Clouded Judgement 5.20.22

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

Have We Hit The Bottom?

Right now I believe two things to be true: 1) We’ve overshot the “bottom” in cloud software. 2) That doesn’t mean we won’t still go lower, and lower before higher appears to be the most likely path forward. Here’s how I get to this:

Right now, everyone is risk off. As this tweet noted, cash holdings are the highest they’ve been since Sept 11, 2001. We’re dealing with inflation, QT, raising rates, a looming recession and many other factors. Making sense of it all is nearly impossible, but the important point is that the upper bound of what’s possible (to the downside) is incredibly negative. The worst case scenario (which isn’t some crazy six sigma event but something definitely in the realm of possibilities) is very much on the table. What could this look like? Rates >5%, inflation stays high with Fed unable to control, stagflation and a global recession where EPS forecasts are slashed. If this scenario plays out, we most likely have a lot of room left to fall still. And because this is still possible, no one wants to wade into long duration assets. Even on up days (these bear market rallies) trading volumes are low. There’s no substance to the rallies. And when the market falls, there’s never an incremental buyer. The market is waiting for a clearing event that brings down the upper bound or what’s possible.

At the same time, people are hurting. Funds are down big. Individuals have seen wealth wiped out. Making a bet now followed by another 10-20% leg down could put funds at risk of blowing up, or individuals even deeper into margin calls. Even if many companies look attractive on 2 year time horizons it doesn’t matter if you can’t survive the next 6-12 months to see the upside 24 months out. People are in survival mode. And in survival mode you don’t take risks. The only event path I see towards a rally upwards is either a Ukraine resolution (doesn’t seem likely), or Powell coming out dovish and making a comment that he sees “balanced risk to growth and rates.” This would imply the actions the Fed has taken sufficiently curbed inflation, and further aggressive hikes risk pose a real risk towards significant economic contraction (and thus a deep recession). Powel has guided to 2-3% rates by end of year. But the market just doesn’t believe that. In the best case scenario I don’t think Powel “removes the upper bound” for at least another 1-2 months. In the interim, it’s hard to see any rally being anything other than a bear market rally.

And as far as I can tell, Powell wants to push a Volcker-esque persona (not action plan necessarily, but persona). He wants the market to believe he’s in control and will stay firm

Personally, I think we’re seeing quite a bit of demand destruction, and the Fed’s actions are having the desired effects. At the same time inflation is starting to fall. When Powell guides to 2-3% rates by end of the year, I believe him that this scenario is the most likely outcome and the Fed won’t have to go above this. With this in mind, software valuations are probably too low. What we’re seeing in the market (valuations) is more consistent with a 10Y in the 4-5% range (as of this writing it’s 2.9%). The implicit assumption I’m making here is that business fundamentals for software won’t be as adversely affected in a recession as feared. Yes, multiples look low today (even on FCF in some instances!) if you assume growth will hold. However, if growth decays, multiples should as well. Maybe further than where we are today. Just another variable to wade through. And it’s naïve to think software won’t be affected in any capacity in a recession. It will! Everyone will tighten their belts. Most likely net new customer adds will slow. The hard part to predict is who will be affected proportionally less, and by how much. I’ll dig into this topic next week with my views on how software will preform in a recession.

Quarterly Reports Summary

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: 6.6x

• Top 5 Median: 16.8x

• 3 Month Trailing Average: 8.5x

• 1 Year Trailing Average: 12.9x

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: 8.1x

• Mid Growth Median: 6.6x

• Low Growth Median: 3.4x

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: 25%

• Median LTM growth rate: 32%

• Median Gross Margin: 74%

• Median Operating Margin (24%)

• Median FCF Margin: 3%

• Median Net Retention: 120%

• Median CAC Payback: 26 months

• Median S&M % Revenue: 46%

• Median R&D % Revenue: 27%

• 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.

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.