Just Crushing It

We attended Avalara’s (AVLR) annual customer conference, CRUSH19, and its first ever Investor and Analyst Day in Huntington Beach, CA last week. The event attracted over 900 attendees, marking the company’s largest customer conference yet. For those, like us, that are less familiar with Avalara, the company provides a SaaS platform enabling customers to ensure tax compliance. While a fairly simple sounding proposition on the surface, there is significant complexity in determining the jurisdictions in which a business is subject to transaction taxes, identifying the appropriate rate(s), calculating and collecting taxes, preparing and filing returns, and remitting taxes while still maintaining records and compliance documents for potential audits in the future. Domestically, this complexity has only increased, particularly for e-commerce merchants selling on various online marketplaces, due to the Supreme Court’s Wayfair (aka South Dakota v. Wayfair) ruling in mid-2018, which paved the way for individual states to require businesses to collect and remit sales taxes even if the seller lacks a physical presence in said state. Over 30 states have already implemented internet sales tax laws, all with varying thresholds before registration and taxation are required and of course all differing from one another with respect to state and local tax rates. It’s no wonder Founder and CEO Scott McFarlane quipped “the only certainty in life is death and taxes, and we are closer to solving death.”

The genesis of Avalara began with a simple premise: a centralized location where everyone could connect and have content available to them. Mr. McFarlane realized that every single transaction is affected by sales tax and compliance to some extent. Thus, whoever aggregates all of the data, in this case all of the invoices, wins the market. Avalara is ahead of the curve in this regard having built over 700 integrations with leading business applications and marketplaces like Magento, QuickBooks, Microsoft, NetSuite, BigCommerce, and Shopify. With access to data and a large and growing library of content pertaining to product SKUs, tax regulations, and rates, the company’s task now is to have all businesses choose Avalara to calculate their indirect taxes. Management believes this represents an $8.0 billion total addressable market with Avalara’s sweet spot being the $2.3 billion opportunity with the nearly 91 thousand U.S. firms with 100-499 employees. At present, Avalara is on a revenue run rate in excess of $300 million with 9,700 core customers spending in excess of $3,000 per year and tens of thousands of customers with the potential to grow. International expansion also represents a substantial opportunity going forward considering an estimated $1 trillion in cross-border e-commerce activity by 2020. With value-added taxes (VAT) and goods and services taxes (GST) coming into play for cross-border transactions, Avalara’s customers can be assured of proper compliance even as they expand into new markets.

Aside from aggregating a significant number of the invoices in existence, Avalara’s moat also arises from having the most and up-to-date content available. In this regard, much of the company’s M&A activity has been predicated upon expanding its content verticals and technology. For instance, the acquisitions of ZyTax in 2014, EZtax and HotSpot in 2015, and Compli in 2019 brought the company expertise in fuel excise, communications, lodging, and alcohol taxes, respectively. The purchase of CertCapture in 2013 added document management and compliance technology, and we note that new capabilities for managing vendor W-8s and W-9s were featured at CRUSH19. More recently, Avalara acquired Indix for its artificial intelligence and product classification capabilities. With Indix, the company aspires to automate the process of onboarding a new customers’ product catalog and applying the requisite tax rules to ensure compliance. The ultimate goal for the company over time is to automate as much of the tax and compliance process as possible, which not only creates more revenue potential but also produces cost savings in its tax filing operations.

From a go-to-market standpoint, Avalara’s numerous technical integrations not only provide access to invoices, but also drive partnerships that reduce its cost to acquire a customer. Avalara counts approximately 35,000 sales reps across 3,500 resellers, software integrators and accounting firms providing referrals to the company. Per management, leads from partners close at a much higher and faster rate than its lower yielding marketing and web activities. Of note, partners earn revenue shares in perpetuity for referring business to the company. In Q1 ’19, Avalara’s top line growth accelerated to 38.4% Y/Y, resulting in total revenue of $85.0 million. Non-GAAP operating income and non-GAAP EPS were $(1.5) million and $(0.01), respectively, both benefiting in part by the adoption of ASC 606, which resulted in the capitalization and deferral of commissions from both direct sales and the partner channel. Management anticipates achieving breakeven in free cash flow in 2H ’19, and longer-term, believes Avalara should achieve a non-GAAP operating margin of 20%-25% with gross margin of 80%-82%, sales and marketing representing 33%-35% of revenue, research and development comprising 14%-16% of sales, and general and administrative expenses accounting for 8%-10% of revenue. While no specific timeframe or revenue threshold was provided with respect to achieving these goals, we believe these targets are reasonable with the most uncertainty likely to stem from gross margin, which requires further efficiency gains in the company’s international operations, and sales and marketing, which requires trade-offs in growth to be considered. On the whole, we were impressed by the opportunity the company has carved out for itself, the recent additions to the management team, and the partner strategy. Our primary concern pertains to valuation as shares of AVLR already trade in excess of 10x consensus revenue projections for FY ’20, suggesting expectations for outsized growth over a prolonged period are already reflected in the stock.