Top Technology Picks For 2018 - Seeking Alpha

The technology sector has had a banner year in 2017, rising >30% (as shown by the S&P 500 Technology ETF (NYSE: XLK) chart below) and beating every other sector, including ~20% gains in Financials, Materials, and Consumer Discretionary. While the rally in technology shows no signs of cracking - unlike the dot-com era, stock prices are rising in tandem with top and bottom line growth - it would be wishful thinking to assume 2018 will be as kind. With valuations pushing their upper limits, stock selection has become even more important.

XLK data by YCharts

With high valuations a consistent topic on investors' minds, I think value-oriented growth stocks will have their moment in the sun this year. Gone, I believe, is investors' love affair with growth-at-all costs companies, the market darlings like Workday (NASDAQ: WDAY) and Okta (NASDAQ: OKTA) that are trading at 8x-10x revenue multiples. Against this backdrop, I'm on the hunt for winning themes in 2018 that will deliver outperformance against the broader market. In particular, I'm identifying companies that are still posting strong top line growth (think 30%, 40%) and closing their profitability gap to deliver positive or breakeven cash flows. Growth is still the key element - but it must be accompanied by reasonable valuation and a strong profitability story.

These are the names in my portfolio, across the sub-industries in technology, that I believe are best positioned to rally this year. These are companies that have been beset by below-market performance in 2017, yet strong fundamentals should spark a bullish trend in 2018:

Application software: Yext

As a front-end application developer that went public in 2017 along with dozens of its compatriots, Yext (NYSE: YEXT) is in no shortage of public comps in the app software industry. Yet, as most of the software industry soared in 2017, the stock remained range-bound, actually ending the year down ~10% from its Day 1 close in the mid-$13 range. I picked up shares in mid-December at $12/share (where they closed the year) and am holding out for $14.50, implying a 6x EV/FTM revenues target (above its current 4.9x valuation and representing 21% upside to current levels).

YEXT data by YCharts

There's a lot to like about Yext aside from its undemanding valuation. The company operates a solid niche that's not commonly replicated in enterprise software - within location data management, Yext is really the only game in town. This gives Yext a solid moat for high-double digit growth for years to come, as it doesn't have to worry about hitting a wall with competition as other common enterprise software vendors do in spaces like CRM (customer relationship management) or HCM (human capital management).

In its most recent quarter, Yext grew 39% y/y. Its -38% operating margin is still several years away from profitability, but the company is burning far less cash than other high-growth peers such as Cloudera (NASDAQ: CLDR) and MongoDB (NYSE: MDB). Yext has consistently outperformed Wall Street targets in each of its earnings releases since going public, yet hasn't received the same recognition in the markets as its peers.

The fact that Steve Cakebread is Yext's CFO is another strong point for the company. As a former executive of several large public software and internet companies that have scaled toward maturity - including prior roles as chief strategy officer of Salesforce (NYSE: CRM) and CFO of Autodesk (NASDAQ: ADSK), Cakebread's presence in the C-suite underlines the company's potential for sustained growth. Another nod for Howard Lerman, the company's founder and CEO - a self-styled genius (according to his LinkedIn profile), Lerman is the strong founder/CEO personality that startups need to succeed. While comparisons to Mark Zuckerberg or Elon Musk aren't yet appropriate given the company's smaller size and TAM potential, it's important to note that Howard Lerman and Yext are recognized as thought leaders in location data as well as broader enterprise software, elevating the company's cachet.

Infrastructure software: Twilio

My top pick in back-end infrastructure software is also the company that's stung my portfolio the most this year: Twilio (NASDAQ: TWLO), the CPaaS (communications platform-as-a-service) company that went public in 2016 to great fanfare, only to nosedive deeply in 2017. Twilio is down -18% this year and is trading near all-time lows, deeply undervaluing the company for its massive revenue base and far-reaching potential.

TWLO data by YCharts

Two factors are to blame for Twilio's poor performance. The first was its announcement in May that Uber (Private:UBER) would gradually move from using Twilio as its back-end communications provider to an in-house solution. At its peak, Uber was Twilio's largest customer, representing 17% of revenues in 4Q16; now, as a fellow SA contributor notes in an incisive Twilio analysis, Uber's estimated contribution has fallen to just $4 million (4% of revenues) in the current quarter.

Yet all the while, the company's base revenues have been growing at a rapid clip, up 43% y/y in Q3 and growing faster than total revenues (+41% y/y). Base revenues are derived from all of Twilio's other clients (excluding its primary anchors, Uber and WhatsApp (NASDAQ:FB)), which have contractual monthly minimums. Though Uber has shrunk its Twilio spending by two-thirds, Twilio is showing that it is still able to post strong growth in the 40% range without its mega-customers. The company has also recently announced a limited rollout of its ELA (enterprise license agreement), which commits customers to a certain amount of spending over the term of the ELA instead of the usage-based, per-text/per-call pricing that Twilio clients typically pay. ELAs can be a win-win for both Twilio and the customer: customers get visibility into how much spending they should expect on Twilio rather than being surprised by the monthly bill; and Twilio can have floors for its revenue. Twilio announced that it signed its first ELA in Q3, which it described as "a lighthouse deal with nearly 8 figures of total committed revenue over the life of the three-year contract."

The other bogeyman that caused the stock to drop after Q3 earnings was a small hiccup in gross margins - gross margins dropped to 52% in Q3, down from 56% in the prior year quarter. This sparked concerns that Twilio was becoming a commodity service and was losing pricing control over its customers, compounding worries about it already being one of the lower-margin companies in the software sector.

Gross margins, though, can fluctuate over time, and the slight gross margin contraction is also offset by Twilio's solid operating margin performance. The company's low operating cash burn (an OCF margin of just -7% in the year-to-date) is far closer to breakeven than that of other software peers. Twilio has generated OCF-breakeven quarters in the past, and if the company can continue to hold its revenue growth in the high 30s/low 40s while maintaining margins, it can quickly return to positive OCF.

With the stock hovering under 4x EV/FY18 revenues, Twilio is trading on the clearance rack - very few software companies, especially those growing in excess of 30-40% y/y, ever trade below 5x (an exception is Yext). As I wrote in a prior article, I'm electing the company to hit a 7x valuation in the coming year if it continues to post strong quarters and manages a reversal in its margins, implying a $39 price target and 65% upside from current levels.

Hardware: Pure Storage

The hardware sector - particularly storage stocks - seems to have clawed its way out of the penalty box in 2017. Though VCs and investors tend to shy away from hardware companies as if they are diseased (and indeed, high-profile smart lock company Otto just announced it's shutting down), makers of storage products, particularly flash storage products, have seen tremendous growth in 2017.

Pure Storage (NASDAQ: PSTG), unlike Yext and Twilio, saw strong overall performance in 2017, though the stock has seen a rapid and unexplained sell-off in December, creating a tactical buying opportunity. Shares are still up 40% in 2017 but are down ~18% from its late November peak.

PSTG data by YCharts

Pure Storage's financial profile is the stuff of dreams - at least as far as "boring" hardware companies go. It grew 41% y/y in its most recent quarter and is breakeven on an adjusted earnings basis (adding back stock comp to GAAP net income). Pure Storage also comes with fantastic gross margins (66%) for a hardware company, and its year-to-date operating cash flow of $13.7 million is a huge boost over last year's -$51.9 million.

I wrote in a prior article that if Pure Storage fell to a 2.1x EV/CY18 revenues valuation, in line with NetApp (NASDAQ: NTAP), it would be a no-brainer long. The last week of December has continued to be unkind to the company, sending the stock to that magic threshold. NetApp, for reference, is growing only single digits - its fast-growing flash business isn't doing enough to offset declines in its legacy storage businesses. There's no reason for Pure Storage, which is a pure high-growth company with no legacy businesses weighing it down, to be trading at a revenue multiple anywhere near NetApp.

Flash memory - while more expensive than its legacy counterparts - is the technology of the future, with its performance potential infinitely better than the magnetic spinners used in cheaper, older hard drives. Improvements in NAND production (the primary input in flash arrays) are on the horizon - Micron (NASDAQ: MU) estimates that the industry will supply 50% more NAND in 2018 - will continue to make flash more cost-effective and more profitable for end-product makers like Pure Storage to produce.

With fundamental drivers supporting Pure Storage's high top line growth and accelerating cash flow profile, the stock looks heavily undervalued, and only for a temporary window of time before it resumes its rally.

Internet: CarGurus, Inc.

I'm typically allergic to names in the Internet sector, Facebook (NASDAQ: FB) aside. I've shied away from the plethora of Internet IPOs this year and am glad I did so, as companies like Blue Apron (NASDAQ: APRN) and Snap (NYSE: SNAP) continue to underperform massively. But the one Internet company in my portfolio that I'm perfectly confident in is CarGurus (NASDAQ: CARG), the used car marketplace that went public in October at $16 and opened its first day of trading at $29. Since then, shares have seesawed and are virtually unchanged in the three short months that it's been a public company.

CARG data by YCharts

Perhaps one of the reasons I like CarGurus so much is that it behaves much more like a software company. The company sells subscription packages to car dealerships across the U.S. to advertise its used car inventory on the CarGurus platform, which is the most-visited online marketplace in the U.S., according to comScore.

As an aside, I've got a friend who runs a used car dealership and who told me, grudgingly, that his advertising bill on CarGurus is going up (corroborating CarGurus' disclosure of its "average revenue per paying dealer" metric, which is up 16% y/y to $11,526 in its most recent quarter). Like the thousands of other dealers locked into the CarGurus ecosystem, he has no choice but to continue paying its fees to remain competitive and visible to customers.

CarGurus' fees and subscription revenues carry sky-high 95% gross margins, higher even than just about every other software and internet company in the markets. Though its earnings are still slim, in the year to date the company has reported GAAP net income of $11 million - more than 4x what it generated in the prior-year period. As CarGurus continues to scale, signing on more dealerships in the U.S. as well as expanding abroad (the company has just recently entered into Canada and Germany), 95% gross margins makes its profit potential virtually limitless.

At $30/share, CarGurus currently trades at a market cap of $3.16 billion and an enterprise value of $3.21 billion. Assuming it grows revenues at 50% y/y in FY18 (growth in its most recent quarter was 56%) to $468 million, the stock trades at a polite 6.8x EV/FY18 revenue, a cheap multiple when considering growth in the 50s, positive GAAP earnings and near-pure gross margins. I think a continued onslaught of positive earnings releases in 2018 will ratchet CARG stock well into the $40 range. After all, if a company like Roku (NASDAQ: ROKU), which is still more predominantly hardware than software, can triple its stock price since going public, there's no reason why a high grower like CarGurus with 95% gross margins can't outperform as well.

Final thoughts

Tread carefully among the high-growth technology sector in 2018 - I've got a feeling that the strong performance in 2017 has left the space full of landmines. But turning over some of the forgotten stones of 2017 reveals that there are still bargains to be had. The stocks mentioned in this article may not be the most well-known or flashy companies in technology, but they are supported by strong fundamentals and reasonable valuations - and I believe that should carry the day in the year ahead.

Disclosure: I am/we are long YEXT, TWLO, PSTG, CARG.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

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