2018 Investing Trend No. 4: Rule Breakers

AppFolio (NASDAQ: APPF) Dorman Products (NASDAQ: DORM) Redfin (NASDAQ: RDFN) Stamps.com (NASDAQ: STMP)

Why We Think This Trend is Going to be Massive

Rule Breakers are the types of businesses that are marching to a different tune and playing a different game compared to the established incumbents. In this Rule Breakers theme, we are looking at four businesses that are each bringing a new and innovative approach to their respective industries.

Buying — and ruthlessly holding — these sorts of companies over the long term can deliver game-changing returns for patient shareholders. Think of where Netflix was in the early 2000s, pioneering a new model — a DVD-by-mail subscription service — that was typically laughed off and ignored by established incumbents, like Blockbuster (which even passed on a chance to acquire Netflix for $50 million in 2000).

Of course, we know the rest of the story with Netflix. Remaining ever the innovator and disruptor, Netflix launched its online streaming service in 2007. And it was just a few years later that Netflix started producing original content like House of Cards and Orange Is the New Black.

Today, Netflix has become a global media giant worth more than $90 billion — projecting to spend up to $8 billion on content in 2018 alone. The stock, meanwhile, is up 6,400% over the past 10 years and a whopping 26,500% over the past 15 years. (That’s what we mean by game-changing returns.)

Netflix took a technology- and software-driven approach to a large, established industry. The company won over customers with its easy-to-use platform that also saved its members money on video rentals (no late fees!).

As investors, we can apply pattern recognition and find other companies doing to their industries what Netflix did for home entertainment.

For instance, think about the real estate market — a large, fragmented industry that hasn’t seen much in the way of innovation compared to many other industries. In the U.S. alone, there are 2 million active licensed real estate agents working with over 86,000 real estate brokerages. Anyone who has bought or sold a home knows it is a time-consuming, expensive process with multiple pain points. This is precisely the type of industry ripe for disruption from a user-friendly, technology-driven Rule Breaker.

Another example could be within the shipping and logistics space, which is booming as e-commerce continues to gain steam in North America and around the globe. (Not surprisingly, parcel volume is at an all-time high.) With multiple online marketplaces like Amazon, Etsy, and Shopify, and a variety of carriers (like UPS, FedEx, and DHL), there is a growing opportunity for a Rule Breaker to seamlessly tie these marketplaces and carriers together onto a seamless, user-friendly software platform — allowing e-commerce merchants to bring all their orders into one place and automatically find the carrier with the best shipping rates.

The Foolish Bottom Line

Rule Breakers are just the sort of companies we love as Foolish investors who, by definition, are thinking about where the world is going over the next three years and beyond.

Rule Breaking companies often start small with a new approach to an established industry — just as Netflix started with a simple DVD subscription model — but sometimes that new approach is all that’s needed to win over a significant number of customers and capture meaningful market share before the incumbents take any action. In the meantime, patient shareholders can be rewarded with extraordinary gains, simply by hitching their wagons to transformative Rule Breakers for the long haul.

Within this bracket are four U.S. Rule Breakers that are bringing a fresh approach — and, in some cases, an entirely new model — to their respective industries.


Our Top Four Small-Cap Stocks Leading the Way in Rule Breakers

AppFolio (NASDAQ: APPF)

Why AppFolio is potentially a Hidden Gem: AppFolio is a quickly growing, under-the-radar software company serving specific industries

Headquarters: Goleta, California
Website: www.appfolio.com
Industry: Internet Software and Services
Recent Price: $44.95
Market Capitalization: $1.5 billion
LTM Revenue: $133.9
LTM Revenue Growth: 36.7%
3-Yr Revenue Growth: 58.4% (2016)
Cash/Debt: $43.2 / 0
Insider ownership: 44.65%
Amounts in USD millions except for recent price
LTM = last twelve months
Data as of: January 12, 2018
Data provided by S&P Global Market Intelligence

Meet AppFolio…

AppFolio is a software company that helps small and medium-sized (SMB) law firms and property managers run their businesses. The company got its start back in 2006 by providing software-as-a-service (SaaS) solutions for property managers who have 20 to 3,000 rental units under management. Its software aids every step of the property-management process — including acquiring new tenants, communicating with tenants about maintenance, and accepting payments — all through a single digital platform. Today, AppFolio serves nearly 11,000 property customers overseeing almost 3 million units.

AppFolio began serving small law firms (20 or fewer employees) after it acquired MyCase in 2012. MyCase helps legal practices track timing and billing, communicate with clients, coordinate lawyers and staff, and manage legal documents within a single system. At less than 10% of AppFolio’s total sales, MyCase is still a small contributor to revenue, but it has grown from 2,218 customers in 2014 to 9,000 today.

AppFolio also offers add-ons to its software through what it calls Value+ services, which made up 57% of overall revenue in the most recent quarter. These extra features, such as an electronic-payments platform and resident-screening services, get integrated into the core platform and create additional high-margin revenue from AppFolio’s most engaged customers. AppFolio is in the early stages of monetizing MyCase with Value+ services, which makes us think it’s just a matter of time before MyCase contributes more meaningfully to AppFolio’s overall sales.

AppFolio’s customer-centric focus is bolstered by a vibrant employee culture that starts at the top. Co-founders Klaus Schauser and Jonathan Walker (who combined own almost 19% of the company) remain with AppFolio today as chief strategist and chief technology officer, respectively. Several of the company’s executives have worked together for up to 15 years over the course of their careers. AppFolio has an impressive 4.6/5.0 approval rating at Glassdoor, and it’s won awards as one of the best companies to work for in the small and midsize category.

AppFolio’s existing customers are spending more money in AppFolio’s ecosystem each year — just what we like to see with a subscription business — and this has helped the company hit consistent profitability and positive free cash flow production in recent quarters. There’s also plenty of market share for AppFolio to grab in the years ahead: The two industries AppFolio currently supports have a combined market opportunity of $7 billion — $5 billion for property-management SMB software and $2 billion for legal SMB software.

Management also aims to expand to other industries where small and midsize businesses would be served by easy-to-use, cost-effective, industry-specific software solutions, just as it’s in the early stages of doing in the legal space. This vision gives the company even more growth opportunities in the coming years. In the meantime, AppFolio has a large market opportunity with its existing solutions, a debt-free balance sheet and improving cash production, and an experienced management team leading the charge. All these qualities give AppFolio a healthy dose of Hidden Gem potential.

Andy Cross contributed to this report.


 

Dorman Products (NASDAQ: DORM)

Why Dorman Products is potentially a Hidden Gem: Dorman Products is a behind-the-scenes innovator and a leading aftermarket supplier of dealer exclusive parts.

Headquarters: Colmar, Pennsylvania
Website: www.dormanproducts.com
Industry: Auto Parts and Equipment
Recent Price: $73.60
Market Capitalization: $2.5 billion
LTM Revenue: $904.6
LTM Revenue Growth: 8.3%
3-Yr Revenue Growth: 6.6%
Cash/Debt: $116.8 / 0
Insider ownership: 19%
Amounts in USD millions except for recent price
LTM = last twelve months
Data as of: January 12, 2018
Data provided by S&P Global Market Intelligence

Meet Dorman Products…

Dorman Products was founded in 1978, when brothers Richard and Steven Berman began selling auto parts out of a garage. (Steven remains chairman and CEO today.) The company later acquired brands that date back as far as 1918, eventually building an integrated distribution network that includes the big parts retailers like AutoZone, O’Reilly Auto Parts, and Advance Auto Parts, as well as large distributors like NAPA. Today, Dorman’s parts are used either by individual “do-it-yourself” customers repairing their own vehicles or professional installers like vehicle repair shops and dealership service departments.

Dorman engineers and sells what the company calls “Formerly Dealer Only” parts, previously only available through the original equipment manufacturer. Dorman has established relationships with installers that allow them to identify which of these parts are most likely to need repair and focus corporate attention on supplying these components. Dorman’s parts portfolio is vast, covering more than 180 categories, over 155,000 SKUs, and more than 51,000 unique parts,

In addition to the network of installers, Dorman uses its staff of more than 145 engineers and quality control folk to refine the original designs. For instance, certain improvements have produced products that will fit a variety of makes and models, giving Dorman’s customers the ability to stock one part that fits five models rather than stocking five different parts.

Another key for the business is Dorman’s strategy to source the lion’s share of its components through third parties, with no single manufacturer supplying more than 10% of Dorman’s products. Rather than worry about managing manufacturing assets, Dorman can focus on what it does best: identifying hard-to-find auto parts, then engineering and selling solutions for those applications. In fact, nearly a fifth of Dorman’s total revenue comes from products introduced within the past two years.

Dorman’s focus has largely been on light-duty automotives, but the company expanded its turf in 2012 by launching Dorman HD Solutions, which supplies products to the medium- and heavy-duty markets. This segment still makes up only 2% of sales, leaving plenty of room to run. While the HD market is about a third the size of the light-duty market, it can serve as another growth driver for Dorman nonetheless.

Dorman’s attractive business model has produced a debt-free balance sheet flush with cash, which management has put to work with opportunistic share repurchases over the past several years. In the meantime, the core business continues to churn out steady results amid ongoing product innovation. As a unique supplier with clear competency in the automotive aftermarket, Dorman is proof that quality businesses can indeed be found in challenging industries.

Seth Jayson contributed to this report.


 

Redfin (NASDAQ: RDFN)

Why Redfin is potentially a Hidden Gem: Redfin is disrupting the real estate brokerage industry and gaining market share with its technology-based real estate brokerage platform.

Headquarters: Seattle, Washington
Website: www.redfin.com
Industry: Real Estate Services
Recent Price: $26.08
Market Capitalization: $2.1 billion
LTM Revenue: $341.1
LTM Revenue Growth: 42.6% (2016)
3-Yr Revenue Growth: N/A
Cash/Debt: $213.7/$0.7
Insider ownership: 2.98%
Amounts in USD millions except for recent price
LTM = last twelve months
Data as of: January 12, 2018
Data provided by S&P Global Market Intelligence

Meet Redfin…

In the U.S., the fragmented real estate industry is comprised of approximately two million active licensed real estate agents working with over 86,000 real estate brokerages. A recent IPO, Redfin is changing the game and looking to become a national, technology-powered real estate brokerage. (Fittingly enough, the name Redfin comes from “real estate redefined.”)

Similar to listings platforms like Zillow and Trulia, someone can use Redfin’s platform to search for listed homes in a given region. However, Redfin differentiates itself in a big way by acting as a brokerage. While Zillow is becoming the go-to destination for traditional real estate agents to market their services — a $14 billion market — Redfin is going after the $75 billion real estate commissions market. Redfin acts as a brokerage, facilitates the transactions itself, and pairs buyers and sellers with its own agents.

Redfin has over 1,000 agents across the U.S., all of whom are salaried and paid in part based on customer satisfaction scores, enabling lower commissions for buyers and sellers alike. Redfin refunds homebuyers an average of $3,500 per transaction in 2016, and Redfin charges most sellers just a 1% commission (compared to 2.5%-3% at most traditional brokerages). And with more than 20 million monthly visitors to Redfin’s site and app (a number growing over 40%), Redfin’s agents are fed leads directly from the platform and can spend their time serving customers rather than searching for them.

Early signs suggest this could be a powerful business model. In 2016, repeat transactions on Redfin increased 53%, transactions from customer referrals grew 81%, and the company gained market share in 81 of its 84 markets. Redfin also has the highest market share (and profitability) in markets where it has operated the longest — suggesting it could just be a matter of time before the company’s model catches on with consumers and its market share (and profitably) grows.

Redfin’s tech-based platform also bodes well for the company as the younger generation — those coveted millennials — move out of mom and dad’s basement. Studies have shown that, compared to other generations, millennials are both more likely to negotiate their agent’s commissions down and purchase a home without seeing it first. As a low-cost and online platform, Redfin could be just the brokerage a growing number of millennial homebuyers are craving.

Redfin’s national market share today stands at just 0.64%, but that number could go quite a bit higher as the company gains clout with more homebuyers and sellers across the U.S. Put simply, Redfin is a young public company which may very well be in the early stages of a multi-decade expansion opportunity.


 

Stamps.com (NASDAQ: STMP)

Why Stamps.com is potentially a Hidden Gem: Stamps.com is showing signs it’s becoming the “Shopify of shipping” thanks to its portfolio of shipping software solutions, positioning the company to be a hidden beneficiary from the boom in e-commerce (and number of packages shipped).

Headquarters: El Segundo, California
Website: www.stamps.com
Industry: Internet Software and Services
Recent Price: $197.25
Market Capitalization: $3.5 billion
LTM Revenue: $422.1
LTM Revenue Growth: 34.7%
3-Yr Revenue Growth: 47.5%
Cash/Debt: $183.5/$148.2
Insider ownership: 5.63%
Risk Rating:
Amounts in USD millions except for recent price
LTM = last twelve months
Data as of: January 12, 2018
Data provided by S&P Global Market Intelligence

Meet Stamps.com…

Stamps.com has come a long way since 1999, when it became the first “PC postage” vendor to get approved by the United States Postal Service (USPS) to sell postage through its software solution. This early software solution enabled home offices and small businesses to affordably print postage without having to wait in line at the post office — a novel concept for the pre-21st century world.

Starting in 2014, Stamps.com started acquiring four new platforms — ShipStation, ShipWorks, Endicia, and ShippingEasy — to expand the breadth of its offerings to cover more carriers beyond the USPS (like FedEx, UPS, and DHL). ShipStation, for example, integrates with over 100 partners and carriers, enabling its customers to automate the collection of orders from multiple e-commerce sites and shopping carts — including Amazon.com, eBay, Etsy, and Shopify — and then determine which carrier offers the best postage rates for those respective orders.

These acquisitions suddenly allowed Stamps.com to support a wide array of customers of all sizes, ranging from small businesses to e-commerce merchants to warehouse shippers. The company’s increasing focus on higher-volume shippers (rather than just home offices or smaller businesses) has packed a powerful financial punch, with those customers now accounting for over 70% of overall revenue.

Compared to its smaller clients, these higher-volume shippers stick with Stamps.com longer and pay more each month in the process. As high-volume shippers have become a larger driver of Stamps.com’s revenue, the company’s average revenue per user (ARPU) has grown and its churn rate has decreased. These are precisely the trends we like to see with a subscription-based business, and they’ve done wonders for the company’s free cash flow production (which has increased nearly 6x since 2013).

There should be sizable room for future growth, too — especially now that Stamps.com effectively has five different product solutions that will address mailers and shippers of virtually any size. The volume of packages shipped in the U.S. has accelerated since 2010, and should continue to grow as e-commerce becomes a chunk of overall retail (growing at about 15% per year in the U.S.). Given these tailwinds, management has set the ambitious goal of growing revenue at a 20% annualized rate over the next five years.

Despite its growth in recent years, Stamps.com still accounts for roughly 6% of all postage printed in the U.S., leaving plenty of room for the company to capture additional share while enjoying the tailwind of e-commerce in the years ahead. The company’s solid cash production, healthy balance sheet, tenured management team, and large market opportunity suggest the makings of a potential first-class Hidden Gem.


John Mackey, CEO of Whole Foods Market, an Amazon subsidiary, is a member of The Motley Fool’s board of directors. Fool contributor David Kretzmann owns shares of Amazon, AppFolio, AutoZone, Dorman Products, Etsy, Netflix, Redfin, Stamps.com, and Zillow Group (C shares). Fool contributor Taylor Muckerman owns shares of Amazon and Shopify. David Gardner owns shares of Amazon, FedEx, Netflix, and Zillow Group (C shares). Tom Gardner owns shares of Netflix, Shopify, and Zillow Group (C shares). The Motley Fool owns shares of Amazon, eBay, Netflix, Shopify, Stamps.com, and Zillow Group (C shares).