Motley Fool co-founder David Gardner reminds us that great stocks are obvious, self-evident, and self-explanatory. Q2 Holdings (QTWO 2.82%) may not be a household name; it operates behind the scenes helping small and medium-sized banks offer digital solutions to customers. But while the company doesn't have profits yet, Q2's promising story might still make it the next great fintech stock.
Once upon a dime
The U.S. banking industry is big, complex, and competitive. According to First Research, the U.S. has more than 10,000 banks and credit unions. Of course, this space is dominated by a few very big players which are household names. In the early days of the shift to online and mobile banking, Q2 saw the need to help smaller, regional, and community banks and credit unions offer digital experiences that could compete with the likes of Bank of America, JP Morgan, and Wells Fargo.
Today, one in 10 Americans using digital banking are using Q2's software. Since its founding in 2004, Q2 has grown to a $5 billion valuation, and has slowly expanded its software offerings to include lending for retail and commercial banking, leasing, sales, and security. Collectively, Q2's products help smaller banks stay competitive and meet their customers' needs.
Helping small businesses compete can be very big business. Companies with the technology to democratize a product, service, or industry can often have long roads of success ahead of them. Etsy and Shopify have seen their stocks rewarded as they continue to empower and level the playing field for small businesses.
In short, Q2's story and potential are compelling -- but where are its profits?
Far far away?
So what's Q2's strategy for getting there? "Land and expand." More simply: Get more customers, keep them, and grow the relationship by offering additional services. Q2 is a software-as-a-service company, a proven business model with predictable revenue and high incremental margin. The incremental margins of this model are so high that if a company can surpass a threshold of profitability, it tends to see steady profits for years.
Q2 has plenty of runway, with 414 customers as of the end of 2019, or about 4% of the market. That said, the company may not be moving down that runway very quickly. In 2019, Q2 only added 13 net new customers.
That is a small number, but financial institutions are called institutions for a reason: They tend to make large changes slowly. Take one of Q2's competitors, Jack Henry and Associates (JKHY -0.44%), which added zero credit unions to a base of 830, and lost 30 banks from its base of 1,060 between 2017 and 2018.
Since it's not adding many new customers, Q2 grows by expanding its relationship with existing ones. Q2's customers consistently add about 30% more revenue over their first three years. That organic growth accounts for the lion's share of the company's overall revenue expansion. Over the last seven quarters, Q2 grew revenue at roughly 30% annually.
Alongside that revenue growth, Q2 posts consistent net losses and still falls short of posting positive free cash flow. The space in which it operates is very competitive, and Q2 needs to continually invest in its operations to keep up with rivals.
While Q2's revenues have tended to grow around 30% per year, so have its cost of goods sold and its operating expenses over the past four years. In the most recent quarter, reported in May 2020, the company said operating expenses grew 30% because of increased headcount and the implementation of Q2's 2019 acquisition of PrecisionLender. When the company reports later this week, hopeful investors need to see that spending pay off in the form of growth from PrecisionLender, software aimed at larger institutions to help inform better lending decisions.
If Q2 can maintain its pace of about 30% revenue growth, but slow down the corresponding rise in costs, the company could see profits by the end of 2021 -- potentially carrying the stock into its next chapter of earnings growth.
Happily ever after?
Q2 reports its second-quarter earnings this week on Aug. 6. COVID-19 has damaged the entire American economy in ways that will be unfolding for years. Certainly, many of Q2's existing or potential customers may no longer be able to invest in technology. However, for any resilient financial institution, COVID will likely accelerate its technology and digital plans to better serve customers seeking remote and digital options. If Q2 holds revenue growth arounds its trend of 30% year-over-year, that's a very positive sign that Q2 has maintained momentum through the COVID challenge and opportunity. The story has promise, but cautious investors could consider adding Q2 to a basket of other digital banking stocks.