Three Small-Cap Tech Companies for Your Watch List

Lately, on Industry Focus: Tech, we've focused on the megacap businesses that have been dominating the news -- at the cost of shedding some light on smaller companies with massive growth potential. In this week's episode, host Dylan Lewis talks with Fool.com contributor Brian Feroldi about three ultra-compelling small-cap tech companies: HubSpot (HUBS 2.57%), AppFolio (APPF 2.17%), and Paylocity (PCTY 0.56%).

Tune in to find out how each business works, how companies like AppFolio thrive in markets that are too small for the big guys, the biggest risks investors should know before taking a closer look at these companies, which particular one is the most exciting story today, and more.

A full transcript follows the video.

This video was recorded on April 20, 2018.

Dylan Lewis: Welcome to Industry Focus, the podcast that dives into a different sector of the stock market every day. It's Friday, April 20th, and we're talking small-cap tech stocks. I'm your host, Dylan Lewis, and I'm joined in the studio by fool.com's Brian Feroldi. Brian, awesome to have you here!

Brian Feroldi: Yeah, great to be here in person!

Lewis: Yeah! It's a very different dynamic, doing the show with someone in the studio rather than on Skype.

Feroldi: Yeah, no doubt.

Lewis: And it's fun to do it with you. You're someone who traditionally covers healthcare for fool.com. As an investor, you really like the tech space and the software space, though.

Feroldi: I do love the software space, I do love to tech space. So, even though I do write primarily about healthcare stocks, I do own and invest in many tech companies.

Lewis: I was excited to have you on because so many of our recent episodes for the Tech show have been about these megacap tech stocks. There's been so much news about Facebook, we had this recent Spotify issuance. We haven't really been talking a lot about discovery stocks for investors. We haven't been uncovering a whole lot. I know that you're someone that looks at the sub-$10 million market cap space a lot for companies. That's where you can find some really big growth opportunities, and some companies that maybe people aren't as familiar with. So, that's going to be the slant of today's show. We're going to talk about a couple of different stocks that you're particularly excited about.

Before we get over to that discussion, though, why don't we talk a little bit about what you look for in a business?

Feroldi: Sure. I primarily like to invest in companies that have some kind of a moat, obviously; so, either they're protected by the network effect, or when users use their products it's painful for them to stop using them, or they have a great brand name. And I'm primarily interested in businesses that have already figured something out, they already have a platform in place, and the investment thesis is, they just need to keep doing what they're doing. I don't like to invest in anything that requires some Herculean effort or a new product to be introduced, and you're hoping that consumers will love it. I like to go with as close to a sure thing as I can possibly get. 

So, when I'm analyzing a business, one of the things that I love to see is lots of recurring revenue -- so, the customers that they have buy from them continually, so that way, as the platform attracts new customers, revenue and profit continue to tick higher and higher and higher every single quarter. I like a clean balance sheet. I don't like to see companies with debt. I like to see that the business is young, which usually means that the founder, the people that really put their heart and soul into the business, are still running the show in some way. And I like to see companies that have really great reviews from employees, because in today's really competitive talent environment, attracting and retaining key employees is absolutely critical, especially in the small-cap tech space. So, if they don't have a great culture that people want to work at, I'm not interested.

Lewis: All these businesses that we're going to be talking about today check all these boxes. Why don't we first start talking about this company HubSpot?

Feroldi: Sure. I have a question for you. When is the last time, Dylan, that you answered a cold call, opened up a letter in the mail, or watched a TV commercial, and you actually changed your buying behavior?

Lewis: I will tell you that I get a cold call every single day. You get those phone calls that, it's your area code, and some telemarketer or some automated telemarketer is sending you some garbage automated message, and I've learned to just block every single one of them. So, never, to answer your question. [laughs] 

Feroldi: And that's the world that we're living in today. For decades, the traditional way that companies founded new businesses is, they would advertise with spots on TV and spots on the radio. But consumers really hate to be interrupted. That's why they use caller ID, to make sure they never pick up a phone call that they don't recognize. Or, they use DVR to skip TV ads. Or, they put their phone number on Do Not Call lists. These realities are making it harder and harder for companies to shout out their message to their consumers that they want to reach.

In response to that, this company called HubSpot basically is taking the traditional marketing playbook and flipping it on its head. They're pioneering a strategy that they call inbound marketing. And the idea there is, don't spend all your time, money and energy shouting at people and interrupting people to get them to learn about your product. Instead, try to create easy-to-use content like blog posts, like videos, so that when people are searching for a product or service like the one you're offering, that you are easy to find. The idea is to put out blog posts that are helpful, that people will actually want to read naturally when they have a problem, and to essentially get people to come to you when they have a need.

Lewis: So, instead of blasting a message, you're creating these organic "outreach," because the people are actually coming to you, experiences with potential customers.

Feroldi: Exactly. And think about your own shopping. When you have a problem, and you're interested in learning about a new product, what's the first thing that you do?

Lewis: Search it on Google. 

Feroldi: Exactly. You type in the problem to Google, or maybe you go to YouTube and look at a video for how to solve it. That's exactly what HubSpot does. They offer tools that help companies to grow their social media presence, or to rank highly in search engine optimization, and to really put out free-to-consume content that builds up their brand and helps them to build trust with customers, so that when they are actually ready to buy, they're already familiar with the company. This has proven to be hugely impactful for getting new customers to come onto the brand.

Lewis: It sounds like a business that rides the tailwinds of e-commerce and digital marketing very well, too.

Feroldi: Absolutely. And HubSpot's target market is, they're going after businesses that have between 10 and 2,000 employees, so they're going after the small companies that don't traditionally have the huge budgets.

Lewis: So, they're kind of a fix for resource-poor companies, basically. [laughs] It's nice to be a one-stop-shop. And that's actually something we're going to see with a lot of these businesses we're going to talk about, is, you have a provider that makes it really simple to do something that you would have an entire department do if you were a larger company.

Feroldi: Absolutely. HubSpot sells using a software-as-a-service or SAAS model. Customers come on and they subscribe, and they can use all kinds of tools to help manage, basically, that filter process that brings new customers into their business. 

And these guys are growing like crazy. They currently have over 41,000 customers that have signed on to their platform, and the average customer spends over $10,000 per year with HubSpot, so that translated into about $375 million in revenue last year. So, these guys are just growing like crazy, and companies everywhere are really signing onto their platform.

Lewis: And that growth comes at a price, and we'll see that with all these companies we talk about. I think they're a roughly $4.5 billion company right now. So, you think about that, that's a little bit more than 10X sales.

Feroldi: Yes.

Lewis: And that's what you're going to pay for these very scalable businesses that are growing very quickly.

Feroldi: Absolutely. And these guys are growing like mad, and they're absolutely in build-out mode. HubSpot only recently became profitable and cash flow positive because they were investing everything that they earned back into the business to scale out their platform. But, I'm personally interested in this business because they are free cash flow positive, so, they're no longer consuming cash at the rate that they once were. Their co-founders are still highly involved in the business. In fact, they're the CEO and CTO. Their company culture just gets rave reviews on review sites like glassdoor.com. 

And while they've already grown like mad, and investors have already done very well by buying into the company after the IPO, the company thinks that its total addressable market is about $45 billion annually. You compare that to the $375 million that they pulled in last year and the tailwinds that they're riding, and I think this business can grow very, very quickly for years to come.

Lewis: Yeah, it certainly seems like there's a pretty good growth runway ahead of it. Why don't we talk about company No. 2, and this is AppFolio?

Feroldi: Sure. This is a company that I really like a lot, too. These guys cater to the needs of small and medium-sized businesses that are kind of in niche, niche markets that you wouldn't normally think of, and none of these are consumer-facing. AppFolio was founded, and their initial target market was the property management business. So, you think about companies that own, say, a small apartment complex or a multi-family building. If you were a property manager, what kind of things are critical to making your apartment profitable? Well, you need to attract clients. You need to make sure that they're paying their bills. You need to be able to foster communication between the client and the property manager if there's maintenance things. You need to help with background checks on potential tenants and screening. 

So, there's a hodgepodge of software that's out there that can help with each of those things. AppFolio basically took all of that and put it together on a cloud-based platform, and they sell their service to property managers. So, they can come on to AppFolio's platform, they pay a small subscription fee, and they get access to basically all of those services in one easy-to-use cloud-based system that can be managed through a cellphone or on a tablet.

Lewis: And you talk about this market, and even just hearing you describe it, property managing software, there's a niche there. [laughs] 

Feroldi: It's pretty niche.

Lewis: There's a pretty clear niche. And frankly, it's a space that's probably a little too small for big players to want to hop in.

Feroldi: Absolutely, yeah. There can be a big advantage to stay in the niche. The big software boys, it's just not a big enough market for them to go after, to really invest the resources to make a customized solution. But, AppFolio, they're not so much a property management company as they are just trying to dominate a few small niches, and by combining them together, they can grow into a much bigger software platform.

Lewis: Yeah. They're getting outside property management, right? They're doing something in the legal space, as well?

Feroldi: Exactly. A couple of years ago, they bought a company called MyCase, which caters to the needs of legal professionals. So, you think about a small law practice. Well, they also need help with billing and tracking their time and attendance and marketing themselves. There's always back-office stuff that these companies need help with. So, AppFolio recently entered into that business, too, through an acquisition. It's still very small, it's less than 10% of their revenue. The property management business is about 90% of their market right now. But, between these two, they're adding customers to both platforms at a double-digit rate. 

The way that they make money is, their customers pay a recurring monthly subscription fee just to be on the platform, but they also sell premium, what they call value-plus services, on top of that. So, if you wanted AppFolio's app to facilitate taking money out of the client's checking account and sending it over to the property manager, like, so they can pay their rent, AppFolio's platform can do that for them, and they charge an extra small fee for that. Or, if they wanted to do a detailed background check when they're screening for tenants, you can also do that on AppFolio's platform, but they also charge a small fee for those kinds of services.

Lewis: You talked about the stickiness of the platform. I think they have a customer retention rate of 97% or something crazy like that.

Feroldi: It's extremely high. That's a big reason why I love software-as-a-service businesses. Once a customer gets into the platform, and their entire back office gets set up around using this platform, it becomes extremely painful for them to consider switching providers, because everything is built for this one platform. So, it makes the business very, very sticky.

Lewis: And, you have employees that are trained on using that, right? So, there's the actual friction of switching systems and maybe not having the data interplay the way that you would like it to, but there's also the cost of having to retrain employees to use these programs or to bring in vendors and review these offers from new vendors, which is going to be tough for everyone's time, especially if you're a smaller business.

Feroldi: Absolutely, especially since, if you're a smaller business, you don't really have time to do that kind of stuff. AppFolio is growing its top line extremely quickly. Last year with 40% year over year top line growth, about $144 million in revenue. So, again, they're going after niche markets, but they're still big enough to actually become profitable, become cash flow positive. Their balance sheet is squeaky clean. Another thing I like about this company in particular is, the founders of the business are the Chief Technology Officer and the Chief Strategy Officer, so they're still very involved. Very high inside ownership rates. And, this is another company that just gets rave reviews from employees about the culture that they have.

Lewis: And this is a business that's around a $2 market cap. So, we talk about serving these smaller markets, you don't need to be humongous to make that happen. And if you see good growth in those markets, there's certainly a lot of upside. It's a lot tougher to double as a $10 billion business. It's a lot easier to find that big multiple as a $2 billion company.

Feroldi: Absolutely. And management claims this business, between their legal channel and their property management business, they think it's about a $5 billion opportunity. Compare that to their $144 million in revenue. There's still plenty of room for this company to grow.

Lewis: Much like HubSpot, just scratching the surface of what management sees.

Feroldi: You got it.

Lewis: Another smaller player here is Paylocity. This company, I think it's about a $1.7 billion market cap business, what do they do?

Feroldi: Paylocity does cloud-based human resources software. As you might have guessed from their name, their bread and butter is payroll. They go after small businesses that have a few employees, just to get them on a platform for doing payroll. But they also offer a number of other services on top of that. Payroll is kind of how they get their foot in the door, but they also offer things like benefits management, you can do time and attendance on there, you can do employee reviews, a whole bunch of general HR functions, on their platform. 

As you can imagine, this is a very old business. When you think about your ADPs and your Paychexs of the world, those guys have existed for years. What Paylocity does that's a little bit different is, they were founded on a mobile-first strategy. Their software is 100% based in the cloud, and it's really designed to be used on a phone, a tablet, or PC kind of last. That's how they set themselves apart from the big boys.

Lewis: Yeah. Hearing you talk about this company, I'm reminded, in a way, a little bit, of another business that I really like, and that's Square. You think about how it's mobile-first, it seems like it's very oriented toward small shops and making the getting-setup very simple for small business owners.

Feroldi: That's exactly right.

Lewis: HR stuff, one, it's a space that you want to have your stuff together. You want to be organized. But it's something that a lot of people don't have training doing. And having organized systems coming into, this is what this should look like, and picking up that template from a business, is really helpful. It's also stuff that a lot of people don't really want to do. So, having a company that can take care of some of the messier or maybe less-sexy parts of your business is always going to be a good opportunity, if you're looking for places to serve customers.

Feroldi: Absolutely. Payroll is boring, but it's absolutely mission-critical. I don't know about you, I like getting a paycheck every week.

Lewis: Yeah. I only get paid every two weeks, but every two weeks, I look forward to it. [laughs] 

Feroldi: Absolutely. And when you take on an employee, there are some things that they just naturally expect from the business. They expect you to have your 401(K) set up, they expect you to have your payroll act together, they expect to be able to have some kind of system for logging their hours if they're hourly. So, what I like about Paylocity is, once they get their teeth into a business, they can then layer on services on top of that to bring in more functionality. These guys recently just acquired a small company that provides flexible spending accounts and health savings accounts, so they're starting to get into the health insurance side of it. And with that acquisition, they can then take this thing that they built and offer it out to all of their clients to grow their revenue within their client base, let alone when they add on new customers. 

So, this is a repeat purchase business. Their top line is growing very quickly, 25% annually. 97% of their revenue is recurring. They did about $300 million in revenue last year, which was high enough to get them to profitability. They're cash flow positive. And management sees an opportunity in the U.S. of about $26 billion. 

Now, these guys are facing much more competition, I would say, than the other two, because, again, they'll eventually butt heads with the likes of ADP and Paychex, but I think that they have a solution that's unique enough that they can still continue to grow quickly.

Lewis: We talked about three different businesses here. The reason we're talking about these companies, you own all these companies, Brian.

Feroldi: I own all three of them, yes.

Lewis: If you have to pick one that you're like, "This is my highest conviction of the three," which one is it?

Feroldi: Again, I own all three. I plan on holding all of them for a long time. But if I had to pick one, I would probably go with HubSpot. I think what they're doing with flipping the marketing script on its head, I think that's a very long tail opportunity. And these guys are absolutely the leader in this space. They're the ones that are pioneering this. Much like the way that, say, salesforce.com pioneered the shift to the cloud 15 years ago, these guys are pioneering the shift to inbound marketing. And I think their opportunity is just so massive that it's probably my favorite idea.

Lewis: Yeah. Thinking about what all these different businesses do, HubSpot is the one that's almost creating a space. 

Feroldi: Absolutely.

Lewis: Some of the others are creating functionality that's mirroring what's also out there already, or just making it simpler. It seems like there's a whole new space for these companies to be playing in, and, oh, by the way, we have the institutional knowledge to get you there --

Feroldi: Absolutely, yeah.

Lewis: -- when a lot of these companies don't have that.

Feroldi: Yeah. And these guys, like I said, they're absolutely the leader, so much so that they actually hold an annual, they call it the INBOUND Marketing Conference, and it's attended by like 20,000 marketers every year, and the attendance keeps going up. They actually also have an Inbound Certification program. So, if you're a company and you're interested in this, you can send your employees to HubSpot to get certified at becoming an inbound expert. So, these guys, I think, are by far and away the leader. And I don't know about you, I don't see it going back to the way advertising used to be, because that just doesn't work anymore.

Lewis: I hope it doesn't, [laughs] because I hate getting those calls. Well, thank you so much for hopping on, Brian! I hope you didn't bore your son Tyler too much while he was hanging out behind the glass with Dan Boyd.

Feroldi: He looks like he's got an iPad over there, so, he's happy as can be.

Lewis: Awesome to have you at HQ! Thanks for coming by!

Feroldi: Thanks for having me!

Lewis: Listeners, that does it for this episode of Industry Focus. If you have any questions or if you just want to reach out and say hey, you can shoot us an email at [email protected], or you can tweet us @MFIndustryFocus. If you want more of our stuff, you can subscribe on iTunes or check out The Fool's family of shows over at fool.com/podcasts. As always, people on the program may own companies discussed on the show, and The Motley Fool may have formal recommendations for or against stocks mentioned, so don't buy or sell anything based solely on what you hear. Thanks to Dan Boyd for subbing in behind the glass today. For Brian Feroldi, I'm Dylan Lewis. Thanks for listening and Fool on!