Vertex: Share Price Weakness Represents Another Buy Point

Investment thesis

Vertex (NASDAQ:VERX) provides services for managing various types of taxes, including those imposed on purchases, services, communications, lodging, leases, and employee salaries. VERX's clientele includes businesses in the retail, publishing, and heavy manufacturing sectors. I first recommended to go long VERX was in late January which has worked out well with the stock going from $12.15 to a height of ~$24, a 100% return at one point. While the rally has been strong, I believe the recent drop in share price presents another opportunity for investors to size up / enter the stock. Since the peak of ~$24, the stock is now down 25% to ~$18, which I believe is due to VERX's competitor - Avalara launching an integrated plug-in for ChatGPT that will allow users to calculate sales taxes based on their location in the U.S. As investors realize that this probably does not impact VERX as much as they think, I expect valuation to rerate back to 6x forward revenue. Hence, I reiterate my buy recommendation.

Performance momentum continues

So far, performance has been as expected, and all of the most important metrics continue to show positive trends. While a drop in direct clients to 4,278 is concerning, the strong 21 new logos from the indirect channel more than make up for the decline. This further proves the value of VERX's partnerships with industry leaders like Microsoft (MSFT), Workday (WDAY), and Salesforce (CRM) in bringing in new business through indirect channels. It's noteworthy that both the gross and net retention rates have stayed consistently high, at 96% and 110%, respectively, as guided by management. Additionally, ARR increased 17% y/y to $447 million, which accelerated ARRPC growth to $104.k (16.4% y/y) from 15.9% in 4Q22. Growth seems likely for VERX in the near future, as the company is now much more robust than it was a few years ago, with multiple channels through which to win customers. These channels include indirect partnerships mentioned, as well as additional front office solutions from Salesforce. VERX relationships with procurement systems have provided VERX a source of customers. In addition, I think Vertex is making out okay thanks to the market upheaval and additional opportunities brought on by the Vista acquisition of Avalara. Moving forward, given that VERX's investments appear to have reached their peak, I anticipate that its EBITDA and FCF will continue to perform healthily, while ARR will grow steadily in the coming quarters as momentum continues.

Avalara ChatGPT not a threat

In my opinion, this won't have much of an effect on VERX's existing business or growth. For several years now, across a wide range of complex tax categories, Vertex has used AI/ML to curate content and improve the operational efficiency surrounding its content library. The fact that competitors are adopting generative AI shows the importance of integrating AI and how useful it is, which VERX has been doing all long, suggesting the experience lead it has in deploying AI to enhance the product. Given the importance of getting tax calculations right for complex businesses, I anticipate that many organizations will continue to favor a hybrid approach, combining human and automated processes. Investors should be aware that VERX's ability to integrate with complex, multi-ERP enterprises is a core value proposition to customers, and that the AVLR ChatGPT plugin does not provide this critical value proposition. In my opinion, there has been an exaggerated response to the disruptive potential of generative AI like ChatGPT. These solutions (like VERX) are used by businesses so that they can rest easy knowing that the output is accurate. It's also difficult to put faith in a brand-new system when comparing it to one that's been consistently reliable.

Valuation

Because of the unjustified share price weakness which I believe was caused by the AVLR ChatGPT plugin, I believe the upside remains appealing today. Given the business's growth momentum and value proposition, I believe it can maintain the same rate of growth projected for FY23. I also believe that the market will revalue the stock to its previous valuation (prior to the share price drop), realizing that it has no negative impact on VERX's business. All of these leads to a target share price of $28.

Risks

Cloud revenue deceleration

Decelerating Cloud revenue in 1Q23 (26% vs. 34% last quarter) is not a red flag today, but it is something to keep an eye on. At this time, I attribute the slowdown to poor timing on the part of deals and have taken note of the atypical trajectory of Cloud growth in FY22. But if it continues for another quarter, I'll start to worry about the growth's sustainability.

Limited penetration left in the enterprise segment

VERX is already well-established in the enterprise market. Upselling and cross-selling will have to provide future expansion. While this approach makes sense, it will be difficult to expand if there aren't enough new customers to attract.

Conclusion

VERX has shown strong performance momentum with positive trends in key metrics. I believe VERX integration of AI/ML in its offerings has given it an experience lead over competitors, making AVLR ChatGPT plugin less of a threat. The market's exaggerated response to generative AI overlooks VERX's proven reliability and ability to integrate with complex enterprises in my view. Despite the recent share price weakness, the upside remains appealing, and I believe the stock will be revalued to its previous levels. However, risks such as decelerating Cloud revenue and limited penetration in the enterprise segment should be monitored.