sean O'Malley
Or you need to find bigger businesses, which is, it's hard to do as well. So yeah, I mean, KPG is really interesting, I'll tell you that much. And maybe after we speak with Brett in our intrinsic value community, which you can sign up and apply to be a member if you want to join the call with us with Brett, maybe I'll feel differently about it. And with these opportunities, I do think it makes such a big difference difference to meet the people behind the scenes. Technion is a serial acquirer in Sweden and I remember meeting the CEO and CFO at Berkshire in Omaha two years ago and really, really nice guys. And I didn't end up investing personally in Technion, but I could see how it's just a nine day difference. You're trying to read the reports and you're trying to read between the lines and get a feel for how you think these people are and then you actually meet them in person and it's a totally different impression. And with Technion it was good impression for sure. And so yeah, for me to personally get comfortable with it, I would just need to do a bit more homework on KPG and like I said, wait to connect with Brett in our community before deciding how I feel about the investment. But if you're really excited about it, I think there's enough upside that we could make it a very small position such that our risk would be hedged, but then we would capture a meaningful amount of upside still, if the thesis works out, and maybe not what you would call a tracker position, but just a small asymmetric bet.
- [73:07]
Daniel Munka
And just for the listeners, you know, of the podcast here, Sean and I spend a lot of time talking now about you know, position sizing and all of that. And also the difference between what do we consider a tracker position and what do we just consider, you know, a small asymmetric bag. So, for example, company Chapters that we own is when we bought it, we still felt like it's trading significantly above the intrinsic value of the company, which is why it was a position, you know, 1% or less of our portfolio. And technically that's also what you could do with Kelly Partners. I do think the valuation here is significantly more attractive than the Chapters. But again, it's also a different industry and business. And I do still feel that while I'm confident that Bert Kelly knows all of that, what we talked about, and has a very precise plan for how he makes that work, I still feel like I want to better understand, like, the exact amount of companies in the funnel and especially in the last type of the funnel. And maybe that's something that we can talk to him about in the community meeting. And until then, I would say it's going onto the wait list, but I would say high up in the spotting of where it stands. All right, with that, how about you give us your hints for next week's episode?
- [74:17]
Sean O'Malley
So I am guilty of just wanting to pitch the stocks of companies that I love to use personally, which are, you know, often these large to mega cap names. And Daniel, you are much better about digging into the weeds to pick out something potentially special like KPG today. But yeah, I will be doing more of that besides maybe iMessage and of course, Slack for work. The company I'm pitching is easily my most used app on my phone. I use it every day, passively in the background. I've done it for at least a decade. And no, I'm not pitching Reddit a second time. I'm also not talking about YouTube, Facebook or Instagram, since we've covered Alphabet and Meta in the past. And if I cut off any more apps in the list, you'll know exactly what I'm talking about. So I'll leave it there for now, but maybe you can figure out what I'm referring to.
- [75:05]
Daniel Munka
I actually, I don't think it's too easy. I think I have an idea in mind, but it wouldn't be completely certain it is. Although the more I think about it, I think I have a good idea for a company to come up. All right, let me close it for today with a quote by Bernardo, who we just mentioned, who basically is someone who actually inspired Brett Kelly a lot. And he said money is just a consequence. I always say to my team, don't worry too much about profitability. If you do your job well, the profitability will come. And that's something that Brad Kelly talked a lot about in all of his talks and his podcasts. I hear him talk about it quite often and with that I would say we see you next week for the mystery Pitch of Sean next Sunday and have a good day.
- [75:46]
Podcast Narrator
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