Clouded Judgement 3.17.23

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

What Happened at SVB?

I want to start by saying I’m no banking expert. Before last week I didn’t even know what the term “held to maturity” meant (more on that later). I’ve digested as much as I can, and tried to summarize what led to SVB’s collapse. Please spot out any errors in my description below as I’m still learning!

** I’ve updated the original post. I originally incorrectly commented that SVB sold securities from their HTM portfolio. They actually sold securities from their AFS portfolio which necessitated the announced capital raise

• Banks are in the business of managing risk. They take in customer money (deposits), pay out interest on those deposits, and then invest deposits in an attempt to get a higher yield than interest they pay out

• This is the borrow short lend long saying you may have heard of. Deposits, which can get pulled at any moment are short term, and money they invest tied up in long duration assets like mortgages are long term (short / long)

• In 2020 / 2021 - SVB received a TON of new deposits as companies, startups and SMBs raised more money and were flush with cash

• SVB then had a decision to make - how do we invest those deposits? At the time, the messaging from the Fed was rates were going to be kept low (through end of ‘23)

• SVB then invested heavily in long duration assets / securities (like mortgage-backed securities) in a HTM portfolio. This total was ~$90B

• These securities are held on their balance sheet as Held To Maturity (HTM). This means that SVB did not plan to sell these securities until they matured. If you buy a bond you get interest along the way and then get your principal back at the end of the bonds duration.

• And this part is key - because they are held as HTM the bank is not required to mark them to market. IF you hold a bond until it matures, you’ll get all of your principal back and won’t loose money. But along the way, the bond price can move above / below par as rates move

• Why does this matter? The implicit bet SVB was making was that rates were going to stay low, because if rates rose, the value of this portfolio would fall (even though they don’t have to mark-to-market. More on this in a moment, this was the big bet SVB made that ultimately caused their downfall

• So what happened? The Fed pivoted and started raising rates extremely quickly in 2022. At the same time, startups stopped raising money as funding markets dried up (while also burning money) so deposits stopped flowing in (and actually went out)

• As rates rose, the value of SVB’s HTM portfolio fell (bond prices inversely corelated with rates)

• HOWEVER - because they are HTM, SVB didn’t have to mark them to market. The tricky part - anyone could run the analysis and see the $90B of HTM portfolio is actually worth closer to $75B. That $15B “hole” was quite large

• This hole led to fears about the banks soundness / liquidity (whether warranted or unwarranted, there were fears)

• This fear led depositors (who were concentrated in startups) to pull some deposits. Before the craziness of last week, it was reported the bank had already seen meaningful withdrawals. They had just been happening slowly over the course of weeks / months

• SVB then had to sell some of their portfolio to meet the withdrawal demands (the sales came from the AFS, available for sale, portfolio of ~$21B. This locked in an after tax loss of $1.8B (**in the original version of this post I incorrectly wrote that SVB sold securities from their HTM portfolio at this step. I’ve updated to show that this sale came from their AFS portfolio)

• This loss then led to a capital hole. They announced a capital raise to shore up the balance sheet, but the stock started dropping

• Fears picked up that if they weren’t able to complete the capital raise the bank would have solvency issues

• This led to a mass movement of withdrawals. At a bank - when there’s smoke you don’t wait to see if there’s fire. Everyone pulled out their money at once ($42B in one day!) and the bank couldn’t meet these requests. This is when the FDIC stepped in and seized the bank.

Couple call outs - some blame the Fed for signaling they wouldn’t raise rates (and then immediately raising them). If the Fed did what they said they were going to do, SVB wouldn’t have run into any trouble. At the same time - SVB clearly deserves blame for not anticipating the potential for rates to go up (or by at least hedging their HTM portfolio with an interest rate hedge). The other knock on SVB was the timing of their capital raise announcement. The announcement DIDN’T reduce peoples stress (ie “they’ll be fine, they’re raising money). Instead it INCREASED peoples fears (“ie “what if they can’t raise it will they go under?!”)

Either way - SVB made a number of investments / managed risk in a way that proved catastrophic.

Quarterly Reports Summary

Top 10 EV / NTM Revenue Multiples

Top 10 Weekly Share Price Movement

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: 5.8x

• Top 5 Median: 11.3x

• 10Y: 3.6%

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: 8.3x

• Mid Growth Median: 6.5x

• 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: 16%

• Median LTM growth rate: 27%

• Median Gross Margin: 74%

• Median Operating Margin (22%)

• Median FCF Margin: 1%

• Median Net Retention: 116%

• Median CAC Payback: 30 months

• Median S&M % Revenue: 47%

• Median R&D % Revenue: 28%

• 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.