Qualys - A Potential Multibagger that has Compounded by 26.4% Annually and is Currently Undervalued

<5 min read

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The Business & Business Model

Qualys is an interesting small-cap stock with fantastic fundamentals. The stock has compounded by 26.4% annually since its inception in 2012, which is a 10X.

The company has a clear value proposition and is riding several software trends and are set to keep growing at a rapid rate over the foreseeable future.

Qualys offers a cloud-native software solution that covers multiple security layers. A business might use Crowdstrike for IT security, Skybox for Compliance, Rapid7 for Web App Security, Armis for Asset Management, and Palo Alto for Container Security.

Qualys offers a service that covers all of these layers. This means that the value proposition to their customers is cost reduction in direct costs, lower platform maintenance costs, and less complexity in managing different vendors (Contracts and alignment)

Qualys is used by several of the largest businesses in the world, such as Mastercard, Google, and Mcdonald's. Hence, Qualys is well-diversified and not reliant on a single client.

The business model is: i) Scalable, ii) Delivers a clear value proposition iii) Uniquely positioned to benefit from more companies consolidating their software stack to reduce complexity.

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The fundamentals

Operational

• ROIC: 25.4%

• Gross Margins: 79%

• FCF Margin: 37%

• Operating margins: 26.6%

• Cash Conversion 5Y: 202%

• Net debt/FCF: 2.26X

• Interest Coverage: 150X

Valuation

• Earnings yield: 2.43%

• Fwd. PE: 27

• Avg. Fwd. PE 5Y: 40

• FCF Yield: 3.85%

The Stock

Qualys stock price has grown by ~26% annually since its inception in 2012. The stock is a 10-bagger. As you can see from the chart below, the journey has been rather linear for a micro/small-cap stock. This is a plus for investors as it suggests that Qualys has continuously created shareholder value.

The Growth (5-Year / 10-Year)

• Revenue: 15.88% / 18.22%

• Earnings per share: 33.20% / 52.90%

• Free cash flow: 24.41% / 38.12%

• Book Value: 3.62% / 14.62%

Source: SeekingAlpha

Qualys different markets are set to grow 1.42x in the next 3 years (12.4% CAGR)

Strong revenue growth which is mostly organic

An increase in platform adoption drives customer spending

Qualys generates high amounts of cash with an FCF margin of 37%. The FCF margin is somewhat contracting, which is something to keep an eye on in the next quarterly reports:

Capital Allocation

Qualys is returning cash to its shareholders through stock buybacks. Stock buybacks are only a positive in my book if the purchase price is lower than the intrinsic value. At current levels, repurchasing shares seems like a profitable capital allocation decision.

Sustainable competitive advantage

Qualys has impressively continued to grow profitably even though they compete with several other larger companies. They have managed to expand their margins and ROIC over time which suggests that they are doing something right and have a competitive edge.

Sticky products

Qualys is able to sustain a high retention rate for its customers, which suggests that its product is sticky. Their net retention rate is 110% and their gross retention rate is 90%. Once a business adopts Qualys’ services, it requires an integration project to change it in most cases. As long as the product works at a satisfying level, customers are unlikely to use resources to change to a competitor.

Network effects

As Qualys get more clients, their product becomes better. They get more data points in their security system, meaning they are able to detect more malicious attempts toward their clients (DDoS attacks, phishing attempts, viruses, and so on).

This suggests that new users increase the value of the offering. This, however, is not a unique edge - companies like Crowdstrike use the exact same system to improve their services.

Qualys’ industry-leading margins vs. peers:

Comparison between other SaaS and Security peers using the "rule of 40" as a proxy. Rule of 40 = Revenue growth % + Ebitda margins should be above 40.

Qualys has impressive margins, but less impressive growth compared to peers like $CRWD and ZS 0.00%↑:

Why own Qualys?

• High demand for their services in the next 10 years

• A narrow competitive advantage

• Doesn’t need debt to achieve superior returns

• High return on capital

• High FCF margins

• Solid management and capital allocation

The Risk

• Disruption: New technology, substitutes, and competitors offering a better product.

• Competition: In the security space, Qualys competes with best-in-class companies like Crowdstrike and Palo Alto Networks.

• Economic factors: Interest rates and lower business spending can affect existing clients’ willingness to expand services, and for new clients to adopt their product.

• For investors, there is also a risk of paying too much for a company with high multiples. If they start losing market share to competitors, it can be a double whammy - lower earnings and multiple contractions.

Is Qualys priced fairly?

Using a simple discounted cash flow analysis to determine the fair value of Qualys.

Using the following scenarios:

• Normal case: 16% growth in FCF for the next 5 years, followed by 14% growth for the consecutive 5 years, ending the period with a multiple of 25.

• Best case: 20% growth in FCF for the next 5 years, followed by 18% growth for the consecutive 5 years, ending the period with a multiple of 30.

• Worst case: 10% growth in FCF for the next 5 years, followed by 8% growth for the consecutive 5 years, ending the period with a multiple of 20.

Note: If Qualys’ growth is set to stagnate over the next 5 years, these estimates are invalid and the price will not develop as anticipated.

Weighing the different scenarios as follows: worst x 0.3, normal x 0.6, best x 0.1.

Our fair value estimate for Qualys is ~$7.2 billion. Today, Qualys trades at $4.8 billion. This suggests an upside of 50%.

Keep in mind, this valuation is based on future growth in FCF. As investors, our certainty in this valuation boils down to how certain we are about Qualys’ competitive position, and its ability to expand to existing customers, while also bringing on new clients in a competitive environment.

Reversing the DCF and changing the discount rate to 15%, as this is our requirement for investment, we need Qualys to grow its FCF at 14% for the next 5 years, followed by 12%.

We believe there is a good chance that Qualys will manage to do this, based on the elements in this analysis.

Additional reccomended reading on Qualys:

• Qualys: Roaring Sales With Huge Cybersecurity Tailwinds

• Qualys: With Risks, It Is A Cheap Cloud Cybersecurity Trade

Conclusion

Qualys is an interesting SaaS company with exposure to several software trends. Clients may choose Qualys as their provider as they can satisfy more than just one product area. Their business model is superior and provides operating leverage as their costs are mostly fixed, and revenues from new customers will be mostly profitable.

We believe Qualys has a narrow competitive advantage, proven by its sustained high margins, its return on capital and margins vs. its peers, and its high retention rate.

Demand will only grow for Qualys’ services in the future as more companies become digitalized. We believe Qualys is well-positioned to benefit from several software trends.

Disclosure: We’re long Qualys