TIP698: Best Quality Stock Idea Q1 2025 w/ Clay Finck & Kyle Grieve
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You're listening to TIP. On today's episode, my co-host Kyle Grieve and I give an overview of our best quality stock idea for Q1 2025. This quarter, we're discussing Appfolio. Appfolio is a high growth software company revolutionizing property management. Since its IPO in 2015, the stock has compounded at around 35% per year. As you'll hear during this episode, the more Kyle and I dug into this business,

the more we came to like it. During this conversation, we discuss Appfolio's business model, the five parties that Appfolio supports with their software services, how they're utilizing AI to create a moat around their business, why they just might be a payments business disguised as a SaaS business, an overview of the competitive environment, and why we would consider adding back R&D expenses to determine a proper valuation for the stock.

At the end of the episode, we also touch on the events we're hosting for our TIP Mastermind community in Omaha during the Berkshire weekend in May 2025. We'll be temporarily closing the community to new members at the end of March, so be sure to stick around until the end of the episode to learn more. We're also hosting a couple of free events in Omaha, which will be organized by my colleague, Sean O'Malley. You can find more information on those events in the show notes. With that, I bring you today's episode on AppFolio.

Since 2014 and through more than 180 million downloads, we've studied the financial markets and read the books that influence self-made billionaires the most. We keep you informed and prepared for the unexpected. Now for your hosts, Clay Fink and Kyle Grieve.

Welcome to the Investor's Podcast. I'm your host, Clay Fink. And today, Kyle and I present our best quality idea series, where each quarter we dive into a quality stock to share more about the business, its competitive advantages, potential risks, and what we think of the valuation. So Kyle, after speaking with Adam Ziesel here on the podcast, he's the author of Where the Money Is, I've really wanted to cover a tech business here in our series.

Because tech is just a trend that has brought some of the best and most profitable businesses the world has ever seen. Everyone's familiar with the Magnificent Seven, but I really didn't want to cover a $2 or $3 trillion company here on the show that everyone already knows about. So we sifted through a number of names to find one that we felt fit into our investment style, as well as our circle of competence. And I've personally found it a bit of a problem

to do this because so many tech businesses pay a high amount of stock-based compensation, which is a bit unfortunate, but it's just the reality of how these businesses are attracting top talent. And that was the primary reason actually I passed on Airbnb, for example. I think it's a great company. And it was one I was pretty close to selecting for our series here. And I think Sean O'Malley, our colleague, might be covering that on the Intrinsic Value Podcast sometime in the future. So this journey of sifting through a number of names

brought us to AppFolio. AppFolio was one for me where the more I uncovered and the more I researched this business, the more I really came to like it. So for those not familiar, AppFolio provides software services to property managers in the United States. And they streamline many of the tasks that property managers just need to do, whether it be tenant screening, online rent payments, maintenance tracking, and accounting.

And on the surface, one would probably think this just can't be an amazing business. But then you look at the numbers and it's just unbelievable how well they've executed over the years. Over the past decade, AppFolio has compounded revenue growth of 37% per year. In each of the past three years, they've grown revenues at over 30% a year. And this level of growth has also been quite profitable as they've significantly reinvested back into their business and back into future growth.

Since the IPO in 2015, the stock's compounded at north of 35% per year. And today, it's a sizable company, of course, given how much they've grown, but the market cap's around $9 billion. And this also happens to be a vertical market software company, which is really a fancy way of saying that they create software for a very specific niche or vertical to best serve the customers in that vertical. Kyle and I have also studied the work of

Mark Leonard at Constellation Software for quite some time. Leonard has talked about how each quarter Constellation will profile a vertical market software company, look at how they approach business, how they penetrate markets, what the economics are. Leonard actually mentioned AppFolio by name as an example of a high-quality VMS company that they've been studying personally. So he described AppFolio as a stunningly attractive property management software company that

that penetrated a relatively mature market and did so in a very economic fashion. So it's pretty neat to me that Leonard, after being in this VMS space for 20 plus years, he's just publicly showing how he's continuing to study these types of businesses and learning new things. And how he called out AppFolio, I thought was quite interesting and made me want to learn more about it. So I'm super excited to dive into this name with you today.

Yeah, so am I, Clay. And I echo pretty much all of your sentiments there. Appfolio looks like just an exceptionally run vertical market software business. And one thing that really stood out to me while researching the business was just how focused they are on their customers. They constantly mention that they talk with their customers and they communicate with them to basically continue improving their products.

And you can tell they place a lot of emphasis on this side of the business and they see it as just a key generator for growth into the future as well. And I think given their growth that they've gone through, it's pretty obvious that they have the history to back up this ability to continue scaling their products by building things specifically for their customers and not necessarily just through acquiring other VMS businesses as add-ons. And there's another area that you mentioned there, Clay, that I think I'd like to highlight, which is just to do with

tech businesses in general, just not necessarily being the most attractive businesses for value investors who don't want to get diluted. Unfortunately, with a lot of tech, that's what they have to do. A lot of times these businesses don't have profits. And so if they want to bring in talented people, they can't pay it out of their profits that are non-existent. They have to end up issuing lots of shares. And I think sometimes that can be really, really dilutive and a big negative for a lot of potential investors. Robert Leonard

But look at the numbers from Atfolio, and it's actually really impressive. So from 2015 until today, the total shares outstanding have grown by 0.8% compound annual growth rate, which is really good. I mean, even if you look at a non-tech business, that's still really, really good. And so I think both Clay and I love seeing really high quality businesses that can grow mostly through self-funding. Yes, they do have this a little bit of stock-based compensation, but they're doing it in a way that hasn't been dilutive and isn't harming other shareholders. Robert Leonard

Yeah, that's right. And there just definitely seems to be this strong culture around creating the best possible product and better serving their customers and building that long-term win-win relationship. And to piggyback a bit on your comments on dilution, they don't do excessive stock-based comp like many tech businesses, even the Airbnbs of the world. They're pretty profitable businesses, but they're still issuing a lot of shares. So at Folio, there's definitely the minimal share dilution in the first place.

And what some of these businesses do is they'll do buybacks to offset that level of dilution. And with AppFolio, there's just not a ton of dilution happening in the first place. So they can take those profits and just reinvest it, or maybe even return it back to shareholders if they get to that level of maturity in their cycle. So I'll get this episode kicked off by diving a bit deeper into the business here.

So the company was started in 2006 by Klaus Schauser and John Walker, both of which had extensive startup experience in tech prior to starting AppFolio. So they started the business and given the name AppFolio, they wanted to create this sort of ecosystem of software products that they felt would serve different verticals.

And they ended up creating this property management software product, and it ended up being a huge success. So instead of building these other software products, they just doubled down on what worked really well. And this is really just the core of what they do to this day. The two co-founders today, they're no longer around in terms of being inside the business, but the management team that filled in for them has delivered just exceptional business results.

We would prefer to have the founders still in the business, but it's still nice to see that they do have sizable ownership stakes in the business and they seem to trust the current management team. Shazer, he owns 8.8% of the company, around $800 million, and then Walker owns 2%. That's around $180 million of stock. Since the company started, they've substantially expanded their offerings to address the various needs within the property management industry.

So they initially started with managing single family residential units for smaller property management companies. And then they moved really just up market to these companies that just have more complex needs and necessities within their operations. They have multiple different offerings just based on the size of the property manager, the complexities in managing all these units. Initially, I guess they started trying to go really small, like managing five, 10 units, but they came to find out that

a lot of these smaller property managers, they weren't as serious. It was tougher to build long-term relationships with them. So they decided to focus on 50 plus units, and they really have just grown tremendously in that arena. And today they're focusing more on 1,000 plus units, which requires a more complex, comprehensive solution. And over time, they've built that up and have been able to compete in that arena. Robert Leonard : And I should probably also take a step back and mention that oftentimes the owner of a property is separate from

from the property management company. In many cases, the owner, of course, they own the property, but they likely want nothing to do with managing the tenants, collecting rents, dealing with maintenance requests, et cetera. All of that is the job of the property manager who charges the owner a fee to manage and take care of the property for them. In the United States, there's around 300,000 property managers and 20,000 of them work with Appfolio.

They break their pricing down into three primary tiers. They're referred to as core, plus, and max. The core product, they charge $1.49 per unit per month, plus is $3.20, and max is $5 per unit per month. And these prices are just for residential units, and for the other customers, the pricing might vary a little bit. They also have a value-added services segment, which allows Affolio to deliver a

additional offerings to their customers, which is also where they generate a lot of their revenue. And at first glance, there are just a number of things that I wanted to highlight that are appealing to me about this business. The first thing I want to mention is that America is trending more and more towards a nation of renters. So unfortunately, homeownership is becoming more and more difficult for the younger generations. And with affordability decreasing, the rental market isn't going anywhere. So today it's

It's a slow growing and pretty mature market, of course. The second thing I'd like to mention here that stands out to me is that AppFolio not only benefits from the rental housing market growing, but also from their customers themselves growing. So as a property manager goes from 200 to 500 to 1,000 to 2,000 units under management, that's more and more revenue going to AppFolio, assuming the property manager doesn't churn and convert everything over to a competitor software. Robert Leonard

And AppFolio has shown the value of their product to their customers. So as their customers use their products, see the value in it, oftentimes they're going to be upgrading their service over time. And the average revenue per customer continues to take up at a healthy clip year after year. And the final thing I'll mention is that these types of software services are absolutely essential, like many VMS businesses. So

If you manage five rental units and you want to update your pricing, your schedule showings, you could probably do that just fine and use Microsoft Excel. But if you have a thousand units, working with someone like AppFolio is just a part of doing business. So if we put ourselves in the shoes of a property manager, you got into business to manage properties, not to create software. So they're going to outsource a lot of this work to someone like AppFolio, which will help them be more profitable and run more efficiently. And related to this is that...

Like many VMS businesses, the product is very sticky. A customer has to be pretty upset or see a ton of value in another software offering to churn out. And I would expect AppFolio's retention rates to be very good, but I don't think it's something that they disclose publicly. Yeah. Great points there, Clay. And I really like your third point about how essential this software is specifically for property managers managing many more significant amounts of units.

With just how seamless and useful the software like AppFolio is, I think that businesses that don't utilize some sort of software, whether that's AppFolio or one of their competitors, is just going to be left for dead. We're living in a time now where you pretty much are forced to use some of these tools that really help you optimize your business and also cut costs. I think AppFolio is doing just a wonderful job of accomplishing both those tasks. Robert Leonard

Now, the Appfolio platform here supports five primary parties in relation to real estate. So that's the investors, people who just invest in property. They might not necessarily actually consider themselves the owners. They might have owners who have different investors out there. Then there's the owners. Then there's property managers, vendors who are people who take care of a variety of maintenance tasks. And you have to also remember those can be insourced and outsourced. And there's also the residents who are the people that are paying bills. So a lot of times,

these parties all have to talk to each other, but the property manager isn't going to relay the same information to the renter as they're going to relay to the owner. And so AppFolio allows these different parties to talk with each other with a lot more efficiency, and it allows you to scale it up at a very high degree. Again, comparing that to something like Clay just mentioned with using Excel, which is obviously going to be very, very time consuming or require additional people to just fill out those forms. Clayton Morales :

Let's go over just a few examples here that help show you kind of how communication is so important in property management. Let's say that there's a resident who needs maintenance done on their property. They're going to have to either contact the maintenance vendor or the property manager. So using AppFolio, they can actually just contact the property manager who then creates a ticket and then sends that ticket out to the vendor so that they can go and work on this person's problem, whatever that is, a leaky faucet, or maybe there's

loose bolt or their heat's not working. So on top of that, then the property manager can also send reports for the entire buildings to the owner. So a lot of these property managers might have multiple buildings with hundreds of units in each single one. And obviously the owners of that building want to know how are the economics of their business? Is it doing well? Is it doing bad? How much are they spending? How much are they making? And so they can kind of create these pretty comprehensive reports for the owners to help them understand their

the economics of their units better. And then once the owner has that data, they can share that data with potential investors if maybe they're looking for more money or to expand, and they have these accurate data points to help show what kind of returns potential investors could get on an investment. And then on top of all this, the payments need to be tracked. So vendors obviously need to get paid for the work that they do,

The property managers need to collect rent from renters and they need a vehicle to accept these payments, which also AppFolio offers as well. Putting it all together, let's just look at some of the tasks that are involved with managing, let's say, 1,000 units. So you're going to have to hire a few accountants. You're going to have to collect rent from each unit. You're going to have to handle monthly maintenance requests, which can run into the hundreds. You're going to have to manage a bunch of different maintenance workers. Again, that's insourced and outsourced.

You're going to have to manage move-ins, you're going to have to manage move-outs, you have to screen new tenants, you have to manage leasing agents, and then you have to report back to the owner. So there's just a ton of recurring tasks that need to be fulfilled each and every single month. I found a stat here that said that about 76% of property managers find that operational efficiency is actually their number one challenge. I think that's exactly what AppFolio is going after.

When you think about this entire process, the property matters owners and investors need to know if the process can be repeated at scale. Obviously, if you're doing a really good job with 50 units, well, that's great, but can you do a really good job with 500 units or 1,000 units? And I think AppFolio really helps facilitate and show an accurate view of how you can scale that business going forward. Let's take a quick break and hear from today's sponsors. Would you wear the same shoes for every occasion or rock the same outfit seven days a week?

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Yeah. For AppFolio's 2023 Investor Day, they brought in some of their larger customers and interviewed them and talked about the value they were getting in using AppFolio. So one of these customers had mentioned that they would take about a week to update their pricing, which you think about pricing and it can get incredibly complex incredibly quickly. You just think about you have all these different types of units in a complex.

You have the move outs versus the lease renewals. Those are going to have different price increases. You look at the market rates, which are constantly changing, and it gets incredibly complex. So they shared that with Appfolio's system. They were able to bring down that task from taking one week down to one hour. And we'll be getting into the competition a little bit later. But to see that given how sticky VMS businesses can be,

I've been quite impressed about their ability to just capture share from their competitors, which I think goes to show the value proposition they're able to offer to customers and actually be able to market that to them. If you're using a software product and someone's giving you a call trying to sell you on their product, it can be a pretty difficult task. And AppFolio has shown that they've been able to do it for many years. Robert Leonard

Also, when you look at the business, they have a couple of key performance indicators that I think also back up the fact that they're going in this right direction. So the two primary KPIs that I want to discuss here are, the first one is just customers, right? So customers are the people that are paying AppFolio for access to their software. And typically we can think of the customers as being the property managers. And then the second one is just the units. So the property managers, like Clay has already mentioned, they obviously have a specific amount of units that they're managing. So

If you're seeing the customer count growing and you're seeing units growing, that's obviously going to be very, very good. So let's go over some of those numbers here. So around their IPO date back in 2015, they had about 7,500 customers. As of Q3 of 2024, they have 20,400 customers. So that's been growing at a steady 10% compound annual growth rate. And then looking at units, they've gone from about 1.9 million units in 2015 to about 8.5 million units today, which comes out to a 19% compound annual growth rate. So

This means that the units per customer is scaling up as their customers also scale up. And the average units per customer has actually gone from about 262 in 2015 to 416 today. And I think that this is really, really good evidence that their customers are seeing a lot of value in their product because they're continuing to use AppFolio on more and more of their units as they grow together. Now, another interesting part about AppFolio's product is their approach to AI. So yeah, they have an AI angle. And so they have this

product they call RealmX, which is their AI engine that has many, many highly attractive features for AppFolio's customers. And I want to dive into a couple of the examples here now. So as I just discussed, a property manager must contact a lot of people so they can do this manually, which was how it would have been done kind of in the legacy model before AI tools have now come along.

But this is tedious and definitely time consuming. So let's say a manager wants to have specific answers to a question and then delegate a specific response once they have the answer to that question. So an actual use case would be something like, show me unrenewed leases that are expiring in the next three months. So the AI can then gather all the renters who meet these specifications,

And then the property manager can prompt RealmX to draft an email to all those people to renew their leases at a given rate. And RealmX will do all this for you rather than having to do it manually.

Another case study would be, let's say there's a renter that needs to fix a leaky faucet and they need to create a work order. So they'll communicate with the property manager using RealmX, who then communicates with the maintenance team. So RealmX will create a work order and contact the maintenance team to fix the problem. And then once the issue is resolved, the maintenance team notifies the property manager, and then the renter is automatically notified that their work is completed. So it's just a really easy way to simplify some of these processes. And then

Just another one here is concerning workflow. So let's say that a property manager wants to automate contact with people based on different outcomes. So for instance, let's say a property manager is looking for a new tenant to fill out a vacant unit. They create this workflow. Let's say the first trigger is that a new application to become a tenant is received. RealmX will then organize a workflow that runs a screen on that tenant to make sure if they're a good fit or not.

review that application, and then it'll send an approval or denial email to the applicant. If the application is approved, an additional workflow for moving in is then sent out. And if the application is denied, it reposts the opening to get more applications in the future.

Yeah. The AI side of the business is definitely interesting. What was intriguing to me was how customizable this is going to be with the development of LLMs. So there's going to be an LLM where a property manager can say, hey, give me this data, set up this workflow, and it'll just automatically do it. As a renter myself, the communications from the property manager almost feels constant every week or every other week. There's always this communication. So the

The more they can automate, the more efficiently the property manager is going to be able to run. And what I also found really interesting about AppFolio was also digging more into their payments business. So I think this is actually an area that might be easy for investors to underestimate or overlook. So in a way, AppFolio is actually a payments business disguised as a SaaS or an AI play. So they have a payment processor that...

property managers can use to collect rents from tenants. And it turns out that payments is really a core part of their business, at least from a revenue standpoint. And when you look at the most recent annual report from 2023, it shows that about three quarters of their revenue are from their value-added services, and the remainder comes from their core offerings. Robert Leonard

And the AI tool you just outlined is included in the value added services, but most of that revenue is actually generated from facilitating payments. And we don't know the exact numbers, but it's estimated to be somewhere around 60% to 65% of AppFolio's total revenue just from payments. So this really makes it a key part to understand, at least for the investment thesis. And it's also worth noting that in 2023,

AppFolio started charging a $2.50 ACH fee, and that goes to the tenants for each payment they make every month. So for those unfamiliar with what an ACH fee is, essentially you can just think of it as a fee you get charged when you link your bank account for paying rents. And this is an option many people use instead of writing a check or paying with cash or paying with a credit card. And since ACH fees tend to be much lower than a credit card fee, this is how

a lot of people are going to be paying. And I was a bit surprised that AppFolio was able to implement this fee because it feels a bit like skimming their customers or skimming the tenants with these unnecessary fees. And it's largely just pure profit for AppFolio. But when you look at the numbers so far, it's just been business as usual. They're continuing to grow 30% plus. For the most part, I think property managers are not going to switch just because of this fee. And based on some of the people I've spoke with in the industry,

I don't think Yardi charges a fee in a similar manner. I believe they do charge a $1 fee per unit to the property manager instead of the tenant. So it's a bit different in that aspect. Another important aspect of the payment segment is that a small portion of the tenants, it might be around 5%, they pay with a credit card. And Atfolio charges a 2.99% fee on credit card payments, which is also very high margin.

And if you run the numbers, this actually tends to work out to be quite a substantial part of the revenue mix as well. Say someone's paying a rent of $2,000 a month, that would equate to a fee of around $59 for Appfolio. So fees on the credit cards also is another piece of this business to understand. And it makes me a little bit uneasy because the fees are just so much higher than what they're getting for the ACH. Robert Leonard :

Yeah, that's a fascinating part of the business, Clay. I think some renters are going to prefer maybe paying with their credit card due to specific cashflow issues they might have. I don't think you or I are at a point where we can speculate on where that's likely to go in the future, but it's definitely worth noting. I do agree with you. It does seem to me a little bit odd that they're collecting such a large percentage of their revenue from these fees.

They kind of come off as this business that truly cares about giving their customers the best possible experience. And it seems a little off-brand to charge these excessive fees, especially when it's so much higher than Yardi. I realize it's a little bit different with Yardi charging the customer than the Uniholder, but still, it's a little interesting. But perhaps it just speaks, like you said, to the superiority of their products that customers are willing to pay for Atfolio's products. But I think it's definitely something, if you decide to invest in this, that you should probably pay

pay very, very close attention to. Because if something were to happen, if for whatever reason, as they scale up, if more and more customers are deciding to go with Yardi because they don't like paying the fee, well, then that would be pretty material to the business case of investing into AppFolio. But if you understand AppFolio at a deep level, maybe there's other segments of the business that you're going to think are going to grow faster than the payment facilitation, and that could offset this area of concern. Robert Leonard

I'll transition here to talk about the competitive environment. So the big question that all investors are going to have, especially with a company like AppFolio is, what's their moat and do they have a moat? And can competitors chip away at that moat? So all of AppFolio's major competitors are private. So it can be a little bit difficult to find all of the information we would typically want. RealPage is one close competitor. They were founded in 1998 and they serve the upmarket segment.

They used to be public before they got bought out by private equity back in 2020, so you're able to see some of their filings from years past. Based on the numbers we can see, RealPage appears to be a pretty good business. We also have Entrata. Entrata raised $500 million in financing in 2021, which goes to show how well-funded some of the other players in the industry are and the level of opportunity they see going forward.

And I have a close family friend who's worked in the apartment space for decades. And I asked him what property management software they use. And the CFO let me know that they use Yardi as their software. And Yardi is the number one player in the market by number of units. And he also mentioned that these types of software providers are checking in with him from time to time, seeing if he wants to switch software that he's using. And it's no surprise as it's a very competitive industry, high margins.

Yardi was founded in 1984 by Anant Yardi. He's still the CEO of the business today, which is quite impressive 40 years later. And they have a comprehensive solution that caters to the largest property managers. So since Yardi is the incumbent, it's definitely not easy to displace them and steal market share. But what AppFolio has going for them is that they're largely considered to be the most seamless and the most vertically integrated solution. So

Someone like Yardi or one of these other players might be really good in some of these segments of property management, but AppFolio is really going for this comprehensive, vertically integrated solution. Yardi is, of course, pretty well entrenched and they are more established in the upmarket, and that's where AppFolio, much of their growth is coming from today, the 1,000 plus units. Robert Leonard : AppFolio also seems to be a bit more customer-centric than competitors. I think it's a bit tricky to assess because

a lot of companies are going to tell you they're customer-centric, but we read up on feedback from customers, see the market share gains, and just try and make the best assessment we can given the data we have. So providing a good experience, they want to make the platform easy to use, which is, of course, it helps keep customers around long-term. In RealPage, on the other hand, I've heard that they make it very difficult for customers to switch from their platform because their contracts are tied to the individual properties.

I've been doing a little bit of apartment shopping myself, looking through different options in my area. And when I look at reviews for apartments, so many apartments just have very negative reviews. And a lot of those are related to the staff and the experience and the support that residents are getting. And I thought it was interesting also from their investor day, one of Atfolio's customers talked about how

their business went from 1.4 stars on Google to 4.4 stars. And that was partially with the help of AppFolio because it offers this technology solution that helps provide a good customer experience and it makes the property management employees, it makes their jobs easier as well. It's important to remember that I guess the property manager isn't the only user of the product.

the tenants, vendors, investors, and owners are also using it as well. And one more point on the competitive landscape before I throw it back over to you. Yardi, they were founded in 1984. RealPage was founded in 1998. And when you look at the core users for each of these competitors, AppFolio has more customers than RealPage and roughly the same number of customers as

as Yardi, despite both of these companies having a massive headstart. Appfolio was started in 2006. So that is another signal to me that they've just penetrated this market exceptionally well over the past 18 years.

I totally agree there, Clay. I think the competitive environment is definitely an area of concern while looking at this business, just because the industry, like you've already mentioned, is incredibly, incredibly competitive. But quantitatively, I think this business is really doing all the right things to continue increasing its market share. And the proof is just in their numbers. According to their numbers, they went from a 4% market share in 2015 to 16% market share in 2024. So they're making life very, very difficult on their competitors. Now, getting back to Yardie,

It's a private business, so it's a little harder, of course, to come by public information. But there were two sources that I found. There was Getlatka and Zipia, which have them at 2024 revenues of approximately $1.3 billion. Again, not sure how accurate that is. I'm just going on based off of their numbers. But AppFolio's revenues are about half of that. So they're not the leader yet, but it looks like they're gunning for them pretty hard. A few other metrics to see how AppFolio is doing would be to just look at their margins. So gross margins, for instance, are something that I like to look at. So

They've gone from about 55% in 2015 to 65% today, which is pretty incredible. Sales general administrative as a percentage of revenues have gone from 54% in 2015 and actually dropped by more than half to 24% in the last 12 months, which shows that as they scale, they're not having to require to continue spending more and more money on sales and marketing just to continue growing. And I think this probably has a lot to do with their average unit growth per customer, which I mentioned is almost doubled. So they're

that growth in their current customer base isn't as expensive because they don't have to spend more finding new customers. They can just scale the customers that they already have. But I will say, Afolio is definitely not the type of business where management can get complacent. It's not like a rent-seeking business where you're just there, you can provide a horrible service and people are forced to pay you. That's not the way this industry is. But Afolio seems to be a business that is definitely benefiting their customers and

and also owners of AppFolio's equity.

Yeah. The growth in market share is especially impressive given how sticky this software can be and how much of a headache it can be to replace. You think about a lot of these types of businesses where the software is just, it feels like it's impossible to rip out. It's just entrenched and they're just going to be able to continue to take up prices and it's just going to be too much to switch over. So that property manager from Omaha I spoke with, they have 8,000 units. They use Yardi.

And of course, I asked him if there's ever a chance they're going to switch. He straight up told me that AppFolio likely has a much better product, but it's just not worth the headache for them to switch. All their current processes and systems are linked to Yardi, and it works for them. They've probably used it for decades at this point. And another comment he made that was kind of interesting to me was that he would lose a lot of the data he finds necessary if he were to switch software providers.

And I could see that potentially increasing the switching costs substantially, especially if a company has been with them for decades. So that's one of the parts of this business that's just really fascinating to me. What is it that gets some of these property managers to switch? Because of course, Affolio is getting some of these customers, but there's also going to be other customers where it's not even really an option unless it's just totally obvious. The cost savings are totally there. The efficiency gains are totally there.

So as I mentioned, AppFolio is wanting to try and target that upmarket customer, which of course generate a lot of revenue because they have so many units under management. They want to provide this comprehensive solution. And AppFolio is pretty vocal that they're leaning pretty heavily into AI to try and capture more of that upmarket share. So for example, if AI can make it so a property manager only has to have, say, two instead of three full-time employees or however many the number is,

then that can bring significant cost savings, even if they have to spend more for AppFolio. And with that said, there's just little doubt that continuing to steal share, especially for a number of years into the future, is going to be difficult, which is both good and bad, depending on how you view it, if you're viewing it through the lens of the defensibility of the business, or if you're viewing it of what's their future growth potential. And thus far, AppFolio has shown that they're able to convince customers to switch over and get more value through them.

And they are heavily reinvesting back into the business and developing these AI solutions. So it makes me more optimistic that they're going to be able to continue this at least for the next few years. And I think many people are led to believe that AI is going to disrupt many companies, especially many VMS or software type companies. But so far, AppFolio has been at the forefront of investing in AI to win over more customers, offer the best possible product.

And given how entrenched these solutions are in the property manager's business, it's hard for me to envision how just a low cost competitor can enter and just totally disrupt all these entrenched players.

Yeah, I agree with you, Clay, especially about how good of a job AppFolio is doing at decreasing the costs of its customer base. Many software providers will have this AI tailwind, and I think it's probably going to last quite a long time. And it's not so good for people searching for lower level jobs that can be easily replicated by AI. You already mentioned there that maybe using something like AppFolio could reduce someone from using three employees and take them down to two or one or whatever. And as AppFolio gets better and better, it's probably going to take more and more jobs. But

It's obviously a good thing for the business case of AppFolio. Hopefully they can continue utilizing these tools, improve their margins. And then on top of that, they might be able to pass along their savings to their customers eventually, which could hopefully improve their experience using the product. But since AppFolio is already utilizing AI at a pretty high level here, I don't see them being disrupted by it too much. If they were living in the stone age, not investing in research and development, resting on their laurels, I definitely would be more concerned about their future. But

They do spend money on AI and clearly they're using it. And it's not just a buzzword for them. They're actually utilizing it. So I wanted to transition here to discuss one of my favorite topics, Clay, which is capital allocation. So earlier you mentioned your conversation with Adam Cecil as part of the reason why we chose a tech business for this quarterly best ideas segment. And that leads into why we think this business has a lot of hidden value that doesn't actually show up on the income statement. And this was an area that Adam covered pretty extensively in his book, where the money is.

As of January 24th, 2025, AppFolio is trading for 73 times earnings, which clearly seems incredibly overvalued. But like Adam said, some tech businesses require some adjustments to properly understand their true value. So for instance, research and development makes up a substantial portion of AppFolio's operating expenses, 20% in the last 12 months. So gap accounting actually punishes R&D, essentially treating it like it provides zero value to the business.

But since 2021, AppFolio has grown their gap EPS from zero to $3.60. So during this time, AppFolio has only made one acquisition for about $80 million. This was called LiveEasy. So almost all this EPS growth is from organic sources and from reinvesting into its business. And obviously R&D probably makes up a big reason for that value driving growth. Robert Leonard

So you can think of AppFolio's gap numbers versus an adjusted net income by adding back R&D as kind of being a very valid adjustment. Obviously, some of these tech businesses come up with their own KPIs, and I think a lot of them are mostly nonsensical. They just need to do it so that they can find other people who hopefully want to invest in them in the future. But I don't think in AppFolio's case that it's just a nonsense number. I think that R&D is really delivering value to the business. So

I do think that it's necessary probably to remove it from the equation to get a better idea of the value that you're getting. And you can kind of think of this in Buffett terms as it's similar to removing growth capex from the free cash flow equation to get Buffett's owner's earnings metric. And so the evaluation of a business like AppFolio becomes much more palatable if you make this adjustment.

And then there's another metric that I want to discuss here in relation to capital allocation, which is a rule of one. And for those who need a refresher, this was Buffett's capital allocation tool. And basically what it does is it just states that for each dollar that a business retains or reinvest in itself, it should add at least a dollar of market value. For Atfolio, their CEO has only been the CEO since 2023. So it's not as valuable, but he's actually been with the company since 2020 at a pretty high level. So I think it's still

somewhat valid tool to use. So if we look again, since 2020, AppFolio has retained about $193 million. And in that same time period, the market cap has gone up about $3 billion. So pretty incredible value creation there. So what that essentially means is that for each dollar that's reinvested into the company, they've created about $15 of shareholder value. So I think we definitely need probably three to four years of Shane Trigg, their CEO, retaining that job as CEO to get a better picture of his capital allocation skills. But you know,

it appears the business is already in good hands and Shane obviously clearly understands the business already at a very high level. So turning to returns on invested capital, they've been really, really lumpy for this business. If you add back R&D, the company has definitely been profitable for the last few years, but if you look at the gap earnings, the business looks very volatile. It was profitable in 2022, unprofitable in 2023, and then now it's being back to profitable in 2024. Robert Leonard :

But as I discussed, gross margins are continuing to improve and things like sales and marketing margins are going down, which is clearly a very good thing for the business going forward. With how lumpy the business is, I'm not super trustworthy of using long-term returns on invested capital numbers or even what numbers should be assigned to the business for the long-term.

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Real-time updates only in iOS mobile app. See guarantee details at TurboTax.com slash guarantees. All right, back to the show. My take is that for a business like this, gap earnings just aren't really that useful. They can be a good starting point though, and each individual person can make their own adjustments they deem are appropriate to better reflect economic reality.

My opinion is it is a very profitable business and they can make operating income really look however they like, but management behaves really how I would prefer they did, which is when they see high return opportunities to reinvest back into the business and grow market share, they're going after those. So right now, a lot of that's going up market, investing in AI, paying their sales team to go out and push up market. And it reminds me of a quote from Jeff Bezos' 1997 shareholder letter. He stated,

When forced to choose between optimizing the appearance of our GAAP accounting and maximizing the present value of future cash flows, we'll take the cash flows. And I hear some similar things from AppFolio CEO Shane Trigg when he speaks about the business. So he's talking a lot about putting a big focus on delivering value to customers, their focus on being the very best in this one vertical, and growing free cash flow over the long term.

The company is really starting to reach economies of scale. These traditional metrics are going to become more and more useful, I think. I wouldn't be surprised if their R&D as a percent of revenue declines over time as the business continues to scale. Maybe we'll see more dividend and share repurchases in the future. They were rock solid balance sheet, so any excess cash could easily be returned back to shareholders once they start to get to that point. Management's also discussed how they

they see operating margins continue to grow as they scale up. Operating margins were actually negative in 2022. So from a gap standpoint, they weren't making money. Today, they're around 18% and they expect that to continue to grow over time. So it does, although in the past they have shown to be unprofitable from a gap standpoint, they are communicating to investors that they are putting a bigger emphasis on showing profitability in the future. Robert Leonard

I wanted to transition here to talk management. So the company brought in a new set of managers with a lot of experience in SaaS. So the CEO, Shane Trigg, he joined the business in 2020. He has previous experience at Intuit and Salesforce. And then the other managers also joined fairly recently, most of which joined in 21 and some in 22. So some of these other managers have experience at Salesforce, Oracle, Intuit. And this management team that's in these

past few years have just done really well. Like I mentioned earlier, I would prefer for the founders to be involved, but it gives me a bit more confidence that they still have sizable stakes in the business. What's also interesting, super interesting to learn about this investor named Maurice Duca. So it was hard to find much information about this guy, but his investment firm, Investment Group of Santa Barbara,

He bought into Appfolio's Series B funding ground all the way back in 2008, just two years after the company started. And Appfolio, when they IPO'd in 2015, he looked at the business. He said, I understand this business top to bottom. I understand where it's likely heading. And instead of doing what probably a lot of investors were thinking at that time, which was cash out their shares, he ended up doubling down at the IPO and buying more shares in the years that followed.

So Maurice Duca today owns around 18% of the shares outstanding. That's valued at $1.7 million. So he alone owns almost double what the founders own, which I thought was quite interesting. And he also holds three of the eight board seats, his investment firm does. And based on the information I've gathered, I think that Maurice and the management team overall take a pretty long-term view with this business.

They're willing to sacrifice short-term profitability to invest in the product, expand up market, capture market share. And I think they're quite shareholder friendly as shareholder dilutions less than 1%. And by the way, before I forget, one of the tools I've been using in preparing for this episode that's been pretty useful for me in doing equity research, it's actually a partner of the podcast. It's called Fintool. So if any listeners are portfolio managers, equity analysts, I would recommend checking it out.

Fintool is an AI tool that you can essentially ask any question you could find in the company's filings. So it'll go out and scrape the filings for you and just provide you an answer right there. And it saved me a ton of time in finding some of this information. So for example, I asked Fintool, who are AppFolio's major competitors? And when it mentioned RealPage as a competitor, it actually added a note that RealPage is currently going through litigation.

since they were doing some illegal price fixing. And that was interesting to me because that might actually be a catalyst for growth for AppFolio that I might not have initially discovered without having read through all of AppFolio's filings. So I thought that was quite useful as well.

The Maurice Ducas involvement is very desirable for the business. Obviously, it's nice having this big outside shareholder who's doubled down and is clearly doing a really good job and not selling his shares. But that's actually just a small part of the attractiveness of the insider ownership of this business. There's other areas that I think are attractive as well. So one thing that I like to look at when researching a business is to know how much money are the executives being paid to run the business? Are they treating it like their baby and not just using it as their personal piggy bank?

That's obviously a great thing. You don't want to see people that are just using a business to pad their own pockets, especially when it's at the expense of shareholders. When looking at named executive officers, including the CEO, Shane Trigg, they're all making base salaries around 400 to 500K, which seems very reasonable given how large the business is and how much success they've had. And it's also worth noting that only two of the four named executive officers received an increase in their base salary in 2024, and they were only for 2% and 16% respectively. So

It would be great if some of their competitors were public so we could compare, but as they're private, we don't know what the other executives in the industry are making. However, the executives on top of their base pay are making some pretty significant bonuses. So

The CEO, Shane Trigg, made a total of about $17.7 million in 2023. Their CFO made about $4.5 million in 2023, and their chief legal officer made about $2.2 million in 2023. Now, it's important to note here that a large part of Shane's reported remuneration comes from stock and options rewards. These awards were estimates of fair value at the time that they were granted. So they

they don't necessarily represent exactly what Shane received. And so this means that his actual remuneration was likely quite a bit less, which makes me feel a little bit better about their incentive plan. Now, the performance-based bonus that they have is based on a few key performance indicators. So I like looking for incentive plans that hopefully align management with creating shareholder value. And I think at Folios is a pretty decent plan. It reminds me a little bit of Old Dominion Freight Line, which Clay and I have covered in a previous episode. Clay Gould :

So they have three primary KPIs. The first one is just revenue or how they're growing revenue or whatever their revenue target is for that given year. The second is residential property units. We've gone over that, I think, in quite a bit of length here. And the third one is non-GAAP operating margins. So this is defined as GAAP operating margins, less stock-based compensation expense, amortization of purchase intangibles, and one-time or non-recurring transactions. So one-third of bonuses are connected to each of these three KPIs. So

Just to give you an idea of how they've done on these KPIs, the last recorded date that they have is in 2023. So booked residential units achievement received about 87% of their target. Revenue achievement was 103% of the target. And then finally, non-GAAP operating margin achievements of 197% of target, which is obviously very impressive. Robert Leonard :

So these were all paid out in cash. And I think these are pretty well aligned with creating shareholder value. I don't see any glaring red flags in their incentive plan. And I like how they've created a degree of alignment between managers and shareholders. Now, I'd like to make an additional point here, which is that they have an extra incentive program that pays out performance share units, which tends to be, this is where more dilution is going to happen. So these units are based on the same KPIs as a cash incentive program that I just outlined.

They paid out about 5.8 million in PSUs in 2023. Given how much value they've created, this program looks pretty good and I think will probably continue providing value for shareholders over the long term. Last thing I want to mention here is just the business's strong insider ownership. Clay already mentioned that the insider ownership of the founders and Maurice Ducas is very, very high, which is obviously excellent. Then looking at their 2024 proxy, directors and named executive officers own about 10% of the voting rights to the business.

And this is pretty good. Generally, a business this size, I'm looking to see hopefully at least 10% insider ownership.

Yeah, aligning incentives is a bit more of an art than a science. So it's interesting to see that the managers are incentivized on three different KPIs. Some sort of return on invested capital would probably be ideal. But since they're incentivized based on both revenue and unit growth, as well as operating margin, I could see that also working quite well for them. So I'll turn to the valuation here.

If you're looking for a company that trades at a cheap PE and it's fully mature, then Appfolio is probably not the bet you're looking for. But if you're looking for a company that has a best-in-class product, it's consistently grown at well above average rates over time, and thinks about trying to maximize the long-term value for shareholders and managing the business, then I think this is a company worth taking a closer look at. So the company currently trades at a price-to-free cash flow of around 50 times.

But this is a bit deceiving since they're heavily reinvesting in R&D. So as the company matures and they have less opportunity to gain market share, I would expect them to see higher margins and less of a need to reinvest. So with the help of Adam Ziesel's book, Where the Money Is, walks through these similar exercises on companies where he makes his adjustments to make this sort of multiple better reflect economic reality. And in the book, he uses examples of

Amazon and Google that are super helpful and have really helped shape my thinking and looking at a business like Appfolio.

For anyone interested in learning more about this subject, I would point you to Adam's book. It's a wonderful resource and does a really good job explaining it better than I can. And you can also tune into our previous episodes with Adam Ziesel on the podcast. We've had him on a couple of times. So if we pencil in gross margins expanding from 65% to 70%, and if they're able to convert half of that to earnings before interest and taxes or operating income, they're

The normalized multiple is around 33. And I use air quotes there for those watching on video, because it's up to each person to make their own assumptions on what's normal. When I project the business out five years, I would assume a revenue growth of around 17% and operating margins around 37%. When I run just a quick DCF five years out, I'm getting an IRR of around 12%.

If you're wondering how that 17% revenue growth is going to come to fruition, I think it'll be a mix of growth in customers, growth in the average revenue per customer, and that second part is going to be a mix of a number of things. So you're looking at price increases, additional value-added services, growth in units for each customer, and then just more payment revenue, to use a number of examples there. And another thing I like to do with each business

I invest in is try and gauge the temperature of the market is what we can call it or what Howard Marks would call it. Or just try and assess, is the market being overly optimistic or pessimistic about the business and its future? So for at Folio, I thought some good metrics to look at would be just price to sales or price to gross profit to be a useful measure. It's not a valuation tool. It's just a tool to gauge the temperature of the stock as of today. So the price to sales is around 18%.

which is actually around its historical average. It's one that's varied quite a bit. And I don't think today's price to sales metric signals bubble territory for me, but it's also around 40% higher than what we saw in 2022. So the stock, of course, with the benefit of hindsight, was a bit depressed at that time. And relative to 2021, we're actually seeing lower levels. And then a price to gross profit also shows a similar picture that it seems to be in a normal territory. Robert Leonard

So today, I wouldn't say the stock is by any means a bargain, but it seems fairly reasonably priced given how high quality the business is and its potential growth runway going forward, given the market shares in the mid-teens. So if you're an investor who prefers to wait for things to go on sale, this is a stock that has gone through long periods of underperformance in the past. It might be one to put on the watch list. So given that it can be really difficult for them to move up market, I could see the case for

sitting on the sidelines and waiting to see if the market offers you a better entry price. So the stock hit a local top in February 2021. It declined by 50% and it took over two years for the stock to hit a new high. And then in 2018, that was another point where the stock fell by 30%. So the market does present some opportunities from time to time. And for those in the audience who might be skeptical of AppFolio's ability to continue their above average growth,

I thought it was interesting the CEO has pretty big ambitions. I wanted to share a quote here from their investor day. I quote, "With our focus on real estate, we are not opportunity constrained, and we are positioning ourselves and our platform to go take advantage of this vast opportunity ahead where the entire industry can come to do business with AppFolio." Now, what I just shared is our long-term vision, and we're not quite there yet.

And so in the near term, over the next three years, we are relentlessly focused on growing units, revenue, and margin while building the foundations of the AppFolio platform. Growing units, revenue, and margin is achieved by delivering exceptional value to our customers, by being a healthy business ourselves, and cultivating a high-performance culture. To succeed, we're really going to align on three areas. And then the three areas he highlights are differentiate themselves to win, focus on efficient value delivery,

And three, their focus on people and culture.

Yeah. So Clay, I think your evaluation is very reasonable and conservative. If you think that this business can continue growing at historic rates, obviously your internal rates return are going to rise significantly, but Clay and I will leave that up for you to decide. It's interesting kind of piggybacking on your point there about some of the drawdowns because high quality businesses like this, like Atfolio that have these very, very impressive revenue growth numbers, as well as operating margin expansion,

they usually aren't trading at depressed levels. But as you mentioned there, you had a couple big drawdowns of 30, 50%, but I actually went and looked at more of their drawdowns on this drawdown chart that Finchat has. And there's actually been six times since an IPO that has had drawdowns of 20% or greater. So if you like this business and you're a patient investor, you can definitely have opportunities to load up on shares when they're trading for a much cheaper evaluation at some point in the future. Robert Leonard

If you think that you do want to decide to invest in this business, I think there's a couple of key areas to look at in your modeling. At least this is what I would be looking at. So the first one is regarding payment facilitation. Do you think that payment facilitation is going to continue at its current rate and it's just going to scale up from here? Or is it going to have to decrease at some point in time? How's that going to fit into your future growth numbers? Second question here is, do you think that there's

other business areas inside of the business that can continue increasing revenue growth or decrease revenue growth, or how is that going to impact margins? Obviously, the payments processing business is probably going to have very, very high margins. So if you think that there's other areas, core areas of the business that are going to take more and more market share, that could theoretically drop margins. So obviously, like I just went over, management is incentivized to improve these margins. So hopefully they would figure some way around that, but it's definitely an important question to ask going forward.

If I know that I want to invest in this business or I'm getting close to hitting that buy button, I think I would definitely want to focus on these two questions to make sure that I understand that the growth rates in the future are going to continue at the numbers that I'm expecting.

Definitely. And we've talked a lot about how good the business is, but before investing myself, I would probably want to get more comfortable with their ability to continue to move up market because there's just so much nuance with the thousands of property managers. There's going to be some where the existing software just is not going to get ripped out and there's going to be others that use this old clunky outdated software where it's just totally obvious that they need to switch over. So

If there's strong evidence that they're able to continue to capture more share, I think the investment case is quite strong for AppFolio. But also just want to get a better sense of the competitive landscape. I've heard Entrata is a pretty strong competitor, RealPage. And how likely are they going to be able to put together a similar offering, especially with some of the funding they've received? Yeah, I think that pretty much wraps up the discussion on AppFolio. Before we let the listeners go, I also wanted to make a quick announcement related to our TIP Mastermind community.

We launched the TIP Mastermind community in April of 2023. And honestly, it's been nothing short of amazing for me in terms of the people I've had the pleasure of connecting with, the many Zoom events we've hosted, 100 plus calls and presentations, and then the live in-person events we've hosted as well in New York City and Omaha. For those not familiar, our Mastermind community is the community that we built here at TIP that caters to private investors,

portfolio managers, and high net worth individuals. It's a place to really network with like-minded value investors, meet interesting people, share stock ideas, and continue on this journey of lifelong learning. And I just continued to be amazed by the quality of members that have been joining us over the past couple of years. Some of the Zoom calls we have coming up that I wanted to highlight for the community, we have a social hour with Stig on what he would teach or tell his 20-year-old self. Very excited for that discussion.

We have a social hour with Kyle here on Scuttlebutt Investment Research, which he just did an episode on. We have a stock presentation by a community member on BYD, a couple of portfolio reviews with community members, and then I'm bringing in Leandro from Best Anchor Stocks to do a stock presentation on Adobe. Kyle, you recently did a presentation on your portfolio and your performance for 2024. Kyle Turner :

That's right, Clay. So I recently shared my portfolio update for the full year of 2024 with the community. And I love these updates. They're so much fun because I get a lot of really, really great engagement from the community. And I get really, really interesting, introspective questions as well from them. So during one of my portfolio updates, I usually speak about things like my investing strategy, some of my current wins, some of my current losses.

I talk about specific areas of investing that I'm spending some time thinking about and journaling in. I talk about businesses that I looked at in the previous quarter, maybe some that I like more than others, and I share that with everyone. And then I touch on my results as well, which I enjoy doing. So these events, at least the one that I did was pretty well attended, and I've had really good feedback as well from these types of calls. And as Clay mentioned, we now have our members doing pretty similar presentations as well. It's so nice to share these thoughts with people who are

just other really high-level investors. And they asked incredibly insightful questions that have truly made me, and I think everyone else around as well, better investors. I'm just constantly impressed with the quality of people in this group. And it also allows members to connect with other investors who share similar strategies. I've had a chance to take some ideas from other members just by talking with them, getting on one-on-one calls and having them explain their theses in a lot more detail. And it's just been incredibly impactful for my own investing. Robert Leonard

Yeah. Investing can just be quite a lonely experience. And members, I know they enjoy following along with you and your journey, Kyle, and also just getting together with us in person. We're getting together in Omaha in May during the Berkshire weekend. We'll be in New York City in the fall.

Yes. To touch on Omaha a bit, we're hosting a couple of dinners and socials during the Berkshire weekend, as well as a bus tour to really give the full Omaha experience. Should make for an amazing time. As of today, we have around 25 of our members registered to attend. We have 120-ish in the group, and we're capping the community at 150 members. And I'll also highlight that we really want to focus on providing value to our members. So we're actually going to be temporarily closing the community to new members.

We'll be closing it at the end of March 2025. So if you're interested in joining the community, I'd encourage you to apply before then. So you can join our waitlist to apply by clicking the link in the show notes or going to theinvestorspodcast.com slash mastermind. And then from there, you'll hear back from us shortly with more details on what's all included with the group. So that's theinvestorspodcast.com slash mastermind.

And I think that wraps up our discussion. So thanks so much, everyone, for tuning in and hope to see you all again next time. Thank you for listening to TIP. Make sure to follow We Study Billionaires on your favorite podcast app and never miss out on episodes. To access our show notes, transcripts or courses, go to theinvestorspodcast.com.

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