Please ensure Javascript is enabled for purposes of website accessibility
Small-Cap Confidential
Undiscovered stocks that can make you rich

Cabot Small-Cap Confidential Special Bulletin

NanoString (NSTG), Aerohive (HIVE) and Q2 Holdings (QTWO) reported earnings.

NanoString (NSTG), Aerohive (HIVE), Q2 Holdings (QTWO) Report Earnings

NanoString (NSTG) reported. It was a terrific quarter. Revenue was up 73% to $22.6 million. Product and services revenue was up 40% to $17.5 million, consumables revenue was up 39% to $10.3 million and instrument revenue was up 46% to $6.4 million. Instrument growth in particular was impressive given the shortfall reported in Q1 (down 22% to $3.4 million, which was about $1.5 million light). That event crushed the stock, and we can now almost wave the “all clear” sign for NanoString. The team will, naturally, have to execute in Q3 too to capture the remaining balance that’s still out there from Q1. But given that Q4 tends to be very good from the “budget flush” effect, it seems instrument sales are looking pretty darn good. That’s going to trigger a relief rally in the stock (it’s up 18% this morning), and it’s also going to help consumables revenue grow faster (still averaging around $100K per system per year), since the installed base of instruments will be larger (now at 410). Prosigna, the company’s in vitro diagnostic assay (and part of consumable revenue) has been very strong and enjoyed record sales in the quarter.

The sales team did a great job. Instrument revenue was driven by record SPRINT sales. Management said the team captured around 50% of the opportunities that flipped from Q1, and it expects to be fully caught up by the end of the year. It also sounds like the funnel of potential leads has grown, which portends good things for instrument revenue in the second half. SPRINT sales are expanding, and management expects half of all instrument sales this year will be SPRINT. APAC and Europe have been particularly strong for SPRINT.

Collaboration revenue was well above expectations as the company hit milestones faster than expected. Collaboration revenue was $5.1 million, but management was quick to point out that it achieved milestones that triggered $13.5 million in payments (the balance of $8.5 million will be reflected in Q3 results).

3D biology products (RNA, DNA and protein analysis from a single biological sample) are doing great too. This technology is especially relevant in oncology research. Biopharma customers are the main targets. Customers are very interested in the ability to analyze proteins since that’s a key capability that helps with biomarker research. Management thinks 2017 will be a key year for measuring 3D biology potential because it should enter the year with enough products to actually power a significant amount of research. Management sounds extremely excited about diagnostic biopharma applications.

There is a lot of science I can talk about related to 3D biology, collaboration trials (Merck, Medivation, Celgene, etc.) and oncology potential. But I think we’ll talk about these in Weekly Updates as more news flows our way. For now, the bottom line is that the stock should be back on track. Management raised 2016 guidance by $3 million, to a range of $89 to $93 million, representing 42% to 48% growth over 2015. That increase is due to an improved outlook for collaboration revenue (from $15 to $18 million), which could suggest a coming inflection point in companion diagnostic sales if/when biopharma companies have total conviction in the predictive power of the assays.

The stock is enjoying a relief rally, and my best guess is that it will continue to go up from here. More broadly speaking, I think investor appetite for biotech stocks is on the rise. And today’s pop is going to draw the eyes of portfolio managers looking to add exposure to a solid name that’s been out of the spotlight. It’ll be a challenge for NSTG to break above the 16.50-to-17.50 area, but I think it will. BUY.

Aerohive (HIVE) reported revenue growth of 29.2% to $47.6 million (beating by $150K) and an EPS improvement from -$0.15 to -$0.02 (beating by $0.04). Software subscription grew 32.8% to $8.1 million (and was consistent at 17% of total revenue), while product revenue grew by 28.6% to $39.5 million (accounting for the remaining 83% of revenue). All of these growth rates were slower than Q1, which was a big catch-up quarter from Q4 2015. But they were still ahead of expectations, and it was still a very robust quarter. Not amazing, but solid—and definitely good enough to keep the stock at Buy for now.

Revenue guidance for Q3 was pulled in a little below consensus of $52.8 million to a range of $46 million to $50 million due to administrative issues with the E-Rate program (more on that in a minute). At that level of revenue, the company will be within a few pennies of non-GAAP breakeven, which is a major milestone. I still see non-GAAP profitability in 2017, which is a good thing and should keep interest in the name high (along with acquisition potential). Gross margins were consistent at 68.8% in Q2.

Total mix of business was roughly K12 Education 40%, Enterprise 40%, Retail and Health 20%. The U.S. was 60% of revenue (up 60%), EMEA was 26% (up 32%) and APAC was 14% (up 139%). APAC benefited from the final shipment of the 40,000 AP deal in Japan (discussed in my original report), which won’t repeat in future quarters.

Sales of the new wave 2 access points, in particular the AP250, were very good and accounted for almost 20% of AP sales. This AP has dual 5GHz radio design, which provides a ton more capacity than other APs on the market. It also helps clients future-proof their networks so it’s almost a no-brainer upgrade once they’ve decided to go with Aerohive. The company also has exterior-grade versions with external antennas. Investments in hardware development look to be paying off.

A large French grocery chain with 850 stores was booked in the quarter. Aerohive beat out Cisco and Aruba to win the deal. The partnership with Dell is going well, and the team landed a six-figure deal for a school district in Texas with 25,000 students. It expects revenue from this partnership to ramp up throughout the year and into 2017. The company is seeing more engagement with Juniper. No change in the Apple partnership.

E-rate had some issues, largely related to administrative online glitches related to filing, approval and funding. Sounds similar to the challenges with the healthcare exchanges. The end result is that some schools are abandoning their applications and seeking other funding sources, or waiting to reapply for the next funding cycle. This has led to a 17% decline in total funding requests compared to last year. However, the value of Aerohive’s won awards is down only 12%, suggesting it is gaining market share. It doesn’t sound like the technology issues are indicative of a lack of interest by schools and libraries in upgrading their wi-fi networks. It’s simply a matter of working through the administrative process to secure funding. One of the messages management wants to get across is that, while it isn’t excited with the challenges in E-rate, it feels good about its mix of business. E-rate is just part of the education market, which is still just 40% of total revenue.

Management was asked about Ruckus Wireless and the integration with Brocade, and whether or not there is any opportunity to grab market share there. Management said that the Aruba/HP acquisition was more disruptive to the market (and they jumped on that, and won a lot of business). They were also asked about the new Ruckus cloud wi-fi offering. Management said that product represents a “very thin slice” of what Aerohive offers, and thinks that only small businesses (not its target market) would be interested.

The bottom line here is that it was a good quarter—a slight downward revision to forward guidance, but no major cracks in the big picture, just a few challenges working through E-rate issues. It’s entirely possible that the seasonally slow Q4 2016 and Q1 2017 quarters could see a big jump as E-rate revenues catch up (perhaps similar to what happened in Q1 2015), but management only guides for 90 days, so they’re not sticking their necks out just yet. I think we’ll see a little weakness in the stock, and if there’s a broad market pullback we could see the stock take a more significant dip. I think these are buying opportunities. If you’re not comfortable holding through a little volatility, you may want to step aside and re-enter the stock if/when there is a significant pullback. The risk is, of course, that might not happen. Recognize that enthusiasm for the next three months has waned a little, but that the longer-term picture here remains very much intact. We have a modest gain going at the moment so there’s a comfortable amount of wiggle room. I’m sticking with Aerohive. BUY.

Q2 Holdings (QTWO) reported a great Q2, even though earnings came in lower than expected. Revenue grew 37% to $36 million (beating by $340K) and adjusted EPS fell from -$0.09 to -$0.25 (missing by $0.13). Registered users grew to 7.6 million, up 35%. Gross margin was up to 51% from 47% due to a greater mix of subscription revenue.

Full-year guidance was raised and implies 36% to 37% revenue growth to a range of $147.9 million to $149.3 million. Spending is going up this year, and there will be more administrative costs now that the company has grown past the point of being an “emerging growth company.” But management still forecasts an adjusted EBITDA gain in Q4 2016. That metric of profitability should persist in 2017, although Q1 might be a little lower than the rest of the year due to higher compensation costs that usually fall in Q1.

The company continues to land larger tier 1 banks. And it went live with a $9 billion bank during the quarter. The company says its new corporate product is doing very well. Most larger banks (tier 1) will already have this type of product today. Mid-sized banks (tier 3 and tier 2) and larger credit unions are often stretching a small business-oriented product beyond its capabilities to fulfill this product’s need, so these are the customers who are really interested in the product.

Management said a few projects have been pushed to later quarters (but specified that these aren’t lost opportunities) as banks deal with uncertainty related to Brexit, interest rate fluctuations and the drop in oil prices. Analysts on the call were basically told not to bump 2017 revenue estimates up too much until we get an update on Q3 bookings trends. I think this is management making sure it doesn’t over-promise and under-deliver, which is exactly the tone they we want them to strike.

One analyst made a good point, which is that with a company like Q2, the market is really valuing it based on 2018–2020 numbers. But without more details around bookings and user growth trends, it’s very difficult for analysts to build out an accurate model to project revenue and earnings that far out. As one who has built a lot of financial models, I love the question. But management pointed out that the mix of bookings is so varied between large, medium and small banks, different products, and so on, that it hasn’t found a good metric that will give a balanced picture of user and bookings growth. It’s a good answer, and it’s clear that the company doesn’t want to introduce data that’s going to raise more questions than it answers. As a practical matter, it means quarterly results will be followed that much more closely. But remember that management has a very clear picture of 90% of next 12-month revenue, so it can manage expenses well ahead of time. Bottom line, the company remains well on track, and it sounds very confident in its future.

Management was also asked about competition as it moves up to larger banks, and what the landscape is like when Q2 tries to sell into those institutions. The answer is that oftentimes these larger banks are using different platforms/products for corporate, small business and other areas. So Q2 might go in to replace one, and once that’s done focus on expanding to other areas. Management says its products tend to be more expensive than the competition, and that it goes after customers that like to “use technology as a weapon and not a shield.” That was a great line, and I think it speaks to management’s confidence in its products and go-to-market strategy. It also said it’s been replacing competitor products for years and that it often competes with—but also often teams up with—competitors (in the payment processing space, for instance) to close deals together.

The bottom line here is that things sound good. Heading into the report, the stock was up around 27% since I recommended it four months ago, and was trading fairly close to my target valuation of around six-times 2017 expected earnings. I expect shares will give back part of those gains (and in early morning trading, there was a big dip). But the long-term story here is very much intact. I recommend taking advantage of any dips down to 25, should they appear, to increase your position size or buy in. In the coming days, analysts will be updating their price targets and my best guess is most are going to be around the 32 to 35 mark, mainly because of the aforementioned lack of out-year modeling accuracy. They’ll come around in due course; they just won’t be willing to speculate too much right now. BUY.