Description

CERTAIN STATEMENTS CONTAINED HEREIN REFLECT THE OPINION OF THE AUTHOR AS OF THE DATE WRITTEN. NO INVESTMENT DECISIONS SHOULD BE BASED IN ANY MANNER ON THE INFORMATION AND OPINIONS SET FORTH IN THIS REPORT.  YOU SHOULD VERIFY ALL CLAIMS, DO YOUR OWN DUE DILIGENCE AND/OR SEEK ADVICE FROM YOUR OWN PROFESSIONAL ADVISOR(S) AND CONSIDER THE INVESTMENT OBJECTIVES AND RISKS AND YOUR OWN NEEDS AND GOALS BEFORE INVESTING IN ANY SECURITIES MENTIONED. PLEASE SEE ADDITIONAL IMPORTANT DISCLAIMERS AT THE END OF THIS ANALYSIS.

Investment Pitch

Avalara (NASDAQ: AVLR) provides a compelling way to play the growing global e-commerce market. In our view, the company provides the best sales tax compliance SaaS (software as a service) solutions. In our opinion, the value of its services far exceeds the cost and positions it well to raise pricing in excess of inflation. As AVLR grows its business at a fast clip, the high incremental margin on revenue growth is expected to help fuel earnings growth. While the valuation may not appear compelling on current financials, we believe if one takes a long-term view within the context of the growing global market opportunity, AVLR is attractive at current prices. 

Overview

Avalara provides a suite of indirect tax compliance solutions that help businesses address the complex and often changing tax and reporting regulations. Indirect taxes include sales and use, VAT, excise, and cross-border taxes. Avalara seeks to solve the sales tax pain point by determining the correct tax on transactions in real time and filing tax returns with states. Tax compliance is a horizontal problem with nascent competition and secular growth because of e-commerce and regulatory tailwinds. As the default tax engine for the largest e-commerce platforms, marketplaces, and enterprise resource planning (ERP) systems, Avalara benefits from broad distribution and a winner-take-all dynamic. The largest risks the company faces are the high level of regulatory uncertainty with meaningful laws being passed as recently as this month and the risk of backend commoditization as large platforms increasingly assume the burden of compliance for merchants. We believe Avalara is well positioned to sustain mid-20% revenue growth and expand margins for many years to come.

As evidenced by the strong 2Q 2020 results, COVID is a meaningful accelerator to Avalara’s value proposition. The four tailwinds management discussed as a result of the pandemic were acceleration in e-commerce adoption as physical retail has been forced to shut down, acceleration in cloud adoption as work from home forces large enterprises to modernize their ERP systems, emphasis on cost control as a result of the recession which favors low-cost software solutions over manual alternatives, and a growing regulatory environment as states increase enforcement to combat their fiscal challenges. In the second quarter of 2020, Avalara reported 28% revenue growth, a core customer count of 13,560 (+28% Y/Y; +590 customers in the quarter), a net revenue retention rate of 107%, and a churn rate “meaningfully lower” than the 4% rate reported in the prior quarter.

Industry Background 

Since the introduction of the sales tax during the Great Depression, sales taxes have come to represent a significant portion of many states’ budgets. As shown below, sales taxes represent ~30% of states’ tax revenues, with some states (e.g., Florida) relying on sales taxes for over 65% of revenue. Across the 45 states with a sales tax, sales tax revenue made up 34% of total state tax revenue in 2016, slightly higher than 32% in 1970. 

Sales tax revenues are determined by the tax rate multiplied by the taxable base. As shown below, the taxable base has been in secular decline for decades as consumers have shifted their spending towards services, which are generally untaxed. As a result, states have perpetually raised the tax rate to offset this decline and maintain constant sales tax revenues.

Given the importance of sales taxes to state budgets, states are determined to prevent any form of “slippage”. One example of this has historically been the smuggling of high tax goods (e.g., cigarettes) across state borders for personal consumption or sale on the black market. According to the Tax Foundation, an estimated 57% of cigarettes consumed in New York in 2015 were smuggled in from outside the state.[i]

Over the last two decades, a growing source of slippage has come from e-commerce. According to the Government Accountability Office, states lost an estimated $13 billion in 2017 from e-commerce sales tax slippage – 3% of total sales tax revenue.[ii] In 1992, the Supreme Court set the precedent for out-of-state sales when it ruled in Quill Corp. v. North Dakota that Quill Corporation, a mail-order catalog company, would be required to collect taxes only in states in which it had a physical presence. The Court did not consider the existence of customers alone (i.e., economic presence) as merit to collect taxes partially because it felt the 6,000 separate sales tax jurisdictions in the U.S. would “unduly burden interstate commerce”.[iii]

However, the Court overturned this precedent in the 2018 decision which ruled that retailers had an obligation to collect sales tax if they have over 200 transactions in the state or over $100,000 in sales, regardless of whether they maintain a physical presence.[iv]

During the case proceedings, Etsy submitted a compelling argument explaining the crushing complexity that e-commerce businesses would face if required to calculate, collect, and remit taxes to each state – outlining the pain point Avalara looks to solve.[v] To summarize:

1.     There are over 11,000 tax jurisdictions in America and these various counties, cities, and towns retain autonomy over their tax rates, the definition of their tax bases, and tax exemptions. To quote Etsy, “For microbusinesses to master the sales tax laws of all jurisdictions from which a customer might place an order over the internet, in order to ensure compliance with the sales tax collection requirements of all those jurisdictions, would be impossible”. 

2.     Sales taxes differ by product. In Texas, cowboy boots are exempt from sales tax while hiking boots are not. In Illinois, candy is subject to an additional 5% tax, but candy including flour is not (M&Ms are taxed, but KitKats are not). The classification of products is an additional layer of complexity sellers face. To quote Etsy, “The administrative burden of addressing interjurisdictional sales tax compliance obligations would be devastating to the typical Etsy seller. Sales tax compliance requires more than just the automated collection or remittance of taxes. For a seller, the most arduous part of the process is often placing an item in the correct tax categories for each jurisdiction in which the product may be taxed. Those jurisdictions, in turn, may not use the same classifications.” 

3.     Tax laws are subject to change. First, many states utilize annual tax holidays to incentive sales, such as no sales tax on school supplies during the back to school season. Second, an average of 25% of tax laws change in any given year, including tax rates, tax jurisdictions, and product classifications.   

Recognizing this complexity, states have taken steps to improve the practicality of compliance: 

1.     Streamlined Sales Tax Project (SST). The SST is a cooperative agreement between 24 states which was created in 2000 to simplify sales tax requirements among member states. Member states have uniformity in tax base definitions (not tax rates), offer amnesty for prior uncollected taxes, and offer free sales tax software from one of six providers (including Avalara – although not a material source of revenue). 

Although well intentioned, the program is flawed. First, there is still a significant lack of uniformity among member states. Second, the SST lacks buy-in from most of the country. The five most populated states (California, Texas, Florida, New York, and Pennsylvania) are not members and have little incentive to sacrifice their autonomy. Lastly, the SST was created to encourage voluntary tax compliance at a time when there was no recourse for avoiding taxes; however, the Wayfair ruling now gives states the legal precedent to enforce their state laws. 

2.     Marketplace Facilitator Laws. Following the Wayfair decision, many states passed laws to shift the burden of tax collection and remittance onto marketplaces rather than third-party sellers - simplifying enforcement. While the definition of a “marketplace” is broad, Amazon, Walmart, eBay, and Etsy are now required to collect and remit sales tax on behalf of their sellers. Currently, 44 states have adopted marketplace facilitator laws and most laws were passed in October 2019. However, several additional states passed laws recently, including Louisiana and Mississippi. 

While a net negative for Avalara, the tax environment remains complex for sellers. First, most sellers are omnichannel and maintain their own online store, which still requires them to collect and remit taxes. According to Etsy, 58% of all Etsy sellers in the U.S. also sell their goods through other venues. Next, marketplaces cannot be reasonably expected to comply with this law as it currently stands given the breadth of products sold through their platforms. To quote Etsy, “Requiring a marketplace operator to master product information for millions of sellers, selling tens of millions of products, in order to ensure each seller’s compliance with thousands of jurisdictions’ tax codes, is entirely unrealistic.” Marketplaces are currently attempting to comply by broadly classifying products, building tax software in house (i.e. Amazon) or relying on Avalara for tax calculation (i.e. Etsy / Wayfair), and generally over collecting taxes to be safe. 

Business Description[vi]

Avalara was founded in 1999 and launched its flagship AvaTax product in 2004, currently the largest cloud-based tax determination solution. The company automates the process of identifying applicable local tax rates, determining product classifications, collecting taxes, preparing and filing returns, remitting taxes, and maintaining tax records. The company offers two integrated tools: 

1.     AvaTax (60% of Revenue) is a tax engine which delivers real-time sales tax determination directly into the buying experience. During the checkout process, AvaTax notes the seller and buyer addresses, determines the applicable tax jurisdictions, identifies the taxability of the product based on category, determines the tax rate, and checks for any tax holidays. AvaTax is competitively advantaged relative to competitors because of its: 

a.     Partner Integrations. AvaTax is integrated into over 700 partner workflows, including ERP systems (Netsuite and Workday), e-commerce vendors (Shopify and BigCommerce), and marketplaces (Poshmark, DoorDash). Further, roughly 80% of new customers come from partner referrals. In a typical sales process, an end customer adopts an ERP system, the ERP vendor directs the customer to Avalara for sales tax compliance, and the Avalara sales team closes the deal. In 2018, Avalara paid 8% of revenues to partners as commission. 

Currently, Avalara has 65,000 end customers and 12,710 “core customers” which it defines as customers with which the company has a direct billing relationship, and which contribute over $3,000 in revenue annually. Core customers exclude end-customers of marketplaces and e-commerce platforms which do not pay Avalara directly. In FY19, core customers accounted for 83% of total revenue. This represents both an opportunity and a threat to the company. On the one hand, Avalara has broad market reach and is well positioned to capture incremental customers who outgrow their marketplace / e-commerce platforms. On the other hand, Avalara currently captures very little revenue from these partners and is at risk of further losing negotiating leverage as marketplace facilitator laws aggregate tax compliance responsibilities onto a handful of large platforms.

b.     Cloud-based Architecture. Cloud architecture ensures that AvaTax is always current as new tax content is pushed out to all users instantly. This is especially valuable given the rate of change of tax laws (25% of laws change annually). 

c.     Large Content Portfolio. Avalara has built its content library through M&A and organic investment. The company maintains a database of product classification rules, tax holidays, jurisdiction boundaries, exemption conditions, and tax rates. Avalara employs an internal team of 150 specialists who maintain and add to the library. Further, the company has spent $200 million to acquire the following assets in sales tax and niche product categories (alcohol, fuel, and cross border taxes). 

On 10/5/20 Avalara paid $377M in cash for Transaction Tax Resources, which primarily serves enterprise businesses and their internal tax teams, offering U.S. sales and use tax rates, laws, software and customer support required for the biggest and most complex companies.[vii]

2.     Avalara Returns (40% of Revenue) collects tax data, prepares the necessary tax compliance forms, and automatically files returns in the various state and local jurisdictions. Returns represent another pain point for customers as each jurisdiction has its own set of processes and filing frequencies. For example, a business in Florida must file returns monthly if its tax liability exceeds $41.67/month. However, businesses in California must file monthly only if their liabilities exceed $100/month. California and Florida also have different due dates, different informational requirements, and different tax return forms.

The integration of AvaTax and Returns is another source of competitive differentiation. While other vendors also offer return filing, the ubiquity of AvaTax creates a seamless experience for customers. Avalara charges per filing and estimates a 70% attach rate to AvaTax. 8% of customers are Returns-only customers who use Avalara to file taxes, but use a competitor (or manually track) their sales taxes.  

Market Opportunity

Tax compliance is a horizontal problem for enterprises across industries, of all sizes, and in different geographies – suggesting a global market opportunity with multiple growth levers.

Top Down Analysis

Avalara’s addressable market is directly related to total transaction taxes collected globally. According to the Organization for Economic Co-operation and Development (OECD), in 2016 the U.S. collected $377 billion in state and local taxes and $445 billion in other transaction taxes including excise, customs and import duties, and taxes on specific services. 

In 2016, Avalara determined approximately $6 billion in tax, representing a penetration rate of less than 1% in the U.S. Assuming Avalara is able to capture 20% of the total transactions in the U.S., this would imply a total addressable market (TAM) of over $4 billion based on Avalara’s current implied take rate of 2.7% of each dollar of transaction tax collected. [BB10] 

Bottom Up Analysis 

Avalara primarily targets mid-market companies with 20 – 500 employees in retail, manufacturing, wholesale, and transportation industries. Based on the U.S. Census, there are ~180,000 companies in this segment. At the current average revenue per user (ARPU) of $28,000, this implies a core TAM of $5 billion. With 12,710 core customers, Avalara is currently 7% penetrated into the U.S. mid-market customer base. 

However, at the analyst day on 6/23/20, the company outlined plans to expand down-market, up-market, and internationally, which expands its current TAM to $8 billion (see page 102 of the analyst day presentation). While these are not meaningful portions of revenue today, they represent incremental opportunities for growth.

Competitive Environment

Avalara’s competitors differ significantly across enterprise, midmarket, and small business and Avalara has developed a compelling go-to-market strategy for each category. 

·      Enterprise. The enterprise is currently serviced by legacy on-premise software vendors such as Sovos (which controls over half of the Fortune 500), Vertex, CCH, and Thomson Reuters. These companies have a broad library of tax content and are tightly integrated into on-premise ERP systems. Recognizing the encroaching threat from Avalara, these companies have taken steps to build out a cloud-based product, including Sovos’ 2015 acquisition of next-generation provider Taxify. Sovos intended to leverage its expansive content library to improve Taxify’s incomplete offering and compete against Avalara in the midmarket. Sovos also planned to introduce Taxify’s cloud-based architecture in its existing enterprise product. However, Sovos has had little success in both of these areas as it lacked partner integrations in the midmarket and found the cost and complexity of moving on-prem software to cloud to be overbearing. 

While not a meaningful portion of revenue today, Avalara has introduced a compelling go-to-market strategy for moving upmarket. In the last few months, Avalara introduced a partnership with Workday and has a long-standing relationship with NetSuite. While enterprise customers are unlikely to rip and replace their incumbent tax vendor, Avalara is working to become the default option for companies transitioning their ERP systems to the cloud. 

The recent S1 filing by Vertex (VERX) increases our conviction that Avalara will have success moving upmarket over time. Before this IPO, it was difficult to gauge the competitiveness of enterprise incumbents (Vertex, Sovos, CCH) in responding to cloud-based disruptors. However, the S1 confirmed many of our prior beliefs: 

1.     Vertex was founded in the 1980s and its long-dated relationships have allowed it to capture most of the Fortune 500, including seven out of the top ten marketplaces in North America by revenue. Vertex services 56% of the Fortune 500, has 4,000 customers, and an ARPU of $70,000. 

2.     Vertex sales are closely tied to ERP upgrades. In this case study, Starbucks outlined its rationale for selecting Vertex as its primary tax calculation engine in 2008.[viii] As ERP systems move to the cloud, we believe Avalara is the natural beneficiary given its status as the preferred partner of Workday and other cloud ERP systems. 

a.     Challenge: To deliver a cup of coffee to a customer in a retail store, Starbucks coffee beans must be sourced, roasted, distributed, and sold. Starbucks also purchases materials, cups, office supplies, and more from a global network of suppliers. This complexity makes the accurate calculation of tax at every step a significant challenge. 

Prior to the Vertex implementation, Starbucks employed an internal tax team which manually calculated inventory use tax using Excel spreadsheets. According to Ryan Meas, the head of Sales & Use Tax at Starbucks, “One of the biggest transformational changes with this project is the use of tax automation on all purchases and inventory transactions. Before this project, all purchases were handled by a non-tax professional, and the inventory use tax accrual process was done manually using spreadsheets … Now we spend time analyzing transactional data instead of performing manual tax calculations, which allows us to be more proactive than reactive in addressing tax issues.” 

b.     ERP Integration: The decision to adopt Vertex as a tax solution was part of a broader review of the company’s business systems. To address the increasing scale and complexity of its global operations, Starbucks decided to upgrade its legacy ERP system to Oracle. According to Sheryl Bennett-Holland, a System Analyst Lead at Starbucks, “Integrating Vertex into the Oracle ERP upgrade enabled us to get to transactional level consumer use and inventory tax evaluation, which had previously been impossible with the older systems.” 

c.     International Expansion: After a successful experience in the U.S., Starbucks expanded the Vertex tax solution to EMEA and the rest of North America. “This standardization will simplify support for the company’s IT organization, which will only need to support one version of the solution, and apply uniform treatments across all regions when future changes are required. In addition to keeping up with releases and fixes, the company plans to take advantage of Vertex platform integrations, such as the exemption certificate manager and reporting analytics.”

3.     The majority of Vertex’s revenue is currently on-prem and the transition to cloud will harm the P&L and introduce a switching opportunity for customers. In 2018, 87.1% of Vertex’s subscription revenue was generated from on-premise deployments. In 2019, on-premise deployment contributed 80.9% of subscription revenue. As Vertex aggressively works to “lift and shift” customers, it is experiencing gross margin degradation and customer churn. In 1Q20, subscription gross margin declined to 67% as compared to 71% in 1Q19 due to the increased costs associated with maintaining multiple deployment options. Further, Vertex, and other legacy vendors, are experiencing customer churn catalyzed by ERP upgrades. For example, Adidas switched to Avalara.

4.     The restrictions associated with on-premise software make legacy tax software an unsatisfactory offering for e-commerce. Vertex is currently the primary tax solution for online marketplaces, including Walmart and eBay. However, the complexities associated with e-commerce (buyer location, product classification, changing tax laws) make cloud-based offerings better suited to cater to the needs of the major marketplaces.  Looking at eBay buyer / seller forums shows the customer dissatisfaction with Vertex. During the last analyst day, Avalara outlined a go-to-market strategy targeting the major marketplaces. Avalara already supports 136 out of the largest 350 marketplaces, but the company is working on transitioning the top 50 marketplaces to its platform.   

· Midmarket. The midmarket is largely un-serviced today as most customers are either non-compliant or struggle to manually track sales tax information. This positioning creates a winner-take-all dynamic as partners are incentivized to recommend the largest player, which further solidifies Avalara’s lead.    

Avalara reports a 97% win rate in head to head deals against competitors and a 96% customer renewal rate last quarter. Further, in the recent investor day[KR15] , Avalara disclosed its time to close for net new customer wins in 2020. As shown below, after first contact from the Avalara sales team, 50% of deals close in the next 3 months. However, 30% take over one year to close as mid-market customers defer to the status quo until the complexity becomes overwhelming. This suggests that Avalara’s greatest competition is inaction. 

Source: Avalara Investor Day 2020 presentation, Avalara Virtual Analyst Day, June 23, 2020. 

Legend: Yellow bars: No Previous Closed Lost Opp(s); Blue bars: Previous Closed Lost Opp(s); Orange Line: Running % of Total

·      Small Business. The competitive environment in small business is much fiercer as cloud-based startups like TaxJar, Taxify, TaxCloud, Exactor and others compete for market share. These companies have also been M&A targets as larger companies look to build out their sales tax offerings (Sovos acquired Taxify in 2015; Intuit acquired Exactor in 2017 and integrated it into QuickBooks for simple sales tax calculation). Although these vendors lack deep content libraries and some do not process tax returns, they are inexpensive and often satisfactory for the needs of a small marketplace seller. 

However, after the passing of the marketplace facilitator laws this year, we believe these companies will struggle to compete. As the compliance burden is shifted from the small business to the marketplace, the use case for TaxJar largely disappears. Marketplaces are likely to move their tax compliance in house (as the largest marketplaces have done) or rely on Avalara for backend tax calculation. Avalara has moved aggressively to capture these marketplaces and now handles backend tax compliance for 136 out of the largest 350 marketplaces. Within e-commerce, Avalara has introduced a new partner model named “Avalara Included” which embeds AvaTax as the default tax calculation engine for Shopify and BigCommerce. This serves as a win-win-win for all parties as customers get low cost tax calculation, Shopify/BigCommerce get a differentiated service against competitors, and Avalara gets a marketing database to target and upsell to.   

Important Disclaimers

The provision of this report does not constitute (and should not be construed as) a recommendation, financial promotion, investment advice, encouragement or solicitation to buy, sell, or hold the security of the subject issuer (the “Security”), or any other securities, discussed herein. This report is for informational purposes only. All of the information contained herein is based on publicly available information with respect to the security and the author’s analysis of such information. Past performance is no guarantee, nor is it indicative, of future results.

Certain statements reflect the opinions of the author as of the date written, may be forward-looking and/or based on current expectations, projections, and/or information currently available. The author cannot assure future results and disclaims any obligation to update or alter any statistical data and/or references thereto, as well as any forward-looking statements, whether as a result of new information, future events, or otherwise. Such statements/information may not be accurate over the long-term. The views are those of the author acting in his individual capacity and not as a representative of the firm.  The author’s opinions on this Security may change at any time in the future and the author will not, and disclaims any obligation to, update this report to reflect any change in opinion. The author further disclaims any obligation to respond to any comments or questions posted regarding the Security discussed herin.

NO INVESTMENT DECISIONS SHOULD BE BASED IN ANY MANNER ON THE INFORMATION AND OPINIONS SET FORTH IN THIS REPORT.  YOU SHOULD VERIFY ALL CLAIMS, DO YOUR OWN DUE DILIGENCE AND/OR SEEK ADVICE FROM YOUR OWN PROFESSIONAL ADVISOR(S) AND CONSIDER THE INVESTMENT OBJECTIVES AND RISKS AND YOUR OWN NEEDS AND GOALS BEFORE INVESTING IN ANY SECURITIES MENTIONED. AN INVESTMENT IN THE SECURITY DOES NOT GUARANTEE A POSITIVE RETURN AS STOCKS ARE SUBJECT TO MARKET RISKS, INCLUDING THE POTENTIAL LOSS OF PRINCIPAL.

The author or his or her respective employer or employer’s clients, affiliates, officers, managers and directors, may or may not hold positions in the Security noted in this article. These parties may trade at any time, without notification to this community, and will not disclose this information to this community. The author and his employer disclaims any liability for investment losses that you may incur under any circumstances.

[i] https://taxfoundation.org/cigarette-tax-cigarette-smuggling-2015/

[ii] https://www.gao.gov/assets/690/688439.pdf

[iii] https://www.law.cornell.edu/supct/html/91-0194.ZO.html#FNSRC6

[iv] https://www.law.cornell.edu/supremecourt/text/17-494

[v]https://www.supremecourt.gov/DocketPDF/17/17-494/42288/20180404124615050_17494%20bsac%20Etsy%20Inc.pdf

[vi]https://www.sec.gov/ix?doc=/Archives/edgar/data/1348036/000156459020007791/avlr-10k_20191231.htm

[vii]https://investor.avalara.com/press-releases/press-releases/press-release-details/2020/Avalara-Acquires-Transaction-Tax-Resources-Inc.-Enhancing-Its-Enterprise-Capabilities-and-Creating-the-Leading-Content-Database-for-Tax/default.aspx

[viii]https://cdn.featuredcustomers.com/CustomerCaseStudy.document/vertex-inc_starbucks_73380.pdf

Catalyst

Global e-commerce continues to grow at robust rates for many years to come. States in the U.S. increasingly crack down on non-compliant companies as it relates to proper collection of sales tax, which accelerates companies' adoption of AVLR's services.