Description

I spend most of my time looking for longs that can sustainably generate a high FCF yield over a substantial period of time vs. the current valuation. This is tricky in technology investing because technology stocks with low valuations and apparent high free cash flow yields typically get priced that way because of significant issues such as potential obsolescence, superior competition or unfavorable market trends. Very occasionally, I find the stock of a company that currently falls into the “value” bucket but has the potential to be re-rated as a “growth” company with a significantly higher valuation.

Obviously, the COVID-19 pandemic has been a boon for e-commerce, pulling years worth of e-commerce adoption into 2020. Many e-commerce stocks are up over 100% YTD and some historically marginal e-commerce companies like OSTK and PRTS have appreciated by more than 500%. While ChannelAdvisor (ticker: ECOM) stock has advanced nearly 80% YTD, I believe it represents a perhaps unique opportunity to buy a company benefitting from the surge in e-commerce that also sports solid operating margins and unit economics with plenty of valuation headroom. Along with the surge in e-commerce adoption, various changes in the e-commerce landscape such as the increasing importance of non-Amazon marketplaces and brands’ direct-to-consumer strategies will provide a sustainable tailwind for ECOM. While Q2 was in many ways a breakout quarter for ChannelAdvisor, the company was cagey on forward prospects and the potential for accelerated revenue growth has not yet been incorporated into Wall St. forecasts. Thus consensus estimates for Q3 2020 and all of 2021 may be too low, perhaps substantially. If ECOM can capitalize on the current environment, I believe the company has the potential to go from a “value” to “growth” stock and achieve a different, much higher class of valuation.

Business Overview

ChannelAdvisor Corp’s main software-as-a-service product allows retailers and increasingly brands to sell online through multiple channels, hence its name. ECOM software functions as an adjunct to the core e-commerce and web front-end software that powers an online store, essentially helping the seller to offer its goods in various Internet marketplaces. Sellers use ChannelAdvisor to offer goods via the third party marketplaces at e-commerce sites that we all know such as Amazon, Wal-Mart, Target, eBay and Etsy as well as the dozens of others which make up an increasing percentage of e-commerce sales.

While selling online through a branded storefront is relatively straightforward, selling in multiple marketplaces presents numerous integration and coordination challenges that are poorly addressed by core e-commerce offerings. ECOM’s suite of SAAS products allows customers to manage product listings, inventory availability, pricing optimization, orders and fulfillment and other critical functions across multiple channels. Channel Advisor also offers digital marketing solutions that aid in directing potential buyers to authorized product resellers. My research indicates that ChannelAdvisor is the leader in this particular e-commerce software niche, and typically replaces manual processes or internal IT development and technical integration. ECOM has been named the #1 channel management vendor to the Internet Retailer 1000 annually since 2013.

ECOM generates revenue from subscriptions to its software modules over contract terms which typically cover one year. The company prices subscriptions based on expected gross merchandise value (“GMV”) with customers paying overages if sales exceed contract maximums. In a typical quarter the revenue splits 80% fixed fees and 20% variable overages although during the Q4 holiday shopping season variable revenue ticks up to 24-25% (and indeed it increased to 37% in Q2 2020). The average ChannelAdvisor client spends around $50K per year and customer life averages 5 years. The company generates solid long-term-value to customer-acquisition cost metrics for a SAAS company of around 4-5x.

Current Business Trends

In a market where the average SAAS company trades at over 10x EV/revenue and companies growing over 25% can trade at 15x, 20x and even above 30x sales, ECOM shares trade at only 2.8x estimated 2020 sales today. In a picked-over tech market, a stock will only trade at that valuation because of an issue. ChannelAdvisor’s shares trade cheaply because of recent sub-par growth, as revenue shrank by 1% in 2019 and was originally expected to be about flat for 2020. ECOM’s flat revenue was caused by changes in its underlying customer base, which it divides into retailers which made up 62% of sales in Q2 2020 and brands/other accounting for the remainder. Retailers are either bricks-and-mortar retail companies expanding their online sales channels or independent e-commerce merchants acquiring inventory and selling through various online marketplaces. Within the customer base, ChannelAdvisor experienced higher churn among smaller independent e-commerce vendors along with some traditional retailer clients going out of business. Many smaller e-commerce sellers which depended on eBay as a channel were downgrading service or going out of business due to stagnant GMV at eBay. During 2019 revenue from retailers declined 6.3% while brands/other revenue grew 11%.

ECOM’s Q1 2020 results which were reported in the first week of May showed small steps in the right direction. Revenue grew 1.5% from the year prior (with retailer revenue continuing to shrink at around 6% and brands/other accelerating to 17% growth), while Wall St. had expected slight shrinkage. The revenue beat fell to the bottom line with better EBITDA and robust free cash flow. The March quarter closed just two weeks after much of the country went into COVID lockdown, which caused some disruption in signing new software subscriptions at the end of the quarter. More importantly, the company indicated that April GMV processed was a company record and new software subscriptions closed in April at twice what they initially forecasted. The company had originally guided to at least $130M of revenue in 2020, but pulled this guidance in its Q1 release. This was the rare case of a company affected by COVID pulling guidance not because its current guidance was too high, but because its guidance was too low and it was just starting to see positive impacts on its business. 

ChannelAdvisor validated this idea when it positively pre-announced Q2 revenue and a tuck-in acquisition on July 24th, 2020 and in its full Q2 results a couple of weeks later. Revenue growth in Q2 accelerated to 17% Y/Y and adjusted EBITDA margin tripled on a Y/Y basis to 31%. However, the stock actually gave back most of the gains it made on the pre-announcement because the results did not appear as robust under the covers and the company gave surprisingly conservative guidance. Revenue of $37.4M consisted of $25.7M of fixed subscription revenue which was only flat Y/Y while variable volume-based revenue at $11.7M accounted for all of the growth, up 88% Y/Y. The company’s guidance called for a floor of $34M in revenue and adjusted EBITDA of only $6.5M, both down sequentially and a deceleration to only 7.3% Y/Y growth. Analysts dutifully set Q3 consensus at $34M.

I believe Wall St. reacted too negatively to the results and guidance, and that ECOM will once again substantially exceed revenue and EBITDA estimates in Q3. The end of Q1 and beginning of Q2 contained the worst of the pandemic disruptions, so the company likely had difficulty closing new license transactions that need to go into bookings and implementation before conversion into revenue. ECOM’s licenses are based on GMV volume tiers, and many customers probably waited to see if the new higher e-commerce volumes would be sustained before committing to greater spend. The company also had some offline retailers who used ECOM for online marketplaces experiencing distress, and the company offered a payment relief program to some customers. The guidance basically allowed for the possibility that subscription revenue would only grow modestly sequentially in Q3 while the variable revenue might be down substantially. I am more optimistic on both fronts.

Readers have doubtless seen numerous headlines and research pieces about this, but the COVID-19 pandemic massively accelerated the adoption of e-commerce. E-commerce had been steadily growing as a percentage of retail spend every year since the late 1990s, but estimates we have seen indicate that COVID-19 has compressed several years of adoption into 2020. In July, FedEx estimated that e-commerce as a percentage of U.S. retail increased from 16% in calendar 2019 to 27% in April 2020. As part of my research process, I monitor credit card spending at various public companies through commercial data providers, and the acceleration in growth among the e-commerce pure plays has been nothing short of stunning with many of them continuing to grow at triple digit rates Y/Y. Reported Q3 results by e-commerce companies have validated this continued strength.

The same trends will drive activity among ECOM’s customer base. I believe these are boom times at e-commerce sellers, which should improve ECOM’s customer retention, lead clients to increase their GMV tiers and make selling to new clients easier as an increase in volume necessitates the use of tools that automate the processes around selling through multiple marketplaces. Among the brick-and-mortar clients, e-commerce has been a lifeline with shuttered stores and those clients will accelerate their use of ChannelAdvisor. In terms of brands, most have seen their bricks-and-mortar wholesale channels falling apart, so they are turning to online marketplace selling as part of more and more commerce going directly from brands to end customers. The success of Shopify exemplifies how virtually all brands will need DTC e-commerce strategy, and selling in multiple marketplaces will be an integral part. All of this should lead to an acceleration in growth in ECOM’s software subscriptions. Holiday levels of e-commerce occurring in the middle of the year should also drive higher variable usage revenue until customers upgrade to higher GMV tiers, but this short-term revenue upside is almost beside the point.

Forward Prospects and Potential Re-Valuation

My basic thesis is that the COVID-19 pandemic and attendant acceleration of e-commerce volumes will mark an inflection point for ChannelAdvisor, which we started to see in Q2 but will continue on a multi-quarter basis. Even before this, the company was making moves to re-accelerate revenue growth after a multi-year period of revenue stagnation that had seen the company pull back on investments to become sustainably FCF positive. Prior to the pandemic the company had begun re-growing its salesforce, and as of Q2 had increased its sales capacity by 25%. These reps have likely had the good fortune of becoming productive right as demand for e-commerce tools was accelerating. One of the company’s previous issues was that it experienced high churn among smaller e-commerce sellers such that a good portion of its customer base didn’t last long enough to product good LTV/CAC metrics, but ChannelAdvisor has addressed this by rolling out a self-service tool in partnership with Stamps.com’s ShipStation. The company also bought e-commerce analytics company BlueBoard, adding a new subscription revenue SKU faster than it could have developed the product internally.

Due to the company’s re-focus on growth and 2020’s e-commerce trends, I believe that ChannelAdvisor could demonstrate the revenue acceleration a stock needs to re-rate from a “value” valuation to a “growth” valuation. Since ECOM sells software subscriptions it will not benefit as directly from the huge increase in e-commerce GMV, but I think that customer retention, up-sells and new customer adds will improve across its customer categories. It is difficult to model exactly how much revenue will accelerate for the whole year, and how much of the revenue acceleration will come from overages due to higher GMV vs. software subscriptions, but I believe that ECOM could show sustainable double digit subscription growth by the end of 2020 and even grow 15%+ in 2021. I tend to believe consumers will not shift rapidly back to buying in-store and e-commerce penetration will continue to grow, albeit at a slower pace than in 2020. I do not have a good independent TAM estimate for ChannelAdvisor’s particular e-commerce software niche, but the company believes its future revenue growth will be driven by consumer brands where it current has only 2,600 customers out of a universe of 20,000 to 25,000 targets. 

Software investors colloquially use the “Rule of 40” to determine what a successful SAAS company looks like. Under this framework, analysts add the revenue growth % to non-GAAP operating margin % with the ideal being 40 or above (i.e. growth of 40% and zero margin is healthy, as is 25% growth and 15% margin). Currently SAAS companies measuring a total of 40 or above on this metric trade at 15x revenue and up. ECOM already has a healthy non-GAAP operating margin of 11% in 2019, nearly 16% in Q1 2020 and roughly 27% in Q2 2020. If the company can achieve 14% growth in 2021 and maintain a 24% operating margin (vs. 27% in Q2) as some of the revenue growth is re-invested in sales & marketing and research & development to sustain continued growth, it will achieve 38 on this metric as compared to only 10 in 2019. Note that with 17% revenue growth and 27% operating margin ECOM technically achieved over 40 in Q2 of 2020, but I am not counting on them remaining at this rarified level. Companies scoring near the “Rule of 40” tend to trade at high single digit to low double digit revenue multiples as compared to ECOM’s current 2.8x. Note that if the company can accelerate to 14% growth in 2021, as I believe it can, a 6x revenue multiple would be around $35 or up over 100% from here and remain at “only” 20.5x trailing EBITDA and 30x non-GAAP EPS. ECOM would also make an accretive bolt-on acquisition for virtually any publicly traded e-commerce software provider (i.e. BIGC, STMP or SHOP) so there are multiple ways to get to 50% to 100% upside from current prices.

Disclosure: The fund I work for is long shares of ECOM and may buy or sell at any time without notice.

Catalyst

• Q3 revenue and earnings above analyst consensus, raised estimates for Q4 and 2021
• Re-acceleration of recurring subscription revenue
• Re-rating in line with other SAAS companies
• Potential takeout