3 More Small-Cap Tech Companies for Your Watch List

Back in April, we dug into the details of three fantastic small-cap tech plays you should have on your watch lists: AppFolio, Paylocity, and HubSpot. Listeners seemed to really like learning about small-caps with massive growth runways and low risk profiles -- so much so that we're doing it again! You asked, and we're delivering, with three more small and mid-cap stocks to check out.

In this episode of Industry Focus: Tech, host Dylan Lewis and Motley Fool contributor Brian Feroldi take a close look at GrubHub (GRUB), BlackLine (BL -0.53%), and Mitek (MITK -0.50%). Find out what each company does, and how they do it so well; the biggest risks that each faces; just how big the growth runways are for these relatively niche players; which one is Brian's favorite of the three; and more.

A full transcript follows the video.

This video was recorded on June 8, 2018.

Dylan Lewis: Welcome to Industry Focus, the podcast that dives into a different sector of the stock market every day. It's Friday, June 8, and we're talking small and mid-cap tech stocks. I'm your host, Dylan Lewis, and I'm joined on Skype by fool.com's Brian Feroldi. Brian, great to have you back on the show!

Brian Feroldi: Great to be here, Dylan! Thanks so much for having me back!

Lewis: You were on in mid or late April, and I brought you on so we could talk about some small-cap tech stocks that you're really excited about. Lo and behold, we got some really awesome listener feedback from that show. I think people like the idea of getting some new stocks for their watch lists, maybe hearing about some names that we don't normally talk about. You're back on today to do it again.

Feroldi: Sounds great, can't wait!

Lewis: Before we really got going last time, we talked a little bit about your investment philosophy and some of the things that you tend to look at with companies. Why don't we do a quick refresher on that?

Feroldi: Sure. I generally like to look for, obviously, small companies that have built themselves some kind of moat. I'm extremely favorable toward companies that have very predictable revenue, so, their revenue is recurring, and I like to see that it's growing every year. I love to invest in businesses that I think have a scalable platform. That means that, as their revenue grows, their costs will fall as a percentage of revenue, which leads to outsized gains on the bottom line. I like to see founders that are also still involved, they own a significant portion of stock, the company gets good reviews from employees, all that kind of stuff.

Lewis: One thing that we did leave out last time we were talking that I think might be good to footnote here is the idea of valuation with some of these businesses. A lot of these companies we're going to be looking at, because they're smaller, they're staring at a very large growth runway, and they fail a lot of traditional valuation metric exercises. So, I think it's important to understand that, when we're looking at these companies, yes, valuation plays some role, but really, we're looking at what they capture currently and what their total addressable market looks like, and what the ramp looks like for those businesses.

Feroldi: Yeah, I think that's exactly right. I can tell you, just looking at my own personal investing history, some of the best investments that I've ever made, the best companies that I've ever purchased, at the time that I was purchasing them, the stock was at a 52-week high and the valuation just looked crazy by any normal metric that you can look at -- the price-to-sales ratio, the price-to-cash flow, the price-to-earnings, anything like that, a value investor would look at it and want no part of it. Because of that, I've learned that, if I like everything about a business, I never let valuation be something that keeps me out of investing in it.

Lewis: Alright. Why don't we talk about one of these first businesses that you like? This is a name that I think some folks, particularly in cities, might be familiar with -- that's GrubHub.

Feroldi: I think this is a company, of the three we're going to talk about, that a lot of people have already heard of and used. GrubHub is a leading platform for ordering takeout from local restaurants. These guys have about 14.5 million users. They're operating in 1,600 cities, and they have more than 80,000 restaurants that are participating on their platform. So, you add all those numbers together, and they literally fulfill more than 400,000 orders every single day on their app and website.

Lewis: And they own quite a portfolio of different properties in this space. It's not just that they own their GrubHub main platform.

Feroldi: Correct. They've been quite acquisitive over the last few years. They own a couple of companies that listeners might be familiar with, like Seamless, Eat24, Allmenus, MenuPages, and they also have partnership deals with a lot of other big tech companies, such as Yelp, Foursquare, payment processors like Venmo and NCR. More recently, they've been partnering directly with restaurant brands themselves, such as Yum! Brands, which owns KFC and Taco Bell, and Jack in the Box -- those are two companies that they recently partnered with to offer delivery.

Lewis: Beyond just the conventional e-commerce flip to mobile experience that we're seeing with a lot of general consumer traffic, why do you like this business so much?

Feroldi: In general, I think that this company is all about convenience for users. I'm a believer that, over time, more people are going to want to have food delivered to them. If you think about the traditional delivery model, most people, where they live, they have two choices for delivery: it's either Chinese food or pizza. These guys are trying to expand that to include way more restaurants, so that diners can really get any food that they want delivered to them.

The reason that I like GrubHub in particular is because I think that the home delivery market is going to naturally become a winner-take-most type of market. What I mean by that is, whoever is the top dog, the No. 1 player, and offers the most restaurants on their platform, is naturally going to be a site that consumers will go to when they're hungry. Consumers want choice, so if GrubHub has the most restaurants that are listed locally, that's a natural attraction. The same works for restaurants. Restaurants want to be on the platform that has the most diners.

Right now, GrubHub is the top dog in this industry, and they're really protected by almost double-sided network effects. They attract the most diners, and that in turn attracts the most restaurants. And both of those numbers can grow exponentially.

Lewis: The strategy here reminds me of what we see with Match in the dating space. You have this one property that has basically said, "We're going to buy up anything that looks attractive in this space and put it under our umbrella."

Feroldi: And that's exactly what they've done, that's the reason they've been highly acquisitive. The management team here, this company is run by its founder and CEO, they realized that you have to be the top dog, you have to be the No. 1 player, to attract the most customers. That's one reason why they've been so acquisitive.

One strategy that they've used to grow the supply side, the restaurants that sign up, is they actually don't charge restaurants a subscription fee or any sort of fee for listing on their site. Instead, restaurants get charged and GrubHub makes a commission on each food sale. Restaurants pay about a 15% commission. It's almost a no-brainer for them to sign up. There's very little risk, they can sell full-priced food out of their kitchen to diners that would not have dined with them anyway. That's one reason why restaurants are flocking to GrubHub, in addition to having the most diners. There's almost no financial risk for them to join.

Lewis: Yeah. When you first put this company on my radar, I saw that number of 80,000 restaurants participating at the moment. And I was like, "Well, how many restaurants are there in the United States?" I did a quick search, and I've seen some ballparks around 600,000. I know, over the last maybe three or four years, they've doubled that restaurant number. To think that that is what's in front of them still makes me think that there's a lot of growth in this industry, and there's a lot of growth to be had for GrubHub specifically.

Feroldi: Last year, GrubHub processed about $3 billion worth of total food sales. Management believes that their addressable market opportunity currently is about $200 billion. If you believe that number, they've essentially scratched about 1% of their market opportunity. While that $3 billion is total gross food sales, GrubHub takes a cut of that, but their revenue is growing extremely quickly because, in part, of acquisitions, and also, more customers and more restaurants signing up.

One of the reasons that I really like GrubHub is, it's definitely the leader in this industry. It's definitely growing. Their founder is currently the CEO, he's still running the show. And, as small as GrubHub is, they are already profitable, and they've been profitable for several years. They're generating cash. Last year, their profits grew by 68%. This is a company that's absolutely growing very, very quickly. And, their company is regarded as a pretty good place to work. Their CEO gets great reviews.

I know we talked about valuation earlier. There's no doubt that GrubHub is expensive. GrubHub's currently valued at about 13 times sales, 92 times trailing earnings. But this is a company that I think is very high quality, it's a leader, and it has so much room for growth that I think that it's a good buy even way up here.

Lewis: That was a super strong bull pitch there, Brian. Is there anything that you see on the horizon that really worries you about this business?

Feroldi: I think the biggest threat longer-term is competition. I said before that I think this is a winner-takes-most market, but there are a couple of very strong competitors that are trying to get in here. One of them is a little company called Uber, and they have their platform called Uber Eats, which is trying to do home delivery. Another one is Square, and they have what's called their Caviar service, which also does food delivery. These are well-financed companies with tech talent and big resources, so if they do want to make a big push, it could hurt GrubHub.

Having said that, I think that GrubHub has a big enough lead that they'll still be able to grow even with these competitors. But that's certainly something to keep an eye on.

Lewis: Alright, company No. 2 on your watch list right now is another software pure-play business, and that's BlackLine. I'm guessing this is a name that people aren't quite as familiar with. Why don't you walk us through what they do?

Feroldi: This is a back-office software-as-a-service company that's focused on the sexy world of accounting software. If you're not in accounting, and I'm certainly not, you might not be aware that the accounting industry is basically boom or bust. I think people know, at tax time, accountants go crazy trying to get everything processed on time. But the reality is that every month and every quarter, the accountants have to go look back at what their company did and reconcile all that information to do a period end close. They take all of the internal financial transactions that have happened, and they have to basically translate that into financial statements that can be used by the senior management team.

This happens at public companies and private companies. It's almost like, things are generally quiet during the regular work week, and then, at the period close, it's crazy hours and a mad dash for them to grab all this financial information and then turn it into reports and records that are needed to produce the documents that are needed.

Lewis: This is the point where the entrepreneur goes, "But there's an easy solution." This is the turn in the pitch where it becomes, "This is what we do for you," right?

Feroldi: Absolutely. The founder of this company was actually an accountant herself, and she became so frustrated with the way that accounting was done that she built this business herself from the ground up. Their solution is to take that process, that boom or bust cycle, and to automate as much of it as possible and turn it into something which they call the continuous close.

Think of accounting basically, as it works right now, as batch, where data is aggregated and stored up, and then accountants race to turn that into the financial statements. BlackLine basically provides software that, in real time, processes, analyzes, reports and confirms all transactions that happen in a company. That makes the monthly closing process far more efficient for CFOs and accountants. Really, it takes chaos and turns it into an easy, seamless process.

Lewis: For software businesses, that's where a lot of money seems to be made, when it's taking something that's incredibly complicated and making it easy. Brian, this company reminds me a little bit of a company you talked about last time, that was AppFolio. That was a business that worked within a small, defined space. For them, it was the legal field and the real estate management field. BlackLine works in accounting. But, I see a lot of similarities with these companies.

Feroldi: I think that's fair. Both of these companies are attacking what you would think would be niche, small markets. But I will point out that BlackLine is targeting much bigger companies. AppFolio was focused on really small players. AppFolio targets companies with $50 million and up in revenue. So, I would point that out as a little difference between the two.

Lewis: When you look at the books for this business, what specifically do you like?

Feroldi: This company checks almost every box with something that I look for in a great company. Their business model is software-as-a-service, which means that almost all of their revenue is recurring in nature. Their revenue retention rate, which means how much revenue they earn from a customer from one year to the next, was 110% last quarter. So, just within the customers that they already have, they grew 10%. So when you add on new customers that come on to the platform, their total revenue growth last year was 34%.

Now, these guys are still pretty small. Their revenue last year was $190 million. But they've grown big enough that they recently reached where they generate positive cash flow and they generated positive non-GAAP earnings, which strips out stock-based compensation. And then, their balance sheet is squeaky clean, $112 million in cash, less than $1 million in debt. I really like that their CEO is the founder and still running the show, and she actually owns about 11% of all shares outstanding, so shareholders are extremely aligned with her.

Lewis: I want to go back to that revenue retention rate number for a second, because I think that this is an important concept when you're looking at software businesses and why they're so attractive to investors. You put it that way, as, if they didn't grow at all via new customers, they would still have grown 10%. It's also a testament to them doing something right, and not having to have these blockbuster product releases to hit numbers for following quarters. It's basically, if they keep doing what they're doing, they're going to be able to post this growth.

Feroldi: Absolutely. The software industry calls this the land and expand strategy, where, as you get your foot in the door with a solution, and once you have a customer, it's very easy to upsell them new products or to have them roll out this solution from one office to multiple offices. That's a very, very easy way to post growth.

Lewis: You talked about the competitive risks a little bit with GrubHub. Is that something that's a concern for BlackLine? What are you worried about with this company?

Feroldi: This is the company that, when I was reading through the 10-K, there's always a section on competitors, and almost every 10-K you'll ever read always says, "We operate in an intensely competitive industry." Every industry will say that. What jumped out to me when I was reading BlackLine's annual report was, they literally list two competitors. One is a sort of direct competitor, and another is a small division within Oracle. These guys are basically the only ones that are doing what they're doing in this field that is built for growth. To me, the biggest risk with them is that their solution fails to get CFOs to switch over in time. But, from what I've seen thus far, and their revenue growth as it is, I'm very comfortable that they'll be able to continue doing that.

Lewis: Alright, Brian, we have one more for people's watch lists. This one is quite a bit smaller than the other ones we've discussed. BlackLine was a $2 billion company, GrubHub about a $10 billion company. This is about a $300 million company.

Feroldi: Yeah, these guys are teeny, teeny tiny. The company we're going to talk about is Mitek Systems, ticker MITK. Although they're very, very small, I would wager that the majority of people that are listening to this podcast have actually benefited from Mitek's products and they don't even know it.

Mitek is a leading provider of mobile image capture and identity verification software. Their bread and butter is, they partner with more than 6,000 financial institutions -- companies like PayPal, Morgan Stanley, TD Bank -- and they power their app to allow customers to make mobile check deposits right from their phone. They run the software that turns the camera and allows it to take a picture of a check and allow you to deposit it right within the app itself.

Lewis: This is a company that I'm thrilled it exists, as someone that hates going to the ATM.

Feroldi: I 100% agree with you. In fact, I was a Bank of America customer myself for many, many years, and I made the switch to an online-only bank specifically when this technology became available. The only reason I ever went to my local branch was to deposit a check. So, once I could deposit a check from my home, I basically switched to an online-only bank, and haven't looked back.

Lewis: It seems like the strength here with this company is in working with all of these legacy banking companies. They have partnerships with PayPal, Morgan Stanley, TD. They seem like they're pretty rooted in this industry, and that's what gives them a lot of the stability that they have.

Feroldi: Absolutely. Their market share in mobile check cashing is estimated to be above 90%. In essence, if you use mobile check cashing, you are probably using Mitek's software. They have 6,000 financial customers, which is just a huge number, but it's almost a no-brainer move for banks to partner with them. The reason is, when you deposit a check via your mobile phone, it is literally 10 times cheaper for a bank to process it that way than through an in-person transaction at a branch, and it's four times cheaper to do it through a mobile deposit than it is even through an ATM. So, Mitek's solution is saving banks huge dollars on customer deposits.

Lewis: It's kind of interesting to me that the banks haven't ever decided to do this themselves, they've just kind of all voted that it's easier to find a provider that does it for them?

Feroldi: I think that's exactly the case. Banks aren't necessarily technology experts, and you can imagine that getting the technology behind this right is absolutely critical. I think it's just easier and cheaper for them to partner than it is to build it themselves.

Lewis: Looking at the stock chart for this business, it has been up and down quite a bit over the last couple of years. It seems like there are both some really great factors pushing this business -- I think their penetration rate is super low right now for mobile check cashing -- but also, there are some industry tailwinds that maybe they're not participating in. What are you seeing as strengths and weaknesses with them?

Feroldi: The strengths that I see is that, these guys are the leader, they're the dominant player. Right now, only about 3% of checks that are processed in the U.S. are done via mobile. Given the convenience for consumers and the cost savings for banks, I can absolutely see that as a huge growth opportunity for them. And I think that these guys have been public for quite some time, but this mobile check cashing business that they've got into, they only really got into it in the last several years. If you look at their stock chart over the last couple of years, once they got into that, that's when this business has really caught fire.

And the reason that I really think this business is worth checking out is, mobile check cashing is absolutely a growth industry for them, but it's not their only business. They are currently taking their camera detection software and they're entering the ID verification business. You can imagine that you'd use your phone or some kind of visual image to verify somebody's ID. You could look at a passport, you could use it for a driver's license, you could use it for an ID card. Obviously, that's super important for banks to do, as ID verification gets more prevalent. But, there's a number of industries that are interested in this technology. I could easily see it being used in healthcare, telecommunications, education. That's what I think really excites me about this business, is there's a lot of optionality to them to use their software in other applications.

Lewis: I'm glad you mentioned that. My view in looking at this company was that I was probably the least bullish on it out of the three we're talking about today. That's really because, I think about my own consumer behavior, and, aside from maybe cashing a check from grandma or something like that, I haven't really used checks all that much in the last couple of years. For the most part, it has been mobile payments, using Venmo, using PayPal. That's how money transfers happen for me. I'm sure there are a lot of consumers that are also looking at the landscape that way. That said, I'm guessing there are also a lot of legacy consumers that are using the old way of doing things, cashing checks.

Feroldi: Yeah. I don't know about you; my parents and my grandparents still send me physical checks in the mail whenever my kids have a birthday. The day care that I used to take my children to, they only accepted actual physical checks. So, I agree with your sentiment that, long term, the number of checks in circulation will continue to go down. However, I think there are millions of consumers out there that are happy to write checks for the rest of their lives. Since this company only has 3% market share, even if the overall pie decreases slightly over time, these guys still have an enormous runway within check cashing.

Then, when you layer in the ID verification on top of that, they've thrown out that they think their total addressable market there is $18 billion. This is a company that, literally last year, between the ID verification and check depositing, generated $45 million in revenue. So, there is still a tremendous room for this company to grow.

Lewis: Brian, before I let you go, I'm going to put you on the spot here. Of the three we talked about today, which one are you the most interested in?

Feroldi: I can tell you that I think GrubHub is fantastic, but if there was a concern, it would be the competition. For Mitek, I guess my biggest concern there would be that some company like Apple, or some big tech company, usurps them with some new technology. I don't think either of those are going to happen. But, if I had to pick one, I would definitely go with BlackLine, if for no other reason than, I just don't see any competitor out there that's doing what they're doing, and I just like everything about that business.

Lewis: Alright. Thanks for hopping on, Brian! We will have you on again soon to talk about stocks that are on your radar.

Feroldi: Sounds like a plan!

Lewis: Listeners, that does it for this episode of Industry Focus. If you have any questions, or if you just want to reach out and say hey, you can shoot us an email at [email protected] or tweet us @MFIndustryFocus. If you're looking for more of our stuff, you can subscribe on iTunes or check out The Fool's family of shows over at fool.com/podcasts. 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. For Brian Feroldi, I'm Dylan Lewis. Thanks for listening and Fool on!