AppFolio Deep Dive: Is This Real Estate SaaS Company Worth Buying?

In this week's episode of Industry Focus: Financials, host Jason Moser and Fool.com contributor Matt Frankel, CFP, take a closer look at AppFolio (APPF 3.02%), a software-as-a-service company that offers a subscription-based solution for the property management industry. Plus, hear why Matt has Bank of America (BAC 2.06%) at the top of his watch list this week, while Jason is looking closely at Darden Restaurants (DRI 1.34%) ahead of earnings.

To catch full episodes of all The Motley Fool's free podcasts, check out our podcast center. To get started investing, check out our quick-start guide to investing in stocks. A full transcript follows the video.

This video was recorded on September 21, 2020.

Jason Moser: It's Monday, September 21st. I'm your host Jason Moser. On this week's Financial show, we're going to dig a little bit deeper into a company called AppFolio. A software company targeting the real estate and legal markets. We've also got a couple of stocks for you to keep an eye on this week.

As always, joining me this week, it's Certified Financial Planner, Mr. Matt Frankel. Matt, how's everything going?

Matt Frankel: Just fine. I mean, it's not as great here as my sunny Florida background might suggest. But it's 70 and sunny in South Carolina; I can't go wrong.

Moser: Yeah, I was going to say it, I mean, that doesn't sound like that's all that different. So, you know, hey, listen ...

Frankel: There's no ocean right next to me.

Moser: Now, well, yeah. Well, that just makes the ocean better for when you want to go visit, right? If you're around the ocean all-day every day, it kind of gets boring and mundane. Well, I guess people like to believe that, but I grew up on the water down in Charleston and I can verify that it never really got boring and mundane, I always really [laughs] enjoyed being on the water, so. [laughs]

Hey, so, Matt, we're going to dig into a company today that you and I haven't really talked a whole heck of a lot about on the show. You know, I've seen it in passing and I've looked a little bit into it just because of the type of business that it is. But I'm excited about today, because we're going to learn a lot more about this business. And hopefully, our listeners as well will learn a lot more about it too. And this is a company called AppFolio.

And, Matt, this company that IPO'd back in June 2015, so it's not one of these more recent IPOs that is still just trying to get things going, right? I mean it's a business that's been in the public markets for a while, fairly well established. We'll get into this in a little bit, but it's "gasp!" profitable and "double-gasp!" free cash flow positive. I mean, I don't even know what I'm looking at here, even after backing out stock-based compensation. This is a SaaS company that actually has hit the stage of making money, and it's still growing. That alone has really caught my attention, but I think that once we dig in a little bit more, you realize the market opportunity this company is tapping into. It's an exciting opportunity I think, it's an exciting business to dig into and learn more about.

And so, let's just jump in here with AppFolio. First and foremost, let's start with just what the company does, what does AppFolio do, what markets is it focused on?

Frankel: So, AppFolio, it's a Software-as-a-Service company. They have cloud-based applications. As they put it, they develop cloud-based software for specific industries, but they're really only focused on real estate right now. So, they developed a cloud-based platform for property managers, meaning the companies that operate an apartment building or, you know, for investors like me who own houses, manage our houses on behalf of the property owners so they don't have to. So, they develop software for these companies. It allows the managers to analyze the business, how it's going, and track maintenance requests. For example, if you have a 500-unit apartment building, it can be really hard to track when someone needs an air-conditioner fixed or someone needs a toilet fixed, if you're using a paper-and-pencil ledger or just like an Excel spreadsheet. So, this is meant to simplify processes like that. It does things like online billing and online rent payments. It has marketing tools that property managers can use, because one of the things I pay my property manager for is to market the properties, because I don't have the resources or time to do it properly. And to just, kind of, service a portal for renters and owners to interact with the property manager.

Moser: Yeah. And that's a big market, that's a lot of work actually. And having owned a home that we used as a rental property for, I don't know, seven or eight years, and you yourself having that experience, just on the single unit side, if you then look at big complexes, payments services, tenant screening services, insurance services. I can remember we were very lucky, we had a friend in the real estate business down in Georgia who helped us in doing things like tenant screening and what not, so we were a little bit lucky from that perspective. But I could see immediately how valuable the services that she provided for us were, particularly on the frontend in things like tenant screening, because I think that part of being successful in that line of work is really making sure you get good tenants to begin with. But it does really tackle a lot of those different challenges in that line of work.

And that's a fairly reliable market to me. We talk about home ownership in this country, there's always going to be a large portion of society that needs to rent, that needs to lease places to live. And so, this is a company that's really honing in on that market and trying to make those businesses better with the software they provide. And it seems like they're doing a pretty good job of it.

It's still a relatively small company, market cap is still sub-$6 billion, it's $4 billion-$4.8 billion market cap today, and trailing 12-month revenue is not even $300 million. But with that said, when you look at those revenue numbers, they are growing that topline pretty nicely. I was looking at a five-year compound annual growth rate there on the revenue side, 37% annualized. Which, to me, you know, when you're looking for good ideas, I really always like to look at that topline first to see what kind of growth is happening there. It sounds like there is a lot of growth happening for AppFolio.

Frankel: Yeah, like you mentioned, AppFolio is profitable, which is definitely very nice to see. [laughs] I mean, especially in the context of these IPOs that are just hemorrhaging money. But on the same token, revenue is what is eventually going to translate to profit, especially in a high-growth company. So, AppFolio, as you mentioned, trailing 12-month revenue is under $300 million, which makes the company at about 17X sales today; that's not cheap by any definition of the word.

Moser: No, but it's not 130X sales like Snowflake either, so. [laughs]

Frankel: You mentioned a growth rate in the 30s over the past five years, and what's really interesting to mention is that they grew at 27% in the first half of 2020 when the pandemic was going on. So that's pretty impressive right there. I mean, it's slower than in the 30s, but when you consider what's going on and what the 2020 market environment has done to a lot of other companies, that's a pretty impressive number. And I mean, how long can you sustain a 37% growth rate for? With a market like this, the answer is, for quite a while if things are going well.

Moser: Yeah, I would think so. And when you look at the way they make their money, 90% of their annual revenue just comes from the software solutions services and the data analytics they offer to the real estate market. They touch on the legal services market a little bit, but really this is a real estate play for the most part. When you look at the numbers, I mean clearly, they're doing something right. At the end of the second quarter, they ended the quarter with just over 15,000 real estate property manager customers that were managing an aggregate of 4.9 million units, and that compared to 13,737 customers and 4.23 million units under management just a year ago. So, you can see, over the course of that last year, they've definitely added the customers and the units to their portfolio to help drive that topline. And I would figure that over time, you know, like this type of businesses, any of these other SaaS subscription-type businesses, it's really all about retention, keeping those folks in that network and growing out that network effect over time.

Frankel: Yeah, and I mean, 4.9 million aggregate rental units sounds like a huge number, and it is, but you know, there's roughly 50 million rental households in the U.S. And that's just the U.S.; if they don't expand anywhere else. So, this is a pretty big market. And just to, kind of, quickly run through how they make their money, like you said, right now it's about 90% real estate, that's actually going to go up to about 100% because they just announced they're selling the legal side of their business for $193 million in cash. So, that's going to help their balance sheet and it'll get them a more focused business model. Because, I mean, yes, it's great if they can have more than one software line, but I really like businesses that really are focused on what they do best. And that's, in this case, clearly real estate.

So, they make their money -- and it's surprisingly affordable for landlords -- I don't know if you want to get into pricing yet, but this is a surprisingly affordable software product for landlords.

Moser: Well, yeah, go ahead and jump into that. Yeah, let's talk about that.

Frankel: So, there's two versions of AppFolio's product. There is the basic property management product, it costs for residential property $1.25/unit per month. So, it's for each rental property roughly $15/year to have this software. If it saves you more than $15 worth of time as a property manager, it's worth it, it pays for itself. So, I'm not a property manager, like I said, I'm on the investment side of real estate, but I have to figure that my properties' manager spends more than an hour or two worth of time each year on each one of my properties when it comes to things like maintenance and coordinating vendors and things like that. So, if it saves them that time then a product like this would pay for itself.

There's a pro version meant for large landlords with 500 or more properties in their portfolio, that costs $3/unit per month, but it adds a lot more analytical capabilities and really lets them, kind of, up the functionality and coordination of the entire business, if you will. So, they only really have one core product right now. There's a regular version and what's called the PLUS version. But these are not that expensive, and that's, kind of, part of the investment thesis is, that this is a product that essentially sells itself. And we've seen a lot of that in the Software-as-a-Service space. If something can cost $200 and saves the company $300 then there's no good reason for them not to buy it. You know, it's like paying for tax prep software as opposed to doing my taxes by hand. You know, it saves me enough time that it essentially pays for itself. So, the same thing applies here for property managers.

Moser: Yeah. I mean, I think you said a keyword there that I think matters a lot for a lot of folks regardless of the line of work, and that's "time." I mean, we're certainly finding new ways to value our time, different ways to value our time than we did 20 years ago. And that's in no small part thanks to technology and the internet and just generally speaking how much all of that together has changed our lives and helped our lives in many ways. And so, to me, yeah, it does feel like this is a business where the longer they can go with these property managers in their network, they should, over time, as long as they bring a decent product to market, they should overtime be able to flex some modest pricing power, I guess. I would think that, first and foremost, you got to figure the switching costs there after a while. You know, property managers are going to feel a little bit less enthusiastic about leaving if they've been working with a company like AppFolio for three, four, five years.

And you've certainly seen, over the stretch of time here since they went public, I mean, that gross margin line, in just looking at it in 2015, just under 55%, the last 12 months here, trailing 12-months, they recorded 62.5% gross margin. So, it's nice to see that expansion. And clearly, bringing more of it to the bottom line as well over time. I think that further out even, you know, we start looking at that margin picture and see if there is any pricing power that's trickling through. I wouldn't be surprised to see if that were the case, but I guess, really, with companies like this, it goes back to -- I mean, they're not the only company in this space, they have plenty of competition out there.

A couple of companies that exist out there today, CoStar, which is a $34 billion market cap company. There's RealPage, which is a $6 billion market cap. And RealPage is interesting, I had looked into that business a number of years back when we were doing the real-money portfolio initiative on Fool.com, and I was attracted to RealPage, specifically because of the market they pursued and the value they were bringing. But with CoStar, with RealPage, now with AppFolio, you start to ask, why one or the other, right? I mean, what would be, perhaps, the competitive advantage for one over the other? I am wondering did you find anything that leads you to believe that AppFolio has a leg-up when it comes to the technology or some other type of competitive advantage that would encourage users to choose them over their competitors?

Frankel: Well, I can tell you that when I was researching for this segment, when I googled "best property management software," in virtually every list I could find, AppFolio was the No. 1 rated product. So, that alone is a competitive advantage [laughs] right there, if you ask me. I think the focus of the company on the property management software business is a big competitive advantage. You mentioned CoStar. Property management software is not the only thing they do. So, it's nice to have focus.

And don't underestimate good management as a competitive advantage. I'll give you, kind of, a quick story. When I do premium write-ups for The Fool, one thing I look at all the time when I'm trying to evaluate the management team is employer reviews, just how employees perceive the company and the management team. So, there's a site called Glassdoor that's really great for this. I'm sure Jason has been on there once or twice. So, there's two metrics there. They have the percentage of employees that say they would refer the company to a friend, and the percentage of employees that approve of the CEO. The percentage of AppFolio's employees that approve of the CEO's job performance is 99% based on more than 500 reviews. That is the single highest number I have ever seen on Glassdoor. [laughs] So, there you go.

As far as employees that would refer the company to a job-seeking friend, 93%; also, one of the highest metrics I've seen for that. So, that gives them a big competitive advantage. You're wondering why I'm discussing all that, who cares if they like the CEO? But this is a competitive advantage in the sense that really engaged and happy employees, it's a big competitive advantage when it comes to attracting and retaining the top talent. And that is what you need if you want to develop the best product in an industry. I mean, obviously, there's a lot more that goes into product development than just employee recruiting, but that's a big competitive advantage to have employees that don't want to leave their jobs, that love where they work and love what they're doing with the company. And if you read through some of those reviews, it seems like that's really the case here. And that's a very underutilized competitive advantage in stock analysis.

Moser: Yeah, I like what you're saying there. And I'll point to something I found in the 10-K in just a minute. Before I do, I think it was interesting you noted the difference between CoStar and AppFolio, in that, CoStar, they do more than just that one thing, right? And that is something to remember, and it makes me think a little bit of the conversations I've had with folks in comparing something like an Adobe to a DocuSign, right? It sounds like maybe your CoStar is like your Adobe; and then, you know, AppFolio is like your DocuSign. And having the smaller company that's focusing on that one specific market could be the advantage, or at least the advantage that they're working on. So, yeah, I think that just because it's smaller and does less that's not necessarily a bad thing, and certainly sometimes that can be a very good thing.

But going back to the management of the company as being a competitive advantage. And I agree with you, I think when you have a company with that type of reputation, a culture with a reputation like that, that attracts talent, and really talent is what it's all about; like you said. And reading through the 10-K, they even note in there, they believe in their culture, and they believe in their core values, they believe that culture is a competitive advantage.

And when you look at the culture and the values that they espouse, it's six simple values here. No. 1, simpler is better. No. 2, great innovative products are a key to a great business. No. 3, great people make a great company. No. 4, listening to customers is in our DNA. No. 5, small, focused teams keep us agile. And No. 6, we do the right thing, because it's good for business.

And so, yeah, I know on the surface, maybe those sound like anybody could come up with them or anybody could do that, but the fact of the matter is, there are plenty of companies out there that don't do that, right? Even though it may seem easy. You know, setting that stuff out may not be the most difficult thing in the world, but practicing it, incorporating it, ingraining that into your culture over a long period of time, that is difficult. And it really does feel like AppFolio has been able to do that based on the numbers that you were just telling us there.

Frankel: Yeah. And it's also worth noting, speaking of the management team, that between all of their key executives, they own 42% or so of the company's stock. That's a pretty big insider ownership. That means a lot of people there believe in the company. They also control 71% of the vote, which, if you like that or not, you know, that's an investor preference. But between all the co-founders, the directors, the key executives, owning 42% of the company is pretty big. Normally you see a number [laughs] like 5% when you see the combined ownership.

Moser: Yeah, that is a big number. And one of the Co-Founders is still involved as the CTO, and then one of the Co-Founders is also involved as a Director. And I notice too, just beyond that, you've got this massive stake held by the Investment Group of Santa Barbara, they own a 13% stake in the business, which, you know, you look at venture capital associations, you see they get any of those types of firms, they will get in with these investments early on, and eventually they're looking for an exit strategy, they want to liquidate and take their profits and go elsewhere. But it seems like [laughs] Investment Group of Santa Barbara is happy owning this big stake and I'm starting to understand why.

You know, with a company like this, one of the things I look for in any software company, they always need to keep up on getting better, right? They need to bring more to the market; they need to continue to evolve the relationship to bring more to their customers. And I'll look at things like R&D, research and development spend, for example, just to get an idea of what kind of money they are putting back into the business. And I did know that over the past several years we've seen R&D spend ramp up a little bit here from around 12% to more like 15% of sales.

Assuming that they just continue to focus on this real estate market, which it sounds like they will, I mean, at some point that R&D spend probably gets to level off and it's not something they have to focus on so much, that's when you might start to see them really be able to unlock some profitability in this business.

Frankel: Yeah. And you mentioned, their margins have expanded significantly over time already. And that's notwithstanding the R&D increase in spending. But an interesting thing that I like to look at is revenue growth versus expense growth, because that's going to tell you what direction it's trending in. In the first half of 2020, I mentioned that AppFolio's revenue increased by 27%. Their expenses, during the same period, only increased year-over-year by 22%. So, when your revenue is increasing faster than your expenses, one, it means your business might be maturing, because as you said, R&D spend and stuff like that is going to eventually level-off to where you're not in rapid growth mode, you're more in recurring revenue mode. Right now, they're definitely still in growth mode, but it's nice to see that their margins are expanding; even during the pandemic, it looks like, that's the case. We'll have to wait for the full-year numbers to see if it holds out, but it looks like they're still doing a great job of expanding margins and increasing efficiency of their business, which is definitely promising.

Moser: Yeah, it is. And the only other thing I've thought about with a business like this and its competitors, and the reason why I was thinking about this over the weekend, or really over the last week, I had been digging into a research presentation on Snowflake, learning more about the database management market opportunity, and one of the risks that we're finding, not only in that market, but I think in a number of markets, particularly in this pandemic economy where costs are certainly more under the microscope now than ever before, some customers -- I mean, a risk out there is that, for companies that have always relied on having the best tech or the best software, and you know, that's an advantage, right. I mean, you've built your business off of having a really great product and you bring more customers in. And that's an advantage that you can continue to grow over time.

But what we're seeing too, at the same point, is this threat of "good enough." And what I mean by that is, you know, companies aren't necessarily focused all the time on looking for the best product, the best service as a client, right? They're looking for something that gets the job done, and oftentimes good enough may be better than the best if the cost is attractive enough. You know, if the deal that they're being offered is attractive enough, they may not necessarily feel like they need to pay up for the best software, if there's something out there that's good enough, that's already getting the job done.

And I'm not saying I think that's a problem or something necessarily that AppFolio needs to be concerned with today, but I think generally speaking, in this SaaS market, in this SaaS and cloud-driven world, that's something at least to keep in mind, that "good enough" risk that exists out there today still.

Frankel: Yeah, for sure. And remember, it's not just good enough, it's what's easy, people like easy. And I mention that, because all those, you know, the top property management software list I read that all universally had AppFolio ranked No. 1. The biggest comment I saw was that it's user-friendly. No one wants a big, complicated clunky piece of software, even if it's the best in the business. And it sounds like that's one of the things that they're really good at, is user-friendliness and, kind of, simplifying the process.

There are probably more feature-rich analytics out there. I'm sure there are property management programs that beat AppFolio on one metric or the other, but if you have the overall one-stop software program that's easy to use -- because I was reading one of their customer stories that before they went to AppFolio, they had a paper-and-pencil ledger. And I can tell you my property manager uses primarily just old-school email, pencil and paper, Excel spreadsheets. Point being, this is not a high-tech field traditionally that they're going after. So, that's why user-friendliness is so important. If you're selling your database software to software engineers or to an engineering firm, then it could be a little complex, but if you're selling a software program to property managers who don't have engineering degrees then user-friendliness is a very important quality, and that's what it seems like AppFolio is really good at.

Moser: Yeah, I love that point; I totally agree. So, I guess, the $50,000 question here, Matt, is this a company, is this a stock that belongs on investors' radar? I mean, to me, I look at the history, the performance of the stock, it certainly had a good life thus far as a publicly traded company. It strikes me as keying in on a very important market, and it sounds like they do something and they do it really well, and they've built a company with a culture that is clearly resonating with a lot of folks. I mean, I look at a business like this, I have a feeling what you might say, but I still want to hear you say it. Is this stock that belongs on folks' radars or something you'd like to learn more about?

Frankel: Well, this got it on my radar. And I don't know what you think I'm about to say, but let me see if I could blow your mind a little bit here. Jason is definitely more the growth investor than I am; just from hearing, you know, his ones to watch versus my ones to watch each week.

Moser: I think that's fair to say, yeah.

Frankel: So, I am hesitant, and to a fault I'm hesitant to invest in businesses that trade at such high valuations, especially that have essentially one product. Like I said, having one product is a good thing in the sense that the business is very focused, but when you're trading at 17X sales and you just sold your only other viable product line, it causes me to pump the brakes a little bit. I like a lot about the business, but I probably want to keep it on my radar and, kind of, pay attention to what's going on for the next quarter or two before I would want to pull the trigger.

Moser: Yeah, no, not at all. That was right. Because I think I might surprise you with what I'm saying, I actually totally agree there. I mean, this to me, I might be a little bit more excited about this business perhaps than you, but not to the point where I feel like it's something that investors should be out there just buying today. And I mean, there are so many qualities about it that I like. I love that it focuses on that key market, I love the fact that they're profitable, they're cash flow positive. I mean, this is a business, they've really got some fundamentals that make it -- you know, just make it a little bit more. You can, sort of, see the light at the end of the tunnel there because of the fundamentals of the business.

To me, it's a competitive market clearly and there are other bigger players in the space, so they've got their work cut out for them, but I like so much about what they're doing and I really -- based on what you're saying about the culture, based on what I've read about the business just in googling around, it does seem like they've got a culture that matters.

I mean, this is a business that certainly I would have on my watchlist and, you know, if we see material pullback and that valuation starts to look a little bit more attractive -- I mean, I don't think this is a buy at any price business, but I certainly think it's one that focuses in on a large and growing market opportunity that sounds like they do something really well. And with that founder leadership there, that's another neat quality that we love to see. So, yeah, I mean if I'm an investor, I'm definitely interested. Maybe not pulling the trigger at today's valuation, but I'd keep this one on the shortlist there for the chance of any type of pullback that made the stock look a little bit more attractive.

Frankel: Yeah, I'd say that's fair. Like I said, it's on my radar now. Thank you to whoever has last week for putting it on my radar. But like I said, I'm not ready to pull the trigger on it just yet.

Moser: All right. Well, there you go, AppFolio. That's an interesting business with a lot of potential. And, Matt, I appreciate you digging in there and finding out that information for us.

Before we wrap up this week, let's go ahead and jump real quick into our one to watch, we'll just take a look at what's going on here this week in the market and have a stock for our listeners to get on their radar other than AppFolio. Matt, what's your one to watch this week?

Frankel: Given today's pullback especially, I have Bank of America on the top of my watchlist right now. I don't know if you read that JPMorgan headline. JPMorgan Chase is under scrutiny because they allegedly processed some illicit payments.

Moser: I did read that headline, yes.

Frankel: It's dragging the entire banking sector down now. If you remember, Warren Buffett added more than $2 billion to their Bank of America stake recently. And now after this pullback, you can actually get in for less than Buffett paid. So, yeah, it's an attractive valuation. I already own a lot of Bank of America but may add more if this current valuation persists.

Moser: Yeah, I like that. And you know, the bank that really crossed my radar here, because of this pullback, because it's certainly it's not discriminating, I mean, we've seen Ameris Bancorp also coming back to reality here a little bit, in what's been, obviously, a very difficult market for banks, both big and small. And it sounds like it's not going to get easier anytime soon based on the interest rate policy that we've heard. But Ameris is not my one to watch, so I don't want to drag on about that.

I'm actually taking a little bit of a different approach here. With earnings season more or less wrapped up, there is a company reporting earnings this Thursday and I'm going to be very fascinated just to hear their take on the general consumer economy, it's Darden Restaurants. And Darden Restaurants is best known as the owner of Olive Garden along with a number of other restaurants they've got in their portfolio. And you could see going into 2020, shareholders over the last five years have done very well with the company. Now they have not recovered all of their losses this year, and given what's gone on this year, it's certainly understandable why restaurants are having such a tough time.

But what I noticed in the call from last quarter is this management team is really playing offense. And I think in the restaurant space, the big picture restaurant space has been really, really brutal. I mean, I would not recommend, you know, going out there and just investing in all these restaurants on the dip. I think some restaurants are going to come out of this a lot stronger, and I think most of those restaurants will be the bigger ones that already had a lot of resources at their disposal and Darden is definitely one of those.

Last quarter they had noted 91% of their dine-in stores had reopened with some capacity, mostly that was Olive Garden and LongHorn, but still that's a lot of restaurants. They're doing very well with their to-go sales. And I think that, based on their language in the last call, they're looking at a lot of these restaurants that are closing down as unfortunate, but an opportunity to go out there and gain more presence, gain more physical real estate to open more restaurants to fill that void. Because once things do get back to normal somewhat here, and they will eventually, I mean, folks are going to want to start going back out to dinner more on the reg, and I think that Darden is going to be well-positioned to accommodate that demand. I think it's just going to be interesting to see their take on the consumer here in this next earnings report on Thursday.

So, Darden Restaurants and Bank of America, a couple of good ones to keep on your radar.

Matt, I appreciate you taking the time this week to join. As always, this was a fun one. I enjoyed digging into AppFolio and we'll definitely continue to follow it here on the show.

Frankel: For sure. Always fun to be here.

Moser: Well, that's going to do it for us this week, folks. Remember, you can always reach out to us on Twitter @MFIndustryFocus or you can drop us an email at [email protected]. Hey, I mean, listen, if you have any companies in the financial sector that you would like us to dig a little bit more into for a show, we're always open for ideas. Not going to make any promises, but, hey, we get some compelling ideas out there, you never know, that might make for a good show here in the near future, at least until we get back up to our next earnings-palooza! [laughs]

But as always, people on the program may have interests in the stocks they talk about, and The Motley Fool may have formal recommendations for or against, so don't buy or sell stocks based solely on what you hear.

Thanks, as always, to Tim Sparks for putting the show together. For Matt Frankel, I'm Jason Moser, thanks for listening and we'll see you next week.