Description

Recent Price Action

It would be silly to start this writeup without pointing out that after trading between $8.75 and $9.70 so far this year, ECOM stock has increased to $11.90 since announcing preliminary financial results on April 19.  So while the stock isn’t as cheap as it has been for the last several months:

(i) There is significant probability-weighted asymmetry at this valuation (the stock is currently “mispriced”.  The valuation prior to the recent runup was “stupid”).

(ii) In the absence of a take-out, ChannelAdvisor has the potential to deliver many years of compounding before making a significant dent in its addressable market.  It would not be surprising to see this company quadruple its revenue over the long-term.

(iii) The positive preannouncement may be an indicator that the operational issues are being fixed more quickly than I’ve suggested below, implying a beat in 2018, a lower level of risk, and a faster rerating than I’ve proposed

See the “Catalysts” section for some additional thoughts on how the next few price moves may look.

Summary

ChannelAdvisor Corporation (the “Company,” ticker “ECOM”) is an attractive long.  It’s an okay SAAS company with an okay management team that sells an excellent (mission critical, high ROI), massively underpenetrated product and is awash in structural tailwinds relating to ecommerce.  The Company has only $11mm of PP&E, spends $3mm annually in capex, and has negative net working capital.

At 2.2x revenue, this 80% gross margin company’s past (self-inflicted, correctable) operational missteps are weighing far too heavily on today’s valuation, providing a significant positive asymmetry in potential outcomes: high probability upside of 37% vs reasonable probability downside of 20% and low probability downside of 24%, with a free option on faster-than-anticipated growth (upside of 70%+ based on 20% growth and a 3x revenue multiple) and the potential of being a multibagger over the long term.

ChannelAdvisor has $52 million of net cash on its balance sheet and has managed its business to a slight cash burn ($12mm in 2017 and $4mm cumulative over the last ten quarters), giving the Company lots of runway to fix its operational issues.  ECOM stock also has several large holders who are likely to become “significantly hands-on,” including pushing for a sale to a strategic, in the absence of a timely internal fix.

ChannelAdvisor is based in Morrisville, NC and employed 737 people as of December 31, 2017.  The Company was incorporated in 2001 and went public in 2013.

Note finally that ECOM was written up on VIC in August 2015 at approximately this same price.  Since then, net cash has come down by about $5mm and diluted share count has increased by 7% while GMV (Gross Merchandise Value, or the amount of transaction value that is conducted through the platform) has grown 56%, TTM Revenue has increased 34%, Gross Margin has gone from 77% to 82%, TTM Cash Burn has gone from $27mm to $12mm, number of marketplaces supported has gone from 49 to 107, the management team has had meaningful turnover including a number of external hires, and the Company has added fulfillment and dropship capabilities to its product offerings along with numerous other GMV-driving features.  The Company has also realigned its sales organization to focus on larger, stickier, more profitable customers and has committed to driving additional GMV growth through a customer success organization under Beth Segovia (yes it’s ridiculous that this is happening now and not 15 years ago).

Company Overview

ChannelAdvisor has only one reportable segment but breaks its revenue into three product categories in its Form 10-K: (i) Marketplaces - $93mm or 76% of 2017 Revenue, (ii) Digital Marketing - $18mm or 15% of 2017 Revenue, and Other - $11mm or 9% of 2017 Revenue.  Below is a chart showing the Company’s revenue breakout by product over the last few years. Despite an 80% gross margin, the Company’s subscale revenue relative to its opex has resulted in marginally negative EBITDA and cash flow.

Marketplaces

This is ChannelAdvisor’s core product.  It is a software platform that provides a single interface through which an ecommerce seller can manage its business across multiple selling venues (marketplaces).  The main functions of the Marketplaces product are to help ecommerce sellers (i) expand their business to and manage order flow among multiple channels, (ii) manage product content (i.e. pictures, descriptions, etc. for the items they’re selling), (iii) optimize business decisions such as product pricing, channel selection, and fulfillment, (iv) stay on top of changes made by marketplaces (e.g. eBay changing the number of keywords that a product listing should have), and (v) manage inventory availability across multiple channels.

Implementation may take a couple of months as all of a retailer’s data (in some cases consisting of tens or hundreds of thousands of SKUs) must be converted to an appropriate format and loaded into the platform.  Once implemented, however (assuming that the customer is tech-savvy enough to actually get it properly implemented, which has been an issue in the past when the Company targeted customers that were too small and unsophisticated), the product becomes sticky and mission critical given that every order must pass through the ChannelAdvisor platform.  Switching costs are high given the implementation process and the efficiency that the platform provides by allowing multiple channels to be managed through a single interface.

As one might guess, specific feedback varies by customer and depends highly on the complexity and scale of the seller’s business.  I’ve had customers tell me that they could replace the product with one or two people, and others tell me it could take twenty or thirty.  One mentioned that the product had become his most valuable employee and could be completely managed by his “warehouse guy.” Nearly every customer I spoke with out of fourteen said that ChannelAdvisor’s product, while expensive (1-2% of customer revenue depending on the contract) is far and away the best and most feature-rich solution out there, and that competing solutions seem to always have some sort of “gotcha” such as a key marketplace not being supported or having an inefficient data interface.  One of the positive surprises I came across involved a couple of customers who only used the platform for one or two marketplaces and said that even with a relatively low level of complexity, the product was invaluable to them.

In general I think of the main value proposition of Marketplaces as being the ability to suddenly reach a huge number of new customers (this drives the bulk of the ROI to ECOM’s own customers), keep all your listings and orders correct despite multiple changing channels, and access data to help optimize your business (for one example of this – the platform can show you data regarding where your competitors are selling similar products in order to help you optimize your channel selection i.e. if you sell razors and you see that razors sell extremely well on Jet.com, you may decide to start selling on Jet.com).

Check the customer testimonials at https://www.channeladvisor.com/success-stories/ for some (admittedly biased) success stories.

The platform also includes a large number of features that help sellers maximize sales.  For example, one tool takes any eBay listing more than 30 days old, delists it, and relists it in order to get a better ranking in the search algorithm.  ECOM also offers several pricing tools to help sellers “Win the Buy Box” on Amazon, which is a major determinant of sales velocity. These tools (and many others like them) are examples of how the platform can quickly provide the value equivalent of a large number of employees focusing only on optimizing marketplace decisions.

As stated above, the Marketplaces product supports 107 marketplaces.  The largest is Amazon followed by eBay followed by Walmart. The Company has stated that no marketplace represents more than half of GMV and that the sum of all of its smaller marketplaces are equal in aggregate to the size of its third largest marketplace (and growing rapidly).

Most recently, the Company has incorporated fulfillment capabilities (i.e. if I have a product shipping to the Northeast that needs to be kept cold and weighs over five pounds and needs to be there within two days, which distribution center should I ship from, and should I go UPS ground or USPS priority?  ECOM can help sellers develop rules to automate these questions) as well as a dropship capability as they believe that fulfillment speed and quality will be one of the most important differentiators for sellers over the next couple of years (I agree with this. It seems to be one of a number of things that have worked well for Amazon).

Digital Marketing

This product is somewhat similar to the Marketplaces product but for display advertising.  Customers can manage the look and content of an ad across multiple channels including comparison shopping engines, search engines, and social media sites.  This product, while delivering high margin revenue according to the Company, has been challenged from a growth perspective due largely to (i) an overweighting to retailer customers whose advertising budgets have been challenged, (ii) the decimation of most comparison shopping engines by Google Product Listing Ads.  However, the product actually grew in the most recent quarter according to the Company as a result of Amazon’s new sponsored products offering. ChannelAdvisor has said that sellers using sponsored products on Amazon see a 3x sales lift, and that revenue spent on sponsored products is growing at 70%.

Other

ChannelAdvisor’s smallest but fastest growing revenue segment is made up mostly of its “Where to Buy” product, which allows brands to point website visitors to vendors that are selling its products.  There is also a small revenue stream in this segment that ECOM earns by selling data to brands about where and how a brand’s products are being sold, as well as some revenue that ECOM receives from certain marketplaces in exchange for supporting them on its Marketplaces product.

The Market Opportunity

The high-level opportunity is well understood.  Ecommerce is growing and expected to grow at about 15% according to sources such as eMarketer, U.S. Census data, etc.  This figure is a combination of global retail growth of ~3% and share gain of ecommerce within retail. Some believe that the 15% figure is understated given how quickly some of the large players like Amazon and Walmart.com are growing.

The dollar figure that seems to keep popping up is $4 trillion of global ecommerce sales by 2020.  I won’t pretend to be able to verify the validity of this figure, but if it’s even close, this is an enormous pool for ECOM to play in, with an additional $600 billion of addressable market being added each year.  In addition, the rapid growth of the space implies that ECOM can grow at 15% without ever increasing its penetration of the opportunity.

Clearly the entire space isn’t their addressable market.  Management estimates their penetration of well-fit customers to be 3%, which still leaves many years of headroom and a very significant growth opportunity.  Note that it is important to separate GMV growth from revenue growth. Because ECOM charges its larger customers a lower commission rate, the Company must grow GMV in excess of 15% in order to achieve a 15% revenue growth rate.  The Company has achieved this every year except in 2017, when churn of small customers and share loss of customers vs 1st party marketplace sellers (which have since already reversed), resulted in GMV growth of 10%. The three main levers for growing GMV are (i) bringing new customers onto the platform, (ii) developing new features that help ECOM customers win share against non-customers, and (iii) making sure that customers are using all available tools on the platform to maximize sales volume.  The Company has done a wonderful job of (ii) and a pretty bad job of (i) and (iii). As one might expect, some of the new hires and a tremendous amount of focus are being applied to (i) and (iii) (which honestly should just require the normal blocking and tackling of running a business).

As will be discussed below, the Company’s go-to-market strategy has been pretty misguided historically, but ECOM has refocused on winning large, profitable customers (who also churn at much lower rates than smaller customers).  Also, the increasing comfort of branded manufacturers with selling through ecommerce channels presents a tremendous opportunity to win new large customers and drive GMV (keep in mind though that this will be part of, not additive to, the continuing growth in the ecommerce industry discussed above).  The Company has also started an indirect sales channel, which is off to a good start in providing a new funnel for Marketplaces customers.

What Happened / How We Got Here

Without getting too long-winded, I’ll just say that this Company, despite being founded in 2001, never matured.  When I first met with them in 2014, they didn’t even have metrics to look at what customers of theirs were profitable vs. not (they do now, which has driven their shift in sales focus.  See page 79 of the April 2018 Investor Day presentation for an interesting analysis of their customer cohorts and the effect on consolidated performance. They’ve been speaking to this for several quarters in vague terms and finally provided some data.  Things seems to be moving in the right direction).

It also appears that they stuffed a lot of low-quality revenue (small customers who ended up having a high churn rate because their IT function wasn’t built out enough to actually take advantage of the platform) prior to the IPO, which then churned off over the next couple of years, contributing to the decline in revenue growth from over 25% to under 15% (and the decline in the stock price from over $40 / share to $12).

In the meantime the Company tried to maintain revenue growth at any cost by keeping a large, disorganized, inefficient sales organization chasing after any revenue they could come up with, resulting in the awful sales and marketing spend of 50% of revenue and negative EBITDA and cash flow.  With new sales leadership and the aforementioned focus on large, low-churn customers, the Company expects a reacceleration of growth and a significant increase in sales productivity. Given the market opportunity and the quality of the product, this shouldn’t be that difficult of an ask with the right leadership in place.  Although it is too early to say for sure, it appears that bookings improvement is off to a good start under new Chief Revenue Officer Paul Forte who joined in 2017 (further commentary on this in call transcripts and pages 27-29 of the Analyst Day presentation).

Where We Are Now / Current Misunderstanding

It’s no stretch to say that the huge marketing spend along with declining revenue growth well below the rate of ecommerce has caused the valuation to reach (in this case rise to…) a level that implies a mediocre product, company, and management team, and expectations of middling performance.  While the criticisms of past management decisions and resulting financial performance are certainly fair and warranted, I don’t think they’re necessarily relevant to evaluating ECOM’s future performance.

The product is excellent despite the salesforce’s historic inability to get it into the hands of the right customers.  As stated above, the sales organization, under new leadership, is now focused around signing deals with large, profitable, low-churn customers.  The Company signed 28 deals over $100k of revenue in 2017 compared to 26 in 2016.

The historic lack of an effective customer success organization has resulted in ECOM’s customers “under-selling” in terms of volume, because they haven’t had assistance in taking full advantage of ECOM’s selling tools.  Thus “normalized” GMV is higher than the current realized level. Admittedly I don’t know how much higher, but I will say that at this year’s user conference, speakers discussed feature after feature and asked each time who in the audience (~200 customers) was familiar with each feature, and it was crickets.  I think there’s a lot of opportunity here.

The third prospective improvement that isn’t being valued by the market is also related to customer success, which is bringing churn down across the entire group of smaller, higher churn customers by increasing customer support (both troubleshooting and feature adoption), which should result in a higher effective ROI of the Marketplaces product to these customers.

Valuation

Base Case Valuation

In my Base Case, ECOM reaccelerates revenue growth to 15% (Marketplaces grows at 15% and continued rapid growth in Other offsets slower Digital Marketing Growth) inline with general ecommerce industry growth This is likely conservative as it assumes that (i) revenue growth from net new customers plus share gains by ECOM’s customer base is fully offset by (ii) customer churn plus share losses from ECOM’s customer base plus GMV leakage.

If the Company hits its (also likely conservative given the parade of misses over the last several years) 2018 midpoint guidance of $129mm or 5.3% revenue growth and then accelerates growth to 15% for the next two years, the result is 2020 revenue of $171mm.  I apply a 2.5x EV / Revenue multiple to the business given the mid-teens growth rate, significant headroom for further growth, 80% growth margins, relatively low churn in the core customer base, and very low capital requirements. This results in an Enterprise Value of $427mm and a fully diluted share price of $16.31 after taking into account net cash, NOL, Unvested RSUs, and Option dilution.  This represents upside of 37% from the current level.

Low-Probability Downside Valuation

Downside risk to ECOM stock is reduced by the Company’s excellent product, high gross margins, capital-light business structure, significant net cash balance, and low current multiple.  More important, however, is the fact that ChannelAdvisor (especially given the small enterprise value) would make a very attractive acquisition for either Oracle (acquired NetSuite in 2016) or Salesforce (acquired Demandware in 2016).  These buyers should be able to realize significant marketing and G&A synergies.

My downside case contemplates a failure of this management team to grow the business beyond 2018 guided revenue of $129mm.  An 80% gross margin, synergies equal to 50% of marketing and G&A expense vs. 2017, flat R&D expenses, and $3mm of Capex and capitalized software expenses results in $35.5mm of EBITDA less Capex to the acquirer.  At a depressed 6x EV / (EBITDA less Capex) multiple, ECOM shareholders will realize an acquisition price of $9.10 per share or 24% below the current level.

ECOM has a concentrated shareholder base, with ArrowMark Colorado Holdings owning 16% of the stock, Shapiro Capital Management holding 15% of the stock, and Altai Capital owning 7%.  In the event of continued poor performance, I believe these holders will greatly mitigate stock losses by pushing hard for a sale of the Company or perhaps finding a more effective management team.

Reasonable-Probability Downside Valuation

This case assumes that the Company is not able to accelerate growth beyond 5% resulting in a 1.5x Revenue multiple and a price of $9.43 or a 20% discount to the current value (note that in this scenario again an acquirer could pay a higher price on the basis of marketing and G&A synergies and a 6x EV / (EBITDA less Capex) multiple.

Further Upside

I won’t bother laying out a detailed valuation for additional upside potential that I’m not underwriting but I do think it’s worth noting that it wouldn’t be surprising if any combination of the growth opportunities I’ve identified ends up driving growth of 20% or more.  I would expect such growth to be accompanied by greater margin improvement and a more dramatic re-rating of the stock.

In addition, although I’ve valued ChannelAdvisor on results within the next few years, I believe that the size and prospective growth of the ecommerce opportunity will allow the Company to double its revenue a few times over a longer time horizon.

Risks

Company

Earnings - ECOM doesn’t have them and needs to grow revenue in order to get them.  Revenue-based valuations come with a lot more beta, and obviously companies without earnings require more things to go right in order to have good outcomes

Slowdown in ecommerce.  That doesn’t feel like a major risk to me, which is maybe a good reason to make sure it’s listed here

The huge size of the ecommerce industry may attract huge amounts of competitive capital

There’s an implicit bet in a ChannelAdvisor investment against Amazon taking over the world.  While betting against Amazon isn’t really my thing, I’ll say that (i) the number of marketplaces in existence and supported by ECOM continues to expand, (ii) third-party seller volume at Amazon continues to take share (and AMZN seems to encourage this), and (iii) there was a time when it was completely obvious that no company of any kind would ever be able to challenge Wal-Mart

Selling online is very competitive and always changing, and the “winners” may not happen to be ChannelAdvisor customers

I may be overestimating Paul Forte’s and Beth Segovia’s ability to fix sales productivity, churn, and feature adoption, and too conveniently blaming these issues on prior employees

Even with improved sales productivity, the Company has a lot of wood to chop on the margin side to get to a solid cash-based valuation

In a poor performance scenario, the large holders may not materialize as I’ve suggested they should

Stock

It’s definitely not underfollowed in terms of sellside coverage

Small, illiquid, volatile

Catalyst

Improvements in sales organization result in reaccelerating revenue growth

Margin improvement and consistent positive cash flow as revenue outpaces opex

Rerating of stock based on revenue growth and/or margin improvements

Potential takeout by strategic acquirer

Activist behavior from large shareholders

(Potential negative near-term catalyst) Broader market realizes that ~$600k of Q118 beat was non-recurring revenue from the indirect sales channel

(Potential negative near-term catalyst) Positive Q118 preannouncement turns out to be an aberration and the rest of 2018 reflects minimal improvement