Clouded Judgement 1.27.23 - Azure Sets the Tone for Software with Q4 Report

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

Azure (Microsoft) Quarter

The week the first of the cloud giants reported - Azure. Their results were quite interesting. Q4 ‘22 (I’m talking about calendar quarters here, not their fiscal quarters), came in at 38% growth YoY in constant currency. This was quite a bit ahead of expectations. Their guide was for 37% growth, but all the commentary they had made since last quarter was quite negative on the optimization environment, so expectations for the quarter were more like 35% growth, and bears were calling for closer to 33%. Needless to say, 38% growth was significantly stronger than anyone expected. The initial report sent Microsoft shares up 5% after hours. However, during the earnings call the CFO painted a different picture. While the overall quarter (October - December) was great, things started to turn in December. She called out an exit growth rate of December as “mid 30’s”, and then said they expect Q1 ‘23 (Calendar Quarter) to decelerate “4-5%” from where they exited December. So call it 30-31% growth in Q1. Given the beat in Q4, a guide of 30-31% growth in Q1 was a big disappointment. Consensus for Q1 prior to this quarter was ~33%. Given the beat in Q4, in a normal environment you’d expect that beat to flow through to Q1. The beat on this quarter coupled with the miss on the guide really points to a tricky demand environment. And if things are tough for Microsoft (a behemoth who benefits from the bundling effect going on given macro), it’s most likely tough for everyone. This quote sums up the quarter: “Just as we saw customers accelerate their digital spend during the pandemic, we are now seeing them optimize that spend. Also, organizations are exercising caution given the macro uncertainty.” Wrapping it all up, shares of Microsoft ended down after hours after starting up 5%.

Early Look at 2023 Guides

Given the Azure weakness reported on Tuesday, all software tumbled Wednesday morning with most names down 5-10%. However, as the day progressed everyone slowly climbed back up. The sentiment largely felt like results were better than feared. If we think about the world as a distribution of probabilities, this week (in some ways) raised the floor of how bad things could get (or how bad things are expected to get).

A big reason for that was the guides for the full year 2023 we saw. As I’ve talked about before, a big debate at the moment is “are forward estimates too high.” Or said another way, “has the market appropriately discounted the rocky road ahead, and is this priced in.” The 4 companies to report this week all gave guides for 2023, and we can look at how those guides compare to current consensus estimates to see if estimates (so far) are too high. Here are the results:

• Confluent guided full year 1% below consensus

• Qualtrics guided full year 2% below consensus

• ServiceNow guided in line with consensus

• AppFolio guided 1% above consensus

As you can see, everyone to report this week basically said “forward estimates are about right, we don’t expect things to get worse than current expectations / what’s priced in.” On Thursday, we saw the market lift. Whether companies are being too optimistic is another question, but right now what they’re telling us is forward estimates are about right, and don’t need to come down (this would be bullish for the market as it would remove the doomsday / big slowdown scenario). The caveat here is this is only 4 data points so it’s a small sample size, and there’s of course the possibility that these 4 companies are being too optimistic. We’ll get a lot more data points in the coming weeks on how other companies guide for 2023.

Quarterly Reports Summary

Top 10 EV / NTM Revenue Multiples

Top 10 Weekly Share Price Movement

**SumoLogic is rumored to be in acquisition talks with a PE buyer, this sent their stock up this week

Update on Multiples

SaaS businesses are generally valued on a multiple of their revenue - in most cases the projected revenue for the next 12 months. Revenue multiples are a shorthand valuation framework. Given most software companies are not profitable, or not generating meaningful FCF, it’s the only metric to compare the entire industry against. Even a DCF is riddled with long term assumptions. The promise of SaaS is that growth in the early years leads to profits in the mature years. Multiples shown below are calculated by taking the Enterprise Value (market cap + debt - cash) / NTM revenue.

Overall Stats:

• Overall Median: 5.7x

• Top 5 Median: 12.0x

• 10Y: 3.5%

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: 10.6x

• Mid Growth Median: 6.1x

• Low Growth Median: 3.3x

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: 17%

• Median LTM growth rate: 29%

• Median Gross Margin: 74%

• Median Operating Margin (25%)

• Median FCF Margin: 0%

• Median Net Retention: 120%

• Median CAC Payback: 38 months

• Median S&M % Revenue: 48%

• Median R&D % Revenue: 28%

• Median G&A % Revenue: 20%

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.

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