Opinion: Avalara’s IPO looks hot, but it’s overpriced
Avalara Inc., a provider of cloud-based tax compliance software, priced its IPO at $24 a share, well above its estimated range of $19 to $21 per share. We give the stock an Unattractive rating.
Avalara AVLR, +4.27% joins a long list of cloud software providers that fail to earn a profit at the time of their IPO. However, lack of profits hasn’t stopped investors from plowing capital into cloud stocks. For example, salesforce CRM, +0.17% is up 250% over the past five years (the S&P 500 SPX, -0.53% is up 75%) despite consistently generating negative economic earnings.
This report aims to help investors sort through Avalara’s financial filings to understand the fundamentals and valuation of this IPO.
GAAP net income overstates losses
Avalara earns revenue by charging subscription fees for each of its software solutions. The company notes it processed an average of 16 million tax determinations a day in 2017 and has over 600 prebuilt integrations with leading enterprise resource planning, e-commerce, and customer relationship management systems.
At first glance, Avalara’s GAAP net income fell from -$58 million in 2016 to -$64 million in 2017, or 11% year-over-year. After-tax operating profit (NOPAT) also fell, but at a decreased rate. NOPAT fell just 7% year-over-year.
Avalara GAAP net income and NOPAT since 2016
Non-operating items overstated Avalara’s GAAP losses in 2017, which caused the greater decline in accounting results versus NOPAT. We remove both non-operating income and expense when calculating NOPAT to get at the true recurring profits of the business.
In 2017, Robo-Analyst uncovered non-operating items, such as:
• $0.7 million in amortization of deferred rent
• $9.2 million in goodwill impairment and restructuring charges
After all adjustments, we removed net $13 million in non-operating expenses in 2017.
With only two years of history, it’s hard to draw any firm conclusions about the long-term trend in profitability for Avalara, but our adjustments show that NOPAT is falling less than GAAP net income would indicate.
Expense growth bucks common tech startup trend
In the past, we’ve been critical of business models that operate at a growing loss due to expenses growing even faster than revenue. See Trivago TRVG, -0.78% which is down 53% from its IPO price of $11 a share, as an example. However, Avalara bucks this common trend of rapidly growing tech stocks. Instead, Avalara has shown impressive cost control, which indicates the business may actually be able to effectively “scale”.
Since 2015, Avalara’s cost of revenue, research & development, sales & marketing, and general & administrative costs have grown 19%, 18%, 16%, and 1% compounded annually, respectively. Over the same time, revenue has grown 32% compounded annually. The ability to scale its top-line growth while maintaining cost controls can be credited for Avalara’s NOPAT margins, while still negative, improving from -29% in 2016 to -24% in 2017.
While Avalara is certainly not profitable, the trends in its expenses indicate that the business model is achieving expected benefits of scaling its software across its customers.
Avalara looks undervalued by traditional metrics
The next chart shows the price-to-sales ratio for the 10 technology firms that went public in the first four months of 2018 and Avalara. We used the market cap of each firm at its IPO price to determine where Avalara’s valuation stood relative to recent tech IPOs. As can be seen, Avalara’s price-to-sales ratio is near the middle of its peer firms.
Valuations for tech IPOs in 2018
Our discounted cash flow model reveals Avalara is overvalued
When we analyze the cash-flow expectations baked into the stock price, we find that Avalara is overvalued, despite what traditional metrics show. Our dynamic DCF model quantifies exactly what kind of future cash flows the market price of a stock implies a company will generate.
To justify even a price of $20 (the midpoint of the proposed IPO price range), Avalara must immediately achieve 12% NOPAT margins (average of all software firms with positive margins under coverage) and grow revenue by 21% compounded annually (average of all software firms under coverage) for the next seven years. See the math behind this dynamic DCF scenario here. For reference, Avalara’s NOPAT margin was -24% in 2017 so this scenario implies immediate and drastic improvements in profitability.
In a more conservative scenario, if we assume Avalara can achieve a 4% NOPAT margins (slightly better than salesforce at 3%) and grow revenue by 21% compounded annually for the next decade, the stock is worth just $7a share today — a 71% downside from the IPO price. See the math behind this dynamic DCF scenario here.
Previous owners leave little voting power for investors
Following the completion of its IPO, members of Avalara’s board of directors, executive officers, and 5% or greater shareholders will own about 62% of outstanding voting stock. This concentrated voting power means investors have little say on important strategic decisions such as a sale, merger, acquisition, or additional issuance of common stock. While we’ve certainly seen worse corporate governance when it comes to voting rights — Snapchat SNAP, +0.68% and Dropbox DBX, +7.09% come to mind — Avalara’s voting structure still gives investors little power.
Critical details found in financial filings by our robo-analyst technology
As investors focus more on fundamental research, research automation technology is needed to analyze all the critical financial details in financial filings. Below are specifics on the adjustments we make based on Robo-Analyst findings in Avalara’s 2017 S-1:
Income statement: We made $17 million of adjustments, with a net effect of removing $13 million in non-operating expense (6% of revenue). We removed $2 million in non-operating income and $15 million in non-operating expenses. You can see all the adjustments made to Avalara’s income statement here.
Balance sheet: We made $87 million of adjustments to calculate invested capital with a net increase of $86 million. The largest adjustments was $66 million in operating leases. This adjustment represented 157% of reported net assets. You can see all the adjustments made to Avalara’s balance sheet here.
Valuation: We made $237 million of adjustments with a net effect of decreasing shareholder value by $237 million. There were no adjustments that increased shareholder value. The largest adjustment to shareholder value was $129 million in outstanding employee stock options. This option adjustment represents 8% of Avalara’s market cap.
David Trainer is the CEO of New Constructs, an equity research firm that uses machine learning and natural language processing to parse corporate filings and model economic earnings. Kyle Guske II and Sam McBride are investment analysts at New Constructs.
We Want to Hear from You
Join the conversation