A true test of an individual’s understanding lies in his/her ability to distil complexity into a simple scene in his head.
So to try something new this time, I’ve decided that I will attempt to summarize my investment thesis with a short pitch of the company I’m writing about today – Avalara
Here goes nothing.
The Problem: Compliance and taxation are a massive conundrum for businesses! They are getting increasingly complicated as physical boundaries get blurred by the rise of e-commerce, proliferation of international trade, and a never-ending slew of regulatory changes.
However, many businesses still attempt to handle such processes manually, which is inefficient, lacks scalability, and highly prone to errors!
Avalara’s pitch to clients? Plug our leading cloud-based solutions into your business and let us handle all the cumbersome tasks of determining taxability, identifying applicable tax rate, collecting taxes, preparing and filling returns, and maintaining compliance documentations.
You get to save time and costs, while focusing your resources on what you do best – running your core operations!
If my pitch has piqued your interest in Avalara, read on to find out more!
For readers, it might be necessary to understand a few concepts on the US taxation system and VAT before reading further.
- Sales taxes – Taxes placed on sale of lease of goods and services (Varies by state)
- Tax Returns – After all the sales tax has been calculated and withheld, businesses must file the returns necessary and remit tax owed to each jurisdiction
- Seller exemption – Transactions that are exempted from collection of sales taxes
- VAT – Value Added Tax, most common consumption tax used outside of the US
Note that VAT collection is straight forward but VAT compliance is not because ultimately, the retail consumer pays the VAT. The buyer in each earlier stage of the product’s production is reimbursed for the VAT by the subsequent buyer in the chain
Avalara provides a leading suite of cloud-based solutions that help businesses of all types and sizes to comply with transaction tax requirement worldwide.
Its main offering is the Avalara Compliance Cloud that combines an advanced database of broad, deep, and up-to-date tax content with technology for executing real time tax compliance processes, including tax determination, tax document management, and returns preparation and filing.
It integrates seamlessly with over 1,000+ business applications such as salesforce, workday etc…and is easy to administer and maintain.
Avalara charges for its solutions on a subscription + tiered usage basis. Pricing scales with volume which is designed to grow with their customers. It is also dependent on the number of solutions purchased, partner integrations, and jurisdictions where sales taxes are being collected.
The vision for the Avalara Compliance Cloud is to span across a customer’s end to end compliance journey which Avalara believes to be the below.
The first offering that Avalara introduced – AvaTax was meant to help customers to calculate sales tax collection. Ever since then, Avalara has strategically inched further along the customer journey, organically and inorganically to capture a greater share of the customer journey.
As of today, Avalara Compliance Cloud offers the following:
- AvaTax – Calculation service for sales tax. It can be queried in real-time for every transaction as it is being processed
- Avalara Returns – Tax returns solutions are either integrated or embedded inside AvaTax. Avalara Returns identifies every jurisdiction that requires payment, maintains an updated version of their filing forms/process, and then auto-populates each with the relevant transactional data for the filing period. Avalara can aggregate transactional data across multiple sources. Many businesses will maintain several online sales channels (Shopify, Etsy, Walmart Marketplace, Amazon), in addition to POS transactions. Avalara has integrations with all major e-commerce solutions as well as popular accounting packages.
- CertCapture – Deals with compliance documentation by creating, storing, validating, and managing documentation such as tax registrations and exemption certificates. This solution makes tax documents available for easy retrieval and helps our customers validate them and keep them up to date
- Item classification – service added with acquisitions of Tradestream Technologies Inc. and Portway. This solution addresses the complex process of assigning proper country-specific Harmonized System (“HS”) codes to products. This enables e-retailers and other merchants to easily classify products being sold across international borders so appropriate customs and duty taxes can be applied
- VAT Expert – checks the validity of customer and supplier VAT numbers and provides VAT determinations in the form of invoices that comply with relevant return forms across the European market
- Brazilian tax compliance solutions to address Brazilian transaction tax regimes
Avalara estimates that the market for cloud-based tax compliance solution is relatively unpenetrated with a penetration rate of less than 10% for mid-market and emerging small businesses. The coalescing of an increasing focus on ROI, widespread adoption of ecommerce and cloud, and a dynamic regulatory landscape mean that majority of businesses will have to automate their tax compliance process sometime in the near future.
- Automation is necessary – Focus on ROI
Tax compliance is a highly mundane and burdensome process to begin with. As companies grow and transaction volumes increase, the likelihood of making a costly error increase. Hiring additional manpower to handle such drudgery work is expensive. It is simply not efficient and scalable for companies to continue to rely on manual labour to perform these tasks. Plugging in a cloud-based tax compliance solution such as the Avalara Compliance Cloud, makes tax compliance highly scalable and accurate. It will be ridiculous to not adopt automated tax compliance when viewed through the lens of ROI
- E-commerce and cloud acceleration
The rise of e-commerce has resulted in a parallel increase in the demand for sales tax collection and returns solutions. E-commerce companies can simply integrate Avalara’s API to handle sales tax collection and returns
- Regulatory Changes
Digitalization of businesses has smudged geographical boundaries, resulting in the manifestation of taxation loopholes and grey areas based on existing regulations. As governments become increasingly aware of such occurrences, regulatory bodies are consistently reviewing and changing current guidelines. This is highly time consuming for businesses to stay on top of. Avalara Compliance Cloud offers a clean solution that ensures that businesses are up to date with the latest regulatory developments
As a market leader in this space, Avalara is well positioned to be a huge beneficiary of several tailwinds driving the shift towards cloud-based automated tax compliance.
So how big exactly will this opportunity be?
Avalara believes that the Total Addressable Market for its solutions in the US market is USD 8.0bn. They have segmented the US market into four distinct categories. Here’s how it looks.
Outside of the US, Avalara has widely communicated that they plan to make headway into the international market. They have introduced various product developments and made acquisitions to position themselves to expand internationally. They estimate the TAM of the international market will be multiples of the US.
Game plan going forward
During Avalara’s investor presentation in June 2020, they presented a pie chart summarizing the reasons that deals fail. What was eye-catching was the fact that Avalara was not losing deals to its competitors. They were failing to close deals because customers were reluctant to switch from their existing tax compliance processes.
Avalara’s biggest challenge: To convince customers to adopt a cloud-based tax compliance process.
Here’s my interpretation of how the management intends to tackle this challenge and justify the case for businesses to adopt automated cloud-based compliance solution.
- Expand surface area of compliance journey covered by Avalara’s solutions
Recent acquisitions and product developments have telegraphed Avalara’s intention to extend its presence across the spectrum of industries and stages of compliance journey.
Consider recent acquisitions that are targeted to bolster Avalara’s capabilities in digitalization of tax reports, the insurance sector, and in terms of business licensing.
- Acquisition of Transaction Tax Resources, Inc., Expanded product offerings with a compliance solution for licensing and registration requirement with the acquisition of assets from Business Licenses.
- Acquired Impendulo Limited – London-based provider of insurance tax compliance technology and services, specializing in support for multinational insurance companies
- INPOSIA – German software company focused on e-invoicing, digital tax reporting and business and data integration to address real-time compliance requirements for companies worldwide
In parallel, Avalara launched seven product releases in 2020 to enhance their suite of solutions and position for international expansion. Noteworthy product releases include Avalara Cross-Border, Avalara India GST and e-invoicing Solution, and Avalara for beverage alcohol compliance.
Through M&A opportunities and organic product development, Avalara seeks to present a more compelling proposition for customers to switch to a cloud-based tax compliance solution.
“With our past acquisitions to enter communication, fuel, lodging and beverage alcohol compliance markets, we believe the global insurance compliance market is ripe for automation and a natural addition to our global offering”
– 2020 Q4 Earnings Call
- Reduce Adoption friction – Expand partner integrations
Avalara currently boasts over 1,000 partner integrations and continues to work to grow the number of partner integrations. By making Avalara’s solutions easily compatible with a variety of platforms and business applications, it reduces the friction for businesses to adopt Avalara’s solutions.
For example, an e-commerce business on shopify that uses intuit quickbook’s accounting solutions can seamlessly plug Avalara’s Cloud Compliance solution and automate their tax compliance process without disruption to other processes in place.
- Raise Awareness – Educate Businesses
Avalara recently held Avalara NEXT, their first-ever code-focused event, where they brought together software developers from all over the world to learn about Avalara’s products, API, SDK and best practices to build tax compliance processes into their business applications.
Avalara effectively took a page out of Twilio’s playbook in organizing developer conferences aimed at educating and raising awareness of existing and new product launches. One key difference to note is that unlike Twilio’s communications tools, developers may not be the direct users of an automated tax compliance platform. The effectiveness of code focused events might be impaired by the attendees’ lack of urgency to adopt Avalara’s solution.
In the bid to become a global cloud-based compliance platform, Avalara is looking to cover as many use cases as possible. Simultaneously, they are making it easier for businesses to use their solutions and educating them about the advantages of adopting an automated cloud-based tax compliance solution.
Some headline financials
- Revenue: FY 2020 $500.6 million, up 31% from $382.4 million in FY 2019 . Expected to grow at 20 ~ 25% YoY
- Subscription accounts for ~93% of revenue
- Gross margins of 71% in FY 20 vs 70% in FY 19
- R&D: 25%, S&M: 41%, G&A: 19%
- Operating Loss was -62million in FY 20 vs -55million in FY 19
- Cash Flow
- Operating CF of $ 42.6million in FY 20 vs 22.2million in FY 19
- FCF of 34mio
- Strong Balance Sheet – Significant cash ( 673million) with little to no debt
Long term wise, this is how management projects for Avalara to be operating at
Firstly, I would like to see gross margin to creep higher given that it has exhibited a slight down trend over the past few years. Management laid out a plan in their investor presentations to get gross margins to their LT target of 80-82% but it remains too difficult to appraise given the lack of details.
“We intend to continue investing in automation that we expect will improve gross margin for our core products and geographies. However, we expect these improvements may be offset by new products and recent acquisitions that carry lower gross margin until we automate and drive higher scale. We expect this may result in a 2021 gross margin that is similar to our 2020 results” – 2020 Q4 Earnings Call
Second, unlike software companies such as Twilio and Atlassian, Avalara solutions are targeted at people working in compliance / finance department and not developers. This means that Avalara will be more reliant on the traditional enterprise sales model instead of allowing its solutions to be discovered via word of mouth. This explains the higher S&M expenses
Third, the dip in S&M expense from 2018 to 2019 is due to adoption of ASC 606. Accordingly, operating margin before and after 2019 cannot be compared on an apple-to-apple basis
ASC 606: Because we began to defer a portion of the sales and partner commission costs (over 6 years) in 2019, our sales and marketing expense will not be comparable to prior periods in which we expensed these costs
– Source: 2019 Annual Report
- Core Customers – 14,890 as of Dec 20 vs 11,960 in Dec 19
- Net revenue retention rate*: 104% as of Dec 20 vs 111% as of Dec 19
*Net revenue retention rate: dividing (a) total revenue in the current quarter from any billing accounts that generated revenue during the corresponding quarter of the prior yearby (b) total revenue in such corresponding quarter from those same billing accounts
Lowered NRR rate might appear as a concern but here’s an explanation for it:
“Second, our NRR currently excludes upsell revenue from our Streamlined Sales Tax or SST program, which grew significantly in 2020. Conversely, our NRR calculation includes revenue contraction that may occur when an existing customer changes from our standard subscription returns program to our SST program. While this downgrade is offset by the SST upsell, our NRR calculation only captures the value of the downgrade.”
– 2020 Q4 Earnings Call
Avalara was founded by Scott McFarlane in 2004. Till today, McFarlene is still CEO and owns 2.1% of Avalara. He remains active in the vision and management of the company
There are no apparent red flags in terms of management. A point to note is that management has chosen to use cash for majority of their acquisition which is positive sign in my opinion. Given the considerable usage of Stock Based Compensation today, the argument that a cash-only acquisition provides little incentives for “synergy premium” to work out is of less relevance. Cash-only acquisitions prevents the dilution of shareholders
For a detailed look at the competition for tax compliance, consider looking at Peter Offringa writeup of Avalara on Software Stack investing
Thoughts and discussion specific to Avalara
Avalara presents itself as a robust business for anyone that shares the belief that automation of tax compliance processes is inevitable.
Nonetheless, there are still numerous challenges ahead for the company.
Firstly, Avalara is likely to incur significant Sales & Marketing expenses relative to comparable software companies. As previously discussed, Avalara will have to rely more heavily on a top-down traditional enterprise sales model approach as main users of Avalara’s solutions are from the compliance / finance departments which are typically less tech savy. Software companies targeting at developers are positioned to better rely on the momentum of word-of-mouth marketing once their products have surpassed a certain adoption threshold. However, this may not be all bad news as a lower discoverability of new software translates to greater product stickiness.
Secondly, there is a high dependence on the success of M&A to grow. M&A is highly frowned upon by traditional investors as it has historically proven to fail to reap the anticipated objectives. However, Avalara has shown its capability in successfully integrating acquired companies. Examples include CertCapture for compliance documentations, Tradestream technologies for item classification etc… Acquisitions aimed at expanding product offerings across the cloud compliance present new use cases for existing users, potentially increasing Avalara’s wallet share.
Last but not least, significant competition exists for Avalara’s solutions. This ranges from the likes of Vertex and Sovos that service large enterprise to the nimble start-ups of TaxJar which looks to disrupt from the bottom up. Despite the challenges ahead, Avalara ranks as one of the market leaders in tax compliance software and is positioned well to capture a pressing need for tax compliance automation. With Covid, businesses have been focused on automating urgent needs which tend to be front-end processes instead of back-end compliance processes. Despite so, Avalara stands to be a major long term beneficiary of an accelerating trend of cloud adoption as automation of labourious back-end processes will be inevitable
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See you around!