Small-Cap Confidential’s “One Stock to Buy Now”

Cabot's Tyler Laundon hints at a "stock that could do well regardless of who wins" the election, a high-growth small-cap technology stock -- what is it?

By Travis Johnson, Stock Gumshoe, October 12, 2016

The sturm und drang about the election is just about enough to make me stop watching television and turn off my Facebook feed… but it’s also generating some concern on Wall Street now, and as we get closer to what seems today to be an inevitable Democratic win in November there’s a lot of speculation about who will win and who will lose when it comes to the stock market… particularly because it appears that the market’s favorite outcome is probably in some doubt now.

The average investor seems to want stability and inaction from government — it’s commonly said that Wall Street roots for gridlock, so President Clinton plus a strong republican congressional majority is perfect for ensuring a lack of big changes… but the Republican Party is in such upheaval that what had for a long time been the most likely outcome is now in more doubt.

The reading of the investment tea leaves is what we’re focused on, of course, not political debates or discourse — so the latest little pitch for Tyler Laundon’s Small-Cap Confidential over at Cabot caught my eye when he made some guesses about what the winning sectors will be post-election… and also hinted at “one stock to buy now” that he think will do well regardless of who takes the White House.

His general assertion was that volatility would likely increase going into the election and leadership change, which has seemed logical for a long time but hasn’t really happened yet (the Vix index, which is just a measure of how much people are paying for options, is higher than it was last week but is still far, far below where it was in September, April or February), but he also noted that health care and financial stocks are generally the stocks that have done best when Trump’s popularity surges, while consumer discretionary and industrial stocks favor Clinton, perhaps because Clinton’s stance on trade is much friendlier to most companies that operate globally, and much more predictable.

And Laundon doesn’t mention it, but probably the strongest correlation that folks have identified between political polls and economic activity recently has been the impact of Trump’s poll numbers on the Mexican Peso — when his poll numbers were rising late in the Summer, the Peso fell against the US Dollar… when they fell after the first debate, the Peso strengthened a bit and bounced back a little more recently as his polling woes have continued. (A weak Peso is actually great both for Mexican exporters into the US and for Mexican workers in the US who are sending money home, ironically enough.)

But then he gets into his “who wins no matter what” bit…

“So where does this leave us? Are there any stocks that could do well regardless of who wins? I think so. Technology stocks are looking great. And it should come as no surprise that I like small caps.

“Small caps have two potential advantages relative to large caps during this election year. First, they tend to have lower international exposure, so they should be less impacted regardless of who’s in the White House. And second, their valuation is less expensive than large caps. Both of those factors suggest that small caps will post relative outperformance over the coming year. And given the strength in technology, it makes sense to me to focus on small-cap tech stocks.”

OK… and which small cap is it that he likes?

“There is one in particular that looks good to me right now. It’s a small-cap tech stock that sells software to regional banks, community banks and credit unions, all of which are expected to enjoy a better environment under either Trump or Clinton. And with interest rates likely to go up, banks should be able to generate greater profits, which can be invested back into critical software they need to compete in the digital banking age.”

There are quite a few technology companies who sell software and other solutions into the financial industry… so which one is he talking about? Here are our clues:

“This company has developed a virtual banking platform that supports dozens of different products. It lets account holders move securely and effortlessly between the digital and brick-and-mortar locations of their community bank or credit unions. Its platform was purpose-built to deliver a secure and consistent user experience across online, mobile, tablet, text and voice channels. And it can replace almost all of the disparate software solutions that many RCFIs are currently struggling to maintain….

“The company makes money from every one of the solutions it sells. It also makes money each time a transaction is performed on one of its solutions….”

And one final piece:

“Annual revenue growth has been 38% or higher in each of the last three years.”

So… hoodat? Thinkolator sez this is almost certainly… Q2 Solutions (QTWO)

QTWO is not a complete stranger to these parts, I mentioned it a couple years ago when I was looking at more established bank-tech company Jack Henry (JKHY), and at the time I was not terribly optimistic about their prospects — my guess was that being “cooler” wasn’t enough, and that they would have a hard time pulling small and regional banks away from their core technology providers (like Jack Henry) and becoming profitable.

I was right about them having a hard time becoming profitable, but wrong in my negative sentiment about the stock — the shares have just about doubled over the past couple years. Though the “hot” little mobile banking penny stock of the day back then, Monitise (MONIF), perhaps serves as a warning about the potential for “fad” stocks to hit even the relatively staid banking services industry.

And now Cabot, most of whose newsletters are very much growth and momentum focused, is predicting that QTWO “could be an easier double than Tesla.” So how’s it looking these days?

onlinebankingHonestly, to me it looks about the same as it did a couple years ago — they have done a very good job of growing revenue, which has doubled over the past two years… but it has been expensive, and they’re losing more money with each new dollar of sales they book because the economies of scale of software development haven’t quite kicked in yet. Unless the potential for this revenue growth goes way out into the future, which I don’t really have a handle on right now, it’s hard for me to justify paying this much for a company in a competitive marketplace.

A bet on an emerging cloud/software provider like Q2 (or many others) is really a bet on the premise that they can keep growing their revenue fast enough that the revenue growth will eventually lap the rapid growth in their selling, general, and administrative expenses and allow them to actually book a profit. Analysts are now predicting that this will happen in 2018, when they see QTWO earning 45 cents in profit per share — so if you want to be an old fuddy duddy about it and look at fundamentals beyond the enticing revenue growth rate, that means you’re paying about 60X 2018 forecasted earnings for a company that is probably (according to these same analysts) going to be growing top-line revenue at something like 25-30% a year over the next couple years. It’s important not to over-rely on that assessment, both because analysts are terrible at predicting out a couple years and because there are only four analysts providing 2018 estimates on this one… but that’s likely the base assumption most traders are using.

Revenue growth is the real story for Q2 right now, of course — growth is elusive for a lot of companies, so those that can generate honest-to-goodness organic top-line revenue growth at a high level are often getting bid up. Whether that continues, I don’t know — momentum growth stocks tend to have pretty technical trading, and QTWO has been finding support at the 50-day moving average of late, bouncing off of that level as recently as yesterday, but they are also very susceptible to changes in sentiment when news hits… as when QTWO disappointed in their last earnings release in early August and the stock fell 15% in a week before partially recovering.

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There are likely other smaller competitors in the space that I’m unaware of, and some large banks do their own technology development, but competitors I can think of offhand are the much larger and more established folks like Jack Henry (JKHY), Fiserv (FISV) and Fidelity National (FIS), all of which have also had a very strong couple of years and are nicely profitable… though their stocks have not gone up quite as quickly as QTWO, and their growth is anemic in comparison.

I can see how Q2 may be able to carve out a pretty steady business serving smaller credit unions and banks who can’t afford (or get the attention of) Fiserv or Fidelity National, but I don’t have a sense of what their competition is down at that level, or what the ongoing revenue is like for them beyond new customer acquisitions — if they do indeed price their services on more of a subscription and per-account system, that may mean their current revenue is understated (if you compare to vendors who sell software for larger up-front fees). Before buying stock in Q2, I’d urge you to read through a few of their filings to get a good handle on how they make money, look at what their customer acquisition trend is, and think about whether they’ll likely be able to reach the point where their revenue is growing fast enough to outpace their expenses. They are trading at a nice stiff premium to the logical competitors (most of the others trade at 4-4.5 times sales, QTWO is at 8X sales), both because they’re smaller and because they’re growing more quickly, so you just have to decide whether that premium makes sense to you.

Right now Q2 is a smallish “cloud” banking services provider, market cap just over a billion dollars, with strong revenue growth but no profits for at least another year or two… I don’t know anything about how their products stack up against the competition when it comes to credit unions and smaller banks choosing technology providers, but they are getting new customers. Their balance sheet is solid, so even though they’re losing money they’re not in any danger of running out of cash. And beyond that, I’ll leave it to you to make your own call. Have thoughts on QTWO to share? Let us know with a comment below.

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October 12, 2016 2:47 pm

Why do all of these touted stocks near their highs went touted.. Hardly ever before???

October 12, 2016 2:58 pm
Reply to  john

that’s not an accidental correlation! (a) these guys usually aren’t going to tout a stock that just tumbled and (b) the act of touting pushes a stock up. I won’t expect any of these outfits to be hollering about ILMN (down ~30% in the last 2 days), even though it’s probably a screaming bargain where it is now.

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