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3 Small-Cap Tech Stocks for the Future

Joey Solitro, The Motley Fool

Motley Fool analyst Joey Solitro wants returns, and he wants them big -- so big that established players like Amazon (NASDAQ: AMZN), Alphabet (NASDAQ: GOOGL) (NASDAQ: GOOG), and Facebook (NASDAQ: FB) just aren't going to cut it.

In this week's episode of Industry Focus: Tech, host Dylan Lewis talks with Joey about his big-risk, big-reward investing style -- think getting in on day one of an IPO (initial public offering) with big positions, investing in small-caps with no earnings yet -- and three of his favorite SaaS (software-as-a-service) plays that fit the bill.

Tune in to learn why you might want to add Yext (NYSE: YEXT), Elastic (NYSE: ESTC), and PagerDuty (NYSE: PD) to your watch list. Joey explains what each business does, why he thinks they could all be 10-bagger performers over the next 10 years, which one is his favorite, some of the biggest risks to watch out for, and more.

To catch full episodes of all The Motley Fool's free podcasts, check out our podcast center. A full transcript follows the video.

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This video was recorded on Aug. 23, 2019.

Dylan Lewis: Welcome to Industry Focus, the podcast that dives into a different sector of the stock market every day. It is Friday, Aug. 23, and we're giving you a grab bag of SaaS stocks to watch. I'm your host, Dylan Lewis, and I've got Motley Fool Premium analyst Joey Solitro in the studio with me. Joey, how's it going?

Joey Solitro: It's going great! Thanks for having me!

Lewis: Yeah, yeah. You are a relatively new member of our Premium team, right? In your first year at The Fool?

Solitro: Yes. I have been a contractor since 2013, and I just came in-house in March. It's been a big change for me, but it's been great!

Lewis: Yeah. And you are someone who follows the tech sector in particular. I know you're one of those SaaS folks, much like Brian Feroldi, one of our frequent contributors to the podcast, so I've been waiting for the day that I could get you on. I know you have a bunch of stocks that you want to talk about. We're going to be focusing primarily on some SaaS stocks today. I believe these are all businesses that you own, right?

Solitro: Yes.

Lewis: So, let's talk a little bit before we get into the companies, about your investing ideology. I think it probably lines up a little bit with how some of the disciples of David Gardner and the Rule Breaker approach to investing might be thinking.

Solitro: Yes. So, when I first started investing, I was value-oriented. I loved the Dividend Aristocrats with the long 50 years of growth. And then it just hit me one day, where I was thinking, "I feel like the money has been made in a lot of these big names." And I took a step back, and I realized, rather than trying to just invest in these companies for steady growth, I want to find the next Workday or the next Amazon, and one of those. So I've molded this thinking where I want to see a company and invest in one that I think can rise 10x over the next 10 years. It's pretty hefty expectations, what I look for. But ever since I've had that transformation, maybe three or four years ago, it's worked out well, and I found that mostly in tech stocks. I go where the growth is. Some medical-device stocks have met my needs, but mostly software as a service has been where I've gone.

Lewis: That's been the industry for that kind of growth over the past decade. And as you may expect, listeners, when we're talking about potential for 10x growth, we're generally looking at businesses that are worth less than $10 billion. It's really hard to get that multiple if you're already a $50 billion or $100 billion business. So, we're going to be looking at the small- and mid-cap companies today.

Solitro: Exactly, yeah. I could definitely see a $2 billion company becoming $20 billion in the next 10 years. But $900 billion to $9 trillion, that's a bit of a stretch.

Lewis: Yeah. Hopefully you own those when they hit that point, and you can enjoy that growth. Everyone has their own approach to investing. I wanted to make sure that we covered that first.

All right, let's talk about the first stock on our watch list today, and that's Yext. As I understand it, this is a brand-management company. I think we need to dive into that a little bit, because that's kind of a buzzword-y way to describe this business.

Solitro: They pioneered their own industry. They call it digital knowledge management. What they want to do is to put the best answers in front of everybody everywhere, and basically give companies control of their own data. My primary example would be a Wendy's. Let's say they have around 6,000 locations, and they decide to add a new menu item and make all their stores 24 hours. Rather than going to 6,000 different Google Map[s] cards, 6,000 Facebook pages, 6000 Yelp listings, and so forth, you log into the Yext platform, you update it once, and it automatically publishes across 150 different applications, websites, [and] maps services.

Lewis: It seems like [in] this kind of business, the ideal client is someone who has a massive internet reach, and probably a lot of franchises, a lot of locations. And simply updating it in one spot, rather than doing it in 6,000, makes a lot more sense.

Solitro: Yes. It would definitely be more useful for these companies like the McDonald's, the Wendy's, Home Depots and AutoZones, but then they do have smaller pricing packages for the single grocery store.

Lewis: Is there anyone that you really see in this space right now? You said they created the category. We always love to see that as investors, because it means that they're probably ahead of the curve, and that there aren't going to be other businesses that they're either directly competing with or maybe even for a couple of years -- because once you create the space, you get to enjoy it for a little while.

Solitro: That's the beautiful thing about this. Since they did pioneer this industry, they list zero competition in all their filings. They say that the primary competition for them are the people that handle it in-house -- so people that have an IT department, or chief information officers [who] want to log into each of these pages and make all those adjustments themselves.

Lewis: This is a fun way, in my view, to play on some of the megatrends in a way that you might not expect. We talk about the rise of mobile; we talk about the rise of basically all things internet, whether it's e-commerce or just access to information. Well, this is probably a business that you're interacting with a little bit, but don't even realize it when you're maintaining these things. If you're going to be the simple way to do that for these megabusinesses -- we're talking Wendy's, etc. -- that seems like a good place to be.

Solitro: Absolutely. The other thing that they're really doing to transform search is something they call brand-verified answers. What they're doing there is, let's say you are celiac, and you need to find gluten-free options at a restaurant. If you search "gluten-free options at Panera," it might pop up a celiac blog where they list, "Hey, I went through these ingredients. Here's the items you can have." But if Panera changed how they make those, it may no longer be something that you can have. So, what Yext is doing is putting all the information that you already have on their platform, creating to where they're asking you specific questions that your customers want to know; so then, if that is Googled, rather than going to a blog, it's going straight to Panera, bringing up their allergen menu, showing: "Hey, you can have this, this, and this." That's a way to basically make sure that people are getting the exact answer they're looking for, from the source that they should be getting it from.

Lewis: I know we just said that they don't have competitors; it reminds me a bit of HubSpot in a way. That business is really focused on inbound marketing and helping all of these brands, all of these properties, have organic content that brings them into their funnel. The approach is very different. It's less specifically marketing-oriented. This seems much more brand-presence-oriented. But it is similar, where you're arming brands with the tools to meet people where they want information, about your industry or about your business.

Solitro: Exactly. And when you think about what other companies could do this, you would think a Google or a Facebook or an Instagram. But the beautiful thing is, if a Facebook tried to do this, and they go to Google and [Snap's] Snapchat and say, "Hey, we're creating this product," they'd pretty much be like, "No way. We want to do this ourselves." But having this smaller company that integrates with all the bigger players makes it much easier for them to basically fend off any competitors that want to enter the space.

Lewis: Yeah. It can be very helpful to be platform-agnostic.

Solitro: Exactly. That's the perfect term right there.

Lewis: Looking at some of the numbers here, 35% revenue growth and 110% net retention. That's a number we like to see for a SaaS business. Basically, that's their old cohorts of customers a year out, what are they spending. In this case, it's $1.10 vs. $1 a year ago.

Solitro: Yes. That's what I always like to look for -- a company that existing customers are spending more, they're adding more customers to the platform. Another great thing is having these McDonald's or Wendy's, Home Depots; as those companies add more locations, they are basically upselling themselves to Yext's platform. It's almost playing into the global economy.

Lewis: They've been publicly traded for about the last two years; they haven't been on the public markets all that long. They are definitely one of those sleeper companies. I don't think a lot of people know the name. I love having someone on to talk about these types of businesses.

I think the second stock that we're going to talk about is in a very similar space -- where people maybe see the name, don't know what they do, or have never even heard of the company -- and that's Elastic. You described them to me as the Google for enterprises. They do not have the name recognition of Google, so let's talk a little bit about what Elastic actually does.

Solitro: Elastic: They're basically Google for enterprises, is the key term. They do app search, site search, enterprise search. And what it exactly does is, it allows companies to search their deep dives of data and reach the answers that they're looking for. A real-world example of using this without ever knowing it would be if you hail a ride from Uber [Technologies] (NYSE: UBER). It's actually Elastic's technology that powers those systems, where it looks for the rider and the driver. Even if you're sharing the ride with someone else, it's Elastic's technology that actually shows: "OK, this driver could pick up this person and this person, and still get them to their locations that they're trying to go to in a reasonable amount of time."

Lewis: Yeah. So when we say "Google something" as just common speak, what we mean is, we're putting in a query into basically this thing that has indexed the internet, and we are getting back the most relevant results. What it really is doing is making sense of all the information architecture that's out there on the web. It sounds to me like what this company is able to do is do something similar, but much more for operations.

Solitro: Yes. With the rise of data, it seems like every company is becoming a data company. Now, the problem is, as they collect more and more data, they've got to figure out how to sift through it and actually get actual insights, and once they have those insights, being able to search them. That's the problem that Elastic's solving. I love seeing companies that are basically powering other disruptors. You see, they power Uber, they power [Match Group's] Tinder, they power a company like Adobe [Systems].

Lewis: It's funny, actually, the more I learn about Uber and all of the inputs for Uber -- Twilio worked with them for a while, Elastic works with them -- you realize how many different parts of what we experience as Uber are actually other companies' underlying tech. [laughs]

Solitro: Yeah, it's the disruptors partnering with the disruptors to disrupt. It's a beautiful thing.

Lewis: In this case, there's been some pretty serious growth as Elastic has come in and started doing some disrupting.

Solitro: Oh, absolutely. We're looking at 60% revenue growth. That expansion rate we're talking about, it's over 130%, and they're still doing it in a great way where they're able to maintain gross margins over 70%. So they're growing quickly, and they're not just hemorrhaging cash to do so.

Lewis: It's worth double-clicking into that expansion rate for a second. We described it before as a comps thing. But to think about it a different way: That 130% means, if they added no new customers, that business is growing 30% year over year. Which is incredible. You do add some new customers, then you start to get to that 60% figure that we just mentioned a second ago.

Solitro: Yeah. That's the beautiful thing about these. They call it net dollar expansion rate, net dollar retention rate -- expansion rate, simply. If you can find those in those reports, you can really see where these customers are spending a lot more. And it could be because their usage is going up, or because: "Hey, we tried this company, they had a great product. Let's try this other one of theirs, too." And then you get where they're upselling themselves.

Lewis: I think that metric is a case in point for why it's helpful to read the company transcripts or look at the earnings presentations. If you go out there and you look at the earnings takes from most financial outlets, you are going to see a revenue figure, you're going to see a net income figure, maybe some non-GAAP numbers in there too.

Very rarely are you getting the expansion rate number that we think is so crucially important as investors. You have to dig for it a little bit. It's not as widely reported on. It's more of a wonky number. But it tells you so much more about the direction that the business is going in.

Solitro: Yeah, everybody likes to focus on the top line and the bottom line. I like to look at everything in the middle, because that's where you really find the meat.

Lewis: As you might expect with a software business, this one's fairly high-margin. I think it's about 70% gross margins. And it seems like they're still in the early innings of their addressable market opportunity.

Solitro: Yeah, they currently list a total addressable market of $45 billion, and they're on track for about $400 million in this fiscal year -- less than 1% of their overall market. The runway for growth is quite significant, to say the least.

Lewis: Joey, I have to say, I balked a little bit when I first saw the name on this third stock, because it has an antiquated tech sound to it. The company's name is PagerDuty. I think that immediately conjures up the idea of an '80s businessman, something like that, attached at the hip with this piece of technology that we can now laugh at. Where does the name for this business come from?

Solitro: That's what really made this company click for me. Like you, I thought the name was just silly. What PagerDuty means is: Say you're on the DevOps [development and operations] team and the website goes down. You would be the person that they're paging, saying: "Hey, something's going wrong. We need you to fix this." So, essentially, they're going directly to you; you're on "pager duty" that night. And they might have four different people, and you just go down the list. Each person, as an incident comes up, that's the person that's being contacted for it. So, you pretty much have to be a developer to understand what this is saying. Then, it's kind of cool. They know who their target audience is.

Lewis: Yeah. The pager duty that a DevOps [person] would be on, very similar to maybe a doctor on call, or something like that. This is a business that focuses on when things go wrong in IT. I know they describe themselves as an incident response platform. It seems like it's something that you don't necessarily want to have to use, but know, at some point, you're going to need it, and if you don't, you're going to be stuck.

Solitro: This is one of the companies where, as the rise of cloud and [of] software as a service has come about, more companies have these software-enabled devices or systems. So, say you have your cloud-based accounting, you might have your payment-processing company, you've got your website hosting -- you're connected into all these different softwares that, if something goes wrong, you might not know where it's coming from. Why is our website down? Why is this not loading? You really don't know. What PagerDuty does is, it collects signals from all of your software-enabled systems, and if something's going wrong, or if your website crashes, it tells you exactly why. Of course, part of their upsell is, then it could alert the exact person or team to fix that problem.

Lewis: When we were doing prep for the show, you said it was like a central nervous system; that's the metaphor to use to think about this, and how it makes sense of all of the different signals that it's getting about a business.

Solitro: That's one of the things in their initial S-1 [filing with the Securities and Exchange Commission]. They gave a presentation; they're like: "We are the central nervous system for tech companies." And I was like, that is just beautiful.

Lewis: Yeah, that's brilliant. That's such an easy thing to wrap your head around. Some of the numbers for this business are the kinds of things that investors love to wrap their head around -- 85% gross margins last quarter.

Solitro: That's a thing of beauty.

Lewis: That's darn impressive there, huh?

Solitro: On top of that, they've got accelerating revenue growth, good old ARG. That's another thing -- they've got, I think it's just over 11,000 customers, they're adding more. Existing customers are spending significantly more. We look at the net dollar retention rate: again, over 130%. So you see, with the rise of e-commerce and digital experience, companies just simply can't afford to have their websites not load, because they could lose that customer forever.

Lewis: Yeah. Being down for one day, or even a couple of hours, during a critical period could mean a huge chunk of sales just not being there.

Solitro: Yes. How the CEO actually described it is: If you're going to buy a jersey online on, say, [the] NBA's website, and you get that wheel of death, where it's just spinning -- they're like, "If it's doing that for more than a minute, and you don't fix it, you might never make that sale, and that customer may never return to your shop again."

Lewis: Yeah, and that's a worst-case scenario if you own a site. This business has only been publicly traded now for about four months. I generally am someone who sits on the sidelines for a little bit, waits to see the lockup period come and go, likes to see a couple of quarterly calls from management. I know that we disagree a little bit on that. You're more of someone that's willing to hop in early with some IPOs.

Solitro: Yeah. Again, I'm looking 10, 25 years out. And I see this company, it's currently got a market cap of $2.7 billion; I could easily see this being $27 billion one day, or even bigger. So, I like to not just dip my toe in, but get a significant stake on day one. And then, if it ranges from there, I'll just watch it run; if it comes back down, I'll slowly add. I never really kept myself at a specific position or dollar amount; I go based off how I feel about the company. And "saving best for last" would be how we call this one.

Lewis: So this is your favorite of the three?

Solitro: Yeah, and it's the most richly valued. You look, it's over 20 times sales. Elastic is in the mid-teens, and Yext is less than 10 times sales. This one is the most overvalued, as some would say, but it's by far my favorite.

Lewis: Yeah, given the state of the market, 9 times, 10 times sales doesn't seem that crazy, actually.

Solitro: With Yext, I always look back: If that company went public today, what would it get? Buying IPOs seems like the cool thing to do now, buying on day one. You see all these 70%, 80% jumps on day one. Back in 2017, we didn't see that a lot.

Lewis: Yeah. I think some of that is, we finally have this wave of these private companies, former unicorns in particular, going public. After reading headlines for ages about Uber, Lyft, and Pinterest, Beyond Meat, you name it -- to be able to finally get shares, people are going to jump at that opportunity.

Solitro: Yeah. I love these smaller tech companies. Some, I'd never heard of before the S-1 filings came about. And I start clicking through, and you see these numbers, you see the presentations, you see the net dollar retention -- I think it was 139% for PagerDuty when it filed. And it's almost like you fall in love at first sight.

Lewis: Yeah. I want to talk about these three businesses together quick[ly], before we wrap up. While they're different companies, different stocks, they all have their puts and takes, I think that there are some very common elements here, both on the opportunity side and the risk side. We were talking about valuation a little bit, and, yes, these are all richly valued businesses. I think what gets lost a little bit in the price-to-sales comparison -- which is what you have to use when companies aren't profitable -- is, I think all these companies have gross margins that are over 70%.

Solitro: Yeah, you see a path to profitability for each of these companies. But the problem is, you have to maintain significant enough growth to keep investors interested while you continue down that path. So, yeah, the risk for each of these companies, especially Elastic growing over 60% on the top line: If that slows to 30%, people won't be as optimistic or want to be paying such a lofty price-to-sales valuation if, you know: "If they're not going to be turning a profit on the bottom line soon, then we can't give it this rich of a valuation on the top line."

Lewis: Yeah. They're all very much in that phase of, "We're growing to reach more TAM [total addressable market]. Our penetration is going up. We're not profitable, but once we do become profitable, once we've ramped down our sales and general administrative spend" -- which is generally the lion's share of expenses for these types of businesses -- "we're going to become extremely profitable." So, as long as that story holds, I certainly am willing to pay premiums for these types of stocks. The reality of software is it scales so well, and the margins are so high, that the price-to-sales metric is only so helpful for what it might look like five to 10 years from now.

Solitro: Yeah. It's an ultimate land grab for each of these companies. All three have such low penetration rates to what their total addressable market is that, yeah, you definitely want to see them keep spending to continue to grow. You don't want to see them trying to pare back sales and marketing or anything. You want them to spend, spend, spend, grow, grow, grow.

Lewis: Yeah, because the risk, especially -- we're talking about some of these not really having firm competition -- is that if they're fairly complacent, well, someone else is going to see that opportunity and be willing to spend that cash.

Solitro: Eventually, all of these companies will have bigger competitors. They might be growing faster. Or, hey, an Elastic competitor could move in that has a $1 billion valuation, and then I become to the point where I'm like, "I could see this rising 100x in 10 years." So, yeah, you definitely don't want to wait for the competition to move in. You have to spend now and grow now.

Lewis: Thanks for hopping on today's show and giving us an overview of these three businesses, Joey! Maybe I'll have you back on in a little while, bring some new stocks in and check up on these three.

Solitro: Sounds great! Thanks for having me!

Lewis: Of course. Listeners, that does it for this episode of Industry Focus! If you have any questions or you just want to say "hey," maybe even pitch a stock or two for us to talk about on the show, shoot us an email at industryfocus@fool.com, or you can tweet us @MFIndustryFocus. If you want more of our stuff, subscribe on iTunes, or you can catch the videos from the podcast and some of our other video content over on YouTube.

As always, people on the program may own companies discussed on the show, and The Motley Fool may have formal recommendations for or against stocks mentioned, so don't buy or sell anything based solely on what you hear. Thanks to Austin Morgan for all his work behind the glass today! For Joey Solitro, I'm Dylan Lewis. Thanks for listening and Fool on!

John Mackey, CEO of Whole Foods Market, an Amazon subsidiary, is a member of The Motley Fool’s board of directors. Suzanne Frey, an executive at Alphabet, is a member of The Motley Fool’s board of directors. Randi Zuckerberg, a former director of market development and spokeswoman for Facebook and sister to its CEO, Mark Zuckerberg, is a member of The Motley Fool's board of directors.

Joey Solitro owns shares of Alphabet (A shares), Amazon, Elastic, Facebook, PagerDuty, PINS, TWLO, and Yext. The Motley Fool owns shares of and recommends Alphabet (A shares), Alphabet (C shares), Amazon, Elastic, Facebook, HUBS, MTCH, PagerDuty, TWLO, and WDAY. The Motley Fool owns shares of PINS and has the following options: long January 2021 $120 calls on HD. The Motley Fool recommends ADBE, HD, Uber Technologies, YELP, and Yext. The Motley Fool has a disclosure policy.

This article was originally published on Fool.com