Olo: An Emerging SaaS Category Leader

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Another small cap company that screens favourably when looking at the small cap universe is Olo Inc (NYSE:OLO). With just a market capitalisation of $1.2 billion and some serious growth drivers, I think that the stock has a long way to go and could reward investors who are willing to be patient and take the small cap risk today.

Overview

Olo describes itself as an open Software-as-a-Service (SaaS) platform for restaurants. Its platform is focused solely on the restaurant industry and thus is custom made for the unique and complex needs of the restaurant industry. In fact, Olo has been continuously developing its platform with many of its restaurant customers over the last 10 years and thus, has been striving to continue to be a platform that brings the most value add to the restaurant industry.

On its platform, it has a wide range of modules that are essentially unique solutions offered by Olo to restaurants depending on their individual needs. These are some of their key modules offered:

  1. Order management: This module enables restaurant guests to both order and pay directly to the restaurants via digital means, including mobile, web or kiosk, amongst others.
  2. Delivery enablement: This module enables efficient delivery as it comprises a national fulfilment network, a network aggregator as well as a solution for channel management. This means that restaurants can now not only offer delivery services, but also are able to manage it and optimise it to suit their business needs.
  3. Customer engagement: This solution was only recently offered in the last quarter of 2021 and it offers restaurants marketing solutions to utilise data collected to improve loyalty and long term value of the customer through its marketing automation module, amongst others.
  4. Front-of-House: This module enables restaurants to streamline the part of their operations where they interact with customers, like through the optimisation of seating capacity and reservations.
  5. Payment: This solution is first offered in the first quarter of 2022 and provides an integrated payment system that enhances the payment experience for the customer.

With these solutions offered to its restaurant customers, Olo provides sort of an end-to-end centralized management of the restaurant’s digital needs.

Investment thesis

There are early signs that Olo is emerging as a clear winner as the SaaS category leader in the restaurant industry and these points form the thesis for an investment in Olo:

  1. Olo targets the restaurant industry which is in what appears to be a long term transition to becoming more digital, which provides the company with secular industry tailwinds for growth.
  2. The target market is currently still under penetrated and thus, the total assessable market implies decent room for growth in the future.
  3. Olo is benefiting from the large numbers of restaurant brands, partners and customers it has accumulated over the years, which gives it a network effect which differentiates it from the rest. In addition, this large network forms a flywheel effect to continue to drive growth in the future.
  4. Lastly, Olo still has multiple levers to pull for continuous growth, including expanding internationally, moving more aggressively into small and medium sized businesses and the potential opportunity that it has in payments.

The restaurant industry is in a secular shift to becoming more digital

When the COVID-19 pandemic struck in 2020, restaurants that had primarily offline operations and limited digital capabilities really struggled with the sudden lockdowns all over the world. This was the rude awakening for the restaurant industry to optimize their delivery network to facilitate off-premise dining, digitize the customer experience, and to streamline the restaurant operations through use of digital tools.

This means that as we head to restaurants in the post pandemic world, we are likely to see more digital menus instead of printed ones, ordering of food is increasingly done digitally (like a kiosk) and payment is done through digital means as well. This, in my view, is a much needed improvement in the restaurant business as the technology needed for these improvements have already been available for a decade and restaurants have been slow to innovate. In fact, Incisiv Research estimates that by 2025 almost 54% of restaurant industry sales will be conducted digitally, up from just 19% in 2019. With the restaurant industry digitalization trend kicking off and really accelerating because of the pandemic, this bodes well for Olo as more restaurants engage its innovative and end-to-end solution to enable a much more streamlined and digitalized experience for both staff and customers.

Huge total addressable market

There are more than 300,000 franchise locations and more than $7 billion in spend available for grabs in the industry. Currently, the company has 600 brand customers and roughly 82,000 franchise locations that are active on the platform. This translates to a 27% penetration in its target market based on franchise location opportunity. I think that we could see the penetration numbers go north of 50% due to the fact that Olo is a leading vertical software provider in this space.

A leader benefiting from the network effect as well as the flywheel effect

It is important to note that with 82,000 franchise locations on the Olo platform, this means that it has a much larger scale compared to competitors with only less than 10,000 locations available on their own platforms. On top of that, Olo serves as a centralised platform for delivery services and order management. With delivery services, restaurants using the Olo platform can coordinate delivery through different delivery service providers like DoorDash (DASH) and Postmates. On the other hand, restaurants using the Olo platform can also consolidated and manage orders from multiple market places like UberEats (UBER) and DoorDash to provide better management of orders through the use of the platform.

With more than 600 brands and 82,000 franchise locations, as well as more than 300 partners and 85 million guests, Olo benefits from the network effect and the flywheel effect. With such an extensive number of partners, brands and guest base, this network effect that has accumulated over the years serves as a valuable competitive advantage against peers. In addition, success in each segment helps to drive the flywheel and grow the business to become bigger. For example, by attracting more partners and restaurants to come on board the platform, this will attract more guests to use the platform which then drives the numbers for restaurants and partners. The unique position that Olo plays as a hub for both restaurants and marketplaces as well as customers is another differentiating factor that is hard to replicate.

In conclusion, Olo benefits from the network effect that it has accumulated over the years as well as the flywheel effect, both of which serves to differentiate Olo from its peers and drive long term growth.

Olo's flywheel

Olo’s flywheel (Olo 1Q22 slides)

Multiple future growth levers to pull

The future is exciting for Olo as there are 3 large opportunities for it to capture. First, the most direct strategy to take after focusing on larger sized restaurants will be to focus on the small and medium businesses. These smaller businesses may be just starting their franchise journey and could serve as future growth drivers for the company as they continue to grow. Olo estimates that there are about 400,000 additional locations in this segment. Secondly, Olo can do an international expansion, mainly in English-speaking regions first where the operating environment will be similar to the US. Lastly, there is a huge opportunity for Olo with their recent release of Olo Pay, which unveils a huge payments opportunity to the company.

Strong 1Q22 results

While revenues in the quarter grew by 18% year-on-year due to the increase in active locations as well as partners using multiple products, ARPU fell by 2% year-on-year and net revenue retention was 107%, less than in previous quarters. I think that management’s comments on the reasons on the weakness in these 2 metrics are valid. The high base effects of both the pandemic period as well as the fact that this is the last quarter operating under the previous DoorDash agreement are expected to ease in the next quarter as Olo prepares for ARPU and net revenue retention acceleration in the coming quarters.

Olo introduced a new emerging vertical to the platform: convenience stores. It is estimated by Olo to increase total addressable market by 55,000 locations. Its second quarter guidance has an implied re-acceleration of revenue growth which illustrates management’s view that the covid pandemic impact on its business is now behind us and we can again expect to see the fundamental business grow faster in the coming quarters.

Valuation

My price target for Olo is based on a 10-year discounted cash flow analysis. I applied a 12% discount rate and assumed a 15x terminal P/E.

My price target for Olo is $16.10, implying a 70% upside from current levels. My EPS growth assumption decreases from 70% in 2024 to 21% in 2032, as well as an implied margin compression in the near term due to investments needed for Olo Pay and the acquisition of Omnivore.

Risks

Pandemic induced demand may fade

As highlighted before, the pandemic was the key catalyst for many restaurant brands to consider digitising their operations and this brought huge growth to Olo. As the economy opens up and the pandemic fades away, while some off-premise dining will stay, some of the demand for it will disappear. There is the risk that the transactional portion of Olo’s revenues may face some pressures in the near term due to the higher base and lower demand near term. As highlighted by the company, about 50% of its 2020 platform revenues were transactional and I think that this could bring some pressure to revenues if the newer franchise adds that the company has does not offset this.

Competitive threats from other players or new entrants

First, Olo made face risks if the marketplace partners or delivery service provider landscape becomes consolidated, thereby reducing the complexity in the system and thus, reducing the need for Olo as the hub. That said, I think that while some consolidation will happen in these industries, it is likely that there will remain to be multiple players in the industry and thereby validating the need for Olo in the future.

Second, if the amount paid by restaurant brands is too high, they may decide to do this in-house instead of engaging the solutions of Olo.

Lastly, there may be new entrants that may want to expand into Olo’s business segments. For example, POS providers like Toast (TOST) have intentions to expand into ordering and delivery solutions that might be potential future threats to Olo.

Conclusion

I am optimistic about Olo’s future as it is still in an early stage of growth with many opportunities to capture. First, the restaurant industry is shifting to becoming more digital which is to Olo’s favour. Second, there is a large and expanding total addressable market for the company to expand into as it continues to gain new customers and expand wallet share of each customer. Third, Olo’s differentiation and competitive advantage comes from its network effect, which is brought about by the large numbers of brands, partners and customers it has accumulated over the years. Furthermore, this drives the flywheel effect which further compounds growth. Lastly, there are multiple levers for the company to pull like the opportunities in international expansion, small and medium businesses and the payments business. My price target for Olo is $16.10, implying a 70% upside from current levels.

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