In October, I/O Fund CEO and Lead Tech Analyst Beth Kindig joined Jeremy Owens, Tech Editor, and San Francisco Bureau Chief of MarketWatch, on Barron’s Live. They discussed cloud valuations including those that are trading at 2X above Covid lows, what metrics matter when evaluating cloud companies, and what to watch for in upcoming earnings season — including a few comments on ad-tech.Barron’s Live. They discussed cloud valuations including those that are trading at 2X above Covid lows, what metrics matter when evaluating cloud companies, and what to watch for in upcoming earnings season — including a few comments on ad-tech.
Metrics and Valuations
As discussed in the podcast, the FOMC decisions have forced tech investors to look for cloud stocks that are expanding their margins and also have positive free cash flow. If you look at the best-of-breed companies that command the top 10 in valuations, the majority of them are free cash flow positive.
We had discussed with our premium research members back in May in a special report Compartmentalizing Cloud Stocks that “It’s true that cloud is deflationary but it’s also true that cloud can have profitability issues […] 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.”
Free cash flow is emerging as an important metric because cash gets rerated in a rising rate environment. As stated, not only were many cloud companies were not public during the previous rising rate environment of 2017 to late 2018 – but in addition to this, the previous rising rate environment was quite tame and we are currently in a more aggressive rising rate environment.
Along with free cash flow, GAAP operating margins are being closely examined. This has resulted in companies with high stock-based compensations being penalized during earnings.
The takeaway is that a best-of-breed company with a 10X or higher valuation must remain FCF positive or it will immediately lose its category high valuation. Revenue growth alone is not determining the top spots in this category any longer. This may seem obvious at first thought but we have found it’s better to close a stock at a higher valuation if it has contracting margins.
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The difference between Subscription and Consumption Models
Consumptions models occur in the Big Data and Analytics trend where data storage, processing, and analytic solutions are based on usage rather than on a recurring subscription fee. This trend is becoming popular because with consumption-based pricing model, revenue is uncapped. The consumption billing model does not have a ceiling on revenue, so if customer consumption rises, so does sales. There is what is meant by uncapped revenue potential.
We covered Snowflake’s Consumption Model in January of 2022 when we said in our free newsletter: “While Snowflake uses a “land -and-expand” sales strategy, it also uses a consumption billing model. For instance, Snowflake bills customers based on the amount of data they store and transfer and what resources they use. Accruing revenue based on consumption rather than a ratable subscription model decreases the predictability of quarterly revenue, but it leaves revenue uncapped. This provides revenue upside, because if consumption soars, then so will revenue.”
Some of the drawbacks, however, include the revenue growth being less predictable than subscription revenue. There also isn’t a floor on revenue because if consumption declines, then so will sales. Contracts help protect against this but are often only 1/3 of next 2.5 years of revenue.
The drawbacks were also discussed in the Snowflake’s Consumption Model article in January of 2022, “Another risk is the company’s consumption billing model, which is inherently unpredictable. This can make growth lumpy and some quarters may disappoint the Street. Investors should expect increased volatility in growth from Snowflake in the near term as new customers ramp consumption. However, management does expect revenue growth to smooth and become more predictable in the aggregate as customer consumption scales and matures on the platform.”
The lack of predictability is seen in Snowflake’s earnings history with Q1 earnings reporting revenue growth of 85% YoY to $422.4 million (beat estimates by 2.3%). However, the GAAP EPS missed by $0.02. The management had a hard time convincing the analysts in the earnings call that the company’s revenue was not discretionary and the consumption was lower due to shifting economic circumstances that impacted certain customers, particularly consumer facing cloud companies.
The company’s CFO, Mike Scarpelli, said in the earnings call, “Consumption patterns may fluctuate from quarter-to-quarter. This variability does not detract from our long-term opportunity. Customer’s overall demand for Snowflake remains unchanged. This is supported by the contractual commitments they are making with us and their longer-term plans for adopting the data cloud across their organization.”
Our update on Q3 cloud earnings will come next week following the last round of cloud earnings reports. We still have MongoDB, Zscaler and SentinelOne to report, among others. However, we are still seeing variability with Snowflake’s growth rate as the company reported 67% growth in Q3 and guided for 50% product revenue growth in Q4. Due to beingn consumption based, this variability will be to the upside when economic conditions improve.
In the podcast, we also discussed how net retention rates are often higher for consumption models as spending ramps over time and is uncapped. It’s easier to re-accelerate here for that reason and it’s not the best apples-to-apples comparison for subscription NRR. The net retention rates for subscription-based companies are in the range of 130-140 range while Snowflake has remained in the 170 range. The recent Q3 net retention rate is 165.
Another metric often heavily relied on to predict slowing or accelerating revenue is the remaining performance obligation (RPO). When customers sign onto the platform, they purchase consumption at specified prices, which gets recorded as remaining performance obligations (RPO). These contracts are for about 2.5 years. Although these key metrics are important, as mentioned earlier, what the market will reward or penalize most in a rising rate environment are operating margins and free cash flow.
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Ad-tech opportunity
In the interview, Jeremy Owens reminds me that I was the first person to warn him about how the Apple’s IDFA changes that would negatively impact Facebook’s revenue many years ago. It was a bold call at the time because I called the top for Facebook when it was a stock market darling in 2018. Despite the odds, it turned out to be accurate.
We discuss how ad-tech stocks are trading at historically low valuations with many 50% lower than where they have traded during times of economic uncertainty. The share prices of these ad-tech companies can grow over 100%. When the market senses a bottom is in — which I believe was either Q2 or will be Q3 — buyers will step back in to support higher valuations.
We discuss why CTV ads is the most investable trend in media right now.
Note: as we’ve gotten more earnings reports, it appears the bottom is more likely to occur in 2023. We will be monitoring this and update you as we go along.
What to look in the upcoming Q3 earnings season
The podcast was recorded prior to Q3 earnings, and next week, we will reflect back on the takeaways following cloud earnings. Sign up for our free newsletter here.
Microsoft’s results are to be closely watched since the company is a bellwether for Cloud. Its suite of Cloud products drives down costs and it’s the most insulated cloud company. It benefits from cloud migrations and also the need for organizations to reduce costs.
Analysts in the earnings call are concerned that the enterprise sector is the next shoe to drop following consumers. The consumer cycle is very short, whereas for Enterprises, it depends on the renewal cycle and there is a period of negotiation. In addition to constrained enterprise budgets, many startups are not able to raise funding and are going out of business, which can weigh on cloud, as collectively startups are a sizable customer for cloud companies.
The cybersecurity sector has reported exceptional fundamentals given the economic headwinds. Many companies have been reporting high growth rates and are cash flow positive. This sector also has no exposure to discretionary spending, which will help the category sustain long-term.
For cybersecurity, we have earnings reports next week and the recap will be included in our free newsletter.
Bargain Cloud Stocks
Cloud valuations are trading very low and our analysis next week dives into forward fiscal year estimates and why 2023 is likely to provide returns for growth investors who find quality cloud stocks right now.
The stock initially sold off about (13%) on lower product revenue, which went from 67% reported in Q3 to a guide in Q4 of 49% to 50%. This implies total revenue will follow as the two are closely related with product revenue making up 94% of total revenue. Technically, the product revenue guide implies a miss for Q4 as estimates were for 52.78% growth.
On the call, the stock regained some ground to finish at (6%) AH once management stated the full year 2024 product revenue would be 47%. Technically, this is also a miss as analysts had the number at 51% growth.
I'm not confident SNOW can resist further decel throughout FY2024; that's a bold guide with little to back it up.
It requires a lot of faith in management because they are essentially saying even though Q3 to Q4 dropped by 17% on product revenue growth (67% to 50%), they will only see a 3% drop for the following four quarters or an average decel of less than 1%.
It's also odd to get a FY guide right now as I looked at Q3 2022 call and it was not provided at that time. Yet, we are in even more uncertain macro backdrop than last year.
My concern is if the guide was intentionally provided to soften the blow for Q4’s product revenue meanwhile management has zero visibility to provide reliable guidance of this kind. I bring up zero visibility because at one point, management admitted to not having enough visibility to know how RPO will turn out for Q4, and yet they’re guiding early on FY2024 revenue.
The Q4 guide of 50% is only acceptable if there is no further decel. Otherwise, analysts will model a lower FY2024 and that would have hurt the price quite a bit. The motivation here is clear to me (give a full year guide that implies no deceleration) but how realistic is this? I discuss my thoughts in more detail below under Additional Notes.
Snowflake Financials Overview:
Snowflake beat on product revenue in Q3 with revenue of $522.8 million, and growth of 67%. Management had guided for $502.5 million, at the midpoint. Total revenue tracks in line with product revenue for revenue of $557 million and growth of 67%.
I’ve got a miss on Q4 in my notes as the product revenue growth of 49% to 50% will cause total revenue to fall short of estimates at 53.4%. MarketWatch also confirmed this is miss on product revenue with management guiding for $537.5 million at the midpoint while analysts were expecting $553 million.
The full year is in line with management guiding for $1.91 to $1.92 billion in product revenue, compared to analyst expectations of $1.92 for growth of 68%. Total revenue for the fiscal year is expected to be $2.04 billion for growth of 68%.
GAAP EPS was in line at ($0.63) although this is steeper than the ($0.51) EPS in Q3 last year. The adjusted EPS of $0.11 beat estimates of $0.04.
There were no surprises with the gross margins, GAAP and adjusted GM across total revenue and product revenue were all in line.
GAAP operating margin of (37%) was better than previous quarters. Adjusted operating margin of 8% was also better than previous quarters and came in higher than the 2% guidance offered by management.
GAAP net margin of (36%) was also better than previous quarters.
Snowflake silences the debate on if stock-based compensation affects stock price. The company paid SBC of $229 million in the most recent quarter, or 43.8% of revenue. Yet, the market overlooks this high SBC margin and Snowflake trades at the highest valuation in the cloud universe.
Key Metrics:
RPO was in line at $3 billion with a slight acceleration from last quarter, at $2.7 billion. As stated on the forum prior to the earnings report, “For Snowflake, the market has accepted flat sequential growth on RPO as it really comes down to Q4 for Snowflake — this is where the majority of RPO growth happens sequentially. Last year, the company had sequential Q3-Q4 RPO growth of 30%.”
Net retention rate of 165% is lower than 171% reported last quarter but still a category leading number.
Within customer growth, Global 2K customers accelerated from 15% last quarter to 18% this quarter. The customers with TTM > $ 1million decelerated although still healthy at 94% growth.
Total customer growth was at 34% compared to 36% growth last quarter.
Additional Notes:
My contention is that with the 51% growth estimates — and now management’s guide for 47% — this assumes consistent consumption as we move into a possible recession.
The estimates pictured above help to reveal how little variation there is built into throughout FY204 estimates, and yet this year has shown us Snowflake is capable of wide variability. There are some flat quarters, such as Q1 to Q2, but inevitably there was a strong decel and it’ll require serious trust in management to assume no further material decel from Q4.
Here is what was discussed in the call:
“Sanjit Singh
This is Sanjit Singh for Keith. I wanted to go back, Mike, to some of the guidance framework that you laid out for us, particularly with respect to fiscal year '24, I think you talked about 47% growth. Is there any way you can sort of draw the bridge for us in terms of next quarter you're guiding to think about 49% at the high end; and then for the full year next year, approximately 47%. What sort of gives you the confidence that your Q4 exit growth rate is going to be durable going into next year?
Mike Scarpelli
Sure. Well, I'll say Q4 is — it is a quarter that has a lot of holidays in it, and we do think we've lived through COVID that people are traveling more. There is a big human component as well, too. So we all along have been forecasting that Q4, we'd see the impact of that, but we also have a number of significant customers that we have signed up, that we see them ramping up next year on Snowflake as well as some of the things we're doing with Snowpark with Python, we're starting to see traction in that as well, too. But we think that's going to be more of a 2024 impact.”
Product revenue is expected to grow 3% between Q3 and Q4. Last year, it grew 15.3% sequentially. So, even with the holidays being in Q4, the slowdown is much more prevalent this year than last year’s comps.
Notably, we covered Snowpark with Python last quarter and agree it’s a strong offering that investors should pay attention to. General availability went live Nov 7th.
There was a moment that Snowflake discussed October being weaker than expected, which further complicates a bold FY2024 guide.
“Gregg Moskowitz
Congratulations on delivering very healthy product revenue in this environment. My question relates to Q4, where obviously the product revenue guidance was below where consensus was. And I'm curious, how much of this Mike is a reflection of a moderation in consumption in the month of November or over the last six weeks, as you said, in APJ and across the SMB as opposed to embedding more conservatism amid the existing macro uncertainty. Would you say it's tilted more towards one versus the other?
Mike Scarpelli
Well, the way we do our forecast is based upon historical performance, and we definitely did see a slowdown in the month of October, not that dramatic, but we typically would see week-over-week growth and we saw a number of weeks where it was pretty flat. I will say November is starting to tick back up again, and that's all factored into the guidance given the macro backdrop we have right now.”
Conclusion:
Thankfully Snowflake is not down 20%+ right now like many of its cloud peers. Yet, I can’t quite get comfortable with the FY2024 guide as it assumes no further decel from a company that decelerated quite a bit from the last year’s Q4.
As you saw today, we are not looking to go to the river with a stock that is priced 30% higher than its peers in a cloud-conscious market and that has now provided a guide that is hard to believe. Snowflake is capable of exuberant price action so we will us technicals for entries and exits.
The question of “why did Crowdstrike sell-off” doesn’t seem to be satisfied by the $10 million miss on forward revenue and ARR.
Forward Q4 revenue was expected to be $634M and the company guided $619M to $628M for a miss of about $10 million, if we take a midpoint of $624 million (about 1.5% miss). ARR was $2.34 billion compared to analyst expectations of $2.35 billion, for a $10 million miss (less than 1% miss).
Although this likely contributed, I believe the analyst we quoted in our Pre-ER write-up that was modeling for net new ARR of $224M to $230M-plus may be providing a missing link between analyst expectations for this key metric and actual results of $198 million. At the midpoint, this would be more of a miss of 14.6%.
“An analyst note from Barclays’ Saket Kalia is modeling ARR net addition of $224 million “but thinks upside could be $230M-plus given strong pipeline commentary.” At $230M, it would represent 5% sequential growth and 35% YoY growth. This would be down from 15% sequential growth in the previous quarter and 45% YoY.”
The reason we flagged this is because the net new ARR at high point of $230M would still mark a strong deceleration to 5% sequential growth down from 15% sequential growth last quarter. This means this would have to be met or we would be nearing flat to negative sequential growth on net ARR.
With the actual of $198 million reported, this drops the net new ARR at negative sequential growth of negative (9%) down from $218 million last quarter. This marks a change compared to the comp of 13% in sequential growth from Q2 2022 to Q3 2022.
The market is nervous with cloud becoming the other shoe to drop as enterprise budgets will slow long after consumer slows due to annual billing cycles, annual budget reviews (i.e., likely to produce budget cuts) and due to higher switching costs (or in cloud’s case, slower to switch off than consumer or ad spending, for example).
In my opinion, this is why outsized pressure is being placed on sequential growth. The market does not care about YoY because it’s assuming enterprise spending wasn’t affected yet.
CrowdStrike Q3 Overview:
CrowdStrike beat both top line and bottom line for Q3. In fact, an area where CrowdStrike continues to stand out from its peers is the health of the bottom line and both Q3 actual and Q4 guide was no exception in this regard. For example, the free cash flow margin of 30% is exceptional.
The company reported revenue of $581 million for growth of 53% compared to revenue of $574 million expected for growth of 51%. This is a slight deceleration from 58% last quarter.
For Q4, the company guided for revenue of $619 million to $628 million compared to expectations of $634 million. At the midpoint of $623.5million, this is a $10.5 million miss.
The GAAP EPS of ($0.24) compares to ($0.22) EPS from the year ago quarter and ($0.25) EPS last quarter.
Adjusted EPS for Q3 came in at $0.40 compared to $0.32 expected. This compares to $0.36 last quarter and $0.17 in the year ago quarter.
Adjusted EPS guide for Q4 also beat at $0.42 to $0.45 compared to $0.34 EPS expected.
GAAP gross margin was 72.7% which was in line with a range of 73% to 74% over the past five quarters. The adjusted gross margin this quarter was at 75% compared to 76%-77% over the past five quarters. Subscription gross margins were also in line.
GAAP operating margin of (9.70%) compares to (9%) last quarter and (10.5%) in the year ago quarter. This resulted in GAAP operating loss of ($56.4) million which is a tad higher than the $48 million losses last quarter and the $40 million losses in the year ago quarter.
The adjusted operating margin was a beat in Q3 and Q4. This was a bright spot in the report with adjusted OM of 15.4% compared to 13% estimated. This compares to 16% Adj OM last quarter and Adj OM of 13% last year. This was essentially flat and it’s important it did not contract.
The guide on adjusted operating income of $87.2M to $93.7M implies an adjusted operating margin of 14.5%.
The GAAP net margin of (9.4%) and adjusted net margin of 16.5% was in line with previous quarters. The guide for adjusted net margin is also in line at 16.6%.
CrowdStrike is very strong on cash flow margins and is one of the top ranking cloud stocks in this regard. This quarter the company reported a free cash flow margin of 30% for FCF of $174 million. The company is guiding for a FCF margin of 28% to 30% next quarter. The operating cash flow was $242.9 million for a margin of 41.8%. There is $2.47 billion in cash on the balance sheet.
The company paid $140 million in stock-based compensation for a margin of 23.7%.
Key Metrics:
As stated in the Intro, the key metrics are likely causing the sell-off.
RPO was up 44% year-over-year for $2.797 billion and was up 11.6% sequentially. However, management reminded analysts that ARR is the leading key metric for their business.
Ending ARR grew 54% year-over-year to $2.34 billion and grew 9.3% sequentially. Therefore, because ending ARR was strong, the net new ARR could be easily underestimated in terms of impact. The net new ARR at $198 million in fiscal Q3 compared to $218 million net new ARR in fiscal Q2 indicates a 9% sequential decline.
The market has the jitters right now so the sequential decline is important to pay attention to especially because management said to expect further weakness in the upcoming Q4 quarter. Here is what the CFO said:
“Even though we entered Q3 with a record pipeline, we are expecting the elongated sales cycles due to macro concerns to continue, and we are not expecting to see the typical Q4 budget flush given the increased scrutiny on budgets. While we do not provide net new ARR guidance given the current macro uncertainty, we believe it is prudent to assume that Q4 net new ARR will be below Q3 by up to 10%.”
If I understand the CFO correctly, then this implies a net new ARR of $178.3 million for Q4 (10% lower than the current quarter at $198.1M) compared to net new ARR of $216 million in the year ago quarter. This is important because it’ll mark not only a sequential decline but a year-over-year decline in net new ARR. The market had already sold off for what I presume was a sequential decline in Crowdstrike’s leading key metric, and management then stated the decline would be steeper for Q4 on the call. Once the comment above was made, we were certainly not going to see a reversal in the stock price from the earnings call.
Customer count was strong at 44% growth. The mix of domestic versus international was slightly lower than usual for North America at 69% with EMEA being slightly higher at 15%.
Deferred revenue grew 56.4% year-over-year and backlog grew 19%.
Additional Commentary:
CrowdStrike was transparent about the importance of ARR even in the face of net new ARR being lower than expected. Here is what was said by the CFO:
“And then finally, just to comment on ARR. You pointed out that's how we run our business. ARR, though, is really an X-ray into the contracts themselves. And as we view that as the most important — or most transparent metric into the outlook for our business, that's the one where we're focused on. So, hopefully, that gives some more clarity on how we think about cRPO and ARR.”
Later on, an analyst did zero-in on the (9%) decline.
“Andrew Nowinski
Great. Thank you for taking the question this afternoon. So total ARR of $2.3 billion, growing 54% is still absolutely amazing, I was – and it's at scale. But I was wondering, were you surprised that the net new logos that you added were down 9% this quarter?
Burt Podbere
Thanks, Andy. So when we think of the net new logos, it really corresponds to what we talked about in terms of what we saw in that SMB space. The SMB space is the one that drives the velocity of our net new logos. And as we talked about, we saw an 11% increase in our sales cycle in the SMB space. And that actually equated into $15 million in terms of deals in that space that could push out. And so when you think about 15 million in that space and what it means in terms of logos, where you can do the math, it's a pretty big number.
So that's how we think about net new logos corresponding to what we saw in net new ARR from the SMB space. So from that perspective, we weren't surprised at the end of the day when we saw that what happened with respect to the increased sales cycles and the amount of money that got pushed out in the SMB space.
My note: Just to be clear, when they say “push out” they are referring to a delayed sales cycle for an impact of $15 million.
The CFO did reiterate the 10% further sequential decline in net new ARR between Q3 and Q4 when he said:
“When we do talk about net new ARR, I did talk about in the prepared remarks about how we think about up to 10% headwinds going into Q4 from Q3, and that's just to coincide with some of the headwind activity that we saw accelerated at the end of this quarter. So that's how we think about that.”
Conclusion:
Given the tough macro, our goal is to fully understand why the market may favor some stocks and deeply discount others after an earnings report. The market is getting nervous on cloud. We talked about this with Microsoft and also saw this following Datadog’s report.
“Microsoft is guiding down for next quarter with analyst expectations for the December quarter at $56.04 billion compared to management guidance on the call for revenue of $52.75 billion, at the midpoint. This represents 2% growth. […] That’s a 11% deceleration over the next few months. Some of this may be coming from Azure as the company is expected Azure to decline 5% next quarter for its current growth rate. This will be 37% growth on a constant currency basis, down from 42% this quarter.”
“RPO decelerated and is a concern. The deceleration we noted in our last earnings report and our pre-earnings write-up where we noted the deceleration went from 85% to 51%. This quarter, the deceleration steepened to 31% year-over-year growth for $941 million. RPO is still up on a sequential basis with $858M in RPO in Q1, $881M in RPO in Q2 and $941M in RPO this quarter. If it were to decline on a QoQ basis, the stock would be deeply penalized, so we will monitor this as we go along.”
What we saw today from CrowdStrike sounded very familiar, in my opinion. The market is nervous about cloud and is swiftly discounting these stocks on slowing revenue plus any additional signs revenue may slow in the future. We will need to see more information to draw any conclusions, most especially we will need SentinelOne’s report coming next week.
Twilio is often categorized as cloud yet its business model is truly unique in every sense of the word. It’s not only the company’s gross margin of 50% versus the typical 70% that separates the company, but conversely, it’s also the lower sales and marketing expenses and lower R&D that make this company unique.
Here’s how Twilio compares to Top 10 cloud valuations on sales and marketing at 32% of revenue for sales and marketing (S&M):
Here’s how Twilio compares with Top 10 cloud valuations with 16% spent on R&D:
When you combine the two line items, Twilio makes up for its lower gross margin with lower S&M and R&D. These line items have been range bound with the percentages seen above since 2014 with the company going public in 2016 and some financials from 2014 being available. Therefore, this is not due to scale or any type of customer mix from the pandemic or some kind of economic pressure.
I’ve made the argument that I believe Twilio has established a defensible moat when I covered the stock for MarketWatch in July of 2020. This elusive moat is why I believe those line items track much lower for Twilio as a platform compared to cloud software companies. Here’s what the article said from two years ago:
Twilio works with 1,000 mobile carriers in over 150 countries. The logistics around this are a nightmare for most developers and also for potential competitors. Uber developed this in-house but it was a rare situation where SMS and voice APIs are integral enough to warrant the investment […]
In 2017, Uber had a $60 million annual run rate with Twilio and decided to source different vendors. Even at this level, the company did not build the capability in-house and still remained with Twilio for high-performance messaging. Eventually, Uber migrated to Twilio’s main direct competitor — MessageBird.
Despite chipping away at Twilio since 2011, MessageBird has about 15,000 customers compared with Twilio’s 165,000. The company has been able to do this by serving the developer market and building out an extensive API library and documentation in which telecom features are integrated through a few simple lines of code.”
*Twilio now has 275,000 active customer accounts and MessageBird has 25,000 customer accounts. Some of Twilio’s growth is from the acquisitions.
Twilio raised the number of registered developer accounts from 5 million to 10 million at the 2020 Investor Day. This puts Twilio second to companies like Apple and Nvidia in terms of its popularity with developers. Point being, there are puts and takes with this company – gross margin is low but operating expenses are also low from strong management execution.
Rather than Twilio’s gross margin weigh on the company, I believe it could be the GAAP profitability first and foremost (which is a line item where we are not seeing improvementwe are not seeing improvement in the near term) and then it was the contracting adjusted profitability margin and contracting free cash flow margin second (adjusted OM and FCF are reversing course, which is why we entered).
We also entered the stock because the forward revenue growth is actually quite high and puts the company into a higher valuation bracket than where it currently participates – but this is only important if we see some improvement in bottom line numbers as the GAAP profitability is where Twilio ranks low as a category peer.
The improvement in FCF and adjusted operating margin was not as easy to see in the previous earnings call because the company had only announced plans to be remote first resulting in lower real estate costs. The 11% layoffs announced in September help to complete the picture.
I do believe the end result will be Twilio becoming (narrowly) free cash flow positive, which I expand on below. Management has already stated they will be profitable on an adjusted basis “by early 2023” and analyst consensus agrees with this. Twilio has not missed a top line estimate or a bottom line estimate for four years (as far back as the history allows) and so the probability the company meets this adjusted profitability expectation in early 2023 is high.
It was primarily valuation that caused us to enter as the company is priced for the worst case scenario. Yes, macro can force valuations lower yet I believe Twilio should be in the 5.5X NTM revenue bracket, and instead, the stock is trading at 3X NTM revenue. The 5.5X NTM cohort still has messy GAAP operating margins yet many are FCF positive.
With quarter or two of a return to FCF positive, Twilio can contend with 5.5X up to 7-9X NTM revenue given its growth rate. Technically, this is still at discount as the organic growth rate would put the company in the 11X NTM revenue bracket. However, GAAP profitability weighs on Twilio and must be discounted, which we discuss below.
Twilio Financials
The company reported revenue growth of 41% in Q2 and is expected to report growth of 31% next quarter. Last quarter, the company reported revenue growth of 48%. This is down from 70%-80% growth in 2019 and down from 60%-70% during 2020-2021. The management has stated their goal is 30% organic growth.
The company’s organic growth was 33% in Q2 with $37 million from acquisitions and $44 million from telecom fees. In Q1, the company reported 35% organic growth.
Twilio’s organic growth is broken out because the company collects and then pays 10DLC A2P telecom fees and the company has also had a string of acquisitions (SendGrid, Segment, Zipwhip and Syniverse, for example).
Next quarter is key because the company will only break out A2P telecom fees for total vs organic as the acquisitions will have lapped one year. For comparison purposes, had this change occurred last quarter, then Q2 revenue growth would have been reported as organic growth of 38.5%.
The company’s net retention rate has slowly eroded over time, currently at 123% down from 127% in the previous quarter and down from 131% in the year ago quarter.
The company reported a GAAP gross margin of 47% and an adjusted gross margin excluding A2P fees of 54.3%. The GAAP GM was 48% last quarter and 47% two quarters ago yet the company previously had gross margins at or above 50%. Any slippage here is penalized.
Management stated the gross margin is lower because international is increasing in percentage of revenue at 35% compared to 33% in the year ago quarter. Here is what was said:
“This decline was primarily driven by the strength of our international messaging business. U.S. 10DLC carrier fees reduced gross margin by approximately 330 basis points in Q2. The continued success of our messaging business often serves as a critical foot in the door with our customers, opening up opportunities to add more value with our higher margin software products over time. We believe this will ultimately drive higher gross margins, allowing us to achieve our long-term non-GAAP gross margin target of 60%+.”
This quarter stood out for having less growth YoY in the company’s total gross profit at 34.5% YoY growth to $445M in gross profits compared to 59% YoY growth last year for $331M in gross profits in the year ago quarter.
Twilio stated goal is to reach 60% GAAP gross margin from a mix of the software product and the core product. Although this may take a couple of years to reach 60% GM, I believe with early signs of GM expansion, the stock will be rewarded.
The adjusted operating loss for the quarter was ($7M). For Q3, the company is guiding for adjusted losses of ($65M) at the midpoint which includes a one-time expense for employee sabbaticals of $35M. As stated, Q3 is expected to be the bottom for Twilio’s adjusted operating losses. Let’s hope it’s also the bottom for Twilio’s gross margin although international mix creates some uncertainty on where this could bottom.
The company reported adjusted EPS of ($0.11) compared to ($0.05) in the previous quarter and is flat from the year ago quarter. The adjusted EPS for Q3 is expected to be ($0.35) and will be ($0.13) EPS in Q4. As stated, by 2023, Twilio will be profitable on an adjusted basis.
“And you probably noted that we've taken some actions with respect to slowing down hiring except for some key areas. We're taking — we guided based on having a real estate charge, which I think reflects our kind of remote-first approach to the way that we're going to work going forward. And I think both of those things will drive profitability into next year. And I think irrespective of the macro environment, we're intending to be profitable next year no matter whether it has an impact on growth or not.”
Ultimately, Twilio’s Q2 earnings report weighed on the company due to a slipping bottom line. GAAP EPS was ($1.71) versus ($1.31) a year ago. Stock based compensation was at 25% of revenue for $242M, up from 18% of revenue last quarter.
Looking forward on GAAP EPS, there are one-time items that will weigh on Q3’s GAAP EPS. The first is a $100 million expense due to real estate closures as Twilio is moving toward being remote-first. This this was discussed in the prepared remarks: “We also announced our decision to become a “remote-first company” and made a significant reduction in our real estate footprint. We’ll continue to closely monitor the returns on our investments, and make adjustments as needed, in an effort to recognize further efficiencies as we scale.”
The company also recently announced layoffs, which will result in expenses of $70 million to $90 million. This one-time expense will also be primarily recognized in Q3 – so Q3 setting up to have a couple hundred million dollars of extra one-time expenses in the GAAP operating losses.
Twilio had negative free cash flow of ($78.5M) in the most recent quarter with a FCF margin of (8.3%) this is down from (4%) in the previous quarter although a slight improvement from the (11%) in the year ago quarter.
I believe what the market will be looking for is comments on free cash flow as the company LTM FCF was ($253 million) but with the two reductions — real estate from remote work and 11% headcount reduction, Twilio has to ability to become FCF positive very soon – in the next two quarters (Q4 and Q1) once the expenses pass and the reductions start to take effect.
Due to the market being forward looking, this is likely the line item that will help the stock’s price if management can appease The Street. I believe that’s the goal as Twilio has a median salary of $150,000 and at 11% reduction results in $150 million for the year that follows Q3. If Twilio targets a small percentage higher than its median, the company can get this number to $170 million on headcount alone. It’s also reasonable to assume Twilio will see $75 million reduction in real estate expenses. Twilio's lease ends in 2025 so the $100 million fee has to be able to offset three years left in a lease. Maybe it's closer to $50 million but somewhere in that area to justify the $35 million termination fee per year averaged over three years (is my thinking).
Regarding the headcount reduction, Twilio did state that it would come from the core product where they will push customers to be more self-serve. Due to the developer friendly documentation the company provides, they do not believe there will be any additional churn from this transition. From there, they will focus on new hires for the software team.
In addition, Twilio raised equity in February of 2021 and debt in March of 2021. The company currently has debt of $986M and cash and marketable securities of $4.4B down from $5.4B last year due to a $750 million equity investment in Syniverse. Syniverse was valued at $2.85 billion at the time of that Twilio became a large shareholder. Of this, the company has cash of $800 million down from $1.49 billion in the year ago quarter.
Modeling Twilio’s GAAP Profitability
I thought it would be interesting to see a financial model for Twilio’s GAAP profitability given how many moving pieces there are — primarily, operating cost reductions yet an intention to ultimately increase headcount on the software side. Also, I thought it would be interesting to see the impact a 62% gross margin would have if/when Twilio gets there. You can see below this would result in GAAP EPS of ($0.84). This is an improvement but the company will not be GAAP profitable (by this estimate) until the company scales to much higher revenue. The gross margin will not be enough.
You can see the entire model on this Google Doc here. It was prepared by Arun Gopalakrishnan, a Financial Analyst that we are contracted with.
The following information was used for the model:
Expect sales & marketing expense to continue expanding albeit slowly "as we continue to expand our sales efforts globally" coupled with hiring freeze (Source: Q2 2022 page 31 Financials)
Expect R&D to increase as company continues to hire in growth areas and "focus on enhancing Twilio Segment and Flex products and strengthening platform infrastructure". R&D will house most of the increase in personnel costs (Source: Q2 2022 page 31 Financials)
We're focusing our hiring efforts on areas that we believe will unlock significant value and present strong opportunities for continued growth such as Segment, Engage and Flex, and we’ve frozen the vast majority of new hires and backfills outside of these areas. (Source: Khozema Shipchandler – Q2 2022 Earnings Call Page 9)
We also announced our decision to become a “remote-first company” and made a significant reduction in our real estate footprint. (Source: Khozema Shipchandler – Q2 2022 Earnings Call Page 9)
One-Time Expense of $35M in Q3 2022 for new sabbatical program for tenured employees & non cash impairment charge associated with the closure of several offices (Source: Khozema Shipchandler – Q2 2022 Earnings Call page 10)
Excludes One-Time Expenses, Non-Cash Charges, Capitalizes majority of R&D expense. Management is moving salaries to performance based salaries (non-cash) so not included in Non-GAAP.
For Members who have been with our site for a few years, you’ll recall that I’m quite bullish long-term on Twilio. This has not changed, rather macro forced us to step aside and see how management weathers the new FCF-forward reality. My product thesis is best described in a 1-hour webinar from April 2021 but I’d like to take the opportunity to reiterate a few points.
An important catalyst to look for is when Google eliminates third-party data from Android and Chrome when the company officially launches Privacy Sandbox. This was expected to occur in 2023 yet has been delayed to 2024 although is being beta tested right now.
We want to watch Twilio closely around this time as its customer data platform is based off the importance of first-party data, yet the transition that Apple began with deprecating the IDFA and introducing App Tracking Transparency (ATT) will not be complete until Android and Chrome participate.
The results will be mobile identifiers and third-party cookies become obsolete by 2024 (note: I do wonder if this timeline will be moved up to end of 2023/very early 2024 if Google continues to see macro headwinds to its ad business).
Similar to how Twilio was a few years ahead of the mobile app economy, the management is very early is very early to the shift toward leveraging first-party data. Phone numbers and email addresses make up the most valuable first-party data available on the internet called personally identifiable information (PII). I believe the Twilio management team has been planning for this for 6 years since the 2018 SendGrid acquisition which combines their core product’s access to phone numbers with a trove of email data. This was a very smart strategic move that is not fully recognized yet until access to third-party data is eliminated, which will put immense pressure on companies to make the most of their first-party data. The caveat is the management team must execute.
My understanding is that very few companies will be able to help unlock the enormous value of first-party data as Twilio has a natural path to collecting phone numbers and emails on behalf of B2C companies.
Previously, I had written the following which I still believe to be true yet will take time to fully recognize (Google’s move being a lynchpin for Twilio competitors):
“Keep in mind, the power of data exponentially increases so each signal Twilio adds is not a linear increase in ROI from a marketer’s perspective – it compounds. In other words, by having four signals, Twilio can beat a competitor like Mailchimp with SendGrid because of the cross-channel data and touchpoints they offer*. The same could be said for Zendesk versus Twilio Flex as to why Flex might be stronger (cross-channel data points).
This is why, on a product-level, I see Twilio increasing its market share against competitors.”
Note: Twilio is not the marketer, the customer remains the marketer (Nordstrom’s, Kroeger’s, Chevrolet, Proctor & Gamble, etcetera) remain being the marketer. Instead, Twilio helps those companies’ market more their databases more effectively. This is not the same asnot the same asthird-party datathird-party data where Nordstrom’s (for example) mixes data that is not their own to market customers. This is done through third-party platforms with access to third-party data – which is a marketplace entirely enabled through mobile IDs and cookies.
Twilio is building the antithesis of a third-party ad exchange or marketing platform — and doing so well in advance of the first-party data era which officially began last year with Apple.
This was discussed on the Q2 earnings call:
Q: This is Abhinav on for Siti. I guess the first kind of question would be just with Google delaying recently their application of third-party cookies now, again, from 2023 to 2024, have you seen or do you expect this to change the demand environment a little bit around CDP's customer engagement more broadly and maybe that transition away from third party? And do you see some of the urgency kind of diminish for some of your customers that are coming in?
A (CEO, Jeff Lawson): Thanks for the question. Yes, I think what we see is the — it's taking a little bit of pressure off of companies. I mean, if you think about it, like 2023 is not that far away. So in some ways, it's actually pretty reasonable to give a little more time for such a big change in the Internet ecosystem to roll through.
That said, I mean we did a survey, and it was like — I think it was 70%, some number like that, of companies were not ready for this change. Now that creates demand for our products. But you also can't imagine that, that number of companies are going to magically like put the switch and completely flip their technology stack in just a month's time. And so I think it's giving a little bit of pressure release now.
But it still is a great environment for the CDP given that customers actually do have a lot more time to actually make these thoughtful changes, and we are already seeing some fantastic stories from the customer base emerge that really is giving our customers confidence that this first-party data approach is not just going to be tenable, like it's a big change for folks. But actually, it's going to be tremendously beneficial.”
Twilio also frequently discusses the higher ROI they are proving through case studies from using first-party data instead of only relying on third-party data for marketing purposes. Per the Q2 earnings call:
“A couple of the stories that we've shared publicly is Allergan using Segment was able to get a 41% reduction in their cost of customer acquisition, which is — those are amazing numbers. Another great customer story is from Domino's, who in Mexico was using Segment to build smarter customer audiences. And as a result of that, doing better ad buying, and they saw their return on ad spend increased 700%.”
In 2021, we had also discussed Twilio moving from being developer-centric to now also becoming sales/marketing-centric: “This also means Twilio is going through a pivot, not only on the product level but the customer level. Although Twilio will remain a developer-centric company, they will also need to appeal to the marketing and sales departments […] Developers will, of course, be the ones to implement Twilio’s APIs and products but there’s evidence that Twilio’s target customer is expanding to also include “marketing, sales and service leaders.”
This piece of the pivot (the new customer base being enterprises rather than developers) can be seen as either an obstacle or an opportunity. Twilio has certainly increased its serviceable addressable market and any success here will be seen in the gross margin long-term due to software sales.
5G is also a catalyst for Twilio. The company is quietly building more IoT products and will be able to tap into this market when adoption rises. I’ll leave that for a future deep dive when we revisit 5G from the consumer and enterprise standpoint. Marvell would give us the first signal this market is picking up since they are equipment related.
Risks:
A risk to consider is that Twilio’s gross margin could continue to soften from a higher international mix. Political ads will take effect in Q3 with the majority of spend recognized in Q4, which should bump up domestic spend. In Q4 of 2020, political spend was $23 million. The breakdown was not available for Q3 of 2020. Here is what was discussed in the Q4 earnings call:
“Fourth quarter non-GAAP gross margin was approximately 56% and was negatively impacted by 150 basis points from A2P fees. Twilio's gross margin, ex-Segment, was approximately flat quarter-over-quarter, aided by political traffic in the United States.”
If GM continues to soften, then we will look at how this affects the bottom line and make our decision based on both top line and bottom line margins.
Another risk to consider is Twilio’s revenue estimates are quite high in the current environment considering most ad/marketing companies are seeing reduced spend. However, with the current information we have, it seems B2C companies in some industries are less reluctant to switch off SMS compared to ads. Twilio said the following about their current trends:
“Now we did call out a couple of pockets of softness in Elena's section of the prepared remarks, where we commented that, for example, in crypto or social or on-demand related activities that we're seeing a little bit of slowdown. But on the flip, we are seeing some strength as well in financial services and IT-related spending.”
If Twilio misses on revenue, we will be forced to step aside as every management team needs to build trust right now with Wall Street given the bearish market. This is true for most of our stocks.
The third risk to consider is further acquisitions. We will close our position and step aside if this happens as the company has tested the upper limit of our appetite for M&A activity.
Additional Resources:
Earlier this week, we published a forum post about our entry in Twilio. There are additional posts from Members on Twilio that also articulate the pros/cons of this particular company and are well worth the read.
Earlier this week, I/O Fund CEO and Lead Tech Analyst Beth Kindig joined Jeremy Owens, Tech Editor, and San Francisco Bureau Chief of MarketWatch, on Barron’s Live. They discussed cloud valuations including those that are trading at 2X above Covid lows, what metrics matter when evaluating cloud companies, and what to watch for in upcoming earnings season — including a few comments on ad-tech. Barron’s Live. They discussed cloud valuations including those that are trading at 2X above Covid lows, what metrics matter when evaluating cloud companies, and what to watch for in upcoming earnings season — including a few comments on ad-tech.
Metrics and Valuations
As discussed in the podcast, the FOMC decisions have forced tech investors to look for cloud stocks that are expanding their margins and also have positive free cash flow. If you look at the best-of-breed companies that command the top 10 in valuations, the majority of them are free cash flow positive.
We had discussed with our premium research members back in May in a special report Compartmentalizing Cloud Stocks that “It’s true that cloud is deflationary but it’s also true that cloud can have profitability issues […] 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.”
Free cash flow is emerging as an important metric because cash gets rerated in a rising rate environment. As stated, not only were many cloud companies were not public during the previous rising rate environment of 2017 to late 2018 – but in addition to this, the previous rising rate environment was quite tame and we are currently in a more aggressive rising rate environment.
Along with free cash flow, GAAP operating margins are being closely examined. This has resulted in companies with high stock-based compensations being penalized during earnings.
The takeaway is that a best-of-breed company with a 15X or higher valuation must remain FCF positive or it will immediately lose its category high valuation. Revenue growth alone is not determining the top spots in this category any longer. This may seem obvious at first thought but we have found it’s better to close a stock at a higher valuation if it has contracting margins.
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The difference between Subscription and Consumption Models
Consumptions models occur in the Big Data and Analytics trend where data storage, processing, and analytic solutions are based on usage rather than on a recurring subscription fee. This trend is becoming popular because with consumption-based pricing model, revenue is uncapped. The consumption billing model does not have a ceiling on revenue, so if customer consumption rises, so does sales. There is what is meant by uncapped revenue potential.
We covered Snowflake’s Consumption Model in January of 2022 when we said in our free newsletter: “While Snowflake uses a “land -and-expand” sales strategy, it also uses a consumption billing model. For instance, Snowflake bills customers based on the amount of data they store and transfer and what resources they use. Accruing revenue based on consumption rather than a ratable subscription model decreases the predictability of quarterly revenue, but it leaves revenue uncapped. This provides revenue upside, because if consumption soars, then so will revenue.”
Some of the drawbacks, however, include the revenue growth being less predictable than subscription revenue. There also isn’t a floor on revenue because if consumption declines, then so will sales. Contracts help protect against this but are often only 1/3 of next 2.5 years of revenue.
The drawbacks were also discussed in the Snowflake’s Consumption Model article in January of 2022, “Another risk is the company’s consumption billing model, which is inherently unpredictable. This can make growth lumpy and some quarters may disappoint the Street. Investors should expect increased volatility in growth from Snowflake in the near term as new customers ramp consumption. However, management does expect revenue growth to smooth and become more predictable in the aggregate as customer consumption scales and matures on the platform.”
The lack of predictability is seen in Snowflake’s earnings history with Q1 earnings reporting revenue growth of 85% YoY to $422.4 million (beat estimates by 2.3%). However, the GAAP EPS missed by $0.02. The management had a hard time convincing the analysts in the earnings call that the company’s revenue was not discretionary and the consumption was lower due to shifting economic circumstances that impacted certain customers, particularly consumer facing cloud companies.
The company’s CFO, Mike Scarpelli, said in the earnings call, “Consumption patterns may fluctuate from quarter-to-quarter. This variability does not detract from our long-term opportunity. Customer’s overall demand for Snowflake remains unchanged. This is supported by the contractual commitments they are making with us and their longer-term plans for adopting the data cloud across their organization.”
In the podcast, we also discussed how net retention rates are often higher for consumption models as spending ramps over time and is uncapped. It’s easier to re-accelerate here for that reason and it’s not the best apples-to-apples comparison for subscription NRR. The net retention rates for subscription-based companies are in the range of 130-140 range while Snowflake has remained in the 170 range.
Another metric is the remaining performance obligation (RPO). When customers sign onto the platform, they purchase consumption at specified prices, which gets recorded as remaining performance obligations (RPO). These contracts are for about 2.5 years. Although these key metrics are important, as mentioned earlier, what the market will reward or penalize most in a rising rate environment are operating margins and free cash flow.
Over the last two weeks, we've entered two bargain priced stocks on our premium site where the market may have gone too far, too fast — particularly those with an improving bottom line. Become a premium member to unlock real-time trade notifications on every entry and exit. Over the last two weeks, we've entered two bargain priced stocks on our premium site where the market may have gone too far, too fast — particularly those with an improving bottom line. Become a premium member to unlock real-time trade notifications on every entry and exit. premium site where the market may have gone too far, too fast — particularly those with an improving bottom line. Become a premium member to unlock real-time trade notifications on every entry and exit.
Ad-tech opportunity
In the interview, Jeremy Owens reminds me that I was the first person to warn him about how the Apple’s IDFA changes that would negatively impact Facebook’s revenue many years ago. It was a bold call at the time because I called the top for Facebook when it was a stock market darling in 2018. Despite the odds, it turned out to be accurate.
We discuss how ad-tech stocks are trading at historically low valuations with many 50% lower than where they have traded during times of economic uncertainty. The share prices of these ad-tech companies can grow over 100%. When the market senses a bottom is in — which I believe was either Q2 or will be Q3 — buyers will step back in to support higher valuations.
We discuss why CTV ads is the most investable trend in media right now.
What to look in the upcoming earnings season
Microsoft’s results are to be closely watched since the company is a bellwether for Cloud. Its suite of Cloud products drives down costs and it’s the most insulated cloud company. It benefits from cloud migrations and also the need for organizations to reduce costs.
Analysts in the earnings call are concerned that the enterprise sector is the next shoe to drop following consumers. The consumer cycle is very short, whereas for Enterprises, it depends on the renewal cycle and there is a period of negotiation. In addition to constrained enterprise budgets, many startups are not able to raise funding and are going out of business, which can weigh on cloud, as collectively startups are a sizable customer for cloud companies.
The cybersecurity sector has reported exceptional fundamentals given the economic headwinds. Many companies have been reporting high growth rates and are cash flow positive. This sector also has no exposure to discretionary spending, which will help the category sustain long-term.
Bargain Cloud Stocks
We spoke about Best-of-Breed on this podcast yet we are currently building positions in companies that are undervalued and more of a “basement bargain” or “fire sale” valuation as we believe the market has not been entirely efficient with key stocks that have been penalized with low valuations. These stocks are 50% lower than their Covid low and have the potential to bounce back. In fact, one could argue there is more room for gains in these stocks than the best-of-breed companies which are within 30% of historic valuations for cloud stocks.
00:00 Intro
00:44 Valuations
04:40 Consumption-based pricing
11:24 Snowflake vs MongoDB
13:15 Ad-tech
20:15 Upcoming earnings season
22:08 Cybersecurity
24:22 Best practices for retail investors
Please note: The I/O Fund conducts research and draws conclusions for the Fund’s positions. We then share that information with our readers. This is not a guarantee of a stock’s performance. Please consult your personal financial advisor before buying any stock in the companies mentioned in this analysis.
Snowflake exceeded top line expectations, as outlined on our forum here. Management focuses on product revenue versus total revenue and GAAP metrics are a bit buried under the more accessible adjusted non-GAAP metrics. However, Snowflake delivered what the market needed to see – which was 83% product revenue growth compared to 72% growth expected. The guide for Q3 was in line with expectations while FY2023 was slightly raised from $1.893B at the midpoint for 66% growth to $1.910B at the midpoint for 67.5% growth.
The top key metric to note was a re-acceleration in customers with TTM product revenue above $1 million, which was at 112% this quarter at 246 customers, up from 98% growth last quarter. This is an important forward-looking metric as it takes 9 months to fully onboard new customers. Another reason this key metric holds more weight is the consumption model means the upside is uncapped, whereas with SaaS, the monthly amount has a ceiling (usually). You can read more about the consumption model here.
Net revenue retention rate is down 300 basis points sequentially but it up 200 basis points year-over-year and this re-acceleration is what’s important. RPO growth of 78% is the lowest in reporting history, down from 82% last quarter and 122% in the year ago quarter.
Analysts did note on the call that there are tougher comps for RPO coming down the line in Q4 (quarter ending in Jan 2023). It was in this quarter that RPO moved from $1.8 billion to $2.6 billion. Right now, it stands at $2.7 billion, so not too much H1 growth over the past six months. This is simply something to note. Of this RPO, 57% is recognized over the next 12 months, or $1.5 billion.
Here is what was discussed:
Brad RebackBrad Reback
Hi, thanks very much. Mike, I know you mentioned the 3Q consumption comp. You also have a really, really difficult 4Q RPO comp. But given your commentary, should we expect a healthy end to the year given that renewal pool? Thanks.
Mike ScarpelliMike Scarpelli
Yes. We expect we will have a big increase in RPO. But I’m not guiding to it. You’ll have to wait and see. I’m never going to guide RPO.
Total customer growth was at 36% growth compared to 40% growth last quarter. As noted above, it’s the TTM > $1M that matters.
There is no denying that on a GAAP basis, Snowflake is largely unprofitable. The company’s GAAP operating margin was at (42%) compared to the adjusted operating margin of 2%. The operating losses of $207 million this quarter increased from $189 million in GAAP operating losses last quarter. Stock based compensation increased from $164 million in the year ago quarter to $209 million in Q2 2022.
Free cash flow fluctuates with $54 million in free cash flow this quarter. This is up from ($12) million in free cash flow last year. The free cash flow margin is 11% and the company raised its adjusted free cash flow guide for the year from 15% of revenue to 17% of revenue. The company has $5 billion on the balance sheet.
Moving Forward …
The top catalyst for Snowflake (in my opinion, and was discussed on the call) is Snowpark going into production with Python. It’s not open to general availability yet.
Yes, I will start, and maybe Christian can finish. Python is – so Snowflake for Python is red hot, and people are jumping that for us to declare it GA, which is something and we have customers that are really wanting us to let them use it in production now some of the largest customers that we have. So, pressure is on because the demand is there. The thing about the Iceberg Open Table formats that really completely open Snowflake up to be – for Snowflake cables to be used by anybody and everybody that can support that format. We are seeing incredible results in terms of performance of like executing against that file format. So, these are all very, very, very promising developments for us. And I think that the pressure is on for us to declare these things generally available because people are trying to rip them out of our hands right now.
Mike ScarpelliMike Scarpelli
Yes. As we said at our Summit conference, we expect those to be GA at the end of this year. So, a meaningful contribution to consumption will happen next year.we expect those to be GA at the end of this year. So, a meaningful contribution to consumption will happen next year.
“Snowpark offers the ability to migrate business logic with popular programming languages Python, Scala/Java Virtual Machine or Java. The library and DataFrame API allow querying and processing data without having to move data to where the application code runs. This extends programming functionality for ML model training and allows data processing to run natively in the data cloud.
Prior to Snowpark, code deployment required separate infrastructure. Building applications that interact with Snowflake’s virtual warehouses minimizes processing time and lowers the learning curve/broadens adoption of complex data pipelines by removing the need to move or copy data into other systems to overcome working with SQL.
The recent announcement of adding Snowpark for Python is key because of Python’s widespread popularity among developers. With the Snowpark Accelerator, Snowflake is courting developers to build more applications and this is likely to help Snowflake maintain a competitive advantage with a newer class of machine learning startups.”
Nvidia …
Nvidia remains one of our highest convictions and we’ve laid out those reasons in great detail. We will provide an earnings overview soon but you’ve likely already heard through the pre-announcement that gaming was down 44% sequentially. The company’s guidance also missed by $1 billion with $5.9 billion guided versus $6.9 billion expected.
Nvidia is undeniably the highest priced semiconductor, as well, and the one issue investors face when a company misses on EPS (noted in the pre-announcement) is the valuation gets richer overnight. Nvidia has been trading in the 30-35 forward P/E ratio range, yet is now in the 46 forward PE ratio range.
It’s likely we trim here a bit here and re-allocate (perhaps to Snowflake tomorrow). The position is large so the trim is not for lack of conviction, we can promise you that. We also won’t hesitate to buy back again.
Datadog is a heavy hitter on revenue growth and offers a rare, balanced bottom line. We believe this is because Datadog rides the coattails of digital migrations to AWS, Azure and Google Cloud. As cloud migrations continue – evidenced by growth across The Big 3 – the number of applications and containers to monitor has grown and the complexity has also grown within cloud-native environments. We previously covered this here.
The company is recognized as a Leader in observability and sits comfortably above competing platforms offered by the Big 3 in Gartner’s Leader Quadrant. This is important because Datadog serves the dominant trend of multi-cloud by offering flexibility for companies that prefer to work with more than one cloud vendor (Google, Azure or AWS) while not compromising on quality of observability and security products.
There’s a lot to unpack in the report, but ultimately, we feel it was a strong report and that as more cloud earnings come down the line, Datadog will ultimately stand out among its peers.
Q2 Overview of Financials
Datadog beat on Q2 revenue reporting $406 million for 74% growth compared to a consensus of $381 million, or 63% growth expected. The guide for Q3 came in as expected at $410 to $414 million compared to $410.7M estimated.
The company reported GAAP EPS of ($0.02) with the market expecting ($0.07) EPS. Adjusted EPS also beat at $0.24 reported compared to $0.15 EPS expected.
The GAAP operating margin was at (1%) compared to 2.87% last quarter. Notably, this was a slight improvement YoY with GAAP op margin at (4%) in the year ago quarter although lower sequentially from +3%. As we said with Microsoft and Google, margins that are flat/unchanged are a win right now. This resulted in ($3) million in operating losses compared to a ($10) million operating losses in the year ago quarter.
The company’s operating cash flow of $73 million was down sequentially from $147 million yet was up YoY from $52 million. The free cash flow in Q2 was $60 million compared to $130 million last quarter and $43 million in the year-ago quarter. The company has $1.7 billion in cash on its balance sheet, which is unchanged from last quarter and up $300 million from the year ago quarter.
Stock based compensation more than doubled to $82 million in the recent quarter, up from $34 million in the year ago quarter. SBC this year across two quarters is at $149 million.
Growth of larger customers above $100K ARR grew 54% which is down but not too meaningfully given macro. Last quarter growth was at 60% YoY, and in the year ago quarter, ARR > $100K was up 60%. DBNRR was over 130% for twenty consecutive quarters.
As discussed below, the strength to Datadog is the land and expand, or the upgrades. The company continues to do well here with 79% of customers were using two or more products, up from 75% a year ago. 37% of customers using four or more products, up from 28% a year ago and 14% of our customers were using six or more products, up from 6% a year ago.
The company stated they are aggressively hiring, which makes Datadog an outlier in that regard, and is often a forward-looking indicator.
Datadog guided in line, but the market was expecting the company to raise guidance considering the last two quarters were sizable beats. Q3 guide was for $410 to $414 million with consensus at $410.68 million. The company reiterated the $1.62 billion guide for FY2022, or 58% growth. Adjusted EPS guide for Q3 also came in as expected while full year EPS guide was slightly lower than expected, at the midpoint, with adjusted EPS of $0.74 to $0.81 compared to $0.80 adjusted EPS expected.
Why the Market Got a Little Nervous in the Pre-Market
Although Datadog was able to provide revenue guidance consistent with previous guidance, analysts wanted more visibility into full year guidance as Q4 sits lower than usual if we assume $1.62 billion this year.
Total deferred revenue was $467 million in Q1 with current deferred revenue of $455M and non-current deferred revenue of $12.8 million. In the current quarter this softened to $458.5M in total deferred revenue with $444 million current and $14.5 million non-current. While non-current fluctuates, this was the first decline in current deferred revenue over the past two years. This information was available pre-market.
On the earnings call, Datadog reported Billings and RPO growth that was lower than overall revenue, whereas in the past, these two key metrics typically exceeded revenue: “And pro forma for those adjustments, billings growth year-over-year was in the mid-50s. Remaining performance obligations, or RPO, was $881 million, up 51% year-over-year. Current RPO growth was in the mid-50s year-over-year, and contract duration was slightly lower than the year ago quarter.”
This is down from 85% growth in RPO last quarter and billings growth of 103% last quarter. In the year ago quarter of Q2 2021, RPO was up 103% and billings was up 69%.
The company stated this was due to these three reasons:
1. Due to the land and expand model where customers come in the door and then upgrade:
“As we said in previous quarters, billings and RPO growth can fluctuate significantly and vary from revenue growth, whether higher or lower due to the timing of invoicing and duration of customer contracts. To illustrate this, we note that billings growth for the first half of the year of 2022 was 72% year-over-year.” billings growth for the first half of the year of 2022 was 72% year-over-year.”
2. They believe that even though customers are less likely to commit due to macro, they will still spend in-line and their guidance reflects their expectations: “In addition, we observed that some customers aren't changing their level of usage growth but are being more conservative in their commitments, which impacts billings and RPO growth but not revenue growth.”customers aren't changing their level of usage growth but are being more conservative in their commitments, which impacts billings and RPO growth but not revenue growth.”
3. There was an accounting pull forward to where some customers were billed in Q1 this year yet were billed in Q2 last year: “As in previous quarters, we had some differences in the timing of billings of a few large customers, which were billed in Q2 last year but were billed in Q1 this year.”differences in the timing of billings of a few large customers, which were billed in Q2 last year but were billed in Q1 this year.”
Here is one question on the call about RPO and Billings:
“But if you can help us reconcile your RPO growth. I'm sure there are company specific things that pertain to how you see of your growth on a year-over-year basis, sequential growth basis. How do we look at that in the context of what's happening with the hyperscalers. And they did put up even during an uncertain time, tremendous backlog growth, whatnot. So is there something specific to Datadog? Maybe it's the 18% or so, high teens percentage exposure to consumer discretionary.”
The CEO defended Datadog by saying their growth has exceeded the hyperscalers: “In Q2, we did a lot better than the hyperscalers. So we're growing a lot faster than all of them combined. And they've decelerated actually more than we've done in relative basis. So we actually feel good about the ratio there.”So we're growing a lot faster than all of them combined. And they've decelerated actually more than we've done in relative basis. So we actually feel good about the ratio there.”
The CFO had the following color to add: “So remind everybody that with our land and expand where we start getting used by clients, they scale up the growth and when they get to a certain point through, this has been going on for the whole business model. They go to an increased commit. Because of that, there's variability in the billings and RPO that net-net, over time, on average, go towards the ARR growth. Again, remember, we mentioned that the ARR growth is the best metric. And the way to look at that is that you look at the revenues […]
And I think we said we basically put in there that in the first half of the year, the growth of this was in the 70s, pretty close to revenues. the growth of this was in the 70s, pretty close to revenues. Why? Because there was timing of billing in the first quarter relative to the second quarter Because there was timing of billing in the first quarter relative to the second quarter that moved the first quarter up and the second quarter down, but it really doesn't have much effect on the drivers of our business.”
The other question on analyst’s minds is basically this: Is Consumer Discretionary isolated as the only vertical that is reducing budget and cloud usage oror is Consumer Discretionary simply the first in a row of dominoes with other verticals soon to follow?
Datadog’s answer to this (for their business) is that they are seeing decreased usage in larger customers and not from SMBs. The analysts were surprised by this due to the ongoing reports SMBs are reducing their spend. There was more than one question but here’s an example:
“Good morning. David, I think everyone is still a little confused. You're seeing an inversion with what's happening with SMB and large enterprise. Many companies are kind of weakness in SMB not at large. Can you explain why you think you're seeing this inversion? And are you embedding a more conservative view in the back half?”
The most direct answer was this: “[SMBs] have the same exposure but simply the difference is, what's your time to say, $5,000. Probably not. If you're a much larger customer, it's worth your time to sell $500,000. And that's what we see with those optimizations.”
Datadog didn’t give much improvement in terms of full year guidance.
Here’s what I have right now:
Q1: $363M or 83% growth
Q2: $406M or 74% growth
Q3: $412M at midpoint or 53% growth
Q4: $439M if we factor in FY2022 $1,620 guide or 34.6% growth. Note: Analysts are modeling 45% growth for $471M for Q4.
Management is keeping it safe by remaining with the full year guidance they previously with the word “conservative” mentioned a lot. This is what was stated on the call:
“I wanted to talk a little bit about some of the trends you're seeing in the business and particularly with respect to the guide. I guess the first question is, as the quarter progressed, when did you start to see some of these slower usage trends in some of these verticals? If you could give a comment on that? [..] And then, David, in terms of the guidance in terms of how you were framing it, can you give us a sense of what you're sort of assuming in the back half with respect to Q3 and Q4? Is it some of the trends that you're seeing in July, did that improve or stabilize or worsen?”as the quarter progressed, when did you start to see some of these slower usage trends in some of these verticals? If you could give a comment on that? [..] And then, David, in terms of the guidance in terms of how you were framing it, can you give us a sense of what you're sort of assuming in the back half with respect to Q3 and Q4?Is it some of the trends that you're seeing in July, did that improve or stabilize or worsen?”
The CEO stated, “We saw that start really in late April, May and June. So as we got deeper into the quarter. I should say that this is – if you're thinking of what happened in terms COVID, this is not a sharp pullback as we have seen at that time. But we saw it's just, for some customers still growth, but slower growth for certain types of customers and others than what we would have seen historically”
The CEO later clarified the following on the APM product: “That's a great question. So for APM, there's actually part of APM that looks like logs […] And that's the part on which we've seen some slower growth. It's still growing, but both are actually still growing healthily, but I would say, slower than they were in recent quarters for these types of customers.”
The CFO stated, “On guidance, as you know, we have always been conservative in our guidance by using lower organic growth and other metrics than we've seen historically and continue to maintain that philosophy. I would note that if you look at the raise here and the percentage of the beat that was passed through into the raise from Q2, it is lower, more conservative than we have done in previous quarters. And the reason for that is the macro uncertainty where we can't be as confident about what happens given the macro uncertainty.we have always been conservative in our guidance by using lower organic growth and other metrics than we've seen historically and continue to maintain that philosophy. I would note that if you look at the raise here and the percentage of the beat that was passed through into the raise from Q2, it is lower, more conservative than we have done in previous quarters. And the reason for that is the macro uncertainty where we can't be as confident about what happens given the macro uncertainty.
So I would say there, if you want to take that, there were some incremental conservatism put into this. But I'd remind everybody that we've always been quite conservative in using assumptions that are lower than the past when we give guidance.”there were some incremental conservatism put into this. But I'd remind everybody that we've always been quite conservative in using assumptions that are lower than the past when we give guidance.”
Here is management’s track record in that regard. Notably, this track record was accomplished even given the uncertainty of Covid.
So, for next quarter, we know we need to make sure that Q4 guide comes up to match analyst expectations.
The Gartner Magic Quadrant for APM and Observability came out recently in June of 2022. Datadog’s products are comfortably ahead of what The Big 3 offer.
Conclusion:
I'm guessing by the time we get all cloud Q2 reports, DDOG will be a leader in cloud for both top line and bottom line. The market clearly wants perfection for the higher valuations in cloud and I think DDOG gave us what will be seen “as close to perfection as possible" as we go along. The primary remaining blemish was the company did not raise full year guidance to imply healthy/consistent growth in Q4.
DDOG's report was a bit murky for less defensible cloud companies as they pointed to a slowdown in usage in May and June. DDOG is more defensible due to a few things — it sits at a critical piece in the stack (last to be cut even if there is softness in commitments, revenue growth can still occur as planned), is well diversified across many verticals and is the best direct correlation to cloud IaaS growth (ref. our previous analysis one example is here).
I've felt for some time that if we see AWS, Azure, etc., start to slow then maybe time to look at our (very high) DDOG allocation, otherwise, our goal is to ride on these coattails. DDOG could still have some nice growth once cloud infrastructure slows — it's simply one data point I use when we determine the allocations since it’s so closely correlated.
Knox trimmed 1% from Snowflake because SNOW is certainly more exposed to usage trends as is Confluent. I know Confluent had a nice quarter today, however, it appears their growth is slowing to mid-30% by Q4 and analysts are in agreement with this. Perhaps the company will raise guidance as they go along.
Takeaway:
We already cut ASAN to reduce exposure to discretionary spending. We also cut TWLO due to discretionary cuts we saw from ad-tech and other signs although I suspect we will be back into Twilio by H2 2023. Our goal is to not "call earnings" rather to reduce exposure and add back in when the skies are bit clearer plus we want to allocate to any companies showing strength for 2022. Snowflake could do well but there is exposure to discretionary spending and the company bills on a usage basis – we covered this here.
This article was originally published on Forbes on Jun 10, 2022,12:19am EDTForbes on Jun 10, 2022,12:19am EDT
The market has indiscriminately penalized tech stocks across the board and cybersecurity stocks are simply caught in the cross fire. Q1 earnings proved that cybersecurity stocks are insulated from supply chain issues and remain a number one priority across corporate budgets. Specifically, cybersecurity-related companies reported top line and bottom line beats plus a handful raised guidance while consumer-related tech and less cash efficient cloud verticals lowered or missed guidance this past quarter.
The analysis below looks at why cybersecurity is a more insulated trend and a few of the cybersecurity stocks that stood-out.
Cybersecurity Budgets are Expanding in 2022
Enterprise spending is expected to increase in 2022 from the previous year, according to Chief Information Security Officer (CISO) surveys. Considering the level of cloud spending in both 2020 and 2021, an increase on already high budgets is impressive. The CISO survey states that 44% increase budgets to increase in 2022 compared to 41% in 2021 and only 2% expect a decrease compared to 6% the previous year.
In a similar study from PricewatershouseCooper, 69% predict a rise in cyber spending for 2022 and 26% expect a surge of 10% or higher spending year-over-year. This survey was done across a broader C-suite and executive sampling.
According to a Gartner survey, 88% of the Board of Directors viewed cybersecurity as a business risk. According to Paul Proctor, VP at Gartner, “The influx of ransomware and supply chain attacks seen throughout 2021, many of which targeted operation- and mission-critical environments, should be a wake-up call that security is a business issue, and not just another problem for IT to solve.”
Gartner has also reported from a CIO survey that cyber and information security is the top priority of planned investments for companies for 2022 with 66% planning to increase investments.
Monika Sinha, VP at Gartner, said, “There is a continued need to invest in cybersecurity as the environment becomes more challenging. A high level of composability would help an enterprise recover faster and potentially even minimize the effects of a cybersecurity incident.
According to Global Market Insights, the cybersecurity market is expected to reach $400 billion by 2027 from $170 billion in 2020, representing a compound annual growth rate (CAGR) of 15% during this period. The report mentions that rapid technological advancement is driving the shift to cloud-based solutions. The increasing use of the digital world increases cybercrime, which increases enterprises' spending on cybersecurity.
Cybersecurity Stocks Report Strong Q1 Earnings
We had stated on Fox Business News that a small cohort of companies emerged this past quarter to increase the top line while also reporting narrowing losses on the bottom line. We feel not losing site of opportunities during selloffs is how generational wealth is built.
This quarter, we saw on average a 5% top line beat above guidance across major cybersecurity stocks, including Crowdstrike, Okta, SentinelOne and Zscaler. This is coupled with a beat on the bottom line across all major cybersecurity stocks with both Crowdstrike and Palo Alto Networks proving the sector can be profitable and also increase cash efficiency at scale.
Source: YCharts and Investor Relations (I/O Fund)
Zscaler’s Q3 FY 2022 revenue accelerated by 63% YoY to $286.8 million in the recent quarter. It was the seventh consecutive quarter of above 50% growth. The growth was led by the strong adoption of the company’s Zero Trust Platform. Zscaler has a free cash flow margin of 15% and management expects this to expand to a free cash flow margin of 20% for the full-year ending July 2022.
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Credit Suisse analyst Phil Winslow lowered the company’s price target to $310 from $410 and kept an Outperform rating. He said, “Zscaler reported strong Q3 results, with revenue growth greatly surpassing consensus estimates and operating margins and billings also exceeding consensus. He believes a meaningful runway exists for the company.
CrowdStrike stole the show this quarter with a beat on both top and bottom line; but it was the raised guidance line that stood out. Revenue accelerated by 61% YoY to $487.8 million and annual recurring revenue (ARR) also accelerated by 61% YoY to $1.92 billion. This company has an impressive cash flow margin of 32%.
Crowdstrike also raised revenue guidance for FY 2023 ending January to $2.19 billion to $2.21 billion from the earlier guidance of $2.13 billion to $2.16 billion, representing a YoY growth of 52% at the mid-point of the revised guidance. It also raised guidance of adjusted income from operations from a midpoint of $300.5 million to $312.2 million. Similarly, the adjusted net income from a mid-point guidance of $262.4 million to $289 million.
Morgan Stanley analyst Hamza Fodderwala upgraded the stock to overweight from equal weight. The analyst said, “CrowdStrike (CRWD) is seeing further adoption based on conversations with Chief Information Officers and is seeing 100% growth from its non-endpoint offerings, which now account for 15% of its annual recurring revenue, showing that its total addressable market could be $30B bigger than first thought.”CRWD) is seeing further adoption based on conversations with Chief Information Officers and is seeing 100% growth from its non-endpoint offerings, which now account for 15% of its annual recurring revenue, showing that its total addressable market could be $30B bigger than first thought.”
(I/O Fund)
Cloudflare company reported 54% revenue growth, beating estimates by 3%, 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%. 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.
Needham analyst Alex Henderson has kept the buy rating but lowered the company’s price target to $100 from $245. He reduced the target multiples in his valuation model to enterprise value to expected FY23 sales of 23-times, down from 64-times, given the sell-off in growth equities, but maintains that Cloudflare should be a core long-term holding in all growth portfolios and recommended that investors buy the recent weakness.
Palo Alto’s Q3 FY 2022 revenue grew by 29% YoY to $1.4 billion. The billings and remaining performance obligation grew by 40% to $1.8 billion and $6.9 billion, respectively. The management mentioned in the earnings call that it was the highest billings growth in the past four years. The company raised the full-year ending July revenue guidance from a mid-point of $5.46 billion to $5.49 billion, representing a YoY increase of 29% at the mid-point.
Wedbush analyst Daniel Ives lowered the company’s price target to $580 from $660 and kept an Outperform rating on the shares. He said, “The shift to cloud is a massive tailwind for Palo Alto as the company is in the right spot at the right time to benefit from this multiyear tidal wave of cybersecurity enterprise spending.”
Conclusion:
Cybersecurity is a top priority in budgets and the results are showing up. We found a strong pattern with cybersecurity stocks sustaining growth rates and strong bottom lines this quarter. The cybersecurity sector overwhelmingly beat estimates compared to other sectors within tech and investors may want to take notice.
Zscaler’s product has done exceptionally well considering the crowded cybersecurity market. This is due to its best-of-breed, singular focus on security edge and zero trust. Primarily, Zero Trust architecture began to replace VPNs in a meaningful way in 2020 and this has sustained due to the Zero Trust model offering deeper and more scalable protection by eliminating implicit trust.
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.
Zscaler released its third-quarter fiscal year 2022 results on May 26th with revenue accelerating 63% year-over-year to $286.8 million, which beat consensus by 5.6%. The company also raised full-year revenue guidance by 2.9%. The stock rose 13% the following day from the results.
On the bottom line, Zscaler has a 15% free cash flow margin with a goal to increase this to 20% FCF margin this year. The company saw an increase in adjusted operating income and adjusted net income yet is reporting slightly higher losses on a GAAP basis from (25%) to (30%) due to stock-based compensation.
Cybersecurity Spend is Increasing in 2022
We will copy a few points from our upcoming Forbes analysis on Cybsersecurity stocks here for easy reference. Note: we covered these points in our Q2 2022 analysis. For the full article, please check the forum on Friday.our Q2 2022 analysis. For the full article, please check the forum on Friday.
Enterprise spending is expected to increase in 2022 from the previous year, according to Chief Information Security Officer (CISO) surveys. Considering the level of cloud spending in both 2020 and 2021, an increase on already high budgets is impressive. The CISO survey states that 44% increase budgets to increase in 2022 compared to 41% in 2021 and only 2% expect a decrease compared to 6% the previous year.
In a similar study from PricewatershouseCooper, 69% predict a rise in cyber spending for 2022 and 26% expect a surge of 10% or higher spending year-over-year. This survey was done across a broader C-suite and executive sampling.
According to a Gartner survey, 88% of the Board of Directors viewed cybersecurity as a business risk. According to Paul Proctor, VP at Gartner, “The influx of ransomware and supply chain attacks seen throughout 2021, many of which targeted operation- and mission-critical environments, should be a wake-up call that security is a business issue, and not just another problem for IT to solve.”
According to Global Market Insights, the cybersecurity market is expected to reach $400 billion by 2027 from $170 billion in 2020, representing a compound annual growth rate (CAGR) of 15% during this period.
Although that’s a small CAGR, many best-of-breed companies are only reporting around $1 billion in annual revenue right now, therefore, the size of pie is quite substantial for those that outperform competitors.
According to Gartner’s CIO survey concluded in 2021, cyber and information security is the top priority of planned investments by companies for 2022. Monika Sinha, VP at Gartner, said, “There is a continued need to invest in cybersecurity as the environment becomes more challenging. A high level of composability would help an enterprise recover faster and potentially even minimize the effects of a cybersecurity incident.”
Zscaler’s Product Leadership
Zscaler has been successful in capturing the cybersecurity growth trend with evidence the growth can sustain post-Covid. This is key as Covid was a major catalyst as Zero Trust began to replace VPNs. Although employees are returning to the office, the hybrid nature of work will persist, which means companies will face challenges in protecting their network since most of the information is stored in the cloud and the applications are SaaS-based.
Companies have realized that VPNs and firewalls are no longer safe, and the majority of them are adopting Zero Trust Security. The main reason is allowing remote workers to access through a VPN makes it easier for attackers to gain access through the internet to the company’s networks and gain access to data points. This can be efficiently tackled only by Zero Trust Security which is built on the premise that no one should be trusted within or outside the network.
The company has a large serviceable market of $72 billion. The company is benefiting from the shift from traditional cybersecurity solutions to cloud-based Zero Architecture. The Internet of Things and remote working has further increased the long-term opportunity for the company.
Zscaler primarily protects cloud workloads by controlling access through implementing policy-based access and interconnects for a company’s data centers, cloud infrastructure, software and third-party services. Zscaler is cloud native and its growth is related to growth in cloud migrations. SASE and zero-trust became especially important during the hybrid work-from-home rush that occurred during Covid.
The company offers the following products, Zscaler Internet Access (ZIA), Zscaler Private Access (ZPA), Zscaler Digital Experience (ZDX), and Zscaler Cloud Protection (ZCP). The company offers the flexibility for its customers to purchase products separately, which allows for flexibility in pricing.
ZIA is a security stack that offers reliable access to the internet and apps regardless of their location. ZIA is suited for connecting to external apps like Zoom or Office 365. Since it goes to third-party applications and the public internet, all the traffic is inspected so that no malware attacks occur and the data is secure.
ZPA provides secure access to internal applications that are hosted in data centers or in private/public clouds. ZPA offers secure private app access to its users across all locations with the company’s Zero Trust Network Access (ZTNA) platform. The main advantage is that the apps are not exposed to the internet, limiting external cyber-attacks.
Traditional network performance analysis tools have become obsolete due to the applications moving to the cloud and users being in various locations. Previously, enterprises used to own the network and the applications used to run in their own data centers to identify any issues efficiently. ZDX solves this problem in the modern cloud environment since it helps companies know exactly where the issues lie and how many users are affected.
The company is a leader in the Zero Trust Platform, particularly in the Security Service Edge in the Gartner Magic Quadrant which can be seen in the graph below. The company’s demand for products remains strong, evident from the large multi-year contracts signed by the company. In the recent earnings call, the management mentioned they witnessed solid growth in $1 million annual contract value deals broadly across business verticals and geographies. The remaining performance obligation (RPO) grew by 83% YoY to $2.21 billion, indicating future revenue for the company.
Zscaler has a strong base of growing enterprise customers. The company also has been able to increase the number of Global 2000 customers. In the last two quarters alone, the company added 80 Global 2000 customers. It currently has 30% of the Global 2000 companies and 40% of Fortune 500 companies as its customers.
The company has been able to upsell its products which is evident with the company maintaining the dollar-based net retention rate of over 125% for the sixth consecutive quarter. The company had 288 customers in the recent quarter with annual recurring revenue (ARR) of over $1 million, up 77% YoY.
How is Zscaler Different?
Zscaler management is often asked how the company is different from its competitors. The main thing Zscaler accomplishes when competing against more legacy virtual private network (VPN) offerings is they are able to replace global load balancers, DDoS protection, external firewalls, intrusion prevention system (IPS) and also VPNs. Hackers use numerous attack vectors and Zero Trust is a solid replacement for VPN systems because it aggregates the appliances while broadening the protection.
One way that Zscaler offers enhanced protection for the attack surface is that nothing sits between Zscaler Private Access and the applications and workloads. Rather than build a VPN replacement, the company has extended ZPA to include browser isolation, app protection, interior deception and EIM based policy. This equates to Zscaler offering the widest and deepest coverage.
Secondly, attackers have a hard time finding where to attack with Zscaler’s Zero Trust architecture because the products act like a shield with the applications hiding behind Zscaler. The company’s proxy architecture scales rapidly as applications and workloads scale rapid. The CEO has said “[Zscaler] scales like nothing else out there.”
Regarding CDNs such as Cloudflare entering the market, Zscaler’s response in the earnings call is that it will take a long time for a CDN and DDoS provider that is focused on servers to catch up to the best-of-breed, singular focus Zscaler has. “We start focusing on users to start with. It takes a lot of time and experience to build our richness and breadth of functionality we have built with ZIA, ZPA and associated functionality. I think it will take a long, long time for someone to try to catch us. And we are setting. We are innovating at a very fast pace.”
With that said, certainly Cloudflare aggregates many products under its umbrella and does well on Zero Trust against more VPN-related solutions.
Notably, Zscaler is moving into machine learning-based cybersecurity. Zscaler processes more than 240 billion transactions per day and the company’s AI/ML models can block many types of known threats in real-time before the endpoint delivery. They are also designed to identify unknown phishing webpages before they appear in the end user’s browser. This proactive approach was not possible with traditional cyber security solution providers.
Financials
The company continued to deliver strong revenue growth. Revenue accelerated by 63% YoY to $286.8 million in the recent quarter. This is the seventh consecutive quarter of above 50% growth. The growth was led by strong adoption of the company’s Zero Trust Platform, as discussed above. The management expects revenue to grow 55% at the mid-point of the guidance in the Q4 FY2022 ending July.
Source: YCharts
The company’s key metrics are growing, indicating that growth is expected to continue. The remaining performance obligation grew by 83% YoY to $2.21 billion. The company’s billings grew by 54% YoY to $346 million.
The company reported GAAP operating margin of -30% compared to -25% in Q3 FY2021. The rise in operating expenses is partly due to the return of travel expenses which was absent during the Covid lockdowns. The company’s adjusted operating margin was 9% compared to 13% in the same period last year. The difference in GAAP and non-GAAP operating margins is primarily due to the stock-based compensation. The management mentioned in the earnings call that it should come down as a percentage of total revenue over a period of time. Recently, the market has been concerned about companies using high stock-based compensation, so this is a risk to watch in the coming quarters.
The company reported a net loss of $101.4 million compared to a net loss of $58.5 million in Q3 FY2021. The adjusted net income was $24.7 million compared to $21.4 million in the same period last year.
The company has strong cash flow. In the recent quarter, the free cash flow margin was 15%, and the management expects it to be 20% for the full year.
Conclusion
The strong revenue growth has given the company a premium valuation. The stock is currently trading at a P/S ratio of 22 with year ending in July and forward one-year P/S ratio of 15. The company is not without GAAP losses yet adjusted operating margin and cash flow margin helps offset profitability concerns.
We had discussed cybersecurity being strong this quarter going into Q2 2022 with our Quarterly Webinar presentation and the current earnings season supports this prediction. Primarily, the cybersecurity sector is insulated from supply issues (which we do expect to ease eventually) and also is a #1 must-have in budgets, per the many CISO and C-suite surveys published by multiple third-party consultants.
Undoubtedly, cybersecurity was the strongest category in tech this past earnings season and Zscaler was one of handful that put up a strong report.
The FANG acronym rose to popularity in 2013 and was extended in 2017 to FAANG to include Apple. If history is any indication, the world’s most valuable companies over the next ten years will not look like the previous ten years. Being early to identify which companies can take over this coveted status is how generational wealth is built.
As a tech industry analyst who has seen what one generous winner can do for an entire portfolio, I want to pause and acknowledge that an investor needs to only identify one company that can hold a top 5 position in order to see life-changing gains. To choose all five would be to defy incredible odds. This analysis is aimed at identifying what companies we believe will hold “world’s most valuable” by 2030.
Not only is tech the most valuable industry today, but what the tech industry is setting up to do over the next ten years will provide exponential gains compared to the 2020-2030 era. With that said, tech is going through a period of consolidation and this means the stakes are high in identifying the winners. To complicate matters, the market is not efficient with tech stocks as each product is quite nuanced and impossible to efficiently price without manual deep dives. Instead, the market will indiscriminately penalize all tech and indiscriminately reward all tech — and each time the liquidity tide rolls in and then out again, it becomes sink or swim. At times like this, we are very flexible as we know we only need to identify a handful of winners.
Our portfolio has twenty positions at any given time, yet we believe it will be 5-10 positions total that create 90% of our wealth by 2030. We are long-term buy and hold investors yet we acknowledge and accept this means we exit those who show weaker-than-expected results for more than one quarter — or we trim to 1% to hold a place for the stock in our coverage. Because we are flexible, we can always revisit a stock when the story resumes and the earnings match the thesis again.
The equity market is driven by sentiment and macro factors, which we expand on herewe expand on here, yet the underlying strength of tech fundamentals is hard to deny. The best way to predict what will happen next is to look closely at what happened over the past decade.
In 2007, following Steve Jobs famous iPhone keynote, a burgeoning app economy was driven forth by iOS and Android developers. Google’s search engine was already a success yet mobile catapulted it’s use by putting the mobile device into far more hands over three years’ time than personal computers did over two decades.
There were many ways to capitalize on this massive addressable market — the iPhone and iOS apps dominated the highest spend on mobile, Facebook proliferated to 2 billion people and Google expanded to acquire YouTube. In this way, mobile drove gains for three FAANGs.
The adage is that history rhymes but it does not repeat. I believe a large addressable market is certainly required to produce the new wave of FAANGs – however, rather than consumer driving the gains, I believe it will be enterprises.
Below, I discuss the enterprise-level market that will be four times larger than mobile and two stocks that will directly participate. Imagine participating in 4X the FAANGs by 2030. That’s what I believe will happen due to one key trend and I discuss exactly why this will be achieved below.
Later in the analysis, we look at cloud and the trends that will drive cloud over the next ten years. This will catch investors who are complacent off guard as cloud is already going through a period of consolidation and we are seeing new business models emerge, such as the consumption model whereas the SaaS model with annual recurring revenue has dominated the past decade. Microsoft helps prove that cloud is certainly capable of FAANG-status.
We will also look at blockchain and crypto as I have been covering this space since 2013, which predates the Ethereum network. I was trained in Silicon Valley and my role is to introduce public investors to the next wave of innovation in as safe a manner as possible. I agree that 90% of cryptos will go to $0 yet I/O Fund has been firm for years that Bitcoin would reach $1 trillion in market cap and we have two Layer 1 networks to discuss with you plus a middleware company. Whether you’re ready for it or not, Web3 will replace the internet by 2028-2030 and we are fully prepared to participate in the substantial gains the blockchain will produce.
Lastly, FAANG is not entirely dead and consumer will have its moments too. We discuss the two FAANGs we own and what major catalysts these companies have in their future. We also briefly touch on some consumer-facing stocks we own and the large addressable markets they have the potential to capture.
For those of you who are new to the I/O Fund, we are prolific in our analysis. I began writing analysis on products, startups and enterprise-technologies in 2011 and moved over to the public markets seven years later. There is a library of analysis available to you that dates back to our launch in 2019 and additional free analysis in 2018. Due to the sheer number of products I have analyzed, we are able to hold an all-tech portfolio across semiconductors, cloud, ad-tech, blockchain and more.
We also encourage you to sign up for trade alerts as Knox’s active tradesKnox’s active trades help frame the market and whether we are risk-on or risk-off. We also have an automated hedge signal and are audited annually. You can learn more about how we manage an all-tech growth portfolio here.
Yet, the investors on our site need to do their part, which I can summarize as the following:
Speak with your financial advisor about your risk level. We are not financial advisors. Instead, we simply show you the trades we are making with our own money.
Use our pie chart to view our allocations. The larger the allocation, the higher the conviction – and vice versa, the lower the allocation, the lower the conviction.
As stated, we are flexible as we expect a handful of companies to drive the majority of our gains. If we receive new information, we will manage risk accordingly by lowering allocation or exiting the position.
We firmly believe all tech investors need a long-term time frame for tech. The best tech investors in the world are venture capitalists and they seek an exit 5-7 years after they’ve funded a round. The reason to have a long holding period is that it’s nearly impossible to time an entry, therefore professionals instead time their exit. By having a long-term horizon, you can be patient until the market conditions are in your favor to take your exit.
Accept that tech is volatile. For example, high beta tech has sold off around 40%/year since 2018. I have been down this much and more so on positions that became 1,000% and 2,000% winners. This is not value investing, it’s an entirely different sport.
We have a proprietary hedge that we developed. The hedge went live in April and is designed to help us remain comfortably invested during drawdowns. You can learn more about the hedge here and watch the webinarhedge here and watch the webinar.
Without further ado, let’s talk about who will be the world’s most valuable companies in 2030
Artificial Intelligence and Machine Learning will Exceed the Mobile Economy
Smartphones had a 10-year cycle of maturation with the iPhone distribution beginning in 2008 and the app economy had a similar 10-year maturation for digital advertising. We know mobile is reaching saturation as the iPhone often has flat quarters and Facebook’s DAUs are also flat. Following a decade-long run:
The smartphone market was valued at $720 billion in 2019 and the global mobile application size was $155 billion.
The mobile advertising market was valued at $60 billion — Facebook
The market is roughly $2 trillion for mobile yet the market cap of these companies combined is $4 trillion. Meanwhile, Pricewatershousecooper is predicting the AI market to reach $15.7 trillion with some believing AI will be the next electricity. Semiconductors will not comprise the entire $15.7 trillion but according to McKinsey, they will “capture 40 to 50 percent of the total value from the technology stack.”
“Many AI applications have already gained a wide following, including virtual assistants that manage our homes and facial-recognition programs that track criminals. These diverse solutions, as well as other emerging AI applications, share one common feature: a reliance on hardware as a core enabler of innovation, especially for logic and memory functions.”These diverse solutions, as well as other emerging AI applications, share one common feature: a reliance on hardware as a core enabler of innovation, especially for logic and memory functions.”
The artificial intelligence economy will be four times larger than the mobile economy. Put differently, mobile gave us companies with up to $2 trillion market caps and AI will give us companies with $8-$10 trillion market caps. Let’s break this down.
The size of total addressable market is critical to produce the world’s most valuable companies. FAANG companies have illustrated this well and that the private markets base nearly every investing decision on TAM.
Pictured above: Google’s search engine revenue growth from 2008-2022
Google’s search engine is used by over 4 billion people
Android is used by 2.5 billion people and YouTube 2 billion people.
Facebook is at 2.9 billion users
Apple has 1.8 billion active devices (about 1 billion iPhone)
Microsoft Windows has 1.4 billion users and MS Office has 1.2 billion users = Microsoft coming from the dot-com era shows us that mobile produced much larger addressable markets across three companies compared to the previous decade.
However, not only will AI semiconductors power the accelerated computing and the training and inference that reaches every person on earth, it will ultimately power the automobiles, the streetlights, vehicles, refrigerators, factories, cities and spaceships. This will extend the addressable market beyond the 7 billion global population to reach 100 billion connections. Now, imagine this – it will be writing the software too and running the machine-to-machine automations.
View my Bloomberg appearance here where I discuss the AI market being 4 times larger than mobile.Bloomberg appearance here where I discuss the AI market being 4 times larger than mobile.
Here is a glimpse of what AI will do for GDP in each country:
AI is expected to nearly double GDP in the United States by 2035 and across Europe and Japan. The same study shows the American worker will increase productivity by 35% due to AI.
Accelerated Computing Required for Artificial Intelligence and Machine Learning will Produce Two (New) FAANGs: Nvidia and AMD
Accelerated computing is a term first used by the gaming industry when graphic accelerators were put into use to accelerate the work of a central processing unit (CPU). Nvidia created GPUs to offload tasks from CPUs for rendering 3D images. The CPUs provide the instructions while GPUs perform multiple calculations from streams of data. Parallel processing became a natural fit for the data center including training artificial intelligence and deep learning models due to processing multiple computations simultaneously.
Please reference the additional resources below where we have done previous deep dives on every company mentioned in this summary.Please reference the additional resources below where we have done previous deep dives on every company mentioned in this summary.
Nvidia’s Moat is Called Cuda:
Nvidia has a parallel computing platform and programming model called CUDA that is universally known due to the company’s first mover advantage in GPUs. The GPUs themselves do not create the moat. The compute platform creates the moat. Universities teach CUDA, which helps strengthen the universal platform for building GPU-accelerated applications as students graduate with this universal skill.
Hardware does not offer a moat. The iPhone was not the moat. Instead, it was the strength of the developer ecosystem that propelled Apple to become a $2 trillion company. The moat that Apple has enjoyed was created by the third-party developers who created iPhone applications in C and C++ with XCode, which made the device more attractive due to the mobile app ecosystem.
Android then became the second operating system in the mobile duopoly. Due to the friction of learning too many languages, the mobile ecosystem did not entertain any further competitors. This is despite there being 4 to 5 billion smartphones globally (i.e. it’s certainly feasible from a consumer supply/demand view point to entertain more operating systems and app stores), yet the limitation came from the number of languages developers are willing to learn. Microsoft Windows failed because it launched too late, and developers had already chosen the two languages they were willing to work with.
Developers create a moat because they don’t want to learn new systems – the cost of time, especially when bringing products to market is very valuable. For instance, AI startups are not going to shop a new software layer to program GPUs right now as it’ll slow down their time to market and it’s critical to launch products quickly. If there’s a competitor to Nvidia and the startup is already developing on the CUDA platform, then it better be a heck of a value proposition.
Nvidia’s Game Changer Was the A100 GPU:
In 2019, I had already stated to our premium research customers that Nvidia would become one of the world’s most valuable companies. However, the path became clearer in 2020 when the company released the A100 GPU which combines both training and inference onto one chip. The result is a 20X performance boost from a multi-instance GPU that allows many GPUs to look like one GPU. The A100 offers the largest leap in performance to date over the past 8 generations.
Note: Reference the resources below for more information on the A100 GPU including our coverage in 2020.
Fast forward, and nearly two years later after the A100 GPU launched, Nvidia had this to say in the most recent earnings report:
“[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 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.”
Buried a bit deeper into the previous earnings call, management stated this: “The flagship NVIDIA A100 GPU continue to drive strong growth. Inference-focused revenue more than tripled year-on-year.”Inference-focused revenue more than tripled year-on-year.”
These are the kinds of critical moves we try to get in front of by covering the A100 GPU at its launch. Two years later, and we see management saying inference revenue has tripled and data center revenue doubled due to this specific product.
View my interview on TDAmertrade where I discuss Nvidia’s data center segment and why automotive will be strong in the second half of 2022.my interview on TDAmertrade where I discuss Nvidia’s data center segment and why automotive will be strong in the second half of 2022.
AMD: The Dark Horse of AI Chips
The Dark Horse refers to an underdog or an overlooked competitor that emerges seemingly from nowhere to succeed. We believe AMD is a force of nature that the market often underestimates due Intel’s overhyped public relations strategy. Meanwhile, the competitive prowess of Lisa Su has led to the second biggest comeback in the history of the tech industry after she took over AMD in 2014 on the brink of bankruptcy.
Note: We’ve done a 1-hour webinar exclusively on AMD. Reference the resources below.
AMD’s Strength Came from the Zen Architecture
The Zen architecture was introduced under Lisa Su in 2017. These processors are chipset free and fully integrated. Communication between CPUs is done through Infinity Fabric protocols. The result of the new architecture was more energy efficiency and the ability to execute more instructions per cycle.
The company released the second generation of its Zen architecture and this is when AMD started to clearly outpace Intel in terms of computing power, memory and energy use – all at a lower cost. This was due to multi-chip modules that combine a 7nm with a 14nm to use the most advanced technology when and where it’s needed most by leveraging the more mature process node. The L1 cache and L2 cache locations in the core and across the core also helped the company beat Intel on memory bandwidth.
Intel was still producing a 14nm chip with a 10nm supposedly on the way. Essentially, AMD leapfrogged the incumbent with a product that is more power efficient and allows for more cores per chip.
Note: read more about the Zen architecture in the resources listed below.
If technical jargon around chips isn’t your thing, then this is probably the most important line from our original analysis in terms of AMD’s competitive prowess: “It’s estimated that for every $1.00 in Rome chip sales, Intel loses $2.25 on average in Intel Xeon SP sales. The savings are then deployed to buy more Rome chips, which can further depress Intel’s revenue.”
We can clearly see AMD taking market share in server CPUs although losing ground in desktops and laptops (our thesis is server market share so that’s less important to us). Notably, overall CPU market share for AMD is up.
Most importantly, look at where AMD was when it launched the second generation of Zen (roughly 2%) to today (roughly 11%) market share – or nearly 6X from this major design win. Moving forward, Intel will need to deliver a 7nm chip – but by then Lisa Su will already be releasing a 5nm design.
As the analysis below points out, Intel needs to make up for lost time, meanwhile, Lisa Su is unlikely to allow that now that AMD has clawed its way back from near-zero. Our site was early to AMD overtaking Intel and this was the analysis we chose to publish during the Covid selloff in March of 2020.
Tech investors should pay attention to AMD’s ability to stave off the competitor and the new inroads AMD will have following the Xilinx acquisition. Xilinx’s FPGAs are particularly well suited for accelerated computing yet require an easier software development platform – which I suspect AMD and Lisa Su will fully deliver in the next year.
So far, Lisa Su has simply set the foundation for her company to see substantial AI tailwinds.
AI Acceleration Goes Far Beyond Data Centers
In the months to come, I will detail for I/O Fund members the additional revenue segments that will cause Nvidia and AMD to catapult their current market caps. The data center does not even scratch the surface.
Primarily, these companies will participate in the lion’s share of AI acceleration in the automotive industry, edge computing and edge devices, 3D virtual worlds and robotics simulation, industrial automation, software automation — and probably most crucially, why the leading hardware companies of today are moving into licensing software and why that will cause an eruption in revenue for these particular hardware companies. Look for this special report before next earnings season.
Before I move onto cloud, I’d like to mention that we hold two more semiconductor positions – Marvell and Lam Research. We foresee holding these companies for the long haul and linked resources below spell out why we’ve chosen these two names out of the hundreds of semiconductors on the market.
2030 Cloud Companies Won’t Look like 2020 Cloud Companies
Tech is synonymous with innovation, and consequently, innovation is synonymous with the word change. This is why winning cloud investments from the past ten years will not look like the next ten years. Cloud has treated investors well, yet cloud is going through a transformation that will shake up the previous paradigm. The previous paradigm was one where most cloud stocks were successful, and was distinguished by easy cash. Now that cash is tighter, there will be fewer winners in this category. We covered the fundamental change to cloud’s bottom line here in: Compartmentalizing Cloud Stocks.
Cloud: Only the Strong will Survive
In 2010-2021, the public markets saw hundreds of cloud companies go public. Yet anyone with a decade or more experience in tech will tell you that consolidation eventually will come knocking.
Consolidation is a natural part of the tech industry where competitors become acquired or they merge with stronger companies to avoid failing entirely. This helps a small minority to emerge as the defacto leaders. I believe that cloud companies will survive either through consolidation or standardization, which means cloud companies that have evolved to serve more than one market, which in turn helps drive down costs.
Let me illustrate:
Recently, a report came out that repatriation, or moving some workloads back to on-premise, has resulted in quite a bit of cost savings for companies like Dropbox, Crowdstrike and Zscaler, who use hybrid approaches. The report is quite surprising as the conclusion is that $100 billion to $500 billion in market value is lost on cloud deployments in terms of margins. One use case that is detailed is Dropbox, a company that reported savings of $75 million in two years after repatriation, which in turn, helped the company’s gross margins increase from 33% to 67%.
The problem with cloud is that it’s not uncommon for companies to spend about 60% of their revenue towards committed cloud spend. The solution is aggregating services and products to drive down costs.
Two companies we own that offer standardization are Datadog and SentinelOne. Standardizing means interoperability between various cloud environments and integrated interfaces. This is especially important with multi-cloud or hybrid cloud where companies have more than one environment. This is becoming the new normal to prevent vendor lock-in.
If corporations continue to standardize on Datadog’s platform, then the company will continue to capture market share. Since dealing with multiple cloud vendors quickly becomes cumbersome, there is a natural tendency to standardize in tech, especially with software. Moreover, cloud applications need to communicate, so having everything on one platform can make detecting and resolving issues less complex and costly. The cloud industry is on the cusp of this standardization trend with cloud software vendors, with Datadog leading the way. In this way, Datadog is best positioned to benefit from both the rise in cloud usage and the standardization of cloud software.
SentinelOne is a security position we own. Although the company has many competitors in the EDR space, they extend the acronym to XDR to not only include devices and workstations, but to also include other data points on the network, such as containers and cloud-native applications, and also across the entire stack, such as email, the network, and identity.
SentinelOne uses many data sources to create a data lake. The single pool of raw data is built across a wide range of sources, including other vendors or internal data sources. What matters to customers is that every threat is detected very quickly, and SentinelOne proposes a solution that is able to do both because automation and AI is best done at the data level rather than managing thousands of user endpoints to mitigate attacks.
According to SentinelOne, using their products can produce cost savings can be up to 353% – granted this number is a marketing department, however, the point is that any company increasing ROI in cybersecurity has a real chance of taking market share if their product improves the results. The savings quoted is achieved by reducing the amount of cybersecurity tools a company needs by standardizing endpoint security across more data types. The consolidation in this case saves up to $3 million over a three-year period and the enhanced threat detection saves $671K over three years. Due to automation, $1.2 million can be saved over three years by reducing time and employee hours across the IT team.
Big Data and Analytics/ML – Consumption Model is Here to Stay
There is an oft-quoted statistic that 90% of the world’s data was created in the last two years – and this stat is from 2018. The world produces 44 zetabytes of data across the digital universe as of 2020 and there is expected to be 200+ zetabytes of data in cloud storage by 2025. Each zettabyte has 21 zeroes or is 1,000 bytes to the 7th power. By these estimates, we can expect to see up to 5X growth specifically in data centers. Statista places the number at 181 zetabytes by 2025 up from 64.2 zettabytes in 2020.
In regards to data integration in the cloud, this spans from data lakes, to ETL pipelines, cloud data warehouses and object storage. Data fabrics and data virtualization is key to both hybrid and multi-cloud strategies.
The key thing to know about Big Data, Analytics/ML is that these companies will test financial analysts as they do not bill according to subscriptions like many software companies do. Instead, companies like Snowflake, MongoDB and Confluent bill customers based on consumption. This is a relatively new approach to software billing, which makes it harder to model and forecast near term sales.
As data creation, ingestion and storage soar in the cloud environment, cloud software providers are starting to migrate away from subscription agreements, which are fixed, to a consumption-based pricing model, which are uncapped.
Consumption-based pricing has a few drawbacks. For example, its less predictable than subscription revenue and there isn’t a ‘floor’ on revenue, because if consumption declines then so will sales. However, the flip side is also true, consumption billing does not have a ‘ceiling’ on revenue, so if customer consumption rises, so does sales. This uncapped revenue potential is key to why growth could be quite substantial in this category compared to cloud SaaS peers.
Here is a disclosure from Snowflake in the 10Q:
“Consumption for most customers accelerates from the beginning of their usage to the end of their contract terms and often exceeds their initial capacity commitment amounts. When this occurs, our customers have the option to amend their existing agreement with us to purchase additional capacity or request early renewals”
We want CAGRs that are larger than mobile’s CAGR for 5-10 years. According to industry analysts, the CAGR for machine learning is at 38% between 2022-2029, growing from $15 billion in 2021 to over $200 billion in 2029. Some of this is being driven by Big Tech yet as more companies seek a vendor agnostic approach and multi-cloud workloads, there is ample room for agnostic companies to do well.
Compare this to the smartphone market which grew at 24.9% CAGR with some years in the 12% CAGR range. Here’s an example of a reference for CAGR during Apple’s high-growth years: “The Asia-Pacific smartphones market shipment stood at 87.8 million in 2010 which is expected to reach 294.1 million in 2015 growing at a CAGR of 27.3% during 2010 – 2015.”
Here's how Datadog’s CEO describes what is going on in terms of big data in the Q2 earnings call: “it's almost a given that there will need to be a different way of charging for capturing some of the value provided to customers that can't just be attached to the straight volumes of data that are being exchanged because those volume of data are exploding exponentially while our customers' revenues are not going to explode exponentially.”
To capitalize on the Big Data, Analytics and ML trend – which we fully believe has the potential to produce a FAANG – we hold long-term positions in MongoDB and Snowflake. We are comfortable with the fluctuations of the consumption model, which means some volatility at times, as the consumption model will be tied to higher revenues in the long-term.
Note: We hold a 1% position in Confluent which translates to a lower conviction than MongoDB and Snowflake for this trend. We have recently trimmed 2.5% from Snowflake with the goal of building a bigger position in MDB. Please reference Knox’s trade alerts for more information on these positions and others in real-time.
We encourage tech investors to look at cryptocurrencies with a level head. It’s easy to dismiss the blockchain as a fad and it’s also easy to gamble on crypto for a quick gain. We think both approaches are wrong. Instead, our approach is to fully embrace the blockchain and it’s volatility by being willing to trim when the uptrend hits our targets close to the top and layer back in around the bottom.
Knox has a strong track record in navigating Bitcoin’s volatility and we fully expect to continue to trim at the top and layer-in at subsequent bottoms for the next five years – with real-time trade alerts sent to our premium members.
We own the following cryptocurrencies in a longer-term fashion: Bitcoin, Ethereum, Chainlink and Avalanche. The first three come with a higher conviction simply due to the size of their ecosystems yet we think Avalanche stands-out as a secure, decentralized protocol that can scale.
We also own very small, token positions in what we call a YO/LO portfolio (You Only Live Once) where we are a bit more liberated to take higher risks than we would with our core portfolio. Reference the resources below for more information.
Bitcoin:
We covered Bitcoin within a month of launching our premium site in 2019 and it’s in my top 5 for FAANG status. Notably, we had predicted Bitcoin would reach $1 trillion market cap when it was selling off from the $7-$10,000 range to $3,000 range.
The primary reason we are proponents of Bitcoin is that it is the world’s most secure financial network with a higher level of security than the 10,000 global banks combined. This solves a genuine need for the financial system as payments and transfers cannot be automated without a decentralized blockchain solution.
Crypto transfers eliminate processing fees and also hedges against inflation. There are transaction fees charged by crypto exchanges but these fees are not inherent to Bitcoin and will lower in time with more competition.
Apple, Google, Microsoft, and Amazon crossed market caps of $1 trillion because their products scale to global populations and are required on a daily basis. Bitcoin not only scales to global populations, but it also protects their livelihood – a necessity rather than a convenience. This is why we see populations that are not necessarily tech-savvy most enthusiastic about Bitcoin. In 2019, I argued that Bitcoin will reach a $1 trillion market cap as solving a real financial need for global populations should be worth as much as a search engine, enterprise software, social media network, warehouse fulfillment (AMZN), or iPhone hardware company.
In our original report we used the example of Venezuela, where during a period of hyperinflation, the price of a cup of coffee rose to 2,800 bolivars up from 0.75 bolivars within one year, representing an increase of 373,233%, according to Bloomberg data. Essential goods such as toilet paper and medicine were also very costly.
Bitcoin was immediately available to Venezuelans as a store of value and offered them an option to cross the border and escape an autocratic regime. Since then, El Salvador has adopted Bitcoin as their country’s currency.
Currently, the United States is at debt levels of about 133 percent of gross domestic product (GDP). There has been a steady rise in the level of national debt to GDP due to decreased tax revenue and increased spending, especially on health care.
The United States is unlikely to see hyperinflation to the level of Venezuela (at least, let’s hope not). However, trust in fiat currencies will erode as debt continues to climb.
Japan is an excellent case study for an economy that is struggling due to quantitative easing. The Japanese debt-to-GDP ratio is at an all-time high at 254% due to its quantitative easing. Government debt to GDP in Japan averaged 137.4% from 1980 to 2017.
Easy money policies from Japan’s central bank harmed domestic asset returns by suppressing local interest rates. Ranking as the world’s third largest economy, Japan resorted to negative interest rates in 2016. In April 2016, it was reported that a “Japanese bank buying 5-Year U.S. Treasuries with perfectly hedged currency and duration risk would (lose) 0.9% a year.”
Consequently, Japan is a thriving bitcoin market and has seen increased crypto deposits. According to the Japan Virtual and Crypto assets Exchange Association (JVCEA) Japan’s virtual currency deposits recorded 1.41 trillion yen or about US$13 billion in March last year, the volume was about seven times more than in March 2020.
During the recent Ukraine-Russian war the use of crypto has once again taken prominence. The Ukrainian government has also accepted crypto donations during this crisis. In the words of Alex Bornyakov, Deputy Minister of Ukraine’s Ministry of Digital Transformation, “In times like these, response time is crucial. Crypto is playing a role to give us flexibility to respond really quickly to deliver the army’s required supplies.” The lack of financial access might also increase the use of crypto in both the countries. The Ukraine central bank had suspending electronic transfers and reduced cash withdrawals and there were reports that Ukrainians were turning to cryptocurrency.
According to Alex Gladstein, Chief Strategy Officer at the Human Rights Foundation, “The fact that it can’t be frozen, the fact that it can’t be censored, and the fact that it can be used without ID is very, very important,” He further added, “And they are why bitcoin is such an important humanitarian tool.”
We’ve written extensively on Bitcoin and we encourage you to read more about the importance of the Lightning Network in our resources below, which is a payment protocol that operates on top of cryptocurrency blockchains and enables fast transactions.
The Lightening Network will be used for small transactions that don’t require the security of the bitcoin network. Large transfers that require decentralized security will continue to take place on the original layer.
The final iteration for the Lightning Network will be the cross-chain atomic swaps, which will exchange crypto tokens between different blockchains without the need for a crypto currency exchange.
Benefits of the Lightning Network:
Transactions will take place on the Lightning Network channels and outside of the blockchain:
Fees will be minimal to non-existent for small payments like coffee, dinner, and local stores.
Quick transactions no matter how busy the network is. The transactions will be instantaneous and able to keep pace with Visa, MasterCard and Paypal.
Cross-chain atomic swaps will eliminate the need for separate crypto exchanges.
The Lightning Network can reach 1 million transactions per second.
If you want a perfect parallel to the mobile duopoly of Android and iOS, then it will be Web3. We began with artificial intelligence because by increasing GDP, AI/ML promises to be the technology that delivers the most gains in the public market’s history – far exceeding mobile. Yet, the blockchain offers a parallel to mobile as what layer one networks set out to achieve is very similar to what Apple’s app store achieved.
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. Butkin’s vision is to create an open network for decentralized applications (dapps) and smart contracts based on the Turing complete programming language Solidity. The takeaway is that just like Apple hosted apps on its operating system, Ethereum hosts d’apps on its network.
These three benefits are: decentralization, security and scalability. The issue is that most decentralized networks cannot offer all three without some compromise.
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. 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. Ethereum 2.0 must also replace Plasma with ZK Rollups, which allow for hundreds of transfers to be rolled into a single 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. (Read more in the resources below).
The takeaway: Ethereum has a wide lead in terms of number of d’apps and developers (remember that developers adopting CUDA created Nvidia’s moat). However, the Merge to Proof of Stake is an unknown which leaves the Layer One network market wide open for now.
Avalanche
Layer One Networks are considered early-stage tech investing which carries higher risk. Ethereum clearly has a head start, and after the proof of stake merge, we could see the network take off in a meaningful way.
However, there are other Layer One networks to consider. We hold an allocation in Avalanche due to it’s Ethereum Bridge, application-specific subnets, and the launch of a consumer-facing app over the next quarter. 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.
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.
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.”
Warren Buffet famously said: “The stock market is a device for transferring money from the impatient to the patient.” I believe Chainlink could be our best performing asset in our portfolio by 2030 as the middleware that enables smart contract through decentralized oracles.
Smart contracts are a more advanced use of blockchain where an exchange between two parties is automated based on conditional provisions. These self-executing contracts are written into lines of code, and the agreements contained exist across a distributed, decentralized blockchain network.
Smart contracts offer a more complete use for blockchain. First discussed in 1996 by Nick Szabo, some claim that smart contracts are the real use case for blockchain as they aim to automate financial transactions, and in the future, can automate machines.
We have written extensive deep dives and webinars on what the company does but for those who would rather get the elevator pitch, it’s this: Chainlink is the most likely candidate to become the Google of Web3. In fact, ex-Google executives are joining Chainlink as strategic advisor, former CEO Eric Schmidt, new Chainlink Chief Product Officer, Tensorflow’s Kemal El Moujahid.
We are very bullish on Chainlink and it was our first one-hour deep dive webinar for this reason. However, it requires a longer-term mindset, which we certainly have at the I/O Fund. Our goal for our position is sizable gains by 2025 with an exit in 2028-2030.
“Winners keep winning” is a reliable and true statement. We began this analysis by showing you a chart of how the world’s most valuable companies change every 10 years. However, there is an important caveat: tech overtook oil to become the world’s most valuable industry in 2010 and we have yet to see the pattern that tech sets in terms of how often the top 5 will rotate now that tech is in the driver’s seat.
Microsoft:
We were one of the first analysts to cover Microsoft Azure’s hybrid computing strategy and why that could narrow AWS’ lead in the cloud IaaS market. At the time, tech was selling off in Q4 2018 yet we were firm that Microsoft would emerge as a significant leader in this space by specializing in a mix of on-premise and cloud deployments.
Hybrid cloud allows for scenarios where customers can keep their most sensitive data on their own servers while sending workloads to the private or public cloud that gain an advantage from mining data more efficiently and requires improved accuracy and productivity.
Azure’s strength in offering both on-premise and cloud in a hybrid solution has prompted Amazon to chase Microsoft with recent efforts to improve its hybrid strategy. Today, Azure claims more than 95% of the Fortune 500 as customers because of its hybrid flexibility.
Azure growth of 46% is performing quite well given the tough comps it has overcome, and Microsoft’s best financial metric during this tech selloff is that commercial bookings increased 28% this quarter following 32% increase last quarter. I would look for Azure to remain elevated against AWS and Google Cloud for those two reasons – hybrid cloud leader which attracts large enterprises and its ability to reduce costs with its tech stack.
In our latest Q2 webinar, I discussed why reducing cloud costs is a key trend for 2022 and beyond. To put it simply, Sayta Nadella said in this quarter’s earnings call: “More value for less price means you win.” In the same breath, he also said: “Most businesses are not looking to their IT budgets or to digital transformation for budget cuts.” These two statements echo my first point in the Q2 2022 webinar which is that both are true: increase in cloud spending will continue and companies will want to lower costs associated with cloud.
That’s going to be the trick moving forward – which companies assist cloud migrations while lowering costs. Microsoft is the leader here as the company aggregates many cloud services and products under one umbrella which creates substantial leverage to undercut on price.
Microsoft is increasingly becoming a cybersecurity company, as well, with $15 billion in revenue and growing at a rate of 45%. Microsoft was careful to build a multi-cloud product and is the only Big 3 cloud vendor to be multi-cloud on security right now. This also helps to drive down costs for Microsoft’s customers.
There are additional catalysts for Microsoft beyond Azure’s winning streak, its large security footprint, and the ability to lower costs. The first catalyst is that Microsoft is setting up to own the edge through its telecom partnerships. Another catalyst is that when more enterprises adopt AI/ML, whether it’s automation, super computers and/or other use cases for training and inference, it will a natural decision to use Microsoft if they’re already optimized for Azure. As discussed, enterprises will drive forward the next major market in tech (AI/ML) and Tier 1/Fortune 500 will be the largest customers for AI/ML. Power Automate was up 72% year-over-year, surpassing $2 billion in revenue, and this is only the beginning.
Third, the company ranks with Nvidia and Unity for inroads to the Metaverse as it owns many gaming publishers now and is the most widely used VR headset (HoloLens). The company also has Teams to introduce Metaverse-like qualities to business meetings. It will be industrial that drives forward 3D worlds (not consumer) and Microsoft is auspiciously positioned.
We have been meticulously building our portfolio for the next FAANGs of 2030 since we launched the site in 2019 with the understanding that even getting 1 or 2 correct can create generational wealth. Our goal from the beginning has been to stick with our winners and to cut our losers and we have compiled quite a bit of research along the way.
Alphabet is a new addition to our portfolio and one we’ve been circling for some time. If the 2014-2022 era in digital advertising was known as the walled garden era primarily fueled by third-party data then 2022-2030 will be known as the brick walls of first-party data – meaning, publishers controlling their data become the trend that drives forward digital advertising as we move into more AI/ML-driven ads.
In fact, we are in the midst of what is the biggest shift in digital advertising since advertising went digital. The shift is due to Apple and other real estate owners shutting off how data is collected across mobile and desktop. In the mobile era, third-party data was rampant but all of that changed with the release of iOS 15.
Note: We were one of the top authors on this topic with coverage dating back two years before the change occurred on both Forbes and MarketWatch here.
Google will be following in Apple’s footsteps by changing how third-party data is collected on Android and Chrome. This will greatly strengthen the company as not only is Google an equal or greater real estate owner compared to Apple but the company is also a publisher for the purpose of ads with Search and YouTube. This means long-term ads placed on Google will be more effective and produce higher ROI than those with less signals to work with.
These data collection changes are coming just in time for the advantage from first-party data to be realized across AI/ML (with digital ads) and a myriad of other uses cases.
We’ve focused quite a bit on enterprise for the purpose of this article yet we want to acknowledge that consumer-facing tech carries strength in most macro environments.
We hold the following stocks to capture consumer-driven gains. Notably, we’ve covered in the past how supply chains are contributing to consumer spending and inflation. We are watching this closely for when growth in this area rebounds. You can access our research on this here.
Roku: Netflix made it into FAANG and CTV ads will be a bigger market than subscriptions – primarily CTV ads will do well globally. Roku must prove its hardware strategy will pay off in global markets starting with LatAm.
Snap:: This company has had a brutal month – yet audience metrics have been strong post-Covid and the Gen-Z/Millennial concentration is important to take note of.
Shopify: This company is spending an unknown amount on the fulfillment center yet can rival Amazon simply through unlimited distribution channels. Social commerce will eventually take off despite the setback from Apple’s iOS changes.
Twilio The Twilio management team is known to be visionaries and they are pivoting into an API-forward marketing platform with strong PII data – they are early to API-driven automation taking over marketing and advertising.
Conclusion:
Thank you for taking the time to read this report. Despite tech being one of the most volatile sectors in the market, it is also the most rewarding. Had you entered Apple between 2008-2010, it would have blown away all other positions in your portfolio across all other industries. The same goes for a Facebook or a Google position. Half the battle is finding them, which we think we are particularly well suited for, and the other half of the battle is knowing which stocks to sell and which ones to hold when the tide rolls out. We show you how we do this with real-time trade notifications plus a hedge for ample insurance during drawdowns. There are many positions we own today that we will own in 2030 with the goal of perfectly timed exit. We are patient and thorough in our research as we acknowledge and accept that approximately 5 companies will lead to 90% of our wealth in 10 years.
