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.
We discussed cybersecurity and other cloud trends in our Q2 2022 Webinar found here.
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.
Confluent
Excerpt from forum post here.forum post here.
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
Excerpt from forum post here.forum post here.
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).