I/O Fund lead tech analyst Beth Kindig joined Motley Fool analyst Deidre Woollard on podcast about Women in Investing to talk about the recent downturn for tech investors and how Beth and I/O Fund are weathering the storm.
It’s been a bumpy road, but despite that, I/O Fund and Beth Kindig continue to be buyers. “When we see a quality company being down in price, we try not to overthink it, because there will probably be a day where we will talk about the prices of 2022, meaning that they were so low,” says Beth. “The probability that 2022 was oversold is pretty high at this point. It was just an extreme reaction to the downside, as part of 2020 and 2021 was an extreme action [in] the opposite direction.”
Both Beth and I/O Fund are part of the 2030 club – meaning that we are both fully invested in tech through 2030 at minimum. Especially with tech stocks, Beth says you need to have at minimum a 3-year hold, and ideally a 5- to 7-year time horizon. She notes that her 2018 and 2019 entries are doing very well right now because she has held them for 3+ years.
Regarding the last earnings season, Deidre mentioned that although there were a lot of companies that reported some pretty strong results, the market kept reacting negatively, asking if it represented an opportunity for Beth. The I/O Fund pays really close attention to earnings, and when a company has a really strong report and the market sells off, that’s usually a buying opportunity for I/O Fund. Beth notes that while I/O Fund uses a combination of fundamental and technical analysis, as a long-term buy-and-hold tech industry analyst, she looks for management to give an outlook.
Sign up for I/O Fund's free newsletter with gains of up to 403% – Click hereSign up for I/O Fund's free newsletter with gains of up to 403% – Click hereClick here
Beth notes that even if she doesn’t own the stock, she listens to the heavyweights in adtech because they give you a broad look at the adtech industry. “They have visibility that we don't have,” says Beth. “Analysts can obviously go into channel checks, but channel checks aren't nearly as good as having visibility at the company, and the right management teams are trying to build trust with investors.”
Looking forward to next earning season, Beth states that she thinks the supply chain will have a rebound in the second half of this year – specifically noting the big auto inventory rebound in Q4 of 2021. “We're hoping that funnels through by the second half of the year,” says Beth. “If so, all kinds of industries will start to be positively impacted. Adtech, especially, I would say is one where if it can't come in the current guide, we really are watching it for the Q3 guide, which would be an adtech rebound due to supply chain issues easing. That's one to look for. What we try to remind people is that perfect timing is impossible.”
Listen to the entire podcast and read the full transcript of the interview here.
Disclaimer: This is not financial advice. Please consult with your financial advisor in regards to any stocks you buy.
Timestamps:
00:00 – Intro
00:30 – Air Travel Market
06:25 – Media Stocks
13:30 – Sleep Number
19:05 – Beth Comes In
23:00 – Beth Discusses Earnings and Sentiment with Regard to Earnings
26:42 – What Beth’s Looking for (Also includes Supply Chains and Quarters Data)
We have four more companies reporting in the next week – MRVL today, MDB, S and ASAN next week. Please check back on the forum tomorrow for thoughts on Marvell.
You’ll be getting key deep dives from us on the strongest companies to emerge from the macro-minded quarter. We take a week to thoroughly look through all the reports and to make any necessary changes. We are also scanning semis now for any up and comers. Royston is posting to this effect today. Lastly, we will have more crypto updates coming too. Knox’s trade alerts are provided to help gauge where we are in real-time with an earnings report.
The market is very jittery right now and is requiring perfection during a quarter impacted by a multitude of macro forces.
Our goal is to step aside or lean out of positions if there’s something inherent to the product affecting it for a few quarters but to also lean into positions where the market is not able to efficiently analyze when the transitory headwinds are broad based.
I’ll start with Nvidia since that’s the easiest company for an investor to see the forest through the trees. A $500 million impact from China shutdowns is irrelevant to the long-term story. $400 million is from gaming. Here is how we know this is irrelevant to the long-term story:
“We expect strong sequential growth in Data Center and Automotive to be more than an offset by the sequential decline in Gaming.”
Fundamentally, it has what it takes to be our leading position for some time due to the groundwork it’s laying in AI. We haven’t done a deep dive on Nvidia in some time and in many regards, we are looking at a new and improved company since I last did my deep dives in 2019/2020.
For now, to be brief, the A100 GPU which we first covered two years ago here and again here is showing up in Nvidia’s earnings report in a big way right now. Jensen Huang made it clear on the call that inference is the harder piece over training and this has driven record revenue for Nvidia as the A100 combines both training and inference onto a single chip. In the previous call, he noted that revenue driven by inference use cases had tripled in the quarter.
“[Data center revenue] doubled year-over-year. and we're seeing really strong adoption of A100. A100 is really quite special and unique in the world of accelerators. And this is one of the really, really great innovations as we extended our GPU from graphics to CUDA to Tensor Core GPUs. It's now a universal accelerator.
And so you could use it for data processing for ETL, for example, extract, transform and load. You could use it for database acceleration. Many sequel functions are accelerated on NVIDIA GPUs. We accelerate Rapids, we accelerate which is the Python version a Data Center scale version of Pandas, we accelerate Spark 3.0. And so from database queries to data processing, to extraction, and transform and loading of data before you do training and inference and whatever image processing or other algorithmic processing you need to do can be fully accelerated on A100.”
Personally, I’m excited for when we get through the last of our earnings reports next week and I can focus on writing a full-length analysis on Grace CPUs and Hopper GPUs for our Members. It’s an analysis I’m very much looking forward to and I’ll also lay out why Nvidia will dominate automotive, as well. Additionally, the licensing of software will be another catalyst for Nvidia that has little coverage right now. This four-segment combo: data centers, automotive, software licensing and then professional visualization are not fully appearing in the earnings reports right now. Data centers clearly are, but I foresee a long runway for data centers while these other segments ramp. That’s what I plan to touch base on for our longer-term thesis.
For the near-term, the company is saying that gaming is solid and AMD said something similar.
“The underlying dynamics of the Gaming industry is really solid, net of the situation with COVID lockdown in China and Russia. The rest of the market is fairly robust and we expect the Gaming dynamics to be intact.”
However, Nvidia investors need to be prepared to ride out any turbulence from Ethereum’s merge to proof of stake. The good news (in my opinion) is that the automotive segment should be kicking in around that time.
“Our DRIVE Orin SoC is now in production and kicks off a major product cycle with auto customers ramping in Q2 and beyond.”
The Numbers:
Nvidia reported revenue of $8.29 billion, up 46% and ahead of estimates of $8.1 billion. EPS was $1.36 compared to analyst expectations of $1.29 EPS. Nvidia missed estimates for Q2 with $8.1 billion due to the $500 million impact from Russia and China, with $400 million attributed to gaming and $100 million to data centers.
Data center was very strong, up 83% a year ago and 15% higher sequentially. Gaming was up 31% YoY and 6% sequentially. Professional visualization was up 67% which is a deceleration from the triple digit growth from last year. Automotive was down 10% YoY but was up 10% sequentially. As discussed, we expect this to ramp in Q2 and even more so in Q3-Q4.
Nvidia is repurchasing stock with $2 billion repurchased this quarter with a repurchase program approved by the Board of $15 billion total.
Snowflake:
Snowflake has exposure to consumer due to evidence a handful of its largest customers reduced usage in the quarter. Here is the main comment regarding the current quarter’s revenue miss:
“Last year, we saw certain customers experience much higher than expected consumption — own businesses were growing extremely fast. Today, some customers face a more challenging operating environment. Specific customers consume less than we anticipated amid shifting economic circumstances, we believe are unique to their businesses, most notably consumer facing cloud companies.”
However, Snowflake passed our internal test of needing to have a strong bottom line. Here is what Snowflake’s increase in cash flow looks like compared to other leading cloud companies. Notably, some of this data is from the previous quarter but the trend line is the same.
What is not pictured above is price to free cash flow, which SNOW does not rank well on this metric coming in around 600 compared to CRWD and DDOG around 80. However, if FCF continues to improve so will the bottom-line valuation. The main point of the chart above is to illustrate the progress Snowflake has been making during a time when access to cash is tightening. Snowflake has stock-based compensation weighing on GAAP operating margin yet the FCF margin is hard to deny in terms of being best in class.
Adjusted FCF was 43% – this was positively impacted by the timing of Q1 collections. Normalized over the year, FCF is guided at 16% of revenue. We want to stick with cash efficient companies bc as the CEO of Snowflake pointed out, private companies are becoming cheaper in terms of valuation and a war chest of cash that can be leveraged while private tech valuations are low will help the company come out stronger than its peers.
The company has best in class net retention rate of 174.
In terms of being profitable on an adjusted basis and this profitability increasing in a predictable manner, Snowflake also stands out.
One drawback is how management interacts with the analysts on the call. They can come across impatient and meanwhile SNOW has a fairly hard to understand business for financial analysts to wrap their heads around. Ultimately, management was trying to convey they are not discretionary despite the slight miss while analysts kept poking around trying to get an admission that Snow could be discretionary. Here is the most pointed answer management provided (which may have fallen on deaf ears as questions on macro impacts to core business model were relentless):
“I mean, the reality is that, our type of workloads become very heavily grafted into core business processes. And that, by the way, is also one of the reasons why it's — we've talked about this for the last two years in the calls, how difficult it is to move workloads to Snowflake, because these workloads are so heavily grafted into operational processes.
So these things are not going anywhere. They're not optional. They're not like, what do I feel like doing today? That, by the way, there are workloads like that, that's far more on the data lake side, where essentially you have a massive repository of files. And you may have data scientists that are just sort of fishing falls out of the lake and trying to decide to do some interesting stuff for that. That sort of thing is highly discretionary, but that's not the focus of our business.
[….] But in our world, as I said, it is so embedded into core business processes. It's not something that you can just sort of shut off for a while until things get better.”
And since this happened to be the sticking point — which is analysts grappling with whether Snowflake’s consumer-related miss means the company will see future headwinds related to macro compared to other more enterprise-only cloud companies, I’ll provide another moment on the call where analysts drilled into this point.
Brad Zelnick
Great. Thank you so much guys. So instead of trying to dream up the 16th way of asking you about the macro and the impact it's having, I want to maybe put that aside for a sec, and I mean you're delivering amazing growth at scale, and certainly, that shouldn't be lost. But if we just think about pricing and maybe competitive dynamics, I think you guys have had strong discipline when it comes to pricing, very ROI-focused. But is there any reason to believe pricing is an obstacle for adoption? And maybe any evidence that you have to believe your competitors are seeing the same things you're seeing? And perhaps — I don't know if it's changes the win rates or customers even stratifying their consumption across other alternatives to save money, anything that you can help us to appreciate what's going on along those dimensions would be helpful. Thank you.
Frank Slootman
Yes. This is Frank, Brad. Our business is not commoditized, which is sort of another way of characterizing your question. There's certainly people in our world that are trying to commoditize the business. But customers are trying to do very difficult things, also very amazing things. So what they're paying for credit is already incredibly optimized. It's incredibly competitive. This is physics and economics, right? And there aren't many places to hide in terms of what we charge for.
“Snowflake is steadily improving its margins from 58% gross margin a year ago to 65% gross margin in the recent quarter. The company has improved its GAAP operating margin from (90%) a year ago to (40%) in the recent quarter. The company has a positive adjusted operating margin of 5% and has stated they will end the year with a positive 1% adjusted operating margin. They have to deliver on this promise to maintain a category-high valuation.”
In the most recent earnings report, Snowflake reported GM at 65% in the most recent quarter and operating loss of (44.5%), an improvement from the (90%) OM in the year-ago quarter. GAAP EPS was (0.53) this quarter compared to ($0.70) in the year-ago quarter. Shares outstanding increased from 291 million to 314 million.
We know the top line is decelerating and we noted this in the last analysis. We had said the following:
“The company is expected to report revenue of $412 million, representing growth of 80%. The previous quarters the company reported revenue growth of 101% in Q4, 109% in Q3, and 104% in Q2. For the fiscal year 2023 ending in January, the company is expecting revenue growth of 67% for revenue of $2.03 billion. Analyst consensus shows revenue of $3.17 billion, or growth of 56% for fiscal year 2024.”
I have in my notes a slight fiscal year miss yet some analysts have Snowflake coming in as-expected on FY2023 for the $1.9 billion guide. Regardless, I think the FY2024 growth is key to keep it above the 50% mark while reaching consistent adjusted profitability.
Conclusion:
The analysts on the call are doing what we were doing in our last analysis, which is due diligence on the cloud companies most likely to survive a recession. This is why the analysts continually hammered management on this very minor miss. It’s not about the miss in terms of dollar amount (don’t care about that too much) rather the question is if the miss translates to Snowflake being discretionary.
In terms of our position sizing and allocation, we need more information from MongoDB as we will allocate more to the stronger company between these two.
I’ll have a pre-earnings write-up on Nvidia tomorrow before 2 pm EST on the forum tomorrow and you’ll get a full-length analysis delivered to your inbox by Thursday. You can view a preview of my thoughts here on Nvidia from my appearance on TD Ameritrade Network today where I discuss the gaming segment (main culprit for the current selloff) and the longer-term thesis for the company.view a preview of my thoughts here on Nvidia from my appearance on TD Ameritrade Network today where I discuss the gaming segment (main culprit for the current selloff) and the longer-term thesis for the company.
Pre-earnings announcements don’t give us much to go off of, which is why sentiment and price action can be very negative when these occur. We don’t get a glimpse at the current financials, the forward guide, or an hour with the management team to elucidate what caused the announcement.
We are sticking with our position on Snap right now for the reasons we stuck with it during the October selloff, which is that we like the first-party data, the DAU growth is quite strong, and there is evidence direct response was strong post-IDFA.
Primarily, Snap’s demographic is key for advertisers and we think owning this audience will offer a launching off point for AR/VR. Snap doesn’t need AR/VR necessarily as it’s currently one of the fastest-growing social media companies on the market.
Instagram was growing at 10% year-over-year in 2018 and has leveled off to an estimated 2.2%. Twitter grew 15% year-over-year in Q1. Snap grew 18% and has grown 20% the previous four quarters. I believe DAU growth is critical right now and over the next few quarters as it’ll prove which social media platforms emerge from Covid capable of growth.
Macro has been tough across the board for ad-tech and then there have been additional overhanging changes to how data is collected. Unity’s report a week earlier was another shock dealt to ad-tech investors. We covered this here.
The issue at hand is that Snap had provided a 20% to 25% guide and is now stating: “As a result, we believe it is likely that we will report revenue and adjusted EBITDA below the low end of our Q2 2022 guidance range.”
Below is the transcript of Snap’s discussion around growth as it pertains to Q1 and Q2. We had also covered this in a forum post that Snap was seeing the following revenue growth rates, as discussed in the earnings call.
44% growth through Feb 23rd prior to the Ukraine situation and a “10-day pause on ad campaigns”
32% growth in March
30% growth in April
Here is the quote:
“Total revenue for Q1 was $1.63 billion, an increase of 38% year-over-year. Revenue growth in Q1 initially exceeded our expectations entering the quarter, with year-over-year growth of approximately 44% through February 23. In the days immediately following Russia’s invasion of Ukraine on February 24, we observed that a large number of advertisers initially paused their campaigns. The vast majority of clients resumed their campaigns within 10 days following the invasion. And daily average revenue in March exceeded pre-invasion levels, but the rate of year-over-year growth remained below pre-invasion levels at approximately 32% from February 24 through the end of Q1.”In the days immediately following Russia’s invasion of Ukraine on February 24, we observed that a large number of advertisers initially paused their campaigns. The vast majority of clients resumed their campaigns within 10 days following the invasion. And daily average revenue in March exceeded pre-invasion levels, but the rate of year-over-year growth remained below pre-invasion levels at approximately 32% from February 24 through the end of Q1.”
In the call this caused Snap to issue guidance of 20% to 25%, stating:
“Given the uncertainty caused by these challenging circumstances, we have opted to share that our growth rate thus far in Q2 is approximately 30% year-over-year or just below the approximately 32% growth rate we observed following the invasion of Ukraine in Q1. That said, we are concerned that the operating environment ahead could be even more challenging, leading to further campaign pauses or advertiser budget reductions. As I noted earlier, our prior year comparisons are more difficult in Q2 than in Q1. Given this, we believe that revenue guidance of 20% to 25% year-over-year revenue growth in Q2 is reasonable.”we have opted to share that our growth rate thus far in Q2 is approximately 30% year-over-year or just below the approximately 32% growth rate we observed following the invasion of Ukraine in Q1. That said, we are concerned that the operating environment ahead could be even more challenging, leading to further campaign pauses or advertiser budget reductions. As I noted earlier, our prior year comparisons are more difficult in Q2 than in Q1. Given this, we believe that revenue guidance of 20% to 25% year-over-year revenue growth in Q2 is reasonable.”
Probably the most thorough was this quote from Derek Anderson, although there are others packed into the call:
“Hi, Ross, it’s Derek speaking. I’ll take the first part of your question, and then I’ll hand it over to Jeremi to help with the second part. So, at a high level on what we’re seeing as we look forward to Q2, the operating environment remains challenging and forward-looking visibility, as I noted earlier, is more difficult than probably at any point in recent memory. We have shared that our business has grown at a rate of approximately 30% quarter-over-quarter to-date, but we’re concerned that the operating environment could be even more challenging going forward. More specifically, the headwinds that impacted our business in Q1 have persisted into Q2, and we believe the impact of the war on Ukraine has been significant, and this impact is particularly difficult to predict going forward. As a result, we are concerned we could see additional campaign positives or advertiser budget reductions in the future. The comparisons, as I noted are also getting tougher. As a reminder, our top line growth accelerated by 50 percentage points in Q2 of last year to reach 115%. So, all of these factors together have informed our guide of 20% to 25% year-over-year in Q2. Importantly, though, I’d say the fundamentals of our business remain intact. We’re pleased with what we’re seeing and the strong growth in DAU. We continue to have deep penetration of hard-to-reach demos in the most important advertising markets. And of course, we’ve got a sophisticated ad platform that delivers measurable returns and results. So we are focused on investing in our teams and our products and delivering measurable return on advertising investment to our advertising partners. So hopefully, that gives you some background and context on how we’re seeing the outlook going forward and what uncertainty – what’s uncertain about that. I’ll turn it over to Jeremi to take the second part there.”“Hi, Ross, it’s Derek speaking. I’ll take the first part of your question, and then I’ll hand it over to Jeremi to help with the second part. So, at a high level on what we’re seeing as we look forward to Q2, the operating environment remains challenging and forward-looking visibility, as I noted earlier, is more difficult than probably at any point in recent memory. We have shared that our business has grown at a rate of approximately 30% quarter-over-quarter to-date, but we’re concerned that the operating environment could be even more challenging going forward. More specifically, the headwinds that impacted our business in Q1 have persisted into Q2, and we believe the impact of the war on Ukraine has been significant, and this impact is particularly difficult to predict going forward. As a result, we are concerned we could see additional campaign positives or advertiser budget reductions in the future. The comparisons, as I noted are also getting tougher. As a reminder, our top line growth accelerated by 50 percentage points in Q2 of last year to reach 115%. So, all of these factors together have informed our guide of 20% to 25% year-over-year in Q2. Importantly, though, I’d say the fundamentals of our business remain intact. We’re pleased with what we’re seeing and the strong growth in DAU. We continue to have deep penetration of hard-to-reach demos in the most important advertising markets. And of course, we’ve got a sophisticated ad platform that delivers measurable returns and results. So we are focused on investing in our teams and our products and delivering measurable return on advertising investment to our advertising partners. So hopefully, that gives you some background and context on how we’re seeing the outlook going forward and what uncertainty – what’s uncertain about that. I’ll turn it over to Jeremi to take the second part there.”
Obviously, this kind of thing is disappointing and it can be hard to see the forest through the trees when the market dumps a stock like it did with Snap. I believe Snap investors need to determine if they trust management as the long-term goal for this company is for 50% revenue growth on a high revenue base of over $1 billion annually. If you trust the management when they say it’s macro, then you’d stay in the stock. If you don’t trust the management, and an investor believes it to be inherent to the product, then it’ll be a long road until we get the next earnings call.
The other reason we are sticking with Snap is that this is not an isolated incident by any means. We’ve seen bad news from management teams across the board: Google, Facebook, Snap, Roku, and Unity. As you know, we’ve been clear that we view this as transitory and a buying opportunity. If supply constraints had eased, if there was no war in Ukraine, and if Apple had not made any data collection changes, then we could point to consumer. I think it’s a mix of all four that has led to ad-tech trading at 1/3 to 1/2 it’s reasonable top-line valuation (for the sector) of 10 forward P/S.
I guess if we were to drill deeper into whether its product-related for Snap, it would either be seen in DAUs – which grew steadily – and then also the timing of Apple’s changes. If we use Meta as a baseline for a company where management has agreed they will see IDFA headwinds, revenue growth decelerated from 35% growth in Q3 (pre-IDFA changes) to 20% growth in Q4, 6.5% growth in Q1 and 0% growth at the midrange for Q2. In other words, the impact began much earlier in Q4 and was on full display in Q1.
Snap reported 42% growth in Q4 and 38% growth in Q1. This would point to something unique happening in Q2 which management has stated is due to European ad spend and coming up against tough comps. What we know now is that Snap will not meet guidance for 20% minimum growth this quarter.
Overall, Unity is guiding the lowest across the more major ad-tech companies with 7% growth at the midpoint for next quarter. Roku’s guide is for 25% growth next quarter and The Trade Desk is guided for 30% growth. The market is concerned these guides won’t pan out but the correlation may not be as strong as the market is pricing in if Snap’s is mainly due to the Europe segment. The Trade Desk likely resilient here compared to YouTube, Facebook and Snap as the company does not need to suspend advertising as a publisher due to Russia-Ukraine war. The company also doesn’t have to manage supply/shipping issues like Roku. Again, we think these are transitory issues for publishers and hardware-related companies.
Quick Note on DAU:
Snap is reporting high DAU growth and according to a few analysts, they expect this to be a beat according to their channel checks. We also noted that upfront commitments grew 60% last quarter. We will be watching these two numbers very closely in the next earnings report. Global ARPU had expanded 17% YoY and gross margin expanded 22% over the past three years. The company was profitable for the first time last year, which is key in this market.
Jefferies analyst Brent Thill lowered the firm's price target on Snap to $30 from $52 and keeps a Buy rating on the shares, arguing that the company's pre-announcement that Q2 revenue growth will likely come in below its initial 20%-25% guidance is "indicative of a rapidly deteriorating macro environment that will likely impact the whole ad industry." He is lowering his FY22 and FY23 revenue estimates for a number of other digital advertising companies by an average of 3% and 6%, respectively, but doesn't view the shortfall in revenue as a competitive issue for Snap as his third-party data checks suggest DAUs could beat guidance, Thill tells investors.
Apple’s WWDC in June:
We covered in the past that Apple and Snap are complementary to one another in augmented reality. It was Apple’s LiDAR scanner that furthered Snap’s R&D in augmented reality and when growth in Snap’s creator community began to grow. There are rumors that Apple will release it’s first AR/VR headset either in late 2022 or in 2023.
That may seem like a long ways off but catalysts are most important to identify when a stock’s valuation is trading at an all-time low. How big could AR/VR get? According to this article, Apple expects it will replace the iPhone with AR glasses ten years from now. Whether AR glasses replace iPhones is not something investors need to necessarily have happened, rather it helps illustrate Apple’s size of ambitions around this area. What we want to know is that there’s a heavyweight in AR hardware and distribution that can create an inflection point on the consumer side for Snap’s R&D efforts.
Fingerprinting Announcements at WWDC:
Are you tired of hearing about Apple’s IDFA changes and Apple’s new App Tracking Transparency (ATT) policy? Well, you can start to focus on fingerprinting now and what iOS 16 may hold for publishers who use IP addresses for conversions. I plan to write about this if we do get an announcement. In the meantime, here is some background information
Conclusion:
Here is what management said in their note regarding both the lower guidance and slowdown in hiring:
“we continue to face rising inflation and interest rates, supply chain shortages and labor disruptions, platform policy changes, the impact of the war in Ukraine, and more.”
Knox cut the position from 6% to 3% on May 4th and we sent a trade alert out to that effect. This helps illustrate why we use technicals. We rarely cut this much in one move. He had spotted a weak chart and Knox asked if I cared to stand in front of that chart. I declined to do so as management was pretty transparent in my opinion about the Ukraine situation leading to impact on the Europe segment in the call.
The position sizing we have on Snap is likely to remain until we get our next earnings call and we will update you if anything changes. With that said, adding back 1% is on the table if/when Knox sees strength in the chart.
This article was originally published on Forbes on May 20, 2022,12:10am EDTForbes on May 20, 2022,12:10am EDT
Unity has demonstrated strong price action following the IPO last year due to its unique blend of cash efficient ad-tech monetization and near-monopolistic game development platform. The company is well suited for the Metaverse and industrial 3D worlds due to its history of supporting 3D game development.
In previous earnings calls, the management was confident they would not be affected by Apple’s IDFA changes or the other road blocks that caused ad-tech companies to lower guidance across the board. Unity’s confidence primarily came from their contextual ad positioning as compared to direct response. Therefore, there was high confidence going into earnings yet management delivered a sizable revenue miss due to a product mishap.
Unity previously guided for revenue growth of 36% for full year 2022, which would put the company as the leader in ad-tech growth and mid-range for cloud. In the recent call, the company lowered this guidance to 26% at the mid-point for a negative impact of $110 million. Guidance for Q2 2022 was at 7% at the midpoint, which would put Unity in the lowest quartile for ad-tech on growth and certainly for cloud. The stock dropped 35% following the announcement.
The surprise miss in revenue guidance was due to the company’s product Audience Pinpointer, which is a machine-learning powered user acquisition tool that allows game developers to acquire players based on a targeted return on their spend. Unity’s training data was also affected by ingesting bad data from a large customer. This led to Unity noticing less revenue coming from their monetization platform, and as advertisers saw less performance, they began to spend less.
Below, we weigh the pros and cons of an otherwise solid game engine and Metaverse stock.
Unity Has 2.8 Billion MAUs
Despite the temporary mishap with Audience Pinpointer, Unity has significant proprietary data and insights to feed contextual models. Unity is a game engine where more than 2.8 billion monthly active users (MAUs) play games or apps built on Unity compared to Facebook’s 2.9 billion monthly active users. The total addressable market for gaming exceeds 4 billion MAUs and Unity serves 61% of game developers.
It’s not exactly apples-to-apples with Facebook as Unity powers the games and is not a publisher like Facebook, yet it illustrates the scale the company is capable of. In the game development ecosystem, 72% of the top 1000 mobile games are made on Unity’s platform. There are 5 billion monthly app downloads.
Part of Unity’s substantial presence is the free tools it offers game developers who earn less than $100,000 annually, and for the most part they capture any developer between the indie (small) stage and up to AAA studios although many of these studios prefer to use their own in-house game engine. The company has especially found its stride on mobile.
Unity offers its products under two platforms, Create Solutions and Operate Solutions. The Create platform is used to create, edit and run 3D content. The Operate platform is used to grow and engage the user base and to also monetize content. The company derives 93% of 2021 revenue from these two platforms with a split of 64% Operate and 29% Create.
Create Solutions is where games are built and Operate Solutions is how games are monetized through ads and in-app purchases. There are also analytics offered through DeltaDNA, which collects information on end-user engagement and behavior.
Operate is successful through contextual ads rather than behavioral targeting, which has made the company resilient during Apple’s privacy changes.
On a contrarian note, because Unity has a very specific content type (gaming), there’s a chance the company is very resilient through the iOS 14 changes as targeting can occur through content type (i.e. Gaming, Financial News, Beauty & Health, etcetera). Previously, Unity Ads have been known to be more effective because the audience type and interests are narrow. There’s also a possibility that Unity is stronger with the IDFA changes as they own the game engine whereas their competitors are using third-party data only for targeting. These competitors include Vungle, AdColony, Facebook’s Audience Network, MoPub, Leadbolt, TapJoy, etcetera.Unity has a very specific content type (gaming), there’s a chance the company is very resilient through the iOS 14 changes as targeting can occur through content type (i.e. Gaming, Financial News, Beauty & Health, etcetera). Previously, Unity Ads have been known to be more effective because the audience type and interests are narrow. There’s also a possibility that Unity is stronger with the IDFA changes as they own the game engine whereas their competitors are using third-party data only for targeting. These competitors include Vungle, AdColony, Facebook’s Audience Network, MoPub, Leadbolt, TapJoy, etcetera.
Notably, Unity’s revenue miss was unrelated to Apple’s IDFA changes and was instead related to the company’s internal product Audience Pinpointer.
The Metaverse Opportunity
Developing games on Unity is low code and sometimes no code, which is ideal for 3D creators who are not necessarily developers. This lends itself well to the creator community that is most likely to drive forward the Metaverse, or Web3, and also the various industries that can benefit from 3D or AR/VR right now. The Create Solutions and tools are also great for prototyping, which speeds up the time to deployment. Unity is frequently acquiring tools and plugins to lower the barrier of entry for developers and creators. For example, Bolt2 helps developers implement logic without knowing how to code.
Sign up for I/O Fund's free newsletter with gains of up to 403% – Click hereSign up for I/O Fund's free newsletter with gains of up to 403% – Click hereClick here
Last year, Unity developed a new architecture that provides native APIs to third-party providers and offers a high-level managed API to Unity developers. The new architecture fundamentally improves how Unity delivers and manages SDKs for XR platform integrations.
With Unity Pro, real-time 3D, AR and VR content can also be deployed on HoloLens and Oculus. The Unity Pixyz Plugin works with manufacturing software like AutoDesk to further industrial uses, such as automotive. Additionally, Unity does not compete with creators and is royalty-free.
The main thing to know about Unity’s products is they offer 3D creation for everyone, i.e., democratizes the process. This was initially intended for the gaming industry yet there is a natural affinity for gaming tools, IDEs, chips, etcetera, to be used for virtual worlds and the Metaverse.
The management had mentioned in the earnings call that the company was able to expand its market share in gaming and AR/VR. The company’s non-gaming business outpaced gaming business revenue as it grew 70% year-over-year. Digital twins and the metaverse are a substantial opportunity with 34 deals closed in the current quarter over $100,000, up 126% YoY.
Unity bought Weta Digital for $1.62 billion in exchange for the design tools, assets and data platform that drove film creations such as Lord of the Rings, Avengers, Avatar, and Game of Thrones. The goal is to bring the magic of film assets to the individual creator on Unity’s platform. It will also help the company to remain competitive against Epic’s Unreal Engine.
We had stated the following in a private note to our research customers when Unity acquired Weta:
“The Weta Digital acquisition helps Unity remain defensive against Epic’s Unreal Engine, which was used on virtual sets, such as Star Wars The Mandalorian. It also helps Unity build a Metaverse asset library, such as stadium scenes, character movements, large crowds, fantastical characters and backgrounds, etcetera, which can help the workflow for content creation for the metaverse. With that said, the more near-term opportunity for these acquisitions is for Unity to turn Hollywood into a customer.”is for Unity to turn Hollywood into a customer.”
Earlier this year, the company acquired Ziva Dynamics, the film software used for creating digital humans in Marvel movies, Hellblade, Jumanji, and Godzilla vs King Kong. In the recent quarter, the company received more than 8,000 sign-ups for the cloud uploads of beta version of Ziva Faces. Accroding to CEO John Riccitiello, “This service enables artists to use advanced machine learning models and massive data to train meshes for full expressiveness, instead of requiring teams of artists to spend weeks doing manual rigging.”
The company’s addressable market is growing and the management had mentioned in the last earnings call that the total addressable market for Create Solutions and Operate Solutions is $45 billion, up significantly from $29 billion during its IPO in 2020. The growth in the addressable market was due to the additions of new products and acquisitions.
Financials and Audience Pinpointer Issues:
The company finished the year 2021 strong with revenue growing 44% YoY to $1.1 billion and adjusted operating margins improved 200 bps to -4.6%. As a percentage of revenue, R&D is at 69%, which is slightly higher than it’s been in previous quarters. Expenses are frontloaded at the beginning of the year with the company expected to break even by 2023.
Q1 2022 revenue grew by 36% year-over-year to $320.1 million, which missed analyst consensus estimates by -0.32%. The company’s dollar-based net expansion rate came in at 135% compared to 140% in the same period last year and Q4 2021.
Unity’s management guided for revenue growth of 7% at the mid-point for Q2 2022. This was a stark surprise and lower than the 48% growth reported in Q2 2021. For the full-year, it has guided revenue growth of 26% at the mid-point which was lower than the earlier forecast of 36% provided during the year-end results.
Sign up for I/O Fund's free newsletter with gains of up to 403% – Click hereSign up for I/O Fund's free newsletter with gains of up to 403% – Click hereClick here
The management mentioned in the earnings call that it was mainly due to two issues. According to John Riccitiello, CEO, “The first was a fault in our platform that resulted in reduced accuracy for our Audience Pinpointer tool, a revenue expensive issue given that our Pinpointer tool experienced significant growth post the IDFA changes. The second is that we lost the value of a portion of our data, training data due in part to us ingesting bad data from a large customer.”
Audience Pinpointer is a user acquisition product that is based on machine learning which helps game developers to acquire users based on a certain return on spending. The management expects these issues to be partially recovered in the third quarter and fully recovered by the end of the year. They reassured analysts on the call that there will no negative impact on the revenue for the year 2023.
As we had expected, the company was able to overcome the challenges of Apple’s iOS changes and the deprecation of the IDFA since a majority of games are built with Unity engine and analytics per the company saying: “Pinpointer tool experienced significant growth post the IDFA changes.” The CEO also stated, “We have proprietary data and insights coming from our reach to over three billion monthly active users feeding our contextual models. We have deep context, about game play, what players like to play, when and how they play games. And in gaming, this data has proven to be the most relevant for advertising.”
The management remains confident in the long-term opportunity. They estimate that there are more than four billion monthly active users and that less than 3% of users pay for games.
The company’s Create solutions is doing well and accelerated by 65% YoY to $116 million. This was driven by the strong adoption of real-time 3D. In the Content Solutions segment, some of the notable business use cases of big publishers include, “Angry Birds brought back Angry Birds Classic to mobile app stores using Unity to relaunch this treasured game and easily make it work across multiple modern devices. And Ubisoft used Unity to deliver incredible visuals and fast gameplay in Rainbow Six Mobile.”
The adjusted operating margin improved 280 bps to -7.2% which is lower than FY2021. The company had free cash flow of $86.4 million. However, the cash flow included the license fees for four years of $200 million relating to Weta FX.
Looking forward the management reiterated that it expects revenue to grow above 30% in the long-term. It also expects to be profitable in the fourth quarter of this year.
Conclusion
Unity Software is the market leader in the fast-growing gaming industry. The company’s future growth opportunities extend beyond gaming to include industrial real-time 3D and the Metaverse. Due to its proprietary data from 2.8 billion MAUs and contextual targeting, Unity will likely come out stronger than other ad-tech companies following Apple’s privacy changes (and Google’s upcoming privacy changes circa 2023).
The market has been extraordinarily temperamental towards tech stocks and this is likely to be one of many instances where the current (low) stock price does not fully reflect the opportunity.
Given our high allocation to crypto and specifically Ethereum, we want to track any progress (or lack of progress) towards The Merge to Proof of Stake, and also Shards and Rollups. We’ve also recently placed Avalanche into the LTBH category and this analysis looks at why we plan to trim ETH slightly and re-allocate what we trim to Avalanche.
In 2019, we wrote that the catalysts for Bitcoin trading at higher price levels (and holding those levels) would be economic uncertainty, the Lightning Network for mobile payments and institutional adoption. These three things came to fruition and Bitcoin has held higher prices.
The upcoming catalyst for Ethereum to expand its network and host more apps is well-known, which is The Merge to proof-of-stake. We discussed in March of 2021 that proof-of-stake would be necessary to lower gas fees and to help realize Ethereum’s full potential as a network for decentralized apps (d’apps), which would ultimately function like an operating system. The issue is not what Ethereum needs to do to realize it’s vision rather the question is when will Ethereum do it? When will Ethereum complete The Merge?
The delays on The Merge are one reason we are diversified with a Layer 1 in LTBH. It’s likely you see us add more Layer 1s pending technical analysis, such as Solana. We discuss below the additional delays that Ethereum faces on PoS and the upcoming timing issue in June when Proof of Work is scheduled to “freeze” over a period of five months.
Quick note regarding crypto selling off, I had discussed how OpenSea received a 10X valuation right before crypto sold off. You can read the full forum post here:
“The Series C was led by Philippe Laffont of Coatue Management, who has successes on the public markets such as Anaplan, Snap, Spotify and Databricks not yet public [..] Certainly, OpenSea would likely go for a lower valuation today given the Luna bust and all altcoins being down in sympathy. However, rather than stress over a 4-month bad timing decision, private investors will simply hold until market conditions are favorable for their investments and then go for the exit. Private investors assume their timing will not be entirely perfect and instead they make their exits perfect.”
The reason we have been dollar cost averaging into the crypto selloff is that timing a bottom is futile. It’s much easier to time an exit. According to industry analysts, blockchain should scale rapidly between 2025-2030 from $176 billion to $3 trillion. I imagine we will see Coatue and others exit through IPOs around the later part of this time frame, and as early-stage investors in crypto, we will want to consider doing the same. This doesn’t mean we won’t trim, etc., rather it provides a nice timeline for an exit on middleware like Chainlink and also Layer 2s. I’ll touch more on those in an upcoming analysis.
Ethereum Network Delays on PoS
The primary difference between Ethereum and Bitcoin is that Ethereum is not trying to compete as a currency. The focus of Ethereum is on its network, not the coin. Vitalik Buterin’s vision is to create an open network for decentralized applications and smart contracts based on the Turing complete programming language Solidity.
Ethereum faces constraints in transactions per second (TPS) and how to overcome the high energy costs of mining that comes with decentralized security. The network simply can’t scale without the upcoming release of Ethereum 2.0.
In our premium analysis last year on Ethereum here, we discussed the difference between Proof of Work (PoW) and Proof of Stake (PoS). In addition to the Proof of Stake merge that Ethereum must complete, the network must also launch shards. In last year’s analysis, we said: “Shards are another critical improvement for network bandwidth and the low transactions per second (TPS) as Ethereum 2.0 (ETH2) allows for improved data processing. Nodes in the previous network must download a transaction, calculate it, archive it and read every transaction in Ethereum’s history, which is terribly inefficient. Shards create a subset of the network where nodes are dispersed for more efficient processing. The Beacon Chain ensures the nodes are synchronized and the validators are reporting the blocks of transactions.”
We went into great detail on ZK Rollups, as well. The quick summary on ZK Rollups is they allow for hundreds of transfers to be rolled into a single transaction. This will replace Plasma, the current option where only a single transfer is made per transaction. In this case, the smart contract will verify all of the transfers in the Rollups. The goal is to reduce computing and storage resources by reducing the amount of data held in a transaction.
In November, we wrote another update on crypto and Ethereum, stating that the expectation was for Proof of Stake to merge in late 2021 with Shards and Rollups expected by late 2022 or early 2023. The timeline for PoS is delayed yet again until Q3 2022, which puts Sharding and Rollups out another year potentially to Q3 2023.
Update on Proof-of-Stake (PoS) Merge
In August of 2021, Ethereum went through the London Hard Fork. This was a step towards PoS as Ethereum Improvement Proposal (EIP) 1559 changed the management of transaction fees on the network. Previously, the transaction fees would go to the miner directly. The London upgrade introduced a fixed-per-block transaction fee that is burned. This results in more predictable gas fees and also helps the blockchain network prepare to eliminate miners by Q3 of this year.
According to Statista, the average gas fee in August of 2021 was 136 Gwei. In January of 2022, the average gas fee was 122 Gwei. There have been some lower months for gas fees both pre-London upgrade and post-London upgrade, yet ultimately EIP 1559 will not resolve gas fees by any means and The Merge is still (badly) needed.
Gas fees reflect the fact that blocks reach their maximum capacity during peak transaction periods. However, this can actually work to increase the price of Ether in the event that transaction fees are prohibitively high to transfer ETH. The London Hard Fork also helps to create scarcity as ETH is burned with each transaction.
Ethereum’s Difficulty Bomb is Ticking…
The “Difficulty Bomb” refers to a deadline where Proof of Work (PoW) will become more difficult by impacting block times. The Bomb refers to the exponential difficulty that PoW will face, which will cause block times to implode similar to a bomb.
According to Tim Beiko, the block time will increase 487% from 12-14 seconds to 64 seconds about five months after the difficulty bomb is released. This is achieved by making it more difficult for miners to crack the cryptography, and the result is that it becomes too time-consuming to be profitable. This is referred to as the “Ice Age” when PoW will be effectively frozen and miners will be deterred from minting more blocks.
In addition to pushing miners to move away from PoW, the difficulty bomb also removes the ability to create centralized currency on the Ethereum network, prevents a blockchain fork that could occur if miners continue PoW, and also forces node upgrades.
There have been five delays on the Difficulty Bomb with the current deadline extended to June of 2022. For obvious reasons, it’s ideal if the Difficulty Bomb “goes off” after The Merge occurs otherwise the Ethereum network will be frozen without an adequate replacement for the consensus mechanism. As of early May, however, Ethereum developers have decided to ignore extending the Difficulty Bomb in favor of remaining focused on proof-of-stake.
I believe the (current) decision to ignore the Difficulty Bomb reflects the lack of patience that is growing across ETH investors and also Ethereum users (due to high gas fees) on the Proof-of-Stake Merge. This is the first time that the Ethereum Foundation has decided to forego delaying the ticking bomb as they must heavily weigh the pros/cons of delaying PoS again.
There’s a chance that the All Core Devs meeting on May 27th reverses this decision and chooses to focus on delaying the freezing of PoW. However, it seems that Vitalik Buterin, the co-founder of Ethereum, is prepping expectations that block time increases temporarily: “We have to evaluate the pain of doing an extra delay hard fork versus the pain of living with 21 or 25 second blocks for a while, which is something we have done and the world didn't end.”
Ethereum’s delays with the PoS Merge is one reason we added a second Layer 1 to the LTBH portfolio. To complicate matters, the Difficulty Bomb is now weeks away from detonating (sounds like we need Batman).
Although it’s hard to give up any allocation on Ethereum given its concentration in d’apps and developers, it’s also important to acknowledge that if other Layer 1s want to compete alongside Ethereum, June-September is their chance to lay some serious groundwork on building a developer and app ecosystem because Ethereum will be juggling two hot potatoes – The Merge to PoS and the Difficulty Bomb.
A Member shared the A16Z Crypto Report which helps to illustrate Ethereum’s dominance.
The decision that Ethereum must make between prioritizing Proof of Stake or the Difficulty Bomb is not lost on popular apps on the Ethereum Network as a slowdown in Proof of Work before The Merge would result in higher gas fees and more congestion. Investors should keep an eye out for popular apps diversifying their Layer 1 network due to high gas fees.
In our previous write-ups, we discussed how Time Magazine’s TIMEPieces resulted in exorbitant gas fees where 10 NFTs were priced at 1 ETH for $2500 or $2800 yet due to gas fees, one buyer paid as much as $70,000.
Yuga Labs is the creator of the Bored Apes Yacht Club and is a leading NFT creator. There are 10,000 apes with traits and unique characteristics, which you may recognize such as this:
Three weeks ago, Yuga Labs held a digital land sale that drove $285 million to the company yet resulted in $176 million in gas fees on the Ethereum Network. The average gas price was around 800 Gwei early Sunday and spiked to 6000 and 7000 Gwei during the sale, which equates to $3,000 or more per transaction in gas fees. In fact, there was one $25 NFT that carried a $3,300 transaction fee and complaints abounded on Twitter.
Yuga Labs issued an apology and publicly stated they are going to turn the lights off on Ethereum for a while.
In this high-profile decision, Yuga Labs is reportedly considering other Layer 1s.
Avalanche
The I/O Fund added a new LTBH position in Avalanche last month. We did a deep dive on Avalanche here.
What other Layer 1s will popular Ethereum apps choose to diversify with? We think Avalanche could be a top choice given it’s Ethereum Bridge, application-specific subnets and the launch of a consumer-facing app over the next few months/quarters. Avalanche also has a high Nakamoto Coefficient, which is a number that designates the number of nodes that would need to be corrupted to slow or prevent a chain from functioning properly.
Last quarter, Avalanche launched GameFi subnets with DeFi Kingdoms participating. The bridge protocol Synapse saw volumes surge from a previous high of $157 million to a record $330 million. This accounted for 82.5% of total bridging volume on Synapse.
Recently, the popular game Crabada migrated from Avalanche’s C-Chain to a subnet. This will help prove viability of subnets’ ability to scale and potentially attract more games as Ethereum goes through its growing pains over the next few months. Crabada draws in high daily volume of up to $1.5 million with transactions of up to 400,000 per day. The application has a total value locked of $50 million by the end of the quarter.
Avalanche launched with three chains. Per our YO/LO write-up: The X-Chain is for creating and exchanging assets including NFTs, the P-Chain validates and creates subnets, and the C-Chain is for executing Ethereum Virtual Machine (EVM) contracts. The C-Chain offers interoperability with Ethereum, which is why the Avalanche bridge is the most popular ETH Bridge currently. The P-Chain is what is used to create and manage subnets. The coordination of Avalanche validators occurs on the P-Chain and it can support thousands of subnets and millions of validators.
Subnets are important to reach scale. The customized chains allow blockchain verticals to have enhanced function by grouping together like-kind applications. Gaming d’apps are separate from Decentralized Finance apps (lending, borrowing, payments), which is key because these d’apps have different requirements.
As we stated in the AVAX write-up: “Ethereum is running into issues with 500,000 to 1 million daily active users. Meanwhile, a single mobile application sees hundreds of millions of users, such a Twitter or Spotify. What Layer 1 can handle this level of adoption? That is a platinum-level question for investors to answer. To be clear, it could be Ethereum in 2023 if the developers and users prefer to not migrate. However, if the ecosystem runs out of patience and seriously looks for an alternative, then Avalanche is a candidate.”
Avalanche came to market in 2020 yet in terms of total value locked, started to gain traction in August of 2021. The chart above by A16Z helps visualize how strong Avalanche has been out of the gate in terms of growth. I’ll repost it here for quick reference:
According to Messari’s Q1 report, Avalanche’s average daily transactions grew 82.8% sequentially and total revenue grew 72% from Q4 to Q1 2022. During this time, the market cap was flat at (5.4%) and price relative to revenue went from 160X to 91X (note: AVAX is two years old and very early stage).
In the first week of January, Avalanche had more active users than all of October 2021. The network averaged 70,000 daily active addresses, which grew to 92,000 in Q1. Average daily transactions rose from 473,000 last quarter to 865,000 in Q1 compared to Ethereum’s daily transactions of 1.17 million.
As stated above, some transaction fees on Ethereum were up to $3,000 during a popular NFT sale in the hundreds of millions. Avalanche surpassed $1 million in daily NFT volume for the first time with transaction fees of $0.67 per transaction. This helps illustrate the importance of Yuga Labs shopping for a new Layer 1 as one popular app can raise daily NFT volume substantially during auctions, helping to prove the ability scale for a competing Layer 1.
Perhaps most important for investors, there is an increasingly stronger correlation between revenue and market value for Avalanche. When daily revenue spiked in November, fully diluted value saw a similar spike. As Messari shows below, the spread between revenue and the fully diluted value had a tighter correlation, which helps prove fundamental value as the revenue has a closer relationship with network value.
An analysis on crypto this month would be remiss to not include a note on the Terra crash. TerraUSD (UST) or “Terra” is an algorithmic stable coin that automatically tracks the price of other currencies, in this case the United States dollar. The idea is that transactions will be predictable and investors can hold their assets without the level of volatility seen across fully decentralized currencies.
Luna is the native token of the Terra Layer 1 blockchain that is used for governance and mining. Luna is staked to validators to record and verify transactions on the blockchain in exchange for rewards and fees.
As a stablecoin, Terra was designed to use supply and demand to balance its price. If demand for Terra goes up, then Terra’s price increases, and if demand for Terra is low, the price decreases. The two cryptos, UST and LUNA, have an arbitrage-type relationship as the Layer 1 is made up of two pools. Atomic swaps are made possible through a market module.
Arbitrageurs sell LUNA for UST when the price is below $1 and they buy LUNA when UST is worth more than $1. If UST is priced at $0.90, then traders would buy that coin and sell it for $1 of LUNA. The prices were propped up by the protocol burning both UST and LUNA as they were being minted and converted, which helps bump up the price of the burned tokens due to the restricted supply.
Expansion occurs when Terra is higher than the pegged dollar, and the protocol incentivizes users to burn Luna and mint Terra. The new supply creates a larger pool for Terra, and users mint more Terra from the burned Luna until it reaches its target price. Contraction occurs when Terra is priced too low and supply exceeds demand. The protocol incentivizes users to burn Terra and mint Luna, which causes scarcity and an increase in Terra’s price to be more aligned with the dollar.
The arbitrage relationship between Terra and Luna is important to understand in terms of the Terra crash that occurred. However, the primary use for UST was not for the arbitrage opportunity but rather to earn yield on the Anchor DeFi platform.
Anchor is a DeFi protocol with $16.16 billion total value locked at the end of April, which included 72% of all UST. There was an additional $3.2 billion in UST on DeFi Llama and $152 million on Avalanche.
The reason Anchor had three-quarters of total value locked for UST is that the DeFi platform required funds to be held in UST to earn an interest rate of 19.46%. That yield drew a lot of attention and helped prop up Terra’s success as a Layer 1 blockchain. Between November and the May 2022 crash, UST’s market cap grew from $2.73 billion to $17.8 billion.
Expansion occurred because Terra was in high demand due to the attractive yield from UST. In addition to the expansion, the yield attracted a ratio of 4:1 lenders to borrowers. This meant Anchor’s reserves were becoming increasingly vulnerable to a “run on the bank” in terms of risk that an outsized number of lenders would withdraw their principal and yield. Basically, theoretically, if too many lenders withdraw at once, Anchor would not have enough reserves.
As this incredibly prescient article points out, there were warning signs.
The first was in February when the founder of Terraform Labs, Do Kwon, added $450 million into reserves with Arca CIO Jeff Dorman stating that Anchor would require more capital infusions to maintain the current yield. In late March, a proposal was passed to change the yield. Proposal 20 stated that the rate would change by a maximum of 1.5 percentage points once per month and would be a variable rate.
Here is what the Decrypto.co article stated at end of April in regards to the February cash infusion from Terraform Lab’s Founder and the subsequent decision to allow for lower interest rates:
“Without a clear, long-term solution, though, the rate will continue to decrease. After a certain threshold, which the market will decide over time, investors will generate returns elsewhere. This could lead to withdrawals from Anchor and investors potentially abandoning UST for another stablecoin that can be used for more lucrative opportunities in some other DeFi protocol. If this rotation were to happen en masse, it could be catastrophic for the health of UST as well as LUNA.”If this rotation were to happen en masse, it could be catastrophic for the health of UST as well as LUNA.”
We are not concerned about Terra in regards to our crypto holdings because on a granular level, the risk was unique the arbitrage relationship between Terra and Luna, plus the high yield of 20% on Anchor that was ultimately unsustainable. We will write an update on Aave soon.
Conclusion:
We have a large position in Ethereum that will likely be trimmed over time as we want to be prudent about the issues the leading network must overcome. This doesn’t mean we will exit entirely rather it means that 8% is too high when some of this can be allocated to an up-and-coming Layer 1, such as Avalanche. What we trim from Ethereum should be seen as diversification to lower risk during the transition to PoS and in anticipation of whether the difficulty bomb timeline is extended or not. We believe what happened with Yuga Labs and also the Axie Infinity sidechain hack (which was Axie Infinity’s solution to high gas fees covered here that ultimately hurt the company) could create a window of time where Ethereum sees heightened competition.
We recently added back Microsoft as a LTBH position and we are now adding Alphabet as our second FAANG. We understand our editorials are often behind paywalls on Forbes and Seeking Alpha, and so we have copied the article from April 28th below.
Article on GOOGL Begins Here:
If an investor were to believe market price action this week, it would appear Facebook had strong earnings while Alphabet stumbled. Yet, the opposite is true. Primarily, it was strength in retail ads that led to Alphabet reporting healthy growth of 23%. Meanwhile, Meta Platforms (Facebook) reported revenue growth of 9.7% and is guiding for roughly 0% growth from $28.5 billion in Q2 2021 to $29 billion, at the midpoint for Q2 2022. This analysis looks at why Alphabet is able to provide higher revenue guidance despite 80% of its revenue coming from ads while Facebook is guiding for flat growth.
Notably, Q2 is particularly hard because there are three heavy macro headwinds: supply chain issues, Ukraine-Russia situation, and the transition that Apple has forced with changes to attribution and measurement on iOS. When you add the one-time event of Covid, which plummeted ad spend in Q2 2020, only to lead to a surge in ad spend the following year Q2 2021, the hurdle to clear for revenue growth is at a historic high. We believe those ad-tech stocks that can show top line growth right now are providing important clues for when macro headwinds clear.
BACKGROUND:
The ad-tech industry remains in a whirlwind of changes following iOS privacy changes that limit third-party tracking on Apple mobile devices. I am hyper focused on identifying who the winners and losers will be following these changes, as it will determine who will lead ad-tech going forward. This issue is important because it impacts leading FAANG ad-tech companies, such as Facebook (Meta) and Google (Alphabet). Wall Street particularly likes ad-tech’s bottom line, and will aptly reward those stocks that can capture more ad spend.
In the below analysis, I review Google’s Q1 2022 results and focus on its ad platform (I am ignoring Google Cloud for now) and look for hints if Google is being impacted by the recent iOS changes. You’ll find that Google has held up well relative to other app-based advertising platforms, such as Facebook, following the changes to third-party identifiers. This is because Google has a first-party data advantage, which is critical during a time that attribution and measurement is limited by third parties. I explain why in more detail below.
Google’s Q1 Ad Growth Remains In-Line
While the market is still digesting the macro headwinds previously mentioned – supply chain and Ukraine-Russia; the third headwind of attribution and measurement changes is the headwind that investors should pay most attention to as it leads to a material change in story for ad-tech companies. Meanwhile, the other two headwinds will resolve in time.
Q1 earnings are provide valuable data of who is most and least impacted. Two critical data points will be Facebook’s and Google’s Q1 results, as most of their sales come from mobile ads. Google recently reported that sales grew 23% YoY to $68 billion, which were in-line with estimates.
Furthermore, Google’s Search business slightly outperformed and grew 24% YoY to $40 billion. This follows the outperformance in Q4 as Search sales grew 36% YoY in Q4 while total Q4 sales grew 32% on a year-over-year basis. It may appear that Alphabet’s search revenue is slowing from 30% in the year-ago quarter, but the deceleration in search revenue is due to the tough comps, and relative to Facebook, is outperforming.
The strength in Search highlights the advantage that having first-party data provides. This is because Search is primarily done on a browser, allowing Google to capture valuable first party data from ownership of Google Chrome, Google Search and also from Android OS. Moreover, Google is releasing new products, such as Topics API, which enables behavioral targeting. This is a direct shot at Meta Platforms, who is known to be quite competitive on behavioral targeting through taxonomies.
However, while Search remained strong, both YouTube and Google Network sales underperformed during the quarter. For instance, YouTube grew sales just 14% YoY to $7 billion, a steep slowdown from the 25% and 49% YoY growth rates from last quarter in Q4 and Q1 2021, respectively. Google Network sales increased 20% YoY to $8 billion. This also represented a deacceleration from the 26% YoY growth rate in the prior quarter.
In aggregate, total ad sales increased 22% YoY to $55 billion, a deacceleration from the 33% YoY growth rate in the prior quarter. It is notable that despite the headwinds in YouTube and Google Network, Google’s sales vastly outpaced Facebook’s Q1 revenue growth. As shown below, Google’s ad sales grew nearly 3x faster than Facebook’s 7% growth.
I believe this outperformance was driven by Google’s first-party data advantage. Moreover, YouTube revenue was the biggest laggard during the quarter and YouTube sales grew 14% YoY to $7 billion during the last three-months (fun fact: YouTube is larger than Google Cloud). The slowdown in YouTube may suggest that ads have been impacted by iOS changes, but its important to consider that YouTube grew sales 49% YoY in the year-ago quarter, leading to a tougher comparable base period.
During the Q1 call, Google’s management team explained that the tough comp and “modest” growth from direct response advertising had also impacted the segment, but noted that brand advertising remained an area of strength. The diversification across content types and ability to offer at true omnichannel strategy across mobile, browsers and CTV likely contributed and suggests that brands have shifted ad budgets to YouTube, likely due to its ability to measure ROI at the expense of competing platforms.
Google also reiterated this point during their Q1 Conference Call when CBO Philipp Schindler explained that being able to fully measure what users do after they click on an ad is critical to measuring ROI. He added that “Measurement is also obviously a key component to success [in CTV], and we want to make sure that advertisers can fully measure their YouTube CTV video investments across YouTube and YouTube TV for an accurate view of true incremental reach and frequency and so on.”
CBO Schindler’s comments highlight the importance of measurement, a key aspect of digital advertising that has been challenged following the changes to iOS cookies. If advertisers cannot measure ROI, they tend to limit their ad expenditures, so its critical that ad platforms find solutions to measure ROI in order to sustain growth.
Perhaps the most important comment during the Q1 Conference Call was a statement by management that Google continues to see strength in Retail, reiterating comments made during the Q4 2021 Earnings Call that retail (e-commerce) continues to be strong.
This brief statement is very important, as it adds support that Google will not be as impacted by the iOS changes. Given the signal loss from iOS changes, e-commerce has been one of the hardest hit verticals. Google’s strength here is likely due to its first-party data advantage.
Here is what Facebook CFO David Wehner said about Google’s strength in the retail vertical during Facebook’s Q4 2021 Conference Call:
“e-commerce was an area where we saw a meaningful slowdown in growth in Q4. … But on e-commerce, it's quite noticeable — notable that Google called out, seeing strength in that very same vertical. And so given that we know that e-commerce is one of the most impacted verticals from iOS restrictions, it makes sense that those restrictions are probably part of the explanation for the difference between what they were seeing and what we were seeing.”And so given that we know that e-commerce is one of the most impacted verticals from iOS restrictions, it makes sense that those restrictions are probably part of the explanation for the difference between what they were seeing and what we were seeing.”
Google’s statement that it continues to see strength in retail suggests that it is not as impacted from the iOS changes relative to app-based peers such as Facebook. Importantly, Search is often based on a web browser (Google Chrome), allowing Google to capture first party data and limiting the signal loss from the removal of cookies on mobile based apps.
Our thesis is that in this new cookie-less world, owners of first-party data will outperform going forward. We expect that Google will remain strong given its ownership of first-party data on both its Search platform and also its YouTube platform. However, Facebook will likely continue to struggle here due to its reliance on third-party data and not owning “the real estate,” or essentially the device and/or operating system while needing to collect data from this device in order to support its high ARPU.
Conclusion
Notably, Q2 is particularly hard because there are three heavy macro headwinds: supply chain issues, Ukraine-Russia situation, and the transition that Apple has forced with changes to attribution and measurement on iOS. When you add that the one-time event of Covid, which plummeted ad spend in Q2 2020, and later led to a surge in ad spend the following year Q2 2021, the hurdle to clear for revenue growth is at a historic high. We believe those ad-tech stocks that can show top line growth right now are providing important clues for when macro headwinds clear.
This article was originally published on Forbes on May 13, 2022,01:26pm EDTpublished on Forbes on May 13, 2022,01:26pm EDT
This year, cloud investors have been given a dose of reality on how the market prices growth in this category. For Cloudflare, revenue growth is not an issue at this time. Yet, revenue growth is less meaningful in the current macro environment if the growth does not translate to a healthier bottom line.
It’s true that cloud is deflationary, which is why companies in this sector may continue to see growth during times of inflation. Yet it’s also true that cash is becoming more expensive, and therefore growth must be balanced with a stronger bottom line.
Product Overview
Cloudflare has a formidable customer base and owns the predominant share of the Content Delivery Network market. According to the data from W3Techs, 81% of the websites that use CDN or reverse proxy rely on Cloudflare with a strong presence in small to medium-sized businesses (SMBs).
We had discussed in a podcast on tech stocks last year that Cloudflare is strong in the small to medium-sized business (SMB) category and offers free entry-level services. The company benefits by converting the free customer base to paid services, and it can also use the free customer base to test any new features before they are launched. Cloudflare has been able to upsell its products with a dollar-based net retention rate that increased by 400 basis points YoY to 127% in the recent quarter.
Zero Trust Security is gaining prominence due to rising security threats as the data is not 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.
Cloudflare One is the company’s flagship Zero Trust network-as-a-service. 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.
Zero Trust has helped the company to increase its Total Addressable Market from $32 billion in 2018 to about $100 billion in 2024. The company is playing a major role in the transition from a traditional hardware-based security approach to modern zero-trust security.
In late September, Cloudflare company announced its R2 storage product. 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.
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.
Cloudflare’s Q1 Earnings
At the time the low-cost R2 cloud storage service was launched, Cloudflare’s CEO has stated “we’re aiming to become the fourth major public cloud.” Big Tech has the advantage of strong margins and quite a bit of cash on the balance sheet to build out cloud infrastructure. For this ambition to materialize, not only must Cloudflare build more Points of Presence (PoPs) but the company must also undercut AWS on egress fees, for example, in order to remain competitive.
In the current quarter, network capex was 9% of revenue. For the full year, the network capex is expected to increase to 12% to 14% of revenue. I believe this is a primary reason Cloudflare’s valuation could come under pressure.
I think the thing which is powerful about as we build out more POPs is that counterintuitively, because of the design of our network and because of the efficiency of our network that both Thomas and I just alluded to, it actually drives our cost down over time rather than driving it up. It takes a certain amount of servers in order to process a certain number of requests. So your CapEx is actually driven by the amount of usage of your service more than anything else.
What is powerful is because we have done the hard work on the networking and software side to make it so that any server, anywhere can handle any request, that means that as we continue to expand our network out that we're able to directly interconnect with the various ISPs and eyeball networks around the world and drive our cost down for things like bandwidth, co-location and other variable costs that are part of our business.
At this time, revenue growth is not an issue for Cloudflare as it’s been quite robust for many quarters. The company reported 54% revenue growth beating estimates by 6% with 49% growth expected next quarter. The company raised full year revenue guidance to $957 million, at the mid-range, for growth of 46%.
Sign up for I/O Fund's free newsletter with gains of up to 403% – Click hereSign up for I/O Fund's free newsletter with gains of up to 403% – Click hereClick here
There is additional supporting evidence that growth will not be an issue for Cloudflare, including remaining performance obligations (RPO) up 57% year-over-year and dollar based net retention up 400 bps YoY. Customers paying over $100K increased 63% year-over-year to 1,537. This outpaced total customer growth of 29%. Notably, the >$100K segment was a deceleration from 71% in the previous two quarters.
Large customers contributed 58% of revenue. There was solid growth in the >$500K customer base of 68% year-over-year growth and >$1 million customer base grew by 72% year-over-year.
The company has a gross margin of 77.80% but had a GAAP operating margin of (18.90%) and adjusted operating margin of 2.30%. The primary difference being stock based compensation which doubled to $34 million in Q1, up from $18 million in the year-ago quarter.
Similar to the note about network capex, the company is stating they will not see improvement to operating margin in the near term. I believe this could put pressure on valuation if cloud peers are able to improve operating margin during the current macro environment.
Here is what management said:
“We intend to grow our operating expenses in line with the revenue staying here or at breakeven and reinvest excess profitability back into the business to address the enormous opportunity in front of us.”We intend to grow our operating expenses in line with the revenue staying here or at breakeven and reinvest excess profitability back into the business to address the enormous opportunity in front of us.”
Free cash flow was negative $64.4 million (30% of revenue) in comparison to a negative $2.2 million (2% of revenue) in Q1 2021. Of this, $30 million was due to a unique withholding tax payment in the recent quarter. This would still show a marked decline in free cash flow from last quarter during a time when the market is especially sensitive to cash flows. The company reported positive free cash flow of $8.6 million in Q4 2021, and it was the first positive free cash flow quarter since the company became a public company. Management stated they will be cash flow positive in the second half of the year while the first half of the year will have negative free cash flow due to the investment in network and redesigning of physical offices post Covid-19.
The company had cash and available-for-sale securities of about $1.7 billion, out of which cash is $152 million.
Conclusion:
Cloudflare is showing strong customer growth and its steady revenue growth also helps substantiate that cloud is, indeed, deflationary. What is likely weighing on the market’s mind is what the CapEx will be to become the fourth cloud provider. Management has confirmed that operating margin will not improve anytime soon as the company plans to re-invest and the company’s recent quarter showed a decline in free cash flow. The I/O Fund exited the stock based to focus on higher conviction companies that have a better cash flow margin.
Maintaining focus can be really tough when the market is penalizing tech stocks across the board. How do we determine which ones to trim/exit and which ones to add/enter? Despite it being counterintuitive, usually the best entries are made when the market is in a state of fear.
My first instinct is to protect our stocks with the highest allocations with a few of these certainly in the cloud category. I am less concerned with near-term price action and much more concerned with how the fundamentals mesh with the current macro environment. If a company has a strong report (AMD, Datadog) then I don’t stress market moves as fundamentally these companies are showing strength. It’s not an investor’s job to control the market or change positions based on 6-month price action. That’s why we haven’t changed positions such as AMD or Datadog. I’m using them as an example because they already reported.
The I/O Fund is positioned for an ad-tech rebound in H2. We’ve published quite a bit on this. We understand this requires a bit of speculation and we have been keeping our members up to date on this over the past few months with this research here and here. Ultimately, ad-tech valuations are well below the median in 2018 and 2019.
Strong growth in ad-tech is often awarded a 10 Forward EV to Revenues. The bottom line can fluctuate depending on how much a company is investing in growth, yet rarely does ad-tech have cash flow issues at scale. Snap and Roku are certainly at the scale where the path to profitability has been proven. Ultimately, we believe there is alpha here due to the market over-reacting to macro which is why we own ad-tech positions. There are many more ad-tech positions than the ones we own for investors to consider.
This analysis goes over cloud as what happened last Friday to Bill and Cloudflare caused me to shelf a deep dive on ad-tech post-earnings in favor of a cloud overview of our holdings. Many cloud companies have not been public during a rising rate environment (2017- early 2019). With the FOMC decisions being out of a tech investor's control, we have been forced to evaluate our cloud stocks to look for expanding margins and positive cash flow. There was some evidence last week that the market’s appetite for growth in this category has changed if the growth doesn’t contribute to the bottom line. I understand there is a relief rally today but my job this week has been to make sure fundamentally our cloud stocks can withstand macro pressure.
It’s true that cloud is deflationary but it’s also true that cloud can have profitability issues. As you saw last Friday, cloud is quite resilient in terms of growth, due to being deflationary, but those weak bottom lines may be questioned over time. Cash came easy over the past decade, and as cloud investors, we need to reframe our thinking on what constitutes an attractive cloud stock.
For long-term cloud investors that hold sizable allocations, like the I/O Fund does, I believe the following has to be answered:
1. Is there something inherent to the product that weighs on margins? If so, these companies have an additional hurdle beyond rising rates that must be resolved.
Cloudflare could fall into this category due to CapEx (something to monitor – we closed this position for now). The CapEx went from 9% in the current quarter to 12% to 14% for the year, and the market is likely assessing the cost it requires to become the fourth cloud provider.
Twilio falls into this category until Segment and other products can improve its core product gross margin (I believe it will and we will layer back in when it does). I expand on this more below.
2. GAAP operating margin versus Non-GAAP operating margin; this is where stock based compensation can affect a company’s GAAP profitability and companies that recently went public or had an acquisition often see an impact. There are also many cloud companies that invest their cash to grow rapidly, yet the leniency for “growth at any cost” may shift substantially.
3. Free cash flow is probably the most important in a rising rate environment for a sector that is often unprofitable and/or must spend heavily for growth. Below, we examine our top cloud holdings on the basis of their ability to become free cash flow positive.We need to recognize that the innovation cycle is such that venture capitalists exit through public offerings and there is often no path to profitability at the time a tech companies goes public. When you couple the historically loose FED policy we’ve had, it compounds the issue of figuring out which companies can become profitable and sustain in a slowing economy. Cloud will be put to the test the longer interest rates remain elevated and/or slated to rise, and I believe this will catch tech investors off guard because the sector has treated them so well. These relief rallies also do not help to distinguish which are fundamentally stronger as the price action reflects more of a rising of all boats.
Our Cloud Stocks
SentinelOne
SentinelOne is a company where we like the product very much. However, there is no denying that this company has weak margins albeit the margins are improving quite rapidly.
SentinelOne leads the cloud category in growth at 120% last quarter. In the previous quarter, SentinelOne accelerated to 128%, up from 121%. The company is expected to report $74.7 million in revenue for growth of 99.5%, assuming they come in at this number, that would be a deceleration in revenue.
Full year revenue is expected to be $370 million, up 80%. The 1-year forward for fiscal year 2024 ending in January is expected to be $605 million, up 64%. The main key metric that forecasts strong revenue growth is that ARR was up 123% year-over-year. This is a highlight from the last earnings report.
SentinelOne has a particularly weak operating margin of (108%) last quarter. The adjusted operating margin was at (66%) compared to (104%). The management guided for (85%) this quarter. The company emphasized this is improving with a full year adjusted operating margin guide of (55%) to (60%) for full year.
I believe this improvement in the guide is why the stock recovered after hours the evening of its earnings report. Will SentinelOne be able to provide a meet/beat on operating margin in the upcoming quarter and a meet/beat for the full year guide? This must happen and we also need revenue to remain strong.
We covered here in the Q2 2022 webinar how cybersecurity budgets are indicated to grow this year over 2021.
Management seemed to be quite sensitive to understanding this is key as it was the second thing they mentioned in the opening remarks:
I'm pleased to share that we ended the fourth quarter with double-digit year-over-year improvement in both our gross and operating margins. Our gross margins expanded 12 percentage points year-over-year, and our operating margin improved 38%. This progress reflects our growing scale and increasing efficiency.
The number of shares owned by institutions and the percentage of shares owned by institutions is also high at 92% (compared to Cloudflare at 80%). However, the number of institutions has declined by about 13%.
For SentinelOne, weighing on operating margin is also sales and marketing expenses at 64% of revenue and R&D at 65% of revenue. Compare this to Crowdstrike with S&M at 38% of revenue and R&D at 24% of revenue. To be clear, Crowdstrike has a better bottom line than SentinelOne. The operating margin has been at (10%) over the past few quarters and is at (5%) in the most recent quarter.
SentinelOne’s free cash flow has been improving but certainly needs work, which is common for a company that has not reached scale. The company reports cash flow of ($7.1) million improving from ($25.6) million in the same period last year.
SentinelOne has $1.67B in cash and the company burns about $400M so that’s three years. If we assume the margins improve, and the company reaches profitability by 2025 (analyst consensus believes this will happen) then the negative free cash flow should not hinder the stock. We had discussed why SentinelOne is similar to Crowdstrike at this stage of growth here.
Notably, last year, SentinelOne was weakest in Q1 and they’ve mentioned strong seasonality in Q4.
“The strength of our performance was broad-based, coming from a healthy mix of new customer additions, existing customer renewals and upsells. All of this was further magnified by the strong underlying seasonality of our fourth quarter.”All of this was further magnified by the strong underlying seasonality of our fourth quarter.”
Here was their comment about the upcoming Q1 quarter:
“Our ARR and revenue growth track very closely. Our revenue guidance for Q1 implies that we should be at or better than typical Q1 net new ARR seasonality, which has been down between 25% to 35% sequentially in the past 2 years.”
Here was our comment about Q1 following the last earnings report:
“Total ARR is nearing $300 million while annual revenue for the upcoming fiscal year 2023 is guided at $368 million, with ARR suggesting this guide could be easily met over the next four quarters. Most importantly, customers over the $100K range are growing at a rate that is double overall customer growth at 137% and 70%, respectively.
The overall customer growth represents a slowdown from 79% YoY to 70% YoY while larger account growth was fairly flat at 141% in Q3 to 137% in Q4.
The company guided for Q1 revenue of $74.5 million, compared to revenue in Q4 of $65.6 million. This is important because management has stated in the past, Q1 revenue was down sequentially by 20% to 25%. “Our revenue guidance for Q1 implies that we should be at or better than typical Q1 net new ARR seasonality, which has been down between 25% to 35% sequentially in the past 2 years.”
Notably, the I/O Fund is unable to track where the ARR was down “for the past 2 years” but the sequential growth is headed in the right direction. The numbers we have show Q1 FY2021, net new ARR declined 37% QoQ to $8 million yet in Q1 FY2022 it grew +8% QoQ to $30 million. This year, the sequential growth will be +13.5%.
Higher ARR sequentially for the upcoming Q1 is likely driven by the record number of 100,000-plus deal and a record number of million-dollar plus deals. International is another area of strength as the company saw revenue grow 140%. This represents 31% of revenue – so something to watch closely as a near-term driver.”
Takeaway: No changes to our position right now, if there is a meaningful change to operating margin, we will update you.
MongoDB
MongoDB had an acceleration in revenue from 50.1% in Q3 to 55.85% in Q4. The market rewarded this earnings report with an increase in price, moving from $280 to $338 on the report. At the beginning of April, the stock price was nearly flat YTD.
There was an acceleration in revenue for FY2022 to 48% year-over-year, up from 40% growth in FY2021. Looking forward, FY2023 revenue growth is expected to be 35% year-over-year.
Key metrics supporting future revenue growth include customers over $1 million in ARR growing 67% and customers over $100,000 growing 34%. Atlas customers outpaced total customer growth at 35% compared to 33% growth, respectively.
MongoDB has a 72% gross margin and GAAP operating margin of (29%) due to stock-based compensation, or a loss of $78.6 million. The adjusted operating margin is (0.49%) or essentially a loss of $1.3 million. The net margin is (32%) or a loss of $84.4 million with adjusted net margin of (2%), or a loss of $6.3 million.
With that said, MongoDB is cash flow positive. It needs to remain cash flow positive for the market to be confident in its valuation. I do believe where Cloudflare was penalized was the surprise to the downside in cash flow. This is a marked change to how the market treated cloud companies in the past.
MongoDB has $474 million cash on its balance sheet with operating cash flow of $22.3 million and free cash flow of $16.8 million. This represents a free cash flow margin of positive +6%. The company holds $1.2 billion in debt.
The difference between MongoDB’s GAAP EPS and Non-GAAP EPS is primarily due to SBC. Here we have a forward GAAP EPS of ($1.22) and Adjusted EPS of ($0.10). Overall, MongoDB has improved it’s adjusted EPS as it was typically in the ($0.20) range.
MongoDB’s catalyst for growth is Atlas, which we covered in a deep dive here. We also covered how this company fits into our Big Data and Analytics positioning here. We are more likely to hold a cloud stock that falls into the Big Data theme and/or cybersecurity due to seeing evidence of growth in these markets. Primarily, Microsoft pointed towards the following trends in the recent earnings report, which we covered here:
Starting in September, we began to position for Big Data, Analytics and ML. Microsoft has grown their Cosmos database (DB) transactions and data volume by 100% year-over-year for the third quarter in a row. Synapse data volume has also doubled. Monthly machine learning inference requests increased 86% year-over-year. for Big Data, Analytics and ML. Microsoft has grown their Cosmos database (DB) transactions and data volume by 100% year-over-year for the third quarter in a row. Synapse data volume has also doubled. Monthly machine learning inference requests increased 86% year-over-year.
As stated above, MongoDB’s cash flow margin is what can keep the stock strong given stock based compensation is weighing on GAAP operating margin. We want a meet/beat on revenue, strong Atlas growth (bonus for acceleration) and we must continue to have a healthy, positive cash flow margin.
Analyst consensus has MongoDB reaching profitability on an adjusted basis by calendar year 2023.
Snowflake
Snowflake is seeing a deceleration in revenue yet is reaching adjusted profitability this year.
The company is expected to report revenue of $412 million, representing growth of 80%. The previous quarters the company reported revenue growth of 101% in Q4, 109% in Q3, and 104% in Q2. For the fiscal year 2023 ending in January, the company is expecting revenue growth of 67% for revenue of $2.03 billion. Analyst consensus shows revenue of $3.17 billion, or growth of 56% for fiscal year 2024.
There has been an outflow of institutional shares since December with a 30-day change from 330 million shares to 305 million shares.
As Snowflake continues to grow revenue, the losses are narrowing. When the company reported roughly $300 million revenue, the GAAP operating losses were around $200 million. The company is now reporting a little over $400 million in revenue with GAAP operating losses of about $150 million. What you don’t want in this environment is an inverse relationship to where losses increase as revenue increases.
Snowflake is steadily improving its margins from 58% gross margin a year ago to 65% gross margin in the recent quarter. The company has improved its GAAP operating margin from (90%) a year ago to (40%) in the recent quarter. The company has a positive adjusted operating margin of 5% and has stated they will end the year with a positive 1% adjusted operating margin. They have to deliver on this promise to maintain a category-high valuation.
Revenue grew 64% to $126 million and customers over $100K grew 41%. Analyst consensus on revenue was for $127.4 million. The company reported EPS of (0.19) and analysts were looking for (0.20).
However, free cash flow for Confluent is a blemish at ($58.4) million, or 46% of revenue. Adjusted operating margins are at (41%) and GAAP operating losses of (88.4%). Adjusted gross margin is 69.7% with employee bonuses and employee stock purchase plans hurting the operating margin. FCF is to be the lowest in Q1.
Confluent has cash and marketable securities of $2.0 billion with cash of $1.05 billion.
Adjusted operating margin is expected to be (38%) on revenue growth of 44% for FY 2022.
We all know how the market feels about those margins right now – Confluent was not alone in the AH bloodbath.
On a positive note, Confluent Cloud is ripping at 180% YoY growth. This has led to RPO accelerating to 96% YoY. The company signed an 8-figure deal that was not recognized in Q1. Cloud net retention rate is 150%.
Analysts on the call were excited about the net new add in customers and the company reiterated its goal of positive FY2023 operating margin.
Note: We believe the negative free cash flow margin is too steep for Confluent to be a high conviction company at this time. We very much like the Confluent Cloud growth and will look for the more normalized growth rate once it scales. If Knox asked me where to raise cash in cloud, I would choose Confluent although we do not have all earnings reports yet.
Datadog was down after putting up a solid report and we bought a small tranche following the earnings report.
The company beat and raised on all accounts. Customers over $100K grew were up 54%, growing from 80% of revenue to 85% of revenue. The company also said the magic words: “36% free cash flow margin” in Q1 with a TTM cash flow margin of 28%. Free cash flow (FCF) grew from $250 million in Q4 to $335 million in Q1.
The company was expected to report 70% revenue growth and instead reported 83%, with revenue up 11% sequentially. Guidance also impressed at $378 million at the midpoint, or 62% growth. That should be enough to keep Datadog in the top 5 on forward growth in the cloud category. FY2022 guidance raised to $1.61 billion for growth of 56.4% at the midpoint, up from $1.53 billion.
They said the other magic words which is that “dollar based net retention rate continued to be over 130% as customers increased their usage and adopted newer products.” During covid, this DBNRR wouldn’t be as meaningful as many cloud companies were at the 130 mark but Datadog proving itself best-of-breed here by maintaining this level for 19 consecutive quarters.
Datadog’s strength is cross-selling or standardization, which we’ve covered in detail. Number of customers using 2 or more products increased to 81%. The company signed its largest contract in terms of ARR (they said it was 8-figures with a next-gen fintech company). There were examples on the call of customers consolidating monitoring tools from 5 products to 10, and from 1 product to 6.
Notably, on top of accelerating revenue growth YoY from 51% in Q1 last year to 83% in Q1 this year, Datadog also improved operating margin from 10% to 23% in the current quarter.
Note: Datadog is the strongest cloud company on the market if you look at the relationship between the top line and the bottom line.
Twilio
We covered Twilio pre-earnings here and also post-earnings here on the forum. We ultimately trimmed our position due to the reason stated post-earnings: “Analysts asked if increased costs in core product could affect gross margin and/or user fall-off. This comment is probably the most concerning to me. Lots of questions on Gross Margin, which the main concern being any fluctuations here if there's pricing pressure from telcos.”
Ultimately, we will layer back into Twilio when we see the software business help to sustain the gross margin.
Here is what was asked on the call:
Michael TurrinMichael Turrin
Gross margin saw a meaningful improvement sequentially. The prepared remarks still referenced just some near-term fluctuation potential. Just in sort of adding some more context around that. I guess the question is just why wouldn't that be at least somewhat bottoming if we're looking at sort of a point in time where U.S. growth is moderating? Some of these 10DLC impacts are playing through. Are you at all comfortable that gross margin can at least remain around a similar ZIP code regardless of our messaging mix plays through? Or anything else you could just provide to help us think through normalization of what these fluctuations can look like?. I guess the question is just why wouldn't that be at least somewhat bottoming if we're looking at sort of a point in time where U.S. growth is moderating? Some of these 10DLC impacts are playing through. Are you at all comfortable that gross margin can at least remain around a similar ZIP code regardless of our messaging mix plays through? Or anything else you could just provide to help us think through normalization of what these fluctuations can look like?
Khozema ShipchandlerKhozema Shipchandler
Yes. That's a good question. I mean I think with respect to the gross margins in Q1, we are obviously happy with them improving to 53%. I think, Michael, the thing I'd encourage you to keep in mind is that just the size and scale of our messaging business is what tends to drive it. And so that's why we're kind of signaling some level of fluctuation in gross margins in the near term. I think it'll be in the ZIP code. I mean I'm not going to be prepared to call the bottom or anything like that. But I'd also remind you that we like the messaging business a lot. And while it does carry that lower gross margin, it also generates a lot of gross profits that we reinvest back into the business.And so that's why we're kind of signaling some level of fluctuation in gross margins in the near term. I think it'll be in the ZIP code. I mean I'm not going to be prepared to call the bottom or anything like that. But I'd also remind you that we like the messaging business a lot. And while it does carry that lower gross margin, it also generates a lot of gross profits that we reinvest back into the business.
If you go back to Q1 of 2020, Twilio’s growth rate in customers was about 23.5% from 190K customers to 235K customers. The most recent year-over-year growth was 14% from 235K customers to 268K customers. The company does not break out the growth rate but the presentations provide number of customers. This would imply some churn due to increased fees passed onto customers on the core product.
In terms of margins, the company guidance missed expectations at adjusted EPS of ($0.23) to ($0.20) compared to consensus of ($0.13). The forward growth of 27%-29% is to be expected during this pivot. I want to emphasize the management has been preparing for the core product to hit saturation essentially which is why we want to remain invested to participate in this management team bringing API-driven marketing to marketing departments. Twilio certainly is consumer-facing and thus what we are seeing with ad-tech affects Twilio, as well. This is unique from more deflationary cloud products at the enterprise-level.
Cloudflare
We covered Cloudflare this week for the free newsletter, which will hit your inboxes soon. The stock hit our stop and here is the main thing that drove our decision on fundamentals.
At the time the low-cost R2 cloud storage service was launched, Cloudflare’s CEO has stated “we’re aiming to become the fourth major public cloud.” Big Tech has the advantage of strong margins and quite a bit of cash on the balance sheet to build out cloud infrastructure. For this ambition to materialize, not only must Cloudflare build more Points of Presence (PoPs) but the company must also undercut AWS on egress fees, for example, in order to remain competitive.
In the current quarter, network capex was 9% of revenue. For the full year, the network capex is expected to increase to 12% to 14% of revenue. I believe this is a primary reason Cloudflare’s valuation could come under pressure.
Here is what the company said on the call:
I think the thing which is powerful about as we build out more POPs is that counterintuitively, because of the design of our network and because of the efficiency of our network that both Thomas and I just alluded to, it actually drives our cost down over time rather than driving it up. It takes a certain amount of servers in order to process a certain number of requests. So your CapEx is actually driven by the amount of usage of your service more than anything else.
What is powerful is because we have done the hard work on the networking and software side to make it so that any server, anywhere can handle any request, that means that as we continue to expand our network out that we're able to directly interconnect with the various ISPs and eyeball networks around the world and drive our cost down for things like bandwidth, co-location and other variable costs that are part of our business.
At this time, revenue growth is not an issue for Cloudflare as it’s been quite robust for many quarters. The company reported 54% revenue growth beating estimates by 6% with 49% growth expected next quarter. The company raised full year revenue guidance to $957 million, at the mid-range, for growth of 46%.
There is additional supporting evidence that growth is not an issue for Cloudflare, including remaining performance obligations (RPO) up 57% year-over-year and dollar based net retention up 400 bps YoY. Customers paying over $100K increased 63% year-over-year to 1,537. This outpaced total customer growth of 29%. Notably, the >$100K segment was a deceleration from 71% in the previous two quarters.
Large customers contributed 58% of revenue. There was solid growth in the >$500K customer base of 68% year-over-year growth and >$1 million customer base grew by 72% year-over-year.
The company has a gross margin of 77.80% but had a GAAP operating margin of (18.90%) and adjusted operating margin of 2.30%. The primary difference being stock based compensation which doubled to $34 million in Q1, up from $18 million in the year-ago quarter. The market has not been very friendly to companies diluting GAAP operating margins due to SBC, and we see evidence this may have impacted Cloudflare.
Similar to the note about network capex, the company is stating they will not see improvement to operating margin in the near term. I believe this could put pressure on valuation if cloud peers are able to improve operating margin during the current macro environment.
Here is what management said:
“We intend to grow our operating expenses in line with the revenue staying here or at breakeven and reinvest excess profitability back into the business to address the enormous opportunity in front of us.”We intend to grow our operating expenses in line with the revenue staying here or at breakeven and reinvest excess profitability back into the business to address the enormous opportunity in front of us.”
Free cash flow was negative $64.4 million (30% of revenue) in comparison to a negative $2.2 million (2% of revenue) in Q1 2021. Of this, $30 million was due to a unique withholding tax payment in the recent quarter. This would still show a marked decline in free cash flow from last quarter during a time when the market is especially sensitive to cash flows. The company reported positive free cash flow of $8.6 million in Q4 2021, and it was the first positive free cash flow quarter since the company became a public company. Management stated they will be cash flow positive in the second half of the year while the first half of the year will have negative free cash flow due to the investment in network and redesigning of physical offices post Covid-19.
The company had cash and available-for-sale securities of about $1.7 billion, out of which cash is $152 million.
Clearly, many investors like Cloudflare and the company is not without merit by any means. Rather, I can’t rely on cash flow improving in H2 and/or CapEx not rising beyond the current 12% to 14% to personally maintain conviction in the current environment.
For costs inherent to the product, my personal choice is Twilio as I can see the product road map a bit more clearly on Segment/software side and how this can expand the company’s gross margin.
Asana
Please note, Asana is a small 1% position and we covered the company’s financials here and the unexpected rise in expenses. We will update you on the next earnings report. We hold the stock because the product should be deflationary (more than most).
This article was originally published on Forbes on May 5, 2022,11:44pm EDTForbes on May 5, 2022,11:44pm EDT
Shopify reported slowing growth and rising expenses. As of late, the market tends to penalize companies that report slowing growth and declining margins and Shopify has not been spared. However, with Shopify’s stock in the gutter, is now a good time to buy the company? The answer is that it depends on your time horizon. The long-term story is intact but there are also opportunity costs to holding a stock that must be considered.
By now, we all know that macro conditions are affecting most consumer-facing businesses. In addition to macro, Shopify faces high investment costs for the Shopify Fulfillment Network (SFN) coupled with the unknowns around the company’s growth rate now that the economy is reopened. Essentially, it’s hard to model this because the return on the investments made in SFN will not appear until H2 2023 or early 2024. This presents a predicament for Shopify’s stock if the market is uncertain of how SFN will perform.
What could overcome these headwinds would be Shopify’s strength in merchant software solutions including an omnichannel approach and the company’s social commerce inroads. Because Shopify offers an omnichannel strategy through point-of-sale (POS) and various products, the company may be able to regain the Street’s confidence even while e-commerce continues to soften.
Notably, one more headwind that Shopify will have over the next three months is the company’s pattern to not provide guidance. This may have worked well when the ecommerce sector was on fire, but investors need more to go off of with macro putting pressure on the consumer-facing companies. This lack of visibility may work against the company while others are striving to reiterate full year guidance and discuss more granularly their current revenue growth.
Shopify’s Q1 2022 results
In the most recent quarter, Shopify’s growth slowed as GMV increased just 16% YoY, nearly half the 31% YoY growth rate the company reported in the prior quarter. Total sales increased 22% YoY to $1.2 billion, which was the slowest rate of growth since Shopify went public.
The company stated the lower revenue was due to Omnicron easing and inflation pushing consumers towards discount retailers in Q1. Long-term, management believes despite the macro backdrop that “e-commerce will continue to penetrate commerce overall”- a $6 trillion market.
Subscription sales increased just 8% YoY to $345 million while Merchant services increased 29% YoY to $859 million. Management noted that a change in how they share revenue impacted subscription sales, without this subscription sales would have been up 15% YoY.
The tough macro environment flowed down to gross margin, which declined 354 bps YoY to 53%. Shopify also guided that Merchant sales would grow 2x as fast as Subscription sales in 2022, which is likely pressuring Shopify’s valuation. This is because Merchant sales are lower margin and implies further margin compression.
Also pressuring gross margin were investments in Shopify Fulfillment Network, which are expected to pressure earnings for the next couple of years. During the Q1 2022 call, management stated that “the expectation [for SFN] is that scale will still be towards the back half of 2023 and into 2024, and we've always said that's where the unit economics really start to shift to favorable. So, we fully expect the volumes to continue to increase into that timeframe.”
In other words, there will be a delay until Shopify’s income statement reflects the benefits of scaling up its fulfillment network. In the meantime, the optics of slowing growth and rising expenses are temporarily pressuring Shopify’s multiple. However, these investments are necessary to support long-term growth and Shopify’s multiple will likely improve as the benefits of scale are reflected in earnings.
Adjusted operating income declined YoY from $210 million to $32 million. The decline was driven by a ramp in R&D and sales and marketing expenses, coupled with the investments being made in SFN outlined above. Shopify also reported a large $1.6 billion unrealized loss during the quarter related to its investments in Affirm and Global-E, which have seen their equity values more than halve since last year. The rapid decline in Shopify’s equity investments has also likely impacted by the company’s valuation due to a lower sum-of-the-parts valuation.
Nevertheless, last year Shopify had reported over $1 billion in equity gains from the aforementioned investments, and excluding the impact from equity investments, adjusted earnings per share were $0.20, which missed estimates of $0.65. As mentioned above, margins and earnings were impacted by numerous short-term trends.
Deliverr
Shopify also announced the acquisition of Deliverr for $2 billion during the quarter. Even though it makes sense to add logistics software, the timing of this announcement was not great given Shopify’s low top line growth and weakness in the margins. Analysts have to digest that Shopify is spending another $2 billion on Shopify Fulfillment Network, while it was previously stated the company would spend $1 billion per year until 2024. It’s possible that we have not seen the end to the investment that will be required.
Deliverr is an asset-lite business that brings logistics and inventory management capabilities to Shopify. CFO Shapero explained that Deliverr accelerates fulfillment volumes, which will help accelerate the development of SFN.
Sign up for I/O Fund's free newsletter with gains of up to 403% – Click hereSign up for I/O Fund's free newsletter with gains of up to 403% – Click hereClick here
Yet, the $2 billion acquisition adds to the total cost of SFN and management noted that the acquisition will be dilutive to earnings in the near term. In the current market, where investors want profits today, this commentary likely hit Shopify’s valuation. Importantly, margins will improve as the company scales, highlighting how this is yet another one-time concern impacting Shopify’s valuation.
As a tech investor, I like it when tech companies re-invest for growth. However, the timing of when return on the investment will begin to appear could cause Wall Street to grow impatient. This year, the investment will be $3 billion if you factor the original statement of $1 billion per year plus the $2 billion Deliverr acquisition.
Amazon Could Become a Partner
Shopify management shrugged off concerns that Amazon was a competitor and reframed the company as a partner. Here is what was discussed on the earnings call:
“So we are actually thrilled with Amazon making a decision to take the amazing infrastructure that they've built because they have a second to none infrastructure and want to share this broadly with small merchants across the Internet. And so we are happy to integrate this into Shopify, just in the same way how we integrated what — the infrastructure that Meta built, the infrastructure that Google built and the infrastructure that TikTok built and so on.”
Speaking of Meta, Google and TikTok, Shopify’s social commerce revenue was up 4X year-over-year – and this was despite direct response and smaller businesses being the hardest hit from Apple’s IDFA changes. I believe the growth in social commerce is key to Shopify re-accelerating revenue.
Conclusion:
Shopify recently reported slowing growth, rising expenses and shrinking margins. Which is exactly why Shopify could very well be trading at its low as all negativity is probably priced in. The real question is whether Shopify can bounce back as quickly as peers with management teams who are providing more visibility? We won’t know for another three months how Shopify weathered Q2. Tech investors should always have a long-term horizon or the gains will not outweigh the losses, that is a fact, because timing is nearly impossible given the volatility in this sector. If you don’t have long-term horizon, you’ll end up selling at the low. While many are panicked over losses right now, the more common problem that tech investors face is closing winners too soon. I believe Shopify was quite clear on the horizon required for Shopify investors to see a meaningful return, which will be around the time Shopify Fulfillment Network begins to scale in 2023/2024.
At my firm, we manage allocations very closely for long-term high conviction plays. We prefer to rotate our higher allocations into stocks that have strong relative strength and fundamental strength today. At the same time, we believe in putting high conviction plays that are struggling, like SHOP, on the back burner at a very low allocation until we start seeing signs of a breakout move. We believe that finding the right combination between being nimble and conservative in position sizing while at the same time remaining invested in a great long-term story is the key to successful tech investing. Shopify may need more time, and for that reason it will remain as a low allocation in our portfolio, but we do believe the company has the right ingredients and warrants being in a top 5 position once the moving pieces come together.
Financial Analyst Bradley Cipriano, CFA, CPA at I/O Fund, contributed to this analysis.
This article was originally published on Forbes on Apr 28, 2022,10:45pm EDT
If an investor were to believe market price action this week, it would appear Facebook had strong earnings while Alphabet stumbled. Yet, the opposite is true. Primarily, it was strength in retail ads that led to Alphabet reporting healthy growth of 23%. Meanwhile, Meta Platforms (Facebook) reported revenue growth of 9.7% and is guiding for roughly 0% growth from $28.5 billion in Q2 2021 to $29 billion, at the midpoint for Q2 2022. This analysis looks at why Alphabet is able to provide higher revenue guidance despite 80% of its revenue coming from ads while Facebook is guiding for flat growth.
Notably, Q2 is particularly hard because there are three heavy macro headwinds: supply chain issues, Ukraine-Russia situation, and the transition that Apple has forced with changes to attribution and measurement on iOS. When you add the one-time event of Covid, which plummeted ad spend in Q2 2020, only to lead to a surge in ad spend the following year Q2 2021, the hurdle to clear for revenue growth is at a historic high. We believe those ad-tech stocks that can show top line growth right now are providing important clues for when macro headwinds clear.
BACKGROUND:
The ad-tech industry remains in a whirlwind of changes following iOS privacy changes that limit third-party tracking on Apple mobile devices. I am hyper focused on identifying who the winners and losers will be following these changes, as it will determine who will lead ad-tech going forward. This issue is important because it impacts leading FAANG ad-tech companies, such as Facebook (Meta) and Google (Alphabet). Wall Street particularly likes ad-tech’s bottom line, and will aptly reward those stocks that can capture more ad spend.
In the below analysis, I review Google’s Q1 2022 results and focus on its ad platform (I am ignoring Google Cloud for now) and look for hints if Google is being impacted by the recent iOS changes. You’ll find that Google has held up well relative to other app-based advertising platforms, such as Facebook, following the changes to third-party identifiers. This is because Google has a first-party data advantage, which is critical during a time that attribution and measurement is limited by third parties. I explain why in more detail below.
Google’s Q1 Ad Growth Remains In-Line
While the market is still digesting the macro headwinds previously mentioned – supply chain and Ukraine-Russia; the third headwind of attribution and measurement changes is the headwind that investors should pay most attention to as it leads to a material change in story for ad-tech companies. Meanwhile, the other two headwinds will resolve in time.
Q1 earnings are provide valuable data of who is most and least impacted. Two critical data points will be Facebook’s and Google’s Q1 results, as most of their sales come from mobile ads. Google recently reported that sales grew 23% YoY to $68 billion, which were in-line with estimates. Furthermore, Google’s Search business slightly outperformed and grew 24% YoY to $40 billion. This follows the outperformance in Q4 as Search sales grew 36% YoY in Q4 while total Q4 sales grew 32% on a year-over-year basis. It may appear that Alphabet’s search revenue is slowing from 30% in the year-ago quarter, but the deceleration in search revenue is due to the tough comps, and relative to Facebook, is outperforming.
The strength in Search highlights the advantage that having first-party data provides. This is because Search is primarily done on a browser, allowing Google to capture valuable first party data from ownership of Google Chrome, Google Search and also from Android OS. Moreover, Google is releasing new products, such as Topics API, which enables behavioral targeting. This is a direct shot at Meta Platforms, who is known to be quite competitive on behavioral targeting through taxonomies.
Sign up for I/O Fund's free newsletter with gains of up to 403% – Click hereSign up for I/O Fund's free newsletter with gains of up to 403% – Click hereClick here
However, while Search remained strong, both YouTube and Google Network sales underperformed during the quarter. For instance, YouTube grew sales just 14% YoY to $7 billion, a steep slowdown from the 25% and 49% YoY growth rates from last quarter in Q4 and Q1 2021, respectively. Google Network sales increased 20% YoY to $8 billion. This also represented a deacceleration from the 26% YoY growth rate in the prior quarter.
In aggregate, total ad sales increased 22% YoY to $55 billion, a deacceleration from the 33% YoY growth rate in the prior quarter. It is notable that despite the headwinds in YouTube and Google Network, Google’s sales vastly outpaced Facebook’s Q1 revenue growth. As shown below, Google’s ad sales grew nearly 3x faster than Facebook’s 7% growth.
I/O Fund
I believe this outperformance was driven by Google’s first-party data advantage. Moreover, YouTube revenue was the biggest laggard during the quarter and YouTube sales grew 14% YoY to $7 billion during the last three-months (fun fact: YouTube is larger than Google Cloud). The slowdown in YouTube may suggest that ads have been impacted by iOS changes, but its important to consider that YouTube grew sales 49% YoY in the year-ago quarter, leading to a tougher comparable base period.
During the Q1 call, Google’s management team explained that the tough comp and “modest” growth from direct response advertising had also impacted the segment, but noted that brand advertising remained an area of strength. The diversification across content types and ability to offer at true omnichannel strategy across mobile, browsers and CTV likely contributed and suggests that brands have shifted ad budgets to YouTube, likely due to its ability to measure ROI at the expense of competing platforms.
Google also reiterated this point during their Q1 Conference Call when CBO Philipp Schindler explained that being able to fully measure what users do after they click on an ad is critical to measuring ROI. He added that “Measurement is also obviously a key component to success [in CTV], and we want to make sure that advertisers can fully measure their YouTube CTV video investments across YouTube and YouTube TV for an accurate view of true incremental reach and frequency and so on”.
CBO Schindler’s comments highlight the importance of measurement, a key aspect of digital advertising that has been challenged following the changes to iOS cookies. If advertisers cannot measure ROI, they tend to limit their ad expenditures, so its critical that ad platforms find solutions to measure ROI in order to sustain growth.
Perhaps the most important comment during the Q1 Conference Call was a statement by management that Google continues to see strength in Retail, reiterating comments made during the Q4 2021 Earnings Call that retail (e-commerce) continues to be strong.
This brief statement is very important, as it adds support that Google will not be as impacted by the iOS changes. Given the signal loss from iOS changes, e-commerce has been one of the hardest hit verticals. Google’s strength here is likely due to its first-party data advantage.
Sign up for I/O Fund's free newsletter with gains of up to 403% – Click hereSign up for I/O Fund's free newsletter with gains of up to 403% – Click hereClick here
Here is what Facebook CFO David Wehner said about Google’s strength in the retail vertical during Facebook’s Q4 2021 Conference Call:
“e-commerce was an area where we saw a meaningful slowdown in growth in Q4. … But on e-commerce, it's quite noticeable — notable that Google called out, seeing strength in that very same vertical. And so given that we know that e-commerce is one of the most impacted verticals from iOS restrictions, it makes sense that those restrictions are probably part of the explanation for the difference between what they were seeing and what we were seeing.”And so given that we know that e-commerce is one of the most impacted verticals from iOS restrictions, it makes sense that those restrictions are probably part of the explanation for the difference between what they were seeing and what we were seeing.”
Google’s statement that it continues to see strength in retail suggests that it is not as impacted from the iOS changes relative to app-based peers such as Facebook. Importantly, Search is often based on a web browser (Google Chrome), allowing Google to capture first party data and limiting the signal loss from the removal of cookies on mobile based apps.
Our thesis is that in this new cookie-less world, owners of first-party data will outperform going forward. We expect that Google will remain strong given its ownership of first-party data on both its Search platform and also its YouTube platform. However, Facebook will likely continue to struggle here due to its reliance on third-party data and not owning “the real estate,” or essentially the device and/or operating system while needing to collect data from this device in order to support its high ARPU. We wrote about this for Forbes recently: Facebook Stock: A Permanent Change to the Business Model
Two weeks ago, I held a webinar that discussed Facebook’s business model change and why I believe there will be meaningful erosion to ARPU. This is a thesis we first published four years ago in 2018 when we warned this FAANG faced considerable headwinds. In the webinar below, we discuss why we believe Meta Platforms (Facebook) will continue to underperform and who the winners will be from this shift, including first-party data owners, supply side platforms, and contextual advertising publishers and platforms.
Conclusion
Notably, Q2 is particularly hard because there are three heavy macro headwinds: supply chain issues, Ukraine-Russia situation, and the transition that Apple has forced with changes to attribution and measurement on iOS. When you add that the one-time event of Covid, which plummeted ad spend in Q2 2020, and later led to a surge in ad spend the following year Q2 2021, the hurdle to clear for revenue growth is at a historic high. We believe those ad-tech stocks that can show top line growth right now are providing important clues for when macro headwinds clear.
