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Silicon Valley Dispatch 1
Motley Fool Explorer

Silicon Valley Dispatch 1

The Explorer team stops by a biotech company that saw revenues soar 5X last year, a recent IPO with red-hot sales growth, the "Google of the Internet of Things," and more!

Dispatch1
 
Take me to my Motley Fool Explorer member invitation now!

The Explorer team has completed their 2,628 mile journey to Silicon Valley, and they're ready to pull back the curtain on the first four stocks David Gardner has selected.

In the video above, Explorer lead advisor Simon Erickson takes you directly to Silicon Valley and reveals why each of these companies made the cut.

This batch of companies includes...

Exelixis: A tiny cancer-fighting biotech located just south of San Francisco that went "all in" on a promising pipeline of drugs in 2011 and is seeing a huge payoff today, with sales quintupling in 2016 alone!

Ellie Mae: Investors in David's first Zillow call are already sitting on a 359% gain, but the biggest winner in the next generation of real estate might be a tiny company most investors have never heard of named Ellie Mae.

Splunk: Called "The Google of the Internet of Things," Splunk has already grown revenue eightfold in the past five years. However, with huge trends at its back, it's a company that could still be in the first inning of its growth.

Twilio: One of Silicon Valley's newest IPOs, Twilio is quickly establishing itself as the "pipes" that the most innovative companies will rely on for the next decade of mobile growth.

All four companies face what David believes are incredible futures...

But in the coming days, the Explorer team will be trimming David's original list of eight stocks down to a final four.

This is all part of this month's mission, in which David Gardner and the Explorer team will be revealing the #1 stock out of Silicon Valley and investing $100,000 of The Motley Fool's own capital in it!

Tell us which stock YOU think will be Silicon Valley’s "Next Big Thing."

Simon just ran down the first four stocks David picked... But we want to hear what YOU think.

Which company do you think deserves the title of 2017's "Next Big Thing" out of Silicon Valley?

Tell us by voting in the poll below!

Please make a selection.

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Now get the full story on these companies

We've laid out the full story on each stock below. Scroll down for analyst research on all four stocks.

Exploration Stock #1

Ellie Mae

Ellie Mae

NYSE: ELLI

chart - elli

Company Snapshot

Headquarters: Pleasanton, CA

Website: www.elliemae.com

Recent Price: $107.00

Market Cap: $3.71B

Increasing regulation in the mortgage industry is driving the need for automated solutions. Ellie Mae (NYSE: ELLI) offers an innovative solution that streamlines and automates the mortgage origination process.

What it does

Most of us would agree that paperwork is a real hassle.

It's particularly onerous in the mortgage industry. Constantly changing regulations make it increasingly challenging for mortgage brokers to originate and close new loans. On top of that, the subprime crisis has left many banks hesitant to make any loans unless borrowers meet a long list of standards.

Fortunately for the industry (and for us as investors), Ellie Mae has a more efficient solution. The company has spent years developing an Internet-based platform called Encompass, which makes the mortgage origination process much simpler for both brokers and clients.

Ellie Mae's corporate mission is "to be the industry standard platform for residential mortgage origination in the United States." It's been doing a great job at improving loan quality and increasing efficiency, which has translated into excellent investor returns.

Why Ellie Mae could be the "Next Big Thing" out of Silicon Valley

Encompass is a one-stop shop for mortgage originators to manage the entire loan process from start to finish. The solution is cloud-based, so it's available online at any time and is easily updated with new features.

There are nearly 534,000 state-licensed or federally registered individuals who are engaged in originating residential mortgages in the U.S. Nearly 40% of these mortgage professionals work at the nation's largest lenders (such as Wells Fargo or Citigroup), while the rest work at more than 27,000 regional lenders that are licensed to originate mortgages.

Ellie Mae has done a fantastic job of building its brand and adding new customers. The company now has roughly 165,000 Encompass users, and is adding more at an accelerating pace.

Once signed on, most users set up a license, which allows them to take advantage of the bells and whistles that Encompass has to offer. Features such as compliance, pricing, and customer relationship management make the process of closing more loans even easier. Ellie Mae charges users a monthly license fee, which increases as clients add more features.

In addition to the internal features, a lot of other steps are required to close a loan. Appraisals, flood certifications, credit reports, and other services normally take a significant amount of time to coordinate. But the Ellie Mae Network allows users to manage these services directly within Encompass. Ellie Mae takes a cut of each transaction.

Navigating Encompass becomes easier over time — a win for both Ellie Mae (which is generating more revenue from licenses and fees) and its customers (who are making more in commissions by closing more loans). The average revenue per user has steadily increased during the past few years.

Why this stock has room to grow

Ellie Mae's business model allows for excellent scalability. Times are good for the real estate market right now, with the National Association of Realtors reporting that existing home sales are growing at their fastest pace in 10 years.

Of course, the real estate market is notoriously volatile. Times will get tough, and the number of new mortgages will decrease. But Ellie Mae's platform provides a steady recurring revenue stream to pay the company's bills. In fact, down cycles present an opportunity to add new brokers and get them up to speed while things aren't quite so hectic.

The company is in excellent financial shape, with no long-term debt and $393 million in net cash. Operating cash flow far exceeds internal investment needs, and I would expect to see Ellie Mae continue to make strategic acquisitions to strengthen its core platform and add to its dominant competitive position.

What could go wrong

We think Ellie Mae is an excellent business with a massive opportunity and the right leadership. Still, there are several risks we think are worth keeping an eye on. Here are a few:

  1. A prolonged housing downturn. Even with recurring subscription revenue as a safety net, another housing downturn would bring the number of new mortgages approved to a standstill. This could significantly reduce quarterly earnings and scare away shorter-term investors.
  2. A massive security breach. Last March, Ellie Mae experienced a one-day outage that brought its entire platform down right at the end of the quarter. The company confirmed that no data was breached, but the glitch gave a few mortgage professionals quite a scare. A larger breach could break down the trust the company has worked so hard to build with customers.
  3. A management shake-up. Management has been instrumental to the company's outsized investment returns. A change in the top ranks that takes the company in a different strategic direction could be a red flag.

That said, we think that rising mortgage volumes and increasing regulations are likely to provide great returns for Ellie Mae's shareholders. We love the company's scalable business model, visionary management, and strengthening competitive advantages.

This comes from ELLI's 2013 10-K, so it's probably out of date. In the same section of the latest 10-K, ELLI says that "there were more than 6,0001 mortgage lenders in 2016 in the United States, including national banks, regional banks, non-bank lenders and credit unions" and that those lenders issued $1.9 trillion in loans for 1-to-4-family homes in 2016.

And this is from the 2015 report: "there were approximately 531,195 state licensed or federally registered individuals and 25,929 licensed companies or federal institutions engaged in originating residential mortgages across the United States at September 30, 2015... Based on information provided by Inside Mortgage Finance, 35.9% of mortgages originated nationwide during the nine months ended September 30, 2015 were funded directly through the retail channels of mega lenders and the remaining 64.1% were funded through other wholesale channels, mortgage lenders, and brokerages."

Exploration Stock #2

Exelixis

Exelixis

Nasdaq: EXEL

chart - EXEL

Company Snapshot

Headquarters: South San Francisco, CA

Website: www.exelixis.com

Recent Price: $21.76

Market Cap: $6.28B

If there's a "holy grail" of modern medicine, it's turning the tide in the battle against cancer.

Because even after recent progress in limiting the rate of death in cancer cases, the numbers are staggering. Each year, there are roughly 1.8 million new cancer cases in the United States. And the number of deaths from cancer still stands at 600,000 annually.

Exelixis is in the trenches of this ongoing battle against cancer. The company's drugs form a powerful one-two punch when paired with other drugs in the promising field of immune oncology — that is, using your own immune system to fight cancer.

Whereas large biotech companies produce drugs that take off cancer's "cloaking device" and teach the body to recognize cancer cells, Exelixis produces a drug that targets the cancer directly.

Its drugs are improving the lives of thousands of cancer patients... and present incredible opportunity for biotech investors. Exelixis' revenue recently quintupled, soaring from $37 million in 2014 to $191.5 million in 2015.

Looking ahead to the next three to five years, we see a path for Exelixis to potentially grow to more than 10X its current size today. Here's why Exelixis made the short list of David Gardner's favorite opportunities in Silicon Valley. 

What it does

Exelixis is a cancer-focused biotech with drugs already on the market and several more in its pipeline.

Like many biotech stocks, Exelixis has had its share of disappointments and false starts. Founded more than two decades ago in 1994, Exelixis made the decision to sell off the majority of its drug portfolio in 2011 to go "all in" on a promising pipeline of newer drugs.

A year later, the company's decision began paying off. It received FDA approval for a drug (Cometriq) for treating advanced medullary thyroid cancer. That's a rare cancer, which made the market for Cometriq relatively small. In 2015, the company recorded just $37.2 million in sales from the drug. 

However, Exelixis was able to reformulate Cometriq into a drug named Cabometyx, which targets significantly larger markets.

Cabometyx was approved in April 2016 for patients with renal cell carcinoma, the most common form of kidney cancer. In head-to-head clinical trials, Exelixis' new drug beat the past standard of care for second-line kidney cancer (Novartis' Afinitor), increasing the median overall survival by 4.9 months.

Put another way — Cabometyx reduced the rate of death by 34%!

Why Exelexis could be the "Next Big Thing" out of Silicon Valley

After the FDA's approval of Cabometyx and promising clinical trial results, it didn't take long for sales to begin skyrocketing. In 2016, Exelexis' sales more than quintupled.

And 2017 has also started off with a bang — revenue in the first quarter grew at 424.3%!

However, even with Cabometyx's incredible early success in the kidney cancer space, the drug's biggest opportunities may lie ahead as it targets expansion into even larger markets.

Recent trials have shown the drug's potential as a first-line treatment in renal cell carcinoma. If Cabometyx is approved for earlier-stage patients, that could significantly expand the drug's market size.

In addition, by mid-2017 there should be a readout on Cabometyx's effectiveness in treating the most common form of liver cancer.

Why this stock has room to grow

Exelixis estimates that there are 17,000 renal cell carcinoma patients in the U.S. who have failed at least one treatment — the population Cabometyx is approved for. At a cost of $165,000 per year and an average treatment duration of 7.6 months, Cabometyx has a potential market of about $1.8 billion.

Exelixis won't capture this entire market, but its potential pipeline extends well beyond this market. Success in any of the trials the drug is currently in could grow Cabometyx's market by many multiples.

In addition, the company has lucrative partnerships with pharmaceutical giants like Roche and Bristol-Myers Squibb. First off, these partnerships show that the "smart money" in health care is betting on Exelixis' success.

Second, these deep-pocketed partners will help control Exelixis' cash burn as it shepherds its pipeline through clinical trials, enabling the company to spread its bets across more drugs and focus on the science while partners handle difficult tasks like marketing ramp-up upon FDA approval.

Third, if the combination of Exelixis' drug with Bristol's or Roche's shows a benefit, that sets up a win-win for both Exelixis and its partner, enabling them to go to doctors and present the combination data. That could further expand Exelixis' opportunities.

Biotechs are always inherently risky, but continued success of Cabometyx and expansion into new treatments could position Exelixis to grow revenues tenfold or even more in the coming decade.

What could go wrong

Exelixis' biggest risk is that Cabometyx might not be able to penetrate the kidney cancer market like we expect. Initial results have been incredible, but we'll continue monitoring progress in the coming quarters.

Exelixis isn't likely to be profitable for a while, so we'll also need to watch its cash burn rate. At the end of March, the biotech had more than $400 million in cash and long-term investments, so it has a nice runway to get cash flow-positive.

Finally, success breeds imitators, and the word is out on Exelixis' treatments working well. That puts additional pressure on Exelixis to show better results than competing drugs.

Exploration Stock #3

Splunk

Splunk

Nasdaq: SPLK

chart - SPLK

Company Snapshot

Headquarters: San Francisco, CA

Website: www.splunk.com

Recent Price: $67.00

Market Cap: $9.40B

The Internet of Things (IoT) has been a little slow to take off, but we're confident that it will in due time. Its potential to revolutionize broad swaths of industries is simply too great — everything from improving efficiency in the energy sector to transforming customer retail experiences to building entire smart cities. The IoT industry continues to explore innovative new ways to leverage ubiquitous connectivity, and Splunk (Nasdaq: SPLK) is right at the forefront of this trend.

What it does

Splunk's mission is to help companies make sense of their data and leverage those insights into increased operational efficiency and performance. The company's flagship offering, Splunk Enterprise, provides enterprise customers with powerful collection, indexing, searching, reporting, analysis, alerting, monitoring, and data management functionalities.

The platform is capable of collecting and indexing hundreds of terabytes of machine data every single day. The company also offers a cloud-based version of the service, Splunk Cloud, which was launched in 2013.

Why Splunk could be the "Next Big Thing" out of Silicon Valley

One of Splunk's most important differentiating factors is its ability to handle unstructured data. This is a much more nascent field relative to structured data, or data that is already organized and easier to interpret.

There is now a large — and ever-growing — quantity of unstructured data being generated by an increasing number of connected devices. The IoT promises to create vast amounts of machine data, and being able to parse that information is the key to unlocking its value.

Rivals, including large enterprise software giants, have begun expanding their unstructured data offerings in recent years, but Splunk is an early mover and top dog, ranking No. 1 in market share in the worldwide IT operations analytics software market for the past two years.

Splunk has uniquely positioned itself to capitalize on this opportunity, and the company's focus on customer satisfaction translates into strong customer retention.

Why this stock has room to grow

Splunk continues to grow and gain momentum because of strong demand for Splunk Enterprise. Revenue for fiscal 2017, which just closed, soared 42%, to $950 million, of which $547 million was license revenue. The company now has over 13,000 customers worldwide, having added roughly 2,000 customers throughout the fiscal year and 700 new customers in the fourth quarter alone. The diverse customer base reduces customer concentration risk, as no single customer represents over 10% of sales.

In February, Splunk increased its guidance for fiscal 2018 and now expects sales for the full year to be approximately $1.2 billion, which represents 25% growth from fiscal 2017.

What could go wrong

There are several important risks that Splunk faces. The first is intensifying competition from larger rivals looking to strengthen their position in unstructured machine data analysis. We're talking about companies like Oracle, IBM, SAP, and Microsoft, among others, all of which offer comprehensive analytics services, including a growing emphasis on unstructured data. This risk could materialize in market share loss, margin compression, or both.

Like most companies that cater to the enterprise market, Splunk is also vulnerable to broader IT spending budgets, which fluctuate naturally over time. The enterprise software market is especially susceptible to changes in spending patterns, which is why sector players often move together, depending on the macroeconomic environment.

Additionally, the broader IoT trend is still in its early innings. While third-party estimates predict massive growth in IoT devices and applications in the years ahead — IDC predicts that the installed base of IoT units will grow to over 28 billion by 2020, for instance — there is still considerable uncertainty.

If the IoT fails to live up to high growth expectations, that could translate into a reduced need for Splunk Enterprise. This risk is magnified by the fact that Splunk continues to invest heavily in future growth: Operating expenses jumped 30% last fiscal year, widening operating losses.

Exploration Stock #4

Twilio

Twilio

NYSE: TWLO

chart - TWLO

Company Snapshot

Headquarters: San Francisco, CA

Website: www.twilio.com

Recent Price: $23.50

Market Cap: $2.04B

Since David Gardner recommended Netflix in Stock Advisor on Dec. 17, 2004, the stock has racked up an incredible 8,337% gain.

However, the path to that fortune-changing gain has been far from smooth. After disappointing earnings in October 2011, Netflix collapsed 35% in a single day. Less than a year later, in July 2012, Netflix reported disappointing earnings once again, and shares were down 25% in the next day's trading.

In fact, you might be surprised to learn that many of David's most profitable recommendations encountered periods of deep negativity where Wall Street analysts screamed "SELL" in over-the-top research notes.

Yet David has a keen eye for holding the highest-upside companies through these troubled times, sometimes re-recommending them and giving investors better prices and returns after short-term sell-offs. This patience and an eye for the long term are huge secrets to David's incredible stock-picking success.

Which brings us to Twilio (Nasdaq: TWLO). Last week, the company reported disappointing earnings and promptly saw its shares collapse more than 25% the next morning. Could investors buying Twilio today be getting a screaming deal?

What it does

Twilio arms developers with tools to embed communications features within their existing platforms and applications. If that description doesn't exactly jump off the page at you, consider the company Twilio keeps.

Amazon.com's Amazon Web Services and Facebook's WhatsApp are two marquee customers. But lots of others are embedding Twilio's services in their products to make them more responsive. Netflix leans on Twilio to deliver text, push, and voice notifications for everything from speedy password resets to critical updates. Twilio provides live lead notifications for Trulia, two-factor authentication for Box, and even volunteer shift scheduling for the American Red Cross.

In total, the company's customer base continues to soar, clocking in at more than 40,000 in Twilio's most recent quarter.

Why Twilio could be the "Next Big Thing" out of Silicon Valley

The best way to think about Twilio's business is as the "pipes for the mobile age." Companies increasingly need to reach their customers through mobile alerts and messaging, which can be complicated to manage. Twilio fills this market need by providing the most user-friendly services that allow companies to stay connected to their customers.

And once Twilio has acquired new customers, it has proven very adept at expanding those relationships and expanding the revenue it receives from each account. For example, Twilio maintains a base net expansion rate — a measure that shows how much additional revenue it is receiving from customers between one year and the next — of 141%.

In fact, you could say that Twilio has been a recent victim of its own success — its 25%+ plunge last week was caused by disclosures that key customer Uber would be moving some of its messaging back in-house.

While that news caused Twilio to miss near-term targets, Uber felt a need to pull messaging back in- house only because it was spending so much with Twilio.

It's important to note that few companies could afford to invest tens of millions of dollars a year to replicate many of Twilio's features by building an in-house design team. We believe few of Twilio's other customers have the scale to attempt what Uber's doing. If anything, recent events increase our confidence in the value of Twilio's services.

And the trend of customers increasingly spending more money on Twilio's essential services is great news for Twilio's prospects with the 40,000 + customers that aren't Uber.

Why this stock has room to grow

Excluding Uber, last quarter Twilio grew revenue by 62%. Even after factoring in recent events, we believe Twilio could cross $1 billion in sales within the next five years.

A stock like Twilio will likely see plenty of volatility and uncertainty. But ifTwilio can rebound from the decline in business with Uber and begin beating Wall Street's expectations in the coming years, we see significant upside in its share price.

That should give investors with a long-term focus on the bigger picture the same opportunity Netflix investors were able to capture after short sighted earnings panics.

What could go wrong

The biggest threat to Twilio is that other major customers might follow Uber's game plan and begin moving Twilio's services to in-house engineering teams. One company we'll be watching is Facebook, which is a major Twilio customer and, like Uber, has significant resources.

We're also asking when Twilio's quarterly deficits will turn the corner. It's not easy for conventional investors to pin an earnings multiple on a company that lacks positive net income. Twilio has a large cash cushion and no debt, so it can sacrifice near-term profits to spend on acquiring a larger customer base today. However, we'll be closely watching revenue growth and expense management in the coming years.

Finally, disruptors can be disrupted themselves, so, naturally, we'll keep an eye on anyone rolling out a potentially better mousetrap in Twilio's niche.