(Several notes: Shares outstanding include options; EPS is cash EPS, but not adding back stock compensation)
RealPage (RP) is a cloud computing company that offers a suite of applications for rental landlords and management companies. I spoke with two CIO/Director of IT at two medium to large regional operators who use RP software. It is solid software and they very much appreciate RP bringing the software to the cloud. I could draw out nothing more than the usual complaints you hear about any enterprise software company. This is not a "bad" company by any stretch.
However, I believe the timing and valuation are right to short RP now. The highlights:
- The stock has rebounded strongly with the market (and momentum stocks) and again trades at a lofty valuation.
- The 30+% headline growth numbers are gone starting in Q3 as the last major acquisition was made in August 2011.
- The unit growth numbers are decelerating sequentially, and in 2012, there has been even less customer growth as unit growth has come from existing customers.
- There will be some operating leverage, but it is also decelerating.
- RP is different from other cloud business application companies because it serves a narrow vertical rather than offering a horizontal application (e.g., SuccessFactors) that can become a strategic piece in the battles between SAP, CRM, etc. As well, this focus on a particular vertical limits its scalability.
- The company has a moat in that switching costs are significant. However, this will certainly not be a winner-take-all market and there will be lots of vendors. As well, the application pieces are not essentially integrated and a single customer can use pieces from different vendors or no vendor at all.
RP was written up as a short two years ago by Heffer. The thesis has not changed considerably, but I do believe that the timing is right to re-initiate a short in here.
First, let me recap the back-of-envelope bull case:
- There are 40mm residential rental units in the U.S.
- The average rent is $1,000 per month --> $500bn of rent paid annually.
- The company estimates that the market size for its applications is $9bn annually, or about $225 per unit annually and about 2% of the total rent.
- Let's say they get a 33% market share ($3bn in revenue)
- 30% EBITDA margin --> $900mm (company says this is long-term goal)
- 25% EBIT margin --> $750mm
- FCF --> $500mm (with inflation-like growth)
So, put a 12x multiple on it and get $6bn valuation (or about 3x current value). This is the upside that the management team promotes. Obviously, it is not going to happen overnight, and you can build your cash flow model with your growth assumptions, but even if they achieve this almost-perfection scenario, the stock is not terribly cheap.
I think there are several major flaws in this rosy scenario.
(1) Number of units eligible
- The majority of the rental units have zero need for any specialized business software. They are owned by individuals who own one or two properties. In a U.S. census study done in the mid-90s, almost half of all rental units are owned by individuals that own exactly one property. The RP sales organization has its smallest group as operators with fewer than 5,000 units. If you are selling to operators with 3,000 units, are you going to pursue the operator with 30 units? Probably not. I should note that they do earn some revenue on these small owners if the small owners use a management company to manage the property. However, from what I could find via research and asking RP, this is not a huge number.
I spoke to a small operator (300 units) with two properties. He uses Quickbooks and a work order tracking system to run his properties. He was not familiar with RP but when I described its functions, he said that would not interest him. He said that would only appeal to large operators that had lots of turnover.
- On the last call, the CFO basically admitted as much. The CSFB analyst asked him about sequentially declining unit growth. In Q1 and Q2, unit growth is only growing at 6% annually. The CFO answered very defensively and said that they did not need to add new units. They only needed to sell the full product suite to their existing 7.5mm units and they will have $2.5bn of recurring revenue, or $333 per unit. He would not answer the question, and I could get no answer to the question from IR or him after the call. I think that RP has largely established its natural customer base and growth will need to come from cross-selling additional products to existing customers.
- While there is a switching-cost moat, there is no winner-take-all network effect moat in play here. There is no dominant advantage that will let RP push out other vendors with competetive offerings.
(2) Revenue per unit
- At present, RP is generating $40 of revenue per unit. In order to grow into their valuation, they need to quadruple this . . . quickly. And I do not think this is likely.
- The product suite is "complete." They may add apps here and there, but there are no killer apps in the pipeline. (See my risk concerning MPF below.) I expect the RPU growth to slow over the next few quarters as the suite has matured.
- The nature of the applications is such that they do not gain a ton by being integrated. RP has stated as much when they advertise that their "front-end" apps work with Yardi's "back-end" apps.
- Both operators I spoke with gave a fairly consistent answer that many of the RP apps did not interest them because they used a different system for that task or were not interested in that app from any vendor.
- Most importantly, they both balked at the idea that they would be paying $200 per year per unit. They had no idea where I came up with that number, and they could not imagine paying that level of fees for what one termed "administrative" tasks.
- Note that for q2 y-o-y, organic revenue grew 15.7% while units grew 10%. So RPU grew about 6% y-o-y, hardly the sort of number that implies RPU is headed to $200. As well, this RPU growth included some new applications that were developed and acquired.
I use their EBITDA except that I include stock compensation in expenses. Their stock compensation is persistent and not going anywhere and cannot be excluded.
Revenue 2012 = $330mm
EBITDA 2012 = $58mm
Depreciation = capex = $18mm -ish
Tax rate should be 37%-ish
So, FCF '12 = $25mm (81x)
In the medium term (5 years) I expect to see a fairly stable 4-6% unit growth along with 4-6% RPU growth. And op margins will expand over time. So, I expect to see a company growing at 10% top-line and 13% bottom line for the medium term. Such a company deserves a 25-30x multiple, not an 80x multiple.
RP is being valued as a horizontal-application vendor rather than a vertical-application vendor. And it will have neither the growth nor the strategic value of the horizontal-application vendors.
There are the usual momentum stocks risks with respect to timing, etc. However, in terms of fundamental value, my most pressing concern is their ability to grow their MPF research business, SEO product, and rentmineonline.com into a value-add product that apartment owners see as adding significant value worth 1-2% of the rent. I do not think these product offerings are driving the stock movement at present, but I will be checking whether these products are gaining strategic value that makes RP more than an administrative enterprise software company.
I have tended to stay away from many enterprise app cloud computing companies because I think that there is going to be more crazy acquisitions by SAP, CRM, etc. However, I think the strategic takeover risk for RP is minimal because of its vertical concentration.
- In Q3 (partly) and Q4 (fully), the headline 30+% growth numbers will be gone. We will see the less glamorous 15% organic growth numbers.
- The lack of sequential unit growth will show up in q3 and q4 as well. In the q2 numbers, the organic unit growth y-o-y was +10%, but q1 was only 1.8% and q2 was only 1.4% sequentially, or about 6% annually. Unit growth is a bit lumpy, but I believe the deceleration of unit growth should show up in q3 and q4 numbers.
- The q3 and especially q4 outlook from the company is fairly aggressive.