Description

SPS Commerce sells supply chain software that utilizes a cloud-based network to automate the transfer of information among retailers, vendors, and 3PLs.  The business enjoys substantial network effects, as more customers make the product itself more valuable.  SPS grows recurring revenue organically 18-20%/yr, earns 5-6% GAAP EBITA margins, has almost no direct competition, and is selling into a TAM that is >10x current run rate revenue.

SPS achieves this growth using a predictable and repeatable sales model that generates high ROICs on S&M spend, so we estimate will reach $1B in revenue over the next ~10 years.  If SPS instead chose to grow at GDP-like levels, thereby meriting a 14x NOPAT multiple, they could earn 40% GAAP EBITA margins.  If you assume a ~35% mature tax rate, the justified “steady state” revenue multiple is thus 14x * 40% * (1 - 35%) = 3.6x.

SPSC currently trades at ~3.5x forward revenue, so at current prices you’re getting the “invest money in S&M to grow” call option for free.

Business overview

SPS products integrate retailers with vendors:

• Fulfillment (estimated 75% of revenue).  This is a SaaS product that plugs into existing supplier, retailer, and 3PL ERP systems, thereby allowing organizations to share fulfillment data.  Think of it as an advanced form of EDI.  Most common usage is for warehouse inventory replenishment: the retailer places an electronic order for more inventory, the vendor acknowledges receipt of the order, the vendor sends a shipping notification, and the retailer acknowledges receipt of the goods.  All of that communication happens via the SPS network.
• POS analytics (estimated 20% of revenue).  This is a SaaS product that pulls store-level inventory data from the retailers and presents it in an easily digestible and analyzable format for the vendors.
• Other (estimated 5% of revenue).  New products like item management, which allow vendors to share SKU-specific attributes with retailers for use on e-commerce sites.

The SPS sales model is unique and difficult to replicate:

• SPSC first gets a retailer to spend a nominal amount (estimated $15k) to engage SPSC in a “vendor automation program.”  This is typically a loss leader but results in the retailer being seamlessly integrated with the SPSC network.
• The retailer gives its supplier list to SPSC and mandates that its suppliers use SPSC software or get tested and certified by SPSC.  This gives SPSC a prospect list and a hunting license to sign up vendors as new customers.
• SPSC reaches out to vendors and offers them one of three options to ensure compliance with the vendor automation program:
• Utilize vendor’s proprietary EDI system, which SPSC tests to ensure compliance.  Tests are estimated at ~$500 each.
• Utilize SPSC’s web portal to manage orders for a fee of an estimated ~$780/year per retailer connection
• Fully integrate the vendor’s ERP systems with the SPSC network…essentially akin to outsourcing the EDI function to SPSC.  This can range from an estimated $500-$25k/month.  Vendor can reduce EDI headcount as many tasks are automated.
• After acquiring a new vendor customer, SPS can:
• Cross sell other products like POS analytics and item management into the vendor base
• Encourage vendors to get other retailers onto the platform, creating a virtuous circle of customer acquisition

SPS implementations are sticky:

• It’s time consuming, costly, and risky to re-build connections between vendors and suppliers.
• As a result:
• We know of no major retailer defections in the core fulfillment business
• Renewal rates with vendors are an estimated 94% (revenue-weighted, excluding upsells), with most losses due to natural business attrition.

SPS’s fulfilment product enjoys network effects:

• Integrating with SPS eliminates the need to connect individually with each trading partner
• Once a retailer or vendor is integrated with the SPS network, adding new trading partners requires no additional coding.  Therefore more customers on the network = greater value provided by the network.
• This limits competition and protects pricing power as SPS continues to grow.

This unique position in the retail supply chain allows SPS to expand services beyond fulfillment:

• POS analytics: allows vendors to see sell-through and inventory by store
• Item management: allows vendors to transmit item descriptions, pictures, and videos to retailers
• Vendor selection: allows retailers to find new vendors by product type (“Retail Universe”)

S&M ROIC is extremely high, so SPS prioritizes growth over cash flow:

• S&M spend is largely discretionary, so SPSC can choose how much to spend, and thus what margins to earn
• SPSC currently earns GAAP EBITA margins of 6%, is increasing margins 100 bps/yr, and at this level of investment is able to grow recurring revenue 18-20%/yr
• We don’t have a great view on whether this growth/margin trade-off is optimal…it could make sense to grow faster or instead generate more cash.  The answer depends on the marginal ROIC of S&M, which is hard to measure.  But it seems reasonable.

TAM

There are a number of ways to come at the TAM.  For reference, current run rate revenue is $180M.

• Approach 1 – average revenue per vendor.   Since the 2010 IPO, management has used this approach to estimate the TAM at $4B.  They get there by estimating $20k/vendor/year in full potential ARPU ($10k for fulfillment and $10k for POS analytics) and 200,000 addressable vendors.  This compares to 24,000 customers at $7k/customer/yr today.
  
  Management could be aggressive in the number of addressable customers and/or the number of customers for whom the POS analytics product makes sense.  Even when haircutting those two assumptions, however, we still end up in the $2-3B range.

• Approach 2 – SPSC revenue as % of retail revenue.  There is an estimated $5.2T of retail sales in the US, of which perhaps $1-2T is in SPSC’s sweet spot (areas like sporting goods, building supplies, grocery, drug, etc).
  
  Our research suggests that retailers are spending, for example, $60k / $400M = 1.5 bps of revenue with SPSC while vendors are spending, for example, $90k / $100M = 9 bps of revenue with SPSC.
  
  If retailers make 40% gross margins, SPSC’s fulfillment TAM represents 1.5 + 9 * (1 - 40%) =  7 bps of addressable retail sales.
  
  If addressable US retail sales for SPSC are $1-2T out of the total $5.2T of US retail sales, that implies that the US fulfillment TAM is $1-2T * 7 bps = $0.7-1.4B.
  
  This compares with management’s $1B estimate for US fulfillment TAM (another $1B of the management TAM comes from US POS analytics and another $2B comes from international for a total of $4B)..

• Approach 3 – comparison with other supply chain software vendors.  SPSC is meaningfully smaller than other supply chain software companies, most of which don’t have the same network effects that SPS enjoys.
  
  
• Legacy EDI competitors
• Sterling: $560M (as of 2009)
• GXS: $490M (as of 2013)
• Other supply chain software companies
• Manhattan: $590M (as of today)
• JDAS: $660M (as of 2012)

• Approach 4 – recent trajectory in S&M ROIC.  If the ROI on S&M declines, it’s likely that competition has increased or that headroom for further penetration has diminished.  In this case, the annual data suggests that S&M ROI has been flat for 8 years.  The only declines were in the GFC and then again in the last couple quarters (discussed in more detail below).
  
  
• Approach 5 – the ratio of recurring customers to nonrecurring customers.  Non-recurring customers use SPS to test legacy EDI solutions to ensure compliance with SPS vendor marketing programs…rather than use a fully integrated, recurring revenue SPS solution.  SPS typically gets new recurring revenue customers by converting existing non-recurring customers.  Today there are ~24,000 recurring customers and ~70,000 total customers, so recurring make up ~35% of the total.
  
  Over the past 5 years, this ratio has remained roughly constant, suggesting that the sales funnel for recurring revenue customers remains full.
  
  
• Approach 6 – incremental retailer opportunity.  SPS has ample room to continue deepening relationship with retailers.  Right now, SPS has:
• An estimated ~150 retailers who have fully outsourced EDI operations to SPS
• An estimated ~450 retailers who have done a partial vendor onboarding initiative in the past year
• An estimated ~1,400 retailers who are connected to SPS, but don’t actively pursue vendor onboarding initiatives

Growth Trajectory

Of equal importance to the size of the TAM is the rate at which SPS can grow into it. After analyzing a number of different data points, we believe SPSC can continue to grow recurring revenue organically at 18-20% for the next several years.

Here’s the supportive evidence:

• The market opportunity: large TAM with limited competition
• Historical growth: remarkably consistent at 20-25% every single year
• New products:  As SPS continues to acquire fulfillment customers, it becomes the glue connecting the nation’s retailers, vendors, and 3PLs.  New products can take advantage of this positioning to accelerate growth even after fulfillment reaches the end of its TAM.
• Management commentary:  Take this with a grain of salt, but management has consistently said “we believe we have the ability to grow organic recurring revenue at 20% on an annual basis for many years into the future.”  For what it’s worth, management has a track record of conservatism.
  
  

Here’s the evidence that calls for caution:

• Retailer additions: The pace at which SPS has added new retailers appears to be slowing.  Retailer “vendor automation” programs are the first step of the vendor sales funnel, so SPS will be increasingly reliant on the “expanding” portion of “land and expand” (more connections, more integrated connectivity, more products, etc).
• Organic recurring revenue growth of only ~18% in 2016 and ~16% in 4Q16
• We believe most of the slowdown is attributable to two 1x events:
• Under-hiring + subsequent sales force reorganization starting in 4Q15.  Sales reps take 6-12 months to ramp up, so even though new bodies were on-boarded in 1Q16, youth drives a drag on 2016 performance.
• Sports Authority bankruptcy, which had a disproportionate impact on SPS.
• Yet even if you believe the slowdown is structural, we believe it’s more than priced in:
• SPSC’s EV has compressed by almost 30% following this 300 bps slowdown in organic growth
• 3.5x revenue is too cheap for 16% organic growth + MSD GAAP margins + highly sticky, recurring revenue

Mature margins

We believe this business can achieve 40% GAAP EBITA margins in a steady state scenario…ie in a scenario where management chose to take up margins to a level at which the company grows with GDP, rather than 18-20%/yr.

• Prior case studies, particularly of private equity-backed enterprise software companies.  For example, we believe Vista’s portfolio companies eventually achieve 35-40% EBITDA margins on average.
• Business quality.  SPS sells mission critical software into the enterprise, with no major customer losses we were able to uncover.  This should result in their “steady state” margins landing at the high end of peer ranges.
• Bottoms up build.  In the steady state, costs would come from:
• COGS, as implementation costs to onboard new customers are buried here
• S&M, as SPSC currently spends 35% of revenue to add 20% (top line growth) + 6% (estimated churn) = 26% of gross revenue each year.  In a steady state scenario, they would only need to add 2-3% (top line growth) + 6% (estimated churn) = 8-9%.
• R&D, as SPSC currently spends money to build out new products to drive future growth
• G&A, as overhead at least partially scales with the size of the organization

Bear thesis

We believe the majority of the bear thesis relates to the health of US retail in the face of threats from AMZN.  We’re wary, but here’s what gives us a little comfort:

• Vendors foot the bill, not retailers.  These same vendors also sell into e-commerce.
• SPS software drives cost savings via lower labor cost (no longer have to custom code EDI connections)
• A more nimble/interconnected supply chain is required to better compete vs AMZN
• SPS software is required to keep the lights on so hurt more by retail liquidations than weak comps

Ultimately retailers need technologies like those that SPSC provides to survive.

We and our affiliates are long SPS Commerce (SPSC) and may buy additional shares or sell some or all of our securities, at any time. We have no obligation to inform anybody of any changes in our views of SPSC. This is not a recommendation to buy or sell securities. Our research should not be taken for certainty. Please conduct your own research and reach your own conclusion.

Catalyst

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