Clouded Judgement 9.9.22

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

Software Fundamentals

So far, software seems to be holding up well given all the macro uncertainty. GitLab reported earnings this week and even sounded aggressive, saying they’re seeing no slowdown in sales cycles / win rates, and actually seeing buying cycles speed up. One fear was that Q2s were the calm before the storm and Q3 would be where we see weakness, but so far it’s looking like Q3s will look a lot like Q2s - Overall strong quarters, with weak guidance that errs more on the side of conservatism vs grounded in weakness showing up. Anecdotally it sounds like a lot of the deals that were pushed in Q2 have closed already in Q3. Given we’re more than 2/3 through Q3 for companies with September quarter ends, I’m expecting strong Q3s.

The longer term / 2023 outlook is more murky, but in the shorter term through year end I think we see more positive catalysts than negative ones. On top of Q3s probably being at a minimum “better than feared,” I think we get positive surprises on inflation (ie it comes in lower than expected). What happens to inflation in 2023 is more of an unknown (particularly the question of does inflation come down to a certain level, say 4%, and then get stick there), but again in the next 4 months through year end I’m guessing we’ll get incrementally positive signals.

On the fundamentals point, there is a risk I’m cherry picking the best companies to read into. There is a reality that the best of breed businesses are not seeing weakness (call this the upper quartile quality businesses), while the bottom 75% are seeing weakness. I think we’ll see some element of that, but even the lower quality companies are probably doing “better than feared.”

This leads me to my next point on valuation dispersion. Right now we’re seeing a lot more valuation dispersion than we have historically. The median software multiple is basically sitting right at the June lows (5.8x vs 5.6x in June), however the high growth median multiple is 60% higher than where it was in June (11.3x vs 7.1x)! One way to show this data in a chart is comparing where the top multiple companies are trading ralative to the median multiple at the time. The graph below shows (Top 5 Multiple Average) / (Median Multiple) -1. Said another way, it’s the percent the top 5 average multiple is over the median.

From 2015 to the start of 2019 this stayed pretty consistent at ~50%. This trend started to change in 2019 and was exacerbated during Covid. My general views is that the level of dispersion we had from 2015 - 2018 was way too low. Currently the market is differentiating more between what it perceives to be the best, most durable businesses, from the rest.

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: 5.8x

• Top 5 Median: 16.7x

• 10Y: 3.3%

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: 11.3x

• Mid Growth Median: 5.8x

• Low Growth Median: 3.9x

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: 21%

• Median LTM growth rate: 31%

• Median Gross Margin: 74%

• Median Operating Margin (25%)

• Median FCF Margin: 0%

• Median Net Retention: 120%

• Median CAC Payback: 33 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.

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.