2 Picks From a Small-Cap Medalist Manager

Alec Lucas: Hi, I'm Alec Lucas of Morningstar's manager research team. Today I'm joined by Amy Zhang of Alger Small Cap Focus.

Amy, thanks for being here.

Amy Zhang: Thank you for having me.

Lucas: So, on the agenda today we'll talk about a couple of stocks in the portfolio. One is healthcare tech company Veeva Systems and the other is security software services provider Proofpoint. Let's start with Proofpoint. One of the things you look for in a stock is the company's ability to double its revenue in five years. What gives you confidence that Proofpoint is going to be able to do that?

Zhang: Well, Proofpoint is a leading provider of cloud-based software solutions for security and compliance, protecting people, data from advanced risks threats. The company currently only--last 12 months' run rate revenue is only $410 million, and we estimate the addressable market is over $10 billion.

Lucas: So, there's a lot of money it can make relative to market size?

Zhang: Right. And first of all, it's important to have the wind behind them by two powerful secular drivers, one is that cybersecurity has become increasingly mission-critical. And number two is that as enterprises move to cloud they would like to take their email security and other critical business functions to cloud as well. So, those are the two secular forces behind Proofpoint's revenue growth.

But more importantly, this is a very innovative company. They spend about 20% of their revenue on R&D and they are at the forefront of security and threat. So, they are displacing the legacy vendors by providing more effective and more visible threat protection products and rapidly gaining market share, and we expect that trend to continue. So, they have a very wide moat.

Also, they have a very durable business model that we think can be sustainable. The company has close to 100% subscription revenue recurring and over 90% renewal rate. Of the 5,300 customers they have, half of them only have one of the nine products they offer; 25% of them only have two of the nine products they offer. So, there's significant cross-selling opportunities ahead of them. And Proofpoint has also been a company that has created their own markets effectively expanding their TAM by introducing new products. So, to that extent, that's why we're very confident that they can more than double revenue in five years.

Lucas: What do you think the market is missing about Proofpoint that's creating this opportunity for you?

Zhang: Well, I feel that the market is not focused that much on the fact they have reached an inflection point of cash flow generation, that they are really on the verge of exponentially grow their profitability and with further margin expansion as they scale. So, the operating leverage is very powerful. And also, it's a very seasoned management team--that the CEO is the founding CEO, has been with the company for 15 years. CFO is also a very long-tenured executive, has tremendous experience in the industry. So, their execution ability is really second-to-none in the industry.

Lucas: OK. So, let's move on to Veeva Systems, a healthcare tech company. One of the things you focus on when you invest in a stock, and it's currently your top holding, is you pay a lot of attention to downside risk. Can you talk about that stock from the standpoint of its downside risks and what gives you confidence to keep it as your top holding?

Zhang: Yeah. Sure. Viva is a cloud-based software company focused on the life science industry. They want to be the industry cloud for pharmaceutical and biotech companies. They basically have two core products, one is the commercial cloud for life science companies. The key product is CRM with Salesforce.com. And that's sort of their cash cow, even though it's still growing. And a few years ago, they started Veeva Vault, which is content management platform that can be used not only in life science but other regulated industries.

So, for Veeva, it's clearly a high-growth company. Last 12 months' revenue is only $582 million. We estimate their TAM to be over $8 billion. So, clearly, there's a high growth trajectory, lot of runway for growth. But more importantly, the company has extremely high financial quality, which is very rare for a high-growth company. It has close to $700 million cash on the balance sheet, no debt, and structurally, the margin is very high that they have the industry-leading, SaaS industry-leading operating margin at about 22%, and they are actually moving toward more product mix, so there's further room for margin expansion. They also have high recurring revenue, like 80% of revenue is subscription. So, their customers also are very, very sticky in the sense that when they invest in Veeva, they're looking out for five to 10 years because it's very disruptive to change those mission-critical solutions that Veeva provides. So, that's why this is a company that offers tremendous downside protection in our view.

Lucas: So, with a lot of small-growth companies financial leverage can be something to look out for. But it sounds like with this one, there is lots of cash on the balance sheet, recurring revenue, and no debt?

Zhang: Yes, because I think cash is king for small companies. It's important to have that financial cushion, and I do not want our companies to rely on the capital markets to have dilution to shareholders.

Lucas: Amy, thanks for your thoughts on those two stocks.

Zhang: Thank you, Alec.

Lucas: From Morningstar's Manager Research team, I'm Alec Lucas.