Description

Thesis:

Undifferentiated sell-off in tech has created an attractive GARP set-up where a sticky, high-value and rapidly growing SaaS business with limited direct competition and an owner-operator CEO is being valued as if it was a crummy also-ran. Continued execution in the core business will force the market to better appreciate this company's merits.

Description:

Apptio is a subscription software business that has pioneered a new field, Technology Business Management (TBM), which provides IT departments with the ability to monitor, reduce and optimize their spend. Yellowhouse provided an excellent write-up that covered much of the detail of the business back in May 2017 when the stock was $15.89 (2.7x revenue) and thus far the stock has been a terrific investment. While the stock is up ~80% since then and the multiple has re-rated (now ~4x fwd revenue), it has been caught up in the SaaS sell-off and is down 1/3rd from its high in September. I am submitting my own write-up today as there have been several important developments since May 2017 which materially improve the fundamental fact pattern for an investment in Apptio and which are timely in advance of the company reporting earnings later today.

In terms of the business itself, I would refer readers back to Yellowhouse’s comprehensive write-up. The key factors that remain the same are the following:

·       Customer feedback seems to suggest that customers derive a very high ROI from both implementation and on an ongoing basis. Once imbedded, Apptio becomes a critical part of IT planning, budgeting and analysis, with minimal customer churn. This is a highly-valued product among those that use it and there is no obvious replacement product for it.

·       The IT department is of growing corporate importance as more businesses become IT-enabled and this increasing importance and mushrooming complexity should redound to Apptio’s benefit. The TAM is very large, can be discussed coherently (ie this is not a 'hand wave' TAM or an abstract dream) and, crucially, Apptio is a small % of that TAM today ($197M of ARR today vs a $6B TAM).

·       Apptio has an attractive unit economic model (82%+ subscription revenue mix, 83% subscription gross margins, reasonable and improving LTV / CAC).

So what has changed?

·       While Apptio has always been the leader in the space, the competitive dynamic has further improved:

o   In January 2018, Apptio acquired Digital Fuel, the #2 player with 110 customers (vs Apptio’s 440), for $43M. Over the long-term, the plan will be to migrate these customers onto Apptio’s subscription-based offering. While we are only a few months into ownership, the acquisition seems to have been performing well with Digital Fuel outperforming management’s projections and some Digital Fuel customers already opting to shift over to Apptio. This was a savvy acquisition as it was done at a reasonable price, knocked out one of the only material competitors with a pureplay solution and increased Apptio’s strategic value in the event a larger company decides to acquire them.

o   In addition, ServiceNow, which offered some add-on services with Apptio-esque functionality, seems to have pulled back from the space. Our conversations with ServiceNow employees and system integrators suggest that NOW has bigger fish to fry given the large TAM in their other markets and has reallocated resources accordingly. ServiceNow’s website has de-emphasized the IT Financial Management module and the tool was not discussed at all at the 3 hour 20 min analyst day back in May. I think this is telling.

·       In July 2017, Apptio introduced a new module called IT Financial Management Foundation (ITFM Foundation). This module combines some of the greatest hits of its core Cost Transparency (CT) and IT Planning (ITP) but at a lower price point and a much faster time to implement. One of the challenges that Apptio has historically faced is that implementation times can be lengthy and so while the eventual value realized can be enormous, churn can happen before then, especially if the company has a change in CIO (which is a reasonable probability, as the average CIO has a tenure of 4 years). While it is still early days, ITFM Foundation appears to be generating good traction with new logos and who are then moving up to fully fledged CT and ITP or one of Apptio’s other portfolio of products (Bill of IT, Business Insight, IT Benchmarking). Importantly, there are no signs of this offering cannibalizing existing business. I believe ITFM Foundation will continue to lower the barrier to adoption and time to value, enable faster new logo growth, increase retention rates and increase upsell potential, which should also greatly enhance the LTV / CAC.

·       Apptio has also been introducing several other new products, the most important of which is the Cloud Cost Management (CCM) tool. As many readers are aware, the shift of infrastructure to the cloud is one of the key IT megatrends as the cloud can provide benefits such as much lower cost, greater flexibility and security. However, if enterprises don’t carefully manage their cloud spend, the shift to the cloud can end up costing them far more money than envisioned. Apptio now has a tool in place to address this issue and can ingest data from all the major cloud providers (AWS, Azure, GC) to provide visibility into costs and better management.

·       In addition, these new products have given Apptio additional touchpoints within an organization to attach their tentacles to. CT is focused on the CIO, where ITFM Foundation could be the CFO of IT or an IT Finance exec) and CCM could be the infrastructure buyer or a person managing cloud spend.   

·       After disappointing in the Q4 2016 report with 2017 guidance (guided to 11% to 13% revenue growth), Apptio’s operating performance has dramatically improved:

o   Organic subscription revenue ex one-time items (FX/timing) from Q1 2017-Q2 2018 has grown as follows: +19.5%, +18.6%, +18.3%, +19.9%, +22.6%, +27.3% and 2018 guidance calls for 22% to 24% revenue growth

o   Net dollar retention fell from 100% in Q3 2016 to a trough of 98% in Q4 2016 – Q2 2017, rebounded to 100% in Q3 2017 and has remained at 102% since Q4 2017

·       The business model is nicely scaling:

o   EBIT margins have gone from -24.6% in 2015, -11% in 2016 (-14.6% at the time of yellowhouse’s write-up), -5.7% in 2017, 0% in Q1 2018 and 3.4% in Q2 2018. This operating leverage has been across all expense lines

o   FCF has gone from -$18M in 2015, -$9M in 2016 to $5.8M in 2017 and likely >$15M in 2018.

·       During Q2 2018, Apptio’s dual class share and super voting structure was collapsed. Prior to then, the Class A shares held by management and VCs had 10 votes, but with the exit of the majority of the VCs, one share = one vote. The CEO, Sunny Gupta, still owns 15% of the business.    

What is the expected return?

Due to the dynamics above (great product with excellent customer feedback, new modules gaining traction, backdrop of increasing emphasis on IT department and transparency), we believe Apptio can continue to grow subscription revenue at 20%+ for at least several years to come and will continue to see improving unit economics and operating leverage. Like most software businesses in their early phase, Apptio will be valued by the market on a revenue multiple. Today, Apptio screens as one of the cheapest SaaS companies on a revenue multiple (4x fwd) relative to its business mix (83% subscription) and growth profile (22% to 24% revenue growth guided for 2018). If you just believe the multiple holds, you will make a 20%+ IRR, but if the multiple re-rates to its September peak (6.7x) or closer to other SaaS businesses (6x-8x), the IRRs may be 40% - 50%. At a $1.1bn TEV, Apptio is also a bite-sized acquisition for many of the larger software companies who have an interest in the space.

We fully acnowledge that this does not screen as a traditional statistical value investment by any means but part of what is attractive to us about the SaaS space is that there is limited differentiation between those SaaS companies with bad and good economic models. APTI is very much in the latter category and, on that basis, I think clearly qualifies as a GARP opportunity based on the growth and underlying economics. 

Catalyst

Continued 20%+ subscription revenue growth and improving margins

Likely acquisition target in the future (made more likely by the single-class share structure)