Today I am fulfilling your dreams and profiling a company that specializes in tax collection. Three cheers for taxes!
Seriously, nobody likes taxes. With the exception of state treasurers. Taxes are just one of those parts of life that you’d prefer to ignore. But if you’re a retailer you can’t do that. In fact, retailers across the U.S. - and the world for that matter – have to devote more and more attention to sales tax compliance.
That’s the big picture trend powering one company’s growth. All the details are inside this month’s Issue. And I promise, it’s going to be more interesting than you think!
Cabot Small Cap Confidential 237
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THE BIG IDEA
On June 21, 2018 Supreme Court Justice Anthony Kennedy issued his final decision before retiring, and reshaped the laws that will govern future taxation on interstate e-commerce sales.
For decades, states had been prohibited from collecting sales taxes on residents’ transactions when goods were purchased from out-of-state online and mail order retailers. Justice Kennedy had actually been one of the most reliable defenders of the dormant commerce clause, and repeatedly voted in favor of litigants who challenged it.
But that precedent evaporated last June when he had a change of heart. Kennedy shifted his position with respect to the online-sales-tax problem, and cast a decisive vote in favor of the states. With the Supreme Court’s 5-4 decision, e-commerce sales by firms outside of a state are no longer tax-exempt.
States can now require out-of-state retailers to collect sales tax from customers, even if they don’t have a brick-and-mortar store, or warehouse, in that state. They’re not taking long to write new laws. For example, California will tax sales by out-of-state sellers starting this April.
The Supreme Court’s decision is good for some companies, such as Home Depot, Target and Wal-Mart, since it creates a more level playing field. For others, such as Wayfair, Newegg and Overstock.com, it’s not so great. It means they have to deal with a new layer of tax complexity in their businesses.
Personally, I think it makes sense. The 1992 opinion (Quill Corporation v. North Dakota) that previously governed interstate sales tax remittance wasn’t written based on the realities of how e-commerce would evolve over the following two and a half decades. It just doesn’t make sense that all retailers aren’t treated the same today. Or that sales tax remittance sometimes falls on the shoulders of consumers.
The Wayfair decision has also helped raise awareness of just how complex sales tax compliance is today.
For instance, there are over 12,000 regulations involving tax in the U.S. alone, and they’re constantly changing.
The OECD (Organization for Economic Cooperation and Development) estimates that sales tax collections are approaching $400 billion a year in the U.S., while other transaction taxes (excise, customs and import duties, taxes on specific services, etc.) are well above that figure.
In Europe, well over $1.2 trillion of VAT is being collected each year.
With awareness of sales tax complexity growing, partly because of the Wayfair decision, and a robust compliance solution increasingly necessary, retailers are looking for software that can automate all of their sales tax processes.
One small-cap company has just the ticket. It is growing quickly in what’s estimated to be an $8.5 billion market.
THE COMPANY/PRODUCT
Avalara (AVLR) is a cloud-based provider of sales and indirect tax compliance software. Its motto is “tax compliance done right.” To achieve its vision of being part of every transaction in the world the company has developed solutions that help customers become more efficient and accurate with respect to sales tax calculations, returns filing and remittance.
The company was founded in 1999, but because of a name change the official founding date is often quoted as 2004. It was started by Scott McFarlane, Rory Rawlins and Jared Vogt; McFarlane is the current CEO. Its first cloud-based solution, AvaTax, hit the market in 2004 and has been followed by additional products (some through acquisition) over the years. Many retailers say they couldn’t do business without AvaTax.
Avalara went public in June 2018, and is now based in Seattle. It has a market cap of $2.6 billion. As of the end of September 2018, it had 8,490 core customers, up 13.4% from the same time in 2017. Core customers spend over $3,000 with the company over a 12-month period. On average, they actually spend closer to $30K, and they drive over 85% of revenue.
All in, over 20,000 customers currently use Avalara, including big names like Pinterest, Thule, Adidas, Superfeet, Smartsheet (SMAR), Marketo, Life Is Good and Crocs (CROX).
But Avalara’s core market really is the small business to mid-market segment, or companies that have 20 to 500 full-time employees. Here, management sees roughly 270,000 potential customers, and due to the law of large numbers this is its biggest growth market.
That said, there are also around 19,000 enterprise companies in the U.S., and many of them are looking to upgrade to modern cloud-based systems too. Management sees a lot of potential in this enterprise segment and if it can break into the market in a meaningful way it would do tremendous things for Avalara’s stock.
Avalara is primarily a North American business today, with around 94% of revenue coming from this continent. But management is expanding its international presence to support transaction tax compliance in Europe, South America and Asia. While this is creating a headwind for gross margins due to investing, the long-term potential to bring tax collection automation overseas appears to be significant.
The company isn’t putting up supernormal growth rates. Rather, its business model has been churning out consistent annual growth of around 27%. Analysts currently see around 20% growth in 2019 and 2020, but given the newness of the name there’s likely a little wiggle room in those estimates. Avalara isn’t yet profitable – that should be a 2021 milestone.
A Crash Course in Transaction Tax Compliance
Transaction taxes are a part of millions of sales events every day, for businesses of all sizes. Yet, surprisingly, transaction tax compliance remains a very manual process for many retailers.
How can the process NOT be automated to properly tax all the Snuggies and Super Bass-O-matic ‘76s that consumers so desperately need? It’s one of those things that just seems crazy when you think about it, especially given that we live in an increasingly digital world.
But some challenges are hard to overcome. And tax compliance is one of them. The reason is that companies have to navigate an insane maze of continually changing tax rates, rules and exemptions. Then you have things like tariffs that come and go.
There are also geographic boundaries and filing requirements across over 16,000 jurisdictions, just in the U.S. That number grows exponentially when you include Europe and other continents that process VAT taxes.
For example, in New York City a plain bagel, sliced and toasted, is taxable. A plain bagel to go is tax exempt.
Digital music downloads in New Jersey are taxable. In Iowa, they are not.
It’s a big messy patchwork of transaction tax rules that would drive Patrick Ponce insane! Ponce holds the world record for solving a Rubik’s Cube, in just 4.69 seconds. He was 15 at the time. And I don’t think even he could sort out the web of tax requirements for a mid-sized retailer, let alone a big one like Wayfair.
A big part of the challenge is that transaction taxes need to be calculated, collected and recorded in real time, 24 hours a day. That’s very different from other taxes, like payroll tax, which is done on a much more scheduled, periodic basis.
To reduce the strain of manual transaction tax compliance, retailers need to use automated solutions. It seems a foregone conclusion that automation will become the standard, just like it has for payroll tax processing.
But for retailers of any size, with any geographic reach, this isn’t a simple task. Any automated solution needs to have, at minimum, the ability to calculate, collect, record, file and remit transaction taxes. They also need to have deep tax content that covers multiple types of business, across thousands of tax jurisdictions and for a wide variety of specific products. And the solution needs to integrate with other systems that the company is using, otherwise manual processes will persist.
Avalara’s solutions check all the boxes.
THE PRODUCT
Avalara’s Compliance Cloud software offers a broad and expanding suite of solutions that help clients address the complexity of transaction tax.
The platform does all those dreadful things that accompany tax compliance. It can determine taxability, identify applicable tax rates, determine and collect taxes, prepare and file returns, remit taxes, maintain tax records, and manage compliance documents, all in real time.
Products can be purchased individually, or as a suite. Most customers start with the core product, AvaTax, and then add more as needed. Here’s a quick overview of the three Avalara products available in its tax compliance suite, in the company’s own words:
Avalara AvaTax: Delivers sales and use tax calculations to a shopping cart or invoicing system at breakneck speed, crosschecking thousands of rates, rules and jurisdictional boundaries for more accurate results.
Avalara Returns: A seamless end-to-end service that prepares and files returns and handles remittance according to a filing calendar that can easily be managed online.
Avalara CertCapture: Collect, validate and store all compliance documents (W-8, W-9, licenses, registrations, etc.) in one central, secure repository for instant access and accountability.
In addition to these core products, Avalara also offers a few Global Suites – including VAT Compliance Suite, GST Compliance Suite and Brazil Compliance Suite – that are specifically tailored to meet the needs of customers that require cross-border compliance solutions.
What’s Avalara’s Secret to Future Success?
All indications are that Avalara is well positioned to keep gaining market share in the roughly $8.5 billion tax compliance market.
Why?
For starters, Avalara is the first company of significant scale to offer a cloud-based set of solutions. This first-mover advantage is helping raise awareness of how small, mid-size and large enterprises can improve their tax compliance processes by purchasing Avalara’s software.
The enterprise-scale potential is significant since these global retailers increasingly see Avalara as a potential sales tax provider for their complicated sales tax operations. Their businesses could be run more efficiently and accurately by outsourcing tax compliance to Avalara, and the company’s scale is one of the selling points.
Second, Avalara has a powerful and deep tax content database that tracks boundaries, rates and exemptions across 12,000 jurisdictions, just in the U.S. This massive library of classified content is a competitive advantage and, as it grows, Avalara can assist more companies.
There is no central database of tax information. Avalara has to go out and collect it and keep it current. The heavy lifting is done up front, however, so after a new set of content is added it can be sold to new customers in that market for low incremental cost. A good example that management flagged on the Q3 2018 conference call is excise tax for automobiles and industrial batteries. It added that content for a new customer, and just needs to maintain it now.
Avalara can also build its content through acquisitions. A perfect example is Compli, which was just acquired on January 23.
Compli provides compliance services and software to producers, distributors and importers of alcoholic beverages in the U.S. Compli is small, but it operates in a complex environment. For instance, certain states only permit alcohol sales on certain days, and different types of alcohol are taxed differently (wine has a different tax than distilled spirits in many states, for instance). Once this content is ingested into Avalara’s system the company can offer it to other clients, while also cross-selling additional solutions to Compli’s customer base.
Finally, Avalara’s platform integrates with over 700 small business back-end applications, from enterprise resource planning (ERP), and e-commerce solutions to point-of-sale (POS) and customer relationship management (CRM) suites.
Integration partner names you’ll recognize include Microsoft, Magento, NetSuite, QuickBooks, 3dCart, Sage and Salesforce. It also has partnerships through what’s called “Avalara Included” deals, which involve the big players in Small Office Home Office (SOHO) market, including Shopify, WooCommerce, BigCommerce and Wix. This scale of integrations not only reduces the upfront pain points for customers that go with Avalara, it also increases the efficiencies after they are up and running.
The Business Model
Avalara sells cloud-based tax compliance software on a subscription basis (approximately 93% of revenue). It also generates sales from professional services (the remaining 7%). Its financial statements refer to the subscription portion as “subscription and returns” revenue, which includes calculation services (priced on blocks of transactions) and returns service (priced on returns filed). Customers select a subscription plan that includes a maximum number of transactions, while tax return services are sold as separate subscriptions (or on a per-filing basis).
Growth is driven by the number of core customers, the price plans they choose, and customer lifetime value (how long a customer remains with Avalara). A core customer is defined as one that generated over $3,000 in revenue over the most recent 12-month period. Smaller customers often move up to become core customers as their business grows.
Initial customer contracts are usually 12 to 18 months, with one-year renewals. As with most subscription business models, related costs (sales, commissions, etc.) are recognized upfront, while revenue is recognized over the contract term. This leads to front-end loaded costs, higher profit margins later in a subscription term, and highly profitable renewals. The company’s average net revenue retention rate of 107% over the last four quarters (ending 9/30/18) is very good.
The Bottom Line
In 2017, Avalara grew revenue by 27% to $213 million and improved profitability by $0.12 to deliver a loss of -$0.77. Through the first nine months of 2018 revenue was up 26% to $194.6 million. Growth comes primarily from new client adds, expanded relationships with existing customers, and consistent go-live activity.
In Q3 2018, Avalara grew revenue by 26% to $69.5 million and subscription revenue grew by 24%. Core customer count grew by 410 to 8,490. Gross profit was $50.9 million, which works out to a 73% gross margin. Gross margin declined by 3% over Q3 2017 due to hiring and investments in content. EPS loss was -$0.14, an increase from a loss of -$0.09 in Q3 2017 (when Avalara was private). Net revenue retention was 105%.
At the end of September 2018, the company had $138.1 million in cash. That’s down $35 million from the previous quarter, $30 million of which went to pay off a term loan, meaning Avalara is now debt free. Operating cash flow in Q3 was $1.2 million.
Management is guiding for Q4 2018 revenue of $71 million to $71.5 million (up around 21%) and adjusted operating loss of $13 million to $12 million. Analysts have translated that to an EPS loss of -$0.19. For the full year that guidance implies revenue of around $270 million (up 27%) and an EPS loss of -$0.70 (a 9% improvement).
Current consensus estimates are calling for 19% revenue growth in 2019, to $320 million, and a 37% improvement in EPS, to a loss of -$0.44.
RISK
Market Doesn’t Materialize: It appears tax compliance automation is a no-brainer. But that doesn’t mean companies aren’t going to stick to old methods. Should they do so, Avalara’s addressable market may not be as large as expected.
Tax Transactions Reduced If Economy Tanks: If the economy turns south then taxable transactions could be reduced and Avalara might not be able to offset the reduced traffic with new customer adds.
Margin Expansion Doesn’t Occur: Avalara’s gross profit margin will fluctuate based on a lot of factors, but spending on content development, R&D and sales people are three of the big ones. If the company isn’t able to scale the business and trend toward profitability because of these types of investments the market isn’t likely to reward the business with the valuation investors expect.
Content and Integration Issues: A huge part of the pitch for Avalara’s software is that the company has a deep content base of tax information, and the integration partnerships to reduce friction for its customers. If it has major issues in either of these dimensions, customers will likely look for other solution providers.
Litigation: In October 2018, PTP OneClick filed a lawsuit against Avalara alleging, among other things, that Avalara’s tax solutions (AvaTax, Returns and TrustFile) infringe on PTP OneClick’s sole patent (the ‘915 patent) by allowing users to accurately and comprehensively calculate multi-level local sales and use tax or prepare or file returns for the same. While PTP claims Avalara’s tax solutions perform the same function, that company’s website marketing materials claim Avalara’s products do not. Avalara has moved to dismiss the lawsuit, have the patent held invalid, and transfer the case to Seattle. It doesn’t seem there’s much here and analysts, and the market, haven’t reacted negatively to the news. That said, you never know. We’ll see where it goes.
Young Stock: Avalara just went public in June 2018. It hasn’t been public for that long, and investors aren’t all that familiar with it. That could limit the stock’s potential to go up in the short term.
Low Float: Avalara has 66.5 million shares outstanding but a public float of just 27 million shares. That means insiders and beneficial owners still control a large portion of the company.
COMPETITION
Avalara competes with larger companies, including CCH Incorporated (owned by Wolters Kluwer NV), ONESOURCE Indirect Tax (owned by Thomson Reuters), Savos and Vertex. It also competes with large accounting firms that offer state and local tax services to large enterprises. In the mid-market it competes with TPS Unlimited (TaxJar) and SalesTaxPro, among others.
THE STOCK
Trading Volume: Avalara has a market cap of $2.6 billion and trades around 335,000 shares a day. That’s equivalent to $13.4 million. Over the last three months 500,000 to 1.2 million shares have represented big volume days. Trading volume will likely pick up over time as the company’s public float increases.
Historical Price: AVLR came public last June at 24, toward the high end of its expected range. Shares initially jumped more than 80%, and even spiked up near 60 during intra-day trading within two weeks of being public. That was a wild time, and AVLR cooled off quickly. It began to trade in a choppy downtrend in July, and mostly made a series of lower highs and lower lows through late summer and into fall. It wasn’t particularly volatile when the broad market melted down in November and December. During those months, shares traded between 28 and 35, with 30 to 33 being the most occupied price range. The stock enjoyed a little lift in the last week of 2018 and walked steadily up to 42.55 by the third week of January. That’s the recent high and over the last couple of weeks AVLR hasn’t had any clear direction.
Valuation & Projected Price Target: As always, valuation is a guessing game and a moving target, not something to aim for. Same with price targets since I expect to be in a stock for years, and no analyst in their right mind puts a 5-year price target on a stock! With that in mind I think Avalara has the potential to rise by 35%, to around $54, over the next 12 months. That’s based on the stock trading up to a multiple of 9x estimated 2020 revenue of $380 million (at which point 9x will be the current-year multiple). For precedent, I’ll note that the stock traded above that price briefly in June after it came public, and that Avalara has the potential to surpass $380 million in 2020 revenue, which would likely mean more upside.
Buy Range (for the next week): I like the stock for initial purchases in the 37 to 42 range, until earnings come out next Thursday. We’ll have a better idea of the stock’s direction once that event is behind us, at which point I’ll be providing weekly guidance via updates.
The Next Event: Management will announce official Q4 2018 results and host a conference call on Thursday, February 7.
Avalara (AVLR) Financials
Avalara (AVLR) |
UPDATES ON CURRENT RECOMMENDATIONS
Due to the nature of the stocks recommended, it is to your advantage not to share these recommendations.
This month I’ve decided to include the full text of my 2019 Small Cap Outlook in lieu of stock specific updates.
I’ve done this so that you don’t miss this Special Report, and because there is a current lull in news flow related to our stocks. That will change as earnings season heats up.
As we head into earnings our portfolio is looking pretty good and riding the strength in the broad market. Over the last week all but one of our stocks went up, with Rapid7 (RPD), up 12%, Everbridge (EVBG), up 7%, and Q2 Holdings (QTWO), up 6%, pulling our portfolio up an average of roughly 4%.
Here is the table of current returns, followed by my 2019 Small Cap Outlook.
Buy means accumulate shares at or around the current price.
Hold means just that; hold what you have. Don’t buy, or sell, shares.
Sell means the original reasons for buying the stock no longer apply, and I recommend exiting the position.
Sell a Half means it’s time to take partial profits. Sell half (or whatever portion feels right to you) to lock in a gain, and hold on to the rest until another ratings change is issued.
2019 Small Cap Outlook: Equity Strategy & Opportunities
By Tyler Laundon, Chief Analyst, Cabot Small-Cap Confidential
First, a Look Back to 2018
Small-cap stocks got off to a great start in 2018, continuing the strong performance they posted in the back half of 2017. The S&P 600 Small Cap Index began 2018 at 943 and rose more than 4%, to a high of 982, by the end of January.
Volatility picked up as we moved through Q1 but the index never broke below its long-term moving average line (200-day), and as we moved into Q2 small caps began advancing steadily again. That strength lasted through the entire summer. By September 2018 the S&P 600 had kissed 1,100 for the first time in history and was enjoying a year-to-date gain of 17%.
Ironically, that 1,100 level was the high end of the range I estimated the index could trade up to when I put together my 2018 Small Cap Outlook. Talk about getting lucky.
If only we could have ended the year then! Things took a turn for the worse in October as the Fed seemed to signal it would keep raising rates into 2019, earnings results became more mixed than in prior quarters, geopolitical concerns ramped up, and trade tensions/tariffs became more prominent in daily news feeds. All these factors finally weighed on areas of the market that had been resilient for so long (FANGs, software, small caps, etc.), and they, along with the broad market, rolled over.
Unlike all the other market retreats over the past three years the one in late 2018 didn’t stop when the market reached its long-term moving average line. Small caps fell through multiple zones of support, including where they had begun the year, and where they had consolidated in the first half of 2017. Many well-respected analysts suggested that algorithmic trading was a factor in the decline.
By the time the dust cleared the S&P 600 index had finally found a bottom at 794, a level which it hadn’t traded at since just after the Presidential election in late 2016.
That low marked a retreat of 28% from the small-cap index’s 2018 high, and a 16% decline from where it began the year. Things improved a little in the last week of 2018. But small caps still finished 2018 in the red, having fallen 10%, to 845, from where they began the year.
No doubt, this correction was far deeper and far more painful than most of us expected. The complete and utter lack of any buying demand for stocks was something we hadn’t seen in over a decade. In the fourth quarter of 2018 over 90% of growth stocks in the Russell 2000 and Russell 2500 indexes posted negative declines. That’s more than in the fourth quarter of 2008!
The precipitous drop in stocks and investor sentiment elevated concerns that the market’s historic bull run was over. And it pushed many investors to believe it was time to batten down the hatches and prepare for another recession.
What to Look for in 2019
Theoretically, there should be nothing magical in terms of stock market performance when the ball drops and we enter a new year. But the beginning of 2019 sure does feel different from the end of 2018.
Stocks, including small caps, are off to a good start this year. That’s despite the fact that Washington is a mess, there appears to be a global slowdown (China in particular), Brexit is a huge question, and analysts see an earnings slowdown.
On the flip side, U.S. unemployment is below 4%, inflation is subdued, the Fed seems flexible, data from Investors Intelligence shows sentiment is bearish (which is bullish!), stocks are relatively cheap (especially if forward earnings estimates are accurate), and many good economists and analysts have stated firmly that near-term recession fears are overblown.
Depending on who you ask, 2019 GDP estimates range from around 2.5% to 3%. That relatively wide range reflects differing assumptions on major issues, including trade with China, the U.S. government shutdown and higher business uncertainty.
If actual GDP growth tracks in that range and progress can be made on the big issues, business growth could be better than expected and, importantly, the growth outlook for 2020 could be much better than the rate of close to 2% that many are penciling in now.
Given that big-picture challenges are likely to persist and that we’re in the third year of the Presidential cycle, with an unconventional President, and an upcoming and likely contentious battle for the Oval Office in 2020, it’s incredibly difficult to come to any conclusions about where we are headed.
In other words, it’s business as usual when it comes to prognosticating on future stock market performance!
On the one hand, it’s not difficult to see more than one of the aforementioned headwinds becoming a hurricane and throwing the market into turmoil.
On the other hand, it’s also possible to imagine the U.S. economy grinding through these challenges, as well as new ones (like we have for years), and winding up with a sustained (albeit more modest) pace of growth in a generally healthy business environment.
While we’ll stay flexible throughout the year and not get pigeonholed into trading based on any particular outlook (better to take what comes at us with a grain of salt and stay flexible) it’s still fun to try to pin the tail on the donkey, so to speak.
With that in mind, my best guess is that in 2019 the S&P 600 Small Cap Index will rise around 30% (roughly 21% from where it is now) to retest its 2018 high of 1,100. This implies the index can trade up to a current-year P/E of around 18.9 and a forward-year (2020) P/E of 16.4, based on estimated EPS of $58.25 in 2019 (up 13.3%) and $66.97 in 2020 (up 15%). Naturally, any major changes to estimated EPS would drive a change in this estimate.
Here are five specific reasons why I think small caps can get there in 2019.
5 Reasons to Be Bullish on Small Caps in 2019
Bullish Reason #1:
Tax Cut Will Continue to Help Small Cap Profitability
At the beginning of 2018 the Tax Cuts and Jobs Act reduced the corporate tax rate to 21% from an average rate of 32% for small caps (the previous average for large caps was 28%). While the year-over-year beneficial impact on the average small cap’s bottom line won’t be as dramatic as it was last year, the tax cut will still help profitability and should give small companies more wiggle room to invest in R&D and expansion initiatives, complete acquisitions, hire more people and, importantly, offset higher costs represented by rising wages and interest rates. Consensus estimates currently suggest the average profit margin in the S&P 600 will come in around 4.8% when 2018 results are in the books, but climb to 5.5% in 2019, and then 6.1% in 2020. By comparison, large-cap profit margins are expected to be flat, at around 12%, in 2018 and 2019, before rising modestly to 12.7% in 2020.
Bullish Reason #2:
Small Caps Outperform During Economic Expansions
This has been on my list for four years in a row and continues to be one of the big picture themes contributing to my positive small-cap outlook. While growth is expected to moderate in the U.S. (along with many other regions around the world), economists are still looking for 2019 GDP growth in the 2% to 3% range, and 2020 GDP growth north of 2%. It’s a little premature to make bold predictions regarding what will happen two years out, but at the moment there seems to be very little risk of a recession this year or next. And while we’ll always have years that are outliers (like 2018) history shows that when GDP growth is in the 2% to 3% range it pays to invest in small-cap stocks.
Bullish Reason #3:
Small Caps Should Benefit from High U.S. Exposure
This is another repeat from last year, and that’s a good thing. Long, positive trends are good for small-cap stocks! Remember that investing in small caps is like a leveraged play on the U.S. economy since roughly 80% of small-cap sales come from within the U.S. (compared to about 70% of S&P 500 revenues). Domestically-focused small caps have less exposure to foreign currency fluctuations and trade disputes.
Bullish Reason #4:
Small Caps Lagged in 2017 and 2018 – They are Overdue for a Good Year!
In 2018 small caps posted their worst annual performance since 2008, falling by 9.8%. In the fourth quarter alone the S&P 600 was down 20%! These lackluster returns mean small caps have now trailed the broad market for two consecutive years. The last time that happened, in 2014 and 2015, small caps roared back with a 25% gain in 2016. Given that the small-cap asset class tends to outperform over the long term it seems about time for a good year, especially when we consider that the late-2018 selloff was overdone.
Bullish Reason #5:
Small Caps Trading at an Attractive Valuation
The S&P 600 trades with a forward P/E of around 15.7. That’s well below the forward P/E of between 17 and 20 that persisted for most of the 2016-through-2018 period—and near the low end of the valuation range dating back to the beginning of 2013. Relative to expected EPS growth of 13.3% in 2019 and 15% in 2020 the index looks very attractively valued. In comparison, EPS growth in the S&P 500 Index is expected to be a mere 6% in 2019 and 11% in 2020.
If forward estimates prove to be accurate then the S&P 600 could advance roughly 21% from where it is now, to 1,100, by the end of 2019. At that point it would carry a forward P/E of just 16.4, which is still a very reasonable valuation. While buying stocks when they’re relatively cheap doesn’t guarantee short-term returns, over the long term it’s proven to be a successful strategy.
2 Small-Cap Sector Opportunities for 2019
In Cabot Small-Cap Confidential we’ve been riding the strength in two growth-oriented areas of the market—cloud-based software and MedTech—for years. While we’ll continue to round out our exposure with a few stocks from other sectors I expect to continue to focus on software and medical technology stocks in 2019. Here’s why.
Subscription-Based Software Stocks (i.e., Cloud Software)
Software stocks were one of the strongest performing sub-sectors through the first three quarters of 2018, largely due to underlying secular growth trends stemming from an increasingly digital global economy.
Looking forward, I expect the big picture trend for software—and especially cloud-based software—to continue since digital strategies aren’t getting crossed off the to-do list of CIOs across the world. They are just too important.
Many software sector analysts see IT spending up in the 4.5% to 4.8% range in 2019 (which would be just a hair below 4.9% growth in 2018), with software-specific spending up around 5.2% (compared to 5.3% last year). Importantly, many cloud-based software companies are maturing, have strong recurring revenue models, high renewal rates, a broader set of customers, a lower tax rate, and improving profitability (even with slowing revenue growth, margins can expand due to the subscription model).
This maturation of the group, and the SaaS-based delivery model, bodes well for the long-term financial health of companies that deliver software-based functionalities that partners and customers are increasingly dependent upon.
There is also the potential for software companies to expand in China if trade negotiations around intellectual property (IP) enforcement advance. While this is a big if – and any perceived progress won’t result in overnight success for U.S. software companies – there is a huge long-term opportunity for software companies to grow into a massive market that they’ve essentially been shut out of.
Finally, with the market pullback late last year the software group is back to trading at EV/Sales multiples that are essentially in line with their historical averages. That’s despite the data showing that the strategic value of software companies appears relatively high.
In 2018 there were just over 120 publicly announced software M&A deals, well ahead of the 84 disclosed in 2017, and 71 disclosed in 2016. The dollar value of deals was at an 18-year high as well.
The implication here is that, with many small-cap software stocks currently trading with an EV/TTM Sales multiple below the average acquisition multiple (around 8 times EV/TTM Sales) from the last six years, there is potential for deals to be done well above current market prices. That’s especially true in cases where there is strategic and/or scarcity value in the target company/technology/customer base/dataset.
That all said, with global growth slowing and corporate costs rising, it’s likely that we’ll see a narrower group of software stocks outperform in 2019. Therefore, stock selection will play a greater role in small-cap software portfolios in the year ahead.
It will be particularly important to focus on small-cap software stocks that have ultra-compelling secular growth stories, durable business models, attractive M&A potential, reasonable valuations relative to growth, and some insulation from cyclical trends, rising interest rates and trade disruption. No stock will check all of these boxes, but it’s a good idea to try and come close.
In my mind, software stocks with exposure to cloud computing, digital transformation, security and customer relationship management (CRM) are in the sweet spot.
Medical Device Stocks
Last year we saw solid performance from the MedTech sector, which outperformed the S&P 500 index by 17%. However, performance was skewed toward the larger names; small-cap MedTech underperformed large-cap Medtech by 5% (but did beat the Russell 2000 by 18%).
In 2019, small-cap MedTech stocks should benefit from many of the same big-picture trends that helped the entire group in 2018. These include good fundamentals in mature markets, opportunities in emerging markets, and growth contribution from new products/applications - factors that have been helping the sector since 2013.
Besides these trends, I like MedTech in 2019 because this group of healthcare stocks is relatively defensive, growth is relatively durable, and risks are relatively low compared to biotech stocks. That’s because innovation/product development is usually more incremental than disruptive, meaning the value of a stock isn’t likely to completely change overnight, as is often the case with a young biotech stock that has just had a treatment either approved or denied by the FDA.
The timeline to releasing products to the market is often shorter with MedTech stocks as well. The flip side is that MedTech companies tend to have slower ramping revenue growth (again, compared to biotech stocks) since the product ramp is more gradual. But that’s a decent tradeoff, in my mind.
There are also compelling secular trends within healthcare that we can play with pure-play small caps.
Consumerism is an emerging theme, as consumers like me and you become more involved in decisions related to our health and the health of our loved ones. We increasingly have control of how our families spend their healthcare dollars. That’s a good thing, since healthcare costs continue to rise as a percentage of household spending.
Companies like Teladoc (TDOC), which offers a range of telehealth services, and Biotelemetry (BEAT) and Apple (AAPL), which are running the Apple Heart Study to identify irregular heart rhythms with the help of the Apple Watch, are just two examples of consumerism in the healthcare market.
There is also a massive trend in personalized healthcare. The approach, which builds on huge advances in gene research, data analytics and customized prevention, diagnosis, treatment and drug dosing programs, specifically tailored to a person’s unique biochemical makeup, will completely change the future of healthcare.
As the industry moves away from a one-size-fits-all approach for certain diseases and conditions, in part through the efforts of small, innovative companies, investors will be presented with ample opportunities to buy shares in the small-cap “building blocks” of a better healthcare system. CareDx (CDNA), a current Cabot Small-Cap Confidential position that develops non-invasive monitoring solutions for heart and kidney transplant patients, is a perfect example.
MedTech offers investors a relative safe harbor to invest in growth stocks that should grow steadily, and have low risk of blowing up overnight. As always, there will be large performance differences in individual names. The outperformers are likely to be those with improving fundamentals and reported results that surpass analyst expectations. Strategies and/or management comments that help to mitigate concerns about trade tensions will also be important, for those companies exposed.
In Conclusion
As always, we head into a new year uncertain of what will happen in the short term, but optimistic on the long-term potential for small caps to power your portfolio higher.
If I had to summarize what attributes I’ll be looking for in small-cap stocks that we want to own in 2019, irrespective of what sandbox they play in, my short list would look like this:
1. Stocks that have exposure to compelling secular trends that you can wrap your mind around.
2. Stocks where management teams are confident, moving forward and tackling new projects, launching new products/services, completing acquisitions, expanding into new markets, and hiring more people. Steer clear of management teams that are overly defensive and running their business on their heels.
3. Look for companies where forward revenue and EPS estimates are stable, or rising.
4. Look for stocks with charts that look strong! Buying good companies on pullbacks (even big ones) is great. But don’t talk yourself into buying a stock in freefall because it’s just getting cheaper and cheaper. The risks are just too great.
5. Buy stocks where valuation is attractive relative to growth.
You’re not on your own to uncover these stocks, of course. That’s my job!
As we work through 2019, I’m excited to send you many ideas that I believe will outperform the market over the long term.
Next Cabot Small-Cap Confidential issue is scheduled for March 1, 2019
Cabot Small-Cap Confidential is published by the Cabot Wealth Network, an independent publisher of investment advice. Neither the corporation nor its employees are compensated in any way by the companies whose stocks we recommend. Sources of information are believed to be reliable, but they are in no way guaranteed to be complete or without error. Recommendations, opinions or suggestions are given with the understanding that subscribers acting on information assume all risks involved. Copyright © 2018 - COPYING AND/OR ELECTRONIC TRANSMISSION OF THIS NEWSLETTER IS A VIOLATION OF THE U.S. COPYRIGHT LAW. For the protection of our subscribers, if copyright laws are violated by any subscriber, the subscription will be terminated.
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