In January of 2020, we wrote an in-depth analysis on Elastic (ESTC), which you can access here. We recommend that you read this report to get a full understanding of Elastic’s product positioning within the cloud and data security sectors. Recently, it started showing up on our screens from all angles. We will likely begin initiating a position soon, and build in layers until we see a major breakout.
In this quick blog, we present some of the recent changes that ESTC made to their positioning within cloud. We also address some of the concerns regarding their competition with AWS. We believe these changes will be a boon to their future growth, and want you to get a better idea why we are focusing on ESTC from a fundamental perspective.
Fundamental Overview:
Early in 2021, Elastic modified its open-source license so that it is no longer free for use if it is being repackaged and sold as a SaaS product. This was done to address cloud vendors’ repackaging of Elastic’s opensource code and selling it themselves. Elastic clarified that the vast majority of users will not be impacted, rather “the folks who take our products and sell them directly as a service will be impacted, such as the Amazon Elasticsearch Service.”
AWS responded to this news by stating that it will maintain its open-source fork of Elastic search. Specifically, AWS stated “In order to ensure open source versions of both packages remain available and well supported, including in our own offerings, we are announcing today that AWS will step up to create and maintain a ALv2-licensed fork of open source Elasticsearch and Kibana.” ESTC’s stock sold off in January, possibly in-light of the news that tech giant AWS was going to maintain Elastic’s open source code, which would pressure Elastic’s ability to charge for its software going forward.
However, we believe that Elastic will be able to overcome this AWS threat. This is because cloud customers often want an independent third-party monitoring their cloud stack. Elastic should be able to continue to grow even if AWS maintains a fork of its open-source code. Since Elastic is already embedded in many different organizations and has a large and diverse developer community, we believe that AWS’s open-source fork will not replace Elastic’s open-core platform. We also suspect that the market is wising up to this, as the stock price has recovered most of its losses since the January sell-off.
Being open-source has driven the adoption of Elastic, since being free-to-use increases the size of the ‘cake’ (opportunity). Elastic can get a slice of the cake by charging for certain features. However, cloud vendors such as AWS have been reselling Elastic’s open-source software, so Elastic understandably wants some of that revenue. By changing its license structure, Elastic gets a smaller cake but a bigger slice. The market is still unsure if this is a good path to take, and we will soon find out with Elastic’s results in the coming quarters.
Elastic’s Financials and Outlook
Despite the uncertainty, we have comfort in the quality of Elastic’s recent results and the reasonableness of its forward estimates. For example, Elastic reported high quality revenue in the last quarter (Q4 FY2021). Q4 sales increased 44% YOY to $178 million, while deferred revenue increased 45% YOY to $353 million. Deferred revenue represents cash received upfront, which provides balance sheet support for future sales. Deferred revenue was 199% of three-month sales in Q4, a four-year seasonal high. This is a good trend to see as it means there is relatively more demand for Elastic’s products than in prior years, a sign of strength.
We also see that cash collected from customers also increased in FY2021. We measure cash collections from customers by looking at the YOY changes in accounts receivables and deferred revenue and adding the net change to annual sales. In the below chart, you can clearly see that Elastic has been steadily increasing its cash collections. This is a favorable trend, as it shows that Elastic is not extending payment terms and/or requiring less upfront cash to drive sales. This also validates that there is sustained demand for Elastic’s products. By scaling cash collections from customers to 12M sales, the metric increased to 118%, the highest value since Elastic went public. Stated differently, Elastic is receiving more cash from sales than in any period in its history, another sign of strength. This trend also helped Elastic report positive cashflows in FY2021.
Looking forward, Elastic will report AH on 08/25. The Street expects Q1 FY2023 sales to increase 46% YOY to $189 million, an acceleration from the most recent topline growth rate of 44%. We believe that Elastic will be able to meet its estimates since it has amble support from its balance sheet. As mentioned, deferred revenue increased 45% YOY in the most recent quarter, and was 187% of forward three-month sales. In the last four years, Elastic’s Q4 deferred revenue balance has been ~180% of forward sales. Given the relatively higher levels of deferred revenue, we believe that an expectation for accelerating topline growth is reasonable.
Following the Q1 FY2022 print that will be released soon, we will want to see that Elastic is still growing despite the AWS fork. We believe that Elastic will be able to overcome this temporary threat, and that the narrative around the stock may soon change, which could lead to a large move in the stock price.
As posted on the forum here on Saturday, I/O Fund has plans to initiate a position in Riot Blockchain. Below is a quick summary.
Despite Bitcoin miners’ troubled past with China throughout the years, China’s Central Bank is getting serious about its intent to shutdown cryptocurrencies in the country. In May, China banned financial institutions and payment companies from crypto-related services. In June, there were mass arrests in China of people suspected of using crypto in so-called illegal ways. In July, the Weibo, the Twitter of China, shutdown crypto-related accounts. There are many theories as to why China is moving quickly to shutdown Bitcoin mining, including to meet its climate goals. The more likely reason is to launch a digital Yuan stable coin
The result from these measures is that half the crypto mining world went offline in July. Notably, we are seeing a recovery in terms of TH/s.
Riot Blockchain is a company that offers an interesting hedge with Chinese tensions as the company facilitates bringing Bitcoin mining to the United States. During the crypto boom of 2018, China supplied 74% of the world’s bitcoin production. The crackdown creates a new market for locations like Texas, the only state in the continental United States that owns their own power grid.
In April, Riot signed an agreement to buy Whinstone’s Texas operations, the largest mining organization in North America, for $80 million in cash and 11.8 million shares of Riot stock for a total value of $651 million. The high-performance mining facility is based in Rockdale, Texas, with up to 750-megawatt of capacity after expansion in 2022. In the same month, Riot agreed to buy 42,000 mining machines from Bitmain Technologies, increasing Riot’s mining hash rate by 97%. From December 2019 to December 2020, Riot increased its hash rate by 461%.
RIOT Financials
By Bradley Cipriano
RIOT has yet to report Q2 results (it filed a late filing notice) so our financial analysis is based on Q1 figures which were released in May 2021. Q1 sales increased 872% YoY to $23 million, which missed topline estimates by 5% ($1 million). Gross margin increased 2,650 bps YOY to 68%, which was also above the prior quarter (Q4 2020) gross margin of 60%. Further down the income statement, Q1 EPS was positive at $0.09, but came in well below estimates of $0.20/share.
We are not too concerned with RIOT’s Q1 top and bottom-line misses because the firm is investing heavily right now for an anticipated acceleration in growth in the future. This is happening at an opportune time, as China recently banned bitcoin mining. This is a favorable trend for Riot, as bitcoin’s network hash rate has decreased in recent months, meaning it is relatively easier for RIOT to mine bitcoins. As a quick overview, if RIOT’s hash rate increases as a percentage of bitcoin’s total network hash rate, then RIOT will earn relatively more bitcoins going forward. This will also increase sales and earnings going forward.
Looking forward, analysts are expecting an acceleration in Riot’s sales. This is likely due to two main trends: 1) result of bitcoin’s decreased network hash rate and 2) Riot’s investments in capex. We believe that the robust forward growth rate is more of a function of capex (more bitcoin miners), as Riot has invested heavily in new bitcoin miners in recent months.
Riot is forecasting a material increase in its hash rate going forward. This is because Riot acquired Whinstone in May 2021. Whinstone is a 100-acre site in Rockdale Texas with 190k sq ft. of bitcoin mining hosting space, with another 60k sq ft of hosting space being built right now. This acquisition followed large investments in new bitcoin miners, and Riot will need a place to host them. Importantly, the scale of the new facility also significantly lowers Riot’s costs of electricity. Riot disclosed that its expected costs per kWh will be ~$0.025, which is nearly half of MARA’s costs of $0.045 per kWh at its new facility. This should be a significant advantage in the long run as Riot can operate more efficiently than its peers.
A risk going forward is that Bitcoin’s network hash rate increases going forward. Luckily, Riot invested early in new bitcoin miners and will start receiving the new equipment before the competition. This will allow Riot to reap the benefits of a subdued network hash rate before the competition. RIOT has spent $100 million in capex in the last twelve months, mostly on new mining equipment. Since manufacturers (i.e. Bitmain) require down payments ahead of deliveries, RIOT’s $100 million of capex (which are mostly prepayments on btc miners) will allow the company to receive its equipment faster than the competition.
As of Q1, Riot had 13,750 BTC miners deployed, but this number is expected to 4x by Q4 2022. For example, RIOT has the following outstanding purchase orders for new bitcoin miners:
· 25,400 btc miners (s19) to be delivered in monthly batches between Q1 2021 and October 2021
· 43,500 btc miners (s19) to be delivered in monthly batches between November 2021 and October 2022
This delivery schedule appears favorable to the competition, as MARA has purchase orders for 30,000 machines to be delivered in January 2022 through June 2022. Since bitcoin’s network hash rate is currently subdued due to the purge in Chinese miners, being first to market with new machines will be a significant advantage. This is because RIOT will be able to earn relatively more bitcoins with its new machines since the network hash rate will likely be lower in 2021 than in 2022. It should be noted, however, that MARA has order s19pro bitcoin miners. The pro version of s19 has a higher hash rate but is more expensive.
Given the scheduled deliveries of new bitcoin miners, we estimate that RIOT will have ~24,000 BTC miners deployed as of Q2. This is above the competition, as MARA had 20,000 miners deployed as of Q2. RIOT will also start receiving its next batch of orders in November 2021, or three-months before MARA starts receiving its orders. Furthermore, Riot is getting to market sooner, which we believe is a significant advantage given Bitcoin’s relatively low network hash rate.
Concerns:
While we believe that Riot is positioned well to benefit from bitcoin’s subdued hash rate, the company is not without issues. As mentioned above, RIOT has yet to report Q2 results and had to issue a late filling notice (NT10Q) as a result. The firm also reported a material weakness in its internal controls in its most 10K, which stated that the company had improper controls and a lack of segregation of duties. There has also been some management reshuffling recently, as the old CEO is now the CFO and the new CEO (as of February 2021) is just 35 years old. There is also a new COO as of April 2021. Generally, a late filing, a material weakness and management turnover can be signals that a company has low quality accounting.
We also note that RIOT is a significantly capital-intensive business, meaning that it needs to spend money on capex in order to grow sales. The company is also at the mercy of Bitmain, the Chinese bitcoin mining designer & manufacturer juggernaut. Given Bitmain’s market dominance, buyers of its miners must pay well in advance and received orders in batches. This places miners such as Riot at a disadvantage as they must pay upfront and wait months to receive their equipment, which negatively impacts ROI.
However, we do not believe that these concerns are significant at the moment. Riot made a material acquisition in Q1 which helps explain why it needs more time to file its Q2 results. The firm’s material weakness and management reshuffling are issues to watch going forward, but do not appear to be headwinds to future growth. While Riot is capital intensive, so are its competitors. This also provides a “moat” as it takes significant investments and time to build out industrial grade mining facilities.
Conclusion:
Riot is well positioned to benefit from two market trends: an increased bitcoin price and a decreased network hash rate. Riot had invested early in ordering new bitcoin miners and the company will be rewarded as it will receive the orders earlier than the competition. Given bitcoin’s subdued network hash rate, Riot will be able to mine more bitcoins as its hash rate grows faster than the competition. Riot’s costs of electricity is also half of MARA’s, which should helps further support Riot’s premium position over the competition. If Riot can continue to scale and report lower unit costs, it will likely outperform in the future.
Inflation has continued to concern investors into the month of August, causing many growth stocks to give back any footing they gained in the prior month. Since the February top in tech growth, only select names in the cloud and semiconductor space, as well as big tech, are at new highs, while many high fliers from last year are still building a base. We believe the future for tech is bright, but the sentiment towards these names right now is met with caution as the market digests the potential for real inflation that may not be transitory.
In our last update, we stated that “if we monitor the price relations with intermarket analysis, the market is telling us that inflation fears are likely overblown, even if the trend in inflation continues.” With the inflationary trend accelerating into August, coupled with the Overnight Reverse Repurchase Agreements (reverse repos) exceeding an unprecedented $1 Trillion dollars, it appears that the FED is ready to begin hiking rates sooner than expected.
Just like last month, the market continues to tell us is that inflation fears, as it relates to the continuation of the bull market, are likely still overblown. Most importantly, if we look at history, some of the best market gains in a bull market occur in the final innings. We believe this market still has a lot of room to run, and view any coming pullback as a buying opportunity.
Inflation and Reverse Repo
With the CPI up 5.37% YoY, compared with an average growth rate around 3.4%, the case for inflation is strong. Some would argue that this YoY number is coming from an unusually low water mark due to a global shutdown of the economy, and thus inflating the YoY growth rate. I believe this to be true, to an extent, especially as complex supply chains start to ramp up to meet demand.
However, if we look at the CPI over a 3 month period, which is coming from a high water mark of a newly re-opened economy, then the CPI is suggesting an 8.1% annualized growth rate. This simply cannot be explained by anything other than a build-up of inflation in the economy.
Further concern can be found in the recent and historic growth in the M2 money supply, which is the metric that most economists believe leads to inflation. To better understand M2, it’s important to understand this layer of the money supply in relationship to the FED’s famous Quantitative Easing program (QE), which was started as a response to the Great Financial Crisis in 2008.
Quantitative Easing, in its most simple form, is the FED buying mortgage back securities and treasuries from authorized banks in an attempt to put more liquidity into the economy. It would seem that this is inflationary by nature, yet this is simply not the case.
What many fail to realize is that the FED takes real assets in the form of Treasuries and Mortgage Backed Securities from the economy, and in exchange, banks do not receive cash, rather an increase to their reserve that can be loaned out. So, in order for these reserves to become inflationary, they would need to be loaned out by these banks. If the banks are not loaning out these reserves in an equal ratio that they are selling the securities to the FED, it ultimately has a deflationary effect on the economy – this is due to less securities in rotation, without the cash to replace them.
The FED can create excess reserves for banks to loan out, but they can’t force them to make loans, nor can they direct people on how to spend any cash they receive from loans. This is where the M2 money supply comes into place. M2 is simply not controlled by the FED, and it refers to the part of the money supply that includes highly liquid assets, like bank deposits, money market securities and bank deposits, etc. This is real money in the economy that can be taken out by people to purchase goods and services.
Here’s a quick visual to better understand this concept.
As more and more reserves were being put into the banking system (orange), the actual money that was filtering out into the economy (purple), was staying steady. That is, until February of 2020.
Since February of 2020, we have seen a greater than 30% increase in the M2. This is a clear increase in the level of the money supply that historically affects inflation. Coupled with the immediate shut down of intricate supply chains from the global COVID response, governments around the world have created an extreme case of more money chasing fewer goods. Even if supply chains come back to meet demand, the level of fiscal and monetary response will likely remain.
Further complications are found with the velocity of the M2 money supply. In other words, how fast is this new excess moving through the economy in the form of purchasing goods/services? This metric tells a different story. The speed of money moving through the economy is continuing its historic deflationary decline, even with the M2 money supply reaching its own historic increase.
Some have argued that this phenomenon would counteract the increase in M2. However, what appears to be happening instead is that we are seeing an unusual glut in the banking system that can’t be ignored. The result of these two facts – the increase in the money supply coupled with a decrease in the velocity of money – is that the excess of money being in the economy appears to be in the form of deposits into financial institutions. When you factor in that banks have a limit to the amount of money they can legally hold, it creates an oversupply in the system, which is ultimately what is going on with the reverse repo anomalies.
In short, a reverse repo is an agreement to purchase securities from an authorized institution in order to sell them back at a slightly higher price. Reverse repos (and repos) are used for short-term borrowing and lending, often overnight so that institutions can meet deposits and reserve requirements.
When you realize that these large institutions need to buy and sell overnight funds in order to meet deposits, as well as reserve requirements and reserve limits, it starts to make more sense. If more and more of these institutions have reached their limit on the reserves that they can take in, then less institutions can bid on the offerings, thus causing the issues we are now seeing.
These types of anomalies signal that there is too much liquidity in the system. This typically signals to the FED that they’ve reached their limit on the effectiveness of loose money effectiveness. What usually follows is a campaign to raise rates in order to tighten liquidity in the system.
In our last article, we discussed this chain of events and why it spooks investors. In short, inflation leads to bonds getting sold off in anticipation of the FED raising rates, thus pushing up rates and the cost to borrow. This eventually causes a top in equities, as the business cycle resets through a recession. This is why inflation is so important – it is the first indication that the party is coming to an end.
Regardless of where one stands on inflation, it’s important to acknowledge that the FED recognizes it. They do everything in their power to not surprise the market, and if you pay attention, they tend to signal their intentions well in advance. Recently a handful of historically dovish FED chairs have expressed their opinion that a rate hike needs to occur as early as September.
All signals are pointing to an imminent rate hike sooner than expected. Inflation is continuing its advance, the reverse repo rate is out of hand, and the FED has no choice but the tighten sooner than expected. So, is this the end of the bull market? As stated in our last report, “Even if inflation is likely not transitory, and here to stay, the markets are still telling us that the time to worry may not be right now.”
Yield Curve
Historically, a rare phenomenon that precedes a recession is an inverted yield curve. Investors are expected to be compensated for taking on more risk. When this gets reversed, and a 10 year bond is yielding less than a 2 year bond, this is what’s known as an inverted yield curve.
There are many reasons why this phenomenon might happen, the short answer is that investors have lost faith in the economy and pile into the perceived safety of longer dated bonds. It’s thus believed that the market will be in a recession in the intermediate future, so two-year bonds will likely come due in an environment with rates much lower than they are at the moment. Thus, we see a continued buying of longer duration bonds and the selling of shorter duration bonds.
An inverted yield curve has preceded every recession since 1956, including the 2020 recession. So, why wouldn’t investors just exit the market once this phenomenon happens? There are two primary reasons why:
Once the yield curve inverts the economy falls into a recession, on average, within 24 months. Considering the stock market looks 6-9 months out, we can expect a peak in the stock market about every 1-1.3 months after the yield curve inverts.
History tells us that some of the best gains in bull markets tend to happen in the final push.
The above graph shows not only how long a bull market can continue from the moment of the yield curve inversion, but also the level of gains that typically happen in the final innings of the bull market.
So where is the yield curve today? The spread between the 10 year yield and 2 year yield is just over +1%.
In other words, the yield curve is not inverted, and still showing a healthy slope. Short of a black swan event, the fact that we are not inverted yet suggests that the clock hasn’t started yet for the end of this bull market.
Intermarket Analysis
On February 16th, the high growth market topped, as rates and copper broke through important resistance levels. This signaled inflation was here; however, the extent of which was not fully known. Markets tend to sell first and ask questions later, thus we saw overreactions across the board in rising commodity prices and selloffs in growth stocks and bonds.
Since then, we have a clearer understanding of the extent of inflation we are facing, coupled with the FED announcing that they will likely increase rates sooner than expected. As a result, we are not seeing any trends that suggest the market is overly concerned at the moment.
As the above chart shows, in light of this information, the bond market is continuing to catch a bid, as the 10-year yield is on the doorstep of breaking back below the price level that we saw before the February 16th reaction to inflation. Copper, along with most commodities, is making a lower low from its May 11th top, and is now threatening to test the support that signaled the February 16th breakout due to inflation fears.
Just as intriguing, these trends are continuing despite the various FED chairs’ comments about tightening sooner rather than later. These officials have a history for being dovish, so it is likely that their remarks will filter into policy. The fact that the market is not reacting to the Fed and the inevitable rate hikes means either the market is calling their bluff (and thinks a rate hike will not occur), or the market may not care about a small rate hike in the near future.
NASDAQ100 Levels to Monitor
If we look at the NASDAQ100, one of our key benchmarks, we can see that price is in a classic coiling pattern just below the 15150 level. The pattern appears to be what’s known as an ascending triangle, which is marked in blue. This type of pattern typically resolves to the upside. However, Tuesday we saw a close below any low since the pattern started to form. This means that the immediate breakout scenario we were tracking has failed for now.
It’s my belief that the market is marching towards a large degree correction within a much larger uptrend. Whether that large degree correction has started or not will depend on what supports hold. Below is a visual of what I generally believe is playing out.
As long as NDX can hold the 14460 region, the blue path is my primary expectation. Below 14780 would shift the odds, and also be a warning sign. But, the key support that I am watching is if we break below the 14460 region. If this happens, then I’m expecting a large degree correction to play out, which should take us below the 13300 level at a minimum. If we can hold the above levels, then breakout above 15150, then we can see a push towards 16,000 NDX, at a minimum, before this larger degree correction plays out.
Regardless, what general scenario plays out, we view this coming correction as a necessary part of a much larger uptrend. Rising inflation data coupled with the realization that the FED will be raising rates sooner than expected. More times than not, this causes a larger degree correction than we’ve seen in quite a while, which I believe will likely happen within the next 30 days, if not already.
History tells us that the time to worry is when the bond market starts to worry. Once the yield curve inverts, we are officially on the clock, and plan to shift our strategy towards a long portfolio with tighter risk controls. We believe this market has much farther to run, but a much needed correction will need to reset sentiment for this to happen.
Last May, we covered Datadog’s Q1 earnings report and indicated we would do a deep dive on the company soon. The simplified thesis as we rounded the corner into tough Q2 covid comps, was that the company allows us exposure to the market that AWS, Azure and Google Cloud participate in but with a pureplay. We specifically stated, “If the tech giants are communicating that cloud infrastructure-as-a-service is one of the most critical markets in the future, then who are we to argue with this by not investing in the leader across cloud monitoring products?”
In that write-up, we quoted the CEO on why the company had been so resilient up to Q1. With Q2, the company has further shown its resilience.
I’ll quote what we had written as it’s straight forward and gets to the heart of why they can compete with even an open-source competitor not on the market’s radar:
What matters is to solve the end-to-end problem for our customers. And to make it as easy as possible for them to just plug us in and everything just work everything to show that we don’t get our mess, a gigantic mess with all these different technologies and applications and clouds, everything else. We turn that into something that the understanding is well ordered, without any effort.” -Datadog Olivier Pomel on Q1 earnings callon Q1 earnings call
At the time, we thought Datadog was capable of coming in above guidance, which did occur in Q2. The company came in quite strong at 67% year-over-year growth to $234 million, an acceleration from the 51%, 56% and 61% YOY growth rates in the previous three quarters.
Our original thesis from January of 2020 pointed out that we thought Datadog would do well on hybrid cloud when we said, “Datadog serves hybrid cloud customers and allows for monitoring of both environments. New Relic, on other hand, is SaaS-only (or cloud only). From my perspective, the most growth will come from hybrid over the next few years as the majority of companies today have resisted sending data to another company’s servers and must eventually choose a solution to remain competitive on AI and ML. In my opinion, the future growth of hybrid is an important catalyst and market opportunity for Datadog. You can read more about Datadog’s hybrid offering here. ”hybrid offering here. ”
About nine months later, Datadog announced an integration partnership with Azure, the leader on hybrid cloud environments.
We are especially bullish on the Sqreen acquisition as this helps Datadog take advantage of the trend towards microservices and Kubernetes rather than monolithic architectures. I’ve covered Kubernetes in an editorial here when I discussed Google Cloud, Azure and AWS. Generally speaking, Kubernetes can introduce vulnerable clusters due to default configurations. In the past, the demonstrations at BlackHat, the annual security conference held in Las Vegas, have exploited features in Kubernetes default attack surface rather than bugs. Sqreen specializes in protecting code-level risks across distributed applications by protecting application logic. Sqreen’s main goal is to deliver security solutions to developers and the operations teams, as well, i.e., to “democratize” and emphasize security testing and implementation during the development process, often called DevSecOps. These are the two main points on this acquisition – more market share across security for microservices and more stakeholders at a company who can buy and deploy Datadog products outside of the security team.
We think it’s fairly clear that Datadog’s product is quite strong and able to out-perform competitors. Therefore, we think it’s prudent to focus more on valuation and look for clues as to how the company will perform under the pressure of being one of the more richly valued tech stocks.
As most of you know, we’ve added a CPA to the team. We think a strong financial analyst compliments my analysis on tech products and Knox’s technical analysis and portfolio management quite nicely. Below, Bradley goes through the financials on Datadog and why the company may be able to live up to its valuation.
Please welcome Bradley Cipriano to the team. He will be our team member who dots the i's and crosses the t's on financial reports and who is incredibly detailed with a sharp eye for numbers. We couldn't be more excited to have his specific skillset join the analysts on the site as we feel confident we will see an immediate impact from having a detailed CPA on the team.
We think growth-hope investing is rampant. I would define this as "the growth is there, let's hope the stock goes waaaay up!" We want to do the opposite at the I/O Fund. We say "the growth is there, now let's reduce risk with product analysis (Beth), technical analysis (Knox) and financial analysis (Bradley) to find the one gem out of a list of ten or twenty.
Bradley will help us sort through quality candidates to help us improve our batting average. He is specifically trained to find issues that nobody else sees — and vice versa, to identify opportunities that check out after rigorous financial analysis. Please welcome him on the forum, where he will be spending time daily and weekly, plus keep an eye out for his thoughtful analysis via blog updates.
Here's his bio:
Bradley previously worked as a forensic equity analyst at Gradient Analytics, where he focused on assessing the quality of revenue and earnings for both domestic and internationally listed stocks for institutional asset managers. Bradley has been able to utilize his strong accounting background to identify issues and concerns that the Street may be overlooking, such as low-quality earnings beats and unsustainable revenue growth. He received his BS degree in accountancy from the W.A. Franke College of Business at Northern Arizona University. Bradley is a licensed CPA in the state of Arizona and is also pursuing the CFA charter.
Datadog Deep Dive on Financials and Valuation
By Bradley Cipriano
Datadog reported Q2 results on August 5th and beat the consensus top and bottom-line estimates while forward guidance for Q3 came in ahead of expectations. The stock is up 15% after the Q2 print and is also up 34% YTD, outperforming the Nasdaq’s 13% YTD gain.
At $133/share, Datadog trades at a premium of 43x forward P/S multiple by the market, well above its peers in the cloud monitoring market (shown below). In the discussion that follows, we outline Datadog’s unique opportunity and strong financial performance, which we believe supports Datadog’s premium valuation.
Table 1. Datadog’s Multiple Relative to the Peer Median
While a 43x Fwd P/S multiple appears high at first, Datadog is uniquely positioned to continue to benefit from corporations transitioning to the cloud.
Gartner estimates that spending on public cloud services will reach $661 billion by 2025, more than doubling from the ~$270 billion spent in 2020. Of this, approximately $34 billion will go to infrastructure monitoring by 2024. More specifically, the post-Covid estimates for application performance monitoring market is $12 billion by 2026. Datadog participates in other markets, such as network performance monitoring, as well.
You can read more about our stance on cloud here in the H1 2021 update. On key takeaway from the February report is this: “Gartner’s survey indicates that there is still quite a bit of growth ahead despite the harder comps the cloud software leaders face in 2021. The data shows that 70% of organizations using cloud services plan to increase their spending, stating “the proportion of IT spending that is being allocated to cloud will accelerate even further in the aftermath of the COVID-19 crisis.” plan to increase their spending, stating “the proportion of IT spending that is being allocated to cloud will accelerate even further in the aftermath of the COVID-19 crisis.”
Datadog is more insulated in terms of competition as the company is able to benefit from the growth of Amazon’s AWS, Microsoft’s Azure and Google Cloud. This is because cloud customers prefer an independent software provider monitoring their cloud environments rather than use the cloud IaaS provider for the monitoring of applications. Imagine if a customer of Amazon’s AWS had an issue that she thought was due to AWS, but Amazon was saying the issue was on her end. Having an independent third-party helps resolve this potential conflict of interest and also allows the customer to pursue best of breed products across a multi-cloud environment.
While Datadog compliments the bigger players in cloud IaaS, the company faces competition from its peers. However, Datadog has led the competition, evident by its robust growth rate. As pictured below, Datadog has reported the strongest topline growth rate amongst its peers and its outlook for three-month and next twelve-month (NTM) sales growth is also the most robust in its peer set. Given Datadog’s premium valuation, the market believes that Datadog is the favorite to succeed in this space, and we agree. The cloud market is enormous, and if Datadog can continue to capture share, then the firm has plenty of growth ahead of it. We explain why we think Datadog will continue to outperform in greater detail below.
Chart 1. Trailing and Forward Growth Rates for Datadog and its Peers
You can read more about Datadog’s competitors including AppDynamics (Cisco) here.about Datadog’s competitors including AppDynamics (Cisco) here.
Datadog’s Opportunity
One of the things that sets Datadog apart from the competition is that it is easy to set up. For example, Datadog recently partnered with Microsoft to natively embed Datadog into Azure. Datadog explained that “this first-of-its-kind integration of a third-party service into a public cloud provider reduces the learning curve for using Datadog to monitor the health and performance of your applications in Azure”. This is significant, as Azure is the second largest cloud provider, accounting for ~20% of total cloud market share, according to Gartner. Coming pre-installed is a significant advantage relative to other monitoring peers such as Splunk, which requires highly skilled (and expensive) engineers to configure the software. Being pre-installed also significantly reduces the sales cycle, allowing Datadog to grow its sale faster.
Likely contributing to its easy set-up and installation in the cloud, Datadog was built specifically for the cloud. In other words, Datadog is entirely cloud-native. Before Datadog, Splunk was the market-leader in log management, but Splunk was built for on-premise infrastructure, which is inherently different from the constantly evolving cloud environment. Splunk missed the tectonic shift to the cloud, while Datadog seized the opportunity. This is a rare instance in tech of a first-mover (Splunk) losing its market dominance to a younger company (Datadog).
Another key differentiator for Datadog is its leadership. The company was founded in 2010 by its current CEO, Oliver Pomel. CEO Pomel’s vision from the start was to be entirely dedicated to the cloud, and portable to all different cloud environments. His vision was spot on as cloud spending vastly outpaced on-premise spending in 2020 (shown below). With global cloud spending expected to increase ~23% in 2021, Datadog can be expected to maintain its strong growth rate for the foreseeable future.
Chart 2. Enterprise Spending on Cloud and On-Premise Data Centers
In a rapidly growing and constantly evolving cloud environment, it pays to have a founder CEO with a deep understanding of technology leading the company. We can see the consequences of having the wrong leadership in place by looking at Splunk’s fall from grace. For instance, Splunk’s founder exited years ago and he was replaced with a CEO with a background in technology sales. The assumption at the time was that Splunk had the tech, it just had to sell it. This likely contributed to the company missing the tectonic shift to the private/public cloud and hybrid cloud as the CEO was focused on selling the product rather than adapting it to the changing environment. Now, we see Datadog benefiting from multi-cloud, as well.
CEO Pomel has also done a great job of staying ahead of the competition. He states that Datadog’s focus has been “mostly greenfield, new environments” where the company does not encounter competition. When asked on the Q2 Conference Call about the competitive backdrop, and if there’s been any changes, CEO Pomel replied that “its very boring” and that the competitive landscape hasn’t changed much. This does not happen by chance, rather it takes a leadership team with expertise and a deep understanding of their customer’s needs to anticipate where the “greenfield” opportunities will be, and to get there before the competition.
A big theme going forward for Datadog will be the ‘standardization’ of cloud vendors. CEO Pomel explained this trend at length during Datadog’s Q2 Conference Call. He gave an example of a 7-figure upsell w/ an e-commerce company that had a strategic initiative to “consolidate and reduce costs by standardizing on Datadog.” He gave another example of a different 7-figure upsell for a global firm that was “experiencing rapid growth with their online product and its teams were forced to jump from tool to tool to try and mitigate problems.” He added that by standardizing on Datadog, the firm was able to “decrease mean time to resolution and free up internal resources”.
Standardizing means interoperability between various cloud environments and integrated interfaces. This is especially important with multi-cloud or hybrid cloud where companies have more than one environment. This is becoming the new normal to prevent vendor lock-in. The word standardization/ standardize was mentioned 20 times on the Q2 Earnings Call, highlighting its importance to Datadog’s story going forward. If corporations continue to standardize on Datadog’s platform, then the company will continue to capture market share.
Since dealing with multiple cloud vendors quickly becomes cumbersome, there is a natural tendency to standardize in tech, especially with software. Moreover, cloud applications need to communicate, so having everything on one platform can make detecting and resolving issues less complex and costly. We believe that we are on the cusp of this standardization trend with cloud software vendors, with Datadog leading the way. We believe that Datadog is best positioned to benefit from both the rise in cloud usage and the standardization of cloud software.
Viewing Datadog’s opportunity holistically, we can better understand its premium 43x forward sales multiple. The firm is the fastest growing company in a market that is riding on tailwinds from the tech giants. Its market is rapidly growing, and this growth is expected to continue for the foreseeable future. Furthermore, customers are starting to consolidate cloud vendors to reduce complexities and costs. This trend will allow Datadog to quickly capture market share, adding more fuel to its topline growth rate. Lastly, Datadog also has a founder CEO leading the company, coupled with a proven management team capable of adapting to the constantly evolving cloud environment. We believe that these trends help justify Datadog’s premium valuation. In the next section, we discuss Datadog’s recent financial performance and compare key metrics to industry peers. We highlight both favorable and unfavorable trends, and important metrics to watch going forward.
Datadog’s Financials
Datadog’s Q2 sales beat expectations by $21 million and increased 67% YOY to $234 million, an acceleration from the 51%, 56% and 61% YOY growth rates in 1Q21, 4Q20 and 3Q20, respectively.
Gross (operating) margin was 76% (-4%), in-line with (above) the trailing three-year average of 76% (-5%). Non-GAAP EPS was $0.09, up 80% YOY, and beat the consensus estimate of $0.03 by $0.06. Quarterly cashflows from operations doubled YOY from $25 million to $52 million while TTM free cashflows increased 193% YOY top $132 million. It is impressive to see both sales and cashflows grow at a rapid pace, highlighting how Datadog’s business is firing on all cylinders.
Datadog’s strong topline growth and positive cashflows lends credence to the firm’s premium valuation. Furthermore, Datadog’s outlook for Q3 also came in well ahead of expectations, as Q3 sales and EPS estimates have recently been revised up by 10% and 105%, respectively.
We also note that certain non-GAAP metrics highlight Datadog’s premium position in its industry. For instance, Datadog’s dollar based net retention ratio (DBNRR) has been >130% for 16 consecutive quarters. A DBNRR metric above 100% signals that Datadog’s customers are expanding the amount of Datadog products they use, highlighting how Datadog has been executing on its ‘land and expand strategy’.
Looking forward, we could expect a slight normalization in Datadog’s DBNRR metric. This is because CEO Pomel explained on the Q2 Earnings Call that new customers are starting larger, meaning they are purchasing more products upfront. This is a favorable trend, as it immediately increases revenues, but will be a headwind to DBNRR going forward as there will be less products to expand into. If DBNRR starts to trend back to 100%, we will need to determine if it is because of higher average selling prices for new customers (a favorable trend) or because of an increase in churn/decrease in usage of products (an unfavorable trend).
Another important trend to watch is if Datadog is collecting cash upfront when it signs a customer contract. Datadog’s Q2 current deferred revenue balance increased 63% YOY to $265 million, or 113% of three-month sales. Furthermore, net deferred revenue (deferred revenue less accounts receivables) increased 88% YOY to $78 million, outpacing the 67% YOY rise in Q2 sales. The outsized growth in net deferred revenue shows that Datadog has collected relatively more cash upfront from subscription sales than last year, a sign of strength. Having cash upfront for sales also improves the quality of revenue, which deserves a higher premium relative to sales accrued without cash.
Finally, we also believe that its critical to monitor Datadog’s research & development (R&D) expense going forward. We want to see that Datadog continues to invest in its future, but we also want to see that R&D expense remains under control. As pictured below, Datadog’s R&D expense margin has steadily increased over the years. This makes sense, considering the constantly evolving cloud environment.
In the most recent quarter, R&D expense rose 108% YOY to $95 million, this represented the fastest pace of growth since Q1 2019. While the acceleration in R&D expense has helped Datadog secure its greenfield opportunities, R&D’s current growth rate is ultimately unsustainable.
We also note that Datadog has reported a rise in capitalized software, which stores R&D expense on the balance sheet and temporarily inflates earnings by reducing R&D expense. For instance, capitalized software increased $8 million QoQ ($33 million YOY) to $66 million. The capitalization of R&D expense is up to management’s discretion, and a sharp rise in capitalized R&D expense can signal that a company may be trying to manage its expenses. Had Datadog instead expensed the $8 million QoQ rise in capitalized software as R&D expense, its Q2 EPS would been lower by ~$0.03. Nonetheless, Datadog still would have beat estimates after including this expense adjustment.
Going forward, we will need to monitor both R&D expense and capitalized software to make sure Datadog’s results are sustainable. For instance, the sequential increase in capitalized software plus three-month R&D expense was $103 million, which was below the firm’s quarterly gross profit of $176 million. The trend will likely become unsustainable once the sum of the sequential rise in capitalized software plus R&D expense is greater than Datadog’s quarterly gross profit.
Chart 5. Recent Trends in Datadog’s R&D Expense Margin and Capitalized Software Expense
After reviewing Datadog’s financials, we can see why the firm has been awarded a premium multiple. Datadog has reported accelerating sales growth, a strong outlook and robust cashflows. The company’s DBNRR has remained above 130% for 16 consecutive quarters, demonstrating that the company is executing on its land and expand strategy. Datadog also has cash support for future sales stored in deferred revenue, which improves the quality of revenue and warrants a higher premium. While the current growth rate in R&D expense is unsustainable, the trend is not yet of concern. Taken together, we believe that Datadog’s premium multiple is appropriate given Datadog’s strong financials.
Conclusion
In light of Datadog’s premium multiple, we revisited the story to make sure the company’s valuation remained reasonable. Considering the firm’s unique position in a rapidly expanding market which is ripe for consolidation, we believe that Datadog’s topline has plenty of room to run. Furthermore, Datadog’s founder-led management team has proven resilient in a constantly evolving cloud environment. We also considered Datadog’s financials which appeared robust but were not without concerns. For instance, Datadog’s sales are growing at an accelerating rate and its cashflows appear healthy. However, Datadog’s R&D expense growth rate is currently unsustainable, and the expense has been artificially lowered by the capitalization of software expense. Nonetheless, Datadog’s results remain robust after these adjusting for these considerations. We continue to believe that Datadog is best positioned to benefit from the tectonic shift underway as corporations migrate to the cloud, which helps justify Datadog’s premium valuation.
Disclosure: Bradley Cipriano and the I/O Fund own shares in Datadog and have no plans to change their respective positions within the next 72 hours. You can access the I/O Fund’s positions here. The above article expresses the opinions of the author, and the author did not receive compensation from any of the discussed companies. Disclosure: Bradley Cipriano and the I/O Fund own shares in Datadog and have no plans to change their respective positions within the next 72 hours. You can access the I/O Fund’s positions here. The above article expresses the opinions of the author, and the author did not receive compensation from any of the discussed companies.
Every management team has a style and Wall Street (and/or the NLP machines – these two terms becoming synonymous) often penalize management teams that are more forthright. I actually like these teams better because I’m setting up for many quarters or many years for an investment. I’d rather hear the issues upfront so I don’t have to dig around for them like a detective. Roku is a management team that I can simply kick back and listen to the call because they tell you exactly the risks and the opportunities. The market, however, prefers more of a sugar high and Roku management isn’t great at dishing out sugar highs.
The words “tough year-over-year comps” came up a lot in Roku’s call. It would be easy to focus on those words and assume Roku is in a tough spot coming out of the increase of usage from last year. Meanwhile, I think Roku is as strong as ever. Remember that we are invested in the Pay-TV ad dollars trend. Those who question Roku think we are invested for the cord-cutting trend. The cord-cutting trend began around 2005. The Pay TV ad trend began in 2017 and started to contribute meaningful revenue in 2018. This is critical to understand.
If Roku were only a cord-cutting stock, the 1.5 million net adds could be a concern although it’s still 28% year-over-year. This is why there is market weakness right now. Essentially, Roku is experiencing the same pull forward that Netflix warned about, which is that the customers interested in streaming and converting from cable did so during Covid.
Global User growth does need to get sorted, and I fully expect the management to figure this out. Just remember, that some of the best global stories come from the best domestic stories. Meaning, the teams doing well in the United States are the ones who expand to do well globally. We do have Magnite as a global CTV company but their angles are slightly different, which I covered in the LTBH webinar. Right now, Roku has expanded to Canada, Mexico, Brazil, Germany and UK.
Let me quote Anthony Wood on just how unafraid of Google he is:
We've been competing with large companies, including Google in our space for since we started, and we compete extremely well. And the primary difference in the way we compete versus Google as we built from the beginning, a software platform designed specifically for TV, whereas they take their phone, operating system, Android, and they ported it to TVs. So if you look at the history of computing platforms, whether it's windows on PCs, or Android on phones, or Roku on TVs, purpose built, operating systems traditionally have always won in terms of market share. And it's because, when you build something from the ground up for a new user environment, for new business models, it's just more effective. And so that's really the kind of where the source of our competitive advantage come from. And it's working well for us and has worked historically, you know, we compete extremely well, we're the number one streaming platform in the US by a pretty wide margin., a software platform designed specifically for TV, whereas they take their phone, operating system, Android, and they ported it to TVs. So if you look at the history of computing platforms, whether it's windows on PCs, or Android on phones, or Roku on TVs, purpose built, operating systems traditionally have always won in terms of market share. And it's because, when you build something from the ground up for a new user environment, for new business models, it's just more effective. And so that's really the kind of where the source of our competitive advantage come from. And it's working well for us and has worked historically, you know, we compete extremely well, we're the number one streaming platform in the US by a pretty wide margin.
You can apply the same thought process to Samsung.
In the meantime, keep an eye on ARPU becoming disjointed from user growth. For instance, this quarter it was up 46% year-over-year.
Five-year trend in ROKU’s ARPU metric
Sequential growth in APRU over last 5 quarters – note that 2Q21 was the fast pace of QoQ growth since ROKU went public.
ROKU’s YOY growth in ARPU – YOY growth has accelerated for 4 consecutive quarters
The thing to ponder is why is ARPU going up so much? Here’s why I think this is happening:
The most important statement Roku made in this earnings call was in regards to signing all 7 major advertising agencies and the transition of Pay TV ad dollars. The company is talking about signing upfront contracts for television advertising.
This is a long quote so bear with me bc it’s important on what they’re saying.
Regarding your question about the upfront, it was a pretty transformative upfront season for us. We closed it several months earlier than we have over the last couple of years concurrent with traditional TV networks. I think that's an indication that streaming has arrived as a first-class citizen in the way brands think about allocating their annual budgets, because it deals with all seven major agency holding companies and more than double commitments in terms of dollar basis. it was a pretty transformative upfront season for us. We closed it several months earlier than we have over the last couple of years concurrent with traditional TV networks. I think that's an indication that streaming has arrived as a first-class citizen in the way brands think about allocating their annual budgets, because it deals with all seven major agency holding companies and more than double commitments in terms of dollar basis.
So it's definitely coming out of the pandemic, increased urgency by marketers to follow audiences, especially amidst steep ratings declines. Nielsen reported a 29% decline among adults 18 to 49 year-over-year. But it's also a function of our scale and our capabilities, including one view which played a pretty prominent role, our ad platform, our DSP, and our data. And this upfront season as well, our ability to offer originals exclusive content, the performance of that content in the time since as well as our new brand – branded content studio offering really resonated with brands and stuff, it not just brought in a significant uptick in dollars and earlier commitments. It also brought in a significant new set of advertisers who had not yet committed with us in the upfront. Over 42% of our advertisers were first-time upfront advertisers with Roku. So overall, we're extremely pleased with how we did the upfront and also think it's a good Harbinger for how we'll perform throughout the year during the scatter period. Thanks for the question. But it's also a function of our scale and our capabilities, including one view which played a pretty prominent role, our ad platform, our DSP, and our data. And this upfront season as well, our ability to offer originals exclusive content, the performance of that content in the time since as well as our new brand – branded content studio offering really resonated with brands and stuff, it not just brought in a significant uptick in dollars and earlier commitments. It also brought in a significant new set of advertisers who had not yet committed with us in the upfront. Over 42% of our advertisers were first-time upfront advertisers with Roku. So overall, we're extremely pleased with how we did the upfront and also think it's a good Harbinger for how we'll perform throughout the year during the scatter period. Thanks for the question.
In the LTBH webinar, I went over OneView and how Roku will be monetizing audiences outside of Connected TV and onto mobile and desktop. You can find this on our Roku and Magnite LTBH webinar around minute 28:00. That slide in the webinar is important to revisit if you’re wanting more information about Roku’s strategic advantage as a Pay TV/CTV ad exchange that can monetize beyond its own audience numbers. This is technically Roku becoming a demand side competitor by leveraging first party data. By focusing on Roku’s audience, we are only seeing half the picture (Roku’s position on the supply side). By “demand side,” I mean the side of the ad transaction for advertisers. By “supply side,” I mean the side of the transaction for publishers. In this case, Roku is moving onto the other side to work directly with advertisers. This is a critical change in their story that began with OneView although it’s not surprising or unexpected as strong first-party data ad players who own the stack typically move in this direction (Facebook, Google).
There are other microtrend stats the management discussed that confirms our understanding of where we are in the trend for a Pay TV ad stock (i.e., remember, we are not invested for cord-cutting although it’s a nice-to-have. Similarly, we are in Fubo for live sports and the synergies with sports betting — not the cord-cutting trend that began with Netflix). The first is that Nielsen reported a 29% decline for traditional TV networks among 18 to 49-year olds. The second statistic is that only 39% have a streaming TV service. Roku echoed what we have published in the past, which is that “it’s all going to move towards streaming.”
The Roku Channel is also growing steadily with management stating, "In Q2, we continued to drive robust growth of The Roku Channel with streaming hours more than doubling year-over-year."
Financials Overview
By Bradley Cipriano
Roku’s Q2 sales increased 81% YOY to $645.1 million, beating consensus estimates by 4%. Revenue was driven by a 46% YoY increase in ARPU (now at $36.46) and a 28% YoY rise in active accounts (now at 55.1 million). The firm’s platform sales surged 117% YoY to $532.3 million, an acceleration from the 101% and 46% YoY growth rates in Q1 2021 and Q2 2020, respectively. In fact, this represented the fastest pace of YoY growth since 2017, demonstrating ROKU’s ability to scale its ad business. Importantly, we believe that ROKU is still in the early stages of scaling its ad platform, as the international market remains untapped.
Offsetting ROKU’s platform sales, its player sales increased just 1% YOY to $113 million. However, we note that this number is somewhat subdued as ROKU decided to absorb cost increases (due to a tight supply environment) instead of passing them onto the customer with higher prices. Since ROKU absorbed the price pressures, it reported a -$7 million gross loss in its player segment during this quarter. Importantly, ROKU operates its player segment close to breakeven, as management prioritizes user growth as it scales its ad platform. This is a wise decision by management, considering the acceleration in its ad platform discussed above.
The math also shows that this strategy is sustainable. For instance, ROKU lost $7 million selling its players during the most recent quarter. Considering ROKU nets ~$19.12 per user per year, ROKU can make up the $7 million gross loss in the next twelve months with just ~350k active accounts.
Since ROKU added 1.5 million accounts during the latest quarter, it will easily be able to offset this relatively benigngin loss going forward. Unfortunately, management expects the negative gross margins in the player segment to persist into 2022, which will eat into the firm’s profitability.
On the bright side, ROKU’s platform gross profit rose 149% YoOY to $345 million, easily offsetting the negative margins in the player segment. Consolidated gross margin improved 1,120 bps YoOY to 52%, well above the trailing 3-yr average of 46%. These results flowed down to ROKU’s bottom-line, as 2Q21 EPS increased from a loss of -$0.35 in 2Q20 to a profit of $0.52 as of the latest quarter, which also beat the Street’s expectations by 351%.
However, we believe that ROKU’s current earnings are temporarily inflated. This is because the firm made cost cuts last year due to COVID-19, and management disclosed that expenses will rise going forward as these cuts are unwound to support future growth. Furthermore, ROKU has spent $98 million on media content acquisitions this year, instead of developing this content in-house. This approach temporarily juices earnings since the $98 million acquisition costs are initially capitalized and expensed over-time. If ROKU had developed this media content in house, it would have incurred the expenses more immediately.
ROKU also allocated $47 million of the $98 million of content acquisition costs to goodwill, rather than to media assets. This trend cosmetically inflates ROKU’s earnings growth going forward because goodwill is never expensed to the income statement (it is instead tested for impairment) and hence, distorts the true costs of acquiring the content. Nevertheless, ROKU acquiring media content is akin to a drug manufacturer acquiring a bio-tech firm with solid Phase 3 results. The media acquisition allows management to quickly ramp ROKU’s original media content and to remain laser focused on its ad platform, which is crucial to ROKU’s success.
Looking forward, ROKU guided Q3 sales to $680 million at the midpoint, representing a 50% YOY growth rate which was 5% above consensus. Similarly, 3Q21 EPS was guided to be ~$0.06, above initial expectations of a -$0.22 loss. We expect ROKU to continue to report strong topline growth, especially considering its untapped international opportunity. For example, ROKU has been selling its players to international markets such as Canada, the UK, France, Ireland, Mexico, Brazil and will start marketing its players in Germany in H2 2021.
Magnite Summary:
Roku critics point towards lack of global growth and market penetration. My personal thoughts are that global is way too early to call right now and that Samsung and Google will likely have its hands full competing with Roku long-term in emerging markets. However, Magnite provides exposure to global CTV ad dollars and this has been clearly laid out in our thesis both in our written reports and our LTBH 1-hour webinar. Magnite is our global CTV pick, essentially. With that said, the long-term growth rate of 25% from the company seems low and it’s my hope that the company is setting expectations correctly and plans to easily beat this guidance following its string of acquisitions.
The one thing about ad-tech companies like Magnite is that they use a lot of jargon in their earnings calls. I’ll help simplify the main points before we go into the financials.
Magnite is exposed to desktop revenue, reported under OLV revenue (online video). Therefore, it’s a big win for Magnite that Chrome is pushing out the removal of third-party cookies to 2023.
On the product front, Magnite is now an ad server on top of being a Supply Side Platform (SSP). Strategically, this allows Magnite to compete with FreeWheel and Google and helps them maintain their position “as the largest independent programmatic CTV marketplace.” The SSP allows for programmatic and private market place bidding while the ad server stores the creatives and serves the ads. The SSP facilitates the selling/bidding (auction) while the ad server actually manages, stores and serves the ads. SpringServe is the acquisition that resulted in an ad server for $31 million. The acquisition came from SpotX’s option to buy.
Here’s the flow when you visit a website or watch a connected TV app/show: The page or app calls the ad server, a bid request is sent to the SSP, the SSP auctions off the space to demand-side platforms and ad networks, the winning bid sends its creatives to the ad server, the ad appears on the site you’re viewing or the connected TV show you’re viewing.
In this case, Magnite now owns the full stack. The goal is to give small-to-medium sized publishers even less of a reason to work with FreeWheel and Google.
Overall, management continues to echo our understanding of Magnite’s positioning. They pointed towards India and Asia as markets the company is focused on. The company also repeated it’s discussion of private marketplaces and why an independent SSP on CTV can do well here compared to a public auction marketplace.
I’ve gone into detail on this point in the past, so I won’t elaborate fully here other than to paste this quote:
“With the traditional TV upfront season recently concluded, I’d like to clear up confusion regarding how we participate in these upfronts. Direct-sold and upfront refers to who is doing the selling, but direct and upfront deals increasingly include programmatic media spend commitments, because buyers and sellers want to realize the workflow efficiencies and targeting gains that programmatic provides.
So, how do we participate in upfronts and direct-sold CTV? First through private marketplaces, where our platform serves as the pipes that connect buyers and sellers. As you may recall, a substantial majority of our CTV revenue comes from PMPs. In supporting PMPs, our textures as a self-service productivity and workflow tool to efficiently execute CTV campaigns. We also participate in direct-sold inventory through our managed service business, which provides demand facilitation and serves as a great onboarding source to get buyers into the programmatic ecosystem.”-CEO of Magnite on Q2 earnings call
“However, Connected TV inventory is unique as the inventory is premium and goes for $25 to $40 for placements on a private marketplace. This means that publishers will work with maybe one or two SSPs total as the private marketplace does not result in higher bids because the pricing is already agreed on.
SSPs and DSPs especially come under pressure because they don’t own the audience. However, Magnite is leveraging a few key strengths, such as becoming the primary independent SSP in the Connected TV arena. On the earnings call, the management stated that it would be hard for other SSPs to compete at this point, given the unique private marketplace environment of Connected TV. This is due to Magnite’s acquisition strategy, and we see the effects of this in the Disney partnership, where Magnite is the obvious choice on the supply side.”
The takeaway is that investors in Magnite, like ourselves, should understand that the bids occurring on private marketplaces is partly why Magnite can do well in the CTV environment whereas display ads online became highly competitive in an open marketplace.
Financial Analysis:
By Bradley Cipriano
In the prior quarter (1Q21), MGNI reported results that were underwhelming when compared to ROKU’s strong 1Q21 print. However, during the 1Q21 Conference Call, CEO Michael Barrett explained that growth had started to rebound in Q2 and that “all was well”. CEO Barrett’s comments were confirmed when the company reported 2Q21 results on 08/05/21, as 2Q21 sales increased 170% YOY to $114 million, 22% above the consensus estimate.
However, due to the impact from recent acquisitions, reported sales are not comparable to the prior year. As a result, MGNI also disclosed that adjusted pro-forma quarterly sales increased 79% YOY to $100 million, which assumes that acquisitions were closed last year and also adjusts for traffic acquisition costs (TAC). On a segment basis, CTV pro-forma sales increased 108% YOY to $34 million, while on-line video and display pro-forma sales increased 60% YOY to $66 million. Due to nuances in GAAP accounting following MGNI’s recent acquisitions (discussed below), we believe that adjusted pro-forma sales are the best metric to use to measure MGNI’s true growth rate in the near term.
MGNI’s financial results continue to be tough to analyze from a financial perspective. This is due to all the moving pieces, as the company has made a series of transformational acquisitions in the past year and a half, which has complicated YOY comparisons. Nonetheless, these acquisitions have positioned MGNI to benefit from the rise in connected TV (CTV) ad spend and the industry-wide migration from direct ad sales to programmatic ad auctions.
For instance, MGNI recently closed its $1.2 billion acquisition of SpotX on April 30th, 2021. MGNI stated that “following the Telaria Merger and SpotX Acquisition, we believe that we are the world’s largest independent omni-channel sell-side advertising platform, offering a single partner for transacting globally … and the largest independent programmatic CTV marketplace … allowing buyers access to a global, scaled, independent alternative to "walled gardens," who both own and sell inventory and maintain control on the demand side”. We had also discussed back in April that the SpotX acquisition will allow MGNI to rapidly expand internationally, which should support increased growth and margins going forward.
While the SpotX acquisition positions the company to succeed in the CTV ad market, it also unfortunately complicates MGNI’s accounting. For example, SpotX recognizes sales on a gross basis, while MGNI had previously recognized most of its sales on a net basis (net of TAC). As a result, the company has reported an adjusted pro-forma growth rate to help investors better gauge MGNI true topline growth rate.
Moreover, since SpotX recognizes sales on a gross basis, this can artificially dampen MGNI’s reported gross margins, as the topline is inflated while gross profit remains static. As well, accounts receivables are accrued on a gross basis, which makes MGNI receivables balance appear severely outsized relative to sales. A ballooning receivables balance can signal that a company is pulling forward sales, which is a negative trend and something investors tend to avoid. We suspect that MGNI’s complex accounting is having a temporary negative impact on MGNI share price, due to a subdued gross margin and an inflated receivables balance. However, these concerns will likely dissipate as MGNI’s results start to annualize and the Street gains a better understanding of MGNI’s future growth prospects.
At the moment, the Street is dependent on management’s adjusted, pro-forma metrics. Looking forward, management guided for 3Q21 sales (excluding TAC) to be $115 million at the midpoint, representing a 15% sequential rise in sales (89% YOY). Management also guided for 3Q21 CTV sales of $43 million at the midpoint, which represents a robust 27% QOQ growth rate (307% YOY).
During its Q2 Conference Call, management explained that its long-term expected growth rate (ex-TAC) will be ~25% with 30% to 35% adjusted EBITDA margins.
As a comparison, TTD reported that its Q2 sales grew 101% YOY to $280 million, while the company guided for Q3 sales to grow 31% YOY (1% QOQ) to $282 million with a 35% adjusted EBITDA margin. TTD did not provide long-term guidance.
Vuzix committed the two cardinal sins for an earnings report — which are: 1) a big miss and 2) vague guidance.
Before I go into those issues around the earnings report, I want to point out that the company is actually on the right track. This is a technology that had zero adoption for decades and our report outlined that the medical industry is likely the right industry for Vuzix to see early adopter traction. You can read our previous coverage here where we point towards the medical industry as a main driver: https://io-fund.com/premium/ar-vr-h2-2021-update-and-vuzix-deep-dive
The company reported 240% growth in surgical eyewear sales in the most recent quarter. The earnings call listed many medical corporations and hospitals who are using Vuzix and will continue to buy more from the company. This market is expected to be in the $6 billion range by 2025. If Vuzix owns 8% of the market, that will be $500 million in revenue. It’s looking like that will be reasonable for Vuzix as they are doing well in this this industry in terms of early adoption. Perhaps it’s contrarian right now in the face of a terrible earnings report, but I believe the medical industry and manufacturing are (indeed) moving forward on augmented reality and will require hardware (smart glasses) for this rather than a mobile phone (Apple’s iOS).
We were very early to Unity with coverage at IPO regarding its augmented reality potential. As I write this, the company reports today. If you’re a Unity investor, you’ll need to ask yourself if it’s for AR gaming or AR enterprise. I’d say at least 50% of Unity’s story is for AR enterprise. If you agree with me (read my report here), then keep in mind, enterprise AR will not be displayed or utilized on a mobile phone. As you know, we plan to revisit Unity after we get more information on how IDFA affects the company as gaming is primarily driven by app downloads on iOS. So far, most companies are saying the impact has been delayed so not sure what we will get today AH.
My concern with Vuzix is not its long-term potential. I think the company will be firmly on the map after a few quarters. AR enterprise is a viable market for tech investors to consider, and as I’ve stated in this intro, AR enterprise requires glasses. Snap has a loophole with Apple’s iOS which is why we recommended this one many months ago but what you’re seeing with Snap now will eventually be seen across the entire AR market.
There is no way around the fact that AR will require hardware. That’s not my concern with Vuzix, rather it’s whether we are parking our money in a stock that won’t give us gains in the next 5 months. This is because we have to compete on performance. Therefore, if we close Vuzix, we will likely re-enter early next year. Right now, we are not closing Vuzix rather it’s up to Knox and his chart work (he is laying out a plan for the forum). My understanding is that his thoughts are that he prefers to catch the company on an uptrend.
Vuzix Earnings: Unpacking the Disappointment
I actually don’t mind if a small cap stock that is taking on a sizable TAM has a big miss as long as the key metrics I’m tracking come in strong. Smart glasses grew 21% and as stated the industry where Vuzix is likely to see the most sales were up 240%. Medical sales makes up 25% of revenue.
The company’s official reported that the sales of smart glasses for the three months ended June 30, 2021, rose 21% in the period to $2.8 million led by a 22% increase year-over-year in unit sales in the M400 smart glasses and a 77% year-over-year increase in Blade smart glasses revenues.
There was certainly an increase in expenses with R&D up 50% and sales and marketing up 164%. This is despite engineering services declining from $600,000 to $300,000 (we aren’t invested in the company for engineering services so no matter to us on this).
What bothers me is a lack of guidance. As an investor and shareholder, I’d like some idea as to what a company is expecting in terms of sales. This is all we got:
Christian Schwab
Hey, good afternoon guys. Thanks for the slide presentation. I guess when I'm looking at Page 4 of the slide presentation and in the commentary and the prepared comments, I'm just trying to figure out, can you give us a range of revenue outcome that you expect for the year in 2021 and what type of growth rates we should really be thinking about in the second half of 2021 versus the second half of 2020?
Grant Russell
Yes. 2021 should continue to see consecutive growth as we move from our second quarter. Some of the business in the second quarter was timing related, frankly. That said, none of the SaaS-based software that we expect ultimately will start to add to the revenue stream. I would count in a second, especially in the third and fourth quarter of this year, even though some might be there. So you're probably going to be a little bit softer match. I think it's right in line, Christian, with the numbers that we discussed in the past. I think you look at the 3 million to 4 million units for the kind of a numbers, and then more in the fourth quarter.
Christian Schwab
Okay. Okay.
Grant Russell
That’s hard forecast there. Sorry.
Christian Schwab
Yes. No, I appreciate that. I guess if we sum up those numbers, I mean, could Q4 be big enough to do $20 plus million this year? Is that a little bit too optimistic and it may take too many things going in the right direction right now?
Paul Travers
It would take some things going in the right direction. I mean, it's not impossible to see that some of the business we had could do that, but I mean, I can't, we certainly would not give that advice right now, because there's question marks on the timing for it. And unfortunately, this industry is zero down. It's coming. You can see it, our business continues to grow and move forward. And the size of some of the things that we're talking about are getting bigger and bigger without doubt. It's only a question of, is it this month, the next month, in and out based upon the timing. Yes. It could be there Christian, but we'd have to really work to make that happen.
Knox has been pretty clear on the forum that small caps are out of favor. When this sector is out of favor, it can be brutal. When the sector is in favor, investors run around withbe in a state of FOMO. We want exposure to some small caps because there is outsized reward when you do well in this category. We don’t see any nefarious issues here with Vuzix and we don’t think this quarter defines the opportunity. With that said, we are using purely technicals at this point to determine if we remain or exit the position. We do this with most momentum stocks and I’m stating this as more of a reminder than anything unique to Vuzix.
According to Fubo’s recent earnings call, a free-to-play app is scheduled to launch in Q3 and a sports betting app is scheduled to launch in Q4. As we stated over the past two quarters, owning a live sports audience will convert for a lower customer acquisition cost and better lifetime value on both free-to-play fantasy and sports betting compared to the competing sports betting companies who must find media partners. Fubo management refers to this as a flywheel, and we agree there is substantial potential for a flywheel effect specifically due to the enthusiasm of sports fans.
Below, we review the company’s record-breaking audience growth, the much-debated gross margins, the likelihood that Fubo will have to raise money (and when this might occur), plus what we hope to see in Q3 from the company.
Perfect 10.000 on Audience Growth
We had made the point that short sellers were exploiting the one-time event of live sports being canceled last year. The results of a live sports comeback are seen clearly in Fubo’s results with 196% growth year-over-year in revenue to $130.9 million, beating analyst estimates by $9.46 million. Subscription revenue grew by 189% YoY to $114.4 million and advertising revenue grew by 281% YoY to $16.5 million.
The most important number was the sequential growth, as Fubo certainly had tailwinds from low Covid comps. In this case, sequential revenue grew QoQ by 9%. This is key because Q2 is a seasonally low quarter for sports. My first guess was that this was due to the NBA playoffs. However, according to management’s earnings call, it was due to “engagement reach[ing] record highs as we added exclusive sports streaming rights with CONMEBOL and began beta testing predictive, free-to-play gaming integrated into our streaming platform ahead of our expected launch this fall.”
Going into Q3, we had published Apptopia data showing that the company was already illustrating strong downloads and DAU growth, likely from the Olympics. The return of sports events is a major boost for the company’s year-over-year top line growth, yet the sequential strength is where Fubo provides a glimpse of a more sustainable trajectory. The management now expects the fiscal year 2021 revenue from $560 to $570 million, which represents an increase of 116% at the mid-point. Previously, it had estimated revenue to be $520 to $530 million.
The monthly average revenue per user (ARPU) increased by 30% to $71.43; this was one of the key drivers for the increase in margins. The adjusted contribution margin came in at 8.3%, up from -4.4% in the same period last year. This is a step in the right direction, although there’s more work to be done on profitability before we see institutional interest pick up.
Fubo is in a high-growth phase. It’s not uncommon for a rapidly growing company to show losses; however, we want to see a deceleration of these losses as the company scales. Fubo’s gross losses shrunk from $4 million in Q1 to $2 million in the recent quarter. Considering that their gross losses were $18 million in the year-ago quarter.
It’s also important to point out that Fubo’s cash balance of $400 million supports about 9 quarters of operations ($406 million in cash / $47 million in Q2 adjusted EBITDA). Therefore, it’s reasonable to expect the company may raise money in the near term, which can dilute shareholders. As an investor, I am not too concerned about this (Tesla did it many times), although my preference would be that Fubo raises cash in Q1 or Q2 after the launch of its betting app so the market can understand and assess the company’s full potential.
Source: Fubo Investor Relations
As seen above, the advertising revenue growth was the best ad revenue quarter in the company’s history. Advertising ARPU grew by 62% YoY to $8.70, up 22% on a QoQ basis. The company has a goal to double the advertising revenue this year.
My main contention is that as long the company can grow its audience, the market will reward it in the long-term. Our previous analysis was focused on the microtrend of live sports OTT and we think these users are stickier than Wall Street realizes.
Source: Fubo Investor Relations
The company has successfully been able to increase its paid subscribers. The customers continued to prefer fuboTV over legacy pay TV services due to the unique customer experience, innovative product experience, and bundled wide premium content. The company added 91,291 net subscribers in the recent quarter bringing the total to 681,721. This beat the analysts’ estimate of 602,000 and the management guidance of 600,000 to 605,000.
The company also increased the full-year subscriber guidance to a range of 910,000 to 920,000, from previous guidance of 830,000 to 850,000.
It’s crucial to not only grow the audience but also retain them. The company has been able to improve the churn rate by 203 basis points year-over-year. The company’s investment in subscriber intelligence and insights helps to lower the churn rate. Management points towards its first-party data for reaching household income above $85,000 and mainly males. This can help the company reach its target of $35 CPMs with current CPMs in the low $20s.
Fubo users streamed over 245 million hours which is an increase of 148%. The company’s monthly active users (MAUs) watched 134 hours per month on average, demonstrating strong customer engagement – we hope this engagement translates well for the free-to-play and sports betting app.
Improving Bottom Line Already with Sports Betting on the Way
The company’s margins are improving with increasing revenue and the management expects this trend to continue. Operating expenses as a percentage of total revenue were 155% compared to 252% in the Q2 2020. Subscriber-related expenses, primarily include content cost, accounted for 92% of total revenue compared to 120% in 2Q 2020. Sales and marketing expenses were 16% compared to 18% in Q1 2021.
We think the market has over-penalized the company for its gross margins with evidence that DraftKings’ sales and marketing costs exceed Fubo’s subscriber costs & broadcasting and transmission fees (when we compare operating margins). Meanwhile, DraftKings trades at a 300% higher valuation. Therefore, if Fubo can illustrate its sports betting capabilities, it should fetch a higher valuation.
Net loss per share was ($0.68) compared to ($2.08) in 2Q 2020. Adjusted net loss was ($51.3) million compared to ($51.5) million in the 2Q 2020. The adjusted EBITDA improved from (95%) to minus (36%) in Q2 2021.
The launch of the company’s Sportsbook is an important driver of the overall strategy as it aims to develop a flywheel that turns passive viewers into active participants. The monetization here can be substantial if Fubo sees cohorts spending more than $100 on their platform. As stated, the income of over $85,000 and persona of their viewing audience lends itself perfectly to sports betting, which is men watching sports. You really can’t get a better audience than that to target a sports betting app.
Fubo Sportsbook will represent an industry-first live sync integration between video and the Sportsbook. Recently, the company has released a short video presentation that is worth watching. The short sellers accused Fubo of buying a headline with Balto Sports, which was surprising to me to find out these analysts don’t know that YCombinator often incubates small teams. This is common knowledge in tech.
The unique feature is that FuboTV’s sports betting app will allow its users to watch and bet from the same platform. Fubo announced last month that it had completed a market access agreement in Pennsylvania with The Cordish Companies. Currently, the company has market access deals in 4 states, namely, Pennsylvania, Iowa, New Jersey, and Indiana.
FUBO commands about 6% of the virtual MVPD space. So, it’s very likely that over the long-term, the company is aiming between 3% and 6% of the total betting TAM. Right now, sports betting is expected to be a $218 billion market globally.
In the words David Gandler, “The secular decline of traditional television; the shift of TV ad dollars to connected devices; and online sports wagering, a market opportunity which we believe complements our sports-first live TV streaming platform.”
Analyst views
Evercore ISI analyst Shweta Khajuria responded to the results by repeating her Outperform rating and lifting her target price to $40 from $33.90. “We continue to view Fubo as a key beneficiary to three industry trends,” she writes in a research report. “Cord cutting, as viewers shift away from linear TV to streaming; mix-shift of advertising dollars from linear TV to [streaming]; and growing demand for online sports betting.”
Likewise, Oppenheimer analyst Jed Kelly reiterated his Outperform rating, while lifting his price target to $42 from $32. Kelly cited stronger-than-expected subscriber growth, driven by a “strong sports calendar,” and improved churn. “Most OTT providers have focused on low-cost entertainment offerings, forcing sports fans to remain tethered to pay TV,” he writes. “FuboTV is exploiting the opportunity in sports by providing a comparable viewership experience at a lower cost than its pay TV counterparts.”
What’s next for Q3
We have already published Apptopia data that shows July was strong in terms of audience growth. You can view the full article on Forbes here.
Source: Apptopia
Also, the company’s exclusive rights to South American World Cup Qualifiers is a game-changer as it helps to solidify the company’s brand ahead of next year’s FIFA World Cup. The company was also able to increase the number of consumers in the recent quarter through the launch of LG Smart TVs. It has also partnered with Vizio to launch on their popular SmartCast platform.
Additionally, with the NFL football season, we would expect the growth in the DAUs to continue in the second half of the year. If the company can launch the free-to-play soon, then we may see the flywheel effects of this as soon as Q3.
I/O Fund has partnered three times now with Apptopia to deliver pre-earnings numbers – twice for our free newsletter subscribers and once for premium. Stay tuned for our next pre-earnings coverage next quarter.
As stated in the article, Beth Kindig and I/O Fund currently own shares of FUBO. This is not financial advice. Please consult with your financial advisor in regards to any stocks you buy.
Royston Roche contributed to this article.As stated in the article, Beth Kindig and I/O Fund currently own shares of FUBO. This is not financial advice. Please consult with your financial advisor in regards to any stocks you buy.
Please note, this is a Forbes article to be published Monday morning.
Fubo reports Q2 earnings on Tuesday, August 10th, which is a seasonally low quarter for live sports in North America. According to data from Apptopia, the company had a slower start to the quarter in terms of sequential downloads and DAUs, yet the traffic picked up considerably in the back half of the quarter. This is good news as management raised guidance for both the quarter and the year on May 11th and the app data downloads and DAUs support a strong June.
The I/O Fund has written on Fubo in prior quarters to make the point that live sports is an especially coveted audience in media. Our contention is that as long as Fubo can continue to grow its audience with demonstrable key metrics, the market will eventually acquiesce and reward the stock. Below, we revisit these key points and why Q2’s strength in June is important to our thesis.
Our Thesis on FuboTV
First and foremost, we see live sports OTT as an investable trend as the live sports audience is the most coveted audience across media. According to a March 2021 press release, Fubo offers “42 of the top 50 Nielsen-ranked networks across sports, news and entertainment channels” plus more than 30,000 movies and TV shows on-demand. The company also has the exclusive rights to the South American Qatar World Cup 2022. In this case, the rights to Thursday night football being owned by Amazon pales in comparison to the 3.5 billion soccer fans globally that Fubo can capture with the World Cup. With live sports, investors must think big — including beyond the sports teams they personally watch.
We think investors who are overly concerned with the high and low season of sports is missing the bigger picture as to the potential Fubo has demonstrated in capturing this audience. The NBA playoffs likely increased viewership for Fubo in June. Fubo offered options for the Olympics, such as NBC, USA Network and the Olympic Channel. On that note, we see evidence in the app download data presented below that July continued to be strong, likely from the Tokyo Olympics.
Despite Fubo being centered in an important trend, the company’s negative gross margins are certainly a blemish in the financial reports. Our investment thesis allows Fubo time to execute on the product road map to improve its margins through sports betting. We covered this in-depth in our first Forbes article on Fubo when we maintained that by combining live sports viewership with free-to-play, and later sports betting, that Fubo will be in much better financial shape over time. In fact, we think the cross-sell between the programming and the betting will be key to Fubo taking a leadership position as more states open up betting.
On that point, we think DraftKings is the weaker of the two stocks as the company’s bottom line is worse than Fubo’s. It’s true that both companies have to figure out user acquisition; Fubo has chosen programming while DraftKings has chosen growth marketing. Wall Street has mistakenly priced DraftKings to be stronger because their line item for these costs is further down the income statement, when in fact, DraftKings spends more than Fubo for their audience and has worse operating margins. In this is (indeed) a market oversight, then there’s quite a bit of room in Fubo’s valuation.
Fubo’s earnings report will provide a better understanding of when the free-to-play and betting app will launch. The last earnings report indicated the app could be available as soon as Q4. We see some indication that Fubo is preparing for a successful launch, such as the market access agreement with Cordish Companies to open up sports betting for Fubo in Pennsylvania.
Review of Q2 Numbers
Despite the short seller reports that were published in December, Fubo has become one of the strongest tech companies post-Covid in terms of reporting blowout earnings in both Q4 2020 and Q1 2021. On May 11th, the company went on to report 105% year-over-year growth and 8% sequential growth for 590,430 MAUs with subscription revenue increasing 131% YoY to $107.1M. Net subscriber additions were approximately 43,000 versus a loss of 28,000 in the same quarter last year, which the company achieved while reducing sales and marketing as a percentage of revenue. Monthly ARPU increased 28% year-over-year and advertising ARPU was up 57%. Paid and trial users streamed more than 228 million hours, up 113% YoY. MAUs on average watched 129 hours per month, up 8% YoY.
This led to the company increasing its end-of-year subscriber guide to 830k – 850k, up 53% YoY at the midpoint and an increase from the prior guide of a 40% YoY rise.
The I/O Fund uses app data primarily to see if a company is trending up or down. We do not use app data to predict exact numbers. Please also note, Fubo reports audience size in terms of “Subscribers” while Apptopia tracks “DAUs” or “daily active users” and “Downloads.” Therefore, Apptopia provides an important glimpse as to the direction of Fubo’s growth trend, however, we are not making an earnings call on number of Subscribers.
As shown in the Chart below, Fubo’s DAUs were higher in June than in May, likely due to the NBA playoffs. Notably, Fubo’s DAUs continued to grow into July and August as a result of the Olympics, supporting the firm’s strong growth projections. With the NFL football season on the horizon, we would expect steady growth in year-over-year DAUs to continue into Q3 and Q4 2021.
According to Q2 data from Apptopia, Fubo’s download growth accelerated 235% YoY to 1.25 million downloads during Q2 2021, well above our initial calculation for Q2 published in Forbes of a 181% YoY growth rate back on May 12th, which at the time only included data from 46% of the Q2 quarter.
It is great to see that Fubo’s downloads accelerated in the back half of Q2 2021. The chart below illustrates how FUBO’s daily downloads have been trending up since the end of Q2 and into Q3. Unsurprisingly, DAU growth followed the growth in downloads, increasing 182% YoY (more on this below).
Source: Apptopia
Source: Apptopia
As shown in the chart above, Fubo will likely report a sequential decline in downloads in Q2, however, Q2 has historically been a weaker quarter for user growth due to the seasonality of sporting events. This assumption is supported by 2019 (pre-COVID) data, as Q2 2019 downloads also fell on a sequential basis. Importantly, Q2 2021 downloads only declined 8% QoQ, which is well above the Q2 2019 (pre-pandemic) sequential decline of 37%.
Daily active user (DAU) growth has followed a similar trend as downloads. Back in May, we had initially anticipated a 172% YOY growth rate in DAU by extrapolating Apptopia data. With more complete data on the quarter from Apptopia, we anticipate that DAU growth accelerated in the back half of the year, growing an estimated 182% YOY.
Source: Apptopia
Notably, Apptopia’s data shows a roughly 8% sequential decline while Fubo is guiding for slight sequential 2% growth. Apptopia does not track Roku numbers and this may be partly why there is a 10% gap. Roku owns 1/3 of the Connected TV market in the United States. The main takeaway from the data is that Fubo ended the quarter strong and performed well after management raised guidance. This is what we want to see from Fubo – growth year-over-year despite being a seasonally low quarter.
Therefore, we see the trend is up and this is the most pertinent takeaway. As noted, the expectation is not that these will be identical numbers between what Apptopia provides (DAU and Downloads) and Fubo’s Key Metric (Subscribers). Rather, we are using the app data going into earnings similar to checking a person’s vital signs. We like what we see, particularly in the June quarter, as Fubo continues to clear hurdles.
What if Fubo has a slight miss? We will remain with our position as we don’t expect perfection as this stage in tech growth. Instead, we are looking for exactly that(growth) and we see evidence for growth in Q2 and this growth continued into the first month of Q3.
As stated in the article, Beth Kindig and I/O Fund currently own shares of FUBO. This is not financial advice. Please consult with your financial advisor in regards to any stocks you buy.
Please note: The I/O Fund does not make earnings calls and we do not "play earnings." There are many things that can be reported to shake a stock beyond user growth. Gross margins, EPS miss, etc, will not be reflected by user growth alone. We pull data to reduce risk in positions we already own. We then share that information with our readers. Please consult your personal financial advisor before buying any stock.
Below, we review Twilio, Snap and Shopify. This quarter, Snap separated itself from other ad-tech companies in the ad rebound cycle. On the surface, this was accomplished through user growth and strong guidance. From a product perspective, our readers knew going into this quarter (and last quarter) that augmented reality has quietly begun its trajectory.
Twilio is a company that recently acquired Segment. This is not your typical acquisition, rather it is a hard pivot into first party data. Twilio’s future very much depends on management nailing this transition. We had presented this in granular detail in our Twilio LTBH (long-term buy and hold) webinar. We see no issues with Twilio’s report, in fact, with Segment Journeys Twilio is ahead of schedule on cross-selling, which began July 1st.
Shopify is a steady winner that we had stated in a Motley Fool podcast was a favorite pick of ours going into 2021 and during our two LTBH Top 10 portfolio review found here and our 2021 portfolio review here. Some of these LTBH positions are like hitting singles and doubles while others we swing for the fences. Shopify has the most potential to become a FAANG stock as the company has solidified its place at the e-commerce infrastructure layer. We discuss why Shopify shows evidence of taking market share from Amazon, and one area in particular where Shopify is stronger. Rarely, do we see such a strong product open the flood gates for distribution at this stage in its maturity; the flood gates for distribution are social media.
Summary:
In May, we disclosed that we were looking to increase our Snap position (and Shopify) and we closed our Pinterest position after reviewing our LTBH portfolio. We could not have been clearer in terms of our conviction on this augmented reality (AR) stock. We also broke down the company in great detail in June, which is worth a refresh if you’d like more product analysis and backstory on the company’s AR strategy and how it relates to Apple’s iOS updates.
There are a few key takeaways from Snap’s earnings. The first is that the product is going through rapid iteration to be a first mover in augmented reality. At the consumer level, you could say Snap is an only mover as there isn’t another company reaching early adopters with this much consistency. The second takeaway is that we’ve seen an ad rebound in many earnings results this quarter yet Snap stands out for its user growth in the face of tougher comps – both this quarter and next quarter’s guidance.
Here is a laundry list of AR product features that Snap discussed in the earnings call:
Cartoon 3D Lenses turn people into 3D-animated cartoons. The Cartoon 3D Style Lens shows the potential for AR features to go “viral” with 2.8 billion impressions in the first week.
Connected Lenses which enables real-time shared experiences, like building LEGO models together
Scan which allows users to scan outfits and find recommendations or the right size/look
A Unity plugin for personalized Bitmojis to be used in games
Lens creators can use Lens Studio 4.0 for features like virtual classification, multi-person 3D body mesh and cloth simulation
Spectacles with 3D reality display
Content products like Snap Original Shows including 177 international channels
Spotlight, where Snaps are showcased, grew a whopping 49% quarter-over-quarter
The keywords from this earnings report are “inside and outside of Snapchat.” Many of the AR features above will reach non-Snapchat audiences. Disney is using the Camera Kit at their theme parks. Bumble is using Lenses to create backgrounds and effects. Viber is a calling and messaging app that uses Snap’s lenses. Restaurant recommendations can be overlaid onto Maps and Poshmark is using Snap’s minis platform for daily shopping events. Although “minis” are technically on the Snapchat platform, they’re coming from developers outside the platform, such as Ticketmaster which uses minis to discover shows and buy tickets.
As far as App Tracking Transparency (ATT) is concerned, and the IDFA which we reviewed in a webinar, Snap believes the effects will be seen later down the line. “Apple’s rollout of the most recent iOS update came later in Q2 than initially anticipated, and the pace of updates by iPhone users has also been slower than we anticipated. This has given us more time with advertisers to navigate the transition but also means the effects of these changes will come later than we initially expected.”
Also, the company stated they are seeing higher opt-in rates than what is being reported “across the industry.” The obligatory disclosure that management dropped was this, “It is too early to determine how long it will take until these changes are fully adopted, the scale of the potential interruptions to demand, or the ultimate impact on the longer-term growth of our business.”
Per my previous coverage on IDFA, we aren’t trying to be heroes by making big calls here. With that said, the I/O Fund didstrategically think through what companies will be comparatively stronger than others. Our portfolio reflects this, which you can find here. Despite the obligatory disclosure on the ultimate impact of IDFA, Snap is guiding very strong for the next quarter.
Financial Report:
Snap’s Q2 results beat expectations with sales accelerating by 116% YOY to $982.1 million, which beat analyst estimates by 16% ($135.7 million). The topline beat was driven by an acceleration in both DAU and ARPU during the quarter.
Daily active users (DAU) increased 23% YOY to 293 million, an increase of 55 million and an acceleration from the 22% growth reported in the prior quarter, and also surpassed the 17% growth rate posted in the year-ago quarter.
The rise in DAU was also accompanied by an acceleration in average revenue per user (ARPU), which increased 76% YOY to $3.35, and represented the fastest rate of growth in the last four years. SNAP also guided for Q3 sales to increase 59% YOY to $1.08 billion at the midpoint, which came in ahead of the consensus estimate by 8%.
Revenue growth was driven by the North American market, as sales increased 129% YOY to $701.7 million. The strong topline growth in North America was driven by a surge in ARPU, which increased 116% YOY to $7.37, and was well above the $1.95 and $1.07 ARPUs in Europe and the “Rest of World”, respectively. SNAP’s CBO, Jeremi Gorman, explained during the Earnings Call that “we are continuing to accelerate our investments in sales and sales support beyond North America in order to capture our global ARPU opportunity faster in the years ahead”. An acceleration in global ARPU’s will materially benefit SNAP’s topline going forward. To be complete, we note that Europe’s sales grew 94% YOY to $152.3 million while the Rest of the World grew 86% YOY to $128.1 million.
Continuing down the income statement, adjusted gross margin improved 800 bps YOY to 55% during Q2. Furthermore, SNAP reported that adjusted EBITDA grew by $213 million YOY to $117 million. We note that absent a small loss in Q1, SNAP has reported a positive (and rapidly growing) adjusted EBITDA metric in 3 out of the last 4 quarters. We believe that if SNAP can continue to demonstrate the leverage in its business model by reporting strong topline growth and positive cashflows, the company can sustain a high multiple. Finally, the firm’s adjusted EPS of $0.10 beat the consensus estimate of -$0.01 by $0.11.
Notably, Snap’s earnings included numerous one-time benefits which in aggregate accounted for 60% of the firm’s adjusted earnings during the quarter. For example, SNAP reported $79.9 million in gains from non-marketable securities during the quarter, up from $0 in the prior year quarter. SNAP also early adopted a new accounting standard which cosmetically improved its interest expense by $20.1 million during the quarter. In aggregate, these one-time items provided a $0.06/share benefit to SNAP’s Q2 adjusted EPS and accounted for ~55% of the firm’s $0.11 beat during the quarter. Nevertheless, the firm’s results were still robust after excluding these one-time items.
As we’ve seen, social media is putting up triple-digits after the Covid dip from last year. In this case, Snap reported 116% and Pinterest reported 125% growth. Where Snap separated itself was not on revenue growth, rather on user growth with a 23% increase in daily active users to 293 million. This was primarily driven by DAUs in the Rest of World, which was up 55% YoY. The fact Snap is profitable now for three quarters doesn’t hurt either with impressive gains in ARPU.
Snap’s guidance on user growth is also strong at a rate of 21% year-over-year for an estimated 301 million users. The company expects to see between 58% to 60% in Q3.
Snap was not completely unscathed from the tougher comps that covid created in terms of usage. The company noted that there was a decrease in daily time spent watching Stories and a decline in volume of Story posting activity although the number of daily users grew year-over-year.
Twilio Quarterly Earnings
Summary:
Despite Twilio coming in better than expected on revenue, EPS and dollar-based net expansion rate, it was Segment’s sequential growth that concerned analysts. As stated in the April webinar, Twilio’s acquisition of Segment is an important pivot and the true story we want to analyze and track closely.
Before we review the ER in-depth, let’s look at Segment’s growth:
Segment Sales:
Q2 = $46.6m
Q1 = $44.6m
QOQ growth = 4.5%
Here is a note from our new financial analyst, Bradley Cipriano: “Segment was acquired on November 2nd 2020 and Q2 2020 Segment sales were $23m. It’s not apples to apples to do QoQ calculations since Q4 only included 2 months of Segment sales. By dividing quarterly sales into months, Q4 Segment monthly revenue was $11.5m while Q1 was $14.87m and Q2 was $15.5m, so monthly sales growth did decelerate from 29% QoQ to 4.5% QoQ.”
We are not too concerned with the sequential growth as an immediate impact is unpractical and management stated they began to cross-sell on July 1. In fact, the July 1 date is six months early from management’s previous expectations of when they will be ready to cross-sell. Here is what the CFO said in the prepared remarks: “For go-to-market, we began co-selling Twilio and Segment on July 1, accelerating our timeline by approximately six months, due to the excitement from businesses wanting to leverage the technologies from our combined offering. Lastly, the integration of the back office and G&A functions is mostly complete. We expect to finish this portion of the integration by the end of the year. We are very much on track and excited about what we can do together. “we began co-selling Twilio and Segment on July 1, accelerating our timeline by approximately six months, due to the excitement from businesses wanting to leverage the technologies from our combined offering. Lastly, the integration of the back office and G&A functions is mostly complete. We expect to finish this portion of the integration by the end of the year. We are very much on track and excited about what we can do together. “
The product that Twilio is using to cross-sell is called Segment Journeys. Segment Journeys is a product that unifies the customer experience with some retailers stating they’ve seen 400% revenue growth, such as Rugs.com. The platform allows marketers to know if a customer has seen specific messaging – whether its ads or emails, how the customer has engaged and what step the customer is ready for next on a granular basis with over 300 tools.
Twilio stated the following in terms of forward growth and Segment’s contribution: “Michael, this is Khozema. In terms of the guide, I mean, I guess what I would say is I think you're maybe you're reading a little too much into it. I think in terms of what we see for the third quarter guidance, it's a really strong growth rate of 50% to 52%. And I think on top of which we remain really optimistic about our performance in the near term as well. And we provided guidance previously, for example, of 30% plus growth over the next 4 years and feel really, really good about that over the medium term …. It won't show up in our financials for some period of time. And we haven't even started, right? I mean we basically just started a few weeks ago, and it will just take some time for it to bleed into our financials.I think in terms of what we see for the third quarter guidance, it's a really strong growth rate of 50% to 52%. And I think on top of which we remain really optimistic about our performance in the near term as well. And we provided guidance previously, for example, of 30% plus growth over the next 4 years and feel really, really good about that over the medium term …. It won't show up in our financials for some period of time. And we haven't even started, right? I mean we basically just started a few weeks ago, and it will just take some time for it to bleed into our financials.
While Segment’s sequential growth led to flat price action for Twilio following the ER, one positive point was the slight increase in DBNER from 133% to 135% (more below). This is the pulse or vital sign for a cloud company and it’s nice to see it remain steady while the company ramps up for post-acquisition cross-selling. Analysts also pointed out that Twilio has doubled its headcount in the most recent year. Here was a nice way that management put this: “We just have this sort of really good problem, is how I would characterize it, in that our core business is growing at such a fast rate. You're just — it's going to take some time for the other pieces to start showing up in our financial statements.”
One risk facing Twilio is the increase in fees from AT&T that will now be passed on to customers. Twilio had been absorbing those costs and there could be some falloff as these costs will negatively impact customers moving forward. Total impact is about $4.5 million per month (to the company). The acquisition of Zipwhip may help offset this into the future as the company provides lower cost toll-free messaging. This is more important than you may imagine as telephony costs in a world of readily available web apps (and push notifications) competing with Twilio was making the SMS product cost prohibitive.
In addition to IoT for future growth potential not reflected in current earnings, there is also a product called Frontline that is in public beta and will help workforces that are not located at desks (i.e. mobile workforces). According to the earnings call, this market exceeds the call center market. For instance, many sales people take calls while on the road or between appointments.
Financials:
Twilio’s Q2 sales grew 67% YOY to $668.9 million, which represented the fastest pace of YOY growth since Q3 2019 and beat the consensus estimate by $69.8 million (12%). Twilio’s Segment business, acquired in November of 2020 and central to our thesis, grew its sales 4.5% QOQ to $46.6 million, while active customers increased 2% QOQ. It will be important to monitor these two metrics going forward as Twilio builds its customer data platform and pivots the company around the Segment business.
DBNER remained stable at 135%, highlighting how Twilio has been able to sell new services to its existing customer base. Management also guided for Q3 sales to increase 51% YOY to $675 million at the midpoint, which was 6% ahead of the Street’s estimate (management’s guidance does not include any sales from its recent $850 million acquisition of Zipwhip, which occurred after the close of 2Q21).
The company’s adjusted operating profit declined YOY from $9.5 million down to $4.2 million during the latest quarter. This cost pressure flowed down the income statement as TWLO’s non-GAAP EPS declined YOY from a $0.09 profit in 2Q20 down to a -$0.11 loss during the most recent quarter. The cost pressure is expected to continue into 3Q21, as management guided for a non-GAAP loss of -$0.16/share at the mid-point, which was below the Street’s estimate of a -$0.07/share loss.
Gross margin for Twilio were 54%, a 200 bps YOY decline from 56% and a 100bps QOQ decline from 55%. This is down from 59% gross margins two years ago in Q2 2019. This is the lowest gross margin for Twilio at least two years back. However, during Q2 2021 call, management stated no change to the long-term gross margin guide of 60-65%: "I wouldn't say there's any real change in our long-term framework around gross margins. I mean we're still targeting 60% to 65%."
As discussed previously, TWLO is making investments in enterprise sales, Flex and new growth products coupled with infrastructure investments. While these investments will generate near term losses, they will support the company’s growth in the long run.
Possibly a sign that TWLO’s recent investments are benefitting the firm, we note that deferred revenue has surged in recent quarters, most recently growing by 239% YOY to $98.7 million. As the name implies, deferred revenue will convert into sales in the near term, which provides support for future sales. Furthermore, receiving cash upfront is a favorable trend for TWLO, as it allows the firm to immediately deploy the funds into investments that support future growth.
Shopify Quarterly Earnings
I like to come up with taglines for the stocks I cover, like “dark horse” for AMD and “royal flush” for Roku. I would say Shopify would be “ML-FAANG” or “most likely to become a FAANG.” There are others that we cover that have potential for massive global scale – Nvidia, and even Zoom. In fact, I think Nvidia will become one of the world’s most valuable companies, but the path won’t look or feel like a FAANG.
Regarding Shopify’s potential, it’s not as easy as saying “because they are building a fulfillment center, they will rival Amazon.” Amazon has the store front so these two are not apples-to-apples. However, due to various distribution methods, Shopify could be even bigger than Amazon on e-commerce (notably Amazon’s AWS is roughly half of its EBIT) because Shopify is building the e-commerce infrastructure that will extend well beyond a single storefront. I can’t help but wonder if some of Amazon’s miss is because of Shopify’s new dominance. It’s a natural thought to have when one competitor is thriving and the other guides lower than expected.
Please reference this forum post from our new team member Bradley Cipriano on Amazon’s miss.reference this forum post from our new team member Bradley Cipriano on Amazon’s miss.
You are likely familiar with Shopify’s online products as these are the core products for the company. However, offline was quite strong this quarter as merchants adopted Shopify’s point-of-sale (POS) products. This, in particular, helped Shopify during the re-opening while Amazon struggled to capture growth during the transition of the economy re-opening.
This quote is especially potent from management as to how Shopify plans to dominate online, offline and social combined: “In terms of the legacy point of sale market, we are also starting to see more legacy merchants that are starting to offline begin to use Shopify point of sale as well. They're using it because the product is really good but also because every business today, and frankly, for the next, the next 100 years is going to be omnichannel. Talking about omnichannel going forward will be like talking about color television. Every business by default will be omni-channel and Shopify is the platform that enables that.”because every business today, and frankly, for the next, the next 100 years is going to be omnichannel. Talking about omnichannel going forward will be like talking about color television. Every business by default will be omni-channel and Shopify is the platform that enables that.”
We talk about Gross Merchandise Volume (GMV) below under financials, which was a blowout and the highest in company history, yet on a more granular level we see that GMV in the United Kingdom outpaced the overall GMV despite being one of the first economies to re-open. Here’s a quote from management: “And so we use the UK as an example of one of the economies that reopened first and our UK GMV grew faster than our average suggesting that when we equip merchants with multi-channel, they do better in a very fluid commerce environment.”
This is a key point as Shopify is (perhaps) exploiting Amazon’s biggest weakness: which is too many irons in the fire. We see Andy Jassy, who comes from AWS, taking the helm. If we read between the lines, this means Amazon is prioritizing cloud infrastructure and AI/ML. This isn’t a bad decision, as we are ultra-bullish on AI, but it does leave an opening for strong competitor with a fresh angle and laser focus on e-commerce.
This is seen in Shopify’s ongoing strategy to become the infrastructure – this means Shopify will perform the checkout process, process the payment and other e-commerce services on the backend regardless of: your store front, what country you’re in, if you’re on a website or social media or a mobile app, or regardless of if their fulfillment center processes the order or a global merchant fills the order. Shopify aims to be omnichannel and omnipresent with a full stack offering. Speaking of “[regardless] of what country you’re in,” we will focus on international the next time we write on Shopify. The main takeaway here is that Shopify can quickly move across borders by being more of an infrastructure play than a store front.
We also can’t forget the distribution firehose that is social commerce. This impact will come in future quarters and I imagine it will eventually take over offline POS. Here is what management said: “The rank order of our GMV mix continues to be the online store, offline POS as second, and then all social channels and marketplaces third, and the social channels and marketplaces today represent a small percentage of the mix, but growing very rapidly.”
Pictured Above: Simulation of the open flood gates of social commerce 😉
Financial Overview:
Shopify grew sales 57% YOY to $1.12 billion in the most recent quarter, exceeding estimates of $1.05 billion, while gross merchandise volume (GMV) increased 40% YOY to $42.2 billion. This is impressive considering Q2 2020 GMV grew a stunning 119% YOY last year. The firm’s ability to post strong YOY growth after a blockbuster year raises our conviction that SHOP will be able to continue to compete with Amazon and take share, as discussed above and in our prior coverage of SHOP here and our 2019 coverage here.
Merchant sales increased 52% YOY to $785 million, aided by the expansion of Shop Pay, which took market share during the quarter. Shop Pay increased its GMV penetration rate YOY from 44.6% of GMV in Q2 2020 to 48.0% of GMV for the most recent quarter, perhaps taking share from other payment options such as PayPal.
At the same time, subscription sales increased 70% YOY to $334.2 million, while monthly recurring revenue rose 67% YOY to $95.1 million. Adjusted operating margins increased to 21%, up YOY from 16%.
Notably, SHOP excluded $778 million in gains from equity investments during the quarter and $2.0 billion of gains YTD following a couple of well-timed investments in FinTech companies. Specifically, in April 2021, SHOP received shares of Global-E (GLBE) in lieu of cash payments for its services helping the company build an international payment network.
The GLBE shares had an initial fair value of $192.3 million. GLBE went public one month later in May 2021, and SHOP’s stake in GLBE was worth $1.0 billion as of June 2021, nearly a 10x return in one month. SHOP also received $24.7 million investment in Affirm ($AFRM) last year (July 2020) for non-cash consideration due to its strategic partnership with AFRM. When AFRM went public in January 2021, SHOP’s stake was worth $1.4 billion, resulting in a 55x return in one year.
Despite excluding these large gains from earnings, Q2 2021 non-GAAP EPS still more than doubled YOY from $1.05 to $2.24 and came in well above consensus of $0.96. Likewise, YTD free cashflows nearly tripled YOY from $64.9 million to $188.7 million. The firm’s cash balance of $7.8 billion remains at all-time highs, suggesting that SHOP has ample liquidity to finance growth going forward.
While SHOP does not provide quantitative guidance, management expects 2021 sales to continue to “grow rapidly”, albeit at a slower rate than 2020. However, management expects adjusted operating profit to be above the level in 2020, this is despite the investments SHOP is making in its fulfillment center, which we explored in greater detail in our prior research coverage.
Recently I joined Ed Gotham from CMC markets in the Opto Sessions podcast. I discussed what tech trends will shine in the next five to ten years, how I started I/O Fund, and how we spot the right tech stocks. Also, don’t miss out on the quick-fire questions towards the end of the session.
Here's a timeline followed by a written summary of the key points:
Interview timestamps:
0:29 Introduction
02:06 IPO valuations
06:24 Airbnb
07:50 Trends for the next 10 years
09:00 Isn’t Waymo going to kill AI
9:41 Nvidia
12:50 Robotics
17:29 Market inefficiency with tech
20:00 Palantir
25:43 Snowflake vs Fastly
29:28 Background of Beth Kindig
33:04 I/O Fund focus
36:56 Electric vehicles
39:33 Xpeng
41:54 Thoughts on investing in Chinese market
49:25 Strategy at I/O Fund
59:23 Market trends
1:01:49 Favorite pick
1:06:01 Destructive theme
Trends for the next decade
I believe that Artificial intelligence is an important theme for the next five to ten years. I have a decade working in the tech industry, which helps me to understand the key trends. It’s difficult for someone who is not from a tech background to pick good AI stocks. The reason is that a lot of companies use the buzzword “AI” in their description, and many companies are not actually AI companies.
The optimal innovation will come from private companies. Even though big companies like Google might spend a lot on research and development; they will have to rely on M&A to truly beat their competitors.
When I was working as a privacy advocate around the time mobile data was creeping into every marketer and advertiser’s coffer, I had raised concerns about companies tracking customers without their consent through cookies. With AI, companies do not need to track a customer’s every move. For example, Netflix’s recommendation engines are run on AI. When a customer chooses a few movies, Netflix’s AI will figure out what you might want to watch next without tracking your every move, like the data collection practices of the last decade.
Manufacturing and agriculture are also becoming AI industries. For example, John Deere is a prominent company in robotics. When you look from a budget perspective, the returns on automation are attractive to corporations.
The market is inefficient with tech because tech does not cooperate with forward earnings revisions and cash flow analysis. It is all about the product and so investors have to understand the product and see where the company is headed on a product road map before the market spots it. This was the case of Nvidia back in 2018 when the market could not price it correctly. Meanwhile, if you looked at the product and understood it, you would know that Nvidia was the best choice for the AI accelerator chip because of its parallel computing.
Palantir went public at the same valuation as their last private round; this was the reason why the stock doubled. That was a smart move. I had a done a deep dive analysis on Palantir and the reason why I passed on this company is because they have a lot of government contracts. I have seen in the past that companies with government contracts can make it difficult for them to move to the commercial space. It doesn’t mean that they cannot pull off, but that particular risk was too significant for us to invest at the onset.
Technology Background
I arrived in the Silicon Valley area in the year 2010. I initially worked with real estate companies to fund my education. I then started to write about private tech companies and the granular differences between products. I worked with many startups writing about their products and also worked as a product evangelist for a holding company.
I can build a portfolio of 30 companies from 10 different technologies because I worked with 300+ startups. I was at security conferences, ad tech conferences, streaming media & OTT conferences, among others, and my job was to communicate very clearly why you should go with a particular product over its competitors.
What is I/O Fund focus?
Similar to how I covered private companies, I figured it could be helpful to provide the same level of analysis on public companies and describe why a particular company will be a winner before the market is able to accurately price the company. I started to write about public markets and people made good money on my articles. Some of the stocks I wrote about did very well.
In July of 2019, I joined with a portfolio manager who knows how to build a portfolio. His expertise is in technical analysis and analyzing charts. We began to cover tech stocks together. I strongly believe technical analysis is very much required for tech stocks. One reason is that tech companies can rise 400 percent in a year and the same company can drop 70 percent. So, this is why technical analysis plays an essential role while in addition to product analysis and financial analysis on tech companies.
In May 2020, we combined our money and launched what we call a fund. We transparently send notifications to our subscribers every time we enter or exit stocks. Readers can transparently know we are actively entering these quality companies that we have identified (or perhaps we are pausing and not entering for the time being). Our gains are outstanding and we are ahead of Ark funds partly due to large positions in Bitcoin and Blockchain.
Chinese Electric Vehicles
I stated on the podcast that Chinese EV companies will do well. The people in China are nationalists. The government is giving subsidies for buying Chinese electric vehicles and they are very particular about what tech products are supported (or subsidized). Xpeng and other Chinese electric vehicle companies teamed up with Nvidia for AI features. This helped companies like Xpeng and NIO to develop autonomous features on their cars. Semiconductor companies also benefited from this trend. In contrast, Tesla tried to manufacture their own chips, which in my opinion, is a mistake.
There are risks as a US investor investing in Chinese stocks and it depends on the style of investing. If you are regularly looking into the markets and you are an active investor, buying Chinese companies makes sense; otherwise you have better opportunities in the US if you are a passive investor. In the case of the I/O Fund, our portfolio manager keeps an eye on the markets so we can take advantage of higher volatility.
Strategy at I/O Fund:
Our strategy is to leverage experts from the tech industry and to do deep dive research on stocks. We are very good at shutting out the noise in the market. We believe long-form research has an important, long shelf life. FAANG has shown us that good tech companies will remain quality stocks for 10 to 20 years. We are always looking for buy and hold. We also add momentum so that we make strong gains in six months. We will invest until it peaks and then trim and let it fall.
Most of what I wrote in 2018 is very accurate even after three years, as proven by the earnings call and product roadmap. Knox is very good at trend following. We believe a blend of both is required. We are also very much diversified within tech, which is why we can beat Ark, including our exposure to Bitcoin. As a technology analyst, I see blockchain, bitcoin, and ethereum differently than people who are not from the tech industry. Even though Cathie Wood had spoken about Bitcoin, she did not take the big bets necessary to have gains in the last few months like we did. Notably, I’ve been covering crypto since 2013 and feel strongly that the security (due to hashrate) behind Blockchain is a technological wonder and overlooked by the talking heads on TV.
Regarding our specific portfolio/risk strategy, two-thirds of our portfolio as a long-term buy and hold, and the other one-third is more active.
IPO valuations:
We have seen many initial public offerings (IPOs) at sky-high valuations in the last couple of years. Despite the excellent product, Zoom took about 10 to 12 months to consistently trade above its opening price. Zoom is a good case study as the company had the highest growth rate at year 6 of any tech company that has gone public and was profitable.
If you had bought Zoom in July of 2019, for example, you would be holding losses until February 2020. I count holding a non-performing asset for this long as a double loss as the allocation could have gone to a better investment and seen gains during the same time period.
Snowflake is another excellent example; it went from a $12 billion valuation during its last private round to a $68 billion valuation within a year. On the other hand, Airbnb went from $18 billion to $90 billion in just six months. I strongly believe that overnight rise in valuation cannot sustain. At the I/O Fund, we have an excellent risk management process in place to protect our portfolio in these challenging situations.
