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2 Intriguing Small-Cap Innovators

Christopher Franz, CFA

Christopher Franz: Hello, I'm Chris Franz with Morningstar. I'm here today with Amy Zhang, Portfolio Manager of the Alger Small Cap Focus Fund. Amy, thanks for joining me.

Amy Zhang: Chris, it's great to be here.

Franz: Amy, your fund had a fantastic 2018, returning over 14% in a down market. And one of the key contributors was Abiomed, a medical device company that you've owned since 2016. What do you like about that stock?

Zhang: Well, Abiomed is a medical device company specializing in a very minimum invasive heart pump called Impella. In fact, it's the smallest heart pump in the world. So, what Impella does is to provide temporary circular support for the heart while the surgeon operates on a patient. Usually, it's a heart failure patient that otherwise would be too sick or too old to be operated on. So, Abiomed's mission is recovering hearts and saving lives, which is consistent with what we invest in. And as a result, they also reduce a lot of costs for hospitals.

So, what attracts us to Abiomed is because it really possesses all the qualities that we look for in a company--style-wise, a very strong competitive moat, a very wide moat too in the sense that they are at the cutting edge of innovation. So, they spent over $500 million on R&D on Impella over the last 20 years. That gives them a large lead, way ahead of any rivals in the industry. And also, under the CEO Mike Minogue over the last 15 years, he has a very disciplined execution approach. The company was able to sustain not only revenue growth but also kept expanding margins. So, that was very important for us. So, currently, this is a very high-growth company at 30% of top-line growth, but the GAAP operating margin is also reaching 30%. At the same time, the company has over $450 million in cash, no debt. So, it really exemplifies what we look for in a high-quality but also high-growth company.

Going forward, we think the company is going to continue to expand its addressable market. Currently, it's about $6 billion, that's U.S. alone and current penetration is 12%. While the company will continue to further penetrate within the U.S., we also expect them to expand internationally and also with more usage of Impella in different areas. So, over the next five years we think the company can expand its addressable market more than double to over $12 billion-plus. So, it's still a very long runway for growth.

Franz: Sure. Really interesting. Maybe kind of turning to a more recent addition, Avalara, provides compliance solutions. What do you like about Avalara?

Zhang: Well, yes, Avalara, we invested in since its IPO last June. The company is a cloud-based software company that specializes in sales tax automation. Sales tax itself is very complex and time-consuming, and there's no margin for error. So, it's a very tedious process. In this digital world I think it's inconceivable for that not be automated in the next five, 10 years. And Avalara is really the leader, especially, they are dominant in the middle-market space, which is really the sweet spot for sales tax automation, because for sales tax, especially with the proliferation of e-commerce and the recent ruling--right after they went public the Supreme Court ruled that anybody who sells goods online needs to collect tax to everywhere that they ship. Before it was just a physical presence, only if a company has a store or warehouse. So, that's a huge change which is a big positive for a company like Avalara.

And so, now, sales tax is very complex. Not only you need to have the right rate but also the right moment because the transaction has to be real time and also in the U.S. alone there's over 12,000 tax jurisdictions. So, it's very complex. And Avalara makes that possible for companies which really saves time, money, headaches. So, it's a very strong value proposition. More importantly, the company has a very strong competitive moat over the years. The company is not a startup. It's been--the CEO Scott McFarlane co-founded the company 15 years ago. So, over those years, it spent a lot on R&D. It still spends 18% of its revenue on R&D. And so, it built a very significant proprietary database or tax content and also has the largest network of integration partners. So, the company's revenue is only $300 million now and we think the addressable market is over $8 billion. So, that is a really open-ended growth opportunity that we think the value should compound over time.

Franz: Sure. Well, Amy, thanks for your insight. 

Zhang: Thanks for having me.

Franz: For Morningstar, I'm Chris Franz. Thanks for watching.