I/O Fund’s Lead Tech Analyst Beth Kindig shared her views on cryptocurrency in the Finimize X Ledger Crypto Summit 2021. Here is the video “How to Value the Next Big Crypto Play” and an overview of the discussion.
Time Stamps:
04:00 Methodology to value Crypto or De-Fi project
08:56 Sentiment analysis
16:03 Sentiment Drives Hypergrowth
16:40 How I/O Fund traded Bitcoin
19:08 Audience Q&A
29:00 Promising Ethereum competitors
31:30 Final takeaways
How to Value Crypto:
There are a few valuation metrics that are used to value crypto and Decentralized Finance (DeFi). Total value locked (TVL) is emerging as one of the leading indicators. If you divide the market capitalization by TVL, the ratio could potentially help investors value crypto assets similarly as price-to-sales ratio, which is based on revenue. Crypto does not offer financials or quarterly results so the next best thing is to look at growth in terms of the total amount of funds locked into DeFi projects. In 2021, total value locked grew over 1200% with Ethereum claiming 62% of TVL. Notably, TVL growth benefits from increase in the underlying token price.
In 2018, Ethereum had a much larger share of TVL in the >90% range. This year, Ethereum’s dominance in TVL was challenged by Binance, Solana, Polygon, Terra and others.
Institutional inflows can also be a leading indicator, with Solana seeing upwards of $2 billion in venture capital with $250 million invested into SOL-based exchange-traded products (ETPs) with $42.2 million invested in one month. In a research report from Coinshares dated November 29th, “in terms of inflows relative to assets under management (AuM), Polkadot and Solana continue to be the winners, with inflows representing 8.6% (US$11.5m) and 5.9% (US$14.6m) of AuM respectively last week.”
Polygon’s popularity can be tracked in terms of network usage and the number of addressees from senders/receivers. In early October, the network saw a high of 566,516 which surpassed Ethereum’s 527,158. This represents 30-day growth in October of 168% compared to Ethereum’s 0.6%. Polygon’s usage is driven by NFTs on the OpenSea market and gaming with Arc8 seeing over 100K users within days of launch.
Metrics are fairly fragmented and hard to track yet unique addressees and number of developers on the platform can be tracked. For example, Solana has 2.3 million monthly active addresses on its network, 1 million active users for its Phantom wallet and 1,750 developers as of November.
Network hash rate is a lagging indicator for Bitcoin yet helps determine if the trend is up or down.
The I/O Fund’s Unique Approach:
In a contrarian stance, the I/O Fund does not believe valuation is what drives crypto. Instead, the portfolio manager, Knox Ridley, tracks sentiment in order to actively manage these assets. Notably, the I/O Fund was a pioneer in adding crypto alongside stocks with proper allocation and active management. Most funds and portfolios avoid this as the volatility in crypto is complex. We also send real-time trade notifications for every entry/exit and this helped us drive market-leading returns of 236% in one-year.
Sign up for I/O Fund's free newsletter with gains of up to 1100% – Click hereSign up for I/O Fund's free newsletter with gains of up to 1100% – Click hereClick here
Below is an example of how crypto performs like high beta stocks. On the chart, you can see the price fluctuations for Bitcoin, Ethereum and Upstart are nearly identical in terms of drawdowns. While many investors become concerned by this price action, it’s actually quite normal for the pricing in disruptive tech to be volatile. Over the long term, the gains almost always outweigh the losses, which is why the holding period for tech must be a minimum of three years and up to ten years. Near the bottom, when fear is at its most extreme levels, investors begin to question their holding period and decide to exit early, which is a behavior that leads to devastating losses. It’s much better to assume disruptive tech will have extreme fluctuations and to hold firm to the original plan of holding for an extended period of time. The only exception to this is if the story fundamentally changes.
Source: Ycharts; data as of December 1st
To give you a good example of what we mean by sentiment is that when Bitcoin was trading around $19,000 — everyone wanted to buy (extreme greed), and when it dropped to $4,000 — nobody wanted to buy (extreme fear). The I/O Fund specializes in disruptive tech stocks and Knox Ridley helped guide entries in the $7000 range during this time period. We provide a chart of our Bitcoin entries and exits below. The point is not to time the exact bottom, rather to get in at a reasonable price.
Source: I/O Fund, Portfolio with real-time trade notifications for stocks and crypto assets
According to the technical analysis from our portfolio manager, Bitcoin has the potential to reach $108-$160K before the next major selloff (i.e., note: assets and stocks do not go up in a linear fashion; therefore, pullbacks are distinguished from selloffs). You can also follow our portfolio manager Knox Ridley on Twitter and sign up to our free newsletter to get regular updates on Bitcoin’s price movements.
Lead analyst for the I/O Fund, Beth Kindig, has been covering crypto since 2013 which is three years before Ethereum’s launch. Therefore, we are more comfortable than most in weathering the fundamentals and technicals for crypto. This has helped the research firm build a unique subset of crypto positions. We believe Ethereum competitors have an advantage right now and should be closely assessed for opportunities. This is due to Ethereum’s high gas fees, longer-than-expected proof of stake merge, further 1-2 year delays on shards and rollups, and overall, a complex product road map where many things can create delays for the #1 DeFi network.
We discuss this and more in the Finimize Crypto discussion.
Beth Kindig shared her views on Square’s name change to Block, Jack Dorsey stepping down as Twitter’s CEO, and the upcoming opportunities to watch in an interview with CoinDesk.
Here’s an overview of the discussion.
Square is technically getting disrupted by Blockchain and this is prompting Jack Dorsey to embrace Bitcoin. I had discussed this two years ago in an article for MarketWatch where I stated the following:
“Finance is changing rapidly through mergers and acquisitions, but not rapidly enough. There will be tremendous pressure for traditional payment processors to get with the times and adopt blockchain, or else they will be left behind by lower-cost competitors …. The real value to consumers and merchants has yet to be seen. Square may have replaced cash registers, but the fees the company charges are as old-school as ever. Square charges 2.6% plus 10 cents per transaction … Digitization in the finance industry is built atop age-old infrastructure and ignores the most obvious area in need of disruption: transaction fees. Visa and Mastercard are making acquisitions to remain relevant and competitive, while PayPal and Square are getting on more devices with peer-to-peer apps such as Venmo and Cash App. Those moves won’t lead to massive growth. An overhaul of the infrastructure via blockchain will take some time, and only then will investors enjoy serious investment returns.”charges 2.6% plus 10 cents per transaction … Digitization in the finance industry is built atop age-old infrastructure and ignores the most obvious area in need of disruption: transaction fees. Visa and Mastercard are making acquisitions to remain relevant and competitive, while PayPal and Square are getting on more devices with peer-to-peer apps such as Venmo and Cash App. Those moves won’t lead to massive growth. An overhaul of the infrastructure via blockchain will take some time, and only then will investors enjoy serious investment returns.”
The fees that Square and other fintech names charge are the fees that blockchain promises to disrupt over time. We do not think Square is pushing for Bitcoin adoption and changing its name to Block out of strength, rather we think this is a defensive move.
Regarding Twitter, Beth Kindig points out in the interview that the social media site has many bots which can affect the number of advertisers on the platform sees. According to a Pew Study, 66 percent of tweeted links are shared by bots. Most websites do have some bot traffic at an estimated 29 percent, therefore some of this is unavoidable. The reason Twitter has higher bot traffic is because it does not require a network of friends/family to have a presence and someone with a very low follower count or brand new account can immediately click on ads and links. The CTO of Twitter has recently become the CEO, Parag Agrawal, and these problems are likely to persist under the new leadership as they did when he led the technical side.
How to Find the Next Opportunity
Cloud has been very resilient and we believe this sector will perform well during times of high inflation. We also think the market is currently oversold with the Russell 2000 index being more oversold than during March of 2020. During these times of indiscriminate selling, we stay firm on product and fundamentals as cloud, for example, drives down costs for the companies.
We believe the current sell-off was driven by a high inflation number rather than the Omicron variant. We believe Bitcoin will perform well during times of inflation while more speculative and high beta stocks will not perform well, such as IPOs. The bottom line will also begin to matter more.
Disclaimer: This is not financial advice. Please consult with your financial advisor in regards to any stocks you buy.
Equipment for semiconductor manufacturing usually falls into one of the three categories: wafer fabrication equipment, assembly, or testing equipment. Water fabrication equipment (WFE) is a primary segment for Lam Research, specifically for memory and storage chips. The deposition process creates layers of insulating and conducting materials with techniques like chemical vapor deposition or atomic layer deposition, which allows for thin films of atomic layers to be coated onto surfaces.
The excess material is then etched away. Deposition and etch are processes that require complex machines for wafers to be built into integrated circuits. Lam Research has done well by specializing in memory chips. In order for Lam to do well, the WFE market must be growing and Lam must create new equipment and processes to maintain or grow market share. Our goal is to participate in memory with less cyclical risk through Lam’s specialization, especially with 3D NAND, which is an emerging market where Lam leads.
We pointed this out that Lam lets us participate in the memory market with reduced risk in our original analysis when we stated:
“Analysts covering Lam Research like to point out that the company is protected from supply and demand as memory manufacturers will continue to buy from Lam Research even during a low point in the cycle. This was proven during 2015 when Lam Research did not feel the effects of the memory trough.”
The price action below since we covered Lam helps to illustrate what we mean:
Lam has significant business in supplying equipment for leading edge nodes and this is the leading growth market for Lam. Two years ago, we discussed how Qualcomm will sell up to 50% more dollar chip content per device versus 4G generations, which refers to the dollar value of chips the device holds. Something similar is happening at the equipment level as complexity increases.
“At the leading-edge, semiconductor content growth, large die, and rising capital intensity are fueling increased wafer starts and strong WFE spending. In Foundry/Logic for instance, the next-generation processor chip for a top smartphone maker is more than 20% larger than its prior iteration. In DRAM, higher capital intensity is being driven by the increasing need to correct single bit errors through the addition of an extra on-chip bit. In 3D NAND, increasing device layer counts and the resulting higher degree of manufacturing difficulty is requiring the addition of new deposition and etch processes to address stress management, defect control, and multi-stack integration challenges.”semiconductor content growth, large die, and rising capital intensity are fueling increased wafer starts and strong WFE spending. In Foundry/Logic for instance, the next-generation processor chip for a top smartphone maker is more than 20% larger than its prior iteration. In DRAM, higher capital intensity is being driven by the increasing need to correct single bit errors through the addition of an extra on-chip bit. In 3D NAND, increasing device layer counts and the resulting higher degree of manufacturing difficulty is requiring the addition of new deposition and etch processes to address stress management, defect control, and multi-stack integration challenges.”
Lam’s Reliant equipment has also posted 11 quarters of record revenue. This equipment provides a lower cost of ownership for non-traditional chip markets, such as micro electromechnical systems (MEMS), power chips, radio frequency (RF) filters and CMOS image sensors for better connectivity and more powerful imaging. This particular segment refers to trailing edge nodes, which means larger nodes, such as 24nm, 28nm or 90nm processes. Although we’ve covered leading edge nodes, such as 5nm in the past when discussing AMD, Lam has also found success in supplying equipment for larger nodes as these are used in automotive and medical equipment. In fact, the emphasis on leading edge nodes may be why Lam has found success in the overlooked trailing edge market. Management stated that demand is exceeding WFE equipment.
As Bradley points out below, the following statement was quite encouraging in regards to Lam’s business overall: “As a result, we see the WFE investment required to achieve the same bit growth percentage over the next 5 years to be notably higherbe notably higher than the 5-year period just completed.” Lam has grown sales at a CAGR of 28% over the past five years. Consequently, the stock has seen over 550% gains in five years from a share price of $105 to $724.
While these comments are encouraging, we need to watch Lam Research closely into 2022 as Gartner is predicting a slowdown in WFE equipment in 2023-2024 as integrated circuit manufacturers and foundries “pause to digest the new capacity.”
There are other forecasts predicting a slowdown to occur sooner with 6% growth in equipment for 2022 following an estimated 34% in 2021. The foundry and logic segments, which are more than half the WFE sales, are forecast to grow 8% in 2022 following 39% in 2021. Similar forecasts are provided for NAND and DRAM equipment with a marked slowdown in 2022.
On the earnings call, however, the idea a slowdown would occur in 2022 was negated when an analyst asked about the potential for a slowdown:
Good afternoon and great job on the quarterly execution, guys. You know, the market is concerned that we're heading into a multi-quarter downturn in Memory, kind of similar to the 2018/2019 Memory downturn, which is a pretty severe 6-quarter downturn, but the one thing I clearly remember was that ahead of that downturn, your memory customers proactively cut their CapEx very, very rapidly.
Now, if I look at it this time around, there's some near-term pricing weakness in memory. But the overall memory demand environment remains pretty strong, and I think most memory companies seem optimistic right under the baton outlook for next year.
So I guess the question is, has the Lam team seen any signs similar to the 2018 downturn of customers either getting concerned or canceling or slight pushing out of shipments due to a concern on our projected memory downturn next year? -Harlan Sur, JP MorganHarlan Sur, JP Morgan
Here was management’s response:
“Yeah. Harlan, let me take that first. I think the simple answer is no. When the vast majority of our conversations with customers today is still about delivering equipment that they feel they badly need to meet their near-term requirements. And as Doug mentioned in his prepared remarks, I would say lead times have stretched out to the point where our visibility into demand in '22 is better than usual.. When the vast majority of our conversations with customers today is still about delivering equipment that they feel they badly need to meet their near-term requirements. And as Doug mentioned in his prepared remarks, I would say lead times have stretched out to the point where our visibility into demand in '22 is better than usual.
So I don't think that the hypes of initial indicators that you're talking about are things we're seeing right now. We feel much more constrained by supply chain challenges and ability to meet shipments and an over shipping situation.” -Tim Archer, CEO
Regarding the comment on supply chain challenges, Lam stated on the call that this is the biggest challenge the company faces right now. There are hundreds of parts for WFE and many are now supporting new process flows and 3D architectures. It only takes a delay on one of those parts to slow Lam’s delivery: “We're beginning to see constraints in the supply chain. So we have to work our way back up through some of those things. And that's the biggest thing we're dealing with right now.”
Lam’s Product & Growth Opportunities
Lam’s main competitors are ASML, Applied Materials, Tokyo Electron and KLA with Lam tied for third place. There are a few key products that Lam is developing and bringing to market that could help increase the company’s market share. Certainly, the manufacturing expansion in the United States, Korea, Taiwan and Malaysia hints towards Lam expecting it will need more capacity.
The first growth opportunity for Lam is 3D NAND. We covered 3D NAND in detail in our Micron analysis with the 176-layer release that is 40% higher than the nearest competitor, Samsung. The new NAND device is also 10 times denser than previous 3D NAND devices with increased power efficiency and capacity limitations removed. The data transfer rate is also very fast at 1,600 MT/s while maintaining the same height as the 64-layer device.
“According to Micron, “current 3D NAND design has begun to reach the limits of its monolithic die-level maximum capacity. It will continue to fall short of the immense system-level storage capacities demanded by future data-driven applications. Cell-to-cell capacitive coupling complications and smaller etch requirements account for many of these limitations.” If Micron is correct, then this could be an opportunity for the company to see more market share on 3D NAND.”smaller etch requirements account for many of these limitations.” If Micron is correct, then this could be an opportunity for the company to see more market share on 3D NAND.”
Micron is trying to move very quickly with their new replacement-gate design which replaces the traditional floating-gate design before Samsung or others catchup while Lam is busy solving the issue from the front-end WFE perspective with a high-productivity cryogenic etch solution. The etch removes the material in devices at cold temperatures below 100 degrees Celsius for high-aspect ratios with 200+ layers. The cold temperatures are achieved with liquefied nitrogen gas. You can click here for an article that describes this process.
According to management on the call, the cryogenic etch solution has already gone through QA and is being shipped this year. If the company is successful with this solution, it could extend to leading edge 3D DRAM and foundry/logic (3D DRAM is not on the product road map right now but management hinted that it will be put into production in the future).
“As one example, Lam has developed a new high-productivity cryo etch solution, which increases etch rates in high-aspect ratio features required for NAND devices with greater than 200 layers. We have installed this new capability at every major 3D NAND manufacturer for qualification with additional systems now shipping to support planned ramps to high-volume production next year.”We have installed this new capability at every major 3D NAND manufacturer for qualification with additional systems now shipping to support planned ramps to high-volume production next year.”
In the Micron report, we also discussed EUV or Extreme Ultraviolet Lithography where we stated the following:
“This manufacturing method uses smaller 13.5nm wavelengths of ultraviolet light to etch wafers as opposed to lasers from Deep Ultraviolet Lithography (DUV). You could argue that EUV is a point of weakness for Micron as Samsung is using this manufacturing method while Micron is delayed until 2024.”
EUV photomasks reflect light with alternating layers of molybdenum and silicon as opposed to conventional photomasks that block light with a quartz substrate or chromium layer. TSMC and Samsung are leaders with EUV for 5nm production. This process adds capital intensity, and this is good for Lam.
“In patterning, we're using the learning we have acquired over many years of multi-patterning etch leadership to win new applications as the industry adoption of EUV progresses. EUV requires use of special photoresist materials which, given the material composition, can amplify existing challenges with pattern roughness, and defectivity.
Unaddressed, these will lead to performance in yield loss, especially at smaller device dimensions. Lam has developed critical etch and deposition technologies to help solve these EUV implementation issues. In etch, we introduced earlier this year a new pulse plasma etch capability that has demonstrated an order of magnitude reduction in EUV-related pattern defectivity.” -Tim Archer, CEO opening remarksLam has developed critical etch and deposition technologies to help solve these EUV implementation issues. In etch, we introduced earlier this year a new pulse plasma etch capability that has demonstrated an order of magnitude reduction in EUV-related pattern defectivity.” -Tim Archer, CEO opening remarks
Conclusion:
Lam’s management stated they feel confident that they have visibility into next year and that the company has “significant unmet demand.” The company also stated there are “tailwinds relative to the business” for 2022.
Does that mean every quarter will meet or exceed guidance? No, it could be lumpy and that’s the nature of semiconductor stocks. The analyst on the call mentioned a 6-quarter slowdown. If this doesn’t happen in 2022, it could happen in 2023, etcetera. Semis are especially challenging right now because they’re expected to be cyclical but are transitioning into a more secular trend. Therefore, a slowdown could actually be much further out due to the drivers we discussed in the Micron report.
However, the key reason we think Lam could fare better than its peers is because as 3D layers increase, capital intensity also increases. The process does not scale linearly, instead it’s non-linear because it takes longer than 2X to etch a stack that is 2X high and requires more complex etch and deposition equipment.
Here’s one of the more important statements the company said on the call in regards to our thesis and stock position: “In 3D NAND, increasing device layer counts and the resulting higher degree of manufacturing difficulty is requiring the addition of new deposition and etch processes to address stress management, defect control, and multi-stack integration challenges.” This in turn, leads to increased investments in WFE to maintain percentages in bit growth.
As Micron, Samsung and others continue to compete on 3D NAND, and maybe even 3D DRAM in the future, we think Lam will become a clear winner. Cryo etch is leaving R&D for the first time and this is because Lam is pushing the envelope to serve this emerging trend. Lam is the leading equipment provider on 3D NAND and being a first mover here is key in serving the memory market moving forward. EUV patterning is another area where Lam leads and is seeing demand as the company aims to solve EUV implementation issues and the pattern defects that occur with equipment from its competitors.
Lam Q1 FY2022 Results
By Bradley Cipriano
Lam’s sales, earnings and cashflows all increased over 30% in the most recent quarter, signaling the unique position the company is in. We believe that Lam’s growth and earnings will continue to be robust going forward as the memory market nears an inflection point. Furthermore, capex from key customers signals that sales will continue to be strong in the near term.
In the latest quarter ending in September, Lam’s Q1 FY22 sales grew 36% YoY to $4.3 billion, which met the Street’s estimate. System revenue, which includes Lam’s leading edge equipment in deposition, etch and clean markets, increased 36% YoY to $2.9 billion while customer support and other increased 34% YoY to $1.4 billion. Management guided for Q2 sales to grow 39% YoY to $4.4 billion, which would mark the ninth consecutive quarter of YoY topline growth.
Gross margin declined 150 bps YoY to 45.9% as supply chain issues impacted margins. GAAP earnings increased 48% YoY to $8.27 per share, while non-GAAP earnings were $8.16/share, which beat estimates by 2%. TTM free cashflow increased 51% YoY to $3.2 billion and cash on hand remained high at $4.9 billion, but declined QoQ due to $1 billion in share repurchases during the quarter.
Demand was driven by memory, as 64% of equipment sales were for memory, up from 58% in the year-ago quarter. Lam described the key drivers for its products in its 10Q as “3D device scaling, multiple patterning, process flow, and advanced packaging chip integration, [which] will lead to an increase in the served addressable market for our products and services in the deposition, etch, and clean businesses.”
Lam is benefitting from a secular tailwind in semiconductor demand, and there are signals that memory is becoming less cyclical as the boom and bust cycles of years past are smoothing out due to rising demand from AI, 5G, IoT and edge computing.
Since Lam provides equipment that is used by its customers to manufacture semiconductors, we can measure their capex levels to get an understanding of where the market is moving. As shown below, quarterly capex trends from our sample group of semiconductors (n = 72) have accelerated during 2021. Capex grew 10% QoQ both in Q1 and Q2 and then increased 9% QoQ in Q3 to ~$78 billion.
Aggregate capex is up 32% YTD in 2021, well above the prior five-year Q3 YTD average of 13%.
The above capex trends add support to CEO Tim Archer’s comments on the Q1 call that “[Lam is] exiting this year with significant unmet demand… on the supply side, rising capital intensity, different architectures, new processes that need to be inserted into process flows to deal with increased manufacturing complexity. And those will be drivers for WFE structurally for a very long time. So I think there are a lot of things that will be positives for WFE in 2022, from an equipment perspective.”
The strong capex outlined above and demand for WFE provides more visibility into Lam’s 2022 sales. However, the caveat of the strong capex is that some of the capex should turn into output next year, which could lead to overcapacity. However, there are signs that the memory market is becoming less cyclical as technological innovations drive structural demand. I discuss these innovations in more detail next.
Lam and 3D NAND
Looking forward, Lam is also preparing for new technologies in the memory market. One of the new technologies is 3D NAND – which Beth had previously discussed in Lam’s premium analysis here.
3D NAND moves memory from a 2D plane to a 3D plane, which dramatically improves the storage capacity. It also requires a lot more equipment to manufacturer, which Lam provides.
CEO Archer added that “we see the WFE investment required to achieve the same bit growth percentage over the next 5 years to be notably higher than the 5-year period just completed. However, as the leading equipment supplier to the 3D NAND market, we are investing in new and differentiated capabilities to ensure scaling remains cost effective”
As 3D NAND nears an inflection point, there will be a structural increase in demand for WFE investments, benefitting Lam’s sales, earnings and cashflows. The equipment required to manufacturer 3D NAND is significantly higher. So, if the market increasingly adopts 3D NAND, then demand for Lam’s WFE should also increase at a relatively faster rate than prior years.
A risk to our thesis going forward is that Lam does not innovate fast enough to keep pace with changes to the memory market. While Lam’s research and development expense has increased YoY for sixth consecutive quarters, it fell to just 9% of sales in the most recent quarter. This is below the five-year seasonal average of 12% of sales.
On a TTM basis, R&D expense declined to 10% of TTM sales, which was also below the five-year average of 12% of TTM sales. However, R&D may seem low relative to sales due to the company’s rapid increase in sales recently. Nonetheless, this is a trend we will need to monitor going forward
It is likely that Lam’s prior R&D investments are now starting to pay dividends. Lam is well positioned to benefit from the rise in capital intensity from key customers. We had previously discussed in our Micron analysis that Micron was expected to continue to ramp capex, driven by investments in 176-NAND. Micron disclosed on its most recent conference call (12/20/21) that it expects capex to be around $11 to $12 billion in FY2022. This would represent a 15% increase in spending, which followed a 22% rise in FY2021. In the most recent quarter (q1 FY22), Micron’s quarterly net capex increased 22% to $3.3 billion, a record high. The growth in Micron’s capex is a forward looking metric that translates into demand for Lam’s WFE, driving topline growth at Lam.
Conclusion
Lam’s sales, earnings and cashflows all grew over 30% in the most recent quarter. Management guided for continued growth next quarter and stated that visibility into CY2022 was clear due to strong demand for semiconductors and memory. The company has tailwinds with new technological innovations such as 3D NAND, but needs to keep investing into R&D to ensure it can compete in the future. The company should continue to do well in the near term but we will need to monitor its investments in innovation going forward to make sure growth is sustainable.
Outsourcing is a trend that is at the intersection of two major structural tailwinds:
1) the rise of the cloud environment and
2) transition to hybrid and remote work.
The concurrent rise of these two microtrends allows companies to be decentralized and access talent on a global scale. This has created a unique environment that is well-suited for outsourcing firms, which we expect will grow strongly going forward.
Outsourcing helps solve labor supply imbalances, such as the need for skilled and/or cheap labor. Furthermore, not all outsourcing firms are the same and some are positioned better than others for the current environment.
In the following analysis, I discuss three different firms across the outsourcing market: Grid Dynamics, TaskUs and Fiverr. Each of these firms is uniquely positioned to address different types of labor demands, such as the need for highly technical labor (Grid Dynamics), lower cost labor (TaskUs) or freelance workers (Fiverr). I begin my discussion with Grid Dynamics, the firm we believe is best positioned to outperform in the current environment.
Grid Dynamics: digital transformation trend drives demand
The outsourcing firm we like best is Grid Dynamics (Grid, ticker: GDYN), a $2.5 billion company that was founded in 2006 in Menlo Park, California. Grid is focused on outsourcing highly technical labor to work on big ideas such as NoSQL, cloud computing, and AI/machine learning. The firm’s sales are accelerating and its business structure is low risk, which we believe sets the company up well to capture share in enterprise-level digital transformation, a $700 billion market that is expected to grow at a CAGR 22% for the next decade.
Grid is capturing share in this massive market, demonstrated by its robust 120% YoY growth rate in the most recent quarter. As shown below, enterprises are rapidly migrating to the cloud and digitally transforming their businesses, and we are in the early stages of this massive secular shift impacting nearly every business.
We can proxy the pace of demand for digital transformation by looking at FAANG+M Capex. As enterprises migrate to the cloud and digitally transform their businesses, this spurs capacity expansion at FAANG+M. As shown below, the major cloud providers are ramping capacity expansion. For instance, FAANG+M Capex increased 34% in Q3 to $36 billion and has increased 30% or more for 4 consecutive quarters.
Furthermore, FAANG+M capex is up 42% in the last twelve months to $132 billion. To put this into perspective, this would rank 59th in global GDP if FAANG+M capex was its own country. This analysis helps illustrate how digital transformation is a massive trend that is growing very fast, and Grid is uniquely positioned to benefit from this secular tailwind.
Grid’s Opportunity
Grid Dynamic’s clients are primarily US based, but only 10% of Grid’s workforce is based in the US. In fact, 90% of its employees are based overseas in Central Eastern Europe (CEE), a region that is known for its STEM expertise, especially in programming and computer science.
Grid explained in its 10K that its supply of CEE labor gives it a competitive advantage in the current environment due to its focus on STEM (emphasis added):
“CEE is increasingly known for the quality of its software development talent, enabled in part by decades of focus on fundamental STEM disciplines in higher education. CEE-based teams and individuals are frequent winners of programming contests such as the ones held by the Association for Computing Machinery, or ACM, TopCoder and Kaggle. Grid Dynamics believes that this disparity between the supply and demand for technical talent can be a significant opportunity for Grid DynamicsGrid Dynamics believes that this disparity between the supply and demand for technical talent can be a significant opportunity for Grid Dynamics”
According to DataArt, CEE-based programmers placed 1st, 2nd or 3rd 73 times in the five most prestigious programming competitions in the world, or nearly half of all podium spots available (2011-2020). These competitions are intense, and the most recent competitions had 182,000 registered participants. CEE’s success in these competitions highlights the regions expertise in programming, a skill that is in high demand due the rapid rise in digital transformation discussed above.
A growing digital economy, accelerated by the rise of cloud computing and remote work, is a driving force behind heightened demand for highly skilled programmers, regardless of nationality. Grid explained in its 10K that it “targets the top 10% of technical talent from top technical universities. Nearly 100% of Grid Dynamics’ engineering personnel have advanced degrees in computer science”. We can see that Grid’s labor supply is in high demand, as sales recently accelerated to 120% YoY growth, and there are signs that this acceleration may continue into Q4. I discuss Grid’s recent financial performance in more detail below.
On top of providing access to highly skilled (and cheaper) global talent, Grid is also benefitting from a unique dynamic as job openings in the US have reached record highs (shown below). For instance, a recent Gartner survey highlight that “IT executives see the talent shortage as the most significant adoption barrier to 64% of emerging technologies, compared with just 4% in 2020”.
Software Developer Salaries in USA v Eastern Europe
10-Year Trend in Number of US Job Openings (in thousands)
Grid is well positioned to benefit from the rapid rise of cloud computing, transition to remote work and the supply imbalance of labor in the US. Grid’s supply of highly technical labor should do well going forward, especially as companies accelerate their digital transformation. Highlighting its strength in digital transformation, Grid Dynamics recently earned Google Cloud Premier Partner Status, a status reserved for the top 3% of Google partners. Grid was also labeled a leader in midsize software development service providers by Forrester (below).
Midsize Software Development Service Providers
Grid’s topline growth is accelerating
Due to the tailwinds mentioned above, Grid is growing rapidly and the growth is accelerating. Q3 sales grew 120% YoY to $58 million, an acceleration from the 113% and 21% YoY growth rates in Q2 and Q1, respectively. Absent recent acquisitions, organic sales grew 68% YoY or 15% QoQ to $44 million, which is well above peers (shown below) but slightly below its organic growth rate of 72% in Q2.
It should be noted that Grid’s sales declined in 2020 as spending was cut by its largest vertical (retail/ecommerce). However, this was offset with a rapid rise in its Tech, media and telecom vertical, which has increased sales by 39%, 35% and 43% YoY in Q3, Q2 and Q1, respectively. Furthermore, sales have been growing strongly on a sequential basis, and have increased QoQ every quarter since bottoming in Q2 2020.
Looking forward, management guided for Q4 sales to grow 94.2% YoY and organic sales to increase 52.7% YoY. For reference, Grid guided Q3 sales to grow 93.7% YoY and organic sales to grow 51.9% YoY. This guide may be conservative, considering Q3 sales came in well above guidance, which is typical in the tech industry. Assuming Grid beats by a similar amount in Q4 as it did in Q3, then Q4 sales will accelerate, as well.
Earnings are also robust as gross margin increased 125 bps YoY to 44% which was well above the three-year average of 40%. EBITDA (not adjusted) turned positive in Q3 and YTD adjusted EBITDA is up 227% YoY from $8 million to $27 million, which resulted in an adjusted EBITDA margin of 19%. Q3 adjusted EPS increased 120% YoY to $0.11/share, which beat estimates by 40%.
Grid also has a strong balance sheet and cash is its largest asset at nearly $200 million, or 65% of total assets. The majority of Grid’s customer contracts are under low-risk master service agreements (MSA), which carry little to no risk of cost overruns. Contract types are often an overlooked area for service providers, but high-risk contracts such as fixed-price contracts, can temporarily juice sales but can result in large losses in the future. Grid’s ability to accelerate growth and capture market share while utilizing low-risk MSA contracts is a sign of strength.
Risk
A key risk with Grid Dynamics is its small size and high customer concentration. Grid’s top 5 customers accounted for 42% of sales in Q3, while its top 10 customers accounted for 58% of Q3 sales. However, this is improving, and its top 5 and 10 customer concentration is down from 60% and 78% in Q3 2020, respectively.
Furthermore, Grid is exposed to foreign currency risk as it is paid in US dollars but pays its employees in their local FX. However, Grid has agreements that pay employees in a US equivalent amount, which naturally hedges foreign currency risk to a degree.
Another risk is reputation risk. Providing a service (such as outsourcing) is highly dependent on having a strong reputation and any damages to Grid’s reputation could impact Grid’s ability to win new contracts. However, Grid’s management team appears sound and the CEO (who is from Eastern Europe) has been with the firm since 2014. It is noteworthy that Grid’s founder recently left the company in August 2021 and founded a new company. However, according to her LinkedIn, the company she founded is not an outsourcing firm and does not compete with Grid’s core market.
We really like Grid’s robust growth and low risk business model. Looking forward, Grid appears well positioned to capitalize on the digital transformation trend, a structural tailwind that is expected to grow strongly for the next decade. We will be watching this company closely and might initiate a position given the company’s strong fundamentals. Next, I discuss TaskUs, another fast-growing outsourcing firm that specializes in outsourcing labor to digital-native companies.
TaskUs: backend operator for the tech industry
TaskUs (Task) is a fast-growing, digitally native outsourcing firm that was founded in 2008 in the Philippines and went public this year. Task is increasingly becoming the operation infrastructure provider of choice for digitally native companies, such as Zoom, Coinbase, Facebook and others. Task’s sales recently accelerated to 64% YoY growth, and the company will likely continue to grow strongly going forward. However, Task has high exposure to risky contracts which diminishes the quality of recently reported growth, which is keeping us on the sidelines for now.
Task’s opportunity
Task focuses on providing non-voice customer service, content moderation, and annotations/transcriptions to companies in the digital economy. Task’s employees are primarily based in the Philippines and provide the operational infrastructure for its US-based digital customers.
Task explains that there is demand for its services because technology companies are focused on new products and services and “often lack the desire, expertise, scale and/or geographic presence to build the operational infrastructure to support their growth”. The company claims that since it was founded just 12 years ago, it “grew up” in the cloud environment, which allowed Task to enter the market without investing in expensive, legacy infrastructure.
The company’s model is also highly profitable and produces strong cashflows. Task was profitable throughout 2020 and sales have grown sequentially every quarter since at least Q3 2019 (earliest date of public info). This high profitability and robust cashflow generation are due to the company’s focus on non-voice, digital channels, which accounted for 94% of 2020 revenues. Task explained in its S-1 that non-voice channels allow the company to utilize resources more efficiently, driving higher profitability.
Task’s recent results and outlook
Task’s three sources of revenue are Digital Customer Service, Content Security (Moderation) and A.I. operations. Digital Customer Service provides customer care services through non-voice channels. This is Task’s largest segment and grew 64% YoY and accounted for 62% of Q3 sales.
Content Security (Moderation) deals with misinformation, offensive content, and critical policy issues. This segment experienced strong demand in 2020 during the election cycle and sales grew at a CAGR of 157% between 2017 to 2020. Content Security sales growth has since deaccelerated in 2021 and grew 34% YoY in Q3 2021 and accounted for 23% of sales.
Task’s fastest growing segment is A.I operations, which grew 145% YoY to $30 million, or 15% of Q3 sales. A.I. operations consist of data labeling, annotating and transcription services for training AI and ML algorithms. Management explained that demand is being driven by autonomous driving, which requires annotations by humans down to the pixel level.
Task’s aggregate Q3 sales increased 64% YoY to $201 million, which beat by $9 million and represented an acceleration from the 57% and 49% YoY growth rates in Q2 and Q1, respectively. On the Q3 call, management highlighted that wage pressure in the US is “pushing clients to move more quickly to an overseas delivery mode” which is driving demand for Task’s outsourcing services. On a sequential basis, sales increased 12% QoQ, which slightly lagged the 13% QoQ rise in Task’s headcount. It will be important to monitor this trend going forward to ensure that Task is able to improve efficiencies and grow sales faster than headcount growth.
Gross margin declined 251 bps YoY to 44% and adjusted EBITDA margin also declined by 70 bps YoY to 24% but beat management’s initial Q3 guide by 50 bps. The decline in margins was driven by costs related to the IPO and investments in new initiatives (Q3 call). Despite the decline in margins, GAAP net income rose 2% YoY to $12 million and adjusted EPS increased 25% YoY to $0.30/share, which was in-line with the consensus estimate.
Looking forward, management raised their full-year guide and now expect 2021 sales to increase 57% YoY to $749 million, up from the prior guide of 48% YoY growth (at the midpoint). Q4 sales are also expected to grow 55% YoY to $215 million. The Q4 guide for 55% YoY growth was an acceleration from the Q3 guide of 50%, and if Task outperforms its guide similarly in Q4 as it did in Q3, then sales will accelerate in the upcoming quarter.
Task’s recent performance has been strong as sales accelerated, margins remained robust, and guidance suggests a further acceleration in sales growth. However, there are some key risks that investors should be aware of going forward, which I outline in more detail next.
Risks
While Task has strong operational metrics, there are some key concerns that are keeping us on the sidelines for now. For instance, Task’s customer agreements include risky fixed-price contracts, meaning that Task carries the risk of project cost overruns. While not directly disclosed, we can proxy the company’s exposure to fixed price contracts by looking at the balance sheet for unbilled receivables, which are a direct result of fixed-price accounting. Utilizing this approach, it appears that around 34% of Task’s sales are from fixed-price contracts. As the name implies, the contract amount is fixed, which introduces the risk of cost overruns in the future.
Customers prefer fixed-price contracts since it passes the risk of cost overruns onto the contractor. This tradeoff can make it easier for the contractor to win new contracts but increases the risk of losses going forward. Task has a relatively high exposure to fixed-price contracts relative to peers. For instance, Grid Dynamic’s fixed-price exposure was around 10% of total sales, as Grid primarily utilizes low-risk master service agreements instead of risky fixed-price contracts (discussed in more detail above).
Task also has significant fixed expenses, which may be supporting earnings as expenses are temporarily stored on the balance sheet. For instance, Task’s Q3 capex increased 393% YoY to $15 million, or 8% of three-month sales. Furthermore, Task’s net property, plant and equipment (PP&E) has increased 27% YTD to $72 million, or 10% of total assets. This is high relative to Grid, which reported that quarterly capex was just 1% of Q3 sales and that net PP&E was 1% of total assets. A rise in capex and net PP&E may be shielding expenses from the income statement by storing them on the balance sheet, which temporarily improves margins and earnings.
Included in Task’s net PP&E is a risky account called construction in progress (CIP), which increased $9 million YTD to $14 million. Construction in progress is a unique account that is not depreciated until it is placed into service and is usually utilized by project-based companies (i.e. construction companies) and is not typically reported by outsourcing companies. The YTD rise in CIP was material and accounted 9% of YTD adjusted net income. Furthermore, the account increased by $5 million QoQ, which provided an after-tax $0.04 benefit to earnings during the quarter. Absent the sequential rise in CIP, Task would have missed its Q3 EPS estimate.
Another risk is the company’s significant customer concentration. For instance, Facebook (27% of Q3 sales) and DoorDash (11%) accounted for 36% of Q3 sales, however this is down from 44% in the year ago quarter. Task’s top five and top ten customers accounted for 61% and 76% of total sales in Q3, which also improved YoY from 67% and 81% in Q3 2020, respectively.
Task is growing its topline rapidly due to its exposure to fast-growing technology companies. However, there are risks, such as Task’s exposure to risky contract types and the rise in fixed costs such as construction in progress. The company also has higher customer concentrations relative to Grid. We will be monitoring Task going forward but will likely hold off on initiating a position until its financials de-risk. In the next section, I revisit Fiverr, a marketplace for freelancers that outperformed during 2020.
Fiverr: marketplace for freelancers
The I/O Fund has covered Fiverr in the past, here and here. Below, I will be providing an update on the company’s most recent results and how they compare to other outsourcing firms such as Grid Dynamics and TaskUs. The key takeaway is that while Fiverr has reported strong growth, there are signs that momentum in its business is slowing, leaving us on the sidelines for now.
What differentiates Fiverr from other outsourcing firms is that the firm is a marketplace for freelancers, and Fiverr does not employ the labor that it supplies. The company saw a rapid rise in demand for its marketplace during the covid-pandemic as unemployment surged and remote work took hold, which was an ideal environment for gig workers to capture share. However, engagement on Fiverr’s marketplace has slowed, which is a concerning trend for future growth. I discuss these trends in more detail below.
Recent results and slowdown in topline growth
As shown below, Fiverr’s sales have grown strongly, especially during 2020, but there are signs that momentum is dissipating. In the latest quarter, Q3 sales increased 42% YoY to $74 million, yet sales declined on a sequential basis by 1%, the first time sales have declined QoQ since Fiverr went public. Moreover, the 42% YoY growth rate represented a deacceleration from the Q2 and Q1 YoY growth rates of 60% and 100%, respectively, and represented the slowest pace of YoY growth since Q2 2019. This trend compares unfavorably to Grid and Task, which have both reported accelerating YoY growth and strong QoQ growth in the most recent quarter.
However, it should be noted that Fiverr outperformed during 2020, so its comparables are tougher than Grid and Task, which struggled during 2020. Nonetheless, markets are forward looking and enterprises having strongly rebounded in 2021, which are Grid’s and Task’s main customer cohort, while small business have struggled post 2020, which is Fiverr’s main customer cohort. The outperformance of enterprise customers relative to small business owners helps explain the divergent growth trends between Fiverr and other outsourcing firms such as Grid and Task.
Looking forward, Fiverr’s Q4 guide implies a topline growth rate of 37% at the mid-point, which would represent the slowest pace of YoY growth in Fiverr’s history as a public company. Nonetheless, while Fiverr’s sales are deaccelerating, the Q4 guide still represents 157% growth from Q4 2019, highlighting the overall strength in both Fiverr’s business and the general outsourcing market.
Continuing down the income statement, Fiverr’s gross margin slightly declined by 10 bps YoY to 83%, yet this is well above other outsourcing firms such as Grid and Task. The different gross margin profiles are due to the fact that Fiverr does not employ the labor it supplies, so its gross margins are mostly related to maintaining its software and marketplace rather than employees.
Adjusted EBITDA margin improved 180 bps YoY to 9.8%, which was well below both Grid’s and Task’s 20%+ adjusted EBITDA margins discussed above. Furthermore, the $3 million YoY increase in Fiverr’s adjusted EBITDA was entirely driven by an $11 million rise in stock-based compensation (SBC), which is a low-quality trend. This is because SBC is still a cost to shareholders, and signals that true profitability has not improved. Non-GAAP earnings increased by $3 million YoY and non-GAAP EPS of $0.19 beat estimates by $0.17, yet the beat was driven entirely by a rise in SBC, a low-quality trend.
Risks
The biggest risk for Fiverr going forward is the decline in engagement on its platform. According to similarweb.com, Fiverr’s website visits have declined 2% over the last six months, which is a concerning trend that might signal declining demand for its marketplace.
It is noteworthy that Fiverr’s sales and marketing expense as a percentage of TTM sales increased 300 bps YoY to 54% as of the latest quarter. It is concerning to see that engagement has declined despite the relatively higher levels of marketing spend. Fiverr disclosed in it 20-F that lower engagement is a key risk, stating that “if user engagement on our websites declines for any reason, our growth may slow or stall.”
Another risk to Fiverr’s growth, which applies to most gig companies such as Uber, Lyft and DoorDash, is the political headwinds around gig workers being reclassified as employees. Earlier in the year, there were headlines that the Labor Security supported classifying gig workers as employees. This development could reduce demand for gig workers and thus reduce demand.
Furthermore, as outlined in the I/O Fund’s prior analysis of Fiverr, we explained that “Fiverr benefits from high unemployment and low hiring numbers because companies are looking for ways to save money. If companies need talent on a budget, freelancing becomes the most attractive option.” The rapid improvement in the labor market could reduce demand for gig workers going forward. This trend may be causing a deacceleration in Fiverr’s business.
We chose Fiverr as a momentum play because hiring environments change and the current environment appears to favor outsourcing firms focused on digital transformation. Fiverr will likely continue to grow going forward, but the decline in engagement is a concerning trend that will need to improve before we reenter the name. In the last section, I conclude my discussion with an analysis of valuations and reiterate why we favor Grid in the current environment.
Valuation and conclusion
Below are the market cap and sales and earnings multiples for key outsourcing companies. Grid has been awarded a premium valuation relative to the peer median, yet this appears appropriate given its stronger growth rate and its exposure to highly technical labor, which is in high demand. Task appears relatively cheap compared to peers, based both on sales and earnings multiples. However, Task has exposure to risky fixed-price contracts and relatively higher levels of fixed-costs, which are high risk and warrant a lower multiple. Finally, Fiverr has also been awarded a premium multiple by the market, but this is likely due to its different business model which is primarily software based. Software companies generally receive premium multiples due to their low overhead and ability to quickly scale.
I wanted to cover outsourcing broadly and horizontally because it provides a clearer picture for what we are positioning for and why. The key takeaways are that the digital transformation trend is a massive tailwind that is driving demand for highly technical labor. Furthermore, cloud computing and hybrid work environments set the stage for outsourcing firms to capture share going forward. Grid appears to be best positioned, given its outsized growth and exposure to low-risk contracts. Nonetheless, Task, Fiverr and other outsourcing firms will likely continue to grow strongly as companies look to access talent on a global scale. We favor Grid for the current environment and may decide to add it to the momentum portfolio, but will also be closely watching Task and Fiverr for improvements in their businesses. We will keep you in the loop as we weigh these decisions.
The most exciting products and the most rewarding tech stocks on the market today are the ones that challenge Big Tech. This is because the market will often underestimate the ability of an agile team to disrupt the incumbents despite substantial evidence that this is exactly what the tech industry is built to do.
What’s remarkable about Cloudflare is how the company has leveraged its content delivery network footprint to simultaneously be a leader in application and website security, then to further innovate with Zero Trust security combined with SASE network connectivity, and more recently to leverage the elimination of egress fees for object storage to attract developers. The latter is the most exciting as Cloudflare has already proven its ability in driving down costs and will now take on AWS head-to-head.
However, in light of Cloudflare’s impressive price movement this year, the company is now priced to perfection. When looking at its peers with similar or higher growth rates, which we discuss below, Cloudflare could see a 35% cut in its price to 40X forward sales and the company would still be fully valued.
Below, we look at the products driving Cloudflare to trade at a higher valuation and whether it’s a valuation the company can sustain.
Cloudflare’s Core Products:
Cloudflare is a well-known company that owns a predominant share of the CDN market. Content Delivery Networks contain a cached copy of website content on multiple servers located across the world to help improve page loading times. When a person visits the website, it will provide the content from the server closest to the end-user, which helps increase the delivery speed of the content. When a website is hosted on a server in the United States, the person browsing the website from any part of the globe, like Asia or Europe, will receive the content from the nearest location instead of the server in the USA. The Fastly outage this year shows the prominence of these CDN providers to where one outage can create downtime for sites, such as Amazon, Reddit and the New York Times.
According to data from W3Techs, 81.2% of all websites that use a CDN or reverse proxy rely on Cloudflare. We had discussed in a podcast earlier this year that Cloudflare is strong in the small to medium-sized business (SMB) category and offers free entry-level services. The penetration among SMBs is one reason why Cloudflare has an estimated annual revenue of $648 million this year with over 1 million customers compared to the enterprise-focused Akamai at $3.48 billion with roughly 50,000 customers. The overall revenue is low for its high customer count compared to Akamai partly because of the free-entry level.
According to Intricately, the cloud Content Delivery Network market is expected to grow at a compounded annual growth rate of 28% between 2020 and 2025. Cloudflare has the highest number of customers (this data includes free users). As of June 2020, Amazon Web Services has the highest share among enterprise customers with Cloudflare is in second place. Among the SMB customers, Cloudflare is leading all the other players. Cloudflare also has a better overall rating when compared to Fastly and also compared to Amazon Web Services in the Gartner Peer Insights.
The company has a large free customer base. In addition to the benefit of converting the free base to paid services it can use the free base to test the features before they are launched.
The free user base was mentioned by management in the earnings call,
“One of our secret to success is our broad customer base that we have millions of customers, many of whom use our services for free means that we have an eager pool excited to test new features before they're released.While traditional B2B companies have extensive QA team, we regularly ask volunteers from our community to be our earliest alpha testers. Our iteration cycles can then be extremely fast. And by the time a feature makes its production at one of our enterprise customers, it's full of proof, having been through the paces under real network conditions.”
Cloudflare has built a large footprint, which means the company already owns a large portion of the TAM for CDNs. The 81% footprint is impressive but one could argue this leaves little room for growth. Cloudflare’s potential in a largely-commoditized CDN market will come from the “extremely fast” iteration cycle. There’s ample evidence the company can execute as it now owns a large portion of the application and website security market, especially for DDoS attacks (distributed denial-of-service).
Because Cloudflare has a large global presence of servers and data centers, it’s particularly well suited for analyzing traffic to determine security risks. The company is able to analyze and detect attacks by running a background program known as a daemon on every server in every data center. The scans are shared as threat intelligence among the servers in each data center without affecting the latency of the CDN.
Cloudflare is able to mitigate at optimal locations in the tech stack, for example at L4 inside the firewall or at L7 inside the reverse proxy with a 403 error page. The company is advanced at preventing L3 DDoS attacks, which targets network equipment and infrastructure. The benefit of having access to more of the stack for security purposes is that CPU consumption and intra-data center bandwidth remains relatively unaffected. It’s also autonomous so Cloudflare is not using manual employees for this process.
DDoS attacks are essentially bots that send millions of requests to overload servers and to shut down a specific website by targeting its IP address. Often times, these bots are run from devices infected with malware and operated remotely by an attacker. Cloudflare recently detected and mitigated a 17.2 million request-per-second DDoS attack, which was three times larger than any previous DDoS attack on record. This is two-thirds the average rate per second that Cloudflare had served in all of Q2.
DDoS is one example of what the company offers and certainly Cloudflare has other security and network offerings based on their large footprint. They can also cross-sell security and CDN customers with WAN-as-service, or Magic WAN, which connects office networks through the local area network. The company also offers application delivery controllers located centrally within a customer’s infrastructure for Layer 3 through Layer 7 security for applications and APIs.
Cloudflare’s Move into Zero Trust
Across Cloudflare’s security products, an important one to focus on moving forward is Cloudflare One, which is a Zero Trust network-as-a-service. Zero Trust is gaining increasing acceptance due to rising security threats from data not being stored in one place. Secure access service edge (SASE) is a cybersecurity concept that utilizes Zero Trust to identify users and devices to deliver secure access to specific applications or data. The need for this has grown due to remote teams as SASE allows policy-based security no matter where the user, application or device is located.
Zero Trust Security is built on the premise that no one should be trusted within or outside the network. In the traditional security systems, it is difficult to obtain access from outside the network while those located inside the network were trusted. With Zero Trust, these trust assumptions are removed with tools such as multi-factor authentication, giving access for a limited time and to also verify, authorize and to have a continuous check on all the data points that are given access.
In the earnings call, the company’s CEO assured that the company’s proxy infrastructure could be used for both reverse proxy and forward proxy. He stated, “but it turns out that it's as easy to make the traffic flow one way through the pipe as it is to make it flow the other way through the pipe.” Its proxy has security features built-in and also has the capacity to increase customer’s traffic.
Earlier this year, the I/O Fund covered the launch of Cloudflare One, and the management’s belief in the shift from a traditional hardware-based security approach to a modern zero trust approach, and the company’s confidence to be a leader in making that transition.
Cloudflare One has been getting a good response from customers due to mitigating attacks and improving overall performance. On the earnings call, the company discussed a Fortune 500 pharmaceutical company which was using Cloudflare One that signed a $600,000 expansion deal to increase the total contract value to over $2 million. Another large European software company signed a three-year deal worth $600,000. According to October numbers, Cloudflare signed a social network company which has a contract value of more than $1 million annually. Another video conferencing company also moved to Cloudflare which has a contract value of about $8 million.
Due to the increasing hybrid work conditions, Cloudflare has announced new cloud firewall functionality for distributed environments to overcome the issues with traditional firewalls. The company’s rating on TrustRadius and also on capterra shows that it rates higher than Zscaler, which has also performed well in the market.
Cloudflare R2 storage
Cloudflare began to lead its cloud peers when the company announced its R2 storage product on September 28th, 2021. You can see the dark purple line start a sharp rise upward following the start of October.
R2 storage allows unstructured data to be stored without egress bandwidth fees, which are charged when developers retrieve data from a cloud provider like AWS. The egress fees are essentially a tax without any value. Markups are as high as 7900% in the United States region when calculating what AWS charges. This is an 80X bandwidth markup and was detailed here by Cloudflare’s management.
Eliminating egress fees with R2 Storage places Cloudflare in direct competition with Amazon’s S3. Cloudflare’s motivation is to win over developers and their loyalty.
In the words of Matthew Prince, “We want developers to keep developing, not worrying about their storage bill. Our aim is to make R2 Storage the least expensive, most reliable option for storing data, with no egress charges. I’m constantly amazed by what developers are building on our platform, and look forward to continued innovation as we expand the tools they have access to.”
Primarily, Cloudflare is hoping to attract developers for its Workers product, which is a serverless compute service for developers to build applications and deploy code at the edge. This removes the need for developers to maintain servers or spin-up containers. The cloud service provider (in this case, Cloudflare) provisions, scales and manages the infrastructure required to run the code. Cloudflare wants developers to choose them over the larger cloud providers because of their location at the edge. This is ambitious as most developers are accustomed to AWS, Google Cloud and Microsoft Azure, all three of which also offer serverless at the edge with plans to aggressively expand, such as AWS Lambda and its extension Lambda@Edge.
R2 Storage will help Cloudflare grow its addressable market and will help the company compete as a best-of-breed player in the trends towards multi-cloud. In response, Amazon has lowered prices by up to 31% but this may not be enough if Cloudflare plans to get rid of egress fees entirely. When Cloudflare announced R2 storage, the company’s co-founder and CEO, Matthew Prince, tweeted, “Why R2? Because it’s S3 minus the one most annoying thing: egregious egress.” The product will be launched soon and has a waitlist for customers.
Notably, the outcome from Cloudflare’s R2 Storage, and also the Bandwidth Alliance, which is a consortium of cloud providers who address bandwidth pricing issues, could end up forcing Amazon to drop its egress fees rather than lose customers. Also, as an investor, it’s not clear how much R2 Storage will contribute to Cloudflare’s top line considering the markup will be eliminated. Regardless, the market has rewarded the company for taking on AWS and my hunch is developers will support the cause regardless of AWS’s response.
Cloudflare has done well since its initial focus on the CDN and web security market, increased its TAM with Zero Trust Security, and now adds object storage as a way to attract developers for products like Workers. It is interesting to note that Amazon successfully grew by targeting companies that had good margins with a famous quote from Jeff Bezos, “Your margin is my opportunity.” Now, companies like Cloudflare are doing what Amazon did in its early days by toughening the competition. Amazon’s AWS is a profitable powerhouse, and if Cloudflare can disrupt this, it could be another game-changer for the company.
Financials
The market is excited about how Cloudflare has performed post-Covid as it’s clear the company did not need the one-time bump from 2020 as growth has been stable throughout 2021. Cloudflare decelerated in the most recent quarter —- but not by much; from 54% revenue growth last year to 51% revenue growth in the most recent quarter. The guide for next quarter is also a slight deceleration from 50% revenue growth last year to 47% this year.
The company’s revenue growth was partly helped by growth in large customers with annualized revenue greater than $100,000. We also noticed a similar trend of large customer growth in the last quarter. The company exited the 3Q with 1,260 large customers, a net addition of 172 in the recent quarter for 71% growth. The company had 132,390 paying customers, which represents total customer growth of 31% YoY.
Cloudflare has also demonstrated its ability to be profitable. The company reported break-even adjusted earnings per share, which beat estimates by $0.04. The gross profit margin improved to 78.2% compared to 76.3% in the 3Q 2020. Adjusted gross margin improved to 79.2% compared to 77.3% in the 3Q 2020.
Adjusted net income came at $1.4 million or $0.00 per share compared to an adjusted net loss of $7.3 million or ($0.02) per share in the 2Q 2021 and adjusted net loss of $5.8 million or ($0.02) per share in the same period last year.
Net cash flow from operations was negative $6.9 million compared to a positive $2.0 million for the 3Q 2020. The company had cash and investments of about $1.8 billion at the end of the quarter, including about $790 million of net proceeds from the convertible note issuance in August.
The dollar-based net retention was 124%, the same as the 2Q 2021 and higher than the 3Q 2020 that was 116%.
The company’s revenue guidance for the 4Q is $184 million to $185 million, represents an increase of 46% to 47%. The adjusted earnings are expected to be between ($0.01) to break even. The full year revenue guidance is $647 million to $648 million, representing an increase of 50% and adjusted earnings per share are expected to be between ($0.06) to ($0.05).
Valuation:
Cloudflare has an eye-watering valuation of 47X EV to 1-year forward revenue. As a tech growth portfolio, the I/O Fund is certainly not the valuation police as we often find our best winners carry high valuations if a company is executing against the competitors.
However, it’s the growth rate of Cloudflare that makes me question if this valuation is appropriate. In regards to Cloudflare’s high-valued peers, we see that Cloudflare has one of the lowest revenue growth rates at 51% in the most recent quarter and free cash flow isn’t a strong factor here either. As mentioned, the only other stock on our list carrying this 1-year forward valuation is Snowflake, which had nearly double the growth.
Cloudflare’s analyst consensus for next year is revenue of $886 million with 20 analysts providing estimates. This represents growth of 37.2%. The analysts covering the stock are modeling Cloudflare to be profitable next year with $0.02 EPS. At this valuation, investors should feel confident there will be a beat and raise to at minimum 50% growth although the data above suggests revenue growth must be in the 60% range to be in the top 10 for valuation.
Conclusion:
By the sweat of its brow, Cloudflare has expanded a commoditized content delivery network footprint to become a leader in website and application security, and is not standing still with products such as Zero Trust and R2 Storage. However, being a great company is sometimes confused for a great stock. At the current valuation, Cloudflare has no room to explore these new markets and find its footing.
I have no doubt the company will execute, how it goes about this and if the timing of execution can meet Wall Street’s often unrealistic standards of quarterly perfection is the risk that investors take. This is certainly one to watch, or one to hold if you’re already in the stock, but to enter as of October requires hardened conviction in Cloudflare surprising to the upside on the 37% forward growth estimates for FY2022. We prefer to wait from the sidelines for a more attractive entry.
Please note: The I/O Fund conducts research and draws conclusions for the company’s portfolio. We then share that information with our readers and offer real-time trade notifications. This is not a guarantee of a stock’s performance and it is not financial advice. Please consult your personal financial advisor before buying any stock in the companies mentioned in this analysis. Beth Kindig and the I/O Fund do not own Cloudflare and there are no plans to enter the stock in the next 72 hours.
Going into February of 2021, we warned of a selloff based on weakening momentum trending into an important broad market time factor. We used this opportunity to raise some cash and even had a proactive hedge on QQQ at the time. This shift helped us remain competitive with the pros in the growth markets, as did our proactive move out of crypto (and back in again). Even when the growth selloff intensified into late Q1, many were calling for the end of the bull market, as we used that opportunity to add to some quality companies that were getting beaten up. Like many, we underestimated the difficulty in the high beta market, showing mixed results in our additions to high conviction/long-term plays, but we continued to hold the broader thesis that the bull market is not over, as we do today. I do believe we will see a return to 2020-style growth investing before this great bull market is over, but I also believe that we will get a chance to grab shares of targeted companies at lower prices first.
That being said, what I do want to point out is the difference between February 2021 and today. The economic environment tends to lend itself towards high beta being in favor or out of favor. Coming out of the 2020 bear market, we saw a large acceleration of economic growth with low inflation – ie, the perfect environment for our world. As inflation picked up in mid Q1 of 2021, growth investing became more difficult. We still saw numerous winners in this field coming out of the February/March selloff, so a more discerning filter really paid off. The reason for this is that we saw inflation and growth accelerating up at the same time. However, today's dip in growth assets and rotation into more deflation protection assets is signaling something different, in my opinion. I believe looking at the growth trends in the macro-environment will help clarify what that is…
First up, we'll look at our economic heat map.
Note the difference between February of 2021 and today. In February, inflation was starting to pick up but wasn't a major concern (according to the bond market). Also, note how we were in the early stages of accelerated growth in the US economy. Now, compare that to today – growth is starting to slow as our models expect the rate of change in this deceleration to start turning soft red in mid-late Q1. With inflation in the red as well, we also are expecting this slowdown to lead to inflation slowing down as well. We are seeing signs of this slowdown globally with China leading the way. Much like we saw a global growth push in 2017, the macro environment is suggesting a global growth slowdown into 2022.
Our quadrant analysis, which measures the Rate of Change of both growth and inflation in the US, is supporting this thesis.
The October data is being uploaded soon, but it will have the Oct. numbers closer to the bottom right quadrant – inflation/stagflation. This is a risk-off macro environment where high beta struggles, and we see a flight to real estate, utilities, staples, long-duration bonds, and very liquid mega-cap growth companies (exactly what has been working over the last month). We do believe this quadrant will take us into the lower left quadrant (deflation) in 2022.
With this in mind, think of the FED's position. They waited too long to raise rates so are under the gun to rush this process in order to have ammo to fight the next deep correction. So, with growth slowing, inflation peaking, and the FED in a rush to tighten conditions for the next reflation attempt, probabilities suggest that risk assets will continue to struggle until a floor is found in the economic slow-down.
But, don't take our word for it, just look what the bond market is saying.
Remember, long-duration yields are controlled by market expectations of growth and inflation (not the FED). As long-duration yields go down, it's signaling the same slow down our models are showing. The spread between the 10-year yield (not affected by FED policy) and 2-year yield (highly affected by Fed policy) has seen the sharpest flattening since 1994.
Interestingly, this also lines up with our Elliott Wave analysis. I have always been amazed at how using Fibonacci/golden ratio analysis on charts tends to predict future outcomes. Anyone that has been with us for a while knows that we've been talking about 2022 being a tough year based on this analysis alone. We now have a combined macro analysis, coupled with inflation and FED policy catching up to what Elliott Wave was predicting over a year ago.
Trends move in 5 waves in the direction of the predominant trend. this is true in all markets and on all time frames. Since March of 2020, the predominant trend is up. We have a clean 1st and 2nd wave in place (in red). In order to complete the minimum targets for the 3rd wave, we need the current trend to move us into the SPX 4900-5200 region. This will lead to the larger 4th wave, which we expect to be between a 10%-15% drawdown in early/mid-2022. We also have two important broad market time factors coming up – Dec 27-Jan 3 and one in late January (I'll narrow down the focus as we approach this). Almost every chart I map is showing the same inflection points.
These time factors are marking inflection points and how the market trends into them will be crucial. Interestingly, they are also lining up with what our models are suggesting – an acceleration of the global economic slowdown in late Q1 (remember, markets are looking into the future, so expect a top prior to the data coming out). Furthermore, if we look at inter-market signals, a similar warning is still present.
Our risk-on and economically sensitive sectors are diverging from the broad market. When we see this pattern, only one of 2 things will happen: (1) either the broad market is leading the risk-on sectors; (2) the risk-on sectors are leading the broad markets. With the preponderance of evidence discussed, we believe 2 is more likely as we push into early 2022.
Why This is Not the End of the Great Bull Market
In one word – liquidity. I've talked about this for several weeks, in various ways. Last week we showed the strange phenomenon that money market funds and the S&P 500 are both close to ATHs, which is one of many examples of the excess liquidity in the markets. This week, we will focus on how the flood of liquidity in the economy is affecting the banking system.
I, for one, do believe the central banking system will go down in history as a monumental failure. However, you have to play the market you are dealt – not the one that you want or think makes more sense. Many pundits have stubbornly ignored this reality, and as a result, missed out on one of the greatest bull markets in US history. That being said, this is a FED-driven, liquidity-fueled bull market, and the drastic actions taken by the FED (and global central banks) during the COVID crash last year is why we are continuing to push higher today.
In 2008, we saw a gradual tightening that ultimately put in motion the GFC. During this time we saw the first run on banks (and money markets) since the turn of the century. The fear was sudden and caused banks to shut the borrowing window for even qualified companies to refinance their debts. As a result, defaults intensified, and only exacerbated the problem. This liquidity/credit crunch was the primary driver behind the pain experienced in the GFC.
Compared to 2007/2008, last year the FED flooded the economy with excess liquidity that was needed by struggling companies to stay afloat. In other words, they guaranteed that a credit crunch would not happen. this lead to the bizarro world of monthly economic data that literally went off the charts in a negative way, while the stock market kept powering higher. As a result, it's hard to look at the current landscape and see any hint of a liquidity crunch. In fact, the opposite seems to be true.
Liquidity in Banks
We tend to see the beginning stages of a liquidity crunch in overnight markets. In other words, if a bank needs additional liquidity to meet their normal business demands, they will borrow this cash from other banks in the overnight markets. If these private banks see trouble on the horizon they tend to not want to participate in overnight loans, pushing the overnight borrowing rate up, and thus making liquidity even harder to come by. This lack of overnight liquidity begins to filter into the banking system and ultimately down into the economy. To combat this free-market phenomenon, the FED created the repurchase agreement program (Repos) to be the lender of last result. In other words, when no private bank wants to take on the counter-party risk of another bank needing cash to operate, the FED steps in.
Prior to the economic slowdowns, we tend to see the FED's repo program tick up, signaling that private banks are not willing to loan into the overnight markets.
Note how these repo agreements preceded major market events. It's a signal that liquidity is drying up, and this removal of liquidity from the market by the banking system is what ultimately crashes the markets.
Now, let's overlay this metric with inflation expectations (10 yr. breakeven rate) as well as economic growth (PMI – manufacturing).
Note how inflation peaked as did economic growth going into these liquidity crunches. What preceded was sharp bear markets in both instances. Now, note the 2011 and 2015 deep correction periods. We had a deceleration in both economic growth and inflation (much like we're projecting going into 2022), but there was no liquidity crunch. The result was either a sharp and quick selloff (2011), or a correction that was more in time than price (2015) before the bull market resumed. It's important to see that we are not in a similar liquidity crunch today. In fact, the opposite seems to be happening.
The FED also has a program designed to address this opposite problem banks can face, and it's called reverse-repo agreements (Reverse-Repos). Banks operate under strict regulations, one of which addresses the maximum amount of cash/credit they are allowed to hold relative to assets. If a bank is close to that limit, it will lend this excess liquidity to other banks for a small overnight rate. However, what happens when most banks are flushed with cash and cannot accept anymore? The FED steps in to be the buyer of last result, exchanging cash for bonds at a minuscule rate.
Today, the reverse repo operation is at record highs.
In other words, the FED is "borrowing" excess cash from banks on a nightly basis. This is what too much liquidity in the banking system looks like. Now, factor in that the FED is STILL adding ~$60 Billion of QE per month on top of the chart above!
So, like 2019 and 2008, the economy is starting to slow as inflation is likely about to peak. However, unlike 2008 and 2019 there is tons of liquidity in the system that has to go somewhere, and with the CPI running at 6.8% and likely to move into the 7% region, money markets and bonds are not very attractive. For this single, yet crucial reason, I see 2022's volatility to be more like 2011/2015 – an extended road bump in a much larger bull market, which we want to prepare our readers for.
Remember, the FED and global governments need inflation. It is literally the only way out of the massive debt obligations taken on by governments, aside from a default. the same problem was seen in the post-war 1940's – large increase in money supply as inflation ran hot for over a decade. This allowed the US government to get out from under their war debts, while the stock market went on a multi-decade bull market. This, I believe, is what the FED is trying to do today – get everyone used to higher inflation, so that the US has a shot of unwinding its debt. So, creating a market crash would not be conducive to this end.
Our Game Plan for 2022 and Beyond
Going back to our Elliott Wave analysis, if we are completing the 4th wave of the larger 3rd wave, that means that we have the final 5th wave to go. If everything moves as planned, which is always a BIG if, we will bottom into late December, and rally hard into the late January time factor, which is targeting the 4900 regions, at a minimum. We also know that we are in a stagflation/inflation style macro environment, which tends to favor mega-cap growth names. The type of mega-cap growth that is working right now is FAANG and semis. Since our recent entries in NVDA and AMD, we are sitting on 60% gains in just under 2 months, as LRCX and MRVL were almost at ATHs while the rest of tech sold off hard. You are seeing where the money is flowing in real-time. We plan to continue to ride this momentum as the SPX makes its minor 5th wave push, focusing on a potential MSFT play and continued adds to our semis.
Regarding high beta, we are trending down into the first-time factor, which, as previously stated, I'm expecting to be a low. This should kick off the final minor 5th wave push. Also, even though we are focusing on mega-caps and semis, I do not think risk assets are being completely left for dead on this push, as of now.
The options market is not as bearish on risk assets now as the popular narrative/Twitter suggests. Note how ARKK is showing negative implied volatility on a 30-day basis based on their recent realized volatility. When this pattern is present at market/asset highs, it's a big warning. However, when we see this closer to market/asset lows, it's a signal that the options market believes the volatility in this asset is likely to reverse.
So, over the short term, our plan is to continue to rotate into lower beta positions, ride any momentum of our higher beta plays (CFLT, VYGVF, ASAN, AFRM, etc), and then build cash along the way.
Over the longer-term time frame, we plan to have a reasonable cash position to accumulate shares of great companies for when the economic environment clears up and the bull market resumes. Our targeted themes will continue to be semis, as Beth's long-term thesis is starting to really pick up, as well as Cloud. As growth slows and rates move higher, borrowing costs will be affected as will revenue streams. In a slow-growth environment, we tend to see companies address margins in a much more aggressive fashion. We saw this in 2020 regarding cloud. The cloud migration intensified because companies saw that cutting costly IT infrastructure budgets and moving to cloud systems both reduced overhead and made their business more efficient. We believe the same will happen in the current environment.
Arguably, the most cost-effective microtrend is the work-from-home trend. This allows companies to reduce COL allowances as well as expensive real estate. This trend is here to stay, and we are only in the early stages. For this reason, we like plays like ASAN, ZM, MNDY, etc. Regarding Zoom, it showed a 94% enterprise growth on top of triple-digit comps. Yet, the market continuously beats it down as a consumer play that peaked during COVID. This is a mistake and allows for a great chance to buy a quality company at low relative valuations. Though we did not expect the market to beat it down this much, we do believe a relative floor is under Zoom based on its current price to forward growth projections.
Look for ideas like this as we move into 2022. If/when we start approaching any bottom from the coming correction we will shift our focus to more high beat/speculative plays. But, for now, defense is warranted for anyone looking to not be shocked by 2022. As always, we developed a thesis based on incoming data. If that data changes, so will our thesis and pivot. We are not looking to be right, only make money. Markets are fluid, and thus require the need for pivots If anything changes, you will be the first to know.
Also, it's important to not overreact and sell everything or buy everything in an emotional rush. Instead, we prefer to tilt our portfolio into a defensive/offensive posture. We will target 10-15% cash if our plan for a bounce manifests.
Hybrid and work from home environments are a fundamental tailwind for cloud-based tools that help facilitate this key micro trend. Due to the inherent benefits of hybrid/remote environments, such as decreased fixed expenses (rent) and increased access to global talent, along with the necessary infrastructure in place from the rise of cloud computing, this trend will gain momentum going forward.
Asana is one of the key cloud-based tools that facilitates efficient hybrid work environments and stands to benefit from the structural shift underway that is transforming how people work. Asana is a work management platform that helps teams orchestrate work across an entire enterprise, connecting teams around the globe in an easy-to-use platform. The thesis is fairly easy: do you think workers will go back to being in-office full-time? If not, then more cloud-based tools will be required to perform work efficiently. Notably, these tools were already rising in popularity prior to Covid based on the efficiency factor alone.
Customers use Asana to improve team collaboration and workflow management, helping teams track their progress on projects, assign tasks and responsibilities to employees, set deadlines and keep a record of data related to their work. The company was founded in 2008 by Facebook executives Dustin Moskovitz (co-founder of Facebook) and Justin Rosenstein in 2008.
The two had worked together at Facebook and experienced firsthand the coordination challenges the company faced as it rapidly scaled its business. The two realized that they were spending a significant amount of time trying to figure out who was responsible for what, essentially creating ‘work about work’. This unproductive bottleneck inspired them to create a product that would help organizations coordinate their work.
One of the company’s main focuses has been to increase employee productivity by helping them focus on priority tasks and avoid distractions. Asana has been used by a wide range of companies for multiple uses, such as product launches and marketing campaigns. It helps its users know in real-time what each member of the team is working on and allows managers to easily check project progress to ensure that tasks are completed successfully and on time.
With the rise of remote work environments, Asana’s solutions have experienced rapid growth and demand for its solutions has been especially strong with enterprise customers. Asana went public via a direct listing in September 2020 and the company’s stock is up about 135% since its listing and had gains of about 390% during its peak a month back. Despite the recent pullback in Asana’s stock price, the company remains well positioned to continue to gain share in the rapidly growing work management market (i.e., same story a month ago at a discounted price).
Hybrid-work-from-home will be the future working environment for many organizations, with 73% of employees wanting a flexible remote work option. I am bullish on this micro trend and believe that companies in this space will continue to grow going forward. Asana is a beneficiary of hybrid work environments, evident in its exceptional strong revenue growth, which recently accelerated to 70% in the most recent quarter. The I/O Fund noticed Asana’s rapid growth earlier this year and took a position, realizing an 85% gain in under a month.
Asana, at the time, was quite undervalued based on their expected growth, so we initiated our 1st buy in February at $40. We decided to ride the volatility in Asana in March, and instead looked for breakout, which manifested in May when we added again at $33.25. We became fully allocated in Asana on May 20th, and set our targets above. We trimmed this position 3 times, locking in gains between 65%, 115%, and 224%. We closed the position on November 8th for a 285% gain. Recently, we started accumulating again in the $70s and again in the $60s.
We still like Asana at the I/O Fund, however it’s a position we decided to actively manage rather than buy-and-hold. It could turn into a buy-and-hold but for now requires a more active stance. In the article that follows, I discuss Asana’s market opportunity, product roadmap, financial performance, competitive landscape, and key risks that investors should be aware of.
Market opportunity
The company operates in a large market that is rapidly expanding. According to Allied Market Research, the team collaboration market size is expected to grow at a compounded annual growth rate of 13% for the next decade and reach a total addressable market of $27 billion by 2027. Furthermore, Grand View Research estimated that the global productivity management software market was $43 billion in 2020 and is expected to grow at a CAGR of 14% from 2021 to 2028. In Asana’s recent presentation, they estimate that their total addressable market for workplace solutions will be nearly $51 billion by 2025.
To give a sense of the large market opportunity in front of the company, a recent Forrester Research report estimates that there are about 1.25 billion information workers that would benefit from using Asana’s solutions. The company believes that it is still in the early innings of its the market opportunity and estimates that its market penetration is less than 3% of its addressable population of information workers. Looking forward, there is ample room for Asana’s topline to continue to expand as more information workers take advantage of work management solutions.
Product Roadmap
The company’s platform is built on its proprietary, multi-dimensional data model that it calls the Asana Work Graph. It has features like boards that allow users to easily create tasks for the team, view what other team members are working on, and create different views like calendar list views. Furthermore, the timeline feature allows decision makers to quickly learn the status of a task, who is responsible for executing the work, and helps reduce redundancies.
There are also reporting tools that provide key information about work, such as files, comments and metadata. The result is that Asana helps teams collaborate across an entire organization and ensures that projects are completed on time and efficiently. Asana’s benefits compound in large, complex hybrid work environments such as large enterprises, which I touch on in more detail below.
Another key advantage of the Asana platform is that it has integration capabilities with major apps, such as Microsoft Teams, Okta and Dropbox. These integrations and partnerships with other cloud-based tools help further facilitate the transition to hybrid work environments and improve efficiencies.
With the rising number of information workers who are increasingly working remotely, Asana’s products help employees coordinate core projects, improve productivity across the enterprise and remove information silos that have historically separated teams across an enterprise. Asana’s solutions also yield a solid return on investment for its customers. According to a study conducted by the IDC, respondents reported that Asana has increased organizational efficiencies by reducing time spent on emails by 33%, improved process execution by 42%, and has yielded a 224% 1-year return on investments for its customers.
Asana has also partnered with numerous technology firms to add more features and functionality to its platform. A standout that management highlighted during the Q2 earnings call was Zoom’s integration within Asana. This unique feature allows Asana customers to create a Zoom meeting while they are performing a task directly inside the Asana platform. Once the Zoom meeting is over, the Zoom recording and the transcript can be added to Asana and tasks discussed during the meeting can be assigned to owners. This functionality improves the efficiencies of meetings and helps reduce the amount of time spent “working on work”.
As mentioned above, work complexity compounds as organizations increase in size and become more dispersed with hybrid work environments. Asana’s Work Graph helps reduce the growing complexity for enterprises and replaces micro-management with macro-management, “by aligning [leaders] around key objectives and the work needed to achieve them no matter where they are in the world” (Q3 Earnings Call). We can see the success that Asana has had reducing hybrid complexities by observing growth trends with large enterprise customers, which have accelerated recently. I discuss this trend and Asana’s financials in more detail next.
Financials
Asana released its Q3 FY2022 results on December 02, 2021, which beat both on the top and bottom-line. Revenue growth accelerated to 70% YoY and quarterly sales were $100 million, which beat analysts’ estimates by $6 million. Revenue has increased sequentially for at least 11 consecutive quarters and Asana now has an annualized topline run rate of over $400 million. The growth was led by strong customer metrics as total paid seats surpassed 2 million and total paying customer increased 28% YoY to 114,000.
However, the real story is Asana’s success with enterprise customers, which generally pay more and sign longer-term contracts. Because of this, enterprise customers are generally the most valuable type of customers for a software provider. Asana’s success with this cohort speaks to the overall value that its workplace solutions provide.
For example, while total paying customers increased 28% YoY to 114,000, customers spending $50,000 or more per year (enterprise customers) grew by 132% YoY to 739. This represented an acceleration from the 111% and 92% YoY growth rate in enterprise customer count in Q2 and Q1 FY2022, respectively. The accelerating growth in enterprise customer count highlights the benefits that Asana provides to large, complex hybrid environments. Further highlighting this strength, Asana’s dollar-based net retention ratio for enterprise customers was 145%, up from 140% in the prior Q3 period and exemplifying that enterprise customers are expanding their usage of Asana overtime, a sign of strength.
Some of the large key customer wins in the quarter included Warner Music Group, which chose the company’s enterprise solutions “to organize, manage and track the end-to-end process of how they identify, evaluate and bring new artists into its various labels faster and more effectively”. Asana also expanded its deal with a Japanese customer, which is one of the largest automotive manufacturing companies in the world. Management explained that the Japanese auto customer’s expanded agreement was to help manage their software and product developments (Q3 2021 Conference Call). These customer wins highlight that Asana is useful across multiple industries and different geographies.
It is noteworthy that while Asana is growing its enterprise customer base, it is doing so on a global scale. This provides support that Asana is still early in its topline run rate and has amble room to expand both domestically and globally. Furthermore, Asana is preparing for global growth as it recently expanded its support to 13 different languages, which will help the company capture customers is numerous markets around the world.
Looking forward, Asana expects Q4 revenue to be in the range of $105 million to $106 million, representing a 53% to 54% YoY growth rate. While this represents a deceleration from recent growth rates, the company is likely being conservative with their topline guide. For instance, management guided Q3 sales to grow 59% YoY (at the mid-point) and actual Q3 sales growth came in at 70% YoY.
Management also expects Q4 adjusted operating loss of $53 million to $51 million and adjusted net loss per share of ($0.28) to ($0.27). This represents a larger loss than the Q3 adjusted operating loss of $41 million and adjusted loss per share of ($0.23). While the guide for larger losses is somewhat concerning, the company is investing to grow rapidly to capture market share in the large, untapped work productivity market. As a result, Asana is front-loading investments today that will pay dividends in the future.
We can see the front-loading of expenses by observing trends in sales and marketing (S&M) expense. As shown below, the company’s S&M expense increased as a percentage of total revenues to 73%, which was up 200 bps QoQ but down 900 bps YoY. Asana’s COO Anne Raimondi explained on the Q2 call that the company has been ramping hiring to support international expansion. Specifically, she stated that the company has been “increasing sales and marketing capacity across all of these new offices and regions. So, lots of hiring to support our customers”. Ultimately, I am not concerned with the rise of S&M expense margin since the company is investing in its future growth, which will help the company quickly scale its operations, improving both earnings and cashflows in the long run.
Moving to cashflows, quarterly free cash flow was -$30 million as of Q3 FY2022, down YoY from -$20 million for the same period last year. However, YTD free cash flow -$46 million, an improvement from the prior year metric of -$58 million. Cashflows can be lumpy, but as enterprise customers continue to increase as a percentage of total sales, their recurring upfront cash payments will lead to improving cashflows overtime.
Stock-based compensation and insider purchases
It is also noteworthy that Asana pays some of its salaries with stock-based compensation (SBC), which cosmetically improves the presentation of cashflows. For instance, in the latest quarter, Asana issued $26 million in SBC, up from $9 million in the prior year quarter. However, quarterly free cashflow improved $18 million YoY, or $1 million absent the benefit from increased stock-based compensation. The increase in free cashflow after adjusting for the rise in SBC highlights that Asana has been able to leverage its scale to a degree. Nonetheless, cashflows will remain lumpy going forward and SBC growth may outpace free cashflow generation in the near term.
A benefit of rising SBC is that it makes employees owners in the business, giving them a vested interest in the company’s success. This in turn should improve employee retention and lower turnover, which will help Asana better scale its operations as seasoned employees are generally more efficient than new hires.
Management has also been purchasing shares, which can be a sign that management believes that the company is undervalued. For instance, board member Lorrie Norrington recently purchased 3,733 shares on December 6th for a total purchase value of $248,000 (~$66.51/share). This was the second time she had purchased shares this year after spending $199,000 for 6,200 shares in March 2021(~$32.12/share). Ms. Norrington’s purchases follow a drop in Asana’s price following the general tech sell off that occurred in the back half of 2021. Given the company’s continued strength with enterprise customers discussed above, Asana may be at a decent risk/reward right now.
Another insider that has been purchasing shares is CEO-founder Dustin Moskovitz. CEO Moskovitz has purchased over 6 million shares year to date, which is generally a very bullish signal. However, the purchases likely relate to the redemption of a convertible bond that CEO Moskovitz holds in a trust. As disclosed in Asana’s 10Q, the company elected to convert a convertible note that was “held by a trust affiliated with Mr. Moskovitz and the shares were accordingly issued to the trust. The conversion of the Convertible Notes therefore increased Mr. Moskovitz’s voting power”. Nonetheless, the increase in CEO Moskovitz ownership further aligns his incentives with shareholders, which is generally a positive development.
Competition and why Asana is winning
The work management platform space is very competitive and there are numerous public and private companies competing with Asana. Asana’s main publicly traded competitors are Atlassian (Jira) and Monday.com, but they also compete with Smartsheet and other private companies such as Airtable. For the sake of brevity, I will only be discussing Monday.com and Atlassian’s Jira offering and what sets Asana apart from these competitors.
One of the key pillars separating Asana from Jira is that Asana is built for all teams within an enterprise, while Jira was specifically designed for software developers. Asana claims that Jira is not flexible enough to be applied to teams across an entire enterprise, while Asana was built to be applicable to all employees within an organization. However, the two are not mutually exclusive and users are able to integrate the Jira cloud within the Asana platform, brining Jira’s software development focus into Asana’s easy to use workflow platform. This integration allows all employees to remain in sync and helps various teams, such as business and software development, collaborate across the organization. To remain competitive, Atlassian bought Trello in 2017.
Possibly Asana’s most direct competitor is Monday.com, which went public in June 2021. The two are the leading providers of workflow solutions and both are growing strongly. Asana differentiates itself by being easy to use, transparent and user friendly, making it accessible to all users in an organization, even the non-technical ones. On the other hand, Monday.com claims that it is a Work Operating System, that is more advanced and customizable.
Without getting into the differences in the platform offerings, the key differentiator between the two is likely price. Given that enterprise customers are important to both of these companies’ success, and that neither company directly discloses enterprise pricing, I relied on enterprise customer metrics to get a sense of which platform is favored by large organizations.
As mentioned above, Asana’s enterprise customers growth recently accelerated from 111% to 132% YoY growth, the fastest pace of YoY growth in FY2022. Similarly, Monday.com also reported an acceleration in enterprise customer growth, as customers with annualized recurring revenue >$50,000 grew 231% YoY, up from the Q2 growth rate of 226% YoY.
While Monday.com is growing enterprise customer’s faster than Asana, Asana’s enterprise growth is accelerating more rapidly. For instance, Asana’s enterprise customer growth accelerated 2,100 bps in the most recent quarter, versus to 500 bps acceleration for Monday.com.
Moreover, Asana had 739 enterprise customers in the latest period, which was 20% higher than Monday’s 613 enterprise customers. However, Monday.com was founded in 2012 while Asana was founded in 2008, so Asana’s head start may be the reason why Asana currently has more enterprise customers.
Unfortunately, neither company directly discloses enterprise pricing, but Asana did announce that they have some seven and eight figure deals, highlighting how not all enterprise contracts are not the same. It is noteworthy that both companies report high gross margins, with Asana reporting a GAAP gross margin of 91%, which is about 300 bps higher than Monday.com’s GAAP gross margin of 88%. Asana’s higher gross margin suggests that it is not sacrificing price to drive sales growth, which can be a sign of competitive strength, especially given its recent acceleration in enterprise growth. However, both companies have very similar metrics and are valued about the same (Asana’s market cap is $13 billion while Monday.com market is $12 billion as of publication).
The market likely needs more time and information to fully understand who the winner will be in the work management platform space. However, recent trends suggest that Asana may be pulling ahead given its rapid acceleration with enterprise customers and higher gross margins. We are still early in Asana’s growth story, and there are plenty of risks ahead of the firm, which I discuss in more detail next.
Risks:
Asana faces significant competition in the fast-growing work management space and it is not yet clear who the winner will be. Furthermore, larger companies could very well enter the space and compete with Asana’s solutions, possibly turning customers into competitors.
Asana has also experienced rising losses as it scales its business. The company’s operating expenses are expected to be high as it invests in human capital and office space to expand its operations globally. There is also no clarity as to when the company will be profitable, and shareholders may be diluted if cashflows do not improve going forward. Furthermore, the company recently reported a deceleration in bookings growth, which may forewarn a broader slowdown in sales in the near term. CFO Tim Wan addressed this concern during the Q3 call and explained that bookings are not a great barometer for growth, due to the large amount of customers still on monthly billing plans. Since monthly customer do not impact deferred revenue, they skew the calculation of bookings. Nevertheless, bookings growth will need to be monitored going forward since it is an important metric for Software-as-a-Service companies.
Conclusion
Looking forward, Asana appears well positioned to continue to capture share in the work management space. Hybrid and remote work environments are a structural tailwind that will drive demand for work management solutions. Furthermore, these tailwinds will likely gain momentum due to the inherent benefits they provide to both employees and employers. Asana recently reported an acceleration in topline growth, and enterprise customer metrics accelerated even faster. While it is not yet clear who the winner will be in the work management space, Asana appears well positioned given its high gross margins and strong customer metrics. Asana has a large addressable market in front of it and its penetration is very low, suggesting that we are still very early in the company’s growth story.
Royston Roche contributed to this article.
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We’ve held DocuSign for over a year although we have not added to this LTBH position for some time. Below, we discuss why we closed the position. Our members must make their own decisions, we simply offer transparency on why we add stocks to the portfolio and why we close some positions. We always remain flexible – even with LTBH. The companies we hold must continually earn a position in the portfolio. We add positions and close positions at our discretion and we offer full transparency because we think it’s the right thing to do with anything related to finance.
We plan to re-allocate more towards Asana, Monday.com and Zoom Video for the productivity/WFH/remote trend. We lump DocuSign into this category as a productivity-based cloud company for agreements and signatures and certainly WFH helps the company. However, we think the addressable market and growth will be stronger on the other three we mentioned.
Thank you! 🙂
DocuSign
DocuSign’s earnings report spooked the market with billings growth of 28% year-over-year and billings guidance of 22.2% next quarter. For the fiscal year ending in January, the billings growth is forecast at 36% year-over-year. The company said this was caused by slowing demand, urgent buying patterns that tempered and also “the environment shifted more quickly than we anticipated, and these were the primary contributors to our billing results in Q3 and our outlook for Q4.”
The CEO also took the blame for the slowing billings growth and stated he was more focused with handling the business that came from the urgency of the shift towards cloud rather than generating new demand. “And we really do believe it’s this core phenomenon of the demand was aggressive and we got focused on meeting that demand. And so, when that demand kind of started to come to — back to normalized, we weren’t ready. We weren’t executing. We hadn’t taken all those new folks that had only joined in the time of that meet demand sort of mode and we didn’t shift fast enough back to a mode of a normal generating demand.” And later, it was stated, “But the real — the underlying story here is that we did not execute in our field the way you should expect us to execute and we got to own that and we got to fix that, and that’s why we’re putting the focus as we talked about at the beginning of the call on that execution.”
Probably where our decision hinges even more is the lack of catalyst for DocuSign as it does not necessarily participate in the hybrid or remote work-from-home trend. I’m referring specifically to the trend where 30% of the workers globally and more than 50% of the workers in the United States will remain in a WFH situation after cities fully reopen, and productivity will need to be progressively maintained across remote workforces. These tools are ideally usage based or based per employee, whereas DocuSign is tied to the number of contracts being signed.
The blockchain could be a catalyst for DocuSign or it could be how the company is will become disrupted. According to management, the blockchain is too costly for the number of agreements that DocuSign facilitates but this could change over time. DocuSign has stated the blockchain can help with identity management, however, and it’s one of the use cases the company plans to pursue although this would ideally happen with a blockchain specifically made for auditing documents and e-signatures rather than native protocols suited for the financial industry or gaming.
It's also important to note that the company pointed towards a lack of cross-sells and upsells as another factor weighing on future bookings growth: “However, what we weren’t as successful at is getting as much of the cross-sell and upsell opportunity.” This is concerning to me long-term as the net retention rate for DocuSign has been in the 112% to 119% range and is currently in the 121% range. Ultimately, I’m not convinced there is enough an up-sell with this product to expand the customers that came onboard during 2020.
One analyst attempted to get a clear sign from DOCU on when a turnaround could occur and it seems at least until the second half of next year.
“And then, because it does feel like given the sales cycles for these larger contracts are at least 6 to 9 months, this could be something that impacts you at least until you anniversary Q3 of next year. So, just get a better understanding of the — how long those elements, I guess.” – Alex Zukin, Wolfe Research
Here was management’s answer which seems to indicate H1 could be better:
“Yes, similar to some of the other commentary, I think the right way to think about it is, again, the things that were toughest for H2 of this year are going to be the areas that were dramatically strong all last year and H1 of this year. And from a geography standpoint, that’s basically the U.S., right? And from a vertical standpoint, that’s going to be healthcare, life sciences, that’s going to be financial services, banks, insurance companies, et cetera, and a little bit on the technology telecom side. So, that’s — we just clearly see that in the data.”
Currently, analysts have full year revenue for next fiscal year at $2.61 billion, or 24.8% growth.
DocuSign technically beat on EPS and revenue in the current quarter and the company is profitable. The guidance for revenue missed with analysts expecting $575.3 million and the company guiding for mid-point of $560 million. The company reported free cash flow of $90 million compared to $38.1 million last year, for a EV/FCF of 73 compared to Zoom at 32. The company has $900 million in cash and cash equivalents.
For digging our heels in on Covid stocks, we are waiting to see what Zoom’s Q1 guide says regarding the company’s post-Covid growth potential. We also like Asana and Monday.com due to enterprise growth as well other reasons outlined in our Forbes editorial and published on the forum here.
Shopify reported Q3 results that came in slightly below expectations as consumers reverted to offline shopping during the quarter. However, growth remained robust as sales grew over 40% and YTD GMV increased to over $120 billion. Shopify also announced it is increasingly expanding into social commerce, which I discuss in greater detail below. We are bullish on Shopify and the company will remain a LTBH position into 2022.
Note: Beth Kindig contributed to this analysis
Shopify’s Q3 results
Total Q3 sales increased 46% YoY to $1.12 billion, which missed the Street’s estimate by $22 million (2%). Sales were driven by a 51% YoY increase in Merchant sales, which rose to $788 million. Merchant sales were supported by growth in GMV, which increased 35% YoY to $41.8 billion, after increasing 109% in the prior year quarter. Specifically, GMV penetration in Shopify Payments increased from 45% to 49% including from point-of-sale hardware for offline sales. Shopify’s goal with Merchant Sales was to support both online and offline with the economy reopening. The partnerships with Affirm and Global-E also contributed to this growth.
Here's an excerpt discussing this:
“Just to sort of give a little more color on point of sale because I do think Q3 was our best quarter for the retail business. Retail GMV hit an all-time high. But we are bringing Shopify as a very efficient go-to-market model to the POS industry. We're not leaning on established networks of partners, but rather we're doing this in a really efficient way. … Again, retail GMV is the second largest contributor to overall GMV behind the online store. We also saw point-of-sale with Shopify Payments continue to expand globally… Point of Sale Pro is available now across more devices like Android devices.”
Following the growth in merchant sales, subscription sales increased 37% YoY to $336 million, which slightly outpaced the 33% YoY increase in monthly recurring revenue. According to management, this is being driven by merchants globally adopting the Shopify platform. International is an area where Shopify is investing with currently 28% of purchases coming from international buyers.
While GMV growth has been strong, GMV moderately declined QoQ from Q2, as consumers shopped more offline as restrictions from Covid-19 have been eased and stimulus has dissipated. Through the first nine months of the year, GMV increased to a record $121 billion. In fact, the company pointed out that GMV has doubled over the past 16 months from $200 billion in June of 2020 to $400 billion at the beginning of October. GMV, or Gross Merchandise Volume, represents the total dollar value of orders facilitated on the Shopify platform including revenue-sharing arrangements. It helps to demonstrate the growth of Shopify’s platform and its reach. As of now, Shopify owns 8.6% of the market measured in GMV and is in second place behind Amazon, with a wide lead at 39%. Shopify’s second-place ranking excludes merchant point-of-sale which was a big driver for Shopify this year, so it’s percentage could be higher.
Looking forward, subscription sales will likely continue to be strong given the company’s high levels of deferred revenue. Deferred revenue surged 216% YoY to $378 million, or 113% of three-month subscription sales. However, deferred revenue was skewed by large amounts of non-cash considerations from new partnerships that Shopify has signed. I discuss these partnerships in greater detail below. Nevertheless, after adjusting for non-cash consideration, deferred revenue still increased 42% YoY to $137 million, which represented 41% of quarterly subscription sales, up 100 bps YoY from 40% in Q3 2020. The relatively higher level of deferred revenue positions Shopify for continued growth since it provides balance sheet support for future sales.
Continuing down the income statement, gross profit margin increased 100 bps YoY to 54%, while adjusted operating margin declined 500 bps YoY to 12% as the company ramped investments in sales and marketing expenditures. GAAP EPS surged YoY from $1.59 in Q3 2020 to $9.18 in Q3 2021 while adjusted EPS declined YoY from $1.13 to $0.81, which missed estimates by $0.41. The large disparity between GAAP and non-GAAP was driven by $1.3 billion in unrealized gains from its investments in Affirm and Global-E, which were excluded from earnings. These large gains are a direct result of Shopify’s partnership agreements, which I also discuss in greater detail next.
Shopify expands partnerships into social commerce
Shopify has expanded its reach beyond traditional e-commerce by partnering with and incubating new companies. As mentioned above, Shopify received shares in Affirm and Globe-E last year in return for cash considerations while working as a partnership, which has resulted in over $3 billion in gains in less than a year (note that not all partnerships result in equity awards).
The company has continued this trend and has announced a series of new partnerships that help expand its role into social commerce. For instance, Shopify recently announced partnerships with TikTok, Spotify and Roku ahead of the holiday shopping season. In August, Shopify announced a partnership with TikTok and introduced TikTok Shopping. Business owners will now be able to sync their product catalogues to their TikTok profiles that creates “a mini-storefront that links directly to their online store for checkout … The TikTok community can choose to shop directly from the merchant’s storefront or click a tagged product in a merchant’s TikTok video, which will take them to the merchant's online store for checkout”.
The TikTok partnership could be significant in the future as the platform is one of the fastest growing social media sites with hundreds of millions of users. This partnership should drive demand for Shopify’s merchant solutions, as well.
Shopify also announced a partnership with Spotify in October, expanding further into social commerce. Fans can now purchase merchandise, tickets and even tip artists through a Shopify integration directly on Spotify. Spotify is the largest artist platform with over 365 million global listeners, and this partnership has the potential to grow significantly as fans are increasingly spending more on their favorite artists. For example, the global average music fan increased their spending by 17% from $5.54 in 2019 to $6.49 in 2021. According to Spotify, there are over 8 million artists on the platform, which could be a significant tailwind to Shopify if they begin to set up their own Shopify integrations selling their own merchandise and tickets.
Lastly, Shopify also announced a partnership with Roku in September. Roku is launching an app that allows Shopify merchants to “easily build, buy, and measure TV streaming advertising campaigns. Roku’s addition to Shopify’s marketing solutions will become the first-ever TV streaming app available in the Shopify App Store, opening the door to small and medium-sized businesses to build stronger brands and increase revenue through TV advertising”. This unique partnership allows Shopify merchants with relatively small ad budgets to advertise on television, a medium that has typically been reserved for large companies. Given Roku’s rich user data, they will be able to help Shopify merchants better target their audience. Roku added that a recent poll showed that nearly half of “polled consumers said they have seen an ad on their TV streaming device that caused them to pause their TV and shop for the product online”. Roku’s streaming platform is quickly turning into a shopping platform, and the partnership with Shopify should benefit both companies going forward.
On top of the partnerships, Shopify also makes investments in merchants on its platform. Shopify made $394 million in cash advances and loans to merchants in Q3, up 56% YoY. Shopify Capital has grown to approximately $2.7 billion in cumulative capital funded since its launch in April 2016. These investments help merchants grow, which in turn increases GMV and revenues on the Shopify platform.
Moreover, Shopify adequately provisions for potentials losses with these loans. As shown below, Shopify’s provision for loan losses (which protect against collection risk) have vastly outpaced charge offs in 2021. This signals that Shopify is being conservative and is not using Shopify capital to juice earnings but is instead using the program to foster organic growth at the company.
Outlook
Heading into Q4, Shopify did not directly quantify its guide, which isn’t unusual for the firm as Shopify did not provide a Q4 guide last year. Rather, Shopify stated that it expects to grow revenue rapidly in 2021, but at a lower rate than in 2020 (which was a record year). Furthermore, Q4 is expected to continue to be the largest quarter in terms of revenue generation for the year but due to stimulus in Q1 and Q2, the revenue spread will be more evenly distributed across the four quarters than it has been historically.
Shopify also expects that its GMV will grow “substantially faster than the commerce market”. On the call, CFO Amy Shapero said that she expects Shopify to continue to take share of the retail market. Management also guided that it expects costs to slightly accelerate in Q4 as it reinvests back into its business by hiring more engineers to support growth. Despite the acceleration in hiring, the company expects 2021 adjusted operating income to be above the level in 2020.
Following the above description, the Street slightly lowered their Q4 topline estimates by 2% to $1.3 billion, representing a 38% YoY growth rate. However, analyst raised their Q4 estimate for non-GAAP EPS by 8% to $1.32/share. For the year, 2021 sales are expected to increase 56% YoY to $4.5 billion and non-GAAP EPS is expected to grow by 59% YoY and reach $6.34/share. While Shopify hasn’t provided guidance for 2022 yet, the Street expects sales to rise 34% next year and earnings to increase 7%. It is noteworthy that Shopify’s recent expansions into social commerce may not be fully reflected in forward estimates, which provides a potential catalyst for an upward revision in 2022 estimates going forward.
Conclusion
Looking forward, Shopify is expanding its role into social commerce and has partnered with marquee companies such as Roku, Spotify and TikTok. The company’s partnerships have resulted in large gains in the past (ie Affirm and Global-E) and should support growth of Spotify’s merchant platform in the future. The company’s financials have also been strong and Shopify appears to be positioned well to continue to report strong growth going forward.
We did not touch on the Fulfillment Center, yet this is one of the more exciting prospects for Shopify in the future, as is Shop App and more enterprise-level commerce opportunities. For instance, the company’s Shopify App store is now integrated with ERP systems from Microsoft and Oracle for major, large retailers. This is used for companies like General Mills to launch with Shopify Plus for products like Larabar, and also helps prove the sophistication of Shopify as the company seeks to take more TAM from Amazon and other competitors. We will touch on these developments in the future as more information is disclosed.
The reason we think that UiPath has winning potential is that RPA is in its infancy and historically the company’s retention and upgrades are second-to-none. RPA is one of the best ways to participate in the benefits of AI/ML early-on with UiPath’s scalable automation solutions used by early adopters. As the market matures, we think the analyst jitters over a new business model will clear up over time. This is because it’s clear that once customers adopt PATH, they stay and upgrade – which consequently, a lack of upgrades is one reason why we exited DocuSign. My goal is to get you an update on DocuSign by Monday at the latest.
UiPath:
We’ve covered in the past that UiPath’s annual recurring revenue (ARR) is important to pay attention to and management emphasized again this in the latest call. Prior to the billing change, UiPath’s revenue led ARR growth, yet due to a billing cycle change, this is not the case temporarily. The billing cycle change could be misinterpreted as a sign of weakness, when in reality, it’s is motivated by UiPath wanting to attract a wider range of customers with shorter 1-year billing cycles. If the graph below is any indication, then revenue should normalize in time to where revenue again leads ARR, which is of course, an annual metric unaffected by this billing cycle change.
“We have a structured process in place to calculate and report ARR, because it is invoice based, we believe that it is the most accurate and reliable measure of our true business activity. It most closely aligns to long-term cash flow and best aligns to renewals and given our strong dollar based gross retention rate, which was 98% in the third quarter. ARR is most reflective of customer commitment, regardless of deployment model.”
The global market size for RPA is at $2.07 billion in 2021, up from $1.23 billion in 2020. UiPath is expected to report $885 million in revenue for fiscal year ending in January. This means UiPath owns up to 42% of the RPA market and we expect this lead to continue given the remarks on the call about market share and competitors.
With the market expected to reach $7.01 billion by 2025, UiPath’s 40% penetration would equate to $2.8 billion or 3.3X growth. In 2030, UiPath could be reporting as much as $5.5 billion in revenue or 6.5X growth in revenue. This is all while nearing profitability, which is rare this soon after going public. According to other estimates, RPA services will expand the addressable market to $4.3 billion by 2022, which is higher than the estimates previously listed.
I think these estimates could be low given the cost savings that RPA offers. Below, we see enterprises saving millions of hours per year with savings in the millions of dollars from automation. Morgan Stanley seems to agree with a note that the RPA market could reach $56 billion with the firm concluding UiPath owns 30% to 32% of the market. Notably, Gartner has also pointed out that UiPath’s revenue growth is higher than overall RPA market growth.
We had covered in our original research report that owning Path and RPA is attractive for our portfolio because of the pain point the company solves. Automation is truly unique in terms of the benefits it provides to the enterprise. Here were a few states we had quoted:
“The ROI is astounding when you have an error-free employee who works 24/7 and does not tire or need bathroom breaks. To illustrate, a few automations can save 20 minutes of work per person daily and enabling 10K employees with a software robot could save more than $30 million a year (based on an average salary of $35/hour).
According to analysts like Forrester, 14.9 million jobs will be created by 2027 to work alongside robots. It’s not clear though how many jobs robots will replace and if the 15 million is actually a deficit.
According to McKinsey, $3.6 trillion of work can be automated. The piece of the pie that UiPath is after is the automation of applications for enterprises. The number of applications deployed by enterprises has increased by “approximately 70% over the past four years,” according to Wall Street Journal.
According to McAfee, the average enterprise has deployed 464 custom applications and deploys an additional 37 new applications in a 12-month time span. Companies with fewer than 1,000 employees run 22 custom applications while companies with over 500,000 run 788 custom applications, on average. The majority of these applications (58%) are used internally while 36.2% are used by customers, partners and suppliers. These larger enterprises – with the 788 applications on average — are the companies that UiPath is targeting.”
There are a few stats the company gave in the most recent earnings report, as well:
· Hana Bank has applied automation to 80 processes, an estimated saving of around 1.5 million hours per year.
· Saudi Ministry of Tourism reduced the time needed to collect process and analyze data by 95%, from 30 minutes per record to 40 seconds
· Toll Group freed up 170,000 hours and they are on track for savings of $1.6 million annually.
On the competitive front, the earnings call was quite direct about UiPath outpacing competitors. The primary competitors are Blue Prism, Automation Anywhere and Microsoft.
Microsoft is not building a best-of-breed product and there’s no indication they plan to take UiPath head-on right now.
“Our own data, if we take into account the deals where Microsoft is participating versus the deals where Microsoft is not participating, we are not seeing material changes in our winning rate. So right now currently, I can say Microsoft has — doesn't have a meaningful impact on our ability to win customers. What is going to happen in the next couple of years, first of all, I would like to make a case that Microsoft is focused with their RPA mostly on citizen developer and personal productivity. This is a small part of our overall TAM. So I don't see that in the coming years, Microsoft investment and competing with us will materially derail us from our growth trajectory that we are seeing and we are building right now.”I would like to make a case that Microsoft is focused with their RPA mostly on citizen developer and personal productivity. This is a small part of our overall TAM. So I don't see that in the coming years, Microsoft investment and competing with us will materially derail us from our growth trajectory that we are seeing and we are building right now.”
Regarding Automation Anywhere and Blue Prism, an analyst said the following:
“So Daniel, at your User Conference in Las Vegas, one of your partners was saying that this market in the past was a three-horse race and the two of the horses got broken legs. And there were so many stories of Blue Prism and automation anywhere customers migrating to UiPath, I'm just wondering if you can shed some light on whether you have a little extra tailwind from that type of activity?”one of your partners was saying that this market in the past was a three-horse race and the two of the horses got broken legs.And there were so many stories of Blue Prism and automation anywhere customers migrating to UiPath, I'm just wondering if you can shed some light on whether you have a little extra tailwind from that type of activity?”
The management responded by saying geographies like the Nordics, Canada and the United States are regions where competitors are “withdrawing their presence significantly.” However, management points towards the market being too new for this to be a tailwind (usually this becomes more important in a mature market). Instead, the growth is coming from keeping their current customers happy with the platform and also from new customers for growth.
A Note on Cloud …
There was some discussion on the forum over UiPath’s ability to perform well in cloud-native environments.
We had pointed towards the acquisition of Cloud Elements to expand UiPath from UI-based process automation to also include API-based could be an important competitive advantage for UiPath as it now operates with the same integrations as its competitors yet is more end-to-end. The analyst above is also implying that UiPath is taking market share from Automation Anywhere, the cloud-native automation platform. Here is what management said:
“Automation suite enables our customers to leverage the power of the full UiPath platform with the benefit of a cloud native architecture. However they choose, on-prem, public cloud or third-party hosted with the single install on Linux. 21.10 also included the introduction of Linux based software robots, a capability that is required to be a truly cloud native company. This allows our customers to achieve scalability and auto scalability in a cost-effective manner.”
The integrations with Crowdstrike, Snowflake, Qlik, AWS, etcetera, also point towards cloud-enabled solutions. Gartner seems to agree that UiPath has no issues competing in the cloud with the following analysis on the company’s weakness:
“Web-based development: Despite its strong focus on cloud-based RPA, and its existing web based UX App builder, UiPath still lacks a web-based RPA development environment — a shortcoming that will limit adoption by enterprises that prefer a minimal hardware footprint. However, UiPath does offer cloud orchestration capabilities and plans to build a web-based developer environment soon.”: Despite its strong focus on cloud-based RPA, and its existing web based UX App builder, UiPath still lacks a web-based RPA development environment — a shortcoming that will limit adoption by enterprises that prefer a minimal hardware footprint. However, UiPath does offer cloud orchestration capabilities and plans to build a web-based developer environment soon.”
As far as a decreasing TAM due to on-premises, I don’t see any evidence of this. UiPath’s end-to-end solution across all environments is a strength. The company is seen as a leader in RPA across many reports: Gartner, Forrester, Everest Group, MarketScape, etcetera. You’d be hard pressed to find any product analysis on RPA that doesn’t thoroughly assess UiPath’s product as the leading product across both cloud and on-premise. This is important because RPA may become a winner-takes-all due to scaling complexity.
Below is a chart that shows the percentage of interest in RPA as of 2017 compared to the number of companies that had deployed it:
The most recent survey from Deloitte stated that 73% of organizations have looked into automation, up from 58% in 2019. The issue is that very few have reached automation at scale with the far majority in the piloting stage. We think this will resolve over time and this is the primary reason we are invested in UiPath – real demand with high anticipated penetration being consistently reported across analyst firms, yet many companies are stalling out due to the complexity of the solutions, and UiPath leads the category. We also think that as organizations chose UiPath over other vendors, that the high switching costs will be nearly insurmountable.
Financials:
I agree with the forum comment that the earnings report was unremarkable. The company did beat on both top line and bottom line and increased the forward, yet the market is still trying to factor in the slowdown in growth from previous years which was roughly 127% in fiscal 2019 and 80% in fiscal 2020. Will the slowdown stabilize or continue to meaningfully erode? That’s why the company hasn’t quite won the confidence of Wall Street yet.
Regarding my comment on the fact that high switching costs are nearly insurmountable, I can’t give you a clear reason as to why UiPath did not discuss their net retention rate in the most recent earnings reports. In the past, it’s been an industry-leading number of 145%+ and my hope is that it continues to be above minimum the 130% range for the next few years.
As stated, the company emphasizes ARR, yet this is declining although still above 50% on the forward guide. The YoY growth in ARR was at 64% in fiscal Q1, 60% in Q2, 58% in Q3 and is expected to decelerate again to 55% in Q4. Despite the beat, the company’s deceleration is being penalized as are nearly all decelerations in cloud from the Q3 reports.
If we read between the lines, we see that Covid had a negative upfront effect on UiPath although Deloitte believes in the long-term, digital transformation will be a tailwind for UiPath. Cost could be one factor as to why we are seeing slowing growth and the other could be that organizations had to prioritize cloud migrations. Regardless, the $3 billion market size is communicating that RPA is early and the slowing growth is not because demand is slowing; rather it may have been paused or de-prioritized. It’s true that investing in Path is a bet that it’ll resume stronger growth in the future.
The key metric that is most exciting from the recent report is that customers with $1 million plus ARR was up 82% year-over-year. The customer category above $100K was up 52% year-over-year. UiPath also plans to be profitable next quarter but this could be lumpy depending on how many investments the company makes. Nonetheless, gross margins remained robust as consolidated gross margin was 85% and software gross margin was 93%.
Remaining performance obligations (RPO) increased 80% to $579.5 million, while RPO to be completed in the next twelve months (NTM RPO) increased 11% QoQ to $359 million. Looking forward, NTM RPO represents 33.0% of the NTM revenue estimate, an improvement of 70 bps QoQ. The improvement in NTM RPO relative to forward sales expectations provides a ‘floor’ for future sales, improving the quality of forward estimates.
However, it should be noted that cash support for future sales has declined. For instance, current deferred revenue relative to NTM RPO declined QoQ from 73% to 70%, which lowers the quality of recently reported RPO. However, the billing cycle discussed above may be temporarily skewing this metric, as management is prioritizing one-year deals over multi-year deals. We will be watching this metric going forward and anticipate an improvement as the trend annualizes. Furthermore, current deferred revenue has increased relative to subscription sales for the past two quarters, highlighting that one-year deals appear to be healthy and suggesting the lower cash support is due to the drawdown in multi-year deals.
Moving down to cashflows, quarterly cashflows from operations declined from $7 million down to an outflow of -$25 million. The steep drawdown in cashflows is likely a result of the company’s billing cycle change mentioned above, as the upfront cash payments from multi-year deals is being replaced with relatively smaller amounts of upfront cash payments from one-year deals. We should expect cashflows to improve going forward as this trend fully annualizes. Management has discussed that it does not have to sacrifice as much margin (and cashflows) with one-years relative to multi-year deals, so in the long run this change should improve cashflow generation, all else equal.
Conclusion:
I’ve heard UiPath called a story stock and I agree. The story here is quite compelling in terms of the percentage of organizations that are pursuing automation (70%+) compared to the number that have scaled RPA solutions (low single digits). I believe there is enough evidence that UiPath is the leader and will continue to lead. I tend to not counter invest in product leadership. The ongoing integrations and partner network also certainly doesn’t hurt which we covered in our original analysis here.
