Avalara: Undervalued IPO Opportunity

Summary

  • Avalara, a Seattle-based vendor of tax compliance software, has filed for a $150 million IPO.
  • Initially priced at $19-21 per share, Avalara is indicating an opening valuation of $1.3 billion.
  • The company would be valued at just 4.3x forward revenues, an attractive valuation profile against a field of extremely expensive recent IPOs.
  • The company is selling 7.5 million shares in the offering, or just over 11% of its total market cap. The IPO is expected to go live in the week of June 11.

Silicon Valley has had its fair share of strong IPO starts in the year to date, but the Pacific Northwest – home to the likes of Microsoft (MSFT), Amazon (AMZN) and Redfin (RDFN) – has yet to inaugurate a startup into the public markets this year. Stepping up to the plate next week is the Seattle-based tax compliance software vendor Avalara (AVLR), which prior to its IPO had raised more than $340 million from private investors (primarily from private equity backing, which is less common for software startups) and is considered to be a unicorn. Having recently set its initial IPO pricing at $19-21 per share (for the 7.5 million shares to be sold in this offering), Avalara has set its valuation at $1.3 billion, slightly north of the $1 billion unicorn mark.

Yet, from the outset, it appears that Avalara could potentially be worth far more than its initial pricing. Of course, the pricing is not yet set in stone – most IPOs this year have adjusted their initial pricing ranges upward, and in any case, essentially every technology IPO this year has ended up pricing above the expected range to begin with. Ordinary investors getting in on the IPO date may not have a chance to bite into Avalara at anywhere near the IPO price if the company shows a strong “pop” on Day 1, which is what Avalara and its bankers are propping up the shares to do, given the lowball starting valuation.

Still, it’s important to note how lucrative this IPO could potentially be, especially if shares show early weakness and fail to move meaningfully beyond their starting IPO price. After all, this is a high-profile company which has attracted top-tier private equity backers who have supported the company beyond its venture rounds. TCV and Warburg Pincus are among the PE firms which have a stake in Avalara, along with the VCs that got in earlier including Sageview Capital and Battery Ventures.

The company’s funding timeline is shown below, courtesy of Crunchbase:

Figure 1. Avalara funding history

Source: Crunchbase

The NASDAQ IPO Calendar pegs Avalara’s IPO date for Friday, June 15. Keep a close eye on this name and its price movements and be on the lookout for an attractive entry point.

Automated tax compliance

First things first – what does Avalara do?

Avalara’s core functionality is to provide enterprise software for tax compliance. Businesses today face a complex tangle of federal, state, and local tax regulations, and many companies (especially on the SMB side) are using manual paper-based processes to manage their tax reporting and compliance needs.

Like many of its counterparts in Silicon Valley, Avalara has taken a labor-intensive, “legacy” process into its own niche, fueled by the automation benefits of software. It calls its flagship product the Avalara Compliance Cloud, which has the capability of pulling together transaction data from disparate enterprise systems such as POS (point-of-sale) terminals, CRM software such as Salesforce (CRM), and ERP systems in order to put an entity’s tax information into one cloud-based platform. These systems are often capable of calculating their own tax estimates, but until all of this information is pulled together, a business risks inaccuracy as well as time-consuming integration work.

Figure 2. Avalara Compliance Cloud features

Source: Avalara S-1 filing

Think of Avalara as a kind of TurboTax for businesses. Though mid-sized and large corporations have well-staffed accounting departments to handle their tax needs, software like the Avalara Compliance Cloud is still one of the best ways to manage tax complexity and cut down on manual labor costs.

Avalara has built up a sizable customer base of 7,760 “core customers” as of the end of the March quarter (Q1), which the company defines as a customer that exceeds an undisclosed revenue threshold (aside from these customers, Avalara also services a substantial number of small businesses and mom-and-pop operations). Predictably, Avalara primarily targets mid-market companies, though it also has a number of large enterprise clients.

And like most of its compatriots in Silicon Valley, Avalara is a SaaS company that sells primarily on a subscription basis, meaning it enjoys a recurring revenue base atop high gross margins.

Financial overview and valuation

Here’s a look at Avalara’s financials dating back three years:

Figure 3. Avalara income statement

Source: Avalara S-1 filing

One thing you’ll note is that Avalara is growing at a slightly lower rate than most software startups. FY17 revenues grew 27% y/y to $213.2 million, while growth decelerated two points in the first quarter of 2018 to 25% y/y. This doesn’t mean, however, that Avalara’s growth is stuck below 30% forever. Many recent IPOs have been “late bloomers” – as in, they were able to achieve accelerated growth in the quarters after the IPO, likely due to the infusion of IPO cash and the wave of public acknowledgement that comes with it. Apptio (APTI) and Appian (APPN) are two 2017 IPOs that are good examples of this.

Like other SaaS startups, Avalara also has sky-high gross margins. The company produced 72.8% gross margins in FY17, up 180bps from 71.0% in FY16. Combined with a strong recurring revenue base, this means that nearly every dollar of incremental revenues that Avalara is able to generate can drop straight to the bottom line. The company also posted a 107% net retention rate in FY18, indicating a 7% net upsell into the existing client base – a fairly strong retention metric when you consider that Avalara’s client base is tilted heavily toward small- and mid-sized businesses that will have naturally higher churn than software companies that cater more heavily toward enterprise clients.

And though Avalara has yet to turn a profit, it is slimming its loss margins. Its GAAP operating margin in FY17 was -29.7%, 270bps better than -32.4% in FY16. It also managed to bring down its operating cash burn to just -$3.2 million, indicating that the company may hit OCF breakeven as early as FY18.

With the midpoint of its IPO pricing range set at $20, and with 64.9 million shares to be outstanding post-IPO according to Avalara’s S-1 filing, the company will have a market cap of $1.30 billion at the opening, provided it holds its current IPO pricing (which is unlikely). After we net out the $12 million of cash on its balance sheet (cash is running noticeably low for the company, which is likely one of the driving reasons for pursuing an IPO) and the $136.4 million in net IPO proceeds that Avalara expects to raise from the deal, we arrive at an enterprise value of $1.15 billion.

If we assume that Avalara can hold its current growth rate of ~25% throughout FY18, we estimate total FY18 revenues of $266.4 million, up from FY17’s revenues of $213.2 million. This puts Avalara’s opening IPO valuation at just 4.32x EV/FY18 revenues.

This is tremendously cheap relative to where other software IPOs are currently trading. Here’s where the high-profile names of 2018 are currently trading (valuations based on share prices as of June 8, and forward revenues based on management’s guidance ranges for the year):

  • Dropbox (DBX): 9.09x forward revenues
  • DocuSign (DOCU): 13.23x forward revenues
  • Zuora (ZUO): 12.79x forward revenues
  • Zscaler (ZS): 17.53x forward revenues
  • Carbon Black (CBLK): 7.68x forward revenues

Most of Avalara’s fellow Class of 2018 IPO peers are trading at much higher multiples than what it is currently proposing to go public at. Of course, we have to recognize the fact that Avalara is growing at a decently slower rate than most of these comps, but the valuation spread should not be this wide.

How should investors react?

In my view, Avalara is a strong buy anywhere under 6x EV/FY18 revenues, implying a price target of $27 for the stock, or 35% upside from the current pricing range. In other words, if Avalara maintains its current pricing and “pops” no more than 35% on Day 1 trading, investors would be wise to get in on the name while it’s trading at a substantial discount to the rest of 2018’s crop of software IPOs. Avalara is a strong niche company – and despite its mid-20s growth range, it has a demonstrably sticky product that sells into a recurring revenue customer base, giving it a good setup for long-term growth.

Disclosure:I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Article by Gary Alexander from seekingalpha.com

Leave a Comment