Vertex: Strong Market Position In Enterprise Segment (NASDAQ:VERX)

Investment thesis

I recommend to invest in Vertex (NASDAQ:VERX). VERX is a company that provides services for managing various types of taxes, including those imposed on purchases, services, communications, lodging, leases, and employee salaries. The company’s clientele includes businesses in the retail, publishing, and heavy manufacturing sectors. Taxes are becoming increasingly complicated and important for businesses, and companies risk financial liability, poor customer experiences, and reputational risk if they fail to file their monthly Indirect Tax Returns as required. Additionally, the government relies heavily on this source of income, and many countries’ economies rely on the revenue generated by indirect taxes. VERX offers a comprehensive and unique solution that automates the entire indirect tax process for companies with complicated tax processes and audit risk, backed by proprietary data and analytics.

Business overview

VERX provides services for managing various types of taxes, including those imposed on purchases, services, communications, lodging, leases, and employee salaries. VERX’s clientele includes businesses in the retail, publishing, and heavy manufacturing sectors.

Taxes are complicated and important

One of the two certain things in life is taxes, and it is complicated.

Most companies in today’s global economy find indirect taxation to be increasingly nuanced and complex. Businesses need to know which taxing jurisdictions apply to their operations, what those jurisdictions’ tax rates are, and how to apply those rates to the goods and services they sell. Taxes become more convoluted when dealing with cross-border transactions. Given the scale at which large businesses buy, source, and sell, it can be challenging for tax departments to keep up with all the variables involved in each transaction and how they affect the taxes that must be paid.

Companies risk substantial financial liability, poor customer experiences, and reputational risk if they fail to file their monthly Indirect Tax Returns as required. Since tax audits may cover a wide range of time, accounting for tax information requires a higher standard of diligence than is customary for other kinds of business information. It is also not uncommon for a large corporation to be the subject of numerous simultaneous tax audits in a variety of countries. In order to defend tax positions taken in the past, it may be necessary to provide extensive transaction-level detail for each audit.

Additionally, the government relies heavily on this source of income. Thus, it will not be forgotten in that sense. Many countries’ economies rely on the revenue generated by indirect taxes. Looking at the World Bank’s data, tax revenue as a percentage of GDP, we see that it amounted to 13.5%, or $11.4 trillion, in 2020. This is a very large figure that is used to fund the operation of a country, as such the importance is paramount.

Secular trends that increase compliance of taxes

From the perspective of the government, indirect tax is becoming increasingly popular as an efficient tool for increasing and stabilizing tax revenue. Tax compliance is becoming more stringent and frequent across jurisdictions. Moreover, an increasing number of nations have instituted reporting deadlines for businesses to submit their taxes in real time or very close to it. To expand their businesses, more and more companies are selling internationally and/or online, which means they must adhere to and report on a slew of new tax regulations. Many producers and retailers now face more nuanced questions about which transactions are taxable and which are exempt from sales tax. If we zoom all the way down to the level of individual online vendors, we still see that they are feeling the effects. For instance, in the United States, marketplace websites may be required by law to collect and remit sales tax on all purchases made on their sites, both by the marketplace itself and by third parties, regardless of where the final consumer resides.

VERX comprehensive and unique offering backed by proprietary data

For businesses with complex indirect tax processes and high audit risk, VERX solutions bring together data, analytics, and expertise to automate the entire indirect tax process. The VERX software package has a number of essential modules for handling the full spectrum of tax management tasks. Indirect tax calculations can be made in real time for a wide range of industries thanks to pre-built integrations with the customer’s preferred software applications and systems (e.g., SAP, Oracle, etc.). The VERX software not only boasts a strong calculation engine, but it also streamlines the process of obtaining customer exemptions, and offers a comprehensive solution for validating, analyzing and transforming data in order to meet indirect tax compliance requirements.

Each of these is backed by substantial proprietary data. In addition to hundreds of millions of effective tax rules underpinning indirect tax compliance in nearly 20,000 jurisdictions worldwide, VERX proprietary database also contains educational materials, recommendations for best practices, and other resources for tax professionals. From my perspective, the tax regulations incorporated into the VERX software offer valuable perspectives and direction for companies attempting to manage their tax liability. A solid in-house team is its foundation. The VERX development team incorporates new regulations into the system by conducting legal research, conducting analytical studies, using technical reasoning, and employing automation. I think VERX has a leg up on the competition thanks to the depth, and breadth of its content database.

Future growth from up/cross-selling

Vertex has spent the last four decades developing a tax platform with a primary focus on the largest U.S.-based multinational corporations. Currently, more than 59% of the Fortune 500 are Vertex customers, and the company’s revenues are spread out across many different markets. However, I anticipate that new customer will play a lesser part to growth going forward due to the high penetration level in the enterprise segment. However, I believe VERX is still in the beginning stages of expanding its share of the wallet among its current large enterprise clientele. Consistently growing net expansion rate and rising average ARR per customer are indicative of these. With increased usage and the addition of new tax types and geographies, I believe there is significant room for further expansion within its core customer base.

Thus, I anticipate that future up-selling and cross-selling activity will be the primary drivers of VERX’s long-term growth. Adoption of new tax types (value-added tax, consumer use tax, etc.) and adoption of other modules like reporting and remittance are likely to be the primary drivers of expansion among existing customers. Even though many of the company’s existing customers are multinational conglomerates based in the United States, they have focused primarily on the company’s US sales tax product. In my opinion, Vertex is still in the nascent stages of ramping up its VAT product and is actively investing and expanding its content library into additional geographies and tax types.

Competition is less intense in the enterprise segment

I note that my due diligence (i.e., speaking to customers, reading transcripts, news and extrapolating from personal experience) might not be comprehensive, but nonetheless these are my findings.

In the enterprise sales tax compliance software market, VERX’s main competitors are Thomson Reuters and Sovos. According to my research, Thomson is more widely recognized around the world and is intent on expanding both its financial and accounting offerings and its attention to corporate tax. VERX does compete with Sovos on occasion, but I believe that Sovos is most effective in Europe where they can concentrate on e-invoice compliance. In contrast, VERX is popular among US-based businesses that deal in multi-channel distributions across a wide variety of jurisdictions and transaction systems. Given VERX’s emphasis on large customers with complex tax operations, they rarely come up against Avalara (AVLR) head on because Avalara’s solution is more tailored towards mid-market with far simpler tax needs. In contrast to competitors like Avalara, Vertex’s platform is highly configurable, allowing enterprise customers to tailor the solution to their exact specifications in areas like tax measures related to industry or jurisdiction specificity and deployment options. That said, Avalara has recently announced a plan to expand its market reach, but the company is still in the preliminary stages of reaching enterprise product-market fit and has not yet established a comprehensive enterprise go-to-market strategy.

Also, VERX faces less intense competition from accounting firms, ERP vendors, and manual processes in addition to its top three main rivals. In my opinion, there is room for several successful vendors to serve a single large customer, given the complexity of enterprise IT architecture, which frequently involves several ERP systems. Nonetheless, VERX has spent a lot of time and effort over the course of decades compiling a comprehensive database of tax-specific content covering nearly 20,000 jurisdictions worldwide and including a wide variety of effective tax rules. In my opinion, the company has a substantial competitive advantage thanks to its enterprise configurability and its large and expanding content library, both of which are attractive to current and potential enterprise customers.

Valuation

My model suggests VERX is worth $16.76, if it trades at 33x forward revenue multiple in FY23.

Model walkthrough:

1. Revenue to follow management full year guidance in FY22. Afterwards, I expect revenue to continue growing at a same pace. This assumption is supported by a large TAM and VERX ability to continue upselling (as proven by the net expansion rate) and rising ARR per customer
2. While VERX is trading at a high valuation on absolute terms, I believe this is justified given its ability to sustain growth and expand margin.

Risks

Limited penetration left in the enterprise segment

As I mentioned above, VERX has already penetrated a large part of the enterprise segment already. Future growth will have to come from up/cross-selling. While this is a sound strategy, the lack of new customers to capture is a limiting factor to growth.

Increase competition in the upmarket could impact pricing

From a company like Avalara, which has traditionally targeted the mid-market, I anticipate an increase in competitive intensity. Avalara has begun slowly rolling out new enterprise features on their platform as part of a concerted effort to grow their product offering. In particular, the company is seeing strong enterprise traction in sectors like the transportation and hospitality industries. Long-term growth may be impacted by the fact that VERX will likely face stiffer competition for new deals as more and more businesses pursue digital modernization.

Conclusion

VERX is a business that helps its customers deal with sales, use, excise, communications, lodging, leasing, and payroll taxes. Retailers, publishers, and large manufacturers are among the company’s clientele. Companies risk financial liability, poor customer experiences, and reputational risk if they don’t file their monthly Indirect Tax Returns on time. Indirect taxes are a significant part of the government’s budget, and they are also important to the economies of many countries. For businesses that have complex tax procedures and are at risk of audit, VERX provides a one-of-a-kind solution by fully automating the entire indirect tax process with the help of proprietary data and analytics.