Description

I believe Apptio is a high-quality software company with favorable secular trends trading at a deep discount to every valuation framework I can think of – peers, M&A, run-off value etc. At ~$15.00, the stock is trading at 3x recurring revenue. Given their +80% subscription gross margins, +90% retention rate and skew towards large, high quality customers, I believe their recurring revenue is worth at least 5x, which would result in a $22.75 share price. Although APTI has bounced from its lows, it is still down 20% year-to-date and off 40% from its 52-week high. It is also selling for almost 35% cheaper than its last private round of fundraising in 2013. The stock sold off significantly following a weak Q4 and, as a result, soft 2017 guidance which was then followed by a lock-up expiry that saw VCs and former employees sell somewhere between 8 and 11MM shares in a six week period against a 6.9MM share float. With a strong Q1 in the books and the majority of post-lockup sales complete, I believe that APTI will continue to re-rate.

The weak Q4 results and guidance were impacted by a large non-renewal and extended sales cycles, particularly with government clients. Management seems quite insistent that 2017 guidance is conservative, and Q1 results support this notion. Full year 2017 guidance calls for subscription growth in the 15% range. Q1 subscription growth was 20%, and billings were up 15% (against a really tough +42% billings comp in Q1 2016). I believe that 20% growth in recurring revenue is very attainable.

The lock-up expired on March 22nd. Since then, Greylock sold 4.9MM shares, Andreessen Horowitz distributed roughly 1.5MM shares, and T. Rowe Price sold 1.1MM shares. Also, 2-3MM shares were distributed to former employees. These sales and distributions (which I expect resulted in sales given their low cost basis) accounted for a staggering percentage of the volume during the seven weeks between the lockup expiration and most recent Greylock sale on May 9th. In total, the float increased almost 3x, according to the most recent 10-Q which states that Class A shares outstanding was nearly 19.8MM as of April 30th. While I can’t speak to the reasons for T. Rowe Price’s sales (which likely occurred at a loss considered they came in at later rounds), the shares owned by Greylock and Andreessen Horowitz were part of ten year old funds and had a cost basis well below the current price.

Apptio is the fourth cheapest software company out of fifty under RBC’s coverage. Jefferies estimates that their recurring revenue, which skews to large companies and likely has low-single digit churn, is worth ~5x, a +50% gain from the current price. Credit Suisse has done some regression analysis relating valuation to sales and marketing efficiency. On this basis, Apptio would seem to have +30% near-term upside, with +80% upside going a year out.

If management can’t right the ship then I think there is a decent chance that APTI is sold. A financial buyer could conceivably cut both sales and marketing and R&D (55% and 23% of subscription revenue, respectively) and turn the business into a +20% EBITDA margin cash flow machine. The list of strategic buyers is fairly long, including consultants such as Accenture, ERP guys and complementary software offerings such as ServiceNow. Considering that one of Apptio’s biggest challenges comes from inefficient sales and marketing spend, it isn’t hard to see how a larger sales force with more product could do a better job penetrating the addressable market.

Apptio has a dual share class structure. The CEO, Sunny Gupta, owns around 18% of the company, but holds roughly 38% of the vote. Add in the CFO, CTO and other senior management, and you likely have +50% of the vote and a little over 20% of shares being held by senior management. While Sunny seems quite focused on continuing to execute, our conversations with he and the CFO, as well as feedback from other investors, suggest that they are not averse to selling in the event that they either can’t get a reasonable valuation or it becomes obvious that an acquirer could accelerate growth. Given the frequency of M&A in this space, we think the downside is extremely well protected by even the most punitive M&A comp.

Although the 2017 subscription revenue guide is closer to 15% growth, I believe Apptio can return to +20% growth after annualizing some customer losses, improving customer “time-to-value” and further scaling up the growth of “enterprise” customers (which are smaller than their “strategic” customers). If this happens, in conjunction with improved sales and marketing efficiencies and a lower churn, I expect that the revenue multiple will expand towards 6x. If growth and efficiencies elude the company then I still think the business is comfortably worth 4.5x recurring revenue, or <$20/share (35% upside), in a likely M&A outcome.

The Company

Apptio is a software company that is focused on expanding and implementing the concepts of Technology Business Management (TBM). TBM is the practice of tracking and organizing IT spend in a manner that allows IT managers to accurately communicate the total cost of ownership (TCO) of business functions throughout an organization. Apptio’s software is delivered via five SaaS modules that aggregate and organize technology consumption and costs from disparate sources. The information gathered gives a CIO accurate, near real-time information needed to run IT more efficiently. Furthermore, Apptio enables budget and planning discussions to occur between IT and finance departments that otherwise could not occur.

Apptio has 360 customers, including over 40% of the Fortune 100. Customers frequently refer to Apptio as “the closest thing to an ERP in IT.” Apptio targets a savings of 3-5% on maintenance IT spend, or approximately 2-3% savings on overall IT spend (assuming 70% of IT spend is maintenance). Their fee rates range from 10-50 basis points on company-wide IT spend, varying based on the size of the customer and number of modules they deploy. Our customer calls have generally validated a +10x ROI when implementing Apptio, although attributing savings is somewhat difficult.

CEO, Sunny Gupta, and CFO, Kurt Shintaffer, founded Apptio in 2007. The company was funded by investments from VCs such as Andreesen Horowitz, Greylock Partners, Madrona Venture Group, Shasta Ventures and, more recently, and T. Rowe Price and Janus. The last round of fundraising occurred in 2013 at a valuation of $22.69/share, or nearly $870MM. Somewhat shockingly, this implies a +16x multiple on 2013 recurring revenue. A far cry from the ~3x multiple that’s currently being offered. While Apptio’s growth has decelerated significantly (from +35% to ~15% in 2017), customer retention has underperformed (hovering around 92%) and the last VCs probably had a bit of unicorn fever, I think that the roster of early investors suggests that Apptio is targeting a large, untapped opportunity and their technology is at least reasonably differentiated. We think the end market is still quite attractive and we view the increased complexity of IT (cloud shift, increasing number of vendors and growing IT applications) as a likely driver of accelerating growth.

TBM

Apptio founded the concept of TBM and runs the non-profit TBM Council which boasts a board that includes CIOs (or equivalents) from Microsoft, ExxonMobil, SunTrust Bank, Cisco, Stanley Black and Decker, Nike, DuPont and Subway. In practice, the TBM Council is Apptio’s marketing department. Our calls uniformly referred to the creation of the TBM Council as both extremely smart and effective. The mission of the Council is to: “Establish and promote business management standards and practices that empower IT executives to collaborate with their business partners on identifying and executing the most impactful technology strategies for achieving corporate objectives.” There are a little over 3,200 TBM Council members. Most are Apptio customers, however there are members from over 1,000 companies (Apptio has 360 customers). Last November, the TBM Conference had over 1,200 attendees, a 40% increase from the prior year and 12x larger than four years ago. Besides the obvious socialization benefits of owning the professional network charged with growing Apptio’s end market, the TBM Council (and by extension, Apptio) has created the Apptio TBM Unified Model (ATUM), which is the functional equivalent to GAAP for categorizing IT spend. Based on our research, we believe that cracking the code of standardization for how technology spend data is collected, organized and allocated is one of the keys to growth (particularly the IT Benchmarking module). Over the last nine years Apptio has built significant IP around gathering and analyzing data, and thereby improved the “time to value.” We expect that presiding over the TBM and ATUM will be critical for retaining market leadership.

The Business Need

At the risk of stating the obvious, by tracking and allocating both direct and indirect technology expenses companies are better able to make IT investment decisions; and IT investing is becoming a much bigger deal. Perhaps surprisingly, this approach to managing IT investments is still quite nascent. Even Google is just starting to implement the framework needed for thinking about IT on an “all in cost” basis. Last month Ruth Porat offered the following at a Morgan Stanley conference when speaking about non-GAAP cost allocations:

I think it's been really useful when we look at planning for all of our leaders to have a full picture of all of the resources that they are using for any particular product or project. And the shift has been moving from one where head count was viewed as numbers of the people rather than the OpEx associated with those people. Any decision on planning and prioritization would start with what's the strategic priority and what's the addressable market, what's our differentiated advantage, why do we want to be in it? But I think that it's very important to be able to see across a whole host of different things that we're doing, what types of resources you're applying against it. And some of the opportunities that kind of pop-up or there may be nice project or product, and you start to see the kind of the fully-loaded cost and the question is over the near- to long-term, is that the highest and best use of resources? Are there other places that we should be applying them? And my view very strongly, our view very strongly is anchor decisions and data and you're going to make sharper decisions and so that's what this enables us to do. And you can see as you give people data, they want more data, because it enables them to figure out exactly within all of the other things that they're looking at, how do you make the best trade up?

While I am not 100% certain, based on conversations with the company I believe that Google is a customer and that Ms. Porat is speaking about Apptio here. Given that +40% of the Fortune 100 are Apptio customers, this wouldn’t be a big surprise. Even if they are not, this quote speaks directly to the type of role that Apptio plays in an organization and validates the prominence of the need they fill.

Importantly, Apptio isn’t just a tool for traditional technology companies. Management likes to tell the story of how Subway’s IT budget (and the spend Apptio manages) doubled overnight when the company decided to create a mobile application for ordering sandwiches online and retrofit their point-of-sale system to accommodate the technology. Apptio is a key enabler for accommodating the spread of technology into business lines that extend well beyond the IT help desk. Just last month Coca-Cola announced

(http://blogs.wsj.com/cio/2017/03/24/coca-cola-elevates-it-with-direct-line-to-the-top/) an overhaul of their reporting structures so that the CIO now reports directly to the CEO. We would not be surprised at all if their conversations center around reports generated by Apptio. This trend is only going to accelerate, and as it does many customers have started to use Apptio outside of IT as they find it is also helpful in managing other shared services such as HR.

Competition

Apptio more or less created their industry. Some customers struggle to even name a competitor. When they do its typically Digital Fuel, an unsuccessful VMWare acquisition that was recently peeled off to a private equity firm called Skyview (which is run by a man with the most manicured facial hair I have ever seen

http://www.skyviewcapital.com/about/leadership/alex-soltani/#team-member-target), or ServiceNow, which offers a slimmer version of Apptio with their IT financial management (ITFM) module. Apptio has told us that 50% of the time they are the only company bidding on a TBM opportunity. They encounter ServiceNow and DigitalFuel each about 15% of the time, with consultants and smaller outfits the rest. Apptio has told us that their win rate against ServiceNow is “very, very strong.”

Our understanding is that ServiceNow can provide some ITFM insight, but there are real limits. While we have heard conflicting accounts on the compare/contrast, ServiceNow seems to fall short in their reporting ability and they are not designed to provide budgeting/IT planning. We spoke with one ServiceNow customer who said that Apptio wasn’t as good at providing real-time info needed for managing cloud workloads, where pricing changes intraday. Apptio has said that they are aware of the issues that arise from “batch processing” and they are working on a tool for managing cloud workloads. I think that today’s announcement of real-time analytics for AWS demonstrates a big step in this direction.

While ServiceNow would be a strong competitor if they decided to push their ITFM offering, it seems pretty backburner for the time being. The customers we spoke with who use both Apptio and ServiceNow said they have not been contacted regarding the ServiceNow ITFM module. ServiceNow barely mentioned ITFM at their conference a few weeks ago. Although ServiceNow could steal some of Apptio’s growth (particularly for smaller prospects with more limited requirements), we think their existing customer base is relatively secure. We find it hard to believe that the savings would justify the time and risk associated with switching vendors.

Although ServiceNow is not particularly acquisitive, we expect that if they really wanted to get penetrate the market then they would be much better served acquiring Apptio for 4-5x recurring revenue (or about half the revenue multiple that NOW currently trades for).

The TAM

When it comes to sizing up the market, Apptio defines a $6B total addressable market (TAM), implying a current penetration rate of less than 3%. This $6B estimate is derived by taking the total global enterprise IT spend of $2.7 trillion and multiplying it by their average fee rate of 22 basis points for a customer who has fully deployed all five modules (soon to be six after today’s announcement of real-time cloud analytics

http://www.apptio.com/news/apptio-announces-real-time-analytics-public-cloud-costs-aws). This is a pretty aggressive way to define the total market, but given the low implied penetration and likelihood that IT spend continues to grow I don’t think whittling it down does much to improve the thesis (particularly at the current valuation). Apptio estimates that their average fee rate is close to 11 basis points, which suggests that there is significant upsell opportunity in their existing client base.

In terms of customer count potential, Apptio refers to its large customers (those with +$20B in sales) as “strategic” customers and its smaller customers (those with $1-20B in sales and at least $30MM in IT spend) as “enterprise customers.” We were initially concerned that smaller customers (less than $100MM in IT spend) would struggle to see a good ROI, but our customer calls have largely put those concerns to rest. Even so, Apptio may struggle to drive efficient sales and marketing spend as they go down market.

According to sellside initiation reports, at the time of the IPO Apptio had 98 strategic customers out of 750 identified (13% penetration) and around 250 of 10,000 enterprise customers (2.5% penetration). With a current customer roster of 360, there is a long runway for new logo growth.

Customer Feedback

I will concede that sometimes I give more weight to the customer conversations we have when researching a software company. With that caveat in place, I derive a lot of my conviction in Apptio from the customer interviews we have had and those that were summarized in several sellside pieces. Not to mention the wealth of testimonials one can find on YouTube. At the risk of making this write-up excessively long, I’m going to include a list of customer quotes that we’ve gathered from both internal and sellside calls.

Customer: Global Financial Exchange Company

-          Spend $500k for Apptio to track $1.3B in IT expenses

-          Near 10/10 satisfaction with Apptio

-          Interested in benchmarking tool

Customer: Large Title Insurance Company

-          Apptio provides a framework for how IT gets run as a business

-          Provides complete transparency to execs

-          No other tool could do what Apptio does

-          Estimates ROI at more than 10x

-          Apptio makes cloud discussion much more manageable

-          Not aware of any competition from ServiceNow

Customer: Medium Sized Sales and Marketing Services Company

-          Received a mandate to reduce IT budget from $50MM to $30MM, which Apptio helped us achieve, versus an cost of $100k

-          It would be really difficult to sell Apptio into a decentralized organization

-          Believes Apptio is pretty fully penetrated in Fortune 50 or Fortune 100 companies

-          Implementation is hard, and could have imagined giving up a month 6

-          Someone has to “champion” an Apptio implementation

-          “I don’t want you to increase their revenues by you telling them they have me as a customer for life so they can increase price”

Customer: Large Networking Company

-          Lack of accounting across IT industry is shocking

-          Apptio is the closest thing to an ERP in IT

-          Pervasively using all of the costing modules

-          Relationship is sticky, but not as bad as ERP system

-          Competition is nowhere close

Customer: Global eCommerce Company

-          Apptio is a great product, but TBM Council is great too

-          Was able to measure $20MM in cost avoidance as a result of using Apptio, generating at least a 10x ROI

-          Benchmarking has been extremely valuable

Customer: Large Insurance Company

-          Apptio will not right the wrongs of your data

-          Proof of concept takes a couple of months

-          Saved $6-8MM and optimized cost of software licensing, generating at least a 10x ROI

-          TBM is an “amazing piece of collateral that I don’t see anyone else doing”

In summary, our customer calls on Apptio gave us comfort that the software adds value, the need for the software is growing and that the near- to medium-term risk from competition is quite limited. On the negative, we gained a deeper appreciation for the fact that the low-hanging fruit (companies with very large IT budgets) has been picked and we learned that implementing Apptio can be hard and prone to fail more often than your typical enterprise software solution.

Churn

Apptio’s high-single digit churn rate is somewhat elevated given their skew to large customers. It would be reasonable to wonder whether this reflects a shortcoming in the product. When you talk to the company about churn they will say that the primary reasons for losing a customer are IT executive turnover (i.e. losing their “Apptio champion”) and failure to become operational prior to renewal. They will tell you that churn of fully deployed customers is extremely rare. Initially, I balked at the notion that Apptio would require a “champion” within an organization to ensure retention. If a product has a strong ROI then it shouldn’t require someone to “champion” a continued relationship. However, after customer calls and a conversation with a former customer success manager, I have a little bit different perspective.

For starters, both customers and the former employee fully corroborated the claim that deployed customers seldom leave. The only exceptions seem to come as a result of M&A and the rarities of a company doing something like their Q4 customer loss where a European banking customer (we believe it was Barclays) re-organized their IT into a decentralized manner. However, successfully implementing Apptio requires more buy-in than most software packages. One customer that we spoke with emphasized that deploying Apptio was much more about achieving a culture of accountability than anything technical.

In order to derive value from Apptio, both IT and finance executives have to make a commitment to ensuring that the data feeding into Apptio is accurate and then they have to make driving efficiencies a priority. Many customers have commented that they initially under allocated resources to implementing Apptio. This of course can be difficult in a world where growth projects and major conversions are all competing for mindshare.

From what we can ascertain, the vast majority of churn occurs within the first six months of a customer relationship, including customer losses that are attributed to IT management turnover. Although this leads us to conclude that the current revenue generation is more valuable than a typical high-single digit churn business, challenges with new customers makes efficient sales and marketing spend much harder. This challenge is somewhat amplified when you consider that Apptio is in the process of moving down market.

Growth

Apptio’s 2017 guidance calls for a recurring revenue growth rate near 15%. Management is very dissatisfied with this rate of growth and they will tell you there is no reason that the business shouldn’t grow at a +20% clip. When you add up new logo wins (low-double digits to mid-teens), additional sell-through to existing customers (high-single digit contribution), increasing IT spend (mid-single digits) and subtract churn (mid- to high-single digits) it’s really not hard to pencil out a +20% growth rate. Furthermore, as the smaller, but faster growing (+30% rate), enterprise segment constitutes a larger percent of the overall business it will outweigh the drag from the slower growing, but larger, strategic segment. Anecdotally, management has said that in a few years they expect to sustain 20% revenue growth based solely on growth from enterprise customers.

Although I am confident that the TAM is large enough to support +20% growth, Apptio has struggled to achieve an efficient customer acquisition cost (CAC) ratio (defined here as sales and marketing divided by new sales). In 2014, a year in which Apptio grew subscription revenue 45%, their CAC ratio hovered around 1.4x (assuming an 8% churn rate), which is in line with “best in class” SaaS companies. However, in 2015 and 2016 the CAC ratio averaged nearly 2x. In 2017 it could jump over 2.5x as we annualize the churned customer and weak Q4 2016. Apptio now ranks in the bottom quartile of Goldman Sachs’ software coverage for their lifetime value to acquisition cost ratio. While this certainly warrants a discount to peers, I expect that the CAC ratio will improve to something in the 1.8x range as we annualize out the churned customer and as sales accelerate in long-cycle markets, such as government (getting FedRAMP will help http://www.prnewswire.com/news-releases/apptio-selected-as-one-of-seven-cloud-service-providers-for-fedramp-connect-program-300459299.html). I think improvement here is a key to revaluation.

Financials, Forecasting and Valuation

Valuing a growing software business is difficult, especially when you care about esoteric value investor things like “cash flow.” For those of you who are new to analyzing SaaS businesses and would like to better understand how to be a value investor in software, I’d recommend checking out this piece titled “How to Be a Value Investor in Software” (http://latticework.com/how-to-be-a-value-investor-in-software/). In order to be deemed a healthy SaaS company, you need to be able to demonstrate:

-          +70% gross margins on your recurring revenue

-          at least 90% customer retention

-          a customer lifetime value (gross margin / churn rate) to CAC ratio of at least 5x

-          and finally, some credible path to positive free cash flow

Apptio certainly meets these thresholds, and their 80% gross margin is notably strong given their size, but most lists will currently rank Apptio in the middle of the pack for retention and in the lower quartile for sales and marketing spend efficiency. However, even with its currently depressed retention and efficiency metrics the stock is appreciably cheaper than peers.

The graphic below highlights that APTI is the fourth cheapest software company out of the fifty that RBC covers.

And this graphic, which plots each company based on its valuation and 2018 growth rate, perhaps gives some support for the notion that upon resuming 20% growth that Apptio should receive a 5x revenue multiple.

Finally, Credit Suisse has done some work correlating valuation to CLTV/CAC ratio. Based on my estimates of returning to 20% growth and reducing churn to 7%, by the end of 2018 we would expect a 4.25x multiple on recurring revenue of $215MM in recurring revenue (~$26 share price).

Beyond 2017, we are looking for improvement on the retention rate and sales and marketing efficiency. The following table highlights historical figures, as well as my estimates for 2017 through 2020.

A few notes on this table above. I focus on revenue growth, CAC ratios and CLTV because I think these measures matter the most for rerating the stock.

Revenue: My 2017 revenue estimate is based on their revenue guide of $178-181MM and 83% coming from subscription. As discussed previously, I believe the business can achieve 20% growth once the faster growing enterprise business accounts for a greater percentage of the overall business and the churn rate improves.

Churn: Like many software companies, Apptio reports retention net of additional sales to existing customers, so we don’t have a precise read on churn.  Apptio’s net revenue retention hovered around 100% for 2014 and 2015, but dipped to 98% in 2016 on account of the European bank customer that churned out. The sellside seems to have hovered around a 92% retention rate, which seems reasonable. I think that retention will improve as Apptio decreases implementation time.

Gross Margin: For gross margins I am assuming the company can continue to hit an 88% contribution margin from new revenue.

Sales and Marketing: I’ve taken JP Morgan’s 2017 estimate for sales and marketing. My hope is that the evangelization process gains momentum and that Apptio can drive its CAC ratio under 1.8x in 2019.

R&D: I assume that R&D spend grows at half the rate of subscription revenue as the business scales. In 2016 R&D grew at 14.7%, or just under half the subscription revenue growth rate.

G&A: Over the past three years G&A has grown almost in line with subscription revenue growth. I assume that Apptio starts to see some leverage here in 2018 and significant leverage through 2020.

Summary of Risks

Although it is really not a frequent topic of discussion amongst customers, I think that competition from ServiceNow is the biggest long-term risk. Though I don’t fully understand the magic, we have heard time and time again that ServiceNow is on a warpath to dominate virtually every aspect of how a modern business operates. While ServiceNow is likely to be successful in many areas, I don’t think it is reasonable to assume that they will “go undefeated” across the spectrum of their multi-billion dollar TAM primary areas of focus including HR, vendor management, customer service and IT security and then also take the TBM market from Apptio, where Apptio is solely focused and ServiceNow doesn’t even have the time of day to mention during their almost five hour Analyst Day presentation. (was that really a 77 word sentence?) Nonetheless, I do think that ServiceNow will give Apptio shareholders some heartburn and I think it is important to stay on top of their competitive offerings.

Outside of competition, I think that striking the right go to market strategy for enterprise customers is critically important. The company has only recently divided up the sales effort between strategic and enterprise customers, so it is difficult to tease out efficiency metrics. Nonetheless, the next 300 customers are going to look a lot different from the first 300 and selling into them will require a more “hands off” approach.

Disclosures / Disclaimers

This is not an offer to buy or sell a security. The ideas expressed in this posting are the views and opinions of the author of this posting (Author).  Author has no obligation to update any of the information contained herein and has no obligation to update the posting to reflect any changes in the Author’s opinion on any of the companies or topics contained herein. Do not rely upon the information contained in this posting for making investment decisions; prepare your own analysis or contact your financial advisor. While the Author has tried to present facts it believes are accurate, the Author makes no representation as to the accuracy or completeness of any information contained in this note.  Past performance is not necessarily indicative of future results, and there can be no assurance that targeted or projected returns will be achieved.

Catalyst

get FedRamp and win government customers

announce customer wins for their cloud service, which demonstrates that Apptio manages ServiceNow cost and the discount attributable to competition lessens

Apptio could get acquired