Clouded Judgement 10.1.21

Every week I’ll provide updates on the latest trends in cloud software companies. Follow along to stay up to date!

Impact of Interest Rates on Growth Software Stocks

Many people have asked why rising interest rates effect software stock prices, so I thought I’d do a quick explainer. The TLDR - it’s all about capital flows. At a very high level there are many very large capital allocators (think tens / hundreds of billions, and even $1T+ of dollars managed) that allocate their investments across a diversified universe of financial instruments (stocks, bonds, real estate, etc), each with different risk profiles. The goal is that the overall risk profile / return profile of each asset class they invest as a basket portfolio will generate a target investment return rate. Software stocks fall squarely in the “risk asset” category. Some years they may return 20%+. Some years they may loose money. The variability is high, thus they’re “risky.” When we look at bonds or fixed income financial instruments, the risk is much lower (and in theory 0 when looking at government bonds — risk free). Many of these bond rates track government interest rates.

Now let’s use a hypothetical - a world where you can only invest in software stocks, or government bonds, and let’s say interest rates on these instruments are very low → < 1%. For the large capital allocators I described above, they have a choice in allocating capital to a risk asset like software stocks, or a “safe” asset like bonds. In this instance, the rate of return they’ll get from bonds is incredibly low, so they won’t allocate a big portion of their portfolio to this asset class. We currently live in this world! Over the last ~18 months rates have been incredibly low, thus making the relative attractiveness of risk assets (like cloud software stocks) very high. When rates start to rise (which the fed signaled will happen sooner than previously noted), the relative attractiveness of this safe asset vs the risky asset shifts. And because of this the large capital allocators will reallocate money away from software stocks, and into bonds. If rates went to 10%, they’ll allocate a much higher percentage of their portfolio to bonds. The important thing to remember here is the money that’s moving markets isn’t retail traders. It’s these large capital allocators. When rates start to rise, they start moving massive amounts of money out of one asset class to another. I believe this is what we saw with software stocks on Tuesday of this week - large capital flows out of software risk assets, and into other bond asset classes as rates rose.

This is all very high level and generalized. The summary - when rates rise the relative attractiveness of software stocks vs alternatives goes down, pushing large sums of dollars out of software stocks into other asset classes.

Top 10 EV / NTM Revenue Multiples

Top 10 Weekly Share Price Movement

Update on Multiples

SaaS businesses are valued on a multiple of their revenue - in most cases the projected revenue for the next 12 months. Multiples shown below are calculated by taking the Enterprise Value (market cap + debt - cash) / NTM revenue.

Overall Stats:

• Overall Median: 14.7x

• Top 5 Median: 51.0x

• 3 Month Trailing Average: 15.9x

• 1 Year Trailing Average: 16.0x

Bucketed by Growth. In the buckets below I consider high growth >30% projected NTM growth, mid growth 15%-30% and low growth <15%

• High Growth Median: 31.0x

• Mid Growth Median: 14.1x

• Low Growth Median: 5.4x

Scatter Plot of EV / NTM Rev Multiple vs NTM Rev Growth

How correlated is growth to valuation multiple?

Growth Adjusted EV / NTM Rev

The below chart shows the EV / NTM revenue multiple divided by NTM consensus growth expectations. The goal of this graph is to show how relatively cheap / expensive each stock is relative to their growth expectations

Operating Metrics

• Median NTM growth rate: 23%

• Median LTM growth rate: 31%

• Median Gross Margin: 74%

• Median Operating Margin (16%)

• Median FCF Margin: 6%

• Median Net Retention: 120%

• Median CAC Payback: 25 months

• Median S&M % Revenue: 43%

• Median R&D % Revenue: 26%

• Median G&A % Revenue: 19%

Comps Output

Rule of 40 shows LTM growth rate + LTM FCF Margin. FCF calculated as Cash Flow from Operations - Capital Expenditures

GM Adjusted Payback is calculated as: (Previous Q S&M) / (Net New ARR in Q x Gross Margin) x 12 . It shows the number of months it takes for a SaaS business to payback their fully burdened CAC on a gross profit basis. Most public companies don’t report net new ARR, so I’m taking an implied ARR metric (quarterly subscription revenue x 4). Net new ARR is simply the ARR of the current quarter, minus the ARR of the previous quarter. Companies that do not disclose subscription rev have been left out of the analysis and are listed as NA.

This post and the information presented are intended for informational purposes only. The views expressed herein are the author’s alone and do not constitute an offer to sell, or a recommendation to purchase, or a solicitation of an offer to buy, any security, nor a recommendation for any investment product or service. While certain information contained herein has been obtained from sources believed to be reliable, neither the author nor any of his employers or their affiliates have independently verified this information, and its accuracy and completeness cannot be guaranteed. Accordingly, no representation or warranty, express or implied, is made as to, and no reliance should be placed on, the fairness, accuracy, timeliness or completeness of this information. The author and all employers and their affiliated persons assume no liability for this information and no obligation to update the information or analysis contained herein in the future.