Description

Summary:  CommerceHub (“CHUB”) is a unique and mispriced long opportunity that has ~50% upside over the next 12 months.  The investment thesis in summary:  

• CHUB has significant runway for growth (growing high-teens organically) driven by overall e-commerce growth (+15% CAGR) and continued market share gains for virtual inventory (enabled by CHUB’s solution).  The Company’s entry into the Brand Direct market via the 2015 acquisition of Mercent will expand CHUB’s TAM and should drive growth in excess of the high-teens organic growth of the core business beginning in 2017+.  CHUB represents a pure play way to invest in the growth of e-commerce/omnichannel spend via an extremely high quality business model that is new to the market and not yet well understood.  

• CHUB has a unique business model with no real comparables.  It has all the elements of a top-tier software business model:  

• Extremely stick customer relationships with very low churn rates

• Pure cloud-based SaaS model

• 75-80% gross margins

• Dominant market position with no real competition and network effects to the business model

• Strong organic growth (high-teens/20%) with a long runway

• Sector-leading profitability (40% EBITDA margins in 2017+ after sales and marketing investment)

• Sector-leading sales and marketing expense (low-teens % of revenue which compares to typical 30-50% for other SaaS-based software companies).  Note this low level of sales and marketing reinvestment is unique to CHUB’s business model and is discussed in more detail below

• Sector-leading stock-based compensation (7% of revenue vs. 15-50% for comparables)

• CHUB was spun-out of Liberty Ventures on July 22, 2016.  CHUB represented ~10% of Liberty Ventures’ Enterprise Value.  Most investors of Liberty Ventures were invested as a cheaper way to invest in Liberty Broadband/Charter and Expedia.  As a result, many of these investors have not done diligence on CHUB and have been selling post-spin creating technical pressure.  There has been minimal investor education with no formal road show and no sell-side coverage (which will likely change shortly).  Additionally, there is no good comparable company given the unique nature of CHUB’s business.  Note CHUB is controlled by John Malone which ensures intelligent capital allocation and shareholder value maximizing behavior.  

• Margins are currently understated due to the 2015 acquisition of EBITDA negative Mercent and noise from the spin (~$5mm/yr in public company costs, change in accounting for R&D capitalization) combined with higher investment behind the Brand Direct strategy in 2016.  These costs will leverage in 2017+ and see EBITDA margins revert to ~40-45%.  Note CHUB’s core business (pre-Mercent) was doing 60% EBITDA margins with 5-7% sales and marketing spend as a % of revenue

• Valuation is very cheap versus SaaS companies with similar growth but structurally lower margins and more competition (trading at only 10.3x 2018 EBITDA and 16.7x 2018 P/E using a full 38% tax rate which CHUB actually pays because unlike most software companies it’s profitable).

• The asset has strategic value with potential acquirers including SPS Commerce, EBay, Google, among others.  

Target price:  CHUB could easily rerate to 15x EBITDA / 25x P/E multiple on 2018 earnings which would represent almost 50% upside over the next 12 months with optionality for higher value in the event of a sale of the company (one of the reasons John Malone may have spun it off).  There is arguably even greater upside than we are underwriting given its closest but imperfect comparable of SPS Commerce (with a similar growth rate but structurally lower margins) trades at 24x 2018 EBITDA.  

Background:  In addition to the S-1 from the spin in July 2016, the best overview of CHUB comes from the presentation the CEO, Frank Poore, gave at the Liberty investor day last week (http://files.shareholder.com/downloads/AMDA-6ELUYM/3217897347x0x916872/082D0DF7-A22F-4820-AFE5-527089484064/CommerceHub-Investor-Presentation-Liberty-Investor-Day-FINAL.pdf).  I encourage you to read this as it does a really good job framing the opportunity and the uniqueness of CHUB’s business model.  

CHUB’s primary business is a cloud-based SaaS solution that enables retailers to expand product assortment online through virtual inventory whereby supplier partners/brands directly ship product (a.k.a. “dropship”) to consumers without the retailer needing to make a capital investment in inventory.  It’s important to note that the provision of drop shipping is significantly more complicated than traditional EDI-based supplier relationships (the standard supply chain protocol that enables shipments from suppliers into a retailer’s distribution system) because you are dealing directly with the end customer and delivery date is a critical component of performance.  For this reason, traditional EDI-related software does not enable dropship/customer-direct shipping.  Retailers are rapidly adopting CHUB’s dropship solution as a way to gain competitiveness in e-commerce/omnichannel while spending minimal expense (minimal upfront onboarding costs, no need to expand DCs/logistics to hold and ship inventory directly, etc).  A broad assortment of product is increasingly essential to customer acquisition / conversion for retailers due to the success of Amazon and other online marketplaces and has been shown to be one of the leading drivers of conversion in online transactions.  CHUB has no third party competition of scale as it benefits from network effects working with most of the leading retailers and over 9,900 of the leading brands.  Its customer base is extremely sticky.  It has lost only one major retailer (Circuit City to bankruptcy).  CHUB has three revenue sources that it receives from both retailers and suppliers:  1) Usage (68%) where CHUB receives revenue per transaction, 2) Recurring Subscription (27%) and 3) Non-Recurring Services (5%).  

CHUB is a capital light business (only $4mm of annual capex and no working capital) with ~40-45% EBITDA margins.  Unique compared to most SaaS-based models is that it also requires minimal sales and marketing dollars to win customers as it only markets to the largest retailers in the US since the Top 25 E-Commerce retailers account for ~80% of total E-Commerce sales.  The retail customers direct suppliers onto the CHUB platform creating a network effect as the CHUB value proposition increases with every supplier added.  The Company overall has just under 10,000 customers.

CHUB works with the vast majority of the top retailers within its addressable market.  Our diligence/customer calls suggests that the non-CommerceHub retailers are all potential targets (currently not using an external solution in a meaningful manner).  

As noted above, the Company recently entered the Brands Direct business via the acquisition of Mercent in 2015.  This market serves the nascent but growing number of branded companies that are increasingly selling directly to consumers via their own websites, marketplaces (AMZN, EBAY, etc), and retail e-commerce site.  CHUB’s core dropship business is the only provider of this service in the market.  CHUB is now bundling this with a broader offering that allows brands (many of whom are already CHUB dropship customers) to control their direct to consumer offering across all these channels.  Given CHUB’s dominant dropship position, no other competitor will be able to offer the same service.  We believe this Brand Direct strategy will expand CHUB’s TAM and is already bearing fruit with early wins over the last few quarters (Mattel in Q2, a large footwear company in Q3).  We believe brands selling direct has reached a tipping point and will be a growing trend as they become increasingly comfortable selling around retailers (historically a channel conflict they always avoided).  

Further Detail on Key Components of the Investment Thesis:

1. Long Runway of Growth Potential:  E-commerce has been consistently growing mid-teens as it continues to take share away from brick-and-mortar retailers.  Within e-commerce, virtual inventory is gaining penetration as retailers look for a capital light way to grow product assortment and sales to better compete with Amazon (see CHUB presentation cited above for discussion of virtual inventory penetration %).  Our diligence suggests that CHUB’s penetration of e-commerce should continue to increase for the following reasons: 1) white space opportunity with unpenetrated retailers, 2) increasing the number of brands into the network, and 3) increasing connections between brands and retailers already in the network.

Revenue of CHUB is less sensitive to macro risks as it is a 100% US-based asset with growth determined primarily from the structural shifts of E-Commerce and virtual inventory penetration as opposed to overall retail sales.  

2. Technical Pressure Related to Spin-Out from Liberty Ventures / Lack of Coverage:  Pre-Spin of CHUB, Liberty Ventures was comprised essentially of three assets: Liberty Broadband (Charter), Expedia and CHUB.  CHUB represented only ~10% of the Enterprise Value of Liberty Ventures.  Post-Spin, there are many investors who are either uneducated or uninterested in CHUB as it was not core to the thesis on Liberty Ventures.  This dynamic has created technical pressure on CHUB’s stock price as investors have unload unwanted shares.  CHUB did not do a formal roadshow prior to its spin out (only one day of meetings through Stifel).  As a result, the CHUB spin out did not get meaningful attention and investor education was extremely low on this small-cap asset.  Making matters worse, CHUB is not covered by the sell side.  As a potential catalyst, CHUB management expects the company to be covered as soon as the end of this year.  We think coverage could better help investors understand recent investments that CHUB has been making into its business and raise attention of this high-quality asset.  

3. Misunderstanding of Stock-Based Compensation:  In 2015, CHUB reported Adjusted EBITDA of $43mm.  Of that amount, $42mm was Stock-Based compensation.  There are questions as to how profitable CHUB really is given the magnitude of the reported Stock-Based compensation.  This misunderstanding results from CHUB as a newly-minted public company.  Pre-Spin, CHUB was part of Liberty Interactive.  As a private subsidiary of a public company, CHUB was forced to mark-to-market its Stock Option Liquidity Program that provided eligible option holders the opportunity to tender stock options at the fair value.  To determine fair value, CHUB would engage a third party to conduct an independent valuation.  Given the extraordinary value creation of CHUB in recent years, the majority of the stock-based compensation recorded represents fair-value adjustments.  Post-IPO, CHUB has canceled its Liquidity Program and is recording Share-Based compensation in a manner consistent with public companies resulting in a significantly lower expense.  In Q3, CHUB reported share-based compensation of $2.2mm ($9mm annualized which is significantly lower than the $42mm that was recorded in 2015).  We are modeling ~$9mm/yr going forward which represents an industry-leading 7% of sales.  

4. Margins Understated From Mercent Acquisition / Brand Strategy:  In 2015, CommerceHub acquired Mercent.  Mercent is a technology that enables brands to easily sell on marketplaces (AMZN, Google, Facebook, Jet, etc.).  Mercent is a distant #2 to Channel Advisor in its offering.  Mercent was losing money at the time of the acquisition.  By our estimate, Mercent was losing $4mm.  2015 EBITDA for CommerceHub would have been 10% higher without this acquisition.   

What is misunderstood is that CHUB acquired the Mercent assets not for its current book of money losing business but for its technology.  CHUB is currently in the first inning of intentionally churning the unprofitable Mercent customers as it adopts a new strategy.  The old Mercent strategy was offering low margin digital marketing services.  This is not an attractive business.  CHUB is taking the Mercent technology and building it into its core CommerceHub solution.  The new product offering will be a high-margin, more-scalable solution.  In the interim, however, CommerceHub is investing ahead of any revenue contribution.  As a result, the historical Mercent product has gone from a $4mm headwind at acquisition to a $9mm headwind in 2016.  Our 2018 EBITDA of $61mm excludes any revenue benefit from the brands strategy but includes all the costs.  Adding back the $9mm would result in EBITDA that is 16% higher.  In reality, the brands strategy will ultimately either be successful resulting in accelerated revenue growth (no benefit to date) or CommerceHub will pull back on the investment.  CHUB is already having success with its new brands offering.  It has signed up Mattel and an iconic footwear company.  We think CHUB’s strategy makes a lot of sense because it already has 9,990 suppliers in its network to which it can cross sell the new offering (an opportunity Mercent didn’t have).  The brands strategy of enabling suppliers to sell into marketplaces enables brands to take more control of their business by selling directly to the customer versus being exclusively reliant upon brick-and-mortar retailers for sales.  Through the CommerceHub integrated solution, brands can now manage all of their drop shipping operations through one integrated solution.  

5. Potential Acquisition Target:  We believe that CHUB could be a potential acquisition target.  Greg Maffei (CEO of Liberty Interactive) said the following in November 2015 regarding its decision to spin out CHUB from Liberty Ventures, “It’s not inconceivable that this company could be part of a larger enterprise.  And we would have been loath to do that given a very, very, very low tax basis inside this thing.”  We think CHUB could be an acquisition target for companies that are interested in providing supply chain solutions such as SPS Commerce.  Similar to CHUB, SPS Commerce offers a cloud-based architecture to help brands integrate into retailers’ supply chain operations without having to make a direct EDI connection.  Additionally, the solution could be of interest to Marketplaces such as EBay and Google that try to more effectively compete against Amazon by having stronger relationships with suppliers.

Returns:  There is no historical valuation for CHUB.  There is no great comparable for CHUB either.  The most similar is SPS Commerce however CHUB is a better business in our view because CHUB faces no significant competition for its core solution (SPSC and others say they do drop shipping but our VAR suggests that only CHUB does it at scale) with much higher margins (low-teen margins at SPSC).  SPS Commerce trades at 24x 2018 EBITDA versus CHUB at 11x EBITDA.  We are not anchoring on SPSC valuation – just pointing out the upside potential from a rerating.  Taking a step-back, we think a business that grows its top-line high-teens in a capital light manner with recurring / sticky customers deserves to trade at a multiple in excess of current valuation.  Assuming just 15x EBITDA provides nearly 50% upside.  

Financial Projections:

Key assumptions:

• Continued ~18% organic growth in the core dropship solution.  Modest revenue headwinds in 1H 17 from the churn of legacy Mercent customers that began in 2H 16 with the rollout of the new Brand Direct strategy that anniversaries in 2H 17).  2018+ growth > than core 18% as Brand Direct begins contributing revenue

• Gross margins expand to reflect new R&D capitalization policy implemented in Q3 (will lead to lower D&A which flows through gross margin)

• Higher R&D expense to reflect new R&D capitalization policy

• Modest incremental investment in sales and marketing to drive Brand Direct strategy (~150bp as % of sales)

• G&A run-rates at ~$22-23mm/yr which incorporates the ~$5mm of public company costs.  This will leverage going forward according to management

• $9mm in stock-based compensation expense (current run-rate)

• 38% tax rate (could change if Trump/Republicans reform corporate tax)

Catalyst

Analyst initiations

Investor awareness that comes with post-spin seasoning

Guidance on 2017 cost structure