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Small-Cap Confidential
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Cabot Small-Cap Confidential Special Bulletin

Here are earnings updates on three of our stocks, and there’s drama at another.

Earnings Updates on Airgain (AIRG), AppFolio (APPF) and U.S. Concrete (USCR), and drama at Globalscape (GSB)

This is a good news-bad news day.

First, the bad news.

Globalscape (GSB), our newest addition, came out after the close yesterday with a press release saying it is investigating improper relationships with customer transactions that worked around internal controls to inflate revenue in Q4 2016. Forensic accountants and legal counsel are involved. The company learned of the issues in July, approached their auditors, there was a dispute over whether or not Globalscape should get a new, impartial law firm to investigate (the company said no, its auditors said yes). No new law firm was hired, and the current auditor (BDO) was let go on August 1, and replaced with a new one (Weaver and Tidwell).

The big questions are: (1) how material is the revenue overstatement? (2) how the hell did it happen? (3) is this a sign of an unhealthy and unethical corporate culture? (4) when will we know more? and (5) what should we do?

These are my answers, at this point.

  • The revenue overstatement is moderately significant, according to what we know now. It amounts to $396,000 in software licenses being recorded in Q4 2016 that shouldn’t have been. This means EPS was overstated by $0.01. Because of the Q4 license revenue overstatement, there was a matching AR reduction on the Q1 2017 balance sheet (AR is an asset). There was no revenue or net income adjustment in Q1 2017. The punchline is that 2016 revenue growth was 7.5%, instead of the previously reported 8.8%, and Q4 2016 revenue growth was 6.8%, instead of the previously reported 12.2%.
  • How did it happen? It sounds like a few employees (I suspect sales people) entered into “side agreements” with customers to help boost revenue. These could range from honest mistakes by newbies, or outright deceitful ploys by aggressive and stupid (my word) people that wanted to show deals closed that didn’t quite qualify. I think the most likely motivation could be an effort to boost revenue, earn a higher commission or validate their worth to the company (these are my speculations). It’s hard to know the extent of the issue, whether or not fault lies purely within Globalscape, and how much falls on the customer(s) in question.
  • I don’t know if this points to an unethical culture. It’s a bad look. On the other hand, it could just be a moron employee acting on his own.
  • When will we know more? I don’t know. I’ve been in touch with company representative and I’m trying to pull out what little extra information I can. Globalscape should have been reporting Q2 results soon, but this audit and restatement has become the priority. We hope it won’t get any worse. But again, we don’t know for sure.
  • I’m downgrading to Hold. Why not sell? Because I think selling right now feeds into the pressure on shares today, which are down 30% from their 52-week high, and down roughly 16% today. They moved down first thing in the morning, but have leveled off to trade relatively flat since. The selloff has brought the stock all the way back to where it was in February. If this proves to be a small infraction from a rogue employee, this will likely be a great time to buy. I’m going to keep working on learning more, and take things on a day by day basis. I will keep you posted.

For now, stop buying shares of Globalscape. The stock has been moved to Hold pending further information gathering. HOLD.

Airgain (AIRG) is responsible for the other piece of bad news. Even though revenue growth of 31.8% (to $11.3 million) barely missed consensus (by $50,000), EPS of $0.10 beat by $0.06, and gross margins went up to 47% (well above management’s previous conservative target of 40%, which has now been bumped up to 45%), shares are trading down by more than 15% today. Digging into the details, we see that average selling price of $0.99 was up by 22% and average number of antennas per device was up 16% to 3.5. Those are good metrics, but total customer devices fell 2.6% to 11.7 million, mainly due to lower smart TV demand (probably from LeeTV, although less business here did help push margins up). These three metrics exclude Antenna Plus-related sales, so management said it’s going to reassess how best to present the data in the future.

Management was touting its ability to expand into IoT and connected car markets, largely due to the Antenna Plus acquisition, which it’s only three months into. It also said it displaced an incumbent supplier to expand its relationship with an existing client that makes consumer wireless routers. This should help pull average selling prices up in the future. It sounds like growth in set-top box antennas and gateways remains strong. Overall, the business sounds healthy, but the stock isn’t looking so good.

I think part of the issue with the stock is that management’s presentation of what’s going on is jumbled. They initially said (months ago) that Antenna Plus had gross margins of around 60%. But now, after an audit, that’s come down due to changes in accounting to fit the acquisition into Airgain’s more constrictive methods. Management also said its Key Performance Indicators (KPIs), of average selling price, antennas per device, and total customer devices are now less meaningful because they don’t include Antenna Plus devices. It did begin to give non-GAAP EPS, which is a good, but many of the analysts on the conference call are clearly trying to figure out how to model the company moving forward, and they’re not entirely sure how to do so until Antenna Plus is more clearly presented. Also, we know that management has previously said Antenna Plus is typically stronger in the back half of the year, but it’s hard to pin a tail on a moving target. The market doesn’t like jumbled earnings reports. And Airgain’s management team needs to pull it together, present the business in a clear manner, and leave a lot less room for uncertainty.

That said, what this all boils down to is a company that’s still growing revenue by over 30%, is increasingly profitable, and if it hits its EPS targets, is trading with a forward P/E of under 17. That’s super cheap. It has $36.5 million in cash and, in my opinion, should authorize a share buyback program. Or, a larger hardware company should just sweep in and take it out.

The stock fell fast and early at the open and has leveled off since. I’m moving to Hold to let this news percolate, and will update you again this week on what to do. For now, just hold your shares. HOLD.

Now, on to the good news.

AppFolio (APPF) is probably one of the best-performing and least-followed stocks I know. While I see notes from some very well-respected analysts, nobody appears to be on the conference calls and there’s a reluctance to jump on board, even though analyst price targets keep creeping upward. Oh well. We’re making money on the stock, which, after jumping around 8% today, is now up roughly 25% since I added it in June.

Onto the earnings update. Revenue was up 37% to $35.9 million (beating by $1.9 million) while EPS of $0.08 was up from a loss of $0.03 (and beat by $0.06). The EPS beat is extremely significant as it shows big operating leverage in the business model, especially as AppFolio enjoys better pricing from third-party service providers, and Value+ services ramp up. On that note, Value+ service revenue was up 43% to $20.5 million (remember that integrated payments and tenant screening are part of this category) and core revenue was up 32% to $13.9 million.

The company ended the quarter with 10,800 property manager customers (up 17%) and 9,000 legal customers (up 21%). Property manager units under management jumped by 22% to 2.93 million, with a higher mix of small business customers. That’s a good thing as it shows progress moving up-market (analysts love this kind of thing).

The property management business is still driving most growth with over 90% of revenue coming from that segment. That said, clearly the legal vertical is contributing, and it’s growing at a good clip. I was happy to hear that it added a Value+ service, allowing attorneys to send retainer requests to their clients. I’d like to see more progress in the legal vertical.

There is a transition at the top, with the current President and CEO Brian Donahoo retiring and being succeeded by Jason Randall (current Senior VP), who has worked with many of the leadership team members for over 15 years, including both at Citrix and AppFolio. I think we’re in good hands.

Lastly, full-year guidance was hiked to a range of $138 million to $139 million, implying 30.6% growth. That’s right about where consensus was, but it’s good to get confirmation, and AppFolio typically beats, so this allows the market to increase expectations a little more. Shares are up and I’ve already seen Morgan Stanley and Credit Suisse boost their price targets by $5 to $8 (to the mid 30s), though notably, both remain on the sidelines on concerns that AppFolio’s addressable market is limited in size. That’s perhaps a valid concern, but I don’t think we’re there yet. And the stock just keeps going up. Keep holding. HOLD.

U.S. Concrete (USCR) also reported another great quarter with revenue up 23.6% to $341 million (in-line) and EPS of $0.95 up 76% (beating by $0.09). The ready-mix concrete and aggregate company continues to grow both organically and through acquisitions, the latter of which remains a strategic focus as evidenced by a huge jump of $2 million (to $2.4 million) of acquisition-related costs in Q2 as it ramps up its due diligence work on potential purchases. I’ve been talking about how I expect the company to expand into a new geographic market relatively soon, and management confirmed this to be true in its prepared remarks. It has 21 potential acquisition targets in the pipeline right now, and expects to close significant deals within the next 12 months. The company has plenty of cash to complete tuck-in and bolt-on acquisitions, and management thinks it will have no problem raising more funds, if needed, to allow for bigger acquisitions.

Key operating metrics reported in the quarter included ready-mixed concrete segment revenue of $61.6 million, up 24.8%, driven by volume (up 19.7% to 2.3 million cubic yards) and pricing (up 4.2% to $134.43 per cubic yard). Backlog is up 10.6%, which is good. Aggregate product revenue was up 19% (to $22.8 million), with volume up 8.3% (to 1.5 million tons) and sales price up 7.5% (to $12.86 per ton).

Management said the mix of infrastructure projects is increasing, as is the mix of residential construction projects. This means the mix of industrial and commercial projects is going down, which just reflects where we are at in the construction cycle (not a cause for concern). As a result, the company is expecting continued improvement in pricing and margins. Part of this is the mix right now, but also part is its pricing power and the investments it’s made in aggregate facilities and supply chain improvements.

The bottom line is that business is good, the company is executing its growth strategy, and barring serious unforeseen economic challenges, U.S. Concrete should continue growing revenue by around 20% and EPS above 30%. It’s a great growth story in what’s not typically considered a growth industry. Given that things look good going forward, but the stock hasn’t jumped on this report, I’m keeping the stock at Buy. I expect analysts will begin to bump up their price targets, and when those notices are distributed to clients, we might see the stock move a little higher (the conference call was at 10 am ET today). BUY.