3 Unstoppable Small-Cap Cloud Software Stocks

About a year ago, I wrote a report featuring 10 small-cap cloud software stocks. Since then the average gain of these stocks is 35% and several are up more than 80%. Today, I’m checking back in on three of the best performers.

Two things before I get to the stocks. First, several of them are now mid-cap stocks. I’m now referring to them as SMID-cap cloud software stocks (SMID cap is an acronym for small and mid cap).

Second, earlier this month we saw a sharp retreat in cloud software stocks. It’s too soon to tell if this is the beginning of a real correction, a modest pullback, or a shot across the bow for investors who thought they had purchased a one-way ticket when they snatched up deals in December and early January.

Big picture, the secular growth trend for cloud software is intact and I don’t see any chance of a major drop in demand – quite the opposite, in fact. But global software stocks are up around 30% in 2019 and that’s a big jump, even if it came off a depressed level in January.

Valuations are high too, in many cases at or near peaks last seen in 2014 and/or 2018 (depending on how old the company is, many SMID-caps weren’t public in 2014).

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That fact alone will give big investors pause. For smaller investors, the right strategy now is to keep purchases small, average in, and focus on the best of the best (three of which I feature today).

Save bigger purchases for after these small-cap cloud software stocks have consolidated recent gains, valuations have come in a little and/or we’ve moved a little further through the calendar year.

Three Small-Cap Cloud Software Stocks

Small-Cap Cloud Software Stock #1: Zendesk (ZEN)

Zendesk was started on a desk made from a kitchen door, by three guys in a Copenhagen loft, who wanted to design a sleek and consumer-friendly customer support software platform. They did it, and the result is Zendesk. Today, Zendesk provides cloud-based software to the massive $50 billion customer service market. The company has ballooned into a full-fledged mid-cap stock, with a market cap of $9.1 billion.

The company’s solutions span all the activities companies must invest in to capture and retain valuable clients, including technical support, chat, talk, and messaging. In 2018 Zendesk expanded to serve even more customer experiences with the launches of Zendesk Sell and Zendesk Sunshine, its open and flexible CRM platform.

Since the beginning, Zendesk has been focused on easy-to-use solutions that are convenient for clients to deploy. These differentiating factors have helped drive rapid growth in its core small business market and are helping Zendesk expand into larger enterprises.

In 2018, revenue grew by 39% to $599 million and the company delivered its first full-year profit, with adjusted EPS rising to $0.21 from -$0.05 in 2017. Revenue growth in 2019 is expected to be 34% while adjusted EPS should jump 38%, to $0.29. As you might expect from a company that was started overseas, Zendesk is more than just a U.S. growth story. In 2018 around 50% of revenue came from outside of the U.S.

It took a few years for Zendesk’s stock to get going after it went public in 2014. Looking back, the turning point came in early-November 2017, right after the company delivered a better-than-expected Q3 report. Shares consolidated in a tight range after that then roared to all-time highs above 70 last September. After a rough Q4 2018, ZEN has been on the move again in 2019 and is trading within reach of another all-time high now.

Zendesk (ZEN) is one of three small-cap cloud software stocks I recommend buying.This is a good stock to own for the long haul, but investors need to pick their spots. At current levels Zendesk can be bought in smaller quantities. Keep an eye on the more obvious technical signals, like dips to the 50- and 200-day moving average lines as opportune times to buy larger chunks, assuming there is no significantly negative stock-specific news.

Small-Cap Cloud Software Stock #2: Coupa Software (COUP)

If you’re an executive that needs help managing the millions of dollars your company spends on procurement, sourcing, expense management, inventory and other areas, you’ve probably heard of Coupa Software. The $5.8 billion market cap company is to business spend management (BSM) what Salesforce.com is to sales, and it’s expanding its solutions to address the roughly $56 billion addressable market right in front of it.

Coupa’s software is becoming a strategic extension to enterprise ERP platforms since it consolidates many back-office activities into one, unified solution. Innovative and simple-to-use applications have won Coupa the admiration of industry analysts; it is a “Leader” in its industry, according to Forrester, Gartner and IDC.

The company benefits from powerful network effects resulting from its growing base of customers, suppliers and partners, all of which are funneled into its best-of-breed Coupa Unified Spend Platform. At the end of 2018 this platform is estimated to have over $1 trillion in cumulative spend under management.

The virtuous cycle powering Coupa’s growth is best illustrated by a typical upsell example, which expands the amount of money a customer spends each year. Let’s say a customer initially purchases the company’s core spend management and procurement software. After seeing the value, it commits to the full suite of applications. In this scenario, the customer’s total annual spend increases by a factor of three.

Revenue in fiscal year 2019 (ended January 31) was up 39% to $260 million, and analysts estimate revenues will grow 26% this fiscal year. Coupa also delivered its first year of profits in fiscal 2019: adjusted EPS of $0.18, compared to a loss of -$0.21 in fiscal 2018.

The stock has enjoyed a nice run since it went public at 18 in 2016. As with many cloud software stocks Coupa’s 2018 performance was terrific, but shares topped out in September then fell sharply to end the year. But Coupa has done what the other leaders among its peer group have done year-to-date, namely rising quickly off the December 2018 lows and rallying to fresh all-time highs in February. Over the last two months COUP has been consolidating mostly between 90 and 95.

As with Zendesk, this should be an area to peck away at a few shares, but by no means is it time to go in hard and heavy. Give yourself the opportunity to participate if Coupa jumps from here, but the flexibility to build a bigger position at a lower price if the tide turns against small-cap cloud software stocks on valuation concerns.

Small-Cap Cloud Software Stock #3: Rapid7 (RPD)

The big-picture idea is that Rapid7 is a pure-play security stock growing by over 20% by helping businesses solve complex security and IT operations challenges. Customers use its cloud-based and on-premise software to better understand, prioritize and address the threats facing their physical, virtual and cloud assets, including threats that arise from the actions of people within their own walls.

By unifying operational data from across their systems and running it through Rapid7’s analytics platform, clients gain a live, holistic view of all the activity on their network. This information can help them (1) prevent attacks by shining a light on vulnerabilities, cloud service usage, risky user behavior, and misconfigured assets, (2) allow IT, security, and operations teams to quickly detect compromises and attacks, prioritize fixes, and respond to breaches when they occur, and (3) eliminate and automate repetitive busy work and data analysis.

With a growing set of solutions to sell as part of its entry into the emerging SecOps movement, which brings together security and IT operations (all hosted on the Insights Platform, which launched in 2015), and a transition to an easy-to-deploy Software-as-a-Service (SaaS) pricing model (largely behind it), Rapid7 is landing larger deals, more multi-product deals, and more customers.

In 2018 revenue was up 27% and adjusted EPS improved to -$0.42 from -$0.60 in 2017. In 2019 analysts see revenue up 26% to $308.5 million and adjusted EPS improving to $0.05.

The stock emerged from a sleepy 2017 then enjoyed a choppy uptrend through mid-2018. RPD pulled back during the worst of the November and December market retreat but jumped out early in January then broke out to a fresh all-time high in February. It’s climbed into the low 50s since.

You can pick up a few shares around the current level but save bigger purchases for when valuations have come in a little and/or we’ve moved a bit further through the calendar year and shares have had some time to digest their Q1 2019 gains.

If you’re looking for small-cap stocks (SMID-cap stocks) that I am recommending subscribers buy more aggressively right now, you’ll need to sign up for my Cabot Small-Cap Confidential advisory.

You can learn more about all the stocks I cover in the portfolio, which is up an average of 70%, by clicking here now.

Tyler Laundon

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Tyler Laundon is chief analyst of Cabot Small-Cap Confidential. The circulation of Small-Cap Confidential is strictly limited because the undiscovered stocks with sky-high-potential that Tyler recommends are often low-priced and thinly traded. Don’t share these recommendations!

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