Ooma, Inc. (OOMA) is the leading internet phone company targeting both small business and residential customers. It should be well-positioned to capitalize on the seismic tailwind due to the stay-at-home mandate. And Mr. Market agrees, sending the stock price to new all-time highs.
(Source: Yahoo Finance/MS Paint)
Analysts are giving Ooma a big pat on the back with rising EPS estimates for the current quarter and next year.
According to my relative valuation technique, Ooma stock price is extremely undervalued. These are the positive takeaways that investors may want to consider: a breakout stock, rising analysts’ estimates, and extremely low valuation. On the surface, Ooma appears to be quite a good investment.
However, there is a downside, and I urge investors to be cautious. Ooma’s customer base consists of small businesses and residential, the hardest-hit groups as we head into a recession of unknown length and depth. Even if the company has the “right products”, the customer base will likely be contracting, not expanding, in the next year or two.
Ooma’s business will be a reflection of the economy, and it is unlikely that we will experience a V-shaped recovery. Many of the jobs lost during the pandemic are not coming back despite government optimism and the government-induced sugar rush, which is temporary in nature. Once the November election passes, things are going to get really difficult for both small businesses and consumers. Given my solemn outlook, I believe that there are better investments than Ooma. Investors should be more focused on companies that serve large enterprises as opposed to small businesses and residential customers.
The Rule Of 40
One industry metric that is often used for software companies is the Rule of 40. The rule provides a single metric for evaluating both high-growth companies that aren’t profitable and mature companies that have lower growth but are profitable. Revenue growth and profitability (expressed as a margin) must add up to at least 40% in order to fulfill the rule. Analysts use various figures for profitability. I use the free cash flow margin.
The rationale for the Rule of 40 is as follows. If a company grows by more than 40% annually, then you can tolerate some level of negative free cash flow. But if a company grows by less than 40%, then it should have a positive free cash flow to make up for the less-than-ideal growth. This rule accommodates both young, high-growth companies as well as mature, moderate-growth companies. The 40% threshold is somewhat arbitrary but typically divides the digital transformation stock universe in half, separating the best stocks from the so-so ones.
For a further description of the rule and calculation, please refer to a previous article I have written.
The two factors required for calculating the Rule of 40 are revenue growth and free cash flow margin. Ooma’s annual revenue growth for the last year was 19%, while its free cash flow margin was -5%.
(Source: Portfolio123/MS Paint)
Therefore, the Rule of 40 calculation for Ooma is as follows:
Revenue Growth + FCF margin = 19% – 5% = 14%
Ooma falls well short of meeting the Rule of 40, suggesting that Ooma has a good deal of work to do in order to achieve a healthy balance between growth and profitability.
I would like to mention an issue that I often ignore when discussing the Rule of 40. That is share dilution. In general, I ignore share dilution when analyzing high-growth stocks because the dilution is usually insignificant relative to growth. Ooma, however, is a bit of an exception. The company is consistently diluting shares by 6-7% every year, a significant amount given its score of 14% on the Rule of 40.
(Source: Portfolio123/MS Paint)
Given the low score on the Rule of 40 in conjunction with its record of share dilution, I find that Ooma is not a particularly desirable investment.
The plot below illustrates how Ooma stacks up against the other stocks on a relative basis based on forward gross profit multiple versus forward revenue growth. Note: Please refer to a recent article for more information on the scatter plot relative valuation technique.
(Source: Portfolio123/Private software)
According to the scatter plot, the company is extremely undervalued on a relative basis relative to its peers.
Summary and Conclusions
Ooma is the leading internet phone provider and appears to be capitalizing on the stay-at-home initiatives in the USA and around the world. Analysts are raising earnings estimates for this company, and it shows in the share price, with a breakout to new all-time highs. According to my relative valuation technique, Ooma stock is very undervalued. An investment in the company would certainly make for possible gains.
I would like to encourage investors to be cautious, however. We are heading into a recession that may be long and difficult. An investment in Ooma is really an investment in the economy, and I don’t foresee a quick recovery. I believe that there are other companies that are better-positioned for a slow recovery, companies that cater to large enterprises that are better able to cope in this economy. Ooma’s low score on the Rule of 40, along with its share dilution, doesn’t improve my position on this company. I am giving Ooma a Neutral rating.
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Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.