AppFolio, Inc. (APPF) is a Software-as-a-Service (SaaS) provider that focuses primarily on real estate with a minor interest in legal products. AppFolio has some positive factors going for it, including strong revenue growth of 33% YoY and recent acquisitions that will enhance their suite of products. But in my opinion, the company is heading in a dubious direction as there is strong competition, limited Total Addressable Market (NYSE:TAM) and the stock price is overvalued relative to other SaaS stocks. While AppFolio stock price may appreciate in the current SaaS bull market, I would be careful about long-term performance as the real estate software market is saturated with competition. For these reasons, I have assigned AppFolio a neutral rating.

Company Overview

Founded in 2006, AppFolio offers software for the real estate market called AppFolio Property Manager (NASDAQ:APM), designed to meet the operational and business requirements of property management companies. Four portfolio types are offered: residential, commercial, student housing and community associations.

(Source: AppFolio)

Going Upscale

APM generally caters to small business but has recently been making a move towards larger businesses with the release of AppFolio Property Manager Plus (APM Plus), AppFolio Investment Management (NYSEMKT:AIM) and the acquisition of Dynasty Marketplace, Inc., a company that provides AI for the real estate market.

APM is an extension of AppFolio’s core product and is designed for larger businesses with more complex needs.

AppFolio APM Plus advantages

(Source: AppFolio)

AIM is a product designed for investors providing a single solution that will more efficiently manage their portfolio of investments. In the words of AppFolio management: “We believe this innovation will transform customers’ businesses, improve processes and streamline investors’ experiences.”

In early 2019, AppFolio acquired Dynasty, a company that gives firms the tools to run their business via natural language. The AI software is designed to communicate with prospective tenants, schedule viewings and forward on the most promising applicants to the property management company.

Dynasty capabilities

(Source: Dynasty)

AppFolio has indicated that the Dynasty team and technology, combined with AppFolio’s internal resources, technology, and data, will serve as the company’s foundation for future artificial-intelligence, or AI, software and services for the real estate market.

Company Fundamentals

As I explained in a recent article on Paylocity (PCTY), high-growth companies generally don’t measure up based on traditional value metrics. In fact, they often confound analysts, with the result being a lost investment opportunity. In place of traditional value factors, I generally focus on other measures, such as revenue growth, free cash flow margin, and the software company “Rule of 40.”

AppFolio had an excellent year with trailing-twelve-month (TTM) revenue growth of 33%. The company’s 5-year annual growth rate of 48% is also extremely good.

AppFolio historical growth rates

(Source: Portfolio123)

Free Cash Flow Margin

AppFolio’s free cash flow margin TTM has been positive since the spring of 2017 and is currently sitting at a very healthy 14.8% of revenues.

AppFolio historical free cash flow margin chart

(Source: Portfolio123)

SG&A Expense

AppFolio has excellent control of SG&A expenses which have been steadily declining and are now about 45% of revenues. Most mature software companies have 50-60% SG&A.

AppFolio historical SG&A chart

(Source: Portfolio123)

Note however that the SG&A is starting to rise in the most recent two quarters. Investors should be aware that AppFolio is ramping up faster than revenue growth. In the quarter ending March 31, 2019:

  • Sales and Marketing increased by 52%
  • R&D expense increased by 59%
  • General and administrative expense increased by 59%

Remember that revenues grew 33% yet SG&A increased well over 50%. According to company management, the increase was primarily due to an increase in the average headcount to support growth and investments made in advance of expected revenue generation.

This is my first beef. SaaS companies normally grow SG&A expenses in tandem with revenues, but rarely do I see expenses growing faster than revenues. I am going to give AppFolio a break on this since they have pretty good SG&A margin and have just acquired Dynasty. However, investors should keep an eye on the expenses for future quarters. I know I will!

The Rule Of 40

One industry metric that is often used for software companies is the “Rule of 40.” It is an industry rule of thumb that attempts to help software companies ascertain how to balance growth and profitability. There are different ways of calculating the Rule of 40; some analysts use EBITDA, and others use the free cash flow margin. I use the free cash flow margin, as the figure is useful in a later part of my analysis.

The Rule of 40 is interpreted as follows: If a company’s growth rate plus free cash flow margin adds up to 40% or more, then the SaaS company has growth and cash flow in balance and is considered financially healthy. In AppFolio’s case:

Revenue Growth + FCF margin = 33% + 14% = 47%

Since the calculation comes out at 47%, I conclude that AppFolio is financially healthy.

Efficiency Score

Revenue growth plus FCF margin is sometimes referred to as the “Efficiency Score.” It has been determined that Efficiency Score has a greater than 70 percent correlation to a public SaaS company’s revenue multiple, which is the valuation divided by revenue.

In order to demonstrate this, I have plotted the EV/Sales multiple versus the Efficiency Score in MS Excel for 48 software stocks from my digital transformation stock list. A linear trendline is plotted through the scatter plot that represents the best-fit valuation multiple for a given Efficiency Score.

Digital Transformation stocks EV/Sales versus Efficiency Score

(Source: Portfolio123 /MS Excel)

As can be seen from the above graph, AppFolio sits slightly above the best-fit line through the data points.

The rest of this analysis is somewhat controversial. For me, at least, it seems logical to assume higher valuation for higher-growth companies, and I use the best-fit line to gauge a company’s valuation relative to the rest of the stocks in the custom universe. This is a relative valuation, not absolute as one would attempt to get using a DCF calculation.

Based on the above chart, I conclude that AppFolio’s stock price is modestly overvalued relative to the rest of the digital transformation stocks in my custom universe. On this parameter alone, I would not rule out investment in AppFolio, especially with YoY revenue growth of 33%, but it is one factor to consider.

Class Action Suit

AppFolio recently agreed to pay $4.5 million to resolve class action claims that the rental property company was not clearly identifying the source of information it provides on consumers’ credit reports, thus violating federal law. Note that insurance covered all but $1.1 million of the settlement.

It appears to me that AppFolio got off light. The suit asserts that AppFolio’s standard practice is to use only partial matching in preparing consumer reports. The partial matching leads to reports which include information about people who are not subjects of the report. You can read more about this case here.

The fact that AppFolio settled the suit without admission of guilt, of course, means that there is likely some truth behind the allegations in the suit. Either that or the company decided that the least costly way forward was to settle instead of fighting the case. Either way, the company appears to be guilty in the eyes of public opinion.

To make matters worse, AppFolio also received a Civil Investigative Demand (CID) from the Federal Trade Commission (FTC) requesting information relating to compliance with the Fair Credit Reporting Act (FCRA). While the class action suit has been settled, the FTC investigation is still open.

To be fair, AppFolio is not the only company caught with their pants down. RealPage (RP) also settled charges that the company violated the FCRA. RealPage was accused of failing to take reasonable steps to ensure the accuracy of tenant screening information and settled with the FTC by paying $3 million.

This leads me to my next beef. The Dynasty solution, while impressive, is going to make tenant screening more obscure as it will be performed by AI with little insight into the decision-making process and may use alternative data as opposed to the more straightforward credit reports. Use of Dynasty technology could potentially lead to more violations of the law.

Remember every dog gets one bite! AppFolio has already been caught once. If it happens again, it is quite possible that property managers may leave the fold as they are at risk of getting dragged into lawsuits and the FTC may be less tolerant in the future.

Company Direction

The company direction is where I really take issue with. The TAM for property management software is limited. According to one report, the global property management software market will only be $1.839 billion by 2026. Keep in mind that the report is about the global market, not the US market where AppFolio operates. Given that AppFolio has revenues of $200 million and there is a great deal of competition in the SMB market, I expect that AppFolio will be hard-pressed to keep its sales momentum going without targeting new markets.

According to Appfolio’s annual report, its long-term growth strategy depends upon:

  • entering new verticals
  • increased sales to larger customers
  • expansion to international markets

Entering a new vertical does not appear to be practical. They already made one move by entering the legal market but that has turned out to be rather so-so with mediocre growth and only generating 10% of total revenues. This move may be more of a distraction than a net benefit to the company.

International expansion will not likely occur for a couple of reasons. First of all, the laws and regulations in Europe are much more sophisticated than in the United States. Given the company’s legal difficulties at home, it may not be wise for the company to try to expand across the ocean. They could look to acquire a European company but AppFolio has limited funds and appears to be more interested in buying back stock. AppFolio bought back $21.6 million of Class A shares in 2018 with money that could have been used for an acquisition. And the Board of Directors has authorized a $100.0 million Share Repurchase Program. What’s with that? Mature companies with no growth prospects buy their own shares. This is money that could be used for European expansion.

Eliminating new verticals and international expansion, I have to conclude that AppFolio’s growth strategy is based solely on increasing sales to larger customers. And this is supported by recent initiatives including AIM, APM Plus and the new AI initiative. These are features that RealPage and probably a few other competitors already have. AI is only as good as the data behind the application. RealPage is significantly larger than AppFolio and has acquired much more data. RealPage worked on their AI tenant screening application for two years before it was released. I anticipate that AppFolio has a long and difficult road ahead of it. Expect expenses to grow into the foreseeable future. Revenue growth is less certain.

Summary And Conclusions

AppFolio is a SaaS provider that focuses primarily on real estate (90%) with a minor interest in legal markets (10%). The company has strong YoY revenue growth of 33% and intends to have similar growth during the coming year.

However, I view this to be a risky investment because there is limited growth potential in the SMB software real estate market, a great deal of competition and the only place growth can occur is if the company successfully moves into the large property management market. There is also a great deal of competition, including RealPage, which already has an AI-based tenant screening application based on a two-year development cycle and a much larger dataset than AppFolio has.

In addition, AppFolio is under the watchful eye of the FTC for tenant screening violations. Adding AI into the mix may be the second dog bite that results in further legal action and potential loss of reputation and business.

Growing into new verticals or internationally does not appear practical at the moment. Cash is limited after the recent Dynasty purchase and recent stock buyback.

Expect expenses to grow this year with the likely result that there will be negative earnings surprises as having occurred for the last three quarters.

(Source: Portfolio123)

As a result of the above difficulties listed above, I reluctantly give AppFolio a neutral rating. I am reluctant because the historical growth rate is strong, I just feel that investing in the company is too risky.

Keep an eye out for my soon-to-be-launched Digital Transformation marketplace service!

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.

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2019-07-11