Description Appian is a process automation SaaS company we have followed for years, and have recently purchased shares for the first time. On a stand-alone basis, the company offers an interesting return opportunity for patient investors. Add to that a legal twist, and the risk is relatively low with considerable upside if they continue to execute their growth plans. We think IRRs north of 20% are possible from the current price.
Appian primarily services large organizations with complex process requirements. Their customers have very high legal and compliance standards that must be met, without fail, or they risk significant consequences. Their largest verticals are financial services, life sciences, government, and insurance. Appian describes their platform as “low code” which effectively means that the buyer does not need an army of coders to implement the software (as an aside, we became worried about this description now that AI is making coders significantly more productive – low-code was a bigger selling point when software engineers were the subject of bidding wars and persistently higher salaries).
We have a simple thesis – there are large organizations with enormous data advantages when it comes to segmenting/servicing their customers. Smart management teams realize they need to use this to their advantage through both better pricing and lower costs. They want to implement AI to drive this advantage, but they do not want to use non-proprietary models that introduce risks that are unneccessary given they have the resources to build robust models internally (for their specific business needs). Appian can drive this process automation, so they have a long runway for growth. Importantly, the Appian platform is sticky – revenue retention rates have consistently been north of 115%.
I’ll lay out the financial model quickly, and then run through a legal twist that makes this even more interesting.
The financial model is fairly straightforward. In the past 12 months, Appian reported $617M of revenues. The mix is ~80% software, and ~20% professional services. The gross margins on the software business are basically 90%, and about 25% for professional services. Over time, as one would expect, there has been a dramatic mix shift here. Five years ago, software was 65% of revenues, prof services 35%. We expect the mix shift to continue, especially as Appian has engaged partners to help implement the Appian platform (firms like Accenture, KPMG, E&Y, etc). Overall company gross margin will gently rise as mix continues to shift toward software subscriptions.
Beneath the gross margin line, it gets a little trickier. Appian spends a huge amount of their gross margin on sales & marketing. The company claims LTV/CAC north of 7. This number is hard to verify with precision, primarly because the sales cycle is long (so S&M costs in any given quarter don’t directly correlate with sales that quarter). The company has spent the past year re-thinking their sales organization and working to reduce costs. Those efforts are showing up in the financials, and that should continue. They recently noted that they have the sales infrastructure in place to handle their expected growth.
R&D is another category that has gotten some leverage (lower % of revenues over time), and will continue to shrink as a percent of sales over time.
G&A is a segue to the legal twist that makes Appian even more interesting. If you look at quarterly financials, you’ll notice a spike in G&A as a % of revenues in 4Q 2023. In May 2022, Appian won a lawsuit against one of their primary competitors, Pegasystems, for stealing trade secrets. The judge ruled that PEGA owed Appian $2.036 billion. Of course, PEGA appealed. Keep in mind that the judgment comes with 6% interest, or $122M per year through the appeals process. In September 2023, Appian decided to spend $57.3 million on judgment preservation insurance (JPI). The policy pays Appian $500M if they end up losing on appeal. At the time, Appian had to guess the timeframe of the appeals process and amortize the JPI premium over that period. Thus, G&A is higher by ~$16M/year as they amortize the premium.
The JPI policy works like this – if Appian loses all the appeals, the insurance company pays Appian $500M cash. Any judgment less than $500M, and the insurance company makes up the difference. Any judgment over $500M, and the insurance company pays nothing. A $500M payment today works out to $7/share, or 23% of the current share price. If Appian wins the case, and the original judgment, the payout is equal to the current enterprise value of the business. Appian lost the original appeal. The case went to the Virginia Supreme Court, which agreed last week to rule on the case. There is no time table for the supreme court ruling. No matter what happens, Appian will get a significant cash infusion at some point.
Besides the JPI bump, we think Appian can grow in the mid-high teens for several years. We model things for 7 years, and we think revenues will likely be around $1.5 billion in 7 years. The company believes they will eventually operate with a 20% EBIT margin, while sustaining a sales organization that can grow the topline at double digit rates. We think there is $300M of EBIT in seven years. In the meantime, the company won’t pay much tax given their DTA.
To cut to the point, we think EPS is something is somewhere around $3.50/share in 7 years. We think the company will be growing low double digits by then, so a 20-something mulitple of earnings is warranted. That’s where we get our 20%+ IRR from here, not including the legal twist.
If you made it this far, there is one last thing. Abdiel Capital is a big shareholder in this company. Colin is a fantastic investor who consistently has interesting insights into software and technology companies. We feel very comfortable to be shareholders alongside them.