- Revenue is growing rapidly and coming from reliable and predictable sources.
- Covid and remote work have led to current wins, and are likely to lead to recurring subscription growth.
- The company sells its solutions as an “ROI story,” and they try to condition customers into believing switching from a manual solution to an automated solution is an investment.
- Avalara’s primary competitor is the status quo, not necessarily competing companies.
- Avalara’s recent acquisitions have been strategic and should lead to significant future upsell opportunities.
Avalara (NYSE:AVLR) has operated admirably both before and during the pandemic, with its revenues growing at high double digits consistently year over year. The company operates in a recession-proof industry and is an industry leader in a nearly untapped market with a bright company outlook. All of these factors combined together have driven Avalara's stock price to an unsustainable level. For those looking to get into a good growth company like Avalara, they may be best served by waiting for a fall in stock price or for the company's valuation to be realized over time before jumping in.
Please note our valuation takes qualitative factors and enters as quantitative information into a financial model below that we encourage you to try for yourself.
Avalara's Story So Far
Avalara is an automated tax compliance software provider. Companies can face overwhelming challenges when it comes to the collecting, reporting, and remitting of sales, use, and many other types of taxes they encounter in their normal operations. The products Avalara offer are cloud-based, updated often to keep up with changes in laws, and are generally exclusively transactional tax related.
Avalara has historically targeted the small and midsize market to implement their solutions with. This has worked by having the tax solutions integrate with accounting or other software that smaller clients are already using, such as Quickbooks and WordPress. The company is working on moving upmarket and integrating their software with ERPs that larger customers are using to make it an easier sell for implementation.
One of Avalara's most important internal KPIs is the tracking of core customers to determine its success in gaining market share. The company identifies core customers as generally any customer that was active during the year and the company recognized at least $3,000 in revenue from during the prior twelve months. As of the end of 2020, the company recorded a total of 14,890 total core customers, an impressive increase of nearly 23% year over year.
Percentage increases like those noted above have been a common thread for Avalara for the past few years. The company has seen exceptional growth in its core Subscriptions and Returns revenues of 40% year over year in 2019 and 31% year over year in 2020. Because of its history as a quickly growing Software as a Service company, Avalara's stock price grew from $24 since its IPO in 2018 to around $140 as of writing, an increase of nearly 6x in just 2 years.
Source: Yahoo! Finance
Avalara sits at the intersection of transactional tax compliance and Software as a Service when it comes to the industry it finds itself in. Tax compliance companies have been around as long as sales taxes have been around. These can be manual outsourced accounting firms or the newer version of automated software tax compliance solutions. We'll be looking exclusively at transactional tax Software as a Service companies and this specific industry here to get a better and narrower view.
Automated solutions are relatively new compared to manual solutions, Avalara having been founded in 2004. Potential customers for these firms are essentially any business in the world that sells a product or service that is subject to a transactional tax. According to the research firm Markets and Markets, the global tax management market is expected to grow from $15.5 billion in 2019 to $27 billion in 2024. This means that in 2019 Avalara captured a mere 2.5% market share. This gives Avalara a massive runway for growth, especially considering most of the remaining addressable market is likely not using automated solutions competitors, but instead either is still using manual outsourced firms or handling the transactional tax duties internally with a dedicated-- and likely expensive-- team of professionals.
Avalara competes against other companies in the United States to handle their sales and use tax compliance, however they are moving to a more global focus as time goes on as the company continuously expands its own offerings internally and aggressively grows through acquisitions of international firms. Through these acquired assets and brands, Avalara has begun handling various types of taxes that are region-specific, like VAT tax in Europe. Avalara has acquired or announced acquisition plans for 4 brands within the last year alone.
Factors Impacting Avalara's Revenue Growth
Increasing revenues by double digits year over year is no easy feat, but it especially grabs investors' attention when a technology company is growing its revenues in the 30-40% range compounded annually. It's important to take this number apart and see what is making these growth rates up to determine if this is due to strong products already owned or acquisitions purchased and integrated throughout the year. Then we can take a look at how much global tax compliance and SST is impacting Avalara's revenue growth rates and whether these rates are sustainable going forward.
From Avalara's 2020 10-K, we read: "Growth in total revenue was due primarily to increased demand for our services from new and existing customers. The increase in total revenue for the year ended December 31, 2020 compared to the same period in 2019, was due primarily to $50.8 million from existing U.S. customers, $29.4 million from new U.S. customers, $24.3 million from SST revenue growth, $6.5 million from 2020 acquisitions, and $7.9 million from revenue growth in our international operations, partially offset by $2.4 million lower interest earned on funds held from customers. During 2021, we expect significantly lower revenue growth from SST services due primarily to a reduction in the fee we earn from these transactions."
We see from this that in 2020 Avalara's $118.1 million increase in total revenues was heavily impacted mostly due to domestic new business and SST growth with upselling on existing accounts being the predominant factor. New acquisitions only accounted for roughly 5% of revenue growth and increases in international sales made up 7% of total revenue growth. For comparison, Avalara had a $108.7 million increase in revenues in 2019 compared to 2018, and of that SST sales growth made up 9% and international sales growth accounted for 6%. Growth from revenues of acquisitions made up 4%.
Source: Author's Calculations
Some takeaways here seem to be that Avalara has strong customer retention and ability to integrate new software and successfully upsell it to existing customers. Due to this, subscription revenue should be incredibly reliable and growing steadily. New customer growth is strong in the two years we looked at which tells us Avalara should continue having no problem acquiring new customers both small and large. Also, an increasing portion of Avalara's revenue growth strategy appears to be diverted toward international sales and growth through acquisitions year over year. SST growth, however, may have varying results as fees have been cut, however Avalara being a Certified provider could lead to massive increases in volume.
Avalara's Covid Story
The pandemic has had an effect on every single business over the last year and Avalara was no different. In the first quarter of 2020 the company reported strong revenues, beating estimates. January and February were solid months, but March was having customers show reluctance to move forward due to the onset of the pandemic.
Year over year revenue growth in Q2 2020 was 28%, a seemingly impressive number until compared to prior periods. Even the quarter before had a 7% advantage to 35% growth year over year. By Q4 the company announced it had a total year over year increase of revenues of 31%, a solid growth rate despite being significantly less than the year prior. During Q4 while most companies were cutting budgets to preserve cash, Avalara felt confident enough in its position to keep its expenses in line with prior quarters as a percentage of revenue and also to announce its largest acquisition up to that point.
Avalara's CEO did comment that during 2020 the company's revenue churn edged up higher than it was previously, however it was still below 4% and at a level they feel is insignificant. New customer accounts were far more significant, with the CEO reporting these were due to Avalara's ability to integrate with existing software the customers were already using, a strategy the company had been implementing for years.
Despite a few weaker areas performance-wise in 2020 compared to prior years, Avalara fared extremely well given the circumstances. For the most part, the company operated as if it were business as usual, going about M&A deals and operating expenses as if the pandemic were of little concern to operations. This should give us clues to how well insulated the company is due to not only its own strengths of a mix of strong products and customer relationships, but also the resiliency of compliance industries during recessionary periods.
Positioning Tax Compliance as an ROI Story, not a Cost Center
Even while operating in a global pandemic, Avalara has managed to grow its revenues at admirable rates. There's likely plenty of praise to go around, however when revenues are growing we know it's usually the sales staff that are the front line soldiers making that happen.
The strategy during Covid for Avalara's sales staff was to position its solutions using a "return on investment" sales model. In other words, the company wanted its sales team to explain how using an automated system would essentially cut down on costs and what the customer's company would save on switching from expensive manual processes to an efficient, automated system. After this is written down in dollar amounts saved, it could be explained to the customer what the return on investment would be to switch to Avalara's software solutions in percentage terms compared to operating as normal.
Avalara describes these added expenses of manual compliance as "hidden costs." These "hidden costs" include things like: fines from taxing authorities, third party consulting costs, external filing costs, error checking, and time spent on the processes.
Selling based on a return on investment model works great when dealing with customers that have never worked with an automated tax system before. Luckily for Avalara, most potential customers are still dealing with manual processes, so this type of selling is intuitive and should serve the company well until a bigger portion of the potential market is using theirs or a competitor's automated service. Once the market for automated transaction tax is more heavily penetrated, Avalara will likely have a harder time using an ROI type selling when it comes to proving a high ROI while comparing the benefits of switching from one automated solution to another. Once this happens, a new type of sales strategy will likely be needed and new accounts will likely be harder to close, reducing revenue growth rates in future years, much further down the line.
Status Quo vs. Competitors
Avalara has demonstrated over and over its primary obstacle to closing deals is not other automated tax solutions, but instead it's small and medium sized companies following the status quo. Many smaller firms feel that sales tax compliance is not difficult enough to be worth automating. The value in the automated solution is therefore more difficult to prove to these types of customers. Avalara has one exceptional tailwind working in its favor here: lagging small companies that are just now learning of their sales tax responsibilities brought about by the 2018 Wayfair case. This case made companies responsible for collecting and remitting sales tax to the State they are selling to, not the State they are selling from, a monumental change in sales and use tax law.
This factor has fundamentally shaken up small businesses selling online, meaning the status quo has been thrown out the window. With the concept of a normal sales tax environment turned on its head, Avalara and competitors had the perfect opportunity to position themselves in a way that made it incredibly intuitive to use their products over creating new and clunky manual processes that had to adapt to each individual State the business would sell to.
Even with these factors, the market remains minimally penetrated. According to the company, 77% of lost deals are due to potential customers wanting to stay with the status quo and a minimal 3% are lost due to competitors. This point hammers home the fact that Avalara has recognized the status quo as its primary enemy and is tackling it through its "return on investment" selling method. It will likely be many years before competitors even register as a viable threat to Avalara's revenue growth. If anything, Avalara and competitors have everything to gain by raising awareness of the concept of automated solutions altogether, and not necessarily raising brand awareness or bashing competitors.
Avalara's Mergers and Acquisitions: Latest Stories and Expected Growth
2020 was a busy year in regards to acquisitions for Avalara. The company acquired three brands: Transaction Tax Resources, Business Licenses, and Impendulo. Transaction Tax Resources being an automated research platform for tax compliance appears the most strategic in terms of bolstering existing product offerings and creating additional synergies. The other two acquisitions act more as add-ons as potential upsells to the company's core offerings. In addition to the tax research capabilities brought about by TTR, they also brought with them a large amount of new and large customers.
"TTR, headquartered in McMinnville, Oregon, offers information on U.S. sales and use tax rates, laws, software, and customer support to some of the largest and most complex companies and their internal tax teams. TTR will bring more than 1,400 customers to Avalara, representing more than 30 percent of the Fortune 500." (Source)
If Avalara is looking to move upmarket, this is definitely a move that will likely help them get there. Exposure to 30% of the Fortune 500 as new customers will certainly help bolster the number of core customers upon hopeful conversion to legacy software options.
In more recent company news, Avalara announced it acquired all assets of DAVO Technologies LLC on April 20th of this year. This acquisition appears to be a more straightforward strategic buyout. DAVO Technologies helped small emerging companies with automating sales tax and connects to point of sales systems. These are activities that Avalara already engages in. The strategy here appears to be both an acquisition of additional technology as well as reduction of future competition in the small and midsize business space. In addition, Avalara's goals are to reach out into nearly every type of small business, including coffee shops, restaurants, bakeries, etc. All of these lines of small businesses were where DAVO specialized.
Business Risk: Avalara May Lose Its Place as a Streamlined Sales Tax (SST) Provider Or Lose More Revenue Opportunities From It
Streamlined Sales Tax (SST) is a State-run program for companies that sell in multiple States. Avalara has built an effective moat the past few years by being one of the Certified providers on this system. The States participating in the program pay fees to the Certified software providers, giving Avalara a stable and growing revenue avenue.
SST Members Map
Recently, Avalara noted that fees had undergone a planned restructure. The fees that Avalara generated from the system had been cut and will likely and potentially be cut further over time. Despite the reduction in fees as a percentage of sales processed, Avalara will likely continue to see increased volume of transactions in the years to come. This increase is heavily due to the Wayfair court case and companies becoming aware of their obligations. Also, SST has made it much easier for companies to disclose their positions and be brought into compliance than previously.
In addition to revenues being cut due to declining fee percentages, the States participating in SST may reevaluate their partnerships and fees they are paying to the Certified providers and decide they would rather handle the automation themselves, essentially cutting off Avalara and other providers from the gravy train they have become accustomed to. A move like this would be a massive hit to Avalara's revenues and efforts.
Although the majority of new customers find Avalara independently or through Avalara's sales staff, SST represents a potential avenue for massive growth as more and more companies try to use this system in place of integrating automation software without it. If more companies leave Avalara over time and utilize a State-run program like SST that is missing Avalara as a Certified provider, this would drastically reduce Avalara's future revenue growth potential.
Business Risk: Some Negative Impacts of Covid Could Be Long Lasting
Early on in the pandemic, customer churn remained a nonexistent problem, however new customers proved harder to close and cross-border selling was heavily impacted, as mentioned in the Q1 2020 earnings call. As noted earlier, by Q4 of 2020 the CEO had made remarks of revenue churn increasing, indicating a larger portion of customers are leaving for one reason or another. These two factors combined give us a small glimpse into the future if the effects of Covid are to become longer lasting. Potential customer budgets could be reduced and Avalara's sales growth rates will become heavily affected.
Avalara's strategy of expanding internationally may become stalled out if cross-border selling is restricted due to rising cases and new strains of coronavirus. When undergoing acquisitions, the company has internal estimates on revenues and profitability of each investment. If these are impacted due to Covid, the recent acquisitions the company has undergone recently will fail to materialize their estimated net present value and hurt the stock price. Avalara has proven to be well insulated compared to companies in other industries, but increasing churn and government shutdowns have still managed to leave an impact.
Because the sales tax automation market is so scarcely penetrated, we do not need to focus much on competitors of Avalara as the effects they have on their business will be minimal until more market share is controlled and competition becomes more fierce. However, it is still helpful to look at the players and how they fare compared to each other.
According to the review aggregator site G2 Crowd, a look at their grid of sales tax compliance software providers shows there are two top contenders in this space: Avalara and TaxJar. Avalara has greater market presence while TaxJar has greater customer satisfaction. In addition, Avalara ranks highest as the midmarket option and TaxJar ranks highest as the small business option.
Source: G2 Crowd
Normally, at this point we would do a deeper dive into the company and its competitors' comparable operating metrics to determine potential winners and losers in different categories. However, as we had already discussed there is little reason to do this type of comparable analysis while the market is so loosely penetrated and the companies are still honing software solutions and strategies. This type of analysis would be much more important as the competition becomes more fierce.
Given that Avalara is an industry leader, is focused on keeping its edge through a dialed in growth strategy, and has cornered its niche of midmarket, it is fair to believe that Avalara can mostly stay in its own lane for the next few years and hardly even encounter competition while it continues to grow rapidly.
To keep its goals of growth through acquisitions consistent, the company will have to maintain adequate cash reserves to scoop up target companies when the time comes. We will take a look at how Avalara has handled its cash position over the past two years, and we will also examine some ratios that point to how the company handles debt.
Avalara's current ratio was 2.4 and 2.3 in 2020 and 2019 respectively. The ratio slightly improved year over year, but this tells us that Avalara is concerned with keeping more than enough assets on hand to deal with bills coming due. For both years the cash ratio was 1.9, meaning Avalara is also concerned with keeping the majority of its current assets very liquid. This profile matches that of a company which plans to grow through acquisitions and wants to be ready for when the next opportunity comes.
Source: Author's Calculations
A large amount of Avalara's liabilities are wrapped up in deferred revenues. This is just a consequence of the way the company does business and how it recognizes the revenues. When money is received in advance for a subscription over a year or more, Avalara is forced to hold the cash and show it as a liability on the balance sheet in the event that Avalara is unable to earn the revenue and the money would have to be returned.
Aside from this, we see a few other liabilities that take up larger portions of real estate on the balance sheet: operating lease liabilities, accrued purchase price of acquisitions, and accrued earnout liabilities. The last two categories have to do with the unique finance structuring of acquisition deals. Operating lease liabilities, while a large amount, is a normal ongoing expenditure and no cause for concern in Avalara's case. The company's debt to equity ratio was .74 and .48 for 2020 and 2019 respectively.
Just as we did with the measures of liquidity, we will now look at operational performance metrics for the last two years for Avalara to see how it handled recent events and if its operational efficiencies are increasing or decreasing over time. Additional consideration and slack will be given to performance measures in 2020 compared to 2019 given the unforeseen consequences of the coronavirus.
Avalara hired an increase of 29% of employees in 2020. Even despite this large bump in additional expenditures, the company managed to improve its revenue per employee metric in 2020, meaning: each employee is generating more revenue than they were before, and revenue gains are likely outpacing payroll expense increases. These are both great signs of efficiency improvements in operations year over year.
Asset turnover was .31 and .47 in 2020 and 2019 respectively. Normally we would like to see this number go up, but for two main reasons, the number declined substantially in 2020. One of these reasons is the large increase in cash due to proceeds from a stock offering. Second is the over 500% increase in Goodwill due to the increasing number and size of acquisitions. Because of these factors, increases in the value of assets greatly outpaced increases in revenues. This is little cause for concern in 2020 due to asset gains being used for future revenue increases, but it is something to be aware of and monitor in 2021.
Source: Author's Calculations
Next, we can look at accounts receivable turnover and how it has changed between 2019 and 2020. In 2019 the turnover ratio was 7.4 and in 2020 it was considerably lower at 6.6. Again, this is not a trend we normally want to see but the ratio is still nevertheless at a good point and with how little the company sells on credit versus receiving cash upfront, it is more indicative of how the pandemic has affected the company than it is of any long term fundamental changes in selling or collections.
Valuation Analysis: Base Case
For our base case, we can assume operations return to a more normal environment, even with the pandemic raging on. Customer budgets bounce back slightly but not quite to the level they were pre-pandemic, meaning Avalara's revenue growth rates are squarely in between 2019 and 2020 rates and then slowly declining throughout the forecast period. Sales, marketing, general, and administrative expenses continue their trend of declining slightly in relations to revenues throughout the forecast and most other performance metrics match close to prevailing pre-pandemic.
The most difficult part of forecasting for Avalara will be the acquisition portion of investments. Financial terms were not disclosed for the DAVO acquisition, other than the CEO announcing it was their most expensive merger announcement to date. Because of these factors and lack of guidance in this area, we would be forced to forecast arbitrary acquisition deals into the model. This will make the NPV fluctuate wildly, but to make our point we will leave the acquisitions line blank but encourage you to try your own to determine NPV at various acquisition price levels.
Normally we would use a 3% perpetual growth rate to determine the terminal value, but because so much of Avalara's assumed future growth will happen after the forecast period, we thought it only fair to assign a 4% terminal growth rate and an arbitrary 9% discount rate. Even using these variables, we find in a base case that Avalara's stock price is hard to justify. We end up with a stock value of nearly half of its current asking price, $72, and an IRR of -6%.
Source: Author's Calculations
We encourage you to try our financial model and determine your own stock value of Avalara: AVLR_Financial_Model.xlsx
Valuation Analysis: Bull Case
For our bull case scenario, we assume a complete return to 2020 operational levels and no Covid-induced recession. Revenue growth rates adjust to 2020 rates and then very slowly come down throughout the forecast period. Sales, marketing, general, and administrative expenses come down rapidly in relation to revenue as both operational efficiencies are met and synergies with acquisitions are achieved. Most other operational metrics slowly improve throughout the forecast period as well.
Source: Author's Calculations
With these assumptions, we net a present value of Avalara's stock of $107 and a measly IRR of 1% if bought at today's prices. Even using these inflated and likely unrealistic assumptions, Avalara's current stock price is not justified. Keep in mind, we are valuing Avalara using free cash flow and are not utilizing any inputs for business acquisitions in this example and we still are unable to come to the current value of the stock.
Valuation Analysis: Bear Case
For our bear case, we assume an economic recession beginning in 2021 that hampers both customer budgets and Avalara's revenue growth rates. We forecast revenue growth lower than it was in 2020, and have it decline slowly throughout the forecast period. These assumptions are actually most in line with guidance given on the Q4 2020 earnings call. Here we also have performance metrics deteriorate slowly over time, but not rapidly as we believe Avalara will maintain adequate metrics during a recession due to its value proposition.
Source: Author's Calculations
With these metrics, we never see Avalara achieve profitability during the forecasted timeframe and the stock's net present value is a disheartening $18 coupled with an IRR of -28%.
Avalara is a strong company with exceptional growth rates in an insulated industry. The company has operated admirably both during and before the pandemic. Given its strengths, the company is certainly one any investor should consider looking at. Because of these factors however, we believe the stock price has been driven to euphoric levels and is likely to come down in the short term or stagnate for a while before furthering its ascent up in the long term. Given our analysis of Avalara and its intrinsic value we assigned, we are looking to wait for the stock price to come down to what we believe is a reasonable level before initiating any plans of buying.
This article was written by
Analyst’s Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. 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.
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