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1 High-Potential SaaS Company You've Probably Never Heard Of

By Matthew Frankel, CFP® and Brian Feroldi - Apr 6, 2021 at 6:31AM

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This company aims to level the playing field between smaller banks and the industry's big players.

As far as publicly traded software-as-a-service (SaaS) companies go, Q2 Holdings (QTWO 2.54%) isn't exactly a household name. However, it has an interesting value proposition for the thousands of smaller banks in the United States, and there could be a huge market opportunity over the coming years. In this Fool Live video clip, recorded on March 25, contributor Brian Feroldi breaks down Q2's business and explains why he thinks investors should pay attention to it. 

Brian Feroldi: I'm going to move on to another underappreciated stock called Q2 Holdings. The way I found out if these stocks were appreciated or not was by looking at the popularity ranking on Fools, and this is the 504th most popular Motley Fool recommendation. People don't seem to know or know about this company or like it. It could be because of the name itself, Q2 Holdings, it could do anything. The ticker symbol here is Q2WO.

This company came public in 2014, 2015ish. It has been a great stock to hold. It has thumped these stock markets. It's a five-bagger and counting. This is a company that is a software as a service business that's focused on regional and community banks. They provide all kinds of software solutions for regional and community banks which lack the access to funding and research and development to develop the tools that they need to compete with big banks.

If you're a customer of Bank of America (NYSE: BAC), Wells Fargo (NYSE: WFC), you have access to a great mobile app that was custom-built for those companies to help with ACH and bill payments. If you're a small bank, how do you afford those things? One answer is to partner with Q2 Holdings, which provides all those tools for you and you don't have to build them from scratch.

A couple of the tools that this company offers is bill payments, person-to-person payments, you could do remote deposit with them. On the business side, they can also help with ACH transfers or wire payments. You can do a high-volume transactions. The company has tools that help with fraud detection, with multifactor authentication. You can get to online account enrollment, they can really help you to get your website setup so that local customers can access your bank. They can help with loan decisions, they can help to make sure that loans are processed the right way. They also offer APIs that can be built right into the banking's website and app to make sure that services can be easily accessed. These are all the behind-the-scenes tools that Q2 offers to help small local banks compete.

If you look at their results over time, they have consistently added new banking customers. At a relatively slow pace, their growth is less than 10 percent per year, it's more of a high single-digit grower. But they've consistently grown this number. It takes a huge amount of sales efforts to get a bank to switch over to your solutions. But once they're in, they tend to be very sticky. Q2 as a long history of upselling it's customers over time, so it's nailing the land and expand model. If you look at the company's revenue retention rates, they're well into the 120s, which is a very good number for a SaaS company.

They also have a pretty good churn. Once your bank gets adopted on these, it's really hard to switch over. Five percentage churn suggests that probably these companies are being merged or even failing, that's not a very high number. If you look at the company's revenue growth, it's as smooth as it gets. The company has just consistently grown its top-line basically since its founding, and this is just the numbers since coming public.

Now, this is in a very high-margin business like you might be used to seeing with other SaaS companies. This is a company with a gross margin somewhere between 40-50%. It has bounced around a little bit in recent quarters because it has made some acquisitions. On a GAAP basis, it is losing money. Some of that is temporary in nature. If you adjust for a one-time contribution, it is actually profitable on a non-GAAP basis.

The growth plan from here is pretty simple; launch new products, launch new services, make occasional acquisitions, and they have a pretty big potential. There's over 10,000 banks that they have identified as potential targets. Right now, they're at about 450, and they've pegged their market opportunity at about $10 billion in the United States.

On a valuation perspective, it's not that expensive, it's not that cheap either. It's trading about 14, less about 13 times sales, a few hundered times next year's earnings multiple. That's because it's on the border between profitable, not-profitable. The price to sales ratio is a little bit misleading because again, this has a 40-ish percent gross margin, not an 80-ish percent gross margin. But Q2, it's a stock that I own, a stock that I've owned for a long time and it just doesn't get enough love.

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