Month: June 2020

Will We See Another Dot-Com Crash In Tech?

Posted on by io-fund

This article was originally published on Forbes on May 15, 2020,12:42am EDTForbes on May 15, 2020,12:42am EDT

Tech’s comeback since March has been nothing less than spectacular considering the backdrop of record unemployment and contracting GDP. According to a survey of fifty companies by FactSet, 60% had withdrawn guidance for the year. FactSet also estimates that the S&P 500’s earnings for 2020 have fallen 22% since the beginning of the year, while 2021 earnings have declined 13%.

Meanwhile, many tech stocks have reached all-time highs including one-day moves of up to 40% even when companies withdraw guidance. Twilio, for instance, rallied from $122 to $170 based on an 11% revenue surprise with total returns of 140% in the past two months. Twilio is hardly the exception with Teladoc up 115% and Fastly’s one-day move of 40% on May 7th.

Last month, Goldman Sachs analysts said in a financial note that the S&P 500 index concentration in the top tech companies—Facebook, Amazon, Apple, Microsoft, and Alphabet— was the greatest it has been in 20 years. Meanwhile, these mega-cap companies have reported mixed earnings results (Amazon) or pulled second quarter and full-year guidance (Facebook and Apple).

In a picture, this is what that looks like:

Tyler Durden, Zero Hedge from the article “"Poor Decisions" Galore As Newbie Millennial/Gen-X-ersPour Into Expensive Stock Market: https://www.zerohedge.com/personal-finance/poor-decisions-galore-newbie-millennialgen-x-ers-pour-expensive-stock-market

The saying “history does not repeat but it rhymes” has not yet applied to the dot-com bubble, when five years of euphoria burst into a 78% drop in prices over two years. Tech has largely gone unscathed as it has bumped oil from being the number one industry.

There is some solid support as to why this is not a tech bubble. Mainly, technology now runs nearly every industry. The second reason is that higher valuations are more sustainable today as the revenue growth from tech is much higher than other industries.

Tech Industry Growth has 40-80% growth with outliers up to 148%

TWITTER HTTPS://TWITTER.COM/SAXENA_PURU/STATUS/1256748503050539008

Versus other industries with 1-9% growth with outliers up to 17%

TWITTER HTTPS://TWITTER.COM/SAXENA_PURU/STATUS/1256748503050539008

In addition, cloud software and platforms also allow companies to scale proportionate to revenue growth. There is less overhead and this helps companies keep costs low as you can scale quickly in either direction.

Nearly a decade ago, Marc Andreessen famously said “software is eating the world” in an essay that spelled out how software was disrupting nearly every industry with “real, high-growth, high-margin, highly defensible businesses.” He questioned the low PE ratios of companies like Apple, which at the time was trading at 15 P/E. Notably, Andreessen’s essay came in close proximation to Facebook’s public offering, as well as Zynga, Groupon, Skype and many other exits for his firm’s portfolio.

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At the time, he pointed out that fast-growing companies like Facebook and Twitter were conjuring up memories of the dot-com bubble in 2011: “With scars from the heyday of Webvan and Pets.com still fresh in the investor psyche, people are asking, “Isn’t this just a dangerous new bubble?”

Perhaps just as dangerous as thinking any fast-growing tech company with a high valuation is not a bubble is the idea that any fast-growing tech company with a high valuation is a bubble. This is because the market has a way of doing what you least expect.

Pre-Pandemic, Silicon Valley Grew Quiet

If looking at the number of IPOs, we are not in a bubble as the years 2018-2019 saw less than half the number of IPOs during 1999-2000.

Beth.Technology

However, the value of IPO exits does look bubble-like. According to Pitchbook, the value of exits for venture-backed companies hit a record $256.4 billion in 2019. 82 venture-based IPOs accounted for 78% of the total value, or $198.7 billion – more than the previous four years combined (this was partly due to Uber and Lyft).

The exits were successful for venture capitalists as the $223 billion in post-money valuations came from $35 billion in venture investment, or a return of 637%. In turn, this means the public markets paid a significant premium.

Also, the years that followed the dot-com bust saw a serious leveling off. It is the absence of early stage deals in tech right now that is more concerning. Pre-pandemic, Silicon Valley was already noticeably quiet.

Forbes also recently reported on the slowdown in venture capital being ill-timed with the effects of the coronavirus forcing many startups to shut down. This followed a 16% drop in venture capital deals in Q4. The CEO of Starsky Robotics stated, “the downpour of investor interest became a drizzle.” As the article points out, the failure rates of 2020 could end up resembling 2001.

Recently, I published on the lack of venture funding in the Series A and Series B stage for tech companies. When combined with the data on initial public offerings from last year, we see a clear signal from venture capitalists that the exit window may be closing (or is already closed).

For instance, as reported by The Information, early-stage software deals in 2019 declined from 388 deals down to 279. In the seed stage, the number was below 200, or the lowest in six years. According to Inc.com and CB Insights, the estimate for Series A funding has dropped from one in three startups to one in six startups with an estimated 1,000 startups not receiving funding this year.

Meanwhile, the public market is flooded with high growth software companies that report over 40% growth due to an inverse law of small numbers. Basically, it’s easier to post rapid growth early-on but harder to sustain this growth.

Conclusion:

Many investors focus on valuations as the indication for a bubble. As pointed out, this can be misleading as hypergrowth companies are often outliers. In fact, the companies that challenge key metrics the most are often the ones that see the most upside. Amazon and Netflix are prime examples.

Valuations aside, there is a glut of high-growth software companies on the market that have not been tested by a less-than-ideal economy or slowing business cycle. This may not create a bubble, but it can create losses for both institutional and retail investors as the market attempts to guess the winners and is confronted by those that fizzle out.

The more that startups shut their doors, as well, the fewer cloud software customers there will be as the two ecosystems are closely intertwined. The recent pullback in March did not afford the opportunity to find the stable winners before hyper-speculation resumed.

Playing Defense With Cloud Software Stocks

Posted on by io-fund

This article was originally published on Forbes on May 27, 2020,06:47pm EDTForbes on May 27, 2020,06:47pm EDT

The main risk to cloud software during a less-than-ideal economy is downgrades and churn. Signing new customers can also be a challenge. How a company is faring will often show up in net retention rates. My guess is we will see some cloud software companies remove this metric from their Q2 earnings report or we will see previously strong net retention rates dip below the ideal thresh-hold of 100% to 106%. 

Net dollar retention rate is a key metric in software-as-a-service (SaaS) that has generated a lot of buzz over the past ten years or so. This is because it helps to predict cash efficiency for subscription-based models by calculating the inflows of revenue and upgrades minus the outflows of downgrades and churn. The benchmark that SaaS companies are shooting for is between 100%-106%. Exceptional companies report above 120%. Sammy Abdullah did a great write-up of this in Crunchbase. 

Key metrics like net dollar retention rate come from venture capital deals where the goal is to exit through the public markets or through an acquisition. This key metric is helpful to consider but it also fizzles out over time. Venture capitalists are less concerned with the long-term growth of a company as they have already exited by the time subscriptions see serious churn. 

Box is a great example for this as the company has been on the public market longer than most cloud software companies (although still a relatively short time of five years). Despite having an ideal net retention rate, the company’s revenue growth has declined. Box also had sales and marketing costs at 40-50% of revenue, which I’ll discuss in greater detail in my next article.

2U previously held the record for net retention at 144%. Revenue peaked at 44% year-over-growth in 2019 and now stands at 39.5% year-over-year growth. The stock price has correlated with this growth and the company is trading well beneath all-time highs of $98 with a current price of $35. 

Slack has a net retention rate of 143% and Zoom Video has a net retention rate of 140%. These two may be outliers this year as the work-from-home trend will help sustain both existing and new subscriptions. 

YCharts: Box Inc Revenue Annual YoY Growth

YCHARTS

Recently I published on whether we would see another dot-com crash considering the high valuations in tech despite a questionable economic backdrop. The main takeaway is that tech has many outliers in both revenue and earnings growth when compared to other industries. However, there is an imbalance in the number of cloud software companies on the market as venture capitalists have pushed for exits in recent years. 

The glut in supply will be tested by startup closures and the lack of venture funding in the Series A and Series B stage as the two ecosystems are closely intertwined. This imbalance across the board is more important than focusing on the valuation of any one company.

When I speak of the glut of inventory, I am referencing the three-fold increase in competitors from an average of 2.6 competitors per company five years ago to 9.7 competitors per company today. Companies with more than 250 employees use an average of 124 SaaS applications, while companies with up to 10 employees use an average of 26 SaaS applications.

Cloud software will be more resilient than many other categories. But there will be some cloud software companies that see an impact on one side of the equation or both sides of the equation – this means either fewer new customers new customers or more churn or downgrades in existing customers more churn or downgrades in existing customers or both.both. There are three points where weakness can occur. Notably, companies that have annual recurring revenue will be more protected.

What we know is that the economy is not as strong this year as it has been in previous years. Some will argue the market is not the economy (which is true), however, cloud software can’t stop the spiraling effects of lower IT/cloud spending and tighter budgets that follow a weaker economy. One area that companies might reduce costs is to trim down on the number of cloud software and tools they use. Unemployment could exacerbate this if the subscriptions are paid per employee.

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Lower net retention rates eventually happen to roughly half of the software companies that are on the market for three years but covid-19 may speed this up or cause churn in otherwise strong subscription models. 

Before the coronavirus, I championed cloud software at their low point in September of 2019. It seems like a distant memory now but Zoom, Twilio, Okta and MongoDB were down roughly 30% in a very short time span of one week over no major news or negative catalyst. My article’s subtitle stated, “Investors have dumped cloud stocks, which could prove to be a costly mistake” — this could not have been more accurate as cloud software led the rally off the March lows with some stocks up nearly 200% in one month. I was firm during the value rotation that these stocks would out-perform and I expanded on this as one of my top tech trends in 2020. 

Considering we are at all-time highs and many gains have been clocked, I think it’s the perfect time to identify the indicators that might help determine if a company will be resilient post-covid. This was very important when the market showed signs of indiscriminate selling and is also important now when we’ve seen indiscriminate buying. 

I consider this rally indiscriminate because many companies have withdrawn guidance. There is less information than usual to determine forward growth and valuations. Yet, we have seen massive upward moves based off very little information. With that said, many investors are feeling quite reassured right now as it’s been hard to not make stellar gains in cloud software no matter what company you picked.

I don't think the broad category of cloud software will end the year as strong as it began the year as the market will begin to see cracks in the three weak points mentioned. There will, of course, be many exceptions – this is commentary on the broader category of cloud software.

Conclusion:

Value investors like to focus on valuations as an indication for a bubble, especially since their objective is to find cheap companies. This works in some industries but it does not work in tech. This is because some of the most expensive tech companies are also the top performers with insatiable addressable markets.

Of course, what you want to avoid (at all costs) is a hypergrowth company that fails to report the expected growth rate. The market is a game of musical chairs, especially now that machines are driving the majority of the market. The only way to win at this game without having a team of Python software developers is to either be “early in and early out” or to be “early in and never get out.” 

Paul Tudor Jones is one of many money managers who believe having a great defense is more important than having a great offense. This means you should have a mindset of protecting your money rather than making money. In some cases, net retention rates will become accelerated this year. For those that don’t accelerate, I will be favoring a strong defense.

Next week, I’ll be publishing on why the advent (and now maturing field) of growth marketing may contribute to a few surprise failures across cloud software.

Please note: The I/O Fund conducts research and draws conclusions for the Fund’s positions. We then share that information with our readers. This is not a guarantee of a stock’s performance. Please consult your personal financial advisor before buying any stock in the companies mentioned in this analysis.