AppFolio: This Potential Earnings Turnaround Should Be In Your Portfolio

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Introduction

I'd already spotted AppFolio (NASDAQ:APPF) as a top performer in the Application Software sector, showing all the signs of a potential earnings turnaround this year. Their recent Q2 23 announcement did not disappoint; they reported a return to Non-GAAP profitability, beating by $0.11, and a strong 25% YoY revenue growth. In this article, I will explore why all the quantitative and qualitative information supports my long idea for APPF in the second half of 2023.

About the company

APPF are an application software company that offer a platform for real estate managers and real estate management companies. Their software provides a complete solution for managing a real estate portfolio, automating workflows for key processes like payments, tenant screenings, insurance and maintenance. APPF aim their product primarily at SMB real estate management companies, but they have ambitions to move "up the chain" this year and target more upmarket and lucrative customers.

There are similar real estate management platforms out there, like Yardi, Real Page, Buildium and Entrata, but these are all privately owned companies. APPF's closest publicly traded peers would be Toast (TOST), Procore Technologies (PCOR) and Trade Desk Inc (TTD) who provide niche software for restaurants, construction, and advertising, respectively.

Q2 2023 Earnings Summary

The results for Q2 2023 were all very positive for APPF, meeting all my expectations and suggesting to me that the turnaround story could be starting to play out.

APPF announced a Non-GAAP EPS of $0.24, a beat by $0.11 (84.62% surprise) and a return to profitability after 2 quarters of negative earnings. The GAAP EPS, however, was -$0.53 and a miss by $0.29, so not a perfect result. Total revenue for the quarter was $147.1 million, $3.32 million higher than estimates and a strong 25% YoY growth. Positive results for Non-GAAP Operating Margin, 6.4% and up 540 BPS YoY, and Non-GAAP Free Cash Flow, $6.2m. Finally, APPF upgraded their FY23 outlook for revenue, the estimated range being raised to $592 million-$598 million from $570 million-$580 million, which fills me with optimism for this trade idea.

Sector Tailwinds & Headwinds

Tailwinds

In my top-down approach for picking stocks, I will always look at tailwinds and headwinds for the sector, to make sure I'm picking the best stocks in the juiciest sectors for outsized returns.

The Tech sector has huge momentum behind it and has been outperforming the S&P since March this year.

The sector is benefiting from improved macroeconomic conditions in the US and money pouring into tech large and mega caps, like Nvidia (NVDA), Advanced Micro Devices (AMD) and Microsoft (MSFT). The Bull market has technically kicked off now and if it doesn't relent, then Tech will only continue to grow. APPF is by its nature exposed to the real estate market, so we can get some extra sector tailwinds. We are in the busy summer season for real estate, so expect to see uptake in activity & revenue in Q3. And lastly, all signals point towards a soft landing for the economy and the real estate market, despite the doomsday narratives, which will provide a nice tailwind for the sector and APPF in particular.

Headwinds

On the flip side, the extraordinary growth in Tech this year could result in a harsh and sudden correction, so this is something to be aware of if executing a long trade in APPF. And thinking about the Real Estate sector, despite the positive signals, it is still one of the worst-performing sectors in the market.

Forward-looking estimates vs sector

APPF have an almost ideal setup for a long position when it comes to forward-looking earnings and revenue estimates. This year they expect to turn around their operations, from loss-making to profitable, with a 100% earnings growth for FY23. And FY24 earnings growth is forecast to be an impressive 71%.

Forecasts for top-line revenue growth are 26.35% this FY23 and 22.97% in FY24, way above inflation and very appealing growth estimates in their own right. But do I think they can they meet and even beat these estimates? I dug into the operational data published by APPF, applied some sensible logic & assumptions, and I was able to forecast their volumes and their FY23 earning & revenue performance.

Just to explain my process: I carried forward the steady growth of Units Served and Property Manager Customers, at 3% and 2% QoQ growth respectively. I then applied some sensible logic to project the Customer ARPU, factoring in seasonality. And then I was able to solve for Revenue - i.e., Customer ARPU X Property Managers.

I landed on $600 million revenue estimate for FY23, based on a rational and conservative thought process (I hope you agree). $600 million is just a touch higher than APPF's top-end revenue estimate, $598 million, so I'm not a million miles off here.

Trying to forecast earnings and EPS was not as straightforward, due to the negative earnings over the last 12+ months. But we can certainly look at the trend of Non-GAAP Operating Margin (below) and note that APPF has returned to the operational performance benchmark of Q2 2021. Momentum is there to exceed this and capitalise on growing revenues and boosted summer real estate activity.

Valuation

When I assess APPF's current valuation, and where the price could go this year, I use the Price to Sales (P/S) ratio, or Sales Multiple. Because APPF goes from loss-making to profit-taking, the Price to Earnings multiple is skewed.

The P/S ratio, sitting around 12x right now, is back up to 2021 levels after the slump in earnings last year. So, if you're an investor who likes to get in at the bottom and grab a bargain, then APPF is not your stock right now. Maybe if you were looking at the stock back in October 2022, when the P/S was at 7.51, then you'd get ultimate value.

Does that mean APPF is over-valued or too expensive then? Not necessarily. If I project the current P/S forward and apply it to the FY23 sales estimates, I still think APPF offers fair value and plenty of room for price growth.

(FY2023 Revenue Estimate X Current Sales Multiple)/ Shares Outstanding = Price

($596.3 million X 12)/ 35.64 million = $200.76

With a current price of $184.07, at time of writing, APPF is trading at a $15 dollar discount to the forward-looking P/S. In my opinion, a 9% move to the upside in the next 6 months looks easily achievable for APPF, who historically have a 15% quarterly volatility.

KPIs behind earnings & revenues

I like to look into the company's earnings materials and annual reports, to find out what is really driving a company's impressive (or lackluster) earnings and revenue performance.

Revenue KPIs

Concerning revenue, we can see great positive direction in the revenue KPIs published by APPF.

The core factor driving their revenue growth is volume, and we can see "Volume of Units Served" and "Property Manager Customers" is continually growing. "Average Revenue Per Unit (Customer)" also shows continued growth (note this is my calculation as APPF don't publish their ARPU numbers).

APPF's revenue split is weighted towards the more premium "Value-Added Services" segment, and we can see Revenue split % increasing for this segment. This is what we like to see as investors: companies expanding their more profitable ventures.

Earnings KPIs

When we look at some KPIs driving earnings, we see that R&D as % of Revenue trending higher over time, which is great for innovation, and G&A% coming back under control this year, so a double kicker for earnings.

APPF communicated in their earnings materials that they want to improve Operational Efficiency this FY 23, so we hope to see G&A as % of revenue trickle down and profitability increase. Looking at Cash Flow metrics, the annual Free Cash Flow (FCF) trend tells the story of the turnaround and illustrates APPF is moving in the right direction.

It's nice to see reduced Capital Expenditure as well. Quarterly numbers are affected by seasonality of the real estate industry, so we're looking at annual numbers.

Competitor Comparisons

In order to compare with sector peers more efficiently, I created my own sub-sector of Application Software stocks, the "Niche Management Software" sector. These are software companies that provide a SaaS management platform catered for a very specific industry or use case.

Comparing qualitative KPIs with peers in the Niche Pre-Packaged Software sector was not straightforward, because there was little consistency in KPI reporting across stocks. Some shared Annual Recurring Revenue (ARR), but some didn't. Some gave top-line customer numbers, and some didn't. Therefore, the most sensible and efficient apples-for-apples comparison was to look at some classic backwards quant ratios, relevant to tech companies.

Firstly, Gross Margin % - APPF sits in the middle of the sector with a steady c.60% over the last 4 years. This is the kind of absolute Gross Margin we want to see from a tech company.

Next is the Current Ratio, where we get a snapshot of the company's ability to cover its current liabilities. APPF is second highest in the sector with 3.28 and moving in the right direction.

Moving onto a slightly different ratio, GAAP R&D as % of Revenue. For a growing tech company, we want to see this moving higher over time. This is exactly what we see from APPF over the last 2 years, even though not the absolute highest out of the group.

And finally, we'll take a deep dive into FCF data and ratios.

APPF's steady positive direction for FCF stands out against three of the sector peers. Even during their worst performing years, APPF remained positive FCF which indicates great control by management. PWSC and TTD have a great Free Cash Flow trend, but APPF's turnaround story and positive direction still looks good.

The Free Cash Flow Yield data backs up the steady and positive performance from APPF compared to sector peers, 3 of which bombed to negative FCF Yield in the last FY. Levered Free Cash Flow TTM comparison from the last 2 years also backs up the thesis of the potential turnaround and the return to above average growth.

Earnings

We just had the Q2 23 earnings announcement, so we have a while to wait for the Q3 earnings, due end of October. In Q2 APPF returned to positive EPS, and analysts are expecting another big jump in positive EPS for Q3.

Analysts have upgraded their FY EPS estimates after the Q2 results in a dramatic positive way. This is exactly what we want to see for our long idea, the analysts are validating our thesis.

Catalysts

I always need catalysts in my trade ideas, events that are probable and will actually drive the stock in the direction I want it to go.

Looking at Macro catalysts, if the current bull run continues this summer it's going to drive the price up in a meaningful way. If there is a soft landing for housing market and we have a positive US housing report, then this could also keep pushing APPF stock upwards. And if the US government posts a positive GDP result next quarter, we would likely see APPF benefit from the good news.

Drilling down to catalysts specific for the Tech sector, if a large or mega cap Application Software stock announces some good news or posts a great earnings result, this would have a positive effect on the tech sector as a whole. Some names which could drive this include Microsoft (MSFT), Oracle (ORCL), Adobe (ADBE), SAP (SAP), Intuit (INTU) and Autodesk (ADSK).

AI is the hot trend right now, attracting money from retail and institutional investors alike. So any developments on the AI theme, especially from one of the big Application Software names, could drive up performance of the sector.

APPF are not very communicative outside of earnings; their press releases are all related to earnings or management changes (CEO or CFO). So, we must rely on the Q3 and Q4 earnings calls and the macro & sector catalysts above. That being said, if APPF do announce that they're adding a new game-changing feature or service, then it could push the stock up even further. We also might see some analyst upgrades in their recommendations, as there is still room for more Buys and Strong Buys.

Risks

Macro & Sector Risks

If the US does report a recession over the next 6 months, then I predict it would impact APPF's revenue-driving KPIs; less activity in the real estate market because of shrinking economy, means lower growth in Units and Property Managers on the platform, and less spend on APPF's Premium Services.

APPF is exposed to the real estate sector, which is incredibly sensitive to macro news. So, any macro or real estate sector news could really hurt the APPF trade idea. One example might be a bad monthly US housing report, i.e. contraction in housing permits, starts or completes.

APPF's earnings are affected by the seasonality of the real estate sector, and Q4 is the least active month for revenue. If APPF have an especially bad Q4, because of changes in the macro or global market, it could wipe out strong gains in the spring & summer, bringing down the FY earnings.

Stock-Specific Risks

I note there is stiff competition in the real estate management software category, particularly from Buildium and Yardi Breeze. If one of these competitors launches an effective marketing campaign or a unique game-changing feature, it could really hurt APPF's top line.

APPF announced a lot of innovative new features over the last 12 months, like AppFolio Stack and raft of AI-based functionality. They could have exhausted their innovation backlog and don't release anything new or exciting for the rest of the year.

And of course, if they miss any of their revenue and earnings KPIs in Q3 or Q4 earnings (I'm thinking particularly growth in Units and Property Managers), then investors might react strongly to this and we could see a big drop in the stock price.

Summary

APPF could be a terrific revenue growth and earnings turnaround story for FY23 and FY24, but it's surprisingly not a consensus idea with analysts. Their KPIs driving revenue and earnings are all trending in the right direction and they have the macro & sector tailwinds behind them. On the back of the fantastic Q2 earnings result, I would be adding this to my portfolio to ride the recent positive momentum, which I think will continue for the rest of the year.