Clouded Judgement 9.29.23 - Rates Keep Going Up

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

Rates Keep Going Up

Rates continue to push higher, as the aftershock of the Fed’s “Higher for Longer!!” messaging reverberates through the markets. Yesterday the 10Y hit 4.7% which was up from it’s high of ~4.5% last week. These are pretty big moves in rates in just one week. What’s been most surprising to me is how resilient software valuations have been in the face of pretty massive moves in rates. The current median multiple is ~5.7x. As a reminder - the average software multiple from 2010-2020 was ~7.8x, and the average 10Y over that same period was ~2.3%. Given those two data points alone I’d expect the median multiple today to be closer to 4x! Clearly the bond markets are saying something different than software valuations. The disconnect in rates and multiples is even more stark when we look at growth adjusted multiples (taking revenue multiples and dividing them by forward growth rates). The current median growth adjusted multiple is 0.39x which is actually greater than the long term average pre-covid of 0.28x (so 40% higher!). Pretty crazy to think about - growth adjusted multiples are near pre-covid all time highs (excluding 2020-2021 period) even though rates are as high as they’ve been since 2007 (and double what they were on average from 2010-2020).

So what’s going on? Seems like something has to give… Either software valuations need to fall to more appropriately price in the discount rate, or rates need to fall. The market is really putting on emphasis on the Fed’s commentary of higher for longer. And this is all predicated on their views that the economy is showing signs of resiliency, meaning GDP staying strong and inflation potentially staying sticky. This all rolls up to imply the the economy can sustain higher rates (because GDP growth not falling off a cliff), and will need higher rates given the sticky inflation. This week Neel Kashkari, president of the Federal Reserve Bank of Minneapolis, posted an essay in which he believes there’s a 60% change the economy has a soft landing. You can find the article here

The Fed is making some bold claims about a soft landing. This is also at a time when many others are claiming the lag effects of rate hikes are about to kick in and send the economy off a cliff (ie no soft landing). Should we believe the Fed? Let’s rewind the clock to summer of 2021 when money was free and times were good!

I used Google Bard to help me find some headlines about what Kashkari was saying back in the Summer of 2021. You can find the first link here

Well, we now have the benefit of hindsight, and all the Fed officials who were saying we wouldn’t see rate hikes until the end of 2023 have proven completely wrong… From the time of those headlines to today we saw some of the steepest rates hikes we’ve ever seen! We saw a complete 180 degree opposite scenario from what was being predicted in the summer of 2021.

The reason for all of this - the Fed reserve’s the right to change their mind / policy based on the data, but the problem is the data is lagging. Once something shows up in the data (inflation isn’t transitory, economy is slowing, etc), it’s usually too late to stop and we get big swings in policy.

So the big question we have to ask ourselves now - does the Fed have a better ability to forecast today than they have in the past? Do they have different sources of data? They don’t…So unfortunately while the data today might show the economy is super strong and resilient, that could change quickly. I do think the economy will start slowing next year, and just like they did in late 2021 / 2022, the Fed can very quickly change their course of action.

All of this to say - I’m not sure we can take the Fed quite as literally as the bond markets are today. However - there are other reasons rates may be pushing up. The government is going through quite a bit of quantitative tightening. In simplest terms, the government is selling bonds (ie raising cash) to fund operations and pay down interest expenses on the massive debt burden they have. As they do that it sucks liquidity out of the markets (liquidity comes out of markets / bank reserves and goes into the government accounts). When banks drain their reserves to buy these bonds it naturally pushes rates up (lower supply of cash to loan out means rates go up). I’ve talked about this in the past - this is the structural reason rates might stay higher. So we very well may see a scenario where the Fed starts to cut the Fed Funds Rate (due to inflation tipping over, the economy slowing, or both), but the 10Y stays constant.

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: 5.7x

• Top 5 Median: 13.7x

• 10Y: 4.6%

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: 11.6x

• Mid Growth Median: 8.2x

• Low Growth Median: 3.7x

EV / NTM Rev / NTM Growth

The below chart shows the EV / NTM revenue multiple divided by NTM consensus growth expectations. So a company trading at 20x NTM revenue that is projected to grow 100% would be trading at 0.2x. The goal of this graph is to show how relatively cheap / expensive each stock is relative to their growth expectations

EV / NTM FCF

The line chart shows the median of all companies with a FCF multiple >0x and <100x. I created this subset to show companies where FCF is a relevant valuation metric.

Companies with negative NTM FCF are not listed on the chart

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

How correlated is growth to valuation multiple?

Operating Metrics

• Median NTM growth rate: 15%

• Median LTM growth rate: 21%

• Median Gross Margin: 75%

• Median Operating Margin (17%)

• Median FCF Margin: 7%

• Median Net Retention: 114%

• Median CAC Payback: 35 months

• Median S&M % Revenue: 42%

• Median R&D % Revenue: 27%

• Median G&A % Revenue: 16%

Comps Output

Rule of 40 shows rev growth + FCF margin (both LTM and NTM for growth + margins). 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.

Sources used in this post include Bloomberg, Pitchbook and company filings

The information presented in this newsletter is the opinion of the author and does not necessarily reflect the view of any other person or entity, including Altimeter Capital Management, LP ("Altimeter").  The information provided is believed to be from reliable sources but no liability is accepted for any inaccuracies.  This is for information purposes and should not be construed as an investment recommendation.  Past performance is no guarantee of future performance.  Altimeter is an investment adviser registered with the U.S. Securities and Exchange Commission. Registration does not imply a certain level of skill or training. 

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