SentinelOne continues to be the strongest cloud stock on the top line. This earnings report did not disappoint on the top line with 109% revenue year-over-year of $78.3 million compared to consensus of $74.64 million. ARR was up 110% year-over-year to $339 million. Customer count with ARR over $100K also outpaced revenue growth at 131% increase. Net retention rate grew to 131% which is above the 130 line.
The company is expecting growth of 109% at the midpoint for next quarter with $8 million coming from the Attivo acquisition. My notes have analysts expecting $84.83 million so if we add the $8 million for $92.83 million, the company is beating those estimates (consensus would have been for 103% growth including Attivo). Organic is expected to be in “the low to mid 90%” range, which reflects a raise from the 85% consensus for Q2.
The company raised full year organic revenue to “the midpoint of 80% range” up from the previous guidance of 80%. The full year guidance was raised to 98% including Attivo for revenue of $405 million. The company stated Attivo would contribute $30 million to full year revenue (although one analyst felt the math was off and has Attivo contributing $35 million). Previously, organic revenue growth was guided at $368 million for FY2022 with analyst consensus slightly higher at $370 million.
To SentinelOne’s credit, the company offers clear communication about margins. It’s one of the few companies where the CEO will discuss this at the onset of the opening remarks.
Per the analysis on compartmentalizing cloud stocks here, we went into the earnings report wanting to see an improvement in operating margin. The company was expected to report (86%) to (84%) Non-GAAP operating margin and provided a beat at (73%). This is up from (127%) last year for an expansion of 54%.
The GAAP operating margin remains an eyesore due to stock-based compensation at (115%) of revenue, up from (165%) in the year-ago quarter.
SentinelOne demonstrated strong improvement in gross margin from 51% in the year-ago quarter to 65% in this quarter. It’s up 2 basis points sequentially and up 15% YoY and is the highest GM for the preceding four quarters.
The one thing that could have weighed on the AH price action was the guide on operating margin for Q2 being (75%) to (73%) – as the critical point here for SentinelOne is that the full year guide management has provided for two quarters is for Non-GAAP op margin for FY2023 to be (60%) to (55%). Even though Q1 was a beat on Non-GAAP margin, the path to delivering on the guidance becomes a bit obscure the longer we remain above this level.
The reason we’ve accepted the weaker (albeit improving) margins is that the company is working towards being FCF positive by 2025 and is not likely to raise cash before this occurs. Any change to this would cause us to look at our thesis again.
The company expects to improve adjusted gross margin to 69%-70% and if we assume similar GAAP percentage as this quarter, it would be about 66% GAAP GM for FY2023.
Singularity Cloud was the company’s fastest growing module, growing over 50% sequentially.
Management focused on the strength of their MITRE Attack results with 100% protection, 100% detection, 100% real-time protection, 99% visibility, 99% analytic coverage. I’m sure we will hear Crowdstrike’s response to this on Thursday 🙂
One analyst asked about the European segment and management stated there is a wholesale movement away from Kaspersky either by choice or by mandate and this is a tailwind for them. Secondly, the Broadcom-VMWare acquisition is favorable for them as they are now capturing CarbonBlack business. In terms of taking business from these two vendors: “We expect that to accelerate in the quarters to come.” I’ll expand more on this when I get the transcript.
“Will SentinelOne be able to provide a meet/beat on operating margin in the upcoming quarter and a meet/beat for the full year guide? This must happen and we also need revenue to remain strong.”
SentinelOne’s operating expenses were front-end weighted last year with Q1 being the steepest operating loss and the year getting progressively better (nearly 100% improvement on weak numbers).
If last year is any guide, then SentinelOne is capable of meeting their full year guidance of (60%) to (55%). The company did beat its operating margin guidance this quarter and revenue was strong including key metrics.
I continue to believe the key to this stock is the ongoing revenue strength and its ability to prove to analysts and institutions that it’ll generate cash by 2025. Due to Crowdstrike being a close comparable, it’s likely SentinelOne can (and must) follow in Crowdstrike's cash efficient footsteps, which is what the market will want to see. The product continues to prove itself as exceptional and there was evidence of this in terms of high ARR customer growth, beat/raise on revenue, strong growth on cloud product, and we are likely to see nice movement in the identity product soon. We are keen on SentinelOne's ability to standardize multiple areas of cybersecurity and to do so at a high MITRE ranking.
Despite the red AH on the stock, I see no notable issues with this ER from my perspective.
MongoDB carries a bit of nostalgia for our team as it was one of the first stocks we covered after launching the premium site in July of 2019. At the time, there were concerns DocumentDB would rival Atlas yet Amazon had declared Atlas the segment winner at the open-source conference OSCON that month.
The company reported revenue of $285 million compared to estimates of $267 million for a $18 million beat. This represents growth of 57% and is the highest growth rate since Q3 2019. Particularly, it proves MongoDB can accelerate post-Covid which is rare among its peers.
The company had a sizable beat on adjusted EPS of $0.20 compared to estimates of ($0.10) EPS, which was a ($0.30) beat. The company’s adjusted operating income was $17.5 million compared to a loss of $2.8 million in the year ago quarter.
On a GAAP basis, the company reported EPS of ($1.14). Notably, GAAP losses increased this quarter to ($75.9) million compared to a GAAP loss of ($61.4) million in the year ago quarter. This is due to stock-based compensation expenses of $91 million with shares increasing from 61 million to 67 million over the past 12 months.
Gross margin expanded from 72% in the year ago period to 75% for gross profit of $214.3 million. The company stated this was due to increased efficiencies in Atlas. The company has $1.8 billion in cash and cash equivalents of which $456 million is cash. The company’s cash flow this quarter was $8.4 million, which is down from $16.8 million sequentially. Operating cash flow was $11.6 million compared to $22.3 million last quarter which management explained is partly because Q4 has more days than Q1 for consumption.
MongoDB is estimating a $30 to $35 million headwind. With that said, MongoDB reiterated guidance for the full year at $1.18 billion which would imply the company had expected to beat by $30 to $35 million. Management is also forecasting a $4 to $5 million headwind for next quarter yet was still able to raise guidance from $277 million expected next quarter to $279 million-$282 million provided as new guidance. The headwind of 1% sequential growth this quarter came from slower-than-expected customer growth in self-serve and mid-market channels in Europe yet could spread to impact all geographies.
The earnings guide for next quarter is for adjusted EPS of ($0.31) to ($0.28).
As we had covered three years ago, the MongoDB story centers around Atlas. This was the fourth quarter of over 80% growth and it now comprises 60% of revenue compared to 51% of revenue in the year-ago quarter.
There were ample questions about why MongoDB was able to weather the weakness in consumer-facing businesses better than Snowflake. The management feels they are more insulated because their consumption is tied to the value and usage of the applications and databases are not something that can be shut on, shut off or moderated by choice.
Here is the exact quote:
So the people are not using their application, something has gone wrong. So the more they use the application, the more value they’re seeing. So there’s a direct correlation between the value they get from the apps running on MongoDB and the value we get from those customers. Other software companies that you mentioned, I think are being forced to consider alternatives to be because there’s a trend where there’s a slight mismatch between price to value because as they suck in more data, it’s not completely clear how much incremental value that data is providing. So we don’t see that problem.
Probably the biggest contrast between Snowflake’s call and MongoDB’s call was that Snowflake noted a slowdown in a few of their biggest customers while MongoDB noted only a slowdown in their self-serve and mid-market. MongoDB also emphasized they are well diversified with six times more customers than Snowflake “tens and tens of thousands of customers” and due to representing more industries.
Conclusion:
We had stated the following:
“As stated above, MongoDB’s cash flow margin is what can keep the stock strong given stock based compensation is weighing on GAAP operating margin. We want a meet/beat on revenue, strong Atlas growth (bonus for acceleration) and we must continue to have a healthy, positive cash flow margin.
Analyst consensus has MongoDB reaching profitability on an adjusted basis by calendar year 2023.”
MongoDB proved they can become profitable on an adjusted basis in calendar year 2022 so that’s a plus. The company maintained its cash flow positive status. There were beats and raises alongside conservative guidance, which was really the ticket this quarter. It was easily the better report over Snowflake primarily because Snowflake has begun to concern analysts that the exposure to consumer could cause the company to become discretionary (more information is needed beyond one quarter). Meanwhile, MongoDB clearly illustrated this quarter its document databases are not discretionary.
Maintaining focus can be really tough when the market is penalizing tech stocks across the board. How do we determine which ones to trim/exit and which ones to add/enter? Despite it being counterintuitive, usually the best entries are made when the market is in a state of fear.
My first instinct is to protect our stocks with the highest allocations with a few of these certainly in the cloud category. I am less concerned with near-term price action and much more concerned with how the fundamentals mesh with the current macro environment. If a company has a strong report (AMD, Datadog) then I don’t stress market moves as fundamentally these companies are showing strength. It’s not an investor’s job to control the market or change positions based on 6-month price action. That’s why we haven’t changed positions such as AMD or Datadog. I’m using them as an example because they already reported.
The I/O Fund is positioned for an ad-tech rebound in H2. We’ve published quite a bit on this. We understand this requires a bit of speculation and we have been keeping our members up to date on this over the past few months with this research here and here. Ultimately, ad-tech valuations are well below the median in 2018 and 2019.
Strong growth in ad-tech is often awarded a 10 Forward EV to Revenues. The bottom line can fluctuate depending on how much a company is investing in growth, yet rarely does ad-tech have cash flow issues at scale. Snap and Roku are certainly at the scale where the path to profitability has been proven. Ultimately, we believe there is alpha here due to the market over-reacting to macro which is why we own ad-tech positions. There are many more ad-tech positions than the ones we own for investors to consider.
This analysis goes over cloud as what happened last Friday to Bill and Cloudflare caused me to shelf a deep dive on ad-tech post-earnings in favor of a cloud overview of our holdings. Many cloud companies have not been public during a rising rate environment (2017- early 2019). With the FOMC decisions being out of a tech investor's control, we have been forced to evaluate our cloud stocks to look for expanding margins and positive cash flow. There was some evidence last week that the market’s appetite for growth in this category has changed if the growth doesn’t contribute to the bottom line. I understand there is a relief rally today but my job this week has been to make sure fundamentally our cloud stocks can withstand macro pressure.
It’s true that cloud is deflationary but it’s also true that cloud can have profitability issues. As you saw last Friday, cloud is quite resilient in terms of growth, due to being deflationary, but those weak bottom lines may be questioned over time. Cash came easy over the past decade, and as cloud investors, we need to reframe our thinking on what constitutes an attractive cloud stock.
For long-term cloud investors that hold sizable allocations, like the I/O Fund does, I believe the following has to be answered:
1. Is there something inherent to the product that weighs on margins? If so, these companies have an additional hurdle beyond rising rates that must be resolved.
Cloudflare could fall into this category due to CapEx (something to monitor – we closed this position for now). The CapEx went from 9% in the current quarter to 12% to 14% for the year, and the market is likely assessing the cost it requires to become the fourth cloud provider.
Twilio falls into this category until Segment and other products can improve its core product gross margin (I believe it will and we will layer back in when it does). I expand on this more below.
2. GAAP operating margin versus Non-GAAP operating margin; this is where stock based compensation can affect a company’s GAAP profitability and companies that recently went public or had an acquisition often see an impact. There are also many cloud companies that invest their cash to grow rapidly, yet the leniency for “growth at any cost” may shift substantially.
3. Free cash flow is probably the most important in a rising rate environment for a sector that is often unprofitable and/or must spend heavily for growth. Below, we examine our top cloud holdings on the basis of their ability to become free cash flow positive.We need to recognize that the innovation cycle is such that venture capitalists exit through public offerings and there is often no path to profitability at the time a tech companies goes public. When you couple the historically loose FED policy we’ve had, it compounds the issue of figuring out which companies can become profitable and sustain in a slowing economy. Cloud will be put to the test the longer interest rates remain elevated and/or slated to rise, and I believe this will catch tech investors off guard because the sector has treated them so well. These relief rallies also do not help to distinguish which are fundamentally stronger as the price action reflects more of a rising of all boats.
Our Cloud Stocks
SentinelOne
SentinelOne is a company where we like the product very much. However, there is no denying that this company has weak margins albeit the margins are improving quite rapidly.
SentinelOne leads the cloud category in growth at 120% last quarter. In the previous quarter, SentinelOne accelerated to 128%, up from 121%. The company is expected to report $74.7 million in revenue for growth of 99.5%, assuming they come in at this number, that would be a deceleration in revenue.
Full year revenue is expected to be $370 million, up 80%. The 1-year forward for fiscal year 2024 ending in January is expected to be $605 million, up 64%. The main key metric that forecasts strong revenue growth is that ARR was up 123% year-over-year. This is a highlight from the last earnings report.
SentinelOne has a particularly weak operating margin of (108%) last quarter. The adjusted operating margin was at (66%) compared to (104%). The management guided for (85%) this quarter. The company emphasized this is improving with a full year adjusted operating margin guide of (55%) to (60%) for full year.
I believe this improvement in the guide is why the stock recovered after hours the evening of its earnings report. Will SentinelOne be able to provide a meet/beat on operating margin in the upcoming quarter and a meet/beat for the full year guide? This must happen and we also need revenue to remain strong.
We covered here in the Q2 2022 webinar how cybersecurity budgets are indicated to grow this year over 2021.
Management seemed to be quite sensitive to understanding this is key as it was the second thing they mentioned in the opening remarks:
I'm pleased to share that we ended the fourth quarter with double-digit year-over-year improvement in both our gross and operating margins. Our gross margins expanded 12 percentage points year-over-year, and our operating margin improved 38%. This progress reflects our growing scale and increasing efficiency.
The number of shares owned by institutions and the percentage of shares owned by institutions is also high at 92% (compared to Cloudflare at 80%). However, the number of institutions has declined by about 13%.
For SentinelOne, weighing on operating margin is also sales and marketing expenses at 64% of revenue and R&D at 65% of revenue. Compare this to Crowdstrike with S&M at 38% of revenue and R&D at 24% of revenue. To be clear, Crowdstrike has a better bottom line than SentinelOne. The operating margin has been at (10%) over the past few quarters and is at (5%) in the most recent quarter.
SentinelOne’s free cash flow has been improving but certainly needs work, which is common for a company that has not reached scale. The company reports cash flow of ($7.1) million improving from ($25.6) million in the same period last year.
SentinelOne has $1.67B in cash and the company burns about $400M so that’s three years. If we assume the margins improve, and the company reaches profitability by 2025 (analyst consensus believes this will happen) then the negative free cash flow should not hinder the stock. We had discussed why SentinelOne is similar to Crowdstrike at this stage of growth here.
Notably, last year, SentinelOne was weakest in Q1 and they’ve mentioned strong seasonality in Q4.
“The strength of our performance was broad-based, coming from a healthy mix of new customer additions, existing customer renewals and upsells. All of this was further magnified by the strong underlying seasonality of our fourth quarter.”All of this was further magnified by the strong underlying seasonality of our fourth quarter.”
Here was their comment about the upcoming Q1 quarter:
“Our ARR and revenue growth track very closely. Our revenue guidance for Q1 implies that we should be at or better than typical Q1 net new ARR seasonality, which has been down between 25% to 35% sequentially in the past 2 years.”
Here was our comment about Q1 following the last earnings report:
“Total ARR is nearing $300 million while annual revenue for the upcoming fiscal year 2023 is guided at $368 million, with ARR suggesting this guide could be easily met over the next four quarters. Most importantly, customers over the $100K range are growing at a rate that is double overall customer growth at 137% and 70%, respectively.
The overall customer growth represents a slowdown from 79% YoY to 70% YoY while larger account growth was fairly flat at 141% in Q3 to 137% in Q4.
The company guided for Q1 revenue of $74.5 million, compared to revenue in Q4 of $65.6 million. This is important because management has stated in the past, Q1 revenue was down sequentially by 20% to 25%. “Our revenue guidance for Q1 implies that we should be at or better than typical Q1 net new ARR seasonality, which has been down between 25% to 35% sequentially in the past 2 years.”
Notably, the I/O Fund is unable to track where the ARR was down “for the past 2 years” but the sequential growth is headed in the right direction. The numbers we have show Q1 FY2021, net new ARR declined 37% QoQ to $8 million yet in Q1 FY2022 it grew +8% QoQ to $30 million. This year, the sequential growth will be +13.5%.
Higher ARR sequentially for the upcoming Q1 is likely driven by the record number of 100,000-plus deal and a record number of million-dollar plus deals. International is another area of strength as the company saw revenue grow 140%. This represents 31% of revenue – so something to watch closely as a near-term driver.”
Takeaway: No changes to our position right now, if there is a meaningful change to operating margin, we will update you.
MongoDB
MongoDB had an acceleration in revenue from 50.1% in Q3 to 55.85% in Q4. The market rewarded this earnings report with an increase in price, moving from $280 to $338 on the report. At the beginning of April, the stock price was nearly flat YTD.
There was an acceleration in revenue for FY2022 to 48% year-over-year, up from 40% growth in FY2021. Looking forward, FY2023 revenue growth is expected to be 35% year-over-year.
Key metrics supporting future revenue growth include customers over $1 million in ARR growing 67% and customers over $100,000 growing 34%. Atlas customers outpaced total customer growth at 35% compared to 33% growth, respectively.
MongoDB has a 72% gross margin and GAAP operating margin of (29%) due to stock-based compensation, or a loss of $78.6 million. The adjusted operating margin is (0.49%) or essentially a loss of $1.3 million. The net margin is (32%) or a loss of $84.4 million with adjusted net margin of (2%), or a loss of $6.3 million.
With that said, MongoDB is cash flow positive. It needs to remain cash flow positive for the market to be confident in its valuation. I do believe where Cloudflare was penalized was the surprise to the downside in cash flow. This is a marked change to how the market treated cloud companies in the past.
MongoDB has $474 million cash on its balance sheet with operating cash flow of $22.3 million and free cash flow of $16.8 million. This represents a free cash flow margin of positive +6%. The company holds $1.2 billion in debt.
The difference between MongoDB’s GAAP EPS and Non-GAAP EPS is primarily due to SBC. Here we have a forward GAAP EPS of ($1.22) and Adjusted EPS of ($0.10). Overall, MongoDB has improved it’s adjusted EPS as it was typically in the ($0.20) range.
MongoDB’s catalyst for growth is Atlas, which we covered in a deep dive here. We also covered how this company fits into our Big Data and Analytics positioning here. We are more likely to hold a cloud stock that falls into the Big Data theme and/or cybersecurity due to seeing evidence of growth in these markets. Primarily, Microsoft pointed towards the following trends in the recent earnings report, which we covered here:
Starting in September, we began to position for Big Data, Analytics and ML. Microsoft has grown their Cosmos database (DB) transactions and data volume by 100% year-over-year for the third quarter in a row. Synapse data volume has also doubled. Monthly machine learning inference requests increased 86% year-over-year. for Big Data, Analytics and ML. Microsoft has grown their Cosmos database (DB) transactions and data volume by 100% year-over-year for the third quarter in a row. Synapse data volume has also doubled. Monthly machine learning inference requests increased 86% year-over-year.
As stated above, MongoDB’s cash flow margin is what can keep the stock strong given stock based compensation is weighing on GAAP operating margin. We want a meet/beat on revenue, strong Atlas growth (bonus for acceleration) and we must continue to have a healthy, positive cash flow margin.
Analyst consensus has MongoDB reaching profitability on an adjusted basis by calendar year 2023.
Snowflake
Snowflake is seeing a deceleration in revenue yet is reaching adjusted profitability this year.
The company is expected to report revenue of $412 million, representing growth of 80%. The previous quarters the company reported revenue growth of 101% in Q4, 109% in Q3, and 104% in Q2. For the fiscal year 2023 ending in January, the company is expecting revenue growth of 67% for revenue of $2.03 billion. Analyst consensus shows revenue of $3.17 billion, or growth of 56% for fiscal year 2024.
There has been an outflow of institutional shares since December with a 30-day change from 330 million shares to 305 million shares.
As Snowflake continues to grow revenue, the losses are narrowing. When the company reported roughly $300 million revenue, the GAAP operating losses were around $200 million. The company is now reporting a little over $400 million in revenue with GAAP operating losses of about $150 million. What you don’t want in this environment is an inverse relationship to where losses increase as revenue increases.
Snowflake is steadily improving its margins from 58% gross margin a year ago to 65% gross margin in the recent quarter. The company has improved its GAAP operating margin from (90%) a year ago to (40%) in the recent quarter. The company has a positive adjusted operating margin of 5% and has stated they will end the year with a positive 1% adjusted operating margin. They have to deliver on this promise to maintain a category-high valuation.
Revenue grew 64% to $126 million and customers over $100K grew 41%. Analyst consensus on revenue was for $127.4 million. The company reported EPS of (0.19) and analysts were looking for (0.20).
However, free cash flow for Confluent is a blemish at ($58.4) million, or 46% of revenue. Adjusted operating margins are at (41%) and GAAP operating losses of (88.4%). Adjusted gross margin is 69.7% with employee bonuses and employee stock purchase plans hurting the operating margin. FCF is to be the lowest in Q1.
Confluent has cash and marketable securities of $2.0 billion with cash of $1.05 billion.
Adjusted operating margin is expected to be (38%) on revenue growth of 44% for FY 2022.
We all know how the market feels about those margins right now – Confluent was not alone in the AH bloodbath.
On a positive note, Confluent Cloud is ripping at 180% YoY growth. This has led to RPO accelerating to 96% YoY. The company signed an 8-figure deal that was not recognized in Q1. Cloud net retention rate is 150%.
Analysts on the call were excited about the net new add in customers and the company reiterated its goal of positive FY2023 operating margin.
Note: We believe the negative free cash flow margin is too steep for Confluent to be a high conviction company at this time. We very much like the Confluent Cloud growth and will look for the more normalized growth rate once it scales. If Knox asked me where to raise cash in cloud, I would choose Confluent although we do not have all earnings reports yet.
Datadog was down after putting up a solid report and we bought a small tranche following the earnings report.
The company beat and raised on all accounts. Customers over $100K grew were up 54%, growing from 80% of revenue to 85% of revenue. The company also said the magic words: “36% free cash flow margin” in Q1 with a TTM cash flow margin of 28%. Free cash flow (FCF) grew from $250 million in Q4 to $335 million in Q1.
The company was expected to report 70% revenue growth and instead reported 83%, with revenue up 11% sequentially. Guidance also impressed at $378 million at the midpoint, or 62% growth. That should be enough to keep Datadog in the top 5 on forward growth in the cloud category. FY2022 guidance raised to $1.61 billion for growth of 56.4% at the midpoint, up from $1.53 billion.
They said the other magic words which is that “dollar based net retention rate continued to be over 130% as customers increased their usage and adopted newer products.” During covid, this DBNRR wouldn’t be as meaningful as many cloud companies were at the 130 mark but Datadog proving itself best-of-breed here by maintaining this level for 19 consecutive quarters.
Datadog’s strength is cross-selling or standardization, which we’ve covered in detail. Number of customers using 2 or more products increased to 81%. The company signed its largest contract in terms of ARR (they said it was 8-figures with a next-gen fintech company). There were examples on the call of customers consolidating monitoring tools from 5 products to 10, and from 1 product to 6.
Notably, on top of accelerating revenue growth YoY from 51% in Q1 last year to 83% in Q1 this year, Datadog also improved operating margin from 10% to 23% in the current quarter.
Note: Datadog is the strongest cloud company on the market if you look at the relationship between the top line and the bottom line.
Twilio
We covered Twilio pre-earnings here and also post-earnings here on the forum. We ultimately trimmed our position due to the reason stated post-earnings: “Analysts asked if increased costs in core product could affect gross margin and/or user fall-off. This comment is probably the most concerning to me. Lots of questions on Gross Margin, which the main concern being any fluctuations here if there's pricing pressure from telcos.”
Ultimately, we will layer back into Twilio when we see the software business help to sustain the gross margin.
Here is what was asked on the call:
Michael TurrinMichael Turrin
Gross margin saw a meaningful improvement sequentially. The prepared remarks still referenced just some near-term fluctuation potential. Just in sort of adding some more context around that. I guess the question is just why wouldn't that be at least somewhat bottoming if we're looking at sort of a point in time where U.S. growth is moderating? Some of these 10DLC impacts are playing through. Are you at all comfortable that gross margin can at least remain around a similar ZIP code regardless of our messaging mix plays through? Or anything else you could just provide to help us think through normalization of what these fluctuations can look like?. I guess the question is just why wouldn't that be at least somewhat bottoming if we're looking at sort of a point in time where U.S. growth is moderating? Some of these 10DLC impacts are playing through. Are you at all comfortable that gross margin can at least remain around a similar ZIP code regardless of our messaging mix plays through? Or anything else you could just provide to help us think through normalization of what these fluctuations can look like?
Khozema ShipchandlerKhozema Shipchandler
Yes. That's a good question. I mean I think with respect to the gross margins in Q1, we are obviously happy with them improving to 53%. I think, Michael, the thing I'd encourage you to keep in mind is that just the size and scale of our messaging business is what tends to drive it. And so that's why we're kind of signaling some level of fluctuation in gross margins in the near term. I think it'll be in the ZIP code. I mean I'm not going to be prepared to call the bottom or anything like that. But I'd also remind you that we like the messaging business a lot. And while it does carry that lower gross margin, it also generates a lot of gross profits that we reinvest back into the business.And so that's why we're kind of signaling some level of fluctuation in gross margins in the near term. I think it'll be in the ZIP code. I mean I'm not going to be prepared to call the bottom or anything like that. But I'd also remind you that we like the messaging business a lot. And while it does carry that lower gross margin, it also generates a lot of gross profits that we reinvest back into the business.
If you go back to Q1 of 2020, Twilio’s growth rate in customers was about 23.5% from 190K customers to 235K customers. The most recent year-over-year growth was 14% from 235K customers to 268K customers. The company does not break out the growth rate but the presentations provide number of customers. This would imply some churn due to increased fees passed onto customers on the core product.
In terms of margins, the company guidance missed expectations at adjusted EPS of ($0.23) to ($0.20) compared to consensus of ($0.13). The forward growth of 27%-29% is to be expected during this pivot. I want to emphasize the management has been preparing for the core product to hit saturation essentially which is why we want to remain invested to participate in this management team bringing API-driven marketing to marketing departments. Twilio certainly is consumer-facing and thus what we are seeing with ad-tech affects Twilio, as well. This is unique from more deflationary cloud products at the enterprise-level.
Cloudflare
We covered Cloudflare this week for the free newsletter, which will hit your inboxes soon. The stock hit our stop and here is the main thing that drove our decision on fundamentals.
At the time the low-cost R2 cloud storage service was launched, Cloudflare’s CEO has stated “we’re aiming to become the fourth major public cloud.” Big Tech has the advantage of strong margins and quite a bit of cash on the balance sheet to build out cloud infrastructure. For this ambition to materialize, not only must Cloudflare build more Points of Presence (PoPs) but the company must also undercut AWS on egress fees, for example, in order to remain competitive.
In the current quarter, network capex was 9% of revenue. For the full year, the network capex is expected to increase to 12% to 14% of revenue. I believe this is a primary reason Cloudflare’s valuation could come under pressure.
Here is what the company said on the call:
I think the thing which is powerful about as we build out more POPs is that counterintuitively, because of the design of our network and because of the efficiency of our network that both Thomas and I just alluded to, it actually drives our cost down over time rather than driving it up. It takes a certain amount of servers in order to process a certain number of requests. So your CapEx is actually driven by the amount of usage of your service more than anything else.
What is powerful is because we have done the hard work on the networking and software side to make it so that any server, anywhere can handle any request, that means that as we continue to expand our network out that we're able to directly interconnect with the various ISPs and eyeball networks around the world and drive our cost down for things like bandwidth, co-location and other variable costs that are part of our business.
At this time, revenue growth is not an issue for Cloudflare as it’s been quite robust for many quarters. The company reported 54% revenue growth beating estimates by 6% with 49% growth expected next quarter. The company raised full year revenue guidance to $957 million, at the mid-range, for growth of 46%.
There is additional supporting evidence that growth is not an issue for Cloudflare, including remaining performance obligations (RPO) up 57% year-over-year and dollar based net retention up 400 bps YoY. Customers paying over $100K increased 63% year-over-year to 1,537. This outpaced total customer growth of 29%. Notably, the >$100K segment was a deceleration from 71% in the previous two quarters.
Large customers contributed 58% of revenue. There was solid growth in the >$500K customer base of 68% year-over-year growth and >$1 million customer base grew by 72% year-over-year.
The company has a gross margin of 77.80% but had a GAAP operating margin of (18.90%) and adjusted operating margin of 2.30%. The primary difference being stock based compensation which doubled to $34 million in Q1, up from $18 million in the year-ago quarter. The market has not been very friendly to companies diluting GAAP operating margins due to SBC, and we see evidence this may have impacted Cloudflare.
Similar to the note about network capex, the company is stating they will not see improvement to operating margin in the near term. I believe this could put pressure on valuation if cloud peers are able to improve operating margin during the current macro environment.
Here is what management said:
“We intend to grow our operating expenses in line with the revenue staying here or at breakeven and reinvest excess profitability back into the business to address the enormous opportunity in front of us.”We intend to grow our operating expenses in line with the revenue staying here or at breakeven and reinvest excess profitability back into the business to address the enormous opportunity in front of us.”
Free cash flow was negative $64.4 million (30% of revenue) in comparison to a negative $2.2 million (2% of revenue) in Q1 2021. Of this, $30 million was due to a unique withholding tax payment in the recent quarter. This would still show a marked decline in free cash flow from last quarter during a time when the market is especially sensitive to cash flows. The company reported positive free cash flow of $8.6 million in Q4 2021, and it was the first positive free cash flow quarter since the company became a public company. Management stated they will be cash flow positive in the second half of the year while the first half of the year will have negative free cash flow due to the investment in network and redesigning of physical offices post Covid-19.
The company had cash and available-for-sale securities of about $1.7 billion, out of which cash is $152 million.
Clearly, many investors like Cloudflare and the company is not without merit by any means. Rather, I can’t rely on cash flow improving in H2 and/or CapEx not rising beyond the current 12% to 14% to personally maintain conviction in the current environment.
For costs inherent to the product, my personal choice is Twilio as I can see the product road map a bit more clearly on Segment/software side and how this can expand the company’s gross margin.
Asana
Please note, Asana is a small 1% position and we covered the company’s financials here and the unexpected rise in expenses. We will update you on the next earnings report. We hold the stock because the product should be deflationary (more than most).
We are planning on entering Cloudflare (NET) as a momentum holding. Beth had recently written about Cloudflare’s product in depth here for Forbes, and a non-paywall version of the article is posted further below. We also posted on the forum here that we are considering both Bill.com and Cloudflare as momentum holdings.
What we really like about Cloudflare is the company’s ability to lower costs in the cloud by addressing Amazon’s AWS “Egregious Egress” fees, placing Cloudflare in direct competition with AWS. Since cloud will be a multi-year secular tailwind for growth, we believe that companies that can lower costs in cloud environments will outperform, and Cloudflare is positioning itself to significantly lower costs for its customers in the cloud.
Another trend highlighting the success of the company is its strong growth rate. Cloudflare just reported its fifth straight year of 50% or more topline growth. McKinsey found that companies that consistently(and sustainably) grow sales >50% CAGR vastly outperformed peers. The study found that >50% CAGR companies reported a 3-year rolling average total stockholder return of 22%, versus a 9% TRS for companies that sustainably grew at a 10-49% CAGR.
Cloudflare is also growing sustainably, evident by its improving cashflows. Free cash flow margin improved YoY from -19% in 4Q20 to 4% in 4Q21 and on a TTM basis, FCF margin was -7%, up from -21% in the year-ago period. Improving cash flows highlights that Cloudflare is not employing a "growth at any cost" model, rather the company is demonstrating leverage, and is actually reporting positive free cash flow while growing at over 50% YoY. Furthermore, cash flow growth is being driven beyond a rise in stock-based compensation (SBC) as SBC increased $34 million YoY in 2021, while free cash flow improved $49 million. It is a positive sign that cash flows are not being driven by higher rates of non-cash compensation expenses and are instead being driven by operating leverage as sales growth outpace expenses. This trend warrants a premium multiple.
Further highlighting the strength in Cloudflare’s topline growth is the improvement in deferred revenue, which is a forward-looking metric. As the name implies, deferred revenue will turn into revenue in the future, adding balance sheet support to future sales. Deferred revenue increased 112% YoY in Q4, its fastest pace of growth on record. Furthermore, deferred revenue has accelerated YoY for six consecutive quarters, further highlighting the increasing demand for its products as customers are increasingly paying cash upfront, a sign of strength. As shown below, deferred revenue has rapidly outpaced the growth in quarterly sales, and deferred revenue-to-three-month sales surged to an ATH of 60% in Q4. This trend suggests that future sales will accelerate, as there is relatively more pre-paid revenue stored on the balance sheet than in prior years. Looking forward, Cloudflare has relatively more support for future sales, which reduces uncertainty and warrants a premium multiple.
Following the company’s strong product positioning, consistent and robust topline growth, and improving financial performance, Cloudflare is priced at a premium valuation. Looking one year forward, Cloudflare trades at a 31x P/S multiple, which is the richest valuation in our universe of cloud stocks. This may appear odd, considering that the company is not expected to grow the fastest, nor does it report the strongest cashflows. However, the company is one of the best-positioned companies, benefitting from two massive secular tailwinds: cybersecurity and cloud. Furthermore, Cloudflare results are high-quality, as deferred revenue has outpaced sales growth for six consecutive quarters, and the pace has recently steepened. Finally, the company’s strong deferred revenue trends suggest that sales may accelerate going forward, which is at odds with forward estimates, which expect 2022 sales to grow 42% YoY to $932 million, a deacceleration from the 52% YoY growth rate in 2021accelerate going forward, which is at odds with forward estimates, which expect 2022 sales to grow 42% YoY to $932 million, a deacceleration from the 52% YoY growth rate in 2021. Nevertheless, the company’s rich valuation leaves little room for a misstep, and we will be monitoring this position closely, which is why we are allocating it to our momentum portfolio for now.
Below is a repost of Beth's Forbes article on Cloudflare
Cloudflare Stock: Ambitious Company Must Prove Its Valuation
The most exciting products and the most rewarding tech stocks on the market today are the ones that challenge Big Tech. This is because the market will often underestimate the ability of an agile team to disrupt the incumbents despite substantial evidence that this is exactly what the tech industry is built to do.
What’s remarkable about Cloudflare is how the company has leveraged its content delivery network footprint to simultaneously be a leader in application and website security, then to further innovate with Zero Trust security combined with SASE network connectivity, and more recently to leverage the elimination of egress fees for object storage to attract developers. The latter is the most exciting as Cloudflare has already proven its ability in driving down costs and will now take on AWS head-to-head.
However, in light of Cloudflare’s impressive price movement this year, the company is now priced to perfection. When looking at its peers with similar or higher growth rates, which we discuss below, Cloudflare could see a 35% cut in its price to 40X forward sales and the company would still be fully valued.
Below, we look at the products driving Cloudflare to trade at a higher valuation and whether it’s a valuation the company can sustain.
Cloudflare’s Core Products:
Cloudflare is a well-known company that owns a predominant share of the CDN market. Content Delivery Networks contain a cached copy of website content on multiple servers located across the world to help improve page loading times. When a person visits the website, it will provide the content from the server closest to the end-user, which helps increase the delivery speed of the content. When a website is hosted on a server in the United States, the person browsing the website from any part of the globe, like Asia or Europe, will receive the content from the nearest location instead of the server in the USA. The Fastly outage this year shows the prominence of these CDN providers to where one outage can create downtime for sites, such as Amazon, Reddit and the New York Times.
According to data from W3Techs, 81.2% of all websites that use a CDN or reverse proxy rely on Cloudflare. We had discussed in a podcast earlier this year that Cloudflare is strong in the small to medium-sized business (SMB) category and offers free entry-level services. The penetration among SMBs is one reason why Cloudflare has an estimated annual revenue of $648 million this year with over 1 million customers compared to the enterprise-focused Akamai at $3.48 billion with roughly 50,000 customers. The overall revenue is low for its high customer count compared to Akamai partly because of the free-entry level.
According to Intricately, the cloud Content Delivery Network market is expected to grow at a compounded annual growth rate of 28% between 2020 and 2025. Cloudflare has the highest number of customers (this data includes free users). As of June 2020, Amazon Web Services has the highest share among enterprise customers with Cloudflare is in second place. Among the SMB customers, Cloudflare is leading all the other players. Cloudflare also has a better overall rating when compared to Fastly and also compared to Amazon Web Services in the Gartner Peer Insights.
The company has a large free customer base. In addition to the benefit of converting the free base to paid services it can use the free base to test the features before they are launched.
The free user base was mentioned by management in the earnings call,
“One of our secret to success is our broad customer base that we have millions of customers, many of whom use our services for free means that we have an eager pool excited to test new features before they’re released.While traditional B2B companies have extensive QA team, we regularly ask volunteers from our community to be our earliest alpha testers. Our iteration cycles can then be extremely fast. And by the time a feature makes its production at one of our enterprise customers, it’s full of proof, having been through the paces under real network conditions.”
Cloudflare has built a large footprint, which means the company already owns a large portion of the TAM for CDNs. The 81% footprint is impressive but one could argue this leaves little room for growth. Cloudflare’s potential in a largely-commoditized CDN market will come from the “extremely fast” iteration cycle. There’s ample evidence the company can execute as it now owns a large portion of the application and website security market, especially for DDoS attacks (distributed denial-of-service).
Because Cloudflare has a large global presence of servers and data centers, it’s particularly well suited for analyzing traffic to determine security risks. The company is able to analyze and detect attacks by running a background program known as a daemon on every server in every data center. The scans are shared as threat intelligence among the servers in each data center without affecting the latency of the CDN.
Cloudflare is able to mitigate at optimal locations in the tech stack, for example at L4 inside the firewall or at L7 inside the reverse proxy with a 403 error page. The company is advanced at preventing L3 DDoS attacks, which targets network equipment and infrastructure. The benefit of having access to more of the stack for security purposes is that CPU consumption and intra-data center bandwidth remains relatively unaffected. It’s also autonomous so Cloudflare is not using manual employees for this process.
DDoS attacks are essentially bots that send millions of requests to overload servers and to shut down a specific website by targeting its IP address. Often times, these bots are run from devices infected with malware and operated remotely by an attacker. Cloudflare recently detected and mitigated a 17.2 million request-per-second DDoS attack, which was three times larger than any previous DDoS attack on record. This is two-thirds the average rate per second that Cloudflare had served in all of Q2.
DDoS is one example of what the company offers and certainly Cloudflare has other security and network offerings based on their large footprint. They can also cross-sell security and CDN customers with WAN-as-service, or Magic WAN, which connects office networks through the local area network. The company also offers application delivery controllers located centrally within a customer’s infrastructure for Layer 3 through Layer 7 security for applications and APIs.
Cloudflare’s Move into Zero Trust
Across Cloudflare’s security products, an important one to focus on moving forward is Cloudflare One, which is a Zero Trust network-as-a-service. Zero Trust is gaining increasing acceptance due to rising security threats from data not being stored in one place. Secure access service edge (SASE) is a cybersecurity concept that utilizes Zero Trust to identify users and devices to deliver secure access to specific applications or data. The need for this has grown due to remote teams as SASE allows policy-based security no matter where the user, application or device is located.
Zero Trust Security is built on the premise that no one should be trusted within or outside the network. In the traditional security systems, it is difficult to obtain access from outside the network while those located inside the network were trusted. With Zero Trust, these trust assumptions are removed with tools such as multi-factor authentication, giving access for a limited time and to also verify, authorize and to have a continuous check on all the data points that are given access.
In the earnings call, the company’s CEO assured that the company’s proxy infrastructure could be used for both reverse proxy and forward proxy. He stated, “but it turns out that it’s as easy to make the traffic flow one way through the pipe as it is to make it flow the other way through the pipe.” Its proxy has security features built-in and also has the capacity to increase customer’s traffic.
Earlier this year, the I/O Fund covered the launch of Cloudflare One, and the management’s belief in the shift from a traditional hardware-based security approach to a modern zero trust approach, and the company’s confidence to be a leader in making that transition.
Cloudflare One has been getting a good response from customers due to mitigating attacks and improving overall performance. On the earnings call, the company discussed a Fortune 500 pharmaceutical company which was using Cloudflare One that signed a $600,000 expansion deal to increase the total contract value to over $2 million. Another large European software company signed a three-year deal worth $600,000. According to October numbers, Cloudflare signed a social network company which has a contract value of more than $1 million annually. Another video conferencing company also moved to Cloudflare which has a contract value of about $8 million.
Due to the increasing hybrid work conditions, Cloudflare has announced new cloud firewall functionality for distributed environments to overcome the issues with traditional firewalls. The company’s rating on TrustRadius and also on capterra shows that it rates higher than Zscaler, which has also performed well in the market.
Cloudflare R2 storage
Cloudflare began to lead its cloud peers when the company announced its R2 storage product on September 28th, 2021. You can see the dark purple line start a sharp rise upward following the start of October.
R2 storage allows unstructured data to be stored without egress bandwidth fees, which are charged when developers retrieve data from a cloud provider like AWS. The egress fees are essentially a tax without any value. Markups are as high as 7900% in the United States region when calculating what AWS charges. This is an 80X bandwidth markup and was detailed here by Cloudflare’s management.
Eliminating egress fees with R2 Storage places Cloudflare in direct competition with Amazon’s S3. Cloudflare’s motivation is to win over developers and their loyalty.
In the words of Matthew Prince, “We want developers to keep developing, not worrying about their storage bill. Our aim is to make R2 Storage the least expensive, most reliable option for storing data, with no egress charges. I’m constantly amazed by what developers are building on our platform, and look forward to continued innovation as we expand the tools they have access to.”
Primarily, Cloudflare is hoping to attract developers for its Workers product, which is a serverless compute service for developers to build applications and deploy code at the edge. This removes the need for developers to maintain servers or spin-up containers. The cloud service provider (in this case, Cloudflare) provisions, scales and manages the infrastructure required to run the code. Cloudflare wants developers to choose them over the larger cloud providers because of their location at the edge. This is ambitious as most developers are accustomed to AWS, Google Cloud and Microsoft Azure, all three of which also offer serverless at the edge with plans to aggressively expand, such as AWS Lambda and its extension Lambda@Edge.
R2 Storage will help Cloudflare grow its addressable market and will help the company compete as a best-of-breed player in the trends towards multi-cloud. In response, Amazon has lowered prices by up to 31% but this may not be enough if Cloudflare plans to get rid of egress fees entirely. When Cloudflare announced R2 storage, the company’s co-founder and CEO, Matthew Prince, tweeted, “Why R2? Because it’s S3 minus the one most annoying thing: egregious egress.” The product will be launched soon and has a waitlist for customers.
Notably, the outcome from Cloudflare’s R2 Storage, and also the Bandwidth Alliance, which is a consortium of cloud providers who address bandwidth pricing issues, could end up forcing Amazon to drop its egress fees rather than lose customers. Also, as an investor, it’s not clear how much R2 Storage will contribute to Cloudflare’s top line considering the markup will be eliminated. Regardless, the market has rewarded the company for taking on AWS and my hunch is developers will support the cause regardless of AWS’s response.
Cloudflare has done well since its initial focus on the CDN and web security market, increased its TAM with Zero Trust Security, and now adds object storage as a way to attract developers for products like Workers. It is interesting to note that Amazon successfully grew by targeting companies that had good margins with a famous quote from Jeff Bezos, “Your margin is my opportunity.” Now, companies like Cloudflare are doing what Amazon did in its early days by toughening the competition. Amazon’s AWS is a profitable powerhouse, and if Cloudflare can disrupt this, it could be another game-changer for the company.
Financials
The market is excited about how Cloudflare has performed post-Covid as it’s clear the company did not need the one-time bump from 2020 as growth has been stable throughout 2021. Cloudflare decelerated in the most recent quarter — — but not by much; from 54% revenue growth last year to 51% revenue growth in the most recent quarter. The guide for next quarter is also a slight deceleration from 50% revenue growth last year to 47% this year.
The company’s revenue growth was partly helped by growth in large customers with annualized revenue greater than $100,000. We also noticed a similar trend of large customer growth in the last quarter. The company exited the 3Q with 1,260 large customers, a net addition of 172 in the recent quarter for 71% growth. The company had 132,390 paying customers, which represents total customer growth of 31% YoY.
Cloudflare has also demonstrated its ability to be profitable. The company reported break-even adjusted earnings per share, which beat estimates by $0.04. The gross profit margin improved to 78.2% compared to 76.3% in the 3Q 2020. Adjusted gross margin improved to 79.2% compared to 77.3% in the 3Q 2020.
Adjusted net income came at $1.4 million or $0.00 per share compared to an adjusted net loss of $7.3 million or ($0.02) per share in the 2Q 2021 and adjusted net loss of $5.8 million or ($0.02) per share in the same period last year.
Net cash flow from operations was negative $6.9 million compared to a positive $2.0 million for the 3Q 2020. The company had cash and investments of about $1.8 billion at the end of the quarter, including about $790 million of net proceeds from the convertible note issuance in August.
The dollar-based net retention was 124%, the same as the 2Q 2021 and higher than the 3Q 2020 that was 116%.
The company’s revenue guidance for the 4Q is $184 million to $185 million, represents an increase of 46% to 47%. The adjusted earnings are expected to be between ($0.01) to break even. The full year revenue guidance is $647 million to $648 million, representing an increase of 50% and adjusted earnings per share are expected to be between ($0.06) to ($0.05).
Valuation:
Cloudflare has an eye-watering valuation of 47X EV to 1-year forward revenue. As a tech growth portfolio, the I/O Fund is certainly not the valuation police as we often find our best winners carry high valuations if a company is executing against the competitors.
However, it’s the growth rate of Cloudflare that makes me question if this valuation is appropriate. In regards to Cloudflare’s high-valued peers, we see that Cloudflare has one of the lowest revenue growth rates at 51% in the most recent quarter and free cash flow isn’t a strong factor here either. As mentioned, the only other stock on our list carrying this 1-year forward valuation is Snowflake, which had nearly double the growth.
Cloudflare’s analyst consensus for next year is revenue of $886 million with 20 analysts providing estimates. This represents growth of 37.2%. The analysts covering the stock are modeling Cloudflare to be profitable next year with $0.02 EPS. At this valuation, investors should feel confident there will be a beat and raise to at minimum 50% growth although the data above suggests revenue growth must be in the 60% range to be in the top 10 for valuation.
Asana and Monday.com were both penalized by the market in Q4 likely due to a rise in costs and concerns that the WFH trend may be waning as employees return to the office. We believe that these concerns are largely overblown, but we decided to reduce our exposure to the space until the dust settles.
Nevertheless, Asana is a much stronger company today than it was a year ago, yet trades at a steep 30% discount relative to its valuation last year. For instance, annual sales growth has accelerated, and the company’s forecasted growth rate is higher than it was last year. Gross margin continues to improve and enterprise customer growth has outpaced sales growth. The market may be concerned about rising competition in the work productivity space, but Asana’s strength with enterprise customers should lead to long-term sustainable growth. We believe that the market is fixated on near-term headwinds from rising costs and is overlooking the long-term strength in Asana’s performance.
Q4 results and outlook
In Q4, Asana’s sales increased 64% YoY to $112 million, which beat estimates by 6%. For the year, Asana’s 2021 sales increased 67% YoY to $378 million. Looking forward, sales growth is expected to slow to 50% YoY growth in Q1, yet this was still 4% higher than initial estimates, and total sales for FY2023 are expected to grow 40% for the year. Despite guiding for 40% growth, which is very strong, it is likely that Asana’s guide is conservative. For example, last year, Asana guided for FY2022 sales to grow 37%, which was well below the actual growth rate of 67%.
Even if Asana’s 40% guide is conservative, it is still a top-ranking cloud stock in terms of growth. Asana also trades at a relatively steep discount compared to its valuation one year ago, which is odd considering Asana is much stronger than it was a year ago. For instance, FY2022 sales grew 8% faster than in FY2021 and management’s guide for FY2023 sales growth was 3% faster than this year’s guide for FY2022 (shown below). Despite the improvement in Asana’s growth, Asana’s forward P/S multiple has declined 29% YoY from 17x down to 12x. This may be due to a few reasons, such as rising competition and lower operating margins in a rising rate environment. I discuss these trends in more detail below.
Continuing down the income statement, Q4 gross profit increased 67% YoY to $100 million and gross margin improved 200 bps YoY to 90%, leading most cloud stocks and above Monday’s gross margin of 87%, its closest competitor. There are also signs of leverage, as sales and marketing (S&M) expense increased 66% YoY, or slightly slower than the YoY rise in gross profit. In fact, S&M expense relative to gross profit declined 40 bps YoY, marking the fourth consecutive quarter of improvement in sales leverage. On a TTM basis, S&M expense declined to 83% of gross profit. The chart below highlights the downward trend in this metric, which means that for each dollar of S&M expense that Asana spends, it leads to relatively more gross profits dollars, highlighting the sustainability in Asana’s sales growth. However, S&M expense did rise on a sequential basis, which appears to be a seasonal trend.
The above trend is important, as investors are likely concerned about rising competition in the work management space. It is notable that Monday.com’s TTM S&M expense-to-gross profit metric was 100%, meaning that all of Monday.com’s gross profit was recycled into S&M expense over the last twelve months. We believe that Asana’s S&M expense leverage relative to peers points to the company’s success with enterprise customers, which are stickier and have larger budgets. I discuss this trend in more detail below.
R&D expense increased 53% YoY to $61 million, G&A expense increased 112% YoY to $38 million. We need the 10K to fully understand the outsized increase in G&A, but note that the growth in the account will likely normalize in the near term, benefitting future earnings growth.
Operating loss was $87 million during the quarter, or -78% of sales, which was down from -75% of sales in the year-ago quarter. Non-GAAP operating loss improved YoY from -51% to -39%, but the difference was driven by stock-based compensation which is still a cost to shareholders.
GAAP loss per share was -$0.48, which missed estimates of -$0.40 and non-GAAP loss per share was -$0.25 which beat estimates of -$0.27. Looking forward, Q1 loss per share is expected to be -$0.35, which was steeper than the -$0.26 loss per share that analyst had originally expected. Investors were likely spooked by the unexpected rise in expenses, a trend I discuss in more detail next.
Rising expenses spooks investors
As mentioned above, Asana beat on the top and bottom-line, its sales guide came in above expectations, but its guidance for earnings disappointed. The rising expenses was top of mind during the Q4 call and when asked about what the company is investing in, CEO-founder Dustin Moskovitz explained that the company is focusing on two key areas: R&D and go-to-market.
The focus of Asana’s R&D investments are building out its work graph product, which helps it stay competitive with enterprises. Beth discussed Asana’s products in more depth here. CEO Moskovitz added that the company’s R&D investments are focused on “improving on and expanding functionality required by the largest and the most complex organizations” he explained further that “we're also investing in all the other things important for large enterprises, such things like making Asana accessible to all employees, improving our compliance capabilities and adding integrations for data loss prevention and e-discovery and scalability to really be able to serve these very large deployments with tens of thousands of people working together in one instance”.
Asana is investing heavily in R&D to land enterprise customers, a trend that we believe supports sustainable, long-term growth. Asana’s R&D investments are also paying off, evident in the strength with enterprise customers. For instance, customers paying >$50,000 increased 125% YoY to 894, outpacing the 64% YoY rise in sales and higher than the 92% YoY growth rate reported in the year-ago quarter. Furthermore, dollar-based net retention rate (DBNRR) for >$50,000 customers was 145% for the third consecutive quarter and was up YoY from 140%. Enterprise customers are growing faster than they were a year ago and they are spending more.
On the call, management added that there were 340 customers spending $100,000 or more on the platform and the company has been closing seven-figure deals recently, highlighting how not all >$50,000 customers are the same. As shown below, sales are increasingly being driven by business and enterprise customers (>$5k), highlighting Asana’s focus on larger customers, which requires more investments in product R&D.
The company’s billings were also strong, which are driven primarily by enterprise customers paying upfront. Billings increased 56% YoY to $131 million, or 117% of three-month sales. This was an improvement from the prior-quarter metric of 115% of sales and suggests that there is relatively more cash support for sales. However, the metric did decline YoY from 123% of sales. Nevertheless, a billings-to-sales metric above 100% signals that future sales will increase, a favorable trend.
The other area of investment is the company’s go-to-market strategy. Asana is ramping hiring to build its sales pipeline and increasing account marketing and customer engagement programs. The company added that they are also investing in customer success programs post-sales, which helps improve its retention metric, which was at a high of 145% in the current quarter for enterprise customers. Given the company’s strength in enterprise, investments in S&M are likely sustainable since enterprise customers are stickier, leading to better ROI relative to smaller customers.
As mentioned above, Asana has demonstrated it has leverage with S&M expense, which has improved relative to gross profit dollars over the last twelve months. Another measure of sales efficiency is the SaaS magic number, which looks at the annualized sequential change in revenue divided by the prior quarter S&M expense. The metric averaged .71 throughout FY2022, up from 0.63 during FY2021. The improvement in this metric suggests that the payback on Asana’s S&M spending is improving, albeit there is still room for continued improvement as the metric declined in the most recent quarter.
Despite the improvements in sales leverage and signs that R&D is leading to stronger enterprise lands, the market has favored companies with rising earnings today, and is discounting earnings growth in the future more heavilytoday, and is discounting earnings growth in the future more heavily. While this has likely contributed to the pressure in Asana’s valuation recently, the company is focused on long-term growth rather than near-term profitability, which we believe is the best strategy given the relatively early stages in the work productivity trend (shown below).
Thoughts on valuation, risks and conclusion
As mentioned above, Asana reported accelerating growth in FY2022 and is also guiding for stronger growth going forward than it did last year, yet the company’s forward sales multiple is down 29% YoY. Looking forward, Asana trades at 12x FY2023 sales or 29% below its 17x forward P/S multiple last year. Asana is guiding for 40% topline growth, which is robust and ranks in the top 10 of all leading cloud stocks. Importantly, this growth is entirely organic. Asana’s gross margin was 90%, which ranks top for cloud and highlights the premium that Asana’s products are priced at.
While the topline and gross profit metrics appear healthy, the company’s bottom-line may have spooked investors. Losses are expected to rise in the near term, and competition has been rising. For instance, both Monday and Asana reported that S&M expense had increased QoQ as a percentage of sales, potentially signaling that work productivity growth is getting more expensive. This is a trend we will be monitoring, but note that both companies are operating in a largely unpenetrated market (Monday stated on its Q4 call that 70% of sales had no competition). We reduced our exposure to both Asana and Monday largely due to this near term headwind, but believe that work productivity and WFH is a secular tailwind and we expect that growth will remain robust for the foreseeable future. In other words, we are likely early.
Another risk to Asana is the trend of workers returning to the office, which has led to a sentiment shift away from companies that benefitted from the WFH trend. However, we believe that hybrid work is here to stay and that there has been a fundamental change in how corporations operate as enterprises have increasingly become more digital. Even if employees return to the office, management explained that they do not expect a change in engagement.
CEO-founder Moskovitz explained on the Q4 call that “I wouldn't expect to see a change [as employees return to the office] because work management was something that was a rising category even before remote work hits. And we really see Asana as an essential platform to use, whether you're working in a distributed way or from an office. And even when you're working from an office, you're often also working in a distributed way because a lot of our customers work across many offices”
We expect the work productivity trend to continue to grow, benefitting from the structural change of an increasingly digital world. However, we have reduced exposure to this space following signs of rising competition and expenses but we may increase our exposure as sentiment improves. Importantly, we expect that the hybrid work trend will persist and that growth will remain robust for the category. We like both Asana and Monday.com, but believe that Asana is better positioned with Enterprise customers which is why we have kept exposure here.
With Q4 earnings drawing to a close, many high-performing technology stocks have been penalized despite reporting excellent results. With macro headwinds taking center stage, many investors are simply tossing high performers aside as they look to de-risk.
At the I/O Fund, we track numerous earnings reports from hyper-growth technology companies, and we believe that Snowflake’s most recent results position the company as a premier software firm. While there were some blemishes in the Q4 print that impacted near-term growth, the long-term story remains very much intact. In fact, key forward-looking metrics improved during the quarter, providing support for future sales and improving the quality of recently reported resultsquality of recently reported results.
However, there remains a difference between great businesses and great investments. Snowflake is a great business, but does its premium multiple pose a risk? In the discussion below, I outline Snowflake’s most recent results and what likely led to the recent the sell-off, followed by a discussion of key metrics that warrant Snowflake a premium multiple. Given the recent market volatility, I believe that there is upside in Snowflake’s valuation given a longer time horizon.
Snowflake’s Q4 Results and What to Look For in FY2022
The I/O Fund’s lead Tech Analyst Beth Kindig had previously released a deep dive on Snowflake’s product for free here. At this point, most would agree Snowflake is a solid tech product that promises to disrupt data warehouses by decoupling compute and storage, which reduces costs. Rather than focus on product in this discussion, I will instead focus on the company’s most recent financial results and its outlook going forward.
The key takeaway is that sales growth remains robust and high quality, however, the company’s consumption billing model can make growth lumpy in the near term. This is unique from subscription models in cloud because growth from consumption billings is non-linear: growth oscillates more than subscription models. Importantly, consumption billing is uncapped and can lead to stronger growth over the long term as customers find new uses for Snowflake’s platform and continue to ramp spending over time.
In the latest quarter, Snowflake’s Q4 product sales increased 102% YoY to $360 million, after increasing 116% YoY in the year-ago quarter. For the year, FY2022 product sales increased 106% YoY to over $1.1 billion. Despite the triple-digit revenue growth during the quarter, this represented the slowest pace of quarterly YoY growth since Snowflake went public. Considering Snowflake’s premium multiple (discussed in more detail below), the market was likely disappointed at a lack of acceleration in sales growth, which may have contributed to the recent sell-off.
Moreover, analysts had anticipated a slow-down in sales during the quarter and Snowflake still beat topline estimates by $10 million. Yet, this represented the smallest beat on record and was half of the $25 million beat reported in the prior quarter. As I’ll discuss in more detail below, management could have reported a larger beat by delaying product improvements and/or by liquidating RPO and deferred revenue. I believe that management’s approach to prioritizing long-term growth over beating near-term expectations should be applauded, and speaks to the quality of managementquality of management.
Looking forward, the company’s guide also came in largely as expected. In FY2023, product revenue is expected to grow 66% YoY to $1.9 billion, which was near the Street’s initial estimate of 67% growth. Since cloud is known for surpassing expectations, the in-line guide was likely viewed as a disappointment, contributing to the recent sell off.
The lackluster guide was due to customer-friendly product improvements instituted in the new year which lowered the costs of using Snowflake’s platform, but also lowered near-term topline growth expectations.
Importantly, the soft guide was not due to a lack of strong demand. Rather, management instituted customer improvements that are expected to be a near-term topline headwind (by lowering prices) but will ultimately lead to stronger growth over time as customers move more of their data onto Snowflake’s platform.
Essentially, the cost savings (which are crucial in the cloud, where data volumes grow exponentially) will lead to more volumes over time, leading to stronger growth in the long run. During the Q4 call, management explained that the process improvements made during the year are expected to reduce costs for customers, which is also expected to reduce FY2023 revenues by about ~$100 million.
Specifically, CFO Mike Scarpelli stated on the Q4 call that “throughout this year, we are rolling out platform improvements within our cloud deployments. No two customers are the same, but our initial testing has shown performance improvements ranging on average from 10% to 20%. We have assumed an approximately $97 million revenue impact in our full year forecast, but there is still uncertainty around the full impact these improvements can have.”
SVP of Product Christian Kleinerman added that “The more improving the economics of the platform, the more use cases come to Snowflake. So we’re looking at this with a very long-term view” and CEO Frank Slootman explained further that the change is expected to stimulate more demand and that “we’ve done this over-and-over and it does stimulate demand but it doesn’t do it in real time, there’s a lag involved in this processand it does stimulate demand but it doesn’t do it in real time, there’s a lag involved in this process”
Had management not made these process improvements, then its FY2023 sales guide would likely have been $97 million higher, and its guide of 66% YoY growth would have instead been close to 74% YoY, besting initial estimates. As mentioned above, these impacts are expected to be only a temporary headwind and will lead to stronger demand in the future. As I’ll discuss in more detail further below, the company’s forward-looking metrics support management’s claims that demand will remain strong going forward.
Continuing down the income statement, Snowflake’s Q4 adjusted product gross margin increased 500 bps YoY to 75%, while non-GAAP operating margin improved YoY from -24% to 5%. For the year, FY2022 adjusted product gross margin was 74% and non-GAAP operating margin was a loss of -3%. Looking forward, management expects FY2023 adjusted product gross margin to increase 50 bps YoY 74.5% in FY2023 and for adjusted operating margins to be positive at 1%. The market tends to award companies that are profitable with premium multiples, and Snowflake’s guide for 66% topline growth coupled with positive earnings warrants a premium multiple, in our view.
The company remains on track to meet its long-term guide for $10 billion in annual sales by FY2029 with 15% free cash flow margins. In fact, the company guided for 15% free cash flow margins in FY2023, driven by strong bookings. It is notable that Snowflake’s Q4 cash flows improved by $59 million YoY while stock-based compensation increased YoY by just $2 million during the quarter. Snowflake has kept its shareholder dilution under control and its fully diluted share count is expected to increase less than 1% in FY2023.
Despite the recent volatility in Snowflake’s valuation, we continue to believe that the company deserves a premium multiple. For instance, Snowflake’s growth is outsized relative to peers, adjusted earnings are expected to turn positive in FY2023 and cash flow growth is robust and is being driven by increased bookings, rather than excessive amounts of stock-based compensation. In the next section, I highlight a few more metrics that warrant Snowflake a premium multiple.
Trends That Support a Premium Multiple
As noted above, management is focusing on long-term growth by reducing costs for customers in order to attract more volumes. This process improvement led to a slight miss on the company’s guidance, and the company has been penalized for this decision. However, I suspect that the market is too fixated on near term growth and has largely ignored Snowflake’s high quality forward-looking metrics, which improved during the quarter and outweighed the near-term growth headwinds.
Below I outline key metrics that improved that I believe support a premium multiple for Snowflake:
Snowflake’s improving net retention ratio (NRR), which remains world-class;
Snowflake’s strength with enterprise customers, which are low-churn with large budgets;
Snowflake’s ramp in RPO bookings, which supports strong growth going forward;
Snowflake’s cash support for future sales, which improves the quality of its recent bookings and;
Snowflake’s demonstrated leverage, as sales and marketing expense continues to decline relative to revenues.
Snowflake’s customer metrics continued to improve:
Snowflake’s net retention ratio (NRR), which measures how much existing customers are increasing their spending on the platform, net of attrition, increased to a record high of 178%. Importantly, Snowflake states that customer spending ramps over time once they start using the platform, implying that there is a long runway of growth ahead of the company.
Looking forward, management stated that its NRR will likely normalize in the near term, but will remain above 150% in FY2023. On the Call, CFO Scaprelli explained that six of Snowflake’s largest 10 customers grew faster than the company’s overall growth rate, highlighting how customer spending is largely uncapped (unlike a subscription model). The company’s NRR metric is one of the strongest in its peer group, which supports a premium multiple.
Coupled with the strong growth in NRR, Snowflake’s enterprise customers’ growth accelerated, and grew 139% YoY, above the 128% YoY growth rate in Q3. Highlighting the strength in enterprise customer growth, CFO Scarpelli explained that the company closed seven deals at or above $30 million during the quarter, up from just one in the year-ago quarter, demonstrating how the below chart includes some very large customers.
The significant contractual commitments highlight the large budgets migrating towards Snowflake’s platform, suggesting that customer consumption will continue to grow in the future. Enterprise customers generally have low churn and have large budgets, and generally pay a portion of their contracts upfront. Snowflake’s strength with enterprise customers supports a premium multiple.
Increasing support for future sales:
Adding further support to the company’s growth going forward is the rapid rise in contractual agreements for future sales. Remaining performance obligations (RPO) represent contracted sales that will turn into revenue in the future. RPO bookings, which is the sequential change in RPO plus quarterly product sales, materially accelerated during the quarter. As shown below, RPO bookings surged by $616 million during the quarter to $1.2 billion, more than doubling quarter-over-quarter. The surge in RPO bookings provides contractual support for future sales, providing more visibility into future sales. Increased visibility into the future lowers uncertainty, and coupled with strong topline growth, supports a premium multiple.
Another important trend to watch is upfront cash payments for future revenue. Cash is king and being paid upfront is a sign of strength and highlights the strong demand for Snowflake’s products. Furthermore, being paid upfront improves the quality of bookings because receiving cash from customers is a sign that they are committing to the contract, which reduces the risk of cancellations.
We can proxy upfront cash payments by observing trends in deferred revenue. As shown below, deferred revenue has increased in-line with the growth in remaining performance obligations. Stated differently, the cash support for RPO implies that the recently reported surge in bookings isn’t just “fluff”, rather customers are committing cash to Snowflake’s platform for future services. Since it is better to have cash today than it is in the future, being paid upfront for future revenue improves the quality of future growth, which warrants a premium multiplequality of future growth, which warrants a premium multiple.
It is also noteworthy that RPO growth accelerated from 94% YoY growth in Q3 to 100% YoY growth in Q4, and deferred revenue growth also accelerated during the quarter. As mentioned above, Snowflake’s sales could have been more robust had management pulled from RPO and/or deferred revenue during the quarter. The acceleration in RPO and deferred revenue offsets the deacceleration in sales, to a degree.
Revenues have outpaced sales and marketing expense:
The last trend that I will highlight that supports a premium multiple is Snowflake’s demonstrated leverage. For instance, Snowflake’s sales & marketing (S&M) expense has declined relative to sales throughout FY2022. Management highlighted that its sales cycle with its customers can be very long, spanning up to three-years, and that customer spending usually needs time to fully ramp. Despite the long sales cycle and lag until customers have fully ramped spending, Snowflake’s S&M expense margin has improved throughout FY2022. Trends in S&M expense continue to demonstrate leverage, highlighting the sustainability of Snowflake’s growth, which warrants a premium multiple.
Discussion on Snowflake’s premium multiple
We have discussed several reasons why Snowflake is warranted a premium multiple. The company has grown sales over 100% in the current year, and growth is expected to be robust going forward. Furthermore, Snowflake has strong customer trends, has reported an acceleration in forward-looking metrics along with cash support, and has demonstrated sales leverage despite having an elongated sales cycle.
The market sell-off following Snowflake’s relatively strong results is likely the result of the company’s premium multiple being too high in the current environment. The market is likely simply rerating the multiples it assigns hyper-growth cloud stocks. Looking ahead, Snowflake trades at 30x forward sales, which is similar to other leading cloud platforms such as Datadog (29x), Zscaler (28x) and Cloudflare (33x). However, Snowflake is expected to report strong growth for the foreseeable future and its sales multiple based on FY2024 sales expectations is 19x, which is slightly below the peer median of 21x.
While there is uncertainty related to the cadence of Snowflake’s growth, management has provided a long-term framework that they expect to grow at a 36% CAGR through FY2029 and reach $10 billion in annual sales with 15% free cash flow margins. This guide should be discounted but does provide the Street with a baseline on how to model the long-term growth of the company. The market pays a premium for companies that it can easily model. It is also noteworthy that Snowflake is already guiding for 15% free cash flow margins in FY2023, well ahead of its FY2029 guide.
While Snowflake’s valuation has been volatile in FY2022, the key metrics outlined above support a premium multiple. The company trades in-line with its peers and starts to trade at a discount the further you expand your time horizon. We believe that Snowflake remains a premier company with a strong product and improving financials. If growth remains on track to management's long-term guide going forward, we would expect the company's valuation to recover going forward.
Conclusion
Snowflake reported strong results but there were a couple of small blemishes that impacted near-term growth. Long-term, the story remains intact and forward-looking metrics suggest that growth will remain robust going forward. The company is also expected to be profitable on an adjusted basis next year, cash flows are positive and the growth in cash flows is being driven by sustainable trends (and not just stock-based compensation).
The recent volatility in the company’s shares is likely due to its premium multiple coupled with a slight deacceleration in near-term growth. However, if management can continue to execute, then there is upside to its valuation over the long term. Forward-looking metrics such as RPO, RPO bookings, upfront cash receipts and enterprise customer strength (coupled with rising NRR), highlight the strong position Snowflake is in. Given the company’s product strength and positioning with large enterprise customers, I believe that Snowflake has been excessively penalized by the market.
Disclaimer: The I/O Fund owns shares in Snowflake and has no plans to change their respective positions within the next 72 hours. The above article expresses the opinions of the author, and the author did not receive compensation from any of the discussed companies.
In the discussion below, we provide an overview of our thesis on Shopify and an update on the company’s most recent earnings. We continue to believe that our thesis remains in play and that Shopify will continue to take share in eCommerce, a massive, long-term secular trend. However, temporary trends such as tough comps and rising costs have introduced near term uncertainty that has momentarily pressured Shopify's valuation. If we decide to trim our position, expect us to reenter fully allocated by Q2.
Here are our recent write-ups on Shopify that outline our thesis in more detail:
Important to our thesis is Shopify’s ability to scale, now that the company has achieved product-market fit. There is no better stock to hold than those that are in this stage as risk is low compared to reward.
Here is what Beth said in the 2019 analysis:
“Shopify has made it clear they are in the product-market fit stage and will scale between 2021-2023, as referenced in a recent investor presentation. Product-market fit is an exploratory stage where profits are not prioritized. Once product-market fit is achieved, the growth trajectory can move very quickly […]
The reason to stay long on Shopify, is that industries get disrupted and e-commerce is overdue for disruption. Amazon’s pay structure is not fair to merchants at 26%. eBay is stagnant in revenue growth for nearly 10 years (fluctuating between $8B to $10B).
Shopify is already the third largest online retailer in the United States and is doing one thing very well that the others neglect: emphasizing the merchant (whereas Amazon’s focus is the customer). I believe this piece to the product-market fit will carry Shopify through the hurdles of taking market share from one of Wall Street’s favorite darlings (Amazon).”
Here is the chart Shopify’s management provided in 2019:
Sales have rapidly scaled since 2019. For instance, 2021 sales were up 192% relative to 2019 levels, nearly tripling in two years. This is above the 2Y growth rate in 2019, which increased 134% relative to 2017. The acceleration in the 2Y growth rate exemplifies Shopify’s product-market fit and its ability to scale.
While there is near-term uncertainty related to forward growth, rising costs, and supply chain issues, we believe that our long-term thesis remains in play: that Shopify will compete with Amazon in eCommerce.
As long-term investors in Shopify, we are prepared to weather the near-term volatility because we believe that the company will be a juggernaut in eCommerce, a $5.5 trillion global market in 2022, which is expected to grow to $7 trillion by 2025.
In the article below, I discuss the near-term uncertainty that may have spooked investors, and also revisit Shopify’s fundamental outlook. I also review the company’s financials and conclude with a discussion about the company’s valuation.
Near term uncertainty is only temporary
Shopify is heading into a quarter with the toughest comps in its history, and gave the market an opaque guide, creating uncertainty. Furthermore, expenses have been rising, and Shopify’s high-margin subscription business is expected to grow slower than its merchant solutions segment. This reduced EPS expectations, which has pressured the company’s valuation. Importantly, these trends are temporary, which we discuss in more detail below.
Shopify reported results that beat market expectations, as both Q4 sales and earnings beat estimates. However, the company once again provided a qualitative guide that did not quantify its top or bottom-line expectations. This is the second year in a row that Shopify provided only a qualitative guide, which has increased uncertainty around near-term growth. While investors likely understood Shopify’s rationale for the qualitative guide heading into 2021 given the unpredictable dynamics around COVID-19 and vaccine rates, the market’s sentiment towards this has changed and the company is being penalized for this uncertainty.
With Q2 2021 representing the toughest comps in Shopify’s history (Q1 2021 sales grew 110% YoY, a record high), investors may be concerned that near term growth will slow. Unfortunately, Shopify did little to ease these concerns with its opaque qualitative guide during the quarter. Specifically, Shopify disclosed that its 2022 outlook “anticipates revenue growth for the full year 2022 that is lower than the 57% revenue growth achieved in 2021, but still rapid and outpacing the growth of eCommerce”. The company added that growth will be lower in H1 but improve in Q4. This opaque, back-end weighted guide likely led institutions to step aside due to the uncertainty heading into tough comps.
Taking a step back from the opaque guide, the company is still forecasting growth, albeit below its 2021 (and 2020) growth rate. Furthermore, the company expects to outpace the overall growth in eCommerce, implying that the company still expects to capture market share.
EMarketer expects global eCommerce sales to grow 13% YoY in 2022, down from the 17% growth rate in 2021 but only slightly below the 14% growth rate in 2019. More importantly, U.S retail eCommerce growth is expected to ramp in 2022 to 13% YoY growth, up from the 6% YoY growth in 2021 and above the 11% growth rate in 2019. The U.S. retail eCommerce market is Shopify’s biggest market.
Considering Shopify grew sales 47% YoY in 2019, the company’s 2022 growth rate may come in around that level (albeit slightly slower) if eCommerce growth is similar and Shopify continues to capture a similar level of eCommerce volume share.
Ultimately, capturing market share remains the most bullish aspect of Shopify’s story and management’s comments that they expect to outpace eCommerce growth is important to our long-term thesis.
Looking forward, the Street anticipates Q1 sales to grow 26% YoY to $1.24 billion. This would represent the slowest pace of YoY growth in at least the last five years, and is well below the five-year quarterly average of 66%.
In FY2022, sales are expected to grow 31% YoY to $6 billion, as sales are expected to ramp in the back half of the year. Assuming that U.S. retail eCommerce sales rise 13% YoY to ~$950 billion (as expected) and that sales as a percentage of GMV (excluding POS sales) remain constant YoY, the Street expects Shopify’s market share of U.S. retail eCommerce volumes to increase 170 bps YoY to 12%. This is equal to the 170 bps YoY expansion in its market share in 2021 but below its 270 bps expansion in 2020.
We think that the forward estimates may be conservative, and note that there is upside in its ability to capture market share, driven by the expansion of its fulfillment centers, key partnerships and investments in its growth.
In order for Shopify to continue to scale and take on Amazon, the company has ramped its investments in its fulfillment centers, with the goal of providing two-day shipping to 90% of the US population. However, this expansion will front-load costs and management stated that they do not expect to recognize the benefits of scale until ~2024.
Furthermore, management explained on the Q4 call that they expect 100% of their gross profit in 2022 to be reinvested into growth initiatives over the next few years, signaling that OpEx and CapEx will equal gross profit, which will limit earnings growth. Shopify also stated that it expects to hire more engineers than in 2021, “despite an exceptionally competitive market for top talent”. The expectations for a rise in expenses in the near term, during an inflationary environment, may have spooked investors during the quarter.
Moreover, management left analysts in the dark when questioned about the ROI and payback of its Shopify Fulfillment network (SFN) investments. Specifically, CFO Amy Shapiro responded to an analyst question about SFN payback by stating that “we're not going to get into the details of how we view payback ROI [for SFN]. But what we can assure you is, we've always been strong allocators of capital to the right opportunities to grow the various parts of the business at the right time, and this is no different”. As stated above, the market does not like uncertainty and the lack of commentary about the cadence of ROI on its SFN investments may have led some investors to step aside from Shopify in the near term, pressuring its valuation.
Despite the lack of commentary on the SFN ROI, we remain confident in management’s ability to deliver value to its merchants (and shareholders). In order to effectively compete with Amazon, Shopify needs to improve the convenience of shopping in its network, which starts with two-day delivery and its fulfillment network.
Furthermore, management has been prudent with their fulfillment network investments. In 2019, Shopify first announced its SFN, and in 2020 COO Harley Finklestein explained that the focus for SFN will be product market fit and added that “we want to ensure that the foundation of the fulfillment network is strong and the merchants’ experience is outstanding before we enter sort of the scale phase” (Q3 2020 call).
In the most recent Q4 call, CFO Shapiro added that Shopify is now entering the scale phase for the fulfillment center. She explained that “we are moving into a new phase in 2022 for building simple and fast fulfillment for our merchants. Over the next 3 years through 2024, our planned investments expand the merchant value proposition even more, including increasing 1-day delivery coverage in the U.S. and increasingly enhanced returns functionality. And we are planning to be able to handle progressively larger merchants with a broader set of needs as we build through 2024. When we launched Shopify Fulfillment Network in mid-2019, we said that we expected to spend $1 billion over 5 years. Through 2021, about halfway through the original asset-light plan, we spent $117 million, which includes funding cash operating losses and a small amount of CapEx.”.
Looking forward, Shopify will ramp CapEx related to Shopify Fulfillment Network, with $1 billion in capex over 2023 and 2024 for self operated warehouses. While the rise in capex transitions Shopify from a mostly asset-light business model to a moderately more capital intensive one, the costs have been well telegraphed to the market since 2019.
Furthermore, the investments in SFN should help improve Shopify’s ability to capture market share, potentially providing upside to future growth estimates.
We suspect that Shopify has been punished by the market due to its opaque guide and expectations of rising costs in an inflationary environment. However, we note that Shopify is expected to continue to capture market share in a massive $5 trillion global eCommerce market, and has a long runway of growth ahead of it. We believe that these are just temporary issues and that Shopify has proven it has product market fit. Forward estimates appear conservative and there is upside to growth expectations, considering Shopify’s commitment to improving its merchant network.
Another potential driver of topline growth will be the global expansion of Shopify’s reach. Shopify has partnered with JD.com, which allows its merchants to reach Chinese shoppers. The partnership with JD.com opens up the opportunity to expand into the biggest e-commerce market in the world. China has a population of 1.4 billion and 52% of all retail sales in China in 2021 were transacted on eCommerce platforms.
Notably, we had stated in our 2021 analysis that partnerships like these are key for Shopify to take market share from Amazon when we cited international growth as a key strategy: “Globally, Shopify has a better chance of penetrating various regions as the merchants (and lack of walled garden) localizes the content and offerings. There is also stigmatism towards Big Tech globally and Shopify works quietly in the background while letting the merchants remain in the spotlight. This will be popular globally […] we see global as an important piece to our thesis as merchants who want to reach global audiences will likely choose Shopify over Amazon. We think this is an important competitive edge.”
According to Shopify President Harley Finkelstein, “China's eCommerce market is estimated to be worth $3.3 trillion by 2025. That is 5x larger than the U.S. market. This channel integration opens up the China market to our merchants who can now reach JD's 550 million active users … This integration removes barriers to one of the most important e-commerce markets and is a major step in solving cross-border commerce for our merchants”
According to the press release, Shopify merchants in the US will be able to begin selling in China in three to four weeks, well below the 12 months typically required for foreign brands to begin selling in China.
The JD.com partnership follows numerous other partnerships, such as Alipay, social media companies such as TikTok, Facebook and Spotify and CTV leader Roku. In this way, Shopify is using Amazon’s weakness against company, which is that it’s too large and too dominant to make an attractive partner. Amazon also competes with many of these platforms in various ways due to its broad reach, while Shopify has instead focused on partnering with other platforms and is intently focused on eCommerce.
These partnerships represent a value-add for merchants and prospective merchants, giving Shopify an advantage over competitors. At this point, an entrepreneur looking to sell products online is likely to choose Shopify for the reach the company offers, as well as the tools Shopify is frequently releasing (such as SFN, Shop Pay, etc).
We also believe this adds to the flood gates of distribution plus more strength on being omnichannel. We wrote about this here.
While there may be near term headwinds from an uncertain guide, rising costs from SFN and supply chain issues, we believe that Shopify’s product market fit in a massive market and its relatively low penetration rate position the company to outperform in the long run. In the next section, I discuss the company’s most recent results and its valuation.
Shopify’s Q4 results and valuation
In 2021, Shopify’s growth remained strong, driven by the 46% YoY growth in Gross Merchandise Volume (GMV). GMV is an indicator of the success of Shopify’s merchants and the overall strength of its platform, and Shopify’s sales are directionally correlated with growth in GMV. Shopify is also a platform with high margins, however margins were a bit thin in this earnings report as the company has ramped investments in the near term to sustain its growth. Importantly, we believe that these headwinds are only temporary and that Shopify’s margins will improve as the company continues to scale its platform. Furthermore, due to Shopify’s product strength, we believe that GMV growth will continue to be robust going forward. I discuss this below.
Shopify’s Q4 sales beat estimates by 3% and increased 41% YoY to $1.4 billion, after increasing 94% YoY in the year-ago quarter. Q4 Sales were driven by merchant sales, which increased 47% YoY to $1 billion. Q4 GMV increased 31% YoY to $54 billion and was $175 billion for the year, up 47% YoY from $120 billion in 2020. As mentioned above, Shopify has captured about 10% of U.S. eCommerce retail sale volumes and has leverage to continue to capture more share as it scales.
Subscription sales increased 26% YoY to $351 million during the quarter, which was the slowest rate of growth in the last five-years. The deacceleration in subscription sales was driven in part by a change in accounting treatment as app and theme sales recognition were changed from being recognized on a gross basis to a net basis, which lowered Q4 subscription sales by ~2%. Subscription sales were also impacted by a tough comparable base period, as subscription sales accelerated to 53% YoY growth in Q4 2020. Monthly recurring revenue grew 23% YoY to $102 million, representing a CAGR of 41% since Q4 2016 and highlighting the long-term strength in Shopify’s subscription sales.
Gross margin declined 140 bps YoY to 50%, which was below the five-year average of 55% and was driven by the outsized growth in merchant solutions, which is lower margin. On a segment basis, subscription gross margin declined 32 bps YoY to 78% and Merchant solution gross margin fell 16 bps YoY to 41%.
Operating margin was 1%, marking the 7th consecutive quarter of positive operating profits while adjusted operating income was $130 million in Q4, down from the $200 million in the year-ago quarter. Management explained during the Q4 call that the decline in profitability was driven by an acceleration in investments and hiring trends. Non-GAAP EPS was $1.36, down YoY from $1.58 but bested estimates by 4%.
The balance sheet remains in good shape with over $8 billion in cash and $1 billion in long-term debt as of December 2021. Merchant advances increased from $244 million in Q4 2020 to $471 million in Q4 2021. These advances help merchants scale, but also introduce risks of impairment.
While there are risks with these advancements, impairments have been low to date and Shopify has advanced over $3 billion since 2016. This program illustrates Shopify’s commitments to merchants, helping them scale and compete with larger brands. Shopify also introduced an ERP program in 2021 to help high-volume merchants further scale their operations. Shopify’s focus on the merchant is different than Amazon’s approach of being focused on the customer. We believe that this differentiated focus helps Shopify compete with Amazon and allows the company to expand globally while operating largely in the background.
As mentioned above, management provided an opaque guide and stated that sales will continue to grow rapidly in 2022, but will be below the 57% YoY growth rate in 2021. Merchant Solutions revenue is expected to grow twice as fast as Subscription sales driven by a higher attach rate as merchants use more of Shopify’s solutions, such as SFN and new features such as Shopify Markets. Management also explained that a change in its revenue share agreement on the first $1 million in app and theme sales will be a headwind to H1 subscription sales.
For the year, FY2022 sales are expected to rise 31% YoY to $6 billion, which we estimate implies a 170 bps expansion in its U.S. eCommerce retail market share. However, there is upside to estimates with the company’s buildout of SFN, its global partnerships and investments in growth initiatives which should help the company continue to capture more market share.
Shopify currently trades at a 17x P/S ratio, which is 32% below its five-year median of 25x and 59% below its three-year median of 42x. Looking forward, Shopify trades 14x 2022 sales, which appears cheap for a company that has averaged 66% topline growth for 20 quarters and has 50%+ gross margins. Relative to other cloud platforms, Shopify appears to trade in-line with peers. For example, HubSpot and Shopify both trade at a 14x forward P/S multiple and grew sales 40%+ YoY, while Adobe trades at a 12x forward P/S multiple but is growing at half the rate as Shopify.
Notably, Shopify is a cloud platform with high margins, so the company has been awarded a premium multiple by the market. We believe that Shopify has clearly demonstrated its product-market fit, and is best positioned to compete with Amazon in the long run, which warrants a premium valuation in our opinion.
Moreover, Shopify’s total market cap is $85 billion, and it operates in a massive $5 trillion eCommerce market. Shopify has captured just 10% of the U.S retail eCommerce market, with plans to continue to expand globally, highlighting the long runway in front of the company.
Moreover, management’s decision to reinvest all of its gross profit back into the business over the next few years is a sign that the company also believes that there is a large opportunity in front of it. As Shopify continues to scale, it has numerous levers to pull to ramp sales and earnings growth in the future. While there may be near term uncertainty embedded in Shopify’s valuation, we expect the company to continue to outperform in the long-run and capture market share. As a result, expect us to remain allocated in Shopify through the volatility.
We recently purchased Upstart as part of the momentum portfolio, and we plan to hold it into strength. The company is well known and had a breakout year in 2021. I provide a brief summary of the company’s business model, what we like about the business and key risks.
What does Upstart do?
Upstart is an artificial intelligence (AI) cloud platform that is used to facilitate loan originations. The company uses over 1500 variables in its AI models, which allows its platform to underwrite superior loans with higher approval rates, lower interest rates and lower default rates for consumers compared to legacy lending approaches.
Upstart was founded in 2012 by a Google technologist, Dave Girouard, who worked at Google in 2004, when the company was quickly scaling. Upstart originated its first loan in 2014 and its AI platform more accurately prices risk for unsecured consumer loans, and has now expanded into auto loans. In 2021, 69% of its loan were fully automated, which helps facilitate more loan volumes. Increasing loan volumes strengthen the company’s AI models, improving its competitive moat and giving it a larger lead relative to competitors. Being the first mover in tech is often the most important aspect of the story, and Upstart has a large advantage with its relatively long history of repayment data that will be difficult for competitors to replicate.
Lending is critical to the US economy, and between 2014 through 2021, commercial banks lent out over $16.5 trillion in loans. However, the pricing of these loans has largely relied on legacy methods invented before the emergence of cloud computing and modern data science. A study by Upstart found that four out of five Americans have never defaulted on a loan, yet less than half of them would qualify for the low rates that banks offer. Furthermore, there are enormous amounts of data points available for lending decisions, such as payment data, banking transactions, employment history and educational background. It is a natural progression for cloud computing, AI and machine learning to be applied to lending, given its massive scale and legacy approach.
Revenue model and opportunity
Upstart is a platform for loan originations, its not a bank. Furthermore, the company partners with banks, it does not compete with them like other Fintech companies. The company’s revenues come from fees from originating loans on its platforms that are paid by its banking partners. These fees accounted for 91% of revenues in 2021. Importantly, Upstart’s revenues are low risk and 94% of its sales have no exposure to credit risk.
Revenues are primarily usage-based, and rising loan volumes contribute to rising revenues. As shown below, 2021 was a breakout year for loan volumes, which increased to over $4 billion in Q4 2021. Volumes have primarily been from personal loans that are used to refinance high interest credit card debt for consumers. For example, in Q4, Upstart originated 495,000 loans for $4.1 billion, or $8,300 per loan, and the personal loan market is large, estimated at nearly $100 billion.
The company has fully scaled into personal loans and has now expanded into new markets, such as auto loans. In Q2, the company purchased Prodigy, which expanded its addressable market in auto loans. Management expects auto loans to grow through 2022, which will weigh on its contribution margin in the near term until the company reaches scale, which it expects to do faster than it did with personal loans since it now “has the playbook down”. Beyond auto loans, the company expects to expand into Mortgages in 2023, a massive market at nearly $5 trillion.
What we like about Upstart:
There are a few key aspects of Upstarts model that we find attractive:
– Flywheel effect: Upstart has first-mover advantage, which has allowed it to amass more repayment data and improve its AI models. Its models benefit from a flywheel effect as repayment data leads to improved accuracy of risk pricing, which results in higher approval rates and lower interest rates, which leads to increased volumes and more repayment data. Upstart’s conversion rate, or the number of loans improved per inquiry, increased to 24% in 2021, up from 15% and 13% in 2020 and 2019, respectively. As its AI models improve, its conversion rate should also ramp, increasing volumes and giving the company a significant data advantage.
– 94% of sales have no credit exposure: Upstart is a platform for banks, the company is not a bank, nor does it compete with banks. It offers a marketplace for loans and charges a platform fee and generally does not own the loans. Even if it's 6% of credit exposure defaults, Upstart's high margin earnings can absorb it. The loans it carries are for R&D purposes (discussed below), meaning that its credit exposure should decline going forward.
– Upstart is highly profitable at scale: Loan volumes soared 338% YoY to 1.3 million and total sales increased 264% YoY to $849 million. Contribution margin increased 400 bps YoY to 50%, adjusted EBITDA increased YoY from 13% to 27% and GAAP EPS soared to $1.73. Cash flows from operations increased to $168 million and co-founder-CEO Dave Girouard explained on the Q4 that “We generated more cash in 2021 than we burned in our entire eight-plus years as a private company”. CFO Sanjay Datta added that “the natural profitability of [our] overall model will trend to its equilibrium direction, which we believe is higher than where it is today”
– Upstart’s customers, banks, are outperforming: Upstart's partner banks are doing really well. For example, Customers Bancorp was its first bank partner and Customers' funding form landing page includes a URL link to upstart.com (https://customersbank.upstart.com/funding_formupstart.com/funding_form). Customers Bank was the 2nd largest PPP lender, despite being a relatively small bank, and is a strong lender in personal loans. The company’s partnership with Upstart has likely allowed the company to outperform. Furthermore, high levels of deposits and liquidity levels following the COVID relief programs has created a unique environment for bank lending, and loan demand has been increasing.
– Market opportunity is wide open: Upstart is currently in personal and auto loans. It can expand into the following credit markets: credit cards, mortgages, student loans, small business loans, point-of-sale loans and HELOC. Lending is one of the largest markets ($16T loans since 2014) and is still primarily based on legacy models developed before the cloud era.
– Room for continued improvement: Conversion rates are still relatively low at 24%. As AI models improve from increased repayment data, the conversion rate will rise, leading to more volumes. Also room for continued improvement in fully automated approvals, which were at 69% of total loans.
– Outperformed during COVID: Upstart disclosed in its 10k that during the peak of the COVID pandemic, 5.6% of Upstart’s borrowers had enrolled in a hardship program, less than half of the rate of online industry benchmarks. Furthermore, 95% of these borrowers exited the hardship program and resumed repayments. The COVID-19 pandemic provided valuable data for Upstart, further improving its models and likely also improving the confidence lenders have with its AI powered models. Prior to COVID, Upstart’s models had not been tested during market turmoil, so it was unclear if its AI models were superior. The pandemic may have been an inflection point for the company that proved that its models worked.
Risks:
– Significant customer concentration: Two customers accounted for 83% of total revenues. High exposure to two customers naturally increases the risk of an investment. Furthermore, customer concentration from these two banks increased YoY from 81% of sales in 2020 to 83%. Upstart's largest customer is Cross River Bank, which originated 55% of 2021 loans for the company and also accounted for 56% of fee revenue. Cross River Bank is a partner to many fintech companies and is a conduit between Upstart and institutional investors that will ultimately buy its loans. As a result, the high customer concentration is not as concerning since its actual customer base is much broader. Furthermore, Upstart's reliance on Cross River Bank has been reduced and its second largest customer increased from 18% of 2020 sales to 27% of 2021 sales.
– Cyclical market: Lending is inherently a cyclical market that is impacted by economic strength. If lending stalls, Upstart’s growth will also stall. However, the company is a technology company and while it may be impacted by short term cyclical trends, it is a long-term secular change to the entire industry that should outperform over time.
– Credit exposure to sales has increased from 3% of Q2 sales to 6% of Q4 sales: Upstart is not in the business of collecting interest income, but a portion of its sales come from holding credit risk (loans). Loans carried on its balance sheet increased YoY from $78 million to $252 million in Q4 2021. Management explained on the Q4 call that the large increase in loans was for R&D purposes, as it expands into auto lending. CFO Datta explained that “Most notably, auto lending has been funded since inception entirely from our own balance sheet. This is, as always, a temporary incubation period until we reach the point where the loans can be directed to our bank partners and institutional investors at reasonable scale, which we anticipate will begin to happen next quarter”. However, in the company’s 10K, it disclosed that only $50 million of its $252 million in loans were auto loans; it is unclear why the company holds an additional $200 million in loans on its balance sheet. We will want to see Upstart’s loan balance decline going forward. Luckily, loans >90 days past due are low at just $287,000, so credit impairment risk is low.
Disclaimer: the I/O Fund owns a beneficial ownership in Upstart. The I/O Fund did not receive compensation for authoring this article from any of the discussed companies,
Below, we do another overview of Confluent’s product and an update following the Q4 earnings report. Here are two resources we recommend reading from our premium site for more information on the company.
We believe open source with enterprise-grade features will become a key market moving forward as it solves for the downside of open source such as a lack of technical support. In Kafka’s case, the downside are things like a lack of data verification and having to manually connect to various data warehouses and other platforms to import/export data. Confluent also makes the argument that multi-cloud and hybrid cloud architectures are best served with a supported enterprise version for multi-tenancy security and data residency.
Notably, from my perspective, we are not betting on Confluent being used over the open-source version of Kafka in a direct competition, rather we are betting that Kafka will increase in importance. In this case, if Kafka continues to grow, Confluent will take a percentage of this market share should more enterprises prefer a managed version of Kafka. 70% of the Fortune 500 use Kafka and 80% of the Fortune 100. According to this site it has a 12.5% market share.
Kafka is popular because of its high-performance real-time data streaming capabilities for mission critical applications. It is distributed and fault-tolerant, which means if one component fails, the system will still work. It can also scale to hundreds of clusters and billions of messages.
As discussed in our original write-up, Kafka was developed at LinkedIN to process the large number of messages per second the social media company handles. The framework enables event streaming, which helps messaging and data integration. There is high scalability with a publish/subscribe model that allows applications to share and create data in a serverless and microservices architecture. What Kafka solves for is the ingestion of events data in real-time with low latency with continuous read/write. If data remains at rest and/or in a mainframe environment, then companies cannot be truly data-driven. Kafka on the other hand can scale from a billion messages per day to a trillion messages per day.
Machine Learning and Kafka
Confluent opens up the amount of data that can integrated. The thesis is the increase in the number of companies that will need real-time data processing and real-time data analytics due to the increase in software driven architectures. The idea is that “data in motion” will replace data at rest, or batch data processing from traditional databases. This is also important for the real-time data streams that machine learning requires.
Kafka is more than a messaging system as discussed in this article and is used for business applications, streaming ETL middleware, real-time analytics and edge/hybrid use cases for the framework.
Here are some examples of how Kafka can be used outside of messaging systems:
Fraud detection through a machine learning pipeline for Paypal’s billions of messages
Data correlation in real-time for Lyft for matching maps, estimated time of arrival and cost calculations
Unity uses Confluent to be internally data-driven across R&D and cloud-services, plus to help drive the monetization network by rewarding players for watching ads and incorporating banner ads
Continuous calculations for betting platforms
Drug discovery that is automated and scalable
Machine learning requires model training from historic data and also model deployment for scoring and predictions. Training can be done with batch yet scoring is partial towards real-time data. ML-powered applications run inferences on large volumes of data to return predictions very quickly (milliseconds). Rather than use Remote Procedure Calls (RPC) and frameworks like gRPC, some companies use a Kafka streaming model.
Here is how the company states the problem that Confluent seeks to solve:
“By becoming more software driven, more businesses will rely on real-time data. Confluent believes that data in rest is not able to meet the current and future demands of software-driven businesses. Daily batch processing and static real-time queries or “point-in-time” queries with stored data lead to an unnecessarily large and tangled architecture that is not capable of data flow between applications.”
Enterprise-grade Features
As with Spark and other open-source projects, there is a marketplace for making the frameworks easier to use. Confluent Kafka opens up the amount of data that can be integrated, for example, to combine transactional data (orders, inventory) with sentiment-driven data (likes, page clicks). This helps with predictive analytics and also machine learning because the “data flow” allows for algorithms to work as they are intended to.
In order for data to be in motion, Confluent’s platform connects data from many different sources. The company has over 50 fully managed connecters with Big Data and Analytics from Azure, Amazon/AWS, Google and Databricks. Without these connectors offered by Confluent, integrations between systems on an open-source framework can take months and also require intensive resources to manage.
Confluent is attempting to stave off competitors through “completeness of product” which touches on our multi-cloud and hybrid cloud discussion. We’ve discussed hybrid for a few years, yet our most recent write-up was here and here on Datadog. The recent write-up is worth a read if you want to know exactly why agnostic, best-of-breed products are sometimes outpacing Big Tech when it comes to cloud services and products. Datadog is the best example of a product where customers are avoiding vendor lock-in.
The completeness of product goes beyond multi-cloud and hybrid as Confluent is attempting to hold off competitors through data security and data governance, as well. Because data is often an organization’s most prized asset, it often has internal processes for compliance. There is often external, geographic compliance required by governments and industry agencies, as well, for global companies.
In order for completeness of product to work, Confluent needs to have a large geographic footprint. The company has added eight more regions for Confluent Cloud with an emphasis on APAC. There is also a new partnership with Alibaba Cloud. This can help offer differentiation for multinationals who have operations in China.
Competitors:
Regarding direct competitors, one example is Amazon MSK which offers a competing managed streaming service. This competitor is a good option for developers provisioning a Kafka cluster and a new streaming platform may not be needed in this case.
Rather than re-architect Kafka to be cloud-native, Amazon MSK cloud-enabled it as provisioned infrastructure. This means Confluent is stronger than MSK with scaling elastically by offering elastic quotas, which eliminates the need to size clusters for spikes. It’s also stronger on multi-tenancy security. Amazon MSK also does not offer Kafka Connect or Kafka Streams.
For more enterprise uses where Kafka Connect or Kafka Streams is required, then Confluent is more likely to be used to save development time and learning curve in writing Kafka Connects sinks and source.
Blockchain and Metaverse Potential
We’ve written at length about Confluent’s core use. However, there is a blockchain potential with Confluent with one case study right now with Dapper Labs.
“These are steps that attracted Dapper Labs. They're one of the most innovative NFT companies delivering fun and games on the blockchain. They have a number of decentralized apps, but one that's risen dramatically in popularity is called NBA Top Shot. To date, there have been over 10 million digital collectible transactions and Confluent is at the center of their data streaming architecture to facilitate these purchases. Dapper chose us to run their mission critical workloads because of the scalability and security of our cloud solution.”
There’s also a case for 5G networks needing data in motion. Here’s what was said about Dish on the call:
“A significant customer for both AWS and us is DISH Network. With their new 5G smart network, DISH is transforming how people and enterprises leverage data. They deployed Confluent Cloud over AWS to connect their network systems and customers with real-time data. This means that Confluent is a key part of their network's data backbone, starting with fault management and network resiliency functions to ensure network availability, and our enhanced collaboration with AWS is making it easier for customers like DISH to unlock data in motion everywhere.”
Confluent Q4 Overview
Confluent has been accelerating in revenue for four consecutive quarters and also across other key metrics.
The company reported fiscal year 2020 revenue growth of 58% year-over-year and fiscal year 2021 revenue growth of 64% year-over-year. Confluent Cloud revenue growth for fiscal year 2020 was 117% compared to FY2021 revenue growth of 200% year-over-year.
If we look at Q4, total revenue is outpacing the fiscal year growth for 2021 and also outpaced Q3. Revenue growth for Q4 was at 71% — the highest growth rate from publicly available information which dates back two years to Q1 2020.
Cloud revenue did decelerate on a sequential basis, however, the company stated Q4 is often seasonal due to engineers being out of the office and on vacations. We will see if this picks back up in Q1. Regardless, on an annual basis there was a significant improvement. Notably, if we look at 2020 cloud revenue, we can see it’s lumpy at times with Q3 2020 being the weakest and Q2 2020 being the strongest.
In regards to “sandbagging” which is essentially the company guiding low and blowing out the guidance, which has happened a few times now, the company has a lot of moving pieces in terms of business model and likely wants to win trust with institutions. We are not opposed to this even if it means the price action was somewhat severe after the earnings report due to the guidance. What we are more concerned with is that Confluent continues to raise and beat, and that the underlying key metrics help us to substantiate the company’s longer-term strength.
Bradley stated the following in our last write-up and got pretty close to the revenue growth that Confluent actually reported:
Looking forward, management guided that Q4 revenue will rise 55% YoY $109 million, which would mark a deacceleration from the most recent growth rate of 67% YoY growth. However, this estimate is likely conservative, as management guided that Q3 sales would grow 46% YoY to $90 million and actual Q3 sales grew 67% YoY to $103 million. If we assume that Confluent beats it guide by a similar amount in Q4 as it did in Q3 ($13 million), then Q4 sales growth will accelerate to 73% YoY (this is merely an observation – no guarantees).If we assume that Confluent beats it guide by a similar amount in Q4 as it did in Q3 ($13 million), then Q4 sales growth will accelerate to 73% YoY (this is merely an observation – no guarantees).
Most notably, the company is reporting high remaining performance obligations growth of 91% year-over-year. This is higher than the 75% year-over-year we saw in Q3.
Confluent also states that RPO is an important metric to monitor in order to measure the health of the sales pipeline. In Confluent’s first conference call as a public company (Q2), CFO Steffan Tomlinson explained that:
“Given the various revenue components and billing terms in our model, remaining performance obligations or RPO and current RPO rather than billings, are important metrics to measure the health of the business. RPO provides insight into the organic momentum of our business as it represents contractually committed revenue to be recognized in the future regardless of billing terms and variability in cloud consumption pattern”. RPO provides insight into the organic momentum of our business as it represents contractually committed revenue to be recognized in the future regardless of billing terms and variability in cloud consumption pattern”
Financials Deep Dive
By Bradley Cipriano
A slight blemish during the quarter was Confluent’s customer growth, which lagged the growth in sales. Customers increased 65% YoY to 3,470, which lagged the 71% YoY growth in total sales. This drove subscription revenue per customer up 4% YoY to $31,000/customer, implying the recent acceleration in sales was driven by higher spending rather than customer growth.
Generally, growth from new customers is more sustainable and higher quality relative to growth from increased spending. However, DBNRR remained robust at over 130%, signaling that customers are increasing their spend over time.
It is odd that customer spending increased but cloud growth deaccelerated during the quarter. Since cloud is a usage-based revenue model, increased spending should have driven cloud outperformance. However, cloud spending slowed from 245% YoY growth in Q3 to 211% in Q4. On the Q4 call, management explained that cloud was impacted by seasonality due to relatively lower spending over the holidays which lead to slightly slower rates of usage. While this may be true, it doesn’t explain the YoY deacceleration, as this trend would have existed in the year-ago quarter. Nevertheless, there is inherent variability in a usage-based model so investors should not expect an acceleration in sales every quarter.
Given the slowdown in customer growth and slight deceleration in cloud sales, the Street may be concerned that Confluent’s growth may be somewhat cannibalistic. This would explain the sell-off in its stock following otherwise strong results which reported a beat and raise. Investors may be wondering if cloud growth is coming at the expense of platform growth, or vice versa?
CEO-Founder Jay Kreps discussed this concern on the call and stated that the company is growing both in the cloud and in hybrid environments. He said that “we don't really view this as kind of a transition where we're just shifting from platform to cloud and just kind of swapping out customers from one product to the other. Effectively, we have to have kind of an outpost in each environment a customer is in. So, we expect to continue to see growth in Confluent Platform throughout this, and we think that's not a bad thing. That's a good thing.” CFO Steffan Tomlinson added that “what our customers are telling us is, by and large, they're running hybrid environments”.
A common issue with ramping cloud sales is that sales in other parts of the business stagnant, but we do not believe this is the case. For example, Confluent’s financial results remain high quality which suggests that cloud/platform sales are not cannibalistic.
For example, net deferred revenue (deferred revenue less accounts receivables) increased 105% YoY to $109 million, or 31% of TTM subscription sales. This was an improvement from the 26% and 23% level in Q4 2020 and Q4 2019, respectively. The rise in net deferred revenue relative to subscription sales signals that the company is receiving relatively more cash upfront, improving the quality of topline growth. If sales were cannibalistic, we would have likely seen a reduction in cash receipts and/or a deacceleration in growth. Instead, cash improved and sales accelerated.
Furthermore, RPO also increased 91% YoY to $501 million, an acceleration from the 75% and 72% YoY growth rates in Q3 and Q2, respectively. While we need the 10K to fully assess the quality of RPO, total RPO represents 92% of management’s NTM guide, up from 81% in Q3. This improves the quality of forward sales and suggests that there is conservatism in management’s forward guide.
However, we do note that cash support for RPO declined slightly during the quarter. Total deferred revenue-to-RPO fell from 52% in Q3 to 49% in Q4. This trend is likely driven by the rise of cloud bookings, since cloud is a usage-based model and new cloud customers are typically on pay-as-you-go plans, which are billed in arrears. On the Q4 call, CEO-Founder Jay Kreps explained that cloud accounted for 50% of ACV bookings in Q4, highlighting how cloud will be the majority of revenues going forward. As customers become more familiar with Confluent’s products, they will likely increase their commitments and convert from pay-as-you-go customers to larger customers that pay upfront. As a result, we view the slight decline in upfront cash receipts as a natural progression for the firm and not a major concern at this time.
Cash Levels and Stock Based Compensation
Confluent recently raised nearly $1 billion in cash following a convertible debt offering in December. Following this raise, the company has over $2 billion in cash, which is well above its current cash burn of ~$108 million (based on TTM free cash flow). The company is focused on growth, so investors should be prepared for continued losses and cash outflows. On the Q4 call, management highlighted that their near-term priorities are to continue to invest in innovation and to expand its geographic footprint, signaling that growth is being prioritized over near-term profitability.
Nevertheless, given Confluent’s relatively large cash balance, we likely should not expect an equity raise in the near term. However, the company will still be dependent on capital markets until it is sustainably cash flow positive. Looking forward, the Street expects EBITDA (a proxy for cash flows) to remain negative through at least FY2023, suggesting that Confluent will remain reliant on capital markets for the next few years. Importantly, there are signs of improvement, as free cash flow margin improved from -30% in the prior year to -22% in the current quarter.
Furthermore, Confluent has relatively high levels of stock-based compensation (SBC), which subsidizes cash used for working capital but dilutes shareholders. Stock-based compensation has trended near 48% of quarterly sales for the last two quarters and was 40% of TTM sales. This is relatively high and ranks in the top 10 for cloud (shown below), but is a function of Confluent recently going public (which frontloads SBC). We expect SBC to decline as a percentage of sale going forward as it laps the IPO and topline growth outpaces expenses.
Cloud reports in two waves, with the first wave of Q4 earnings ramping this week. Microsoft was the first to report on January 25th, and strength in cloud sales helped the company beat expectations. Specifically, Azure and other cloud services revenue increased 46% YoY in the quarter, which drove consolidated sales growth of 20% YoY, beating topline estimates by 2%. In the analysis that follows, I give a brief overview of the cloud industry and discuss key metrics that investors should be aware of heading into Q4 earnings.
Cloud: Top 10 EV/FWD Revenue Multiples
Below we ranked cloud stocks based on their EV/NTM sales multiples. Snowflake (SNOW) has the highest multiple in the cloud sector, as the cloud platform provider most recently reported accelerating topline growth coupled with improving retention and other key metrics. Snowflake is benefitting from increasing rates of data ingestion in the cloud environment, a secular tailwind that will likely continue to be strong in the near term.
SentinelOne (S), Zscaler (ZS) and Cloudflare (NET) follow Snowflake’s valuation and have been rewarded a relative premium in the cloud category. Each of these companies provides cybersecurity solutions, which is a market that will likely continue to see strong demand as companies increasingly digitize and migrate online. As companies move online, their attack surfaces increase, driving demand for cyber security solutions.
It is noteworthy that cloud valuations have normalized in 2022 following the heightened volatility in financial markets. Nonetheless, these leading cloud companies highlighted below will likely continue to report robust growth in the near term as cloud adoption remains a strong secular tailwind for the foreseeable future.
Cloud: Top 10 Three-month Forward YoY Growth Rates
Below is a chart of forward sales growth expectations for cloud stocks expected to grow the fastest in the upcoming quarter. Bill.com (BILL) is expected to report the fastest growth rate in our cloud universe heading into Q4 earnings at nearly 140% YoY. However, Bill.com recently completed its acquisition of Invoice2go, which impacts the company’s as-presented topline growth rate.
Absent M&A, Bill.com’s sales are still strong and recently grew 78% YoY on an organic basis, up from the 73% YoY organic growth rate in the prior quarter. Also noteworthy are the differing growth rates between Monday.com and Asana, two work productivity platforms that are both rapidly growing.
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Monday.com is expected to grow sales 75% YoY to $88 million while Asana is expected to grow sales slower at 54% YoY to $105 million in quarterly sales. The next few quarters will likely shed light on which platform is the leading work productivity solution going forward. Strength in enterprise will be a key metric to monitor to gain insight into which company is the leading work productivity platform.
Top 10 Weekly Share Price Movements
Below is a table of the weekly change in share price for our universe of cloud stocks (week ended 01/21). Markets have been volatile and every cloud stock in our universe was down last week as the Nasdaq declined by 7%. However, there were some relative outperformers, such as Workday (WDAY) and Zuora (ZUO), both of which support back-office operations, and the market may be expecting these companies to perform well given the labor shortage. Furthermore, Anaplan (PLAN), Box (BOX) and Dropbox (DBX) have also outperformed well on a YTD basis, and were up 4%, 2% and 3% relative to the Nasdaq’s 7% YTD decline. Lengthening the timeframe to 1-year and Box has performed the strongest of the three and is up 38% YoY. Likely contributing to its outperformance, Box has reported three consecutive quarters of acceleration topline growth, with sales rising 14% and billings increasing 25% YoY in Q3. The outperformance in billings suggests sales may continue to accelerate, and management guided for Q4 sales to accelerate to 15% YoY.
Top 10 Changes in sales growth estimates – last 90 days
The table below ranks cloud stocks by their topline revisions over the last 90 days. An increase in topline revisions signals that the Street believes that the company will grow faster than initially believed, which can result in outperformance. Confluent (CFLT) has had a 16% topline revisions over the last three-months, which leads cloud stocks. Confluent raised its FY2022 sales guide in November by 8% at the mid-point and also announced a partnership with Alibaba in December, both of which likely contributed to the higher topline estimates. Another standout is New Relic (NEWR), which saw a 9% rise in estimates over the last 90 days, driven by a strong earnings report as the company reported an acceleration in sales and guided for a further acceleration in Q2. New Relic’s shares are up 27% over the last three-months as the company recently revamped its product offering and migrated to a consumption billing model. Time will tell if the recent changes resulted in sustainable growth or if the recent changes provided only a short-term boost to growth.
Update on EV/Fwd revenue multiples:
Overall stats:
Overall cloud forward median: 8x
Top 5 cloud forward median: 24x
Overall cloud forward average: 10x
EV/FWD SALES:
As shown below, the median and average cloud EV/NTM sales multiple was trending up throughout 2021 but has since corrected in 2022 to levels last seen in early 2020. For instance, the median cloud EV/NTM revenue multiple was 8x in the most recent week, which is below the 9x median cloud multiple in May 2020. Furthermore, the delta between the average and median multiple has narrowed recently as the top valued cloud stocks have had their valuations compress, reducing the distortion on the average calculation. If Q4 growth comes in strong for the cloud category, expectations for forward growth will likely be revised higher, leading to a recovery in valuations.
Top 5 EV/FWD SALES:
In the chart below, we can more clearly see the large dispersion in cloud valuations, as the top 5 premium valued cloud stocks have had their EV/Fwd sales multiples expand since 2020. However, the top 5 valued cloud stocks have had their valuations halved since November. The median cloud stock has also experienced a multiple compression in recent weeks.
EV TO FWD Sales Growth Buckets:
We can further dissect the change in cloud valuations by breaking up the group into high growth (>30%), mid growth (>15% and <30%) and low growth (<15%). The below chart shows the historical valuations for stocks in various growth buckets. Each growth bucket has had their valuations compress since November, with the high growth bucket experiencing the steepest decline. The market may be expecting a deacceleration in growth in the near term, which would explain the correction in high growth valuations. If growth in cloud remains robust in Q4 and estimates come in strong, then valuations may rebound in the next few months. Microsoft’s strong cloud results discussed above suggest that cloud will continue to grow strongly in the near term.
Top EV TO FWD SALES:
The below chart provides a more holistic view of the cloud landscape heading into Q4 earnings, sorted by EV to Fwd revenue multiples. As mentioned above, Snowflake (SNOW) sports a premium multiple, driven in part by its accelerating topline, followed by three cyber security firms: SentinelOne (S), Zscaler (ZS) and Cloudflare (NET). Snowflake’s premium multiple is 380% above the cloud median of 8x, which may be warranted given its triple-digit accelerating topline growth rate.
The last chart is based on EV to FWD sales but also takes into account forward growth expectations. By scaling valuation relative to forward growth, we can more clearly see which companies are cheapest relative to forward growth. A low value in the below chart means that a company is cheap relative to growth. Note that some names may be skewed due to acquisitions. It is interesting to note that Snowflake drops from having a 380% premium valuation relative to the median to a 33% premium after taking into account its strong growth rate. Alteryx and Splunk move to being some of the most expensive cloud stocks once we factor in their forward growth.
Finally, the last table we will be discussing includes aggregate cloud operating metrics. The below table illustrates the median topline growth, margins and FCF generation for the cloud industry. The median growth rate was 36%, and the market expects the median cloud stock to grow sales by 28% YoY in Q4. Gross margins remain robust at over 73% and cashflows are slightly positive at 3% of three-month sales for the median cloud company. Cloud remains a category exhibiting rapid growth, with strong margins but relatively low cashflows. As the category matures, cashflows will likely materially improve, rewarding investors in the long run.
While cloud valuations have been volatile in recent weeks, the category remains one of the fastest growing areas in the market. The I/O Fund believes in the long-run success of the cloud category, and we remain invested Find out what the Street is saying about cloud stocks headed into Q4 earnings in our I/O Fund’s Preview of 7 Cloud Stocks for Q4 Earnings.
The I/O Fund is a team of analysts that share their research publicly as they build a portfolio of 30 stocks. Our team has record results for a retail Fund and we also have four-digit gains on some of our free newsletter coverage. You can learn more about our premium service by clicking here or sign up for our free newsletter here.by clicking here or sign up for our free newsletter here.
Disclaimer: This is not financial advice. Please consult with your financial advisor in regards to any stocks you buy.
