Clouded Judgement 6.24.22
Every week I’ll provide updates on the latest trends in cloud software companies. Follow along to stay up to date!
Free Cash Flow - How Much Does It Matter?
Over the last 6 months we’ve seen a huge shift in what the public markets value. We’ve gone from “growth at all costs” to “show me the FCF.” And more recently it’s become “show me the FCF without adding back SBC!” While I think this sentiment shift is very healthy, I think it’s important to take a step back and remember the evolution cloud / SaaS software has been on the last 10 years.
10 years ago the majority of the market doubted that SaaS businesses would ever get profitable. The promise of SaaS was that growth (and no profitability) in the early days of the S Curve would lead to profitability in the mature days (with much slower growth). Why? When companies are in growth (and hyper growth) mode, the majority of revenue comes from newly acquired customers. And it generally takes >12 months for businesses to pay back the costs to acquire those customers. After the acquisition costs have been paid back, every incremental dollar of SaaS revenue (really gross profit) can be viewed as an annuity of free cash flow (this is a gross oversimplification, but using it as an example). As companies move into a slower growth phase, the majority of customers have already paid back their acquisition costs and generate much higher FCF margins. This in turn lifts the overall business to FCF profitability.
This concept was met with heavy skepticism, but around around 2015 / 2016 we started to see proof points of SaaS businesses turning profitable. SaaS believers were vindicated! As a a result, the multiples of SaaS businesses more broadly re-rated higher. Why? Before these proof points people simply didn’t believe that profitability was coming ever. Because of this, the multiple investors were willing to pay for SaaS businesses in their unprofitable days was lower. As a path to profitability was laid out, that increased the multiple investors were willing to pay for software companies earlier in their lifecycle. Given all the doom and gloom out there I think it’s important to remember that this hasn’t changed! The typical path of software businesses is the same as it was 5 years ago - growth early leads to profitability later.
However - inevitably there will be software companies that don’t ever turn a profit. Or get disrupted before they can hit mature FCF margins. What happened over the last 18 months is the market got lazy. One collective assumption that was made (when growth was all that mattered) is that every software company will be able to turn a profit, and keep growth in the 20-30% range. Every revenue multiple has an underlying assumption about FCF in the future. An indiscriminate tide lifted all boats. In reality, the market should have been more discerning around which businesses would in fact be able to turn a profit. I do believe every SaaS business could become profitable if they wanted, the question is at what growth rate. Sure, any SaaS company could drastically reduce costs, and grow top line <5% with positive FCF. But that business deserves a very different multiple, and probably isn’t an attractive profile. There’s a much smaller number that can grow top line >20% with positive FCF.
While I believe we overreacted (positively) over the last 18 months to assume all SaaS was pristine and would generate real FCF margins at scale, I also think we’ve overreacted (negatively) recently by saying every business that doesn’t have FCF today never will. Remember, nothing has fundamentally changed about the path of software. Growth early leads to FCF later. There are plenty of businesses today who don’t have FCF now that will in the future. And we’re starting to see the market try and work this out. Which is good! We need more dispersion in the software world. Not all software is created equal. Software businesses that don’t have a short term path to FCF (call it <2 years) have gotten wacked in the public markets. But, just like pre-2015 when the market assumed software wouldn’t turn profitable, the same thing is happening now. With a longer term horizon we’ll see many software companies turn profitable. The important task is finding the businesses that can turn profitable, while maintaining attractive top line growth. That “holy grail” combo will be a smaller percentage of software businesses - ones growing >20-30%, with FCF margins >20-30%, with annual revenue >$1B.
Final thought - what gets me so excited currently is that we’re seeing companies still in hyper growth mode, at a scale of ~$1B ARR+, hit mature FCF margins. Crowdstrike (>60% growth, ~30% FCF margins), Datadog (>80% growth, ~30% FCF margins), Snowflake (>80% growth, ~20% FCF margins), ZScaler (>60% growth, ~20% FCF margins), and ZoomInfo (~60% growth and >30% FCF margins) all have incredibly impressive profiles.
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 Median: 6.5x
Top 5 Median: 16.5x
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: 6.8x
Low Growth Median: 3.8x
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
Median NTM growth rate: 24%
Median LTM growth rate: 32%
Median Gross Margin: 74%
Median Operating Margin (25%)
Median FCF Margin: 3%
Median Net Retention: 120%
Median CAC Payback: 34 months
Median S&M % Revenue: 46%
Median R&D % Revenue: 27%
Median G&A % Revenue: 20%
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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I have read this blog thread every week for months. You are doing an excellent service to the investment community in providing weekly commentary and making this information easily accessible. Thank you!
Another insightful issue. The only thing I'd add is that I saw the SBC wheeze before; back in 2001-03. Basically, when investors lose money in stocks, they don't like SBC. When they make money, they ignore SBC. And to make this whole issue even twistier, SBC really should be recalculated every quarter because the way the accounting works is that the realized value of the SBC is flat-lined back to the grant date. So if the stock tanks, SBC is lower, and the reverse holds true - the point there is it's a lot more nuanced than GAAP accounting would say. Finally, I really don't think investors would like to go back to the era of Mad Men when there was no equity ownership and pay revolved around high salaries and especially big perks like country clubs, cars, etc. The past wasn't as good as investors remember and there is a reason why you want employee and investor sentiment aligned.