Seeking Alpha

3 Small Under-Followed SaaS Companies That Peter Lynch Would Probably Love

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Includes: APPF, FIVN, PCTY
by: App Economy Insights
Summary

For all investors trying to beat the market with a selection of individual stocks, Peter Lynch is an outstanding source of inspiration.

I came across three small cloud-based services that offer several of the attributes that the former manager of the Magellan fund would find favorable.

Boring, niche, fast-growing in slow industries, owned by insiders and undiscovered by most Wall Street standards are among these attributes.

Chances are, you have never heard of them and won't find them particularly interesting - that's exactly why they are good investments.

In his book One Up on Wall Street, Peter Lynch tells us the particularly favorable attributes that he believes make for a compelling investment that is likely to beat the market over the years. These include:

  • The company has a boring name, the product or service is in a boring field, the company does something disagreeable or depressing, or there are negative rumors about the company. Lynch likes firms with an unattractive business profile because it tends to keep the valuation low, creating bargains. He mentions examples from his portfolio in the 1980s: Service Corporation International (SCI), a funeral home operator; and Waste Management (WM), a toxic waste clean-up firm.
  • The company is a spin-off. Lynch says these often receive little attention from Wall Street.
  • The company is growing fast in a no-growth industry. Growth industries attract too much interest from investors (leading to overvaluation) and competitors.
  • The company is a niche firm controlling a market segment that would be challenging or too specific for a competitor to enter.
  • The company has a product or service that consumers need rather than want. This type of business is more predictable and recession-proof.
  • The company is a user of technology. These companies can take advantage of technological advances, but don’t tend to have the high valuations of firms directly producing technology. He likes to mention Automatic Data Processing (NASDAQ:ADP) as an example.
  • There is a low percentage of shares held by institutions, and there is a small number of analysts covering the stock. Firms under followed by Wall Street have more upside potential.
  • Insiders are buying/owning shares. A positive sign that insiders are involved and feel confident about the firm’s prospects.
  • The company is buying back shares. Lynch prefers companies that buy their shares back over firms that choose to expand into unrelated businesses. The buyback will help to support the stock price and is usually performed when management feels share price is favorable.

And as a reminder, some characteristics Lynch finds unfavorable are:

  • Hot stocks in hot industries.
  • Small Companies with big plans that have not yet been proven.
  • Companies engaged in many acquisitions diversifying from their core business. Lynch calls these "diworsifications."
  • Companies with high concentration, when a few customers account for 25% to 50% of their sales.

As those who follow me already know, I believe that SaaS businesses, particularly enterprise software, are among the best investment opportunities available in this day and age. If I get to choose the type of business I invest in, I'd rather go for strong unit economics that improve over time and compelling economic moat such as high switching costs.

With all the details above in mind, I selected three software companies that are still relatively small (under $6 billion market cap) and satisfy many of the attributes that would make Peter Lynch probably love them.

The three small companies I'm presenting today have barely more than 3,000 followers on Seeking Alpha. That's a very small number when you consider that Apple (AAPL) has more than two million followers.

Let's review the details.

3 small SaaS Peter Lynch would love Five9 FIVN Paylocity PCTY Appfolio APPF

Image Source: App Economy Insights

AppFolio: A small player in cloud-based property management and legal solutions

I covered before how I built a Small Cap Scorecard in my research for companies that have the potential to significantly outperform the market over the next decade.

You may have never heard of AppFolio (APPF). And I can't blame you.

This company of $3.2 billion market cap is focused on providing cloud-based solutions for property management and legal industries. Without working directly in these industries, chances are you would never come across AppFolio's services.

This company is a position of the App Economy Portfolio and already up 133% since I purchased shares in January 2018.

I already wrote a bullish thesis about AppFolio on Seeking Alpha in August 2018, and the shares are up +22% since then (vs. +2% for the S&P 500).

Chart Data by YCharts

What are the attributes that make AppFolio a potential long-term winner?

It's hard not to recognize the many traits favored by Peter Lynch.

Software solutions for legal and property management professionals are boring. There is no breakthrough technology here, and this is certainly not a "hot industry." AppFolio benefits from a strong adoption in its niche market targeted toward small and medium-sized businesses. The company is growing fast despite being in a no-growth industry (property management has been growing at 0.8% CAGR since 2014 according to IBISWorld). Just like ADP, AppFolio is a user of technology, one that benefits from it. It's also pretty clear that AppFolio's customers need the service to be operational.

Besides, the company has many favorable features:

  • Still small with trailing 12 months sales at $221 million.
  • Growing fast (+35% in the last quarter).
  • Profitable and cash-flow positive over the last 12 months.
  • High insider ownership at 8%.
  • Low institutional ownership at 65%.
  • Low daily volume showing little interest from investors.
  • Very small number of analysts (3 in August).
  • Strong culture and leadership based on Glassdoor ratings.
  • Strong stock price appreciation over the last 12 months (winners win).

As a result, AppFolio is the company that comes at the highest premium of the three stocks presented today from an EV/Sales perspective. But given how compelling the profile of the company is, the premium could be justified.

Let's summarize with my updated Small Cap Scorecard for AppFolio.

Source: App Economy Insights (data from Yahoo Finance 8/11/2019, PEG calculated via YCharts).

Paylocity: A niche provider of payroll and human capital management solutions

You may be familiar with Paycom Software (PAYC), a company targeting small and medium sized businesses with cloud-based human capital management solutions. Paylocity (PCTY) is a miniature version of Paycom Software.

Paylocity is targeting smaller customers than Paycom Software, mostly organizations from 20 to 1,000 employees. It's also a much smaller company that has yet to reach half a billion revenue annually and is valued at a market cap below $6 billion.

What are the attributes that make Paylocity another strong prospect?

Software solutions dedicated to back-office functions are boring. Paylocity also has a niche market targeted toward small businesses. The company is growing fast (+23%) in a no-growth industry (as illustrated by ADP and its 4% revenue growth in the most recent quarter). Just like ADP, Paylocity is a user of technology, one that benefits from it. It's also pretty clear that human resource departments need the service to be operational.

Besides, the company has many favorable features:

  • Still small with trailing 12 months sales at $444 million.
  • Growing fast (+23% in the last quarter).
  • Profitable and cash-flow positive over the last 12 months.
  • Very High insider ownership at 33%.
  • Low institutional ownership at 67%.
  • Low daily volume showing little interest from investors.
  • Strong culture and leadership based on Glassdoor ratings.
  • Strong stock price appreciation over the last 12 months (winners win).

Paylocity shows a forward PEG under 1, implying that the company is undervalued based on its projected earnings.

Source: App Economy Insights (data from Yahoo Finance 8/11/2019, PEG calculated via YCharts).

Five9: A small cloud software for contact center

Contact centers are not only boring but also disagreeable. Reaching out to customer support services with a complaint is not an enjoyable experience.

Five9 (FIVN) provides cloud-based software solutions for contact centers.

What are the attributes that make Five9 my third pick?

Five9 targets a niche market with a very specific service offering a virtual contact center cloud platform. The company is growing fast (+27%) in a no-growth industry (contact centers are certainly not a booming industry). Just like our other picks today, Five9 is a user of technology, one that benefits from it. Once the solution is implemented, companies need the service for their customer service to be operational.

Besides, the company has many favorable features:

  • Still small with trailing 12 months sales at $273 million.
  • Growing fast (+27% in the last quarter).
  • Profitable and cash-flow positive over the last 12 months.
  • Relatively low daily volume showing little interest from investors.
  • Small number of analysts (10 in August).
  • Strong culture and leadership based on Glassdoor ratings.
  • Strong stock price appreciation over the last 12 months (winners win).

Unfortunately, institutions are already owning Five9. Insiders own 4% of the outstanding shares, a decent number, but not as impressive as AppFolio and Paylocity. Five9 remains compelling on the valuation side with a forward PEG under 1, implying that the company is undervalued based on its projected earnings, just like Paylocity.

Source: App Economy Insights (data from Yahoo Finance 8/11/2019).

Five9 has been recommended exclusively to members of the App Economy Portfolio when it was trading at $41 in October 2018, and shares have rallied +50% since then.

Chart Data by YCharts

Rule of 40 and valuation

Fast-growing young SaaS companies with most of their business powered by recurring subscription revenue, very high gross margins and heavy reinvestment in R&D, have a tremendous upside potential in the long term. In the meantime, they often have to turn a profit. That's why they often end up looking grossly overvalued if you are using valuation metrics such P/E or PEG ratios.

I have shared before the rule of 40 map, breaking down my methodology and showing how to pit the performance of SaaS businesses against one another using graphs. After reviewing the efficiency score (sales growth + operating margin) of a wide range of SaaS companies, my focus has been on comparing them on an EV to Sales basis.

Important note: I'm using below the GAAP operating margin of the past 12 months. This is meant to reflect better the performance of companies that have seasonality to their sales and marketing or R&D investments. I believe that this adjustment, albeit a subtle one, is a better representation of the performance of these businesses, particularly when comparing them.

As illustrated below with the most recent data pulled from Yahoo Finance, only a few SaaS companies manage to satisfy the rule of 40, the principle that a software company's combined growth rate and profit margin should exceed 40%.

AppFolio is a winner of the rule of 40, and Paylocity and Five9 come very close.

You can find APPF, PCTY and FIVN close to the center of the chart with healthy revenue growth between 23% and 35% and profitability between 3% and 10% over the past twelve months.

Source: Data from Yahoo Finance. Sales Growth from most recent quarter. Operating margin from last 12 months. Graph from App Economy Insights. Bubble size based on market capitalization as of 8/11/2019.

Now, how does this translate into valuations?

Let's look into the most comparable metric between all these companies by reviewing the correlation between the EV/Sales ratio and the efficiency score.

Source: Data from Yahoo Finance. Sales Growth from most recent quarter. Operating margin from last 12 months. Graph from App Economy Insights. Bubble size based on market capitalization as of 8/11/2019.

As previously mentioned, AppFolio has the highest premium of these three picks with an EV/Sales of 15 while Paylocity and Five9 have a slightly more reasonable multiple of 13.

As explained in previous posts, if we assume that the EV/Sales trendline represents what a "fair" valuation could be among this set of 40 SaaS companies, the companies that are overvalued are above the trendline, while the companies that are undervalued are below the trend line.

From that perspective, the three of them appear appropriately valued compared to similar SaaS businesses, with AppFolio benefiting from a performance-related premium due to its strong top-line growth.

Conclusion

The three companies presented today have particularly interesting profiles.

I consider AppFolio the most attractive one thanks to its superior sales growth, niche positioning, and winning position on the rule of 40 map. That's why APPF is a current position of the App Economy Portfolio. But there's also a lot to like about Paylocity and Five9, as their earnings per share keep on growing to new highs. Any weakness in their share price could be worth exploiting.

  • Do you find these three stock picks compelling despite their boring or unattractive services?
  • Do you think Peter Lynch would love them based on their attributes?
  • Can you think of other stocks that would greatly match these features?

Let me know in the comments!

Disclosure: I am/we are long APPF, PAYC. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Additional disclosure: App Economy Insights recommends PCTY and FIVN