Another day, another headline saying Alphabet’s Google and Facebook are being investigated for allegedly breaking privacy laws and engaging in anti-trust behavior.
Google GOOG, +0.95%GOOGL, +0.98% has been the subject of three antitrust investigations conducted by the European Union, resulting in more than $8 billion in fines.
Now the company, which controls 31% of global digital ad dollars, will face the U.S. on anti-trust matters. A big question is if governments will be effective, as they may not understand how social-media and internet businesses operate.
In April 2018, Congress tried to piece together how Facebook’s FB, +2.74% platform works. It ended up being a disaster. Anyone who works in the mobile-ad industry knows that the mobile device, notorious for its massive data leakage, could be used to collect thousands of data points daily to reveal personal thoughts, behaviors and political preferences.
When Facebook CEO Mark Zuckerberg answered a question on how Facebook makes money — “We sell ads, senator” — he wasn’t fooling the ad industry. It’s well aware that Facebook sells audiences and identities, as the company’s ads would be worthless without extracting data points from the mobile device and aggregating them for targeting.
This isn’t your typical targeting of pizza (or beer) ads during football games. This targeting knows you better than you know yourself, as it monitors your actions with data science and look-alike modeling.
The only force that can stand up to the complex tracking methods used by Google and Facebook will be an opposite, yet equal, force. It will not come from governments, which think that paying for search results is the problem. Rather, the problem is the pervasive code and software that continually tracks people, which no competitor can compete with.
Turns out, there is an opposite and equal force in magnitude that has chipped away at the anti-competitive tracking that occurs in the browser with Intelligent Tracking Prevention (ITP). Yet it has not done so on the leakiest device of all: mobile. And that would be Apple AAPL, +0.85%.
Pervasive tracking is anti-competitive
Facebook and Google aren’t the only companies that track users on mobile and browsers. They simply have software and code in more places. For instance, Facebook’s software is in 32% of the top 500 app market — and up to 800,000 applications. They track billions of non-Facebook users with software that can track you whether you have navigated one of their digital properties or not.
There is no way to opt out of Facebook or Google from tracking you, as their tracking is simply everywhere. In fact, security experts, including Bruce Schneier of the Berkman Center for Internet and Society at Harvard, call such tracking outright surveillance.
The incredible depth of information those giant companies have on mobile and internet users is the “moat” that generates unprecedented cash flow in advertising. Both ad-dollar machines have inertia from the data being collected, and it doesn’t appear that the EU’s General Data Protection Regulation (GDPR), anti-trust lawsuits in Europe and the U.S., or the Cambridge Analytica scandal is going to slow those companies.
The flow of data is provided by tracking code across websites. Those include the Facebook “like” button and sign-in. It’s also done through software development kits (SDKs), such as Facebook Audience Network, which is installed in 32% of the top 500 apps on the market. Google simply acquired Android to have tracking across the majority of mobile, and then went further, acquiring AdMob in 2009. That ad network was especially popular on the Apple iPhone.
The moat that Google and Facebook have enjoyed comes from having first-party relationships with nearly every user who has a smartphone. This is called first-party data and is a loophole used to collect data even after a user is on another property where there is no relationship. For instance, Facebook uses first-party data to power ads on streaming service Hulu, but at this point, the first-party relationship does not exist with Facebook’s social network once someone is on Hulu, and this is done without explicit consent (by both Facebook and Hulu). Easy-to-navigate opt-ins are not offered, as it’s unlikely Hulu viewers, who pay for the app, would want Facebook accessing their viewing data if they had to opt-in.
Privacy issues aside, there is no way for another ad company to compete when Google and Facebook collect that much data. Other companies are copying their approach by tracking users with universal ad IDs, including leveraging Apple’s Identification for Advertisers (IDFA).
Apple’s ITP prevents browser tracking
To understand how technology can neutralize tracking, it’s important to look at Apple’s Intelligent Tracking Prevention measures, which were launched in 2017. Apple’s ITP placed a limit on how long cookies are available for third-party contexts by removing third-party cookies after 24 hours.
At first, ITP did not have an effect on Google, as users of its search service and other properties visit those sites daily and, therefore, are not considered third-parties. Some critics say ITP strengthened Google as one of few remaining options to target niche audiences.
In 2018, Apple continued to battle data collection on the Safari browser by shutting down finger printing, a method of triangulating a user’s identity through fonts, screen dimensions and plug-ins.
In March 2019, Apple announced ITP 2.1, which limited first-party cookie storage to seven days. To put that in perspective, a Google Analytics cookie, in theory, would last for up to two years. Safari can now delete it within a week.
Finally, in May 2019, Apple limited tracking to 24 hours, including Google and Facebook.
We’ve seen statistics from publishers where they get half the CPM value — cost per thousand impressions — as a result of ITP’s impact. If they can’t have good targeting, some of their sites become less worthwhile for their advertisers.
Google and Facebook are the companies most affected by ITP 2.2, which was released in May 2019. Still, the companies reported record second-quarter ad revenue — $16 billion for Facebook and $38 billion for Google.
That may be due to Apple’s Safari and Mozilla having a small share of browser activity, or it could be because Facebook and Google have daily first-party relationships with users. A third possibility is that it’s too soon to understand the effects of ITP.
Keep in mind, the browser is not nearly as powerful as the mobile device.
At the Advertising Week conference in New York last week, there was a presentation by Gadi Eliashiv of Singular titled “A World Without IDFA: The Implications for Marketers.” I caught up with him after the presentation to get more background on Apple’s Identifier for Advertisers, or IDFA, and the possibility of Apple restricting the identifier. Unlike cookies on the web, where there is a tag on the browser, mobile identifiers have much stronger tracking capabilities. The identifier belongs to the device and works across applications and devices.
Eliashiv pointed out that attribution, or the tracking of advertising’s effectiveness, will always be a reality as it’s important for advertisers to track return on investment (ROI), and this ultimately supports the mobile ecosystem for the development of new apps and features. He also thought the recent iOS 13 upgrade, which offers users the option to sign into apps via an email address that Apple generates, is a way of logging into apps and getting personalized experiences without having to give up personally identifiable information.
As Eliashiv said, if it were an easy decision, then Apple would have already made it.
Apple’s chance to make a statement
As of now, Apple has no plans to remove the IDFA, although for a company that insists it is a protector of privacy, at the very least, there should be better opt-ins. The changes made with ITP on the browser may not have had a big effect. However, the implications of Apple restricting IDFAs on iOS becomes more serious with the iPhone having a global penetration of up to 20% of smartphone sales.
Even companies that have fancier IDs, such as Trade Desk TTD, +3.04%, with its Unified ID, relies on IDFA to some extent, and any changes to IDFA would limit the ability to collect and stitch together fragments about the user.
That said, perhaps Apple should have addressed those issues before hyping its privacy efforts. As of now, Apple is enabling a lot of tracking with the IDFA, and this may not be an appropriate compromise for attribution as users are completely unaware their activity can be tracked across the entire device.
Furthermore, users don’t have any method for approving the software development kits, from Facebook’s Audience Network or Google’s AdMob.
Even with anti-trust regulations, this level of tracking will continue. That is, unless Apple steps in.
We have a few years before Nvidia will show the market it’s true earnings potential. When a thesis is not reflected in the revenue segments yet, there are typically lower entry points and ongoing volatility. You’ll see in the technical analysis that although I could not be more bullish on this stock long-term, there is weakness in the semiconductor sector and we hope this translates to a lower entry point for our readers.
The market is also in a fierce debate between AMD, Intel, and Nvidia and is also distracted by other chips, such as Micron and NXP. In my analysis, I look for growth. How big is the market relative to how big the company is now?
You can ignore Nvidia’s gaming revenue and other segments for the main trajectory that we are focused on. Gaming is great for stability and earnings reports, but the growth will not be from gaming (a market where Nvidia is already a mature, market leader). I’m also not focused on PC sales or the CPU-powered cloud, as the first is not a growth market and the second is not the piece in the cloud stack that will accelerate future technologies.
I’ve written at length about the Mellanox acquisition and it’s a great reference for Nvidia’s long-term strategy. In this report, I’d like to break down what the GPU-powered cloud is capable of and why it’s important to differentiate Nvidia’s strategy from the competitors (and some competitors to keep an eye on).
I’ve covered Nvidia a few times on my free blog, however, it would be a disservice to my premium members to not formally initiate coverage and provide critical updates to the GPU-powered cloud and AI economy as it’s built out. I believe Nvidia will be on my short list in a decade from now.
To be bold – I believe Nvidia will be one of the world’s most valuable companies by 2030. The research below organizes my investment thesis for the GPU-powered cloud and why I believe Nvidia will emerge as a clear leader.
The question is how long can you have your money in a stock? This is a long-term play that requires a 10-year hold for the full return. Like Amazon, Google and Netflix, it requires ten years before emerging technology goes from a moonshot, to a viable company, to a less volatile company – and finally, to a profitable machine. Nvidia is a viable company that is volatile, proven during the crypto surge. Investors should see the crypto bust as an opportunity as the issues were not based on Nvidia’s core business. The trade war certainly hasn’t helped the stock price, either.
We have a few years before Nvidia will show the market it’s true earnings potential. When a thesis is not reflected in the revenue segments yet, there are typically lower entry points and ongoing volatility. You’ll see in the technical analysis that although I could not be more bullish on this stock long-term, there is weakness in the semiconductor sector and we hope this translates to a lower entry point for our readers.
The market is also in a fierce debate between AMD, Intel, and Nvidia and is also distracted by other chips, such as Micron and NXP. In my analysis, I look for growth. How big is the market relative to how big the company is now?
You can ignore Nvidia’s gaming revenue and other segments for the main trajectory that we are focused on. Gaming is great for stability and earnings reports, but the growth will not be from gaming (a market where Nvidia is already a mature, market leader). I’m also not focused on PC sales or the CPU-powered cloud, as the first is not a growth market and the second is not the piece in the cloud stack that will accelerate future technologies.
I’ve written at length about the Mellanox acquisition and it’s a great reference for Nvidia’s long-term strategy. In this report, I’d like to break down what the GPU-powered cloud is capable of and why it’s important to differentiate Nvidia’s strategy from the competitors (and some competitors to keep an eye on).
SECTION 1: Artificial Intelligence
Artificial intelligence is a collection of categories, including computer vision, natural language, virtual assistants, robotic process automation and advanced machine learning. The AI impact will not be linear, rather adoption will resemble an S-curve pattern with a slow start due to the substantial costs and investment required for applications. The slow start will be followed by an acceleration that is driven by competition across capabilities and innovations. The penalty is steep for laggards, as pointed out below.
The slow start to AI will cause many investors to become complacent, not realizing the artificial intelligence boat will quickly leave the shore, metaphorically speaking, once it is closed to new entrants. If you add in the inevitable recession that will follow this long bull market, we could see many investors rotate back to growth stocks too late to realize the full gains from AI.
As noted in the graph below, we should see an AI acceleration around 2022-2023. The last call for decent gains in AI will be in 2025, although by then, the gains will be somewhat diminished compared to investors who choose their AI stocks by 2021/2022.
Basically, weigh the costs adding artificial intelligence to your portfolio earlier as opposed to later in the tech cycle as it’ll be one of the biggest economic growth drivers in history (more on this below).
Nvidia’s acceleration may happen one or two years earlier as they are the core piece in the stack that is required for the computing power for the front-runners referenced in the graph above. There is a chance Nvidia reflects data center growth as soon as 2020-2021.
Between the years 2025 and 2030, the stage after AI infancy, artificial intelligence is expected to add $13-$15 trillion to global economic activity, or 1.2 percent additional GDP growth per year. Compare this to the spread of information technology (IT) in the 2000s, which added 0.6 percent. Also, compare this to 5G technologies, which are expected to add $2.2 trillion over the next 15 years.
McKinsey points out that front-runners, who are currently investing in artificial intelligence, will reflect an increase in positive cash flow of up to 120% from their AI investments. The capital required to invest in AI, however, is negatively affecting cash flow right now and will continue to do so throughout the next year or two. Laggards are expected to lose at least 20% of their cash flow from the negative impact of investing in AI too late (or not at all).
Most investors today are well aware of what mobile and cloud did for tech stocks. These gains will seem minor in comparison to what artificial intelligence will do for your portfolio by choosing the right companies.
Today, Nvidia is my top pick for AI. I will also be providing more AI stock picks throughout the next 1-3 years to ensure my readers are well prepared for the massive gains AI will deliver by 2030. I believe this report is being delivered before at least one more pullback in Nvidia’s future due to broader semiconductor weakness.
It is too early for the data center to make an impact and this trajectory (data center) is what we are targeting. When I deliver information well before momentum, it helps to be patient with an entry and one of the main benefits of my reports is to give you that time, when possible.
SECTION 2: Competitive Positioning
Desktop GPUs is not the growth category that I am targeting for this investment thesis, which is why many oftcited statistics are irrelevant. For example:
“AMD shipments increased 9.8%, Nvidia was flat and Intel's shipments, decreased -1.4% as indicated in the following chart.” -John Peddie Research
Many financial analysts and authors on Seeking Alpha (etcetera) are quick to think this means AMD is the better investment, whereas this statistic refers to a mature market. To cut through the noise, it’s important to remember this thesis is about the GPU-powered cloud.
I’ve already covered why AMD is not as big of a threat to Nvidia as Wall Street believes. AMD has its hands full competing with Intel on the CPU-powered cloud and does not have the CUDA programming platform (more on this below). The two are competing in other segments (gaming, PCs) but those are less of a concern to the buyand-hold thesis in this report (data center). I can’t stress enough to separate these segments if Nvidia is of interest to you as a growth story.
Competitors to watch for at this layer in the data center stack are:
• Xilinx’s FPGAs,
• Intel’s FPGAs (through the acquisition with Alterra),
• Google’s TPUs (essentially an ASIC on the efficiency/flexibility spectrum).
FPGAs have distinct advantages over GPUs as they offer a higher amount of on-chip cache memory to help reduce the bottlenecks from external memory, and are flexible enough to be reconfigured for various data types, such as binary, ternary, and custom data types, whereas GPUs must be modified at the vendor level.
FPGAs are also known for power efficiency and test at 10x better in power consumption than GPUs and also 4x better than GPUs for general purpose compute. Reconfigurability for FPGAs help provide efficiency beyond deep learning for a large number of end applications and workloads.
The architecture of FPGAs are very adaptable as the chips allow a user to address all of the needs of a workload with the resources provided by FPGAs. Meanwhile, GPUs are restricted as the architecture is a Single Instruction Multiple Thread (SIMT), which provides an advantage over CPUs but can result in lower performance efficiency.
Today, FPGAs require knowledge of machine learning algorithms at the hardware level, in addition to the software development, and this is the barrier to entry for FPGAs.
As readers of mine know, I like Xilinx and this will be a stock I cover in the future with a full-length report. The company operates in a niche, is the inventor of FPGAs and has the ability to attract developers to its ecosystem. The challenge with FPGAs is they are hard to program as most software developers are not able to program hardware. Xilinx is working on becoming more of a platform company to solve this issue, and if the company succeeds, it’ll be a worthwhile investment.
Intel will face headwinds with developers, who are the ultimate decision makers for any ecosystem. Even now, you will be hard pressed to hear much discussion on developer forums and news feeds about Intel/Alterra’s FPGAs. Developers tend to avoid overly-corporate companies and cultures, and Xilinx has a serious shot of overcoming Intel if they execute correctly.
AMD also has a decent chance of eating away at Intel’s market share on the CPU-powered cloud. Overall, I prefer pure play options, when possible, and most of my tech stock coverage focuses on this. In my opinion, Intel is not the growth story in these categories.
This brings us to Google’s TPUs. TensorFlow is rising in popularity as a machine learning language and TPUs primarily run TensorFlow models. This is one of Google’s more successful experiments. They are cheaper and use less power than GPUs and are specifically focused on machine learning.
TPUs train and run machine learning models and power Google Translate, Photos, Search, Assistant and Gmail – i.e. image recognition, language translation, speech recognition and image generation. TPUs do not compete with GPUs in other areas of artificial intelligence.
It’s also important to remember that Nvidia and Xilinx are hardware companies that offer platforms for software developers. This is a distinct advantage compared to software companies (Apple, Google and Facebook) trying to release hardware chips. The market is so valuable, that they will most certainly try, but I think there are a lot of technical hurdles for a software company competing in the chip space other than Google. Workday’s cloud financial management solutions have less traction with 8 companies in the Fortune 500 and 530 customers overall.
SECTION 3: Developer Ecosystem
In November of 2018, I wrote about Nvidia’s developer ecosystem as a primary moat. GPUs are hardware which require software to write applications and utilize GPUs. Nvidia has a special language called CUDA that is universally known due to a first mover advantage in GPUs.
This ecosystem is not apparent to the public markets right now because new technology is developed in waves, and funded by venture capitalists in cycles. We are seeing the last of the mobile era of venture-funded companies with the IPOs of Uber and Lyft, — which began with Twitter, Yelp, Spotify — and was also reflected in Facebook’s epic rise from mobile native app revenue.
We are in the later stages of the venture-funded cycle for cloud software, hence a string of newly public companies over the last two to three years with some runway to go in this category before the majority of use cases are claimed. For artificial intelligence, it is so early that it’s essentially invisible right now to the public markets as development teams are beginning to form.
The strength of the developer ecosystem is what propelled Apple to become a $1 trillion company. While many investors look at iPhone sales, and Mac sales, the ecosystem that created by application developers is why Apple had an impenetrable moat. If the iPhone only had applications from Apple on the device (iTunes, iOS Maps, Safari browser), then many device manufacturers could have competed with Apple. The moat that Apple has enjoyed was created by the third-party developers who created iPhone applications in C and C++ with XCode, which made the device more attractive due to the mobile app ecosystem.
Android then became the second operating system in the mobile duopoly. Due to the friction of learning too many languages, the mobile ecosystem did not entertain any further competitors. This is despite there being 5 billion smartphones globally (i.e. it’s certainly feasible from a consumer supply/demand view point to entertain more operating systems and app stores), yet the limitation came from the number of languages developers are willing to learn. Microsoft Windows failed because it launched too late, and developers had already chosen the two languages they were willing to work with.
This is what is meant by developer ecosystem. Devices themselves do not have moats. The developer ecosystem creates the moat as third-party developers favor developing on certain operating systems and there is a limit to the programming languages they will learn before it impedes progress for the developer and the company the developer works for.
This is what is happening with Nvidia’s CUDA. The chips themselves do not create the moat. The compute platform creates the moat. Due to the need for a universal language to build GPU-accelerated applications, universities are teaching CUDA, and students are graduating knowing Tesla/Volta chips over competing chips, such as AMD’s Radeon or FPGAs or TPUs.
Here’s a quote from Marc Andreessen of Andreessen-Horowitz, one of the most successful venture capitalists in Silicon Valley: “We’ve been investing in a lot of startups applying deep learning to many areas, and every single one effectively comes in building on Nvidia’s platform. It’s like when people were all building on Windows in the ’90s or all building on the iPhone in the late 2000s.”
Here's another quote from a developer on Reddit:
“Nvidia, thanks to the CUDA software stack (which AMD cannot match), has a much more unassailable position than does Intel with Xeon CPUs (where an X86 application just runs on either a Xeon or an Epyc).”
– software developer on Reddit
SECTION 4: Financials
In this case, I began with the investment thesis rather than the financials as the two do not sync up today. Gaming is Nvidia’s strongest revenue segment with $1.3 billion per quarter. Data center revenue has been flat to declining for three straight quarters, ranging between $634 million and $679 million.
The market is encouraged, yet cautious, with revenue of $2.58 billion in the most recent quarter fiscal Q2 2020, up 16.2%, yet down about 17% from $3.12 billion in the year-ago quarter.
GAAP earnings was $0.90, compared to $1.76 a year ago, and $0.64 in the previous quarter. Non-GAAP earnings of $1.24 in the current quarter, compared to $1.94 a year earlier, and $0.88 in the previous quarter.
Similarly, net income was down 50% year-over-year but up 40% quarter-over-quarter at $552 million.
Next quarter, Nvidia is expecting $2.90 billion, plus or minus 2 percent, with gross margins of 62%.
The bigger story this quarter was Nvidia’s gaming growth, which reflected 24% growth sequentially, with revenue of 1.31 billion compared to estimates of 1.29 billion. There is also evidence that inventory is normalizing with an inventory ratio of 50% and on track to lower to around 40% in fiscal Q3 compared to the previous ratio of 71%.
As stated, the current financials do not reflect the growth expected from AI.
SECTION 5: Technical Analysis
By Knox Ridley
5.1 Trend Lines and Internal Strength
Focusing on the black trend lines, you’ll see three sets. The upward trend in price, which coincides with the upward trend in momentum in the RSI, tracks two recent topping patterns in Nvidia’s price action.
The trendlines coincide with each other. When both momentum and price roughly trend together, it can show a healthy trend in place. Using these corresponding trends can also offer reasonable warnings, as well.
By following the approximate time at which both the RSI trend and price trend broke to the downside together, we can see safe and effective exits that allow you to side-step pull backs.
Further information can be found by looking at the set of green and red arrows. Notice that just before the last top in Nvidia, before the May correction, as the price of Nvidia climbed higher, the momentum in the RSI was decreasing. So, when I see a divergence like this coupled with trendlines being violated, it’s a warning of a correction on the horizon.
This exact pattern is unfolding today if we look at the last set of trend lines in the price and RSI. With Nvidia’s RSI closing just below oversold levels and pointing down towards the black trendline, this same negative divergence pattern is unfolding in real time, signaling a weakening of momentum. A break in this trend on both the RSI and price, and we can expect more downside to follow.
5.2 Elliot Wave Analysis
If we are forming a double top pattern, and Nvidia fails to break out above the $200 barrier, we can look at the retrace levels and expected extensions to gauge the likely targets for entry. First, if we zoom into the internal structure of Nvidia’s 3-month drop, which is highlighted by the light blue roman numeral count, you’ll see a very clear 5-wave drop.
It’s hard to see anything other than 5-waves in this move, all of which line up with internal Fibonacci ratios. The first pattern in a correction being a 5-wave drop is a strong indication of a 5-3-5 corrective pattern, which is highlighted in purple.
So, the Purple A was a 5-wave drop, while the purple B was a 3-wave correction, which touched the 50% retrace of Wave A before falling. If this count is correct, we are just now completing the 2nd wave in the final 5-wave pattern.
It’s always worth noting how the stock price reacts to these extensions. The stock found major support at the 61.8% retrace, testing this level before meeting heavy resistance at the 38.2% retrace. If Nvidia cannot break through the 38.2% retrace, the analysis is suggesting that we could see the final C wave play out, which will have Nvidia retest the 61.8% retrace level and likely make new lows.
However, I want to be clear with our convictions in this position. Anywhere between $125 to $160 is a great entry. Even though the analysis in this count is suggesting that we could see lower lows, and correction will be welcomed for a long-term entry. Thus, we will update any entries if the pull-back scenario takes hold.
Due to Nvidia’s fundamental strength, we will now look outside the individual stock for the cause of a sentiment shift. Please also refer to the bullish scenario below.
5.3 Global Semiconductor Sector
Like most semiconductors, Nvidia is a global company that is manufactured overseas (mainly from Taiwan) with 44% of its sales coming from China. Semiconductors are cyclical and sensitive to economic cycles. This is why we must look holistically at this sector when guiding an entry.
The Korean KOSPI Index
South Korea is an economy that is fueled by some of the world’s largest semi-conductor companies, as well as many mid-level players. Companies such as Samsung, and SK Hynix supplied over 60% of the components used in memory chips sold globally in 2018. So, the KOSPI can provide more information about the global health of semiconductors.
Since 2011, the index has been in a long-term uptrend, which it respected until very recently.
The KOSPI broke through this trendline, highlighted in black, which coincides with the 61.8% retrace. This level is now acting as resistance as the KOSPI is showing a negative RSI reversal pattern, which is indicating more downside is likely to follow.
This pattern is highlighted by the blue circles. In short, as the price makes lower highs, the RSI is making higher highs, indicating that the buying pressure is not sufficient to reverse the trend as it reaches oversold levels. This chart is anything but encouraging.
Philadelphia Semiconductor (PHLX)
The Philadelphia Semiconductor index (PHLX) will have some international exposure, such as NXP Semiconductors and Taiwan Semiconductor Manufacturing Company, but it is populated with mostly US companies. Nvidia accounts for nearly 9% of its total value.
Looking at the weekly chart, we can get a glimpse of the bigger patterns at play, which I believe are pertinent for where we are. If we start with the first long term trend from 2013 – 2015, you’ll notice that the price respected the first long-term trend line in magenta.
The black arrows indicate the moment when the RSI and price broke their respective trends. This trend broke first on the RSI, then fell to a lower long-term trend highlighted in black. Once this trend broke along with the black trend in the RSI, the index gave way to a significant correction. When these long-term trends break together, both in momentum and in price, it’s a warning to step aside.
Further evidence can be found by the descending red line in the RSI leading up to the drop. There is a negative divergence with the price and momentum. As the price action increased leading up to the sell-off in 2015, the RSI made significantly lower highs, failing to break out multiple times. When you see negative divergence that is followed by the RSI and price trend lines breaking, this is where technical analysis can help you avoid downside risk.
Today, the price has managed to find a bottom, and has resumed a new trend, which is also highlighted in black, and appears to be trading in a diagonal pattern. The RSI is showing a divergence between the RSI, making lower highs while the price makes higher highs, just like we saw leading up to the 2015 correction. Furthermore, just like in the prior run-up before the correction, the RSI’s momentum keeps failing to break out of the descending trend highlighted in red.
Taking what we are seeing today, the evidence is leaning towards a more cautious stance. The intermarket divergence we are seeing between the KOSPI and the PHLX, coupled with the weakness we are currently seeing in the PHLX, leads me to conclude that the KOSPI is a possible leading indicator of the semiconductor sector.
Nvidia, being a major global player in the semiconductor space, is not immune to this broad market weakness. With the weakness we are seeing with Nvidia’s chart as well, I think letting these patterns play out, will allow a safer and more optimal entry price.
5.4 The Bullish Scenario
I attempt to approach each chart from a blank slate. I let the data and analysis lead me with as little bias as possible. However, especially in a late cycle bull market, I always ask myself where I could be wrong, and what it would take for me to invalidate my primary thesis. The below chart is my alternative invalidation thesis.
From an Elliot Wave Count, the primary Wave 4 correction, which is highlighted in yellow, unfolded in an A-B-C pattern, highlighted in purple, and ended at the December low. This would mean that we are currently in the final 5th Wave push of the larger yellow count. This final 5th Wave will be an impulsive move, so its structure will have its own 5 waves. This means that we have completed the Wave 1 and Wave 2, highlighted in purple and are currently in Wave 3. If we look one degree lower into Wave 3, we have completed waves 1 and 2 of 3, and are about to breakout to the upside.
I have some issues with this count. Specifically, when you zoom into the lower degree structure, we can see a 5wave structure down, who’s ratios line up like we want to see, and we can also see 3-waves up. However, if we see a break above $200, this strongly implies that the Wave 4 in yellow is over, and that the bull trend can continue.
I will need to see the RSI divergence forming to be invalidated by the RSI breaking through the red trend line as well as the price of Nvidia break through the $200 level. At $200, we may have left some minor gains on the table, but it is a much safer entry than where the stock is trading right now and worth the insurance.
Cloud software stocks suffered a reversal that has produced losses of close to 50% from record highs.
The story for those stocks hasn’t changed, but the valuations have, and that could be a good thing for investors who know what they own.
The biggest risk for investors in cloud stocks isn’t the losses that have pummeled prices over the past two weeks, but rather the big reversal that may scare them away from the sector. It’s painful to watch large declines in stocks, yet nobody wants to miss out on a potential 10-bagger either. When the market rewards, and penalizes, all cloud software stocks equally, with little differentiation, it’s prudent to choose a select group that has compelling stories for a buy-and-hold strategy.
An investing adage is to buy when others are fearful. I would say to buy when others can’t differentiate among companies. Clearly, from what we saw over the past two weeks, a broad range of companies are being lumped together, with little recognition as to which are the winners.
To put it simply, this is a great time to know what you own as the story for these stocks is much deeper than the simple descriptor of “cloud software.”
In the graphic above, the orange line represents the First Trust Cloud Computing ETF SKYY, +0.12% which holds about 60 positions, all of which dominate the cloud space. The light-blue line is the Consumer Staples Select Sector ETF XLP, +0.41%, which tracks the consumer staples sector, a group that’s thought to be impervious to recessions. Those have historically been the laggards in this long, growth-driven bull market. The dark purple line is the benchmark S&P 500 Index SPX, +0.29%.
Before the stock market correction in May, cloud stocks were the leader in the market, while the staples were trailing. However, since that first correction, and up till today, there’s been a reversal. Over the past week high-growth leaders in this bull market, mostly cloud, have taken big hits.
For example:
Workday WDAY, -1.26% is down 25% from its high. Twilio TWLO, +3.08%, down 26%. Okta OKTA, -0.20%, down 22%. Zoom ZM, +1.02%, down 27%. MongoDB MDB, -1.57%, down 29%. PagerDuty PD, -0.38%, down 47%. (All prices are current as of 2 p.m. Eastern time Sept. 11.)
Cloud software categories
To start, cloud software needs to be broken up into categories to look more closely at the markets they serve. Here are some examples:
• Twilio is at the intersection of communications and mobile.
• CrowdStrike CRWD, +0.80% and Okta are security companies.
• PagerDuty simplifies operations, and Workday simplifies human resources and the finance department.
• Alteryx AYX, -0.74% and Splunk SPLK, +0.02% are big data analytics.
• Salesforce CRM, +0.43% is customer relationship management (CRM), but the market it serves is the sales and marketing industry.
• Zoom simplifies communications for enterprises and business-to-business (B2B), as does Slack WORK, +1.47%.
• Veeva Systems VEEV, -0.08% serves the life sciences and pharmaceutical industry.
Twilio has more in common with Skype, and even Verizon VZ, +0.50% and AT&T T, -0.93%, than it does with Okta. Workday has more in common with SAP and Oracle ORCL, -4.26% than it does with Alteryx. Yet, cloud stocks experienced a categorical black swan as if they all serve the same markets.
What this means is that some investors don’t understand these companies. The viability of a company’s product and how it fits the market is not factored into the investments, and this is creating a window of opportunity for investors who take the time to study individual stocks.
Valuations
The more logical explanation is that there was a clearance sale for overpriced stocks, and the common denominator in the sell-off was high valuations. However, the issue with this theory is that some of the companies will go on to be big winners, and higher price-to-sales (P/S) or enterprise-value-to-sales (EV/S) ratios are warranted because of the enormous markets they serve in contrast with their small size.
For instance, Zoom’s P/S and EV/S are gut-wrenching (no argument there), but the company’s revenue growth is unusual. You’d be hard-pressed to find triple-digit revenue growth for eight straight quarters in the stock market. The prospects of disrupting Cisco and other enterprise telecommunications at a $22 billion market cap is worth more than other companies that are serving smaller, more saturated markets. Zoom’s rapid growth, which is unprecedented, makes it hard to pinpoint a fair valuation.
Workday is another example of a company that carries high P/S and EV/S ratios, in this case twice as high as its large competitors, Oracle and SAP. In this scenario, you get a pure-play option that is moving quickly on machine learning to reduce the overhead required in human resources and finance departments. What Workday’s software aims to do, which is to reduce the number of employees needed in those departments, delivers a value that is worth many times over the cost of the software. If Workday is successful, the company will be worth much more than two times its current market cap, whereas, Oracle and SAP are essentially defending territory.
See: Beth Kindig runs a forum on tech stocks where she answers readers’ questions.
Splunk has P/S and EV/S ratios of eight compared with Alteryx’s 24 and 22, respectively, yet both were affected by the sell-off despite being in similar markets. Splunk should have held steady if this was a clearance sale on high valuations.
The evidence doesn’t point to a rational reason for the sell-offs. Some stocks are priced high, but knowing which ones deserve to be is going to be more important than ever.
• The larger the market, the safer the investment. Can every enterprise employee in the world use the product for maximum scale? Does the product solve a pain and reduce overhead for businesses? These will outlast the more niche markets and products that are considered a convenience. To illustrate, if you are providing software for office communications that replaces office telecom equipment, not only is your product a necessity but it will be the solution to high telecom bills during a time when costs are being cut. There are numerous examples of fulfilling a (non-negotiable) necessity while reducing costs in the cloud software category.
• Ignore earnings estimates. Many estimates were lowered this past year, and when companies “beat” earnings estimates, they were actually declining year-over-year, sometimes substantially. Apple AAPL, -0.23% is a prime example of this. The stock continues to reach all-time highs and “beat earnings” despite two straight quarters of negative growth and mere 1% growth in the most recent quarter. That may work for Apple, but smaller-cap companies that are declining won’t last long, especially in a value rotation. Another example is Okta, which I believe had weakening fundamentals yet beat earnings estimates. Okta is now one of the hardest-hit cloud software stocks over the past two weeks, with a 22% drop since the end of August.
• We hear a lot about competitive moats, yet high switching costs is a protective buffer that serves two purposes: It locks in subscription revenue and staves off competitors. Often, switching from a cloud software provider will cost a customer time and resources. Look for companies that have high switching costs.
My prediction is this may be one of the last cycles when tech is considered less safe than value stocks. As the market will find out (the hard way), cloud software is actually very safe. It is insulated from trade wars and overseas manufacturing issues. It reduces costs for enterprises, which is ideal for a recession. Lastly, cloud software is at the beginning of a rapid growth cycle compared to its counterparts in tech — such as mobile, e-commerce and advertising — which are reaching saturation, are finding themselves in the cross hairs of anti-trust and are susceptible to consumer spending changes.
The best companies in the category of “cloud software” will continue to post rapid growth regardless of economic conditions, and the investors who run from this sector will suffer bigger losses from missed opportunities than investors who know their winners.
This article appeared on MarketWatch September 12th, 2019.MarketWatch September 12th, 2019.
Zoom Video Communications is a company with a valuation where logic is ignored, and any investor in the stock would need to get comfortable with this. The current valuation of $25 billion comes from a company with $546 million in revenue and EBITDA of $39 million this year. Zoom is expecting revenue of $129 million to $130 million with non-GAAP income of $2-$3 million. Q2 non-GAAP EPS is expected to be $0.01 to $0.02. One reason Zoom is demanding a high valuation is that the rapid revenue growth coupled with achieving profitability should create the perfect storm over the next few years.
According to Gartner, by 2022, 65 percent of meeting solutions users will take advantage of SIP/VoIP-based audio-conferencing tools. This is up from 20 percent in 2017 while 40 percent of meetings will be facilitated by virtual concierges and advanced analytics. The exact size for the video communications market varies considerably depending on the source – this is because the market is very new. According to research from Markets and Markets the video communications market is expected to grow an average of 8 percent a year to nearly $20 billion by 2023 with another report expecting that the industry will register a CAGR of 9.2 percent from 2018 to 2025. IDC, however, pegs Zoom's future addressable market much higher at $43 billion, as cited in last quarter’s earnings call.
SECTION 1: Financials
Zoom Video Communications is a company with a valuation where logic is ignored, and any investor in the stock would need to get comfortable with this. The current valuation of $25 billion comes from a company with $546 million in revenue and EBITDA of $39 million this year.
Compare this to Square with a similar market cap, yet revenue of more than $2.27 billion. Zoom’s enterprise value/sales of 50 is the highest of EV/sales of any U.S. tech company valued at more than $500 million, according to FactSetData. With free cash flow of $15.3 million, Zoom trades for 450 times forward free cash flow.
Revenue in the most recent quarter grew 103 percent to $122 million, surpassing estimates of $111.7 million. This was the eighth straight quarter of triple-digit top line growth. Zoom is profitable with EPS of $0.03 quarter and $15.3 million in free cash flow.
Zoom is expecting revenue of $129 million to $130 million with non-GAAP income of $2-$3 million. Q2 non-GAAP EPS is expected to be $0.01 to $0.02.
One reason Zoom is demanding a high valuation is that the rapid revenue growth coupled with achieving profitability should create the perfect storm over the next few years.
To get an idea of growth over the past few years, Zoom’s S-1 Filing showed $60M in revenue in 2017, $151M in revenue in 2018 and $330M in revenue in 2019 with an estimated $540M in revenue for the upcoming fiscal-year. The 100%+ revenue growth has been accompanied with gross profit margins in the high 70% to low 80% range. I would not be surprised if Zoom exceeds expectations on revenue in the current fiscal-year.
Zoom became profitable in the year ending January 31st, 2019 with $7.58 million in net income or 3 cents EPS. The year prior, Zoom reported a net loss of $4.8 million.
Analysts are currently seeing more downside with a median target of $83 and a low estimate of $55 with a high estimate of $115.
SECTION 2: Growth & Addressable Market
According to Gartner, by 2022, 65 percent of meeting solutions users will take advantage of SIP/VoIP-based audioconferencing tools. This is up from 20 percent in 2017 while 40 percent of meetings will be facilitated by virtual concierges and advanced analytics.
The exact size for the video communications market varies considerably depending on the source – this is because the market is very new. According to research from Markets and Markets the video communications market is expected to grow an average of 8 percent a year to nearly $20 billion by 2023 with another report expecting that the industry will register a CAGR of 9.2 percent from 2018 to 2025. IDC however, pegs Zoom's future addressable market much higher at $43 billion, as cited in last quarter’s earnings call.
At the end of first-quarter fiscal 2020, the company had roughly 58,500 customers (with more than 10 employees), up 86 percent year over year. Zoom has a strong partner base that includes companies such as Salesforce, and these partnerships will be instrumental in future growth.
Additionally, the company announced that its U.S Federal Risk and Authorization Management Program (FedRAMP) authorization has been approved, with the sponsorship of the US Department of Homeland Security. This authorization allows US Federal Government agencies and contractors to securely use Zoom for video meetings, API integrations, and more. The nod to Zoom over competitors Cisco and Microsoft is an important clue for Zoom’s future potential.
Some analysts claim the domestic market is close to saturation, and Zoom will have to look for more opportunities in overseas markets. This is unlikely as video communications is incredibly nascent. However, looking at the first quarter, APAC and EMEA revenue grew a combined 127 percent year-over-year and Zoom sees international expansion as a major opportunity. As such the company plans to add local sales support in further select international markets over time and also use strategic partners and resellers to sell in international markets
Revenue from APAC and EMEA collectively represented about 20 percent of Zoom’s revenue for the quarter and management noted that it could be the beginning of a sizable opportunity to bring the Zoom platform to other regions.
SECTION 3: Product Analysis
Founded in 2011, Zoom describes itself as a leader in modern enterprise video communications. The CEO states that Zoom is enabling greater effectiveness in human-to-human interactions over a distance with use cases that are not possible with legacy systems.
The translation here is that Zoom is a much easier-to-use video conferencing application with very little friction in downloading the app before you’re ready to join a video call. Zoom is an example of the “sum of its parts is greater than the whole.” Its success is based off many micro improvements to video conferencing that adds up to a serious advantage over the competitors.
Cisco is the main competitor that Zoom is disrupting as CEO Eric Yuan was a former engineer at WebEx before it was acquired by Cisco.
Zoom has a “bottoms-up” viral customer base, which means junior employees evangelize the service at the company. These are often some of the most loyal customers. For instance, 55% of $100,000 or higher revenue customers were started with a single employee’s free trial. This is an important insight to the traction of the product.
The secret sauce to Zoom is that the business model has a viral mechanism. Some of the best growth in tech products occur when the product multiplies across users exponentially. This is why social media reported incredible growth – one user invites many users to the platform with a simple link.
“Viral mechanic” means the spread of growth across users as a built-in mechanism to the product. The first Zoom user in an office naturally evangelizes the product by inviting more people to a conference with a simple link. The users who are invited do not need to sign up for Zoom, and the experience is much better than other conferencing solutions that require many steps to join a conference and are not in HD.
Teams are increasingly mobile, switch between many devices and need to join meetings very quickly. The competition does not allow for this as software needs to be installed to join a meeting. Zoom’s easy access URLs to join meetings are essentially going viral in every office where they convert one free user. This is the foundation to Zoom’s success.
SECTION 4: Key Metrics
Software-as-a-service (SaaS) has unique key metrics that venture capitalists look for when privately funding a SaaS startup. Subscription revenue run-rate is one metric used, although it can be overly simplistic
Annual Revenue Run Rate = Monthly Revenue * 12 months
ARR does not account for churn or growth. Zoom’s ARR likely looks better than the more mature companies on the public markets (which are contrasted below) because Zoom is a smaller company and has gone through periods of hyper growth.
For this chart to be completely accurate, you would have to compare growth from the same year of a company’s inception as Zoom is going public early compared to the other companies in this chart, and therefore, demonstrates hyper growth compared to a more mature company that files to go public.
Regardless, this snapshot of annual recurring revenue shows the company not slowing down anytime soon.
Private investors typically calculate the monthly recurring revenue, which calculates the amount of revenue you have in the beginning of the month + the revenue you gain during the month – downgrades or customer churn.
TECHNICAL ANALYSIS:
By Knox Ridley
After an upward trend following the IPO, and a gap-up after its last earnings report, Zoom has completed what appears to be its primary uptrend, and is currently taking a breather. The first move down corrected to the exact 50% retrace of initial IPO uptrend, while the next move, pushed back up to the 78.6% retracement prior move down.
We are currently trading at the 38.2% retrace of the initial IPO uptrend, and this area is providing strong support for ZM. Zoom is a stock that regularly swings from overbought to oversold, so when I see it range bound, which is narrowing while leading up to earnings, we’re likely to see a strong move in the near future.
If we look at the 200-day moving average in orange, you’ll see ZM has been trading just below this average up until yesterday. The 200-day is currently pointing down, and through its slow shift down, ZM has traded in the same direction as this average. Furthermore, if we attach a Volume Weighted Moving Average (AVWAPs), anchored to the beginning of the IPO uptrend and another one at the all time high, just before Zoom’s correction, you’ll notice an additional dimension to this trading range. These 2 AVWAPs can be seen in dark purple, and they are also compressing ZM into a tight range.
These AVWAPs show who is in control. In terms of the primary upward trend, you’ll notice that ZM is trading just above this average, indicating that the bulls are still in control of the primary trend. However, the AVWAP from the all-time high shows who is in control of the correction we are currently in. Even with the move up today above the 200-day, the price is still trading just below this AVWAP. This tells us that the bears are in control of this correction for now. Zoom will remain in this trading pattern until one of these AVWAPs is broken, which we should see in short time.
CONCLUSION:
There’s no reason to believe that Zoom Video will miss on the top line or bottom line. The company is centered in a major shift from audio to video for enterprise communications. The company is overpriced by most standards; however, the product’s strength is likely to defy the bears with the product winning out over time.
However, a $25 billion market cap with $546 million in revenue may be too outsized of a valuation for a buy-andhold. To initiate a long buy-and-hold, I’d like to get Zoom between $78-$83. With that said, I personally like Zoom enough to be in the game for these earnings and in the short-term. I believe the triple-digit revenue growth should continue to excite the market in the near term and makes a decent momentum play.
The primary risk to Zoom Video is a broader market pullback (which would drive pricing down across growth stocks). In my opinion, the tide “for all boats” will have to recede for Zoom Video’s valuation to come down.
Please note: The I/O Fund conducts research and draws conclusions for the Fund’s positions. We then share that information with our readers. This is not a guarantee of a stock’s performance. Please consult your personal financial advisor before buying any stock in the companies mentioned in this analysis.
Zoom Video Communications is a company with a valuation where logic is ignored, and any investor in the stock would need to get comfortable with this. The current valuation of $25 billion comes from a company with $546 million in revenue and EBITDA of $39 million this year. Zoom is expecting revenue of $129 million to $130 million with non-GAAP income of $2-$3 million. Q2 non-GAAP EPS is expected to be $0.01 to $0.02. One reason Zoom is demanding a high valuation is that the rapid revenue growth coupled with achieving profitability should create the perfect storm over the next few years.
According to Gartner, by 2022, 65 percent of meeting solutions users will take advantage of SIP/VoIP-based audio-conferencing tools. This is up from 20 percent in 2017 while 40 percent of meetings will be facilitated by virtual concierges and advanced analytics. The exact size for the video communications market varies considerably depending on the source – this is because the market is very new. According to research from Markets and Markets the video communications market is expected to grow an average of 8 percent a year to nearly $20 billion by 2023 with another report expecting that the industry will register a CAGR of 9.2 percent from 2018 to 2025. IDC, however, pegs Zoom's future addressable market much higher at $43 billion, as cited in last quarter’s earnings call.
SECTION 1: Financials
Zoom Video Communications is a company with a valuation where logic is ignored, and any investor in the stock would need to get comfortable with this. The current valuation of $25 billion comes from a company with $546 million in revenue and EBITDA of $39 million this year.
Compare this to Square with a similar market cap, yet revenue of more than $2.27 billion. Zoom’s enterprise value/sales of 50 is the highest of EV/sales of any U.S. tech company valued at more than $500 million, according to FactSetData. With free cash flow of $15.3 million, Zoom trades for 450 times forward free cash flow.
Revenue in the most recent quarter grew 103 percent to $122 million, surpassing estimates of $111.7 million. This was the eighth straight quarter of triple-digit top line growth. Zoom is profitable with EPS of $0.03 quarter and $15.3 million in free cash flow.
Zoom is expecting revenue of $129 million to $130 million with non-GAAP income of $2-$3 million. Q2 non-GAAP EPS is expected to be $0.01 to $0.02.
One reason Zoom is demanding a high valuation is that the rapid revenue growth coupled with achieving profitability should create the perfect storm over the next few years.
To get an idea of growth over the past few years, Zoom’s S-1 Filing showed $60M in revenue in 2017, $151M in revenue in 2018 and $330M in revenue in 2019 with an estimated $540M in revenue for the upcoming fiscal-year. The 100%+ revenue growth has been accompanied with gross profit margins in the high 70% to low 80% range. I would not be surprised if Zoom exceeds expectations on revenue in the current fiscal-year.
Zoom became profitable in the year ending January 31st, 2019 with $7.58 million in net income or 3 cents EPS. The year prior, Zoom reported a net loss of $4.8 million.
Analysts are currently seeing more downside with a median target of $83 and a low estimate of $55 with a high estimate of $115.
SECTION 2: Growth & Addressable Market
According to Gartner, by 2022, 65 percent of meeting solutions users will take advantage of SIP/VoIP-based audioconferencing tools. This is up from 20 percent in 2017 while 40 percent of meetings will be facilitated by virtual concierges and advanced analytics.
The exact size for the video communications market varies considerably depending on the source – this is because the market is very new. According to research from Markets and Markets the video communications market is expected to grow an average of 8 percent a year to nearly $20 billion by 2023 with another report expecting that the industry will register a CAGR of 9.2 percent from 2018 to 2025. IDC however, pegs Zoom's future addressable market much higher at $43 billion, as cited in last quarter’s earnings call.
At the end of first-quarter fiscal 2020, the company had roughly 58,500 customers (with more than 10 employees), up 86 percent year over year. Zoom has a strong partner base that includes companies such as Salesforce, and these partnerships will be instrumental in future growth.
Additionally, the company announced that its U.S Federal Risk and Authorization Management Program (FedRAMP) authorization has been approved, with the sponsorship of the US Department of Homeland Security. This authorization allows US Federal Government agencies and contractors to securely use Zoom for video meetings, API integrations, and more. The nod to Zoom over competitors Cisco and Microsoft is an important clue for Zoom’s future potential.
Some analysts claim the domestic market is close to saturation, and Zoom will have to look for more opportunities in overseas markets. This is unlikely as video communications is incredibly nascent. However, looking at the first quarter, APAC and EMEA revenue grew a combined 127 percent year-over-year and Zoom sees international expansion as a major opportunity. As such the company plans to add local sales support in further select international markets over time and also use strategic partners and resellers to sell in international markets
Revenue from APAC and EMEA collectively represented about 20 percent of Zoom’s revenue for the quarter and management noted that it could be the beginning of a sizable opportunity to bring the Zoom platform to other regions.
SECTION 3: Product Analysis
Founded in 2011, Zoom describes itself as a leader in modern enterprise video communications. The CEO states that Zoom is enabling greater effectiveness in human-to-human interactions over a distance with use cases that are not possible with legacy systems.
The translation here is that Zoom is a much easier-to-use video conferencing application with very little friction in downloading the app before you’re ready to join a video call. Zoom is an example of the “sum of its parts is greater than the whole.” Its success is based off many micro improvements to video conferencing that adds up to a serious advantage over the competitors.
Cisco is the main competitor that Zoom is disrupting as CEO Eric Yuan was a former engineer at WebEx before it was acquired by Cisco.
Zoom has a “bottoms-up” viral customer base, which means junior employees evangelize the service at the company. These are often some of the most loyal customers. For instance, 55% of $100,000 or higher revenue customers were started with a single employee’s free trial. This is an important insight to the traction of the product.
The secret sauce to Zoom is that the business model has a viral mechanism. Some of the best growth in tech products occur when the product multiplies across users exponentially. This is why social media reported incredible growth – one user invites many users to the platform with a simple link.
“Viral mechanic” means the spread of growth across users as a built-in mechanism to the product. The first Zoom user in an office naturally evangelizes the product by inviting more people to a conference with a simple link. The users who are invited do not need to sign up for Zoom, and the experience is much better than other conferencing solutions that require many steps to join a conference and are not in HD.
Teams are increasingly mobile, switch between many devices and need to join meetings very quickly. The competition does not allow for this as software needs to be installed to join a meeting. Zoom’s easy access URLs to join meetings are essentially going viral in every office where they convert one free user. This is the foundation to Zoom’s success.
SECTION 4: Key Metrics
Software-as-a-service (SaaS) has unique key metrics that venture capitalists look for when privately funding a SaaS startup. Subscription revenue run-rate is one metric used, although it can be overly simplistic
Annual Revenue Run Rate = Monthly Revenue * 12 months
ARR does not account for churn or growth. Zoom’s ARR likely looks better than the more mature companies on the public markets (which are contrasted below) because Zoom is a smaller company and has gone through periods of hyper growth.
For this chart to be completely accurate, you would have to compare growth from the same year of a company’s inception as Zoom is going public early compared to the other companies in this chart, and therefore, demonstrates hyper growth compared to a more mature company that files to go public.
Regardless, this snapshot of annual recurring revenue shows the company not slowing down anytime soon.
Private investors typically calculate the monthly recurring revenue, which calculates the amount of revenue you have in the beginning of the month + the revenue you gain during the month – downgrades or customer churn.
TECHNICAL ANALYSIS:
By Knox Ridley
After an upward trend following the IPO, and a gap-up after its last earnings report, Zoom has completed what appears to be its primary uptrend, and is currently taking a breather. The first move down corrected to the exact 50% retrace of initial IPO uptrend, while the next move, pushed back up to the 78.6% retracement prior move down.
We are currently trading at the 38.2% retrace of the initial IPO uptrend, and this area is providing strong support for ZM. Zoom is a stock that regularly swings from overbought to oversold, so when I see it range bound, which is narrowing while leading up to earnings, we’re likely to see a strong move in the near future.
If we look at the 200-day moving average in orange, you’ll see ZM has been trading just below this average up until yesterday. The 200-day is currently pointing down, and through its slow shift down, ZM has traded in the same direction as this average. Furthermore, if we attach a Volume Weighted Moving Average (AVWAPs), anchored to the beginning of the IPO uptrend and another one at the all time high, just before Zoom’s correction, you’ll notice an additional dimension to this trading range. These 2 AVWAPs can be seen in dark purple, and they are also compressing ZM into a tight range.
These AVWAPs show who is in control. In terms of the primary upward trend, you’ll notice that ZM is trading just above this average, indicating that the bulls are still in control of the primary trend. However, the AVWAP from the all-time high shows who is in control of the correction we are currently in. Even with the move up today above the 200-day, the price is still trading just below this AVWAP. This tells us that the bears are in control of this correction for now. Zoom will remain in this trading pattern until one of these AVWAPs is broken, which we should see in short time.
CONCLUSION:
There’s no reason to believe that Zoom Video will miss on the top line or bottom line. The company is centered in a major shift from audio to video for enterprise communications. The company is overpriced by most standards; however, the product’s strength is likely to defy the bears with the product winning out over time.
However, a $25 billion market cap with $546 million in revenue may be too outsized of a valuation for a buy-andhold. To initiate a long buy-and-hold, I’d like to get Zoom between $78-$83. With that said, I personally like Zoom enough to be in the game for these earnings and in the short-term. I believe the triple-digit revenue growth should continue to excite the market in the near term and makes a decent momentum play.
The primary risk to Zoom Video is a broader market pullback (which would drive pricing down across growth stocks). In my opinion, the tide “for all boats” will have to recede for Zoom Video’s valuation to come down.
Please note: The I/O Fund conducts research and draws conclusions for the Fund’s positions. We then share that information with our readers. This is not a guarantee of a stock’s performance. Please consult your personal financial advisor before buying any stock in the companies mentioned in this analysis.
Slack Technologies is the fastest-growing software-as-a-service (SaaS) company of all time and a Silicon Valley favorite, yet the direct public offering (DPO) clearly did not go well for public investors.
The shares WORK, +8.03% opened at $38.50 on June 20, rose to $42 intraday, and have now sunk to a record-low of $26.25 in after-market hours leading into its first earnings report as a public company.
The losses are at 36% from its intraday high, and that occurred when many cloud-software initial public offerings (IPOs) have enjoyed triple-digit returns since going public.
So what went wrong? And, more importantly for growth investors, will things go right for San Francisco-based Slack soon?
Before the company releases second-quarter earnings Sept. 4, here’s insight into its revenue, valuation and competitors.
Slower growth
Slack’s product — an instant-messaging and collaboration system — has massive potential with a 143% net customer retention rate, yet the financials undermine the company’s growth trajectory. For instance, guidance for the current fiscal year is at 47% to 50% revenue growth year-over-year, down from 82% in the prior year. The slower growth, which was revealed in an updated prospectus two weeks before going public, was unlikely to win over many people regardless of how much traction the product has with current users.
Yet, there is impressive traction, with the average user keeping the app open for nine hours on her computer and engaging with it for 90 minutes a day. Compare that with the daily time spent on Facebook FB, +2.60% 58 minutes, Instagram, 53 minutes, YouTube, 40 minutes, Pinterest, 14 minutes, and messaging app WhatsApp, 28 minutes.
As I covered before the DPO, both sides of the debate have valid points when evaluating Slack’s future stock performance. However, due to Slack’s product strength, my prediction is the stock will have a turnaround as user loyalty will overcome the financial turbulence. The questions that remain: timing and valuation for entry.
Divergence in user base
Slack’s revenue grew 110% in fiscal years 2017-2018, and then slowed to 82% in 2018-2019. The company is now forecasting 47%-50% growth in the current fiscal year with revenue between $590 million and $600 million, compared with $400 million in fiscal 2019. This year’s estimated adjusted loss is estimated to be 41 cents to 44 cents a share.
On June 3, Slack released an updated prospectus that showed growth in customers worth over $100,000 in contracts, yet revealed a decline across paid user growth from 9,000 in the year-earlier quarter to 7,000 in the current quarter.
In other words, there is a divergence as overall paid users are declining, while customer accounts worth over $100,000 are growing. That could be because of internal efforts to raise revenue and focus on enterprise-level customers, which is a common strategy leading up to public offerings. More quarterly earnings are needed to ultimately decide which direction this will go, and if the larger accounts will pay off as a primary focus for growth.
Slack provided the net dollar retention rate in the S-1 filing, which depicts what percent of revenue from current customers is retained from the prior year, after accounting for upgrades, downgrades and churn. This is helpful in predicting growth for subscription-based companies.
The formula for the net dollar retention rate is: Beginning of period revenue + upgrades – downgrades + churn = y with y/beginning of period revenue.
If the net dollar retention rate is above 100%, then the growth from the existing customer base offsets the losses. If the number is below 100%, then downgrades and churn exceed growth.
Slack published a net retention rate of 143%, which is very good and outperforms most cloud software IPOs that provided this number in the past. This is due to Slack’s sticky traction and low churn with the current customer base.
One thing to note about the retention rate is that Slack officially launched in 2014, and has a shorter history than other companies on this list with many having launched 10 years prior to IPO compared with Slack’s five years. Typically, the longer the time period, the lower the net retention rate due to more opportunity for customer churn.
See: Beth Kindig runs a forum on tech stocks where she answers readers’ questions.
Valuation
Slack’s valuation is high — there’s no argument there. If we look at the $600 million in estimated revenue for fiscal 2020 at the $14 billion market cap, then Slack has a forward price-to-sales (P/S) ratio of 24.
Of course, we can name a long list of cloud-software companies with comparable price-to-sales or higher, but the difference is that Slack has not won over sell-side analysts, whereas Shopify SHOP, +0.67%, Zoom Video Communications ZM, +1.16% and Okta OKTA, -0.20% have. Certainly, returns are healthier if you can beat sell-side analysts to a winning stock. (For instance, my newsletter subscribers beat sell-side analysts to Roku ROKU, +7.67% for much higher gains.)
We are also seeing some slight exhaustion in the market with regard to cloud-software valuations. Last week, a few companies beat on both top-line and bottom-line estimates, such as Veeva Systems VEEV, -0.82% and WorkdayWDAY, -0.75%, yet the stocks dipped as much as 6%.
One thing to consider with Slack is that the potential market is nearly impossible to predict as the company is carving out a new category. The global enterprise collaboration market is expected to grow from $34.6 billion to $59.9 billion, with a growth rate of 11.6%.
This is a sizable market for a company with $600 million in revenue. However, it’s hard to determine where Slack’s product fits. Slack CEO Stewart Butterfield alludes to owning 2% of the software market as a force extender for the other 98% of the software market, and that would equate to a market worth $12 billion in annual enterprise software sales.
Okta is a great example of a company that has similar numbers on its profit-and-loss statement, yet Okta earned its market cap through a series of strong earnings reports and gaining the trust of public investors, whereas Slack demanded a record-breaking price-to-sales right out of the gate. TwilioTWLO, +2.02% also has a similar profit-and-loss statement, but is trading at 16 forward price-to-sales. Slack not only priced itself too high for a new company with slowing growth, but it’s also likely the direct public offering didn’t help.
DPOs
In August 2018, Slack was valued at $7 billion in its last venture round and listed at nearly double that in June 2019 when it was listed on the public market.
Herein lies the problem with direct public offerings, which are heralded as a way of cutting out middlemen and fees: The lack of a lock-up period allows the company to price high on the public markets for the benefit of insiders rather than fairly price the stock with the understanding that insiders will lose if the company is overpriced and the stock attracts downward momentum.
Many investors are aware that IPOs can be risky, although tech companies have a penchant for proving these risk-averse investors wrong with many recent triple-digit success stories. In this case, however, both Slack and SpotifySPOT, +0.03% have proven that DPOs are not ideal for public investors as the opening valuations have not been sustained in the long term. This could be due to a lack of consequence for listing too high.
Competitors
There are some valid points on the more bearish side of the debate, but using Microsoft MSFT, +1.17% Team’s 13 million users as the primary weak point is not of them. As with most David and Goliath battles in tech, the market has this backwards.
Slack is a small, relatively unknown brand that has managed to keep pace with one of the world’s most recognized brands — Microsoft. The fact they are almost equal in users at 10 million for Slack and 13 million for Microsoft is a boon for Slack, not the other way around. This proves that Slack is a serious contender and able to attract users with a hundredth of a decimal point in revenue compared with Microsoft’s trillion-dollar market cap.
Slack is a stand-alone app compared with Microsoft’s legacy enterprise software suite, which is now sold as a subscription in the cloud as Microsoft Office 365, yet was originally launched in 1990. Microsoft Outlook has an estimated 400 million users, primarily enterprise.
To say that Microsoft launched Teams in 2017 and has quickly caught up to Slack is not exactly accurate. Microsoft has owned business communications for nearly 30 years and has spent $35 billion in acquisitions to own the messaging space pre-emptively with the acquisition of Skype for $8.5 billion and LinkedIn for $26.2 billion. Those acquisitions occurred around the same time that Microsoft considered acquiring Slack for $8 billion.
Microsoft then leveraged its hundreds of millions of enterprise software customers and copied Slack’s approach. Yet, somehow, Slack should be afraid of Microsoft? I disagree. Investors should be asking themselves why 600,000 organizations are downloading a separate app to hold their business discussions with many being Microsoft Office users.
More importantly, the word Slack is becoming synonymous for business messaging. Like what Kleenex did for facial tissues, “to slack someone” means to send a coworker a message. I do not foresee anyone using Microsoft Teams in this manner, and this is the best free marketing a company can have.
The main product differentiation is Slack’s customization. There are over 1,500 standard integrations with Slack, such as with Zoom video-conferencing and Google Drive. However, there are over 450,000 applications developed internally by Slack customers, according to the CEO. Those applications come from developers who want a more advanced alternative to the closed ecosystem that Microsoft provides.
Conclusion
There is a healthy debate on Slack, and both sides have valid arguments. On the one hand, you have a company with slowing growth, and on the other, you have a product with strong industry key metrics and a highly engaged user base.
When looking at valuation for companies that have similar profit-and-loss statements, it becomes clear that Slack came on too fast and too strong with its valuation. This is a mistake the company has paid for, as the momentum is now downward. Better to have listed at a $10 billion market cap and earned the $14 billion market cap than the reverse, as many public investors can be myopic with tech products and are easily scared off.
For opportunists and visionary investors, however, the downward momentum on a product that is becoming synonymous with business messaging is welcomed for an attractive entry.
This article appeared on MarketWatch September 4th, 2019.MarketWatch September 4th, 2019.
I believe Slack will be one of the better turnaround stories. The question is timing and valuation. Due to weak technicals going into earnings, I am on the sidelines on a product that I believe has some of the best key metrics in the industry right now. I’m waiting because the probability of Slack selling off on any perceived weakness is higher than Slack rallying.
Now, Slack could rally, and that’s a chance that anyone reading this should carefully consider. I wrote in MarketWatch today why I like the product, especially for the net retention rate and stickiness. This is why I have a high conviction that Slack will have a profitable turnaround in the future.
As you’ll see in the analysis, I do not see Microsoft as a primary threat (but let’s hope the market does see Microsoft as insurmountable obstacle so that we can get the stock cheap). As a tech analyst, it is one of my strengths to truly understand the competitive positioning of products compared to financial analysts, who are numbers driven and removed from the startup scene.
Even with Microsoft Teams growing faster than Slack, this will not be a concern for Slack’s trajectory long-term. Slack is taking market share from Microsoft, not the other way around. Regardless, there’s room for both — and Slack is a pure play stock with the right key metrics.
Note: Microsoft is a recommendation of mine for cloud infrastructure-as-a-service and enterprise software revenue segments.
Slack’s profit and loss statement is more positive than its first appearance for a few reasons. To start, the company does not monetize the majority of its users. The company is doing this to gain market share, yet Slack can monetize when the market begins to hit saturation (which will not occur anytime soon as Slack has tapped an estimated 5% of the market). But, when the company is ready – that revenue will be there waiting.
Also, consider that the Slack messaging app is only 5 years old. The product launched publicly in February of 2014. Meanwhile, it already has similar financials as Okta, which launched in 2009. Zoom video has 3 years on Slack, launched in 2011. In startup years, that’s a substantial amount of time.
The third is that Slack is a data powerhouse as messaging is a superior form of data. This is not related to the P&L, but is a future driver of revenue and is a benefit currently invisible in the financial statements. The store of data that Slack has will convert to revenue in the future.
Now, back to the main question – timing and valuation. I would love to get Slack at a $10 billion valuation as I believe the company will grow to a $50 billion valuation once the market for enterprise B2B messaging matures and all of Slack’s integrations are fully understood. I would settle for a $12 billion valuation.
My hope is that Wall Street beats this stock up on the slowing growth and that sell-side analysts don’t want to take the risk on initiating a position until the herd is more positive on the company. The technicals on this stock are weak at $14.5 billion, and that was Slack’s mistake to price high rather than earn its market cap over a series of earnings reports.
I’m rolling the dice that I can get Slack cheaper than where it is today with the understanding this will be a long term holding of mine by early 2020. Nobody can tell you for sure what will happen with an earnings report (or the market’s reaction) – everything is a probability.
Knox has been watching Slack closely since the DPO and he has some thoughts for you on entry.
Technical Analysis
By Knox Ridley
Since its DPO, Slack has been in an obvious downtrend, making lower highs and lower lows. On one hand, because the price action is so new with limited inputs, there is not a lot of information to make an in-depth technical report on Slack.
However, as we mostly see with new IPOs with a fundamental story that is not fully understood, as well as no earnings to spark a reaction, price will typically align with Fibonacci ratios quite succinctly, as can be seen in the chart below.
Support/Resistance Targets
In a corrective move, we commonly see 3 moves in the downtrend, where the third move is usually the same length as the first move, and at times will extend to a ratio of the first move. This is exactly what we are seeing in Slack today.
The B wave retraced almost exactly 50% of the A Wave’s initial move, as shown in the first red resistance line around $38.45. Then Slack trended to nearly the exact length of the A Wave (100% extension) around $31.25, before making a corrective bounce to the $35 region, a price cluster that will hold significance for Slack to break through in a bullish move, which is highlighted by the green dotted line.
Another phenomenon we see in technical analysis is the significance of round numbers. This is evident in the support/resistance region around $30. Slack respected this region with force until recently breaking below it, signifying a new leg down, at which point it became strong resistance. I view this price cluster a significant psychological support/resistance.
Slack has found support again around the price cluster that coincides with the 1.382% extension of the A Wave’s which is between $28.50 region. As you can see, Slack has traded within the trend channel, highlighted by the blue lines, and seems to be looking to break out to the upside, even after making this last push towards this region.
Internal Strength
AVWAPS
I attached a Anchored Volume Weighted Moving Average (AVWAP) to the 4 major bounces, which indicated the lower highs within the downtrend. The AVWAP shows the price of Slack from each of these specific emotional points, which signify failed breakouts and the commencement of the downtrend to new lows.
The AVWAP is like a voting machine that not only looks at the price, but the amount of shares that was purchased at that price. Because of these factors, it’s a very accurate tool for seeing the exact moving averages that need to be reclaimed in an uptrend. These trends are shown in black, and represents the trend we are currently in.
As you can see, Slack has a lot of work to do in order for the bulls to regain control. These moving average will act as significant resistance on any uptrend, and once reclaimed in full, will be a strong statement that the bulls are in control. I will want to see these Slack begin taking back these AVWAPs before committing fully to the uptrend.
Relative Strength Index
At first glance, Slack’s RSI is quite weak. It’s spent the majority of its time below the 50 line, and like we see in downtrends, the 60 line of the RSI is not broken. Reclaiming the 60 line in the RSI will be crucial for Slack to get out its current downtrend.
However, there is a pattern developing in the RSI that is one of my favorite signals to trade – Positive Divergence. This is highlighted in the chart, where the price is making lower lows and the RSI is making higher lows. It’s a strong indication that selling pressure is letting up, at least temporarily, and that a reversal could be underway. Whether this reversal is corrective or the beginning of an uptrend, is too soon to tell.
It’s always dangerous to trade a stock in a defined downtrend. However, we believe Slack is a fantastic long-term play. If you want to roll the dice at the $28 region, make sure that you have very tight stops in this market, and at most, put a stop in just under to 200% extension at $24.
There is less risk at $35 or above (bullish pattern), or at the 200% extension at $24, than where it is currently priced.
Okta is fundamentally weaker than many analysts believe, making its booming stock priced to perfection.
The company was early out of the gate for cloud-subscription IPOs in 2017, and the valuation has reaped the benefits of Wall Street’s enthusiasm for subscription models. However, a reasonable price to initiate Okta as a buy-and-hold investment is now in the rearview mirror, rendering it a momentum play. That will be important for investors when they review its earnings report for the three months through July after the stock market closes Wednesday.
Okta’s stock dropped 10% on weakening guidance for both revenue and earnings per share (EPS) in the March earnings report. The stock quickly recovered, as there was little adjustment given for lower EPS guidance.
Investors put that out of their mind, as the stock recovered with renewed momentum within a few days and has not looked back. Last quarter, Okta raised its guidance to expected losses of $0.45 to $0.49 per share, although this “improvement” is relative, as the original expectations of the full-year loss was at $0.22 per share prior to the March earnings report.
Valuation has been an ongoing worry with Okta, as the company has the highest forward price-to-sales in its category, at 27, with a current price-to-sales of 34. Compare this to Workday at 12 forward price-to-sales, Veeva Systems (which is profitable) at 22, and Twilio at 15.
There is ample evidence that, although Okta is priced to perfection, it does not need to report perfection to continue its momentum. This is one red flag for a buy-and-hold strategy at current prices, but a positive sign for momentum trading. Eventually, the market will want perfection for the price it’s paying when macro conditions warrant more discernment.
For instance, many analysts are touting the stock for positive free cash flow (FCF), although this is from operating cash efficiencies. Okta does not have positive free cash flow from positive net income, which is something financial analysts are writing out of the script entirely.
Free cash flow becomes more indicative of financial health when net income is positive; to separate the two underweights profitability, which is a mistake for buy-and-hold investors (or analysts) when evaluating the stock. Free cash flow positive is much more celebratory when net income is positive.
In fact, Okta suffered a record net loss in the fiscal first quarter that ended in April. Okta’s loss widened nearly 200% year-over-year, to $51.9 million. This led to diluted EPS of negative 46 cents, compared with negative 25 cents in the year-earlier quarter.
Lastly, Okta is no longer a debt-free company and is carrying $275 million in convertible senior notes.
Wall Street is laser-focused on Okta’s top line, and is a little blind-sided to the bottom line as free cash flow and subscription growth were the only touted highlights from last quarter’s earnings report.
Okta posted 53% year-over-year growth in subscription services to $108.5 million, while professional services revenue grew 15% to $7 million. Total calculated billings hit $158.9 million, with trailing 12-month subscriptions jumping 55% to $488.2 million.
The increase in net losses from the most recent quarter was under-reported due to subscriptions driving revenue growth of 50% year-over-year.
In the upcoming earnings report, the bar for revenue is set to less than 40%, which is an easy hurdle for a subscription cloud company that has been posting 50%-plus revenue growth for many consecutive quarters.
In Okta’s case, there are two areas I am watching more closely, as spending is substantial and executive decisions are slightly unusual.
The first is sales and marketing expenses, which are nearly two-thirds of revenue. At Workday, sales and marketing comprise 30% of revenue, Twilio is at about a third and Zoom Video Communications is at about half.
This signifies Okta needs to spend a lot to scale and maintain its footing. Selling, general and administrative (S&GA) expenses were nearly 85%, or $107 million, of $125 million in total revenue in the most recent quarter. Notably, Okta’s S&GA and research and development (R&D) exceed revenue at 114%.
The second clue is a few recent acquisitions that will hurt Okta’s financials. For instance, Okta’s $52.5 million purchase of early-stage startup Azuqua will dent operating expenses. (Early-stage startups tend to have thin margins, although exact numbers from Azuqua weren’t provided.)
There is also a recently announced $50 million venture fund. Creating venture funds is typically a positive, as companies including Twilio and Workday also have created venture funds to help incubate firms that use its product and services. However, in Okta’s case, it’s funding startups to help innovate the core product, which is concerning because Okta is not even profitable yet and is already looking for help to iterate the core product, rather than incubate to increase demand in the market.
Looking deeper, I believe Okta is throwing a lot of weight into product because the mega-cap cloud server companies are in the identity and access management (IAM) market. Okta has to provide a compelling reason to use an add-on service to Microsoft Azure, Google Cloud, Amazon’s AWS and IBM Cloud rather than use the in-house identity and access management service.
See: Beth Kindig runs a premium service that includes a forum on tech stocks where she answers questions from readers. See: Beth Kindig runs a premium service that includes a forum on tech stocks where she answers questions from readers.
Okta does have a competitive advantage due to its superior product, which is confirmed by third-party analysts Gartner and Forrester. The one issue to consider for the long term is that larger rivals are going to protect their turf. Cloud infrastructure is a revenue segment that will determine the world’s most valuable company over the next few years, and Okta has an incredible feat ahead to remain more agile and to iterate faster than opponents that have bottomless amounts of cash. On that note, Okta could make a great acquisition for one of those companies, though any prospective suitor would have to overpay.
Okta is unlikely to miss estimates on revenue as the subscription model helps protect growth, yet other line items may continue to miss or weaken. Okta has no choice but to spend heavily on its market position — either through S&GA, R&D or acquisitions — to fend off larger cloud competitors that are a one-stop shop for identity and access management, and are currently engaged in a battle for cloud infrastructure.
Overall, Okta became a fundamentally weaker company in the past two quarters, yet the stock price does not reflect this, which is why it makes a better momentum play than a buy-and-hold. Previous earnings reports prove that although priced to perfection, the company does not need to report perfection in order for the stock to claw at a higher price-to-sales ratio.
SUMMARY: Workday began to pivot from software-as-a-service (SaaS) to a platform-as-a-service model in 2018. The company is becoming a leader in machine learning and AI in the HCM market, and a PaaS model will assist platform-level ML capabilities. This also helps to leverage the Adaptive Insights acquisition by combining the insights from business planning across the other segments, such as financial management, HCM and analytics.
Market Research Future estimates the global human capital management software market will reach $24 billion by 2023 at a CAGR of 9 percent during the 2017-2023 forecast period. Workday not only is the leader in Gartner’s magic quadrant from a product standpoint, but had led the category in year-over-year growth of between 30-40%.
It is reasonable to believe Workday will control the majority of the $24 billion market if the company executes globally.
As with many cloud stocks on the market today, Workday has solid revenue growth yet is not profitable on a GAAP basis. Workday carries debt on its balance sheet of $1.22 billion. Net losses last quarter were $116 million.
In the previous quarter, Workday’s revenues grew 33% to $825 million, which beat forecasts of $814 million. Subscription services grew 34% to $701 million, exceeding expectations of $692-$694 million.
In the upcoming quarter, Workday expects to earn subscription revenue of $746 million to $748 million and services revenue of $124 million. Zack’s consensus states Workday is expected to report revenues of $872 million, up 29.9% from the year-ago quarter. This is in line with the company’s guidance on the last earnings call.
Unlike other cloud stocks, Workday is profitable on a non-GAAP basis. The company is expected to post quarterly earnings of $0.35 per share for a year-over-year change of 4 cents. Notably, expectations are lower than last quarter’s reported adjusted EPS of $0.43 per share.
Cash Flow is negative due to a streak of acquisitions, such as Adaptive Insights for $1.5 billion last year. In total, Workday has acquired 13 companies; many small startups which hurts its operating efficiency and overhead.
Last quarter, Workday raised its full-year outlook for subscription revenue a hair from $3.03 to $3.045 billion to $3.045 to $3.06 billion. The company states there is a subscription revenue backlog of $6.80 billion, up 30% yearover-year.
SECTION 2: Product Overview
Workday offers tools for enterprises to manage human resources, payroll, and finances. The company is a software-as-a-service company with over 85% of revenue coming from cloud subscriptions.
The company serves the human capital management (HCM) and financial management ERP markets with applications that expand its cloud-based system to include analytics and business planning. HCM allows an organization to staff, pay, organize and develop its workforce. Financial management ERP provides core finance functions, such as general ledger, accounting, accounts payable and cash management.
According to the fiscal Q2 2019 earnings call, more than 35 percent of the Fortune 500 and 50 percent of the Fortune 50 companies use Workday HCM for core HR. The product was placed as a leader in the Gartner Magic Quadrant for Cloud HCM Suites for midmarket and large enterprises in August 2018, with no update released since.
Workday’s cloud financial management solutions have less traction with 8 companies in the Fortune 500 and 530 customers overall.
The acquisition for Adaptive Insights, which is a provider of business planning and financial modeling tools, will help to strengthen Workday’s presence in Enterprise Resource Planning (ERP). At time of acquisition, Adaptive Insights also had 3400+ customers compared to Workday’s 450+ customers due to Adaptive Insights strength in the small-to-medium business (SMB) base.
Workday began to pivot from software-as-a-service (SaaS) to a platform-as-a-service model around 2018. The company is becoming a leader in machine learning and AI in the HCM market, and a PaaS model will assist platform-level ML capabilities. This also helps to leverage the Adaptive Insights acquisition by combining the insights from business planning across the other segments, such as financial management, HCM and analytics.
Machine learning and graph analysis applications were launched in April with Skills Cloud, which discerns team and candidate skills to offer hiring recommendations, team building and training. The newly launched Discovery board will uses ML, graph and pattern-detecting, and natural-language processing (NLP) generation to provide unified reporting.
Looking into the future, Workday’s ML capabilities may be able to reduce employee headcount. Although Workday prefers to not advertise the fact their product enhanced by machine learning can replace jobs, this is an understood benefit of Workday’s product that is presented at conferences.
SECTION 3: TAM and Competitors
Market Research Future estimates the global human capital management software market will reach $24 billion by 2023 at a CAGR of 9 percent during the 2017-2023 forecast period. Workday not only is the leader in Gartner’s magic quadrant from a product standpoint, but had led the category in year-over-year growth of between 3040%. Ceridian and Ultimate Software have posted the next highest growth levels. Ultimate Software is also in Gartner’s leader quadrant, yet was founded in 1990 and has been usurped by Workday. It is reasonable to believe Workday will control the majority of the $24 billion market if the company executes globally.
In my opinion, Workday’s competitors are a strength as Workday is without an attractive alternative. Both Oracle and SAP tend to be overpriced and clunky, which means they require too much software for the desired task.
In Oracle’s case, the company is distracted with data management, and sales and marketing. HCM and financial ERP are not Oracle’s core revenue segment, and this helps Workday standout as Workday invests more into newgen applications. Notably, Workday was spun out of a “hostile takeover” by Oracle of the company PeopleSoft in 2005 for $10.3 billion. After the acquisition, over half of PeopleSoft’s workforce was laid off, totaling 6,000 people. The former CEO of PeopleSoft and chief strategist went on to found Workday approximately two months later. Today, Oracle’s PeopleSoft is known for having security issues with several cases reported between 2010-2016 including social security numbers.
SAP has a similar lack of focus, and is also not entirely cloud based, which makes SAP unlikely to innovate faster than Workday on machine learning. Workday has captured more customers in the United States, as well, where the majority of its customers reside. Notably, SAP will be harder to compete against in its native geo, Europe.
On that note, Workday continues to see global expansion as one of its growth levers, with total revenue outside the U.S. up 41 percent to $184 million, representing 23 percent of total revenue.
See Conclusion Below Section 4 See Conclusion Below Section 4
SECTION 4: Technical Analysis:
By Knox Ridley
4.1 Moving Averages:
Workday is currently trading below its 50-Day Simple Moving Average, and just above the 200-Day Simple Moving Average. The 50-day is a generally accepted measure of determining the uptrend’s primary support, to where the 200-Day is considered the last stand for the uptrend. Workday is trading well below its 50-Day and has been riding the 200-Day.
Simple Moving Averages can seem arbitrary in their time frames, and in a way, they are. The 50-day and 200-day do not really align with any significant accumulation of time other than they are round numbers and are commonly accepted as indicators by the investing community. Because of their popularity, they are powerful tools that any chartist must factor into their analysis.
However, to get a better idea of who is in control of the price for a deeper insight other than popular moving averages, I prefer to use Anchored Volume Weighted Moving Averages (AVWAP). These averages factor in volume to the price, and we can anchor the average to any time we want.
I anchored, in green, the AVWAP, to the November lows in 2018, just as this renewed uptrend began. You can see that it sits just below the 200-Day.
This is a more accurate portrayal of who is in control of this trend. If this average is breached, and the price trades below, then Workday’s pressure will trend down and a larger retrace could be in its future. However, for now, the price is respecting this average, indicating that the uptrend is still intact.
4.2 Retrace Target:
In short, if Workday breaks this average, as well as breaks the current support range it is trading in, we can expect a deeper pullback. My first target is around the $172.5 support. This coincides with closing the gap, and will likely remain at this support for some time.
Below this level, and I will target the 38.2% retrace, which also coincides with the 168% extension. This range has also been a strong price cluster for the Workday’s price action, so it will be a likely target for any deeper retrace, which is around the $142-$140 region.
4.3 Internals:
The RSI was indicating negative divergence leading up to the sell off at all-time highs. This is evident with the red and green arrows going in opposite directions. The RSI has broken through the 40 line, and is attempting to climb back, while price stays flat.
The RSI is now turning back down before even hitting the 50 line. The momentum has faded from Wday, and the RSI is in a selling range. However, looking back at its 3-year trading history, you’ll notice that it’s hit the bearish zone numerous times, and each time it was a short stay.
Until Workday meets resistance multiple times at the 50 line and punctures the 30 line with force, it’s very possible that it could regain its momentum and continue in an uptrend.
Conclusion:
Quite a few stocks are showing weak price action, and are pointing to continued weakness, likely due to broader market issues, such as the inverted yield curve, trade war, etc. – rather than due to factors in the individual stock.
Workday is fundamentally strong with low competition and good prospects for future growth from machine learning, as indicated in the fundamental analysis. Ideal buy-and-hold from technical analysis is in the $142-$140 region. If the earnings report is weaker than expected, I’d see that as a buying opportunity – especially if the price breaks the $172 support and we get a deeper correction.
Short-term, Workday can make a good trade with call options at or near $190 and/or a small position with 10% trailing stop. Less than a month ago, Workday was at $212 and was at $195 less than a week ago. A strong earnings report could renew these prices. I personally like the end of September $190 call options. Per the paragraph below, any calls may need some time as this week has been a little choppy for cloud stocks.
This week, we are seeing mixed reactions to cloud earnings. Veeva Systems beat earnings Tuesday, received analyst upgrades, yet the stock price has dropped a few percentage points today. Anaplan also beat earnings, yet stock price dropped a few percentage points today. Okta, as well, is down after-hours despite an earnings beat. Therefore, there’s a chance, even with an earnings beat, that Workday’s price doesn’t withstand the broader market.
Crowdstrike is another Silicon Valley startup that recently went public with triple-digits across the board including revenue growth, net retention rate, and annual revenue-run rate, which may have you wondering, how does one tell all of these Silicon Valley IPOs apart? For the Crowdstrike IPO, as with most cybersecurity companies, competitive landscape is crucial and requires bulletproof product differentiation as security is a very crowded space. This analysis will look into the product differentiation between Crowdstrike and its competitors for endpoint security to achieve an understanding of valuation and to form a prediction of how Crowdstrike will perform as a public company. Addressable market will also be taken into consideration as endpoint security has demand limitations.
Overview of Endpoint Security
Understanding the basics around endpoint security is important as Crowdstrike’s strength resides in how the software uses artificial intelligence to detect breaches. Some of the company’s growth may also come from offering multiple cloud modules, which provides various product features for flexibility.
The primary category for Crowdstrike is endpoint security, which secures endpoints on a network, defined as end-user devices, such as mobile devices, laptops and desktop PCs, although endpoint security can also include servers in a data center and IoT devices. Endpoint security protects the corporate network from remote devices by securing the endpoints on the network. Traditionally, endpoint security consists of security software centrally managed on a server or gateway and software on the client devices. The server authenticates logins from the endpoints and updates the software when needed.
Crowdstrike’s product improves this process by aggregating the data from the endpoints across their entire customer base, while using AI and behavior pattern-matching to stop breaches. According to CrowdStrike, their Falcon product correlates more than 90 billion security events globally to prevent and detect threats. Relying on AI’s detection capabilities for security breaches and fraud is becoming a trend into the foreseeable future. For instance, I recently interviewed Mastercard’s Vice Chairman on how Mastercard uses pattern-matching to detect fraud and unusual behavior on my tech podcast, and has been successful in preventing high-loss activities such as money laundering as these behavioral patterns appear erratic to AI, and become easily detectable.
Crowdstrike had one offering until 2017 when the company launched multiple cloud modules to provide flexibility, which are all subscription-based. According to Crowdstrike, offering different subscription options has been successful with 47% of customers buying over 4 modules, per the S-1 Filing.
Crowdstrike IPO and S-1 Filing by the Numbers
Crowdstrike has grown at a blistering pace from $37 million in revenue in 2017 to $92 million in 2018 to $219 million in 2019. The numbers published for the Crowdstrike IPO show an undeniable triple-digit growth trajectory, but keep in mind, that cybersecurity is a crowded field with many players dealing in endpoint security – more on this below.
Loads of Competition:
Endpoint security is a crowded space. Not only do you have incumbents like Symantec, but you have small to mid-cap companies – both public and private. The market size for endpoint security was at $6.4 billion in 2018 and will grow to $13.2 billion by 2022, according to Statista. Meanwhile, you have more than 20 companies competing for the $7 billion slice of pie. This is the bigger concern for Crowdstrike. Investors in Crowdstrike will have to believe that crowdsourcing endpoints and scanning for breaches with AI is enough of a differentiator to pull ahead and maintain a lead.
Assuming Crowdstrike claims the entire endpoint security market, the current valuation impedes investor returns. The market cap for Crowdsrike is at $14 billion, at time of writing – or 200% of the current addressable market and over 100% of the addressable market for 2022.
This is not the addressable market in the S-1 filing, however, which is listed at $24.6 billion in 2019 and expectations to reach $29.2 billion in 2021. The addressable market that Crowdstrike claims is a bit distorted, in my opinion, as it aggregates various forms of revenue streams (which are not later broken out in the S-1 filing). For the most part, Crowdstrike is considered an endpoint security product and frequently ranks on analyst reports for this category. There is very little mention of Crowdstrike ranking in any of the other categories which are being used to stretch the addressable market, notably, threat intelligence, security and vulnerability management, IT service management software, and managed security service.
We have some indication that 47% of customers bought over 4 modules, per the S-1 Filing, but it’s unclear if these modules should fall under the endpoint security addressable market rather than under separate addressable markets as these modules cannot stand on their own. This is paramount to valuing the company (is Crowdstrike endpoint security or should it be placed under various categories) as the growth for endpoint security is too lean to have this high of a valuation.
Meanwhile, other cyber security companies such as Carbon Black, Trend Micro and Palo Alto Networks have not don’t particularly well on the public markets recently relative to other tech investments.
Carbon Black went public in 2018 in the $23 price range and is now trading at $15 due to a shift to cloud and other challenges required to keep up with competition. CarbonBlack is going through a “significant corporate transition,” consolidating its offerings into a cloud-based security platform, which confirms the competitive environment.
Trend Micro is the third-largest vendor in the Endpoint Protection Platforms (EPP) market and has a market cap of about $6.3B and has traded sideways for years between $30-$50 with a peak in September/October this year at $60 but saw a correction and resumed the $45 price.
Palo Alto Networks provided weaker guidance in the most recent earnings report and we’ve seen the price drop over the last month from $250 to $195. The company is also transitioning to the cloud and undergoing changes that impacted the recent earnings.
Conclusion
Crowdstrike’s IPO financials sparkle with triple-digit growth percentages across the board, as do many startups going public this year. However, the competitive landscape is fierce and the addressable market of $24 billion provided in the S-1 filing questionable. Perhaps the cloud modules expand the endpoint security addressable market beyond the $7 billion size, but not by much in the current calendar year as endpoint security platforms are more of a value-add than a sum of the aggregate security markets. In addition, cybersecurity is a lukewarm market compared to hotter tech industry verticals. The cloud-level AI aspect to detecting breaches is very interesting for future years, however, I am respectfully on the sidelines for now.
