3 Stealth Tech Stocks

There’s more to the tech sector than software-as-a-service and cloud storage pure plays.

Brian Feroldi
Brian Feroldi
Feb 27, 2019 at 11:30AM
Technology and Telecom

Tech is all around us, even in companies we might think of as consumer goods steadies. In this week's episode of Industry Focus: Technology, host Dylan Lewis and Motley Fool contributor Brian Feroldi look at three tech companies in disguise. There's Axon (NASDAQ:AAXN), with its Tasers, police body cameras, and all the hefty high margins you associate with cloud players. There's Proto Labs (NYSE:PRLB), a company that leverages its tech to be so much more than a small-scale micro-project custom parts manufacturer. And don't forget about Domino's (NYSE:DPZ), which is growing like gangbusters by constantly trying out anything that even looks like it might get a pizza to your house. Tune in to hear more about these unconventional tech companies hiding in plain sight.

A full transcript follows the video.

Check out the latest earnings call transcripts for companies we cover.  

This video was recorded on Feb. 22, 2019.

Dylan Lewis: Welcome to Industry Focus, the podcast that dives into a different sector of the stock market every day. It's Friday, February 22nd, and we're talking about tech stocks in disguise. I'm your host, Dylan Lewis, and I've got fool.com's Brian Feroldi on Skype. Brian, what's up?

Brian Feroldi: Hey, Dylan! The last time we talked together was right before the Super Bowl, and you were dissing me for being a Patriots fan, so I just wanted to say on the show, thank you, your negative juju helped us win.

Lewis: [laughs] Your memory is better than mine. I maybe shielded myself from that because it was a little too scarring for me.

Feroldi: I bet. Must be terrible to be a Jets fan all the time.

Lewis: The best time to be a Jets fan is the off season, unfortunately. That's where we are, so I'm living large right now. I'm also living large because we have Austin Morgan back in the studio, helping us out. Nice to know that he recovered well from his surgery and is back with us at HQ.

Brian, today we're going to be talking about a fun topic. This is something you and I were bouncing around on Slack earlier in the week and thought it would make for a great show, and that's tech stocks in disguise, the idea that maybe some companies that are out there that people think of as CG companies or industrial companies are really more tech operators than they realize. 

Feroldi: Tech has so many companies that you would think are in one sector, but the tech has basically been blurred across so many different sectors that there are some companies that rely on some proprietary technology to really drive the results, so it's unfair to classify them as a non-tech investment. 

Lewis: Yeah. I guess we're just going to have to be a little bit more fluid in how we look at our sectors, and realize that tech is creeping into everything. 

Feroldi: I think that's 100% right. 

Lewis: Alright, why don't we kick things off with Protolabs, admittedly not a company I'm super familiar with. I think it's because I've written it off in the past and looked at it as this industrial manufacturing business that I couldn't quite understand. 

Feroldi: Protolabs is a quick-turn parts manufacturer. If you're a designer and you want to make a physical part out of plastic or metal or something like that, you can hire Protolabs to make a prototype for you. You give them the design, and in a couple of days or weeks, they will send you back a physical part. 

On the surface, you would assume that they were just a low-volume contract manufacturer and prototyping company. That does appear how it looks. However, what makes this company a hidden tech in disguise is that the real secret to Protolabs' success is that it owns this proprietary software that aids in the design, the quoting, and the pricing of tech parts that are uploaded. For example, if a designer creates a part that they want to have made out of plastic or metal, they upload it to Protolabs' computers. Protolabs' software then goes to work to analyze the part, and it actually makes suggestions back to the designer on ways that the part can be manufactured easier and cheaper. It also provides them with a quote within a matter of hours to say, "This is how much we believe we can make this part for." 

That stands in stark contrast to most contract manufacturers. When they get a quote, they have to manually go through and look at it and actually decide how much they want to charge for that. That process, just the quoting process with traditional manufacturers, can take weeks. The fact that Protolabs has automated the process and can get quotes and feedback to designers in a matter of hours gives them an incredible competitive advantage. 

Lewis: I love it when the company's name immediately becomes clear based on what they do. Protolabs, prototypes. Totally makes sense to me, Brian. 

Feroldi: Yeah, they try to make it obvious. 

Lewis: [laughs] What should folks look for in this business? I'm an outsider, so I don't know it super well. What are some of the key metrics people should be watching? 

Feroldi: The traditional ones are worth paying attention to, which is revenue growth, profit growth. This business is scaling nicely. It's growing at about 20% annualized. However, if you dig one level deeper, they report this metric called the number of product developers that are served. This is the number of prototypers and designers that are using their software and uploading and buying products from them. This figure will track pretty consistently with revenue growth over time. This is just like, for a SaaS business, the number of users that are on it. As of the most recent quarter, they had about 46,000 product developers that are uploading designs to them and buying from them. This figure is growing at about 20% per year. This is a key metric for investors to watch. 

Lewis: The gist of this company is basically, they have used software to take something that would otherwise be incredibly onerous and tedious to do, might even make scaling something very difficult, and instead turned it into a pretty significant competitive advantage. 

Feroldi: Yeah, that's correct. Their real advantage is that their software allows them to be much faster than traditional manufacturers. You have the manufacturers on the high end that do very high-volume production. Then there's a lot of mom-and-pop shops that do very low-volume production for specialized parts. Protolabs is in the middle of those two. They can offer extremely fast turnaround on parts. That really matters in today's economy where speed to market is everything. When you consider that a lot of parts have to go back and forth multiple times to get iterations right before it can be mass-produced, working with Protolabs gives designers a huge competitive advantage because it greatly speeds up the design process. 

Lewis: Brian, name No. 2 we're going to be talking about with tech stocks in disguise is one that we both know. It's actually one that we both own, and that's Axon. This is a company that people may not know by its current name, but they probably know by its former name, Taser. 

Feroldi: Taser is a company I've known about for years, but honestly never interested me because I figured that they were just a manufacturer of Tasers, which are used for non-lethal law enforcement. However, when I dug into the details, it turns out that this is a tech company in disguise. 

Lewis: They have the former namesake Taser business. These are the stun-gun-like devices, less lethal than traditional firearms. That's really the company's bread and butter, has been for a long time. It makes up about two-thirds of their revenue. The overarching mission there is, "We want to make the bullet obsolete," which I think is a noble cause. 

The other part of the business that's really interesting to me -- and frankly, is what makes them a tech company -- is the Axon Body Camera business. These are the body and in-car cameras that law enforcement uses while they're on duty. The Axon devices collect footage, but crucially, the content is uploaded to evidence.com, which is the company's cloud storage segment. Brian, that gives us one of our favorite things -- high-margin software revenue.

Feroldi: And dependable recurring revenue, which you know I love.

Lewis: Yeah, they're wonderful things. As a portion of overall sales, relatively small. In Q3, the software segment was about $24 million, up 47% year over year. But you look at those margins, 74% gross margins, and that's up from 63% a year ago. We're seeing those margins expand over time, too. 

Feroldi: The nice thing about that is, as that business scales out, I think that margin number can continue to grow. The exciting thing about Axon's business, to my mind, is that evidence.com is the backbone of the entire operation. When a police force signs on to evidence.com and they upload their footage there and their body cameras are going there, if a police force was to change that to a competing product, that would be an enormously onerous process. Because Axon gets their fingers in with the police force through evidence.com and Taser, it creates this ecosystem that becomes incredibly hard to leave. 

Lewis: One of the other reasons I love this company, Brian, is there really isn't a competitor. You look at the landscape, the non-traditional firearm gun landscape and the body camera landscape, there isn't really another big company. In fact, they scooped up the other player in body cameras. They kind of have monopolies on both of their main businesses, which is excellent. 

You mentioned the recurring revenue on the software side. They've also built a pretty novel recurring revenue model for their hardware business. About a third of their Taser sales come through as recurring revenue payments as of the most recent quarter. They're turning hardware into something that is as-a-service, akin to something that you might see with the wireless carriers giving people, "Have the latest iPhone, pay a certain set amount per month."

Feroldi: Yeah, that's very attractive. If this business was purely a hardware maker, I would personally, even given their position, would have no interest in it. It's really the software and evidence.com that ties everything together that I think makes this a much more predictable, much higher quality business than I would otherwise assume. 

Lewis: They posted pretty solid growth over the last couple of years. What I love, though, is a year ago, management projected a three to five-year CAGR of 16% to 20% revenue growth, and they projected expanding margins. We've seen some of that already. I just talked about how that was happening in the software segment. More recently, this last quarter, they reiterated that outlook. I think a big reason for that is the fact that they have some pretty big hardware releases coming out in 2019. One of them is going to be the Taser 7, and one of them is the Axon Body 3, latest in those lines, giving people a reason to move up into some higher-value contracts for Axon.

Feroldi: Another thing that I want to point out that I think is important is that when a police force signs on to evidence.com, one thing that Axon did that was very smart is they make the data shareable with other police forces that are also on evidence.com, so that data and videos can be shared back and forth, which can make police work a little bit easier. That creates a network effect that, again, locks police forces in even more to the Axon business. This business is fantastic!

Lewis: Brian, the last one that we're going to talk about today I think is undeniably the one that people are most familiar with. I know that I am intimately familiar with it. I actually ordered from it last weekend. We're talking about Domino's Pizza here to wrap things up. 

Feroldi: Yeah, this is probably the one that's going to have tech listeners really scratching their head as to what the heck we are doing talking about this on Friday's Tech show. Everybody knows that Domino's is a pizza company. It's actually the world's largest pizza chain by sales. They have about 16,000 stores spread throughout the world, with about 6,000 of those in the U.S. and 10,000 international. 

The reason why I thought it was important to highlight this as a tech stock in disguise is that this company has hugely invested in its tech capabilities over the last couple of years. They've made tremendous progress with becoming a tech company. One number that just screams that to me is that 65% of this company's sales in the U.S. come through digital channels. That's the website or the app. That's huge!

Lewis: Yeah, you look at this company over the last couple of years, and they have done such an incredible job of finding literally any way to be a point of contact with consumers. Some of them have been totally ridiculous. If you tweet at Domino's and you have a saved order, they will kick it to you, and charge you for it if you have that set up. Some of them are much simpler and what people expect with e-commerce, and that's the standard app experience or standard mobile ordering or ordering online. It doesn't matter, though. They're trying everything. They're throwing it all at the wall and seeing what resonates with people. I think that kind of innovation is what has led to a huge rise in stock price for this company. 

Feroldi: Yeah, this company has produced monster returns for shareholders. Another thing that they're trying is, they recently launched a voice ordering application that they're calling Dom. You can just order pizza by talking to your Alexa device. This company is heavily focused on making ordering and doing business with them as simple as possible. They currently have 20 million active users of their app and site, and that makes it very simple for this company to send out, "Hey, how about you order Domino's Pizza tonight?" And they make it so easy for customers. It's driving huge revenue and profit growth for them. 

Lewis: That active user base is incredible. I think most restaurants would kill to have a fraction of that. For them to be at over 20 million is just unbelievable. 

All told, it has really meant that they have gained share in their core market. They've gone from being a solid player in pizza to being pretty much the main player in fast pizza. 

Feroldi: Yeah. To put some numbers on that, their market share was about 10% in 2008. Today, it's about 18%. Their international business, which is a sizable one, has put up 100 quarters in a row of same-store sales growth. That's an unbelievable track record. The story is very good in the U.S., too, it's been 31 quarters in a row of consistent same-store sales growth. A big reason why is because of their commitment to investing in their technology, to make it as easy and convenient as possible to order their products.

Lewis: I think big picture with all three of these companies -- and this is not a comprehensive list of tech-adjacent companies or companies that are kind of tech; these are just three that we wanted to highlight -- you look out into any industry, and you see companies that are on the cutting edge, whether it's reaching customers with tech or streamlining operations with tech or pivoting a traditionally hardware model and making it a services model via tech. That's where a lot of the money is going to be made. 

Feroldi: Yeah, and that reoccurring revenue, as we both know, is highly attractive for investors. Companies that can invest in themselves can really separate themselves from the competition, especially when they're competing against a lot of mom-and-pop chains like say, Domino's and Protolabs are. They can afford to make the investments to make themselves a tech-first company, and that can really separate them and give them a huge competitive advantage. 

Lewis: Brian, I don't know if you have any tattoos, but if you were to get one, I assume it would be a heart with recurring revenue dead in the middle of it. [laughs] 

Feroldi: [laughs] I think that's what I'm going to go for, yes. 

Lewis: If you ever feel like it, I'm just saying. It seems to align with your personality and your investing tastes. Thanks for hopping on today's show!

Feroldi: Hey, thanks for having me, Dylan!

Lewis: Listeners, that does it for this episode of Industry Focus. As always, if you have questions or you want to reach out and say hey, you can 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 catch video extras on YouTube. Remember, 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. We're so glad to have him back. For Brian Feroldi, I'm Dylan Lewis! Thanks for listening and Fool on!

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Oh, sorry! I moved around the order of the wrap-up. [laughs] I feel like Ron Burgundy. If you put it there, I'm going to say it.