Category: Cloud Software

Zoom Video Stock: Will History Repeat?

Posted on by io-fund

This article was originally published on Forbes on April 9, 2021, 12:35am EDToriginally published on Forbes on April 9, 2021, 12:35am EDT

Last year, I called Zoom Video a “pegasus” because the company stood out from the dime-a-dozen unicorns that have come out of Silicon Valley. Zoom has illustrated rare financial strength from its IPO through today due to exceptional product-market fit.

The term unicorn was first used to describe a startup with a valuation of a billion dollars or more. There have been hundreds of unicorns since the term was coined by Ailene Lee of Cowboy Ventures. However, there has been only one tech company on the public markets that has illustrated the financial strength that Zoom Video has in both its top line and bottom line.

Critics will say Zoom required Covid to generate these numbers, yet one look at the S-1 filing immediately disproves this theory. The market is overlooking Zoom’s long history of category-leading growth, which is discussed in detail below.

In the analysis, I also elucidate my thoughts on “exceptional product-market fit” and Zoom’s product strength pre-covid, during covid, and what the company will do to double its TAM in the coming year.

Please also note, per the analysis below, the I/O Fund has closed its position in Bandwidth and allocated more to Zoom. I explain why Bandwidth remains a solid choice yet we see more upside in Zoom due to the company’s sub-Top 20 valuation.

During the September 2019 selloff in cloud, which saw 40% to 50% drawdowns in many solid cloud names, I made sure to hammer on my thesis that cloud is a secular trend insulated from geopolitical risks and economic drawdowns. My thesis was proven correct by Covid as cloud software performs well in extreme economic climates because it reduces costs when budgets are constrained, and increases productivity, which is important during times of economic expansion.

This year is very unique for cloud software because many stocks are guiding for less than 40% revenue growth. We are not surprised to see lower valuations following the Q4 earnings reports as the market holds its breath to see how cloud will perform following tough comps from Covid. The Q1 reports are necessary to shed light on what companies will be the leaders coming out of the unusual year of 2020.

There is only one way forward for SMBs and enterprises — adopting cloud IaaS, platforms, and software. Traditional IT is expensive and will only hinder a company from taking advantage of AI and 5G. Competitively it can be very harmful to not transition to cloud right now, as I’ve emphasized in my past reports.

My overarching thesis about cloud software’s resiliency extends to other names, yet this analysis focuses on Zoom Video as it’s one the strongest stocks on the market in terms of its historic top line growth, strong margins, incredible free cash flow and growing profitability. I believe the market is making a mistake by dropping Zoom from the top 20 for cloud software valuations. Zoom is and lay out the reasons below.

Zoom is more than Web Conferencing

The market’s biggest misperception about Zoom is that it’s a web conferencing app. The company is more than two years into developing products and services that broaden its use beyond web conferencing with Zoom Phone launching in January of 2019, yet the market has priced Zoom for only one path (web conferencing). The company has since launched Zoom Rooms, a virtual marketplace Zoom Apps, and OnZoom. The company coined the term hardware-as-a-service because Zoom expects to disrupt nearly every area of telephony.

Last August, I pointed out that Zoom’s hardware-as-a-service products allowed companies to replace legacy systems by consolidating software and hardware for one consistent experience. ServiceNow made headlines last year when they chose Zoom Phone to replace their business phone lines by stating, “Going forward, with the addition of Zoom Phone, we’re getting a head start on an even more robust experience with Zoom — one-touch communication and collaboration features, plus Zoom-connected conference rooms.”

Zoom’s partner program saw significant expansion in 2020. Partner sales bookings increased more than 7x year-over-year. Over 20% of international business bookings in the past quarter were driven by Zoom’s partner ecosystem, and Zoom’s Master Agent business was the fastest growing in history for Master Agents AVANT and Intelisys.

Notable partnerships include carriers such as British Telecom, Lumen Technologies, and Orange Business Services. Zoom’s Distributor Partner Program includes Carahsoft Technology Corp. in the U.S., Nuvias Unified Communications in Europe, eLink Distribution AG in DACH, West Telco in LATAM and EMEA, SYNNEX/Westcon in LATAM, SB C&S in Japan, and FVC in the Middle East and Africa.

Master agents AVANT Communications and Intelisys, a ScanSource company, both reached $1 million in monthly recurring revenue (MRR) prior to the one-year anniversary of their partnerships with Zoom. Zoom also added six new Master Agent partners: AppSmart, Bridgepointe, eLink Distribution, PlanetOne, Sandler Partners, and Telecom Consulting Group (TCG).

Last year, Zoom saw growth of use cases in telemedicine, virtual events, and health and fitness after revamping its partnership program for independent software developers. The company supports more than 200 partners through its open API and SDK and expects to see further growth as new industries and markets are developed on top of Zoom.

Zoom also recently announced a multi-year partnership with Formula One, following a successful collaboration in 2020 on the Virtual Paddock Club, which offers VIP sports experiences. As part of the expanded partnership agreement, Zoom is working with Formula 1 to deliver unified communications and new business and hospitality experiences for on-site and virtual guests, including live updates from “legends of the paddock” and Paddock Club Business Lounges set up in Zoom Rooms.

Forward CAGR & Product-Market Fit

The analyst estimates for Zoom are 29.8% CAGR over the next three years through fiscal 2024. This makes little sense as the company has had a net retention rate of 130% over eleven consecutive quarters. This means analysts are essentially guiding for an increase in churn/downgrades and these projections assume Zoom will not add any new customers.

Zoom revenue estimate trends graph

The analyst estimates for Zoom are 29.8% CAGR over the next three years through fiscal 2024. I/O FUND

As stated, management from cloud software companies are not giving analysts much for forward guidance as it’s better to play this transitional period safe. Regardless, the projections don’t match Zoom’s incredibly strong track record.

First, there is no other cloud software stock that has made the leap from enterprise to consumer. Zoom was the top app by number of customers and unique active users this past year. Yet, it is also the preferred enterprise video conferencing app and ranked among the most popular workplace apps overall, according to Okta’s 2021 Business Network Report.

We see further evidence of Zoom’s customer approval across both consumer and enterprise as the security concerns last year were quickly forgiven as the management moved quickly to respond. In Q4, Zoom Phone was the fastest growing product line quarter-over-quarter. During the most recent earnings call, Zoom announced expansions into Zoom Phone by Zoom Meetings customers Equinox, Universal Music Group, and University of Southern California. The company expects strong growth for Zoom Phone going forward with a strategy of selling into the existing install base.

For product-market fit, you need the top line to grow rapidly and for the bottom line to strengthen. This is not the only indication but it simplifies the many variables. Before I go over the recent financials, I want to emphasize that Zoom was already outperforming its category per the S-1 filing that I covered in April of 2019.

The chart below provided by Alex Clayton of Spark Capital shows how Zoom compares to other cloud software companies that had a subscription revenue run-rate of $100M in their disclosure period with the graph indexed to the quarter where they crossed $100M.

Cloud softwares subscription revenue run-rate

Not only was Zoom the fastest growing cloud software IPO from $100 million onward in terms of run rate but also grew 108% in their last quarter YoY compared to a median of 38% in 2018 for the companies pictured above. ALEX CLAYTON OF SPARK CAPITAL

Source: Alex Clayton, Spark Capital

Not only was Zoom the fastest growing cloud software IPO from $100 million onward in terms of run rate but also grew 108% in their last quarter YoY compared to a median of 38% in 2018 for the companies pictured above. Zoom was also the most efficient in terms of customer acquisition cost, with a median payback period of 9 months compared to the median of 30 months.

Below is how Zoom stacked up to other popular cloud software stocks at its IPO:

Cloud software revenue growth at IPO

How Zoom stacked up to other popular cloud software stocks at its IPO. I/O FUND

There’s a catch to the graph illustrated above — Snowflake was only 6 years post-launch while Zoom was 8 years post-launch. Therefore, when we adjust growth rates for age of company, we see Zoom is the #1 company in terms of financial strength in cloud software:

cloud software revenue growth in years

We see Zoom is the #1 company in terms of financial strength in cloud software. I/O FUND

There’s more … Zoom was profitable at the time of IPO while the majority of cloud software companies are not profitable many years after their IPO. Not only is Zoom the strongest IPO in cloud’s history but it was also profitable. Not one other company was profitable at IPO … and only Shopify is profitable now from the list although this occurred many years after Zoom if we adjust for age of company.

Hopefully, this helps the critics see that Zoom has always been best in its class — and cloud software is not an easy category to lead with top performers such as CrowdStrike, Snowflake, Shopify and Slack (a very sticky product) coming from this category.

Doubling TAM

Founded in 2011, Zoom previously described 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 key words here are “not possible with legacy systems.”

Zoom’s ongoing goal will be to disrupt all legacy systems with cloud-native communications — and this means every possible method of communication that is not currently done on the cloud and/or is currently on the cloud but is too cumbersome of a process due to walled gardens.

According to Gartner, by 2022, 65% of meeting solutions users will take advantage of SIP/VoIP-based audio-conferencing tools. This is up from 20% in 2017, while 40% of meetings will be facilitated by virtual concierges and advanced analytics. Here we see Gartner had already predicted audio-conferencing to grow substantially prior to Covid.

The global web conferencing market is expected to grow from $12.58B in 2020 to $19.02B by 2025, at a CAGR of 8.6%, according to Valuates, which offers market research reports.

web conferencing market size

The global web conferencing market is expected to grow from $12.58B in 2020 to $19.02B by 2025, at a CAGR of 8.6%, according to Valuates, which offers market research reports. VALUATES REPORTS

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% per year to nearly $20 billion by 2023, with another report expecting that the industry will register a CAGR of 9.2% from 2018 to 2025. However, IDC pegs Zoom’s future addressable market much higher at $43 billion, as cited in a previous Zoom earnings call.

If we go with the more modest addressable market size of $20 billion, then Zoom Phone will double TAM as telephony is forecast to grow to $23 billion by 2024, per the Q4 fiscal 2021 report. While doubling TAM, Zoom Phone was the company’s fastest-growing product line quarter-over-quarter, according to the report, and executives expect to see strong growth in FY2022.

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 communications is both account based and usage based, not to mention hybrid work-from-home is the consensus among surveys of executives with only 29% stating the office will return to five days in the office per week.

Zoom sees international expansion as a major opportunity. In the first-quarter fiscal 2020, APAC and EMEA revenue grew a combined 127% year-over-year. As such, Zoom 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% 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.

Why Zoom Went Viral and Will Again …

The agnosticism of Zoom compared to Google and Microsoft means the company has the opposite goal of big tech: rather than lock users into a walled garden, Zoom created a flawless and viral mechanism where users can share web and audio-conferencing links without needing to login. Zoom exploited big tech’s weakness — the walled garden — which requires logins and a cumbersome user workflow.

Many critics think the catalyst for the virality was Covid, yet my premium site had stated this mechanism was a viral feature many months prior to the pandemic. “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.

The best growth in tech products occurs 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. 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 was the main competitor that Zoom disrupted 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.

Zoom’s virality with web conferencing is important because I expect the same team (and for the same reasons) to create a frictionless and viral method to replace all forms of legacy communications.

Zoom’s Current Quarter & Forward Growth

In most recent quarter, Zoom reported Q4 revenue of $882.5M, representing growth of 369% YoY, beating expectations by $71.54M. Non-GAAP EPS of $1.22 beat by $0.43 and GAAP EPS of $0.87 beat by $0.39.

GAAP income from operations was $256.1M, up 2327% year-over-year. Non-GAAP income from operations was $360.9M, up 839% YoY.

For the full year, total revenue was $2,651.4 million, up 326% year-over-year. GAAP income from operations for the fiscal year was $659.8M, compared to GAAP income from operations of $12.7 million for fiscal year 2020. GAAP operating margin was 24.9% and adjusted operating margin was 37.1%.

Please note, when you see this level of bottom-line growth, it means Zoom is spreading organically and not needing to pay for its growth. This is extremely rare in Silicon Valley and other tech startup hotbeds, as growth marketing is a tactic used to grow the top line at the expense of the bottom line.

Remaining performance obligation was up 189% year-over-year from $604 million to $1.75 billion with the company expecting to realize 70% of this amount in the upcoming year. This means before the fiscal year even began, the company will already have $1.22 billion of revenue in the pipeline of the $3.7 billion projected for the year.

growing future revenue under contract

Remaining performance obligation was up 189% year-over-year from $604 million to $1.75 billion with the company expecting to realize 70% of this amount in the upcoming year. ZOOM

Non-GAAP net income for the fiscal year was $995.7M, after adjusting for stock-based compensation expense and related payroll taxes, expenses related to charitable donation of common stock, acquisition-related expenses, and undistributed earnings attributable to participating securities. Non-GAAP net income per share was $3.34. Non-GAAP net income was $101.3 million, or $0.35 per share.

Net cash provided by operating activities was $1,471.2M for the fiscal year, compared to $151.9M last year. Free cash flow, which is net cash provided by operating activities less purchases of property and equipment, was $1,391.2 million, compared to $113.8 million last year.

Zoom provided the following guidance for fiscal year 2022:

· Total revenue for Q1 is expected to be between $900.0M and $905.0M vs $835.35M consensus

· Non-GAAP income from operations is expected to be between $295.0M and $300.0M.

· Non-GAAP diluted EPS is expected to be $0.96 at the midpoint versus $0.70 consensus

For the full year, total revenue is expected to be $3.770B versus $3.5 consensus, representing growth of approximately 30% YoY, and non-GAAP income from operations is expected to be between $1.125B and $1.145B.

Full fiscal year non-GAAP diluted EPS is expected to be between $3.59 and $3.65 versus $2.96 consensus, with approximately 311 million non-GAAP weighted average shares outstanding.

In the last three months, 20 analysts set 12-month price targets for Zoom, according to data from E*Trade. The average price target was $472.41, with a low of $360 and a high of $610 representing 98% upside from the current price.

Finally, it’s worth mentioning that the Zoom app is still #1 on the business charts in the App Store.

At the end of first-quarter fiscal 2020, the company had roughly 58,500 customers (with more than 10 employees), up 86% year over year. Zoom has a strong partner base that includes companies such as Salesforce, and these partnerships will be instrumental in future growth. Zoom ended the last fiscal year with more than 467,000 customers with more than 10 employees, up approx. 470% from the same quarter last fiscal year, according to the report.

Bandwidth

One reason we closed our position in Bandwidth is that we feel work-from-home should have been a bigger catalyst for Bandwidth, with major customers including Zoom, Google, Microsoft enterprise, Skype, RingCentral and Square. If there was ever a year that a Tier 1 provider should have seen rapid growth with these customers, last year would have been the year. Instead, for the full year 2020 we see Bandwidth with total revenue of $343.1M, up 48% YoY, versus Square (for example) which reported total net revenue of $9.50B, up 101% YoY for the full year 2020.

Bandwidth is a communications platform-as-a-service (CPaaS) company that offers voice, messaging and 911 APIs built on the company’s Tier 1 network. Although Bandwidth competes in a similar area as Twilio and Messagebird, the company is distinguished by owning its network and by offering competitive pricing and a stripped-down version of voice and SMS.

The company works with the very largest VoIP and video/audio conferencing companies including Google, Microsoft, Skype, Zoom and Ring Central. The work-from-home trend has benefited Bandwidth’s customers. There is a potential for another catalyst, which is the expansion into Europe. This is important as Europe in particular has proven to be a major market for VoIP due to various country codes in close proximity.

Bandwidth is overshadowed by competitors, including Twilio and Messagebird. Five9 is also in the adjacent space of the cloud contact center (top of the stack as a complete solution)

The difference between these companies is important to understand. Twilio enables communications for mobile applications, such as voice or text. When you text or make a call inside of a mobile application, you are likely using Twilio’s APIs. The company works with over 1,000 mobile carriers in over 150 countries for voice and text/SMS services. The features that come pre-packaged with Twilio are ideal for companies who want to cut down on development time, such as startups or pureplay apps. Examples include customer service calls on Zendesk and messaging home owners inside the Airbnb app.

However, large companies in the video and phone conferencing space (including business apps), with a primary focus on communications, are unlikely to incorporate an expensive third-party for out-of-the box development. As a network carrier, Bandwidth undercuts Twilio on pricing with cheaper outgoing and incoming calls plus free incoming SMS. This option is entirely focused on voice and SMS while its customers develop any additional features in-house. Twilio costs $1 for a dedicated number while Bandwidth costs $0.35 per dedicated number. This is why Bandwidth is the network provider for Google, Microsoft enterprise apps and Skype, and also Zoom.

On the flip side, Bandwidth makes a fraction of a penny for every call or message that is sent over the Tier 1 network. Therefore, Bandwidth’s revenue is not up to par with Twilio’s at about $280 million compared to $1.5 billion.

The issue may be that what Bandwidth offers is more commoditized between the various telephone networks and also cellular. Therefore, the better investment may be in the full product stack, like what Zoom offers.

More on Bandwidth’s Financials …

Excluding the acquisition of Voxbone, which closed last quarter, Bandwidth’s standalone CPaaS Q4 YoY revenue growth was 53%. Tailwinds include political messaging and factors related to Covid-19. Political messaging and Covid-related usage contributed 19 points to the company’s Q4 YoY growth rate, according to the report.

Where dedicated, daily user behavior within enterprises around VoIP and cloud native conferencing apps may have been many years out, covid-19 has sped this up. The addressable market growth was estimated to be about $1.7 billion in 2017 to $6.7 billion in 2022 for this market. Yet, we think one issue with Bandwidth having lagging growth for this category is there was too much competition for Bandwidth to increase its market share.

The recent quarter was impressive with 82.3% revenue growth yet the previous quarters were in the 30–40% range. Despite these normal comps, the company is guiding for 58% growth year-over-year for the March quarter.

Within total revenue, CPaaS revenue was $98.1M, up 84% YoY. Other revenue contributed the remaining $14.9 million for the quarter. Other revenue was $8.6 million in the same period last year. Total, CPaaS, and Other Revenue include $17.5M, $16.6M and $0.9M respectively from Voxbone starting on Nov. 1, 2020, the date of the acquisition.

Adjusted gross profit was $55.8M, compared to $31.1M for Q4 2019. Adjusted gross margin was 49% compared to 50% for Q4 2019.

Adjusted net income was $3.5M, or $0.13 per share, based on 27.2 million weighted average diluted shares outstanding. This compares to a Non-GAAP net loss of $(0.5)M, or $(0.02) per share, based on 23.5 million weighted average shares outstanding for the fourth quarter of 2019. Adjusted EBITDA was $8.3M, compared to $1.2M in Q4 2019.

Total revenue for the full year of 2020 was $343.1M, up 48% year-over-year. Gross profit for the full year 2020 was $157.9M, compared to $107.6 million in 2019. Adjusted gross profit for the full year of 2020 was $169.1M, compared to $114.4M in 2019. Adjusted gross margin was 49% for the full year of 2020 and 2019.

In the last three months, five ranked analysts set 12-month price targets for Bandwidth, according to date from E*Trade. The average price target is $210, with a low of $200 and a high of $227 for an upside of approx. 95%.

On the bullish side, Canaccord Genuity raised its price target from $175 to $225 after Bandwidth’s acquisition of Voxbone, stating the purchase: “accelerates Bandwidth’s international expansion plans and creates a stronger position in the global $18B CPaaS market.”

JMP raised BAND from $180 to $206, favoring the deal “because it accelerates Bandwidth’s international expansion in a way that is accretive to its non-GAAP gross margins and non-GAAP net income.”

Conclusion:

Inertia matters with tech growth. The companies that grow rapidly tend to continue to do well long-term. Zoom has been dropped out of the top 20 in terms of valuation for the cloud software category and is now cheaper than before the pandemic, which led to some of the most remarkable earnings reports of any stocks we have covered. Due to the low valuation and the company having plans to double its TAM quickly, among other reasons, we have closed Bandwidth in favor of a larger position in Zoom.

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CrowdStrike Update

Posted on by io-fund

Intro:

We recently initiated a position in CrowdStrike and want to take the opportunity to update you on the company. Previously, I covered CrowdStrike in October 2020 here.  In the report, I explained how cybersecurity would continue to be a key initiative for organizations in the remainder of 2020 and beyond.  I also covered CrowdStrike’s product offerings and explained how the company was uniquely positioned as the top vendor in a critical subsector of cybersecurity.  We discuss the previous coverage below and examine why the company has become even stronger, as well as numerous industry catalysts.

We continue to see strong C-level survey results for cybersecurity in 2021, in particular, with CrowdStrike and Zscaler the undisputed leaders. We discuss why we have chosen CRWD, yet it seems ZS is a strong second choice. We also cover Cloudflare and why we have passed for our own portfolio.

Security Software: Top Priority for 2021

Security software has consistently ranked as a top spending priority among C-level executives, but our research shows it has become the #1 priority in 2021. The Covid-19 pandemic and shift to a more remote workforce uncovered a number of major gaps in the cybersecurity of organizations. 

The high-profile Sunburst hack further highlights the need for businesses to transform their legacy security architectures, as legacy tech is no match for today’s adversaries.  As a result of the Sunburst hack, the current administration has talked about how cybersecurity spending is a top priority, calling on Congress to “launch the most ambitious effort ever to modernize and secure federal IT and networks.” 

Credit Suisse’s recent CIO survey suggests that security spending is the top spending priority in 2021, even more so than in July.

We view CrowdStrike and Zscaler as the best positioned cybersecurity companies to benefit from the growing security spending cycle. We are still in the early innings of the shift in security architecture towards Zero Trust and SASE, of which we believe CrowdStrike and Zscaler will benefit the most.

Here’s a snapshot of government spending and the triple-digit increase in FY2020 growth in federal spending for Zscaler and CrowdStrike.  The current administration’s commitment to cybersecurity should also benefit CrowdStrike and Zscaler as they continue to gain more share of federal spending. 

 

1.       CrowdStrike (CRWD)

In my past coverage of CrowdStrike here, I explained why the company would thrive as the fastest growing endpoint security vendor.  Endpoints are frequently the first point of entry for attackers, so endpoint security is an integral part of a multilayered security strategy.  CrowdStrike has thrived in this area, leading to the addition of a record 1,480 new subscription customers in Q4. 

While CrowdStrike has demonstrated tremendous expertise in endpoint security, the full CrowdStrike Falcon Platform now encompasses much more.  The full CrowdStrike platform, designed to define Cloud Security, includes managed services, security & IT operations, threat intelligence, identity protection, and log management.  The power of CrowdStrike’s platform is demonstrated in the financial data, as 63% of CrowdStrike’s subscription customers have 4 or more Cloud Module Subscriptions.  This number has grown from 47% two years ago and 55% last year. 

The growth of this metric is important to CrowdStrike’s growth, as they have expanded their TAM through acquisitions and the launch of new modules that cover untapped areas of cybersecurity.  We are now seeing the majority of CrowdStrike’s subscription customers, almost 2/3, adapt 4 or more modules meaning most customers are subscribing to the idea of having CrowdStrike handle most of, if not all of, their cybersecurity needs.  CrowdStrike management has talked in the past about how most customers typically sign up for 1 or 2 modules but adapt more modules over time.  This shows the success of the CrowdStrike customer life cycle.  From the time the company onboards a new customer to the adaption of more modules, they are able to add new sources of revenue from already existing customers.      

In Q4, CRWD grew revenue 77% YoY and added a record 1,480 new subscription customers (+82% YoY), with a number of marquee customer additions including Pfizer.  CRWD also enjoyed a record quarter in profitability metrics with its best ever quarter of non-GAAP EPS (+$0.13), Free cash flow (+$97M), FCF margin (+37%), EBITDA (+$45M), and EBITDA margin (+17%).      

CrowdStrike guided for 50% YoY revenue growth in FY 2021 and EPS of $0.29.  The projected growth rate leads the security SaaS industry and our comparisons of ZS and NET, despite the stock trading at a slightly lower valuation than those stocks. 

As previously discussed, with its recent acquisitions of Preempt and Humio, CrowdStrike has enhanced its capabilities beyond endpoint security to also encompass cloud workload security and identity protection.  With Preempt Security, CrowdStrike is leading the charge with a Zero Trust solution focused on endpoints and workloads.  In its Q4 earnings call, CrowdStrike CEO George Kurtz talked about how customers have become increasingly interested in its Zero Trust offering derived from Preempt following the Sunburst hack. 

The acquisition of Humio will combine Humio's data ingestion and analysis engine with CrowdStrike’s technology.  CEO George Kurtz discussed the Humio acquisition the company’s Q4 earnings call:

“With Humio, we are now redefining next-gen XDR through a platform that spans endpoints, identities, applications, the network edge and the cloud… Humio provides us the ability to expand our data leg and to solve more security and non-security use cases in real time… providing CrowdStrike with a greater time advantage over the competition and the adversary.”

It has become evident that CrowdStrike has continued to successfully enhance the capabilities it can offer and has taken a big step toward its goal of providing the “fastest, most cost efficient, and extensible cloud data platform that will deliver best-in-class visibility for security as well as observability for IT operations.”

2.       Zscaler (ZS)

Zscaler ranks #2 behind CrowdStrike on our list of cybersecurity stocks to own.  Like CrowdStrike, we believe Zscaler is well positioned to capture the industry wide shift to Zero Trust and SASE.  We covered Zscaler’s Fiscal Q1 Results here.  Fiscal Q2 was another solid quarter for Zscaler as they continue to show their strength as a major cybersecurity player.  In Fiscal Q2, Zscaler grew revenue 55% YoY and gross billings an impressive 71%.  Although Zscaler is an industry leader with strong fundamentals, our analysis shows that the company is not as strong fundamentally as CrowdStrike despite having a slightly higher valuation. 

Over the next 12 months, Zscaler is projected to grow revenue 37% versus CrowdStrike’s 51%.  ZS has slightly higher gross margins over the trailing 12 months at 78% versus CRWD’s 75% but lags CRWD in Operating Margin and FCF margin.  We compare ZS to CRWD and NET fundamentally in the table below.       

3.       Cloudflare (NET)

We covered Cloudflare’s Q4 earnings here.  Although Cloudflare is not purely a security company, approximately half of their products are security related.  A lot of Cloudflare’s focus on the future is related, according to CEO Matthew Prince.   In its Q4 earnings call, Cloudflare management talked about their expectations for a big shift in 2021 from a traditional hardware-based security approach to a much more modern Zero Trust approach.  Cloudflare is well positioned to be one of the leading companies in enabling organizations to make this shift.  However, we still view CRWD and ZS as better ways to play the shift in cybersecurity spending.

We feel NET is not as strong fundamentally as CRWD or ZS.  The stock is also not as attractive from a valuation standpoint.  For these reasons, NET ranks third behind CRWD (#1) and ZS (#2) on our list of security SaaS stocks to own moving forward. 

Source: YCharts; data as of 3/25/21

Conclusion:

Selloffs are tough, but the silver lining is getting quality companies at much more reasonable valuations. CrowdStrike is a company that we think will do well when the market remembers that tech is not going anywhere and growth in this sector is not Covid dependent. CrowdStrike is my favorite company that had a stretched valuation throughout this past year and we see the selloff as a buying opportunity. 

H1 2021 Cloud Software Update

Posted on by io-fund

315fa45c-80d5-4932-b910-c1d1a6dbed9d_H1-2021-Cloud-Software-Update.pdf

H1 2021 Cloud Software Update

Don’t forget about cloud software!

In the excitement about SPACs and the flood of IPOs that have listed recently, it'd be easy to forget about the tried-and-true. 

Quick Note on the Current Climate … 

My main thesis about cloud has not changed: it's secular and insulated from geopolitical risks and economic drawdowns. Generally speaking, cloud software reduces costs for enterprises and SMBs. Therefore, the category is more insulated from economic drawdowns. You can read more about my views on cloud’s resiliency here. 

There's a caveat to this, which is that the market is flooded with cloud software solutions and tools – both in the public markets and private markets. This is because cloud software has a low barrier to entry. The costs to develop cloud software and go-to-market is very low compared to hardware or a solution that requires specialty engineers, like AI, ML, robotics, etcetera. Venture capitalists are drawn to cloud software because it's relatively cheap to create, and the margins are healthy due to recurring subscription revenue. 

The window of time that you have to be wary is between years 8 and years 12 for a software company. Prior to year 8, it's common for software and new tech startups to report rapid growth. VCs know this and are taking companies public sooner to capitalize off momentum traders (and trading machines), that indiscriminately pile into companies with high growth rates. 

In this case, a VC firm can see a very large exit and move onto another company while the public markets sort out the long-term growth rate and the company's ability to scale. Every startup looks strong at the beginning of the marathon but which ones endure past mile 13? VCs don't have to worry about this as the goal in today's market is to exit before the marathon is half-over.

The ramp-up period for startups is exciting because the product finds early adopters. Can the product sustain long-term after year 8 and continue to take market share? This is a much more complex question. Private investors exit before the long-term viability of a company surfaces and (us) public investors have to extrapolate the longerterm trajectory.  

Consider the fact that 9 out of 10 startups fail. If you’re a VC, you’re going to get the startup to the public markets as fast as possible to get your exit. If the company fails or the growth slows down, as it does for most tech startups, then it's of no importance as the exit was made. Because of this dynamic (that startups are essentially experiments) and there are many new SPACs bringing to market roughly 165 unvetted companies, I believe we will see a string of failures at the peril of public investors. According to these statistics, we could see 148 fail out of the 165, or on the low-end, 132 of the 165 fails. The low-end is the 80% failure rate for VC-backed companies indicated by the statistics. 

SPACs are not inherently wrong (and David pointed out a few benefits compared to IPOs). However, young companies fail very frequently and the public markets are becoming the exit grounds for pre-revenue companies. This piece is new and public investors aren’t prepared for the high failure rate that is a daily reality in the private markets. 

That’s a bit of a tangent to say we will continue to have plenty of exposure to cloud in our portfolio as a hedge against any high-fliers we take. The fact that cloud is out of favor in the market right now is not a concern to us because we know cloud has a resilient growth rate. 

We also want to communicate that we are well-diversified. We have exposure to SPACs and small caps, but we use cloud and semis as a safe haven. I think these comments will become more apparent as we move through the year. Basically, I am contrasting why cloud deserves attention right now despite the fact speculative trading in SPACs and Momentum has been in the driver’s seat.  

Regarding valuations — I've stressed this point with companies like Snowflake because we will see more of this as time goes on and investors need to be careful of merely providing exits for VCs at sky-high valuations. Being patient is an important tool in a retailer's arsenal when a valuation is high. 

Please keep in mind, that we discouraged readers from buying Zoom Video when trading in the forward P/S range of 50 despite owning this stock at a lower cost basis. Therefore, I am not singling out Snowflake but instead using it as an example to illustrate why we have not bought this excellent company as "growth at any price" can lockup your money for a few quarters while the financials catch up to the valuation. This is exactly what has happened with Zoom Video (it took a long breather) although the forward P/S is much more reasonable now.

Our Focus: Product-Market Fit and Valuations

For our portfolio, cloud is a hedge as valuations may fluctuate, but growth will march onward for the companies with product-market fit in this resilient category. The best illustration of product-market fit is Shopify and Zoom Video as both their top and bottom lines prove they are efficiently meeting market demand. 

An example of a company that I have picked on for not having product-market fit is Uber and Lyft as they must subsidize rides. The market price that customers will pay is lower than its operational costs. The market may still move the stock based on the promise of autonomous vehicles or robotaxis but today's financials do not suggest there is product-market fit. 

Opendoor has a similar issue. The financials are upside down as the more the company makes, the more the company loses, and this is inherent to the current business model (not a one-time event or the cost to scale). 

Opendoor was hoping to charge 10% in commissions which is about 4% more than Realtor fees for the convenience of buying the house in cash. The market will not pay this extra 4% and Opendoor is forced to match Realtors at 6% commissions. Like Uber, the price does not cover the operational costs. However, we are in a period of historic liquidity and QE. The market may pile in based off sentiment or other speculative reasons (we’ve entered this stock ourselves and it’s performed well), but the financials today do not show a company that has achieved product-market fit. 

You could argue Fubo does not have product-market fit as seen in the financials. The cost of licensing the content does not cover the cost of operations. So, why am I invested? Because this is the yearthe year for CTV ads and OTT live content so we think the trend is so early and so massive that we are comfortable taking a flier on this company. I’ve said before that OTT live sports is the holy grail and cable networks/media conglomerates will do what it takes to own this transition. There are many market forces at play here and Fubo is centered perfectly in the middle. Therefore, this is an investment in the trend of Live Sports OTT. 

Product-market fit is important to this discussion because finding the gems will protect us from any downside in the market. Even if the market temporarily sells-off in certain names, we can rest easy if we stick to quality. 

The best examples of product-market on the public markets are the FAANGs – where the top line defies the odds, and the bottom line continues to deliver. There are others in the $200B+ market cap range that illustrate this: Salesforce for CRM, Adobe for design and its developer moat, Nvidia for the CUDA platform and its developer moat, etc. Sticking with these companies through market ups and downs did well for early investors. 

Cloud investing was fairly predictable in the previous years because there were clear winners in terms of forward growth. Due to tougher comps, nearly half of all cloud stocks guide between 20% and 40% with very few above this range and priced dearly if they are (see the chart below).

The other factor we will be considering as we move into 2021 is valuation. There is a disconnect in a few names where the market has not been perfectly efficient. Below, we pull out a few names that have room and rely on Knox for any breakouts in valuation. 

As was posted on the forum last week, those with room in valuation include Bandwidth, Asana and Crowdstrike. We are also pleasantly surprised to see Kingsoft Cloud having quite a bit of room although some of this likely represents the risk in China. In the Macro section, you'll see that China's Cloud IaaS is set to take off with Alibaba surpassing Google Cloud for the number three spot. We think this foreshadowing growth for Kingsoft.

Macro Outlook:

The big takeaway from the cloud market going into 2021 is that hybrid work-from-home is here to stay. The market is pricing cloud productivity software as a temporary COVID tailwind but the analysis shows a permanent shift that will accelerate this year. 

According to IDC, the cloud market will grow at a CAGR of 15.7% through 2024 to become a $1 trillion market in 2024. This forecast includes software-as-a-service (SaaS), platform-as-a-service (PaaS), and infrastructure-as-aservice (IaaS). 

The research firm also states that by 2021, 90 percent of enterprises will be relying on a mix of onpremise/dedicated private clouds, multiple public clouds and legacy platforms. Therefore, IDC predicts this to be the year of multi-cloud, which we covered in our Microsoft earnings report write-up here. We see multi-cloud as the first step towards edge computing to where servers from various hyperscalers or CDNs work cooperatively to deploy 5G workloads. 

On a trailing basis, cloud spending grew from $183 billion in 2018 to $233.4 billion in 2019. This puts the $1 trillion prediction into context as IDC calls for roughly 400% growth over the next five years. In 2019, SaaS accounted for $148 billion, or about 64% of the public cloud market.   

SaaS dominating the IT spend for cloud is important because it means there will be many winners in this category as it marches onward to the $1 trillion mark.

According to IDC, more than half of the global revenue in the PaaS and IaaS markets was captured by AWS (33.6%) and Microsoft (18.0%) leaving 34.90% for the rest of the market. 

This is not the case with SaaS where the rest of the market captured 73.9% and the top two vendors, Salesforce and Microsoft, caught 7-8%. 

This is also important for perspective as smaller companies own the SaaS market while Big Tech dominates IaaS and PaaS. Therefore, there is a solid opportunity for investors in cloud software now and into the future. The graph below helps to visualize the opportunity for smaller players:

Source: IDC 2019 Report

According to Gartner, worldwide public cloud spending will grow 18% in 2021 to total $304.9 billion. Relative to overall IT spend, cloud still has a long runway and is projected to make up 14.2% of total global enterprise IT spend in 2024 compared to 9.1% in 2020. 

Gartner’s survey indicates that there is still quite a bit of growth ahead despite the harder comps the cloud software leaders face in 2021. The data shows that 70% of organizations using cloud services plan to increase their spending, stating “the proportion of IT spending that is being allocated to cloud will accelerate even further in the aftermath of the COVID-19 crisis.”  

The analyst firm points towards mobility, remote working and hybrid workforces as trends that will lead to further market growth. 

Source: Gartner CIO Survey

In the graph above, we see survey respondents and Gartner forecast an increase in work-from-home. Meanwhile, the market has been cautious about cloud software post-vaccine, which may be unwarranted with hybrid workforces. 

Here is what Gartner states, “For example, customers and citizens shifted their activity online during the lockdown, but that shift will increase, not reverse, in 2021.”

Forrester’s recent survey showed similar results with 47% of North American managers anticipating a permanently higher rate of full-time remote employees and 53% of employees wanting to work from home postpandemic. 

Although budgets will only increase 2% in 2021, according to Gartner, CIOs' top priorities are digital workplace technologies to support work-from-home, and then AI/ML, robotic process automation (RPA), distributed cloud and multi-experience platforms.

Forrester states 35% of companies will double down on workplace AI with one in four workers supported by automation either directly or indirectly by the end of 2021. B2B sellers will rely on AI and automation with predictions that 60% will rely on tools with these functionalities embedded.  

The analyst firm also states the hyperscale cloud market will “return to hypergrowth” of 35% to $120 billion in 2021. This is up from the original prediction that cloud IaaS would grow 28%. The analyst firm also predicts Alibaba will take the number three spot instead of Google Cloud. 

Adopting serverless apps and containers will continue to grow with increased demand for multi-cloud container development platforms and public-cloud container/serverless services. Forrester also believes a leading trend will be disaster recovery moving to the public cloud. 

Cloud Stocks for H1 2021

I wrote my first thematic PDF on cloud in December of 2019 during an intense cloud sell-off. The First Trust Cloud Computing ETF (SKYY) had posted 22% returns YTD at time of writing in December and closed the year with 24.55% returns for full-year 2019.

Last year, cloud performed much better due to its fundamental, secular strength during COVID with the SKYY ETF closing out with 57.41% returns in 2020. 

We covered many cloud names at their lows during Q3 and Q4 2019 due to our thesis that cloud is insulated and secular. At the time, we pointed out that cloud services were expected to grow 4.5 times more than the IT industry and that future growth through 2022 would be 3 times higher than IT (page 3 from this report).

I believe we are here again in a very similar spot. The market thinks cloud is going to be stunted and forward guidance isn't saying otherwise. However, the analyst firms are predicting we will accelerate and are raising forecasts. We will side with Gartner, IDC and Forrester who do a particularly great job in the cloud category. 

Prior to COVID, our thesis was this: “cloud software is more sheltered from overseas economies, supply chains, trade wars and shifting government policies” and “truly, there is few safer places to invest in technology if the trade war resumes or we see the recession that many economists are predicting.” 

My thesis this year is that work-from-home and hybrid work environments will be the new norm which will keep cloud growth steady and that AI and ML will be another catalyst. You simply can’t compete with AI and ML with on-premise servers and software. Edge computing and 5G is another accelerant for cloud IaaS, PaaS and software. 

Below are the top 35 cloud stocks listed by revenue growth that we consider to be in our universe. The top 10 are shaded in yellow. 

In a Motley Fool podcast, I had said that this would revert to about a 30 forward P/S and we are here now.

 

Some Conclusions:

•       Kingsoft Cloud has a compelling risk/reward ratio as the company will deliver Snowflake-level revenue at rock-bottom valuation.

•       Bandwidth has the ingredients to pass the pack of cloud stocks stuck in the sub-40% growth range. Let’s see if the company can do this – and if the valuation will finally match its potential. 

•       Asana is not in our top 10 due to competition across productivity tools, but we see room here in the valuation. This will be something Knox spearheads as he sees the right setup including this one from last week.

•       Crowdstrike and Zscaler are both leaders in revenue growth and EPS growth. 

•       Zoom Video and Shopify are both strongest in terms of a large base in EPS and we think the products will perform well in the face of tough comps this year. 

•       This year is very unique for cloud software because so many stocks are sub-40% growth and tightly ranked (see the chart above). We are not surprised to see mixed-reactions to the earnings reports as the market is holding its breath to see what the covid comps will be for the March quarter.  

•       We are not too concerned about the market taking a breather or responding to uncertainty. There is only one way forward for SMBs and enterprises (which is adopting cloud IaaS, platforms and software).

Traditional IT is expensive and will only hinder a company from taking advantage of AI and 5G. Competitively it can be very harmful to not transition to cloud right now as we've seen in my past reports citing McKinsey.

•       The last time I talked about cloud on the Motley Fool podcast, I thought valuation was a serious risk as we saw many names trading in the 50 forward P/S range whereas 30 forward P/S is the mean for highgrowers and 20 P/S is the mean for average growers. 

•       Now that we have reverted to the mean, we plan to allocate for cloud while the trend is out of favor. 

My Top 10:

We stand by Zoom Video and Shopify as the relationship between the top-line and the bottom-line proves product-market fit. We understand there will be harder comps this year but these companies are releasing new products to grow market share and continue to be centered in important trends. These were strong companies prior to COVID and we thnk they will be strong companies post-COVID.

Crowdstrike and Zscaler are stocks that David follows closely and are the best positioned cybersecurity companies to benefit from the growing security spending cycle.  The Covid-19 pandemic and the Sunburst hack uncovered a number of major gaps, highlighting the need for organizations to transform their legacy security architectures.  Credit Suisse’s recent CIO survey suggests that security spending is the top spending priority in 2021, even more so than in July.    

Kingsoft Cloud and Bandwidth are both undervalued in terms of forward-growth. China's cloud IaaS should be in the breakout year as Alibaba takes over Google Cloud as number three. Bandwidth is centered in the hardwareas-a-service trend, which may not be as exciting as EVs or SPACs but is essential to the digital transformation we've seen this past year and a hybrid work environment.

We could not be more bullish on Twilio’s long-term trajectory. The company has a moat in cloud communications for native apps and the management is taking on the omni-channel marketing to increase the addressable market. Should the management pull this off (and we think they will), then Twilio is setting up to be a leader in marketing and sales data with Adobe/Salesforce long-term potential.

Datadog has auspicious positioning for hybrid cloud and multi-cloud. The three analyst firms agree that the public cloud is going to accelerate this year and we want exposure. The market taking a breather does not affect our conviction and we think DDOG is the best way to participate in the growth of Azure, AWS and Google Cloud plus the trend towards multi-cloud (which also directly relates to edge computing).

Teladoc’s low forward P/S (comparatively) is a mystery as this is a mega-trend that will be unstoppable as artificial intelligence continues to merge with health care. We can't think of an industry more ripe for disruption as health care costs have risen 400% in the last decade while wages have stagnated. AI and genomics are able to cure terminal diseases, although TDOC is centered in the first problem (health care costs).

DocuSign is a steady performer with solid top-line and solid bottom-line growth. The market tends to overlook this one, but we like DocuSign as the primary choice for legal, real estate and financial industries. There is very little room for competitors as DocuSign delivers a superior product that can become the universal standard. We do not think the world will reverse to paper.

We continue to want exposure to telehealth and so have allocated to Amwell as an 11th position in cloud.

Q3 Earnings: Zoom Video, Okta, Snowflake, Crowdstrike And Elastic

Posted on by io-fund

This article was originally published on Forbes on Dec 10, 2020,11:25pm ESTForbes on Dec 10, 2020,11:25pm EST

In this analysis, we review the recent earnings reports from Zoom Video, Okta, Snowflake, Crowdstrike, ZScaler and Elastic.

Zoom Video Q3 Earnings

Zoom Video provided a nearly flawless earnings report for the first full quarter that followed initial work-from-home orders. The company reported lower-than-expected churn and market-leading growth on both an annual and quarterly basis. Notably, margins were thinner on both a YoY and QoQ basis due to free accounts. Regardless, it's hard to find fault with Zoom Video's current level of profitability in relation to other tech growth stocks (outlined below).

Strong forward guidance also provides a glimpse into Zoom's traction as the company expects revenue growth to continue at a similar rate year-over-year and also quarter-over-quarter. Revenue grew 367% in Q3 with customers that have more than 10 employees growing 485% year-over-year.

Quarterly revenue is at $777 million or a $3 billion run rate – or 500% growth from FY2019 revenue. Quarterly revenue beat the top-end of guidance at $690 million with the company reporting "lower-than-expected" churn. Customers generating more than $100,000 in trailing 12-months revenue grew 136% year-over-year for an increase of more than 300 customers compared to Q2.

The blend of Zoom Video having virality across consumers from its freemium model combined with enterprise is the company's strength strategically as the competitors do not have the virality component. In Q3, customers with more than 10 employees represented 62% of revenue with net dollar expansion rate of 130%. Globally, Zoom exhibits strong growth, as well, with revenue from APAC and EMEA growing 629% year-over-year.

Gross margins were a weakness in the report at 68.2% compared to 82.9% last year and 72.3% last quarter. The company is providing the service for free to many users including K-12 schools during the pandemic. From my perspective, the temporary margin hit in exchange for virality and establishing consumer behavior is a good trade-off.  

Adjusted operating margins improved year-over-year but were slightly down quarter-over-quarter at 37.4%. Adjusted EPS was $0.99 which exceeded guidance by $0.25. RPO totaled $1.6 billion, up 215%, from $517 million year-over-year which is a strong sign the growth will continue. The company ended Q3 with $1.9 billion in cash (nearly unheard of for a tech growth company at this stage).

Guidance for the next quarter is in the range of $806 million to $811 million with adjusted earnings of $0.77 to $0.79 EPS. Fiscal year guidance is for revenue of $2.57 billion to $2.58 billion, representing 314% year-over-year growth (currently company is in Fiscal Year Q3 2021 and the fiscal year ends next quarter). The adjusted operating income for FY2021 is forecast to be $865 million to $870 million for nearly 900% growth and equal to $2.85 to $2.87 EPS.

The Gartner report that Zoom Video references canbe found here. The bigger revelation is not that Zoom Video is listed as a leader but that Gartner forecasts only 25% of enterprise meetings will take place in-person compared to 60% today. The analyst firm also predicts that 74% of companies plan to shift to more remote work — (keyword here is more – not entirely shift)

Chart showing Zoom Video leads enterprise players Microsoft and Cisco

Source: Gartner (2020)

The interesting piece about the chart above is that Zoom Video leads enterprise players Microsoft and Cisco but is also in a wide lead for consumer. The consumer traction may be Zoom's biggest tailwind as consumer behavior will be hard for a competitor to change.

The strengths that Gartner sees include zoom's user-centric design, service reliability and flexible consumption model. Zoom is also moving into verticals, such as healthcare and financial services, to add to its popularity in education.

The primary risk for Zoom Video is security. As I've stated a few times, it's common for an enterprise to not offer end-to-end encryption as the employer prefers to access the data on their employees. In response to the criticism, Zoom Video offers end-to-end encryption for accounts with more than 200 users.

In another Gartner report for Unified Communications-as-a-Service, Zoom appears for the first time due to the recent launch of Zoom Phone and receives a leadership position with its first mention in the UCaaS report. That's a significant entry. Zoom Video offers Zoom Phone at no additional charge and has secured a partnership with ServiceNow. The company is also partnered with Pinterest on hobbyist classes. Despite the Zoom Phone service being relatively new, it offers a 99.999% availability SLA target.

Gartner report: Zoom appears for the first time due to the recent launch of Zoom Phone and receives a leadership position

Source: Gartner (2020)

Visionary CEOs tend to better than competitors who lag because they have a vision for what the space will need next. We see many products rolling out of Zoom that challenge the way video conferencing is done today. As pointed out in the earnings call, Rakuten has partnered with Zoom for the broader UCaaS offering of Rooms and Phone. This is a leader in internet services with 1.4 billion members globally.

OnZoom is a product in beta that will help creators monetize fitness classes, concerts and music lessons. There is also an event discovery feature. Recently, Pinterest has announced a partnership to help creators on their platform reach a larger audience with Zoom.

Analysts on the recent earnings call seemed especially excited about Zoom's ability to sell into the Global 2K with international expansion being a large focus. From Rakuten's recent partnership, plus Lumen/Centurylink and Deutsche Telecom, these larger partnerships with tech providers are my favorite catalyst moving into next year. Essentially, they see Zoom as the best product available (and least threatening) to integrate for unified communications and voice. This is the best evidence that Zoom Video is not a fleeting pandemic stock as large telecommunications providers shift towards cloud.  

Zoom Rooms is a software-defined video conferencing system. Eric Yuan is likely tapping into his experience at Cisco as this will be one of the main competitors he takes on with this move to eradicate conference hardware.

The software-defined solution also extends to kiosks for virtual receptionists, will allow for voice control including an Alexa integration and advanced AWS console. The Smart Gallery will use AI to create a gallery-view of participants for hybrid workforces to where the viewpoint of the camera creates the best imaging possible and other whiteboard features are coming in 2021.

Okta

According to most standards, Okta's earnings report was solid and resulted in an uptick in the stock price. However, the growth has been flat for most of this year.

Revenue rose 42% to $217.4 million ahead of estimates for $202.7 million. Bookings (remaining performance obligations) are growing faster than revenue at 53% to $1.58 billion. Calculated billings were up 44% year-over-year. This was a re-acceleration of calculated billings from the previous quarters in FY2021 where the pandemic weighed on budgets.

The company is profitable on an adjusted basis with EPS of $0.04 and free cash flow of $41.6 million, up from $9 million a year ago. Highlights include a growing number of customers in the financial services sector and government.

The guidance was conservative at $221 million to $222 million, representing a growth rate of 32% to 33% year-over-year. The company is also guiding for an adjusted loss of $0.02 to $0.01 EPS. The fiscal year 2021 offered stronger guidance of 40% growth year-over-year for $822 million in revenue with adjusted EPS of $0.04 to $0.05.

According to the investors deck, the company has a combined addressable market of $55 billion across Workforce Identity and Customer Identity. The contribution margins at 70% for fiscal 2017 cohort analysis on page 14 was impressive. The net retention rate is 123% with adjusted gross margins of 78% and adjusted operating margins of 2.5% and free cash flow margins of 19%. The net retention rate saw a re-acceleration to its highest level in two years. Typical NRR is in the 119-121% range. Free cash flow margin was also its highest in two years.

Quarterly Free Cash Flow Margin Graph

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Total customer count was up 27% and annual contract value was up 34%. The current outlook for the company is 30-35% CAGR through FY 2024 and free cash flow margins in FY 2024 of 20-25%. The total number of $100,000 plus customers stands at 1780, an increase of 34%. The base of customers with annual contract value of greater than $500,000 grew 50%.

Okta's management pointed to three trends in driving business: Cloud and Hybrid IT, Digital Transformation and Zero Trust security. There is a partnership across Proofpoint, Netskope and CrowdStrike which is classified as a deep product integration for an enhanced product stack.

Okta was also recently introduced to the AWS marketplace and is the only identity vendor in the products for Control Tower, which allows for the management of more complicated AWS environments.

Notably, Okta was given a lower-ranking spot in the leader category of the 2020 Gartner Magic Quadrant for Identity and Access Management. One could argue too much attention is given to Gartner at times as Okta has been through a challenging and anomalous year. However, it should be noted that Okta was in a wide lead on the leader quadrant for 2019 and has been bumped down to equal standing with Microsoft and Ping Identity.

Snowflake

Snowflake grew 119% year-over-year to $159.6 million with remaining performance obligations of $927.9 million, or 240% year-over-year growth. Product revenue grew 115% year-over-year. The net revenue retention rate of 162% is impressive although other companies have exceeded this in their 6th year (Snowflake was founded in 2012 but was in stealth mode until 2014 when it began to work with customers).  

Graphs: Showing Stocks Revenue Growth in Year #

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Gross margins are between 58% to 63%, which it's normal for a cloud company to be lower than a SaaS company on margins. However, operating margins were negative (30%) with FCF margins of negative (23%). Probably the biggest issue that Snowflake faces are the sales and marketing costs. In the previous two quarters, they were near or exceeded total revenue and in this quarter they were about 90% of revenue at $134 million compared to the $159 million in revenue.

The issue here is the rapid growth is being paid for in sales and marketing dollars and could slow when the bottom line becomes prioritized. Growth marketing tactics like this can often skew the true growth rate of a company at the expense of the bottom line. When equilibrium is sought, the top line suffers (or the alternative is that profitability is a long way off). Oddly enough, the bleeding operating and FCF margins weren't mentioned by the analysts in the Q&A on the earnings call.

The bigger product announcements on the earnings call include Snowflake expanding from semi-structured to unstructured data (which will be helpful for machine learning), SnowPark which enables users to query in their language of choice (Java, Python, etc). The overarching goal is to consolidate workloads and meet the demand for data governance purposes.

The company issued forward guidance for FY 2021 of revenues between $538 million and $543 million for YoY growth of 113% to 115%. Margin will be decent for adjusted gross at 68% compared to negative (40%) operating margin and negative (18%) adjusted FCF margin.

Snowflake is a strong company. In my opinion, the valuation is a major risk and continues to be considering the high sales and marketing costs that are causing an imbalance between the top line and bottom-line growth. Net retention rate of 169% is impressive although is a consumption model and cannot be compared to SaaS.

CrowdStrike

CrowdStrike beat consensus estimates on both the top and bottom lines and raised Q4 guidance. Revenue grew 86% YoY, representing an 8% beat above Wall Street estimates. Subscription revenue increased 87% YoY while annual recurring revenue advanced 81% compared to a year ago. The company also achieved its most impressive quarter ever in terms of profitability, earning $0.08 per share on the bottom line. This was CrowdStrike's third consecutive quarter of positive EPS and its highest total yet. Free-cash-flow margin increased to 33% and gross margin improved to 76%.

Here is how CrowdStrike's FCF margin compared last quarter:

How CrowdStrike FCF margin compared last quarter

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In the quarter, CrowdStrike added 1,186 net new subscription customers, representing growth of 85% YoY. CrowdStrike also continues to drive new module adoption in existing customers, as 44% of the company's subscription customers have adopted five or more modules versus 39% in the previous quarter. Management guided for $248M in revenue for Q4 (+63% YoY), representing a 7% raise above expectations.  

This was an impressive quarter for CrowdStrike both in terms of increased usage of existing customers and the addition of new customers. As previously mentioned, CrowdStrike continues to excel in its ability to drive new module adoption with 61% of the company's customers adopting 4 or more modules versus 52% in the same period a year ago. 

In the quarter, CrowdStrike announced the addition of three new modules to the Falcon Platform, covering cloud security posture, dark web threats, and incident response investigations. The Falcon Platform now encompasses 16 modules in total. 

CEO George Kurtz highlighted new module adoption as a key to the company's growth strategy in its Q3 Earnings Call: "I'm pleased to announce that in Q3 we reached a new milestone with 22% of our subscription customers having adopted six or more modules. Driving adoption of our expanding module lineup is a keystone to our growth strategy as it increases the strategic value we provide to customers, which also translates to higher retention rates." 

This quarter indicates CrowdStrike is successfully executing on this growth strategy.     

The second key to CrowdStrike's growth hinges on its ability to add new customers, a metric that increased 85% YoY in Q3. One key customer win in the quarter was signing Target, which displaced Symantec and deployed Falcon completely across its footprint in less than 10 days. 

CEO George Kurtz discussed the marquee win in its earnings call: "a win with Target that highlights how our single agent cloud-native architecture, intuitive console, and rapid re-bootless deployment capabilities continue to be significant differentiators for us. Target Corporation was looking to rapidly move away from Symantec and transition to a single agent cloud solution that could be deployed in days, not months or years." 

Zscaler

ZScaler announced Fiscal Q1 2021 results that easily cleared analysts' expectations. Revenue growth accelerated to 52% YoY, which represents the company's third consecutive quarter of growth acceleration.

Adjusted billings growth increased 64% YoY, far surpassing the consensus expectation calling for 39% growth. This beat was driven in part by a record quarter of seven-figure deals. The company's net retention rate of 122% advanced from 120% last quarter and 119% the quarter before. Non-GAAP EPS of $0.14 was 8 cents better than expectations while the company also announced an impressive 30% FCF margin. Non-GAAP operating margin of 14% far exceeds the consensus of 2.9%.

Graph shows one of the best quarters for ZScaler free cash flow

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The acceleration in growth coupled with the record quarter of operating profits and free cash flows makes this one of the best quarters ZScaler has announced.

CEO Jay Chaudry discussed the three main factors that allowed his company to outperform this quarter: "One, building on our growing traction with large enterprises. We closed a record number of seven-figure ACV deals… two, our optimized go-to-market engine is driving significant velocity… Last year, we doubled down on our investment in our sales organization. These efforts are also bearing fruit in two big ways. One, our newly hired sales reps are contributing at a faster pace. And two, our sales productivity is higher than a year ago, despite a high percentage of ramping sales reps… Three, the power of our Zero Trust Exchange platform is resonating with CxOs."

Looking ahead, ZScaler believes that the strong business momentum they have exhibited in the last several quarters will continue. Management raised guidance over 5% for FQ2, now expecting $147M of revenue at the midpoint (+45% YoY). Management attributed the strong FQ1 in part to stronger than expected deal activity and expects these trends to continue into the next quarter. 

In its FQ1 Earnings Call, CEO Jay Chaudry touted the company's position amongst a growing opportunity: "I believe in the current challenging environment and in the post-COVID economy, Zscaler will be the go-to-platform for vendor consolidation, cost-saving, increased user productivity, and better cyber protection.."

Elastic

Elastic announced strong FQ2 earnings on 12/2. Total revenue increased 43% YoY, representing an 11% beat above consensus. Total billings grew 42% YoY while SaaS revenue increased 81% versus the same period a year ago. The company's losses also improved significantly, with non-GAAP EPS of -$0.03 coming in 17 cents better than expected. Non-GAAP operating loss improved to -$1.9 million, representing a -1% operating margin versus -10% projected. Gross margins also came in better than expected with 77% versus a consensus of 75%. FCF margin was -13% for the quarter. 

Subscription revenue totaled 93% of Elastic's total revenue in the quarter, with 45% of total revenue coming from outside the US. Management views this geographical distribution as a strength in the company's business model. Elastic's net retention rate ticked down several points from last quarter but still remained modestly above 130%. Elastic now has a total of 12,900 subscription customers with 650 of those (5%) having annual contract values exceeding $100K. 

At the start of its fiscal year, Elastic's management discussed how COVID-19 would likely create headwinds to calculated billings for a couple of quarters and that they would then see gradual improvement beyond that. 

In its FQ2 Earnings Call, management confirmed that the first half of fiscal 2021 played out as expected. The company has observed longer sales cycles and many customers are looking to conserve cash as spending patterns have not recovered to pre-COVID levels. Management updates its outlook for the second half of the year, noting that they expect the trends they observed in the last two quarters to continue in the next two: "given the global situation with the pandemic, our current assumption is that the mixed demand environment that we experienced in the first half will continue for the rest of the fiscal year. Previously we were expecting the environment to gradually improve during the second half." Still, Elastic's strong execution in the first half of its fiscal year gave management the confidence to increase its guidance for the next quarter. Management raised guidance 4% for FQ3, now expecting $146M of revenue (+29%). However, the company expects EPS to decline to -$0.15 on a -7% operating margin for FQ3.     

Elastic's management ultimately expects the demand environment to return to pre-COVID levels in fiscal 2022, which would align with the summer of 2021. While the company is certainly facing some headwinds due to the pandemic, the digital transformation has provided tailwinds that have allowed growth to remain strong. Management expects these tailwinds to continue beyond the rest of their fiscal year: "the tailwinds of cloud and our solutions adoption position us well for the rest of this fiscal year and beyond."

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.

Momentum is on CrowdStrike’s Side: Will it Last?

Posted on by io-fund

A periodic transaction report filed on September 3rd revealed Nancy Pelosi and her husband Paul Pelosi purchased 5,000 shares of CrowdStrike for a total investment of roughly $650k.  It’s easy to speculate why the Speaker of The House would be purchasing shares of a cybersecurity company that has a history of working with the Democratic National Convention and FBI.  CrowdStrike was instrumental in alleging Russia interfered in the 2016 election, an allegation that led to a multi-year investigation. 

The timing of this purchase, just weeks before the 2020 election, makes one contemplate her reasoning. Perhaps the Speaker of The House believes CrowdStrike will once again be instrumental in maintaining the integrity of the 2020 election results. Perhaps she believes CrowdStrike is positioned to win a large government contract. Perhaps she believes cybersecurity will become a bigger priority in the future in the government and commercial sectors.  Or perhaps we are overthinking this, and the Speaker of The House had nothing to do with this and her husband is simply bullish on the company’s fundamentals and technicals. 

In any case, seeing the Speaker of The House purchase 5,000 shares of CrowdStrike adds confidence to my conviction in the stock.

Nancy Pelosi has not been the only one to make a large investment in CrowdStrike recently. In fact, CrowdStrike saw institutional ownership increase 15% in Q2 from Q1.  The stock has become a favorite of hedge funds and tech/growth focused funds, which further adds to my confidence that the company has a bright future ahead of it.    

Below, I discuss this bright future in regards to security leading budgets and current initiatives.  I also dissect areas of strength in the previous earnings report and why I expect this strength to continue in the future. 

Cybersecurity: More Prevalent Than Ever

The COVID-19 pandemic has increased the importance of cybersecurity, with 3 out of 4 business leaders seeing cybersecurity as a top priority in COVID recovery.  The speed and size of change to a remote workforce has uncovered some gaps in the cybersecurity of many organizations.  Data shows that business leaders are aware of these gaps and cybersecurity spending is expected to increase to address them.

Through the end of July, CrowdStrike observed an increase in eCrime activity up over 330% since the start of the year versus in 2019. In its Q2 earnings call, CrowdStrike’s CEO claimed that in the first-half of 2020, the company saw a 154% increase in distinct and sophisticated intrusions and stopped 41,000 potential breaches, which is more than all of last year combined. 

This survey from Credit Suisse shows Security Software is the top priority among business leaders surveyed.  The 10- percentage point increase from January to July indicates that business leaders are prioritizing security software more than ever in the age of COVID and remote work.

Morgan Stanley recently held a survey on key initiatives in 2020 and found that cybersecurity is the top priority among business leaders.  95% of the leaders surveyed agreed cybersecurity is a priority, with 38% expecting to engage a service provider.  These numbers indicate that cybersecurity is the #1 priority for business leaders and that the industry is expected to see more engagement than any other. 

CrowdStrike: Product Overview

CrowdStrike was founded with the goal of reinventing security for the cloud era.  CrowdStrike’s Falcon platform delivers comprehensive breach protection against today’s most sophisticated attacks on the endpoint, where the most valuable corporate data resides. 

The company offers 11 cloud modules on its Falcon platform via a subscription-based model that covers numerous security markets, including endpoint security, security & IT operations (including vulnerability management), and threat intelligence. 

CrowdStrike’s AI based security model is focused on collecting large amounts of data, centrally storing it in a single model, and continuously training its algorithms with vast amounts of data.  The more data that the Falcon Platform collects, the more intelligent the platform becomes in detecting and stopping breaches. 

CrowdStrike: Opportunity

With cybersecurity spending expected to increase at a 10% CAGR over the next 3 years, CrowdStrike is in an ideal position to continue its momentum.  Endpoint security is expected to be the 2nd biggest priority among security spending. 

Source: AlphaWise, Morgan Stanley Research

Endpoint security is a critical element of a multilayered security strategy, as endpoints are frequently the first point of entry for attackers.  Specific to endpoint security software, CrowdStrike’s market share has nearly doubled over the last year. The company has been identified as the fastest growing endpoint security software vendor by IDC Worldwide. 

In a recent survey conducted by Morgan Stanley, CrowdStrike is shown to be the top endpoint protection vendor among the business leaders surveyed.

Source: Morgan Stanley Research

CrowdStrike’s Falcon is armed to fight sophisticated threats and stop breaches through a combination of malware prevention, enterprise detection and response (EDR), and threat hunting.  Specific to enterprise detection and response, CrowdStrike has been named 1 of 3 leaders by Forrester research and 1 of 5 by Gartner.

Financials:

CrowdStrike reported excellent Q2 results on September 2nd, comfortably beating revenue estimates with an 84% YoY growth rate. Subscription revenue grew 89% YoY, ARR grew 87%, and the company now boasts a total of 7,230 subscription customers (+91% YoY), 57% of which have greater than 4+ modules. 

CrowdStrike has exhibited consistent growth in the number of its customers using 4+ module subscriptions, indicating that existing customers are happy with the platform and continue to spend more to add additional protection.

Source: CrowdStrike Investor Presentation

The company now has 49 of the Fortune 100 companies as customers. Moreover, CrowdStrike took a significant step towards profitability in Q2 with its first quarter of positive operating margin (4%).  The company also generated positive free cash flow for the quarter at an impressive 16% FCF margin.  This was CrowdStrike’s second consecutive quarter of positive adjusted EPS, and the company is expecting to breakeven for the full year with a $0.05 EPS estimate at the midpoint of their FY21 guidance. 

Management raised revenue guidance for Q3 and FY21, calling for 71% YoY growth in Q3 at the midpoint.  This outlook bakes in logical conservatism and represents a fairly easy target for CrowdStrike to beat.

CrowdStrike has a history of outperforming estimates, averaging an 8% revenue beat over consensus in the last 4 quarters.  In its 6 quarters of public history, CrowdStrike has never missed on revenue or EPS estimates. 

Looking ahead to Q3, consensus estimates are calling for 71% YoY growth, exactly in line with the outlook management gave after Q2. CrowdStrike’s history of outperformance will likely continue as the company has posted consistent growth rate percentages of 89-89-85-84 in its last 4 quarters. 

Risks:

The biggest risk for CrowdStrike is related to the intense competition they face within the cybersecurity industry.  The market for security and IT operations solutions is intensely competitive and characterized by rapid changes in technology, customer requirements, and by frequent launches of new or improved products to combat security threats. 

CrowdStrike remains the fastest growing endpoint security platform, but if they are unable to react to new competitive changes, they will see a decline in growth and lose market share.  The company must continue to adapt in a highly dynamic industry to sustain its growth levels. 

Competitive pricing pressure could end up damaging CrowdStrike’s profit margins and forcing the company to lower its prices to compete. 

Many of the company’s competitors, including Microsoft and VMware, have deep pockets and the threat of a price war remains one of the biggest risks to CrowdStrike.  Microsoft is a $1.7T company with the assets and resources to challenge CrowdStrike’s margins in the future. 

Relative to its total addressable market, CrowdStrike appears pricey.  The company is valued at a market cap of $31.3B.  The most recent estimate of CrowdStrike’s TAM comes from its S-1, where management estimated a total global opportunity of $29.2B in 2021.  However, its fair to assume CrowdStrike’s TAM has grown significantly since that report was released in June of 2019.  In that report, management estimated that the global market for endpoint security would reach $8.7B in 2021, but more recent data shows the endpoint security market will be worth $18.4B in 2024. 

Conclusion:

CrowdStrike is ideally positioned to continue its strong momentum as the company continues to benefit from increased security spending.  Within the realm of increased security spending, endpoint protection has been revealed as the 2nd biggest priority among business leaders, where CrowdStrike is the fastest growing vendor.  Nancy Pelosi’s vote of confidence bodes well for the company as we head in to the 2020 election, where CrowdStrike may again play a crucial role.  I believe CrowdStrike will grow faster than expectations over the next few quarters as the company achieves FY profitability for the first time in its history.      

DISCLOSURE: I am Long CRWD call options expiring June, 2021

COVID’s Impact On Cloud Software Stocks

Posted on by io-fund

This article was originally published on Forbes on Oct 8, 2020,11:23pm EDT

Rebound numbers from Q3 will look spectacular following the paralyzing effects of strict shelter-in-place orders in Q2. The economy is officially in a recession after posting two negative quarters of GDP growth at (5%) in Q1 and (32%) GDP in Q2. The latest estimate from Atlanta’s Fed GDPNow for Q3 2020 is showing a record rebound of 35.3%.

This represents an increase of 7.9% quarter-over-quarter and 3.1% below the pre-recession high. For comparison purposes, the Financial Crisis of 2008 bottomed at 4.0% below its pre-recession during the third and fourth quarters of its recession.

frbatlanta.org DAVID MARLIN

The chart above shows the projected Q3 rebound of 35.3% from the Atlanta Fed’s GDP Now released on October 6th, 2020.

Cloud and IT Budgets: Staying Objective

Some will argue the market is not the economy (which is true), however, cloud software can’t stop the spiraling effects of lower IT/cloud spending and tighter budgets that follow a weaker economy. One area that companies might reduce costs is to trim down on the number of cloud software and tools they use. Unemployment could exacerbate this if the subscriptions are paid per employee.

Spiceworks recently released a survey that shows 80% of IT-decision makers expect IT budgets to grow or stay steady over the next 12 months. This supports the notion that even during periods of uncertainty, IT and cloud are central and critical to operations.

With that said, the decision-makers polled stated the primary drivers in IT budgets are noted to decrease year-over-year except covid-related budget allocations. In the past, drivers such as employee growth, security concerns, and the need to upgrade IT infrastructure were expanding to support higher budgets.

Perhaps more indicative is the decrease in revenue that is being forecast across the 1,000 IT-decision makers that were polled. One-third of businesses expect revenues to increase from 2020 to 2021 which is down from 58%. One-third also expects revenues to decrease YoY which is up significantly from the previous two years when only 7% expected a decline in revenue.

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As the survey illustrates, cloud software will be more resilient than many other categories. However, there will be some cloud software companies that see an impact on one side of the equation or both sides of the equation – this means either fewer new customers or more churn or downgrades in existing customers or both. There are three points where weakness can occur (fewer sign-ups, churn, and downgrades). Notably, companies that have annual recurring revenue will be more protected.

In this article, we go back through earnings calls to see what management is saying in each respective company:

These companies had positive things to say about budgets …

Twilio:

“Our customers in nearly every industry have had to identify new ways to communicate with their customers and stakeholders, from patients to students to shoppers and even employees essentially overnight… Twilio was built for this. The things we've always brought to our customers, digital engagement software agility and cloud scale are enabling organizations to innovate now even faster than ever. Messaging, email voice and video are allowing companies to engage with their customers safely while reimagining their digital engagement strategies in ways that will be resilient for years to come…And now we're seeing the strength of that diversification really play out during COVID, as we've seen new industries, new use cases offset some of the more negatively impacted areas.” – CEO Jeff Lawson Q2 Earnings Transcript (8/4/20)

Fastly:

“The need for a trustworthy and modern edge platform has never been greater. Developers and security operators are at the center of the transformation and they can only drive transformation effectively if they can build quickly and securely…Fastly is in this unique position to be a usage-based model with the most innovative companies in the world. And so when you stack on, the most — the largest innovators and you look just at their results, whether it be Pinterest or Shopify, the list goes on and on.” CEO Joshua Q2 Earnings Transcript (8/5/20)

Crowdstrike:

 …. “even in this challenging macroeconomic backdrop, cybersecurity is mission-critical and more important now than ever, as the threat environment escalates and the attack surface continues to grow…as organizations rapidly adapt to the new distributed workforce paradigm and move more workloads to the cloud, it has become clear that the endpoint is the new security perimeter, and the inadequacies of the complex brittle patchwork of legacy solutions continues to be exposed.” — CEO George Kurtz Q2 Earnings Transcript (9/2/20)

Bandwidth:

“The second factor driving our outperformance was the increased usage driven by COVID-19-related remote work requirements which peaked in April and thereafter dissipated throughout the quarter, but remained at elevated levels as compared to pre-pandemic period…While it is becoming increasingly difficult to differentiate COVID-19-related usage from organic usage growth, we estimate that COVID-19 revenue impact in the second quarter to be in the range of $4.5 to $5 million.” — CFO Jeff Hoffman Source: Q2 Earnings Transcript (8/2/20)

Beth.Technology

Price-to-sales change for the stocks covered in this analysis since the start of cloud software earnings reports on August 1st, 2020.

These companies were more some headwinds and some tailwinds cancel each other out for a neutral outlook …

Dynatrace:

“Despite the global pandemic continuing to delay some new sales cycles…Customers tell us that they consider Dynatrace an essential element of executing a successful digital transformation as they drive towards greater agility, efficiency, and business effectiveness…what we’re seeing is that as digital transformation accelerates, the need for a Dynatrace class solution even goes up. And that’s what we saw the beginnings of it in our fiscal Q1 and we continue to see it as we look out into Q2 and beyond with the sales cycles we’re now in.” – CEO John Van Siclen Q1 Earnings Transcript (7/29/20)

Cloudflare:

“We believe the pandemic forced companies [to] distort their vendors into two buckets, nice to have and must have. All indications from the quantitative metrics we’re watching as well as the qualitative conversations we’re having with customers are that Cloudflare is squarely in the must have bucket…COVID-related concession requests peaked in early April and had been tailed off. We came in well below what we forecast for potential downside…our sales cycle has kicked up by a few days in Q1 and trended back down in Q2 and remains well under a quarter and at the low end of our historic range.” – CEO Matthew Prince Q2 Earnings Transcript (8/7/20)

Okta:

“So we're obviously pleased with the results of the quarter and the strength in the quarter. We did see those mild pandemic headwinds. Frankly, they were not as strong as we thought they would be. And so I think what the movement of companies to decentralizing how they're working with the fact that companies are seeing with their customers, they're transitioning to more of an online relationship with those customers are both just big impacts for us, big tailwinds for us that are just accelerating some of the overall mega tailwinds we've talked about before, and that's really what's happening.” -Bill Losch, CFO Q2 Earnings Call (8/27/20)

Beth.Technology

Change in price for the stocks covered in this analysis since the start of cloud software earnings on August 1st, 2020.

These companies were more conservative in their comments about budgets …

Datadog:

“The macro environment did have some impact on our top line results, and in particular on growth of existing customers. Our customers continue to grow usage of our platform in Q2, but the rate of this growth was below the trends we saw before the pandemic. This dynamic was primarily seen in our larger customers, who already had sizable cloud environment. Given macro uncertainty, we saw these customers look to conserve cash where they still could and therefore, optimize the consumption of cloud infrastructure…To put it plainly, customers with large cloud deals from AWS, Azure or GCP look for short-term savings. Note that this is not a new motion, as we see many enterprises go through these optimization exercises on a regular basis. What was unusual this quarter was to see a large number of companies going through it at the same time.” -CEO Olivier Pomel Q2 Earnings Transcript (8/7/20)

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Alteryx:

“The global dislocation experienced as a result of the COVID pandemic followed by shelter in place orders, altered our customers buying behaviors in Q2. We observed notable changes such as higher levels of scrutiny on spending across all sectors resulting in longer sales cycles, smaller deal sizes and less favorable linearity in the quarter…Based on what we see today, we do not anticipate a material improvement in business conditions during 2020.” – Former CEO Dean Stoecker Q2 Earnings Transcript (8/7/20)

UPDATE (10/5): Alteryx currently expects that total revenue for the third quarter ended September 30, 2020 will be in the range of $126.0 million to $128.0 million, representing 22% to 24% year-over-year growth, ahead of the previously issued guidance of $111.0 million to $115.0 million

Slack:

“In Q2, calculated billings were impacted by approximately $4 million of COVID-related concessions and contract duration related headwinds. This brings the total concessions-related billings headwind in the first half to approximately $11 million.

Although we’ve seen a slowdown in concession requests over the past couple of months, it’s still not possible to forecast the effects of the pandemic on our customer base over the next few quarters. We plan to continue to help customers manage through this unique time and expect calculated billings to be negatively impacted and less useful as a measure of underlying growth during the COVID-19 crisis.” -Allen Shim, CFO Q2 Earnings Call (09/09/20)

New Relic:

“On the other side of the equation of customers are reducing their spend. So in the quarter, that number was also – we had $5 million to $6 million of downgrades that were COVID or macro related.” – CFO Mark Sachleban Q1 Earnings Transcript (8/5/20)

DAVID MARLIN

Conclusion:

We think it’s important to remain objective when evaluating cloud stocks. They have already proven to be affected by budgets per second quarter earnings calls and this could extend into Q3 for cloud software business models that are dependent on (1) number of employees, (2) new customers, (3) low churn, or dependent on (4) upgrades.

IDG released a survey stating that 81% of survey respondents were using cloud infrastructure compared to 73% in 2018. Even more bullish than the universal acceptance of cloud is that only 9% of environments are cloud-only with the large majority having a mix of cloud and on-premise at 83%. This will grow to 16% cloud-only over the next eighteen months.

Therefore, regardless of any temporary setbacks, cloud as a category still has quite a bit of runway.

Palantir IPO: Deep-Dive Analysis

Posted on by io-fund

This article was originally published on Forbes on Sep 29, 2020,11:17pm EDT

The Economist was correct when it recently stated that Palantir is “more than a technological project, it is a philosophical, even political one.” Palantir has a mythical and esoteric reputation in the Bay Area. The name is well-known and what the company does has circulated for years, which in a nutshell, is data mining for the government — and now, commercial clients.

Until recently, a customer list and any level of transparency has gone against the core purpose of the company. Therefore, I was somewhat surprised at the leak in 2018 that Palantir was considering a public offering as it seemed odd the company would operate openly and transparently. In fact, about five years earlier, the CEO had said an IPO was unlikely as it would make “running a company like ours very difficult.”

Nonetheless, the company is wanting to attract more commercial accounts and going public should help facilitate this. The old adage, “you can’t sell a secret” may be hindering Palantir’s growth especially as artificial intelligence startups raise their first and second rounds. Now is a good time to make sure to penetrate commercial accounts before AI brings more direct competition.

Below, I go over some of the folklore that surrounds Palantir and then I discuss the S-1 filing.

The Folklore around Palantir

Palantir can neither confirm nor deny if the software was used to kill Osama bin Laden, but the CEO required a body guard as of 2013, and it was generally understood for about a decade that Palantir had only one customer: the CIA; and then three customers: the CIA, the FBI and the NSA.

By 2015, a leaked document from TechCrunch dated in 2013 confirmed twelve government agencies were using Palantir, including the “CIA, DHS, NSA, FBI, the CDC, the Marine Corps, the Air Force, Special Operations Command, West Point, the Joint IED-defeat organization and Allies, the Recovery Accountability and Transparency Board and the National Center for Missing and Exploited Children.” Palantir’s leaked document was the first time the CIA and the FBI had databases linked rather than siloed.

Nearly twelve years after Palantir was founded in 2003, that leaked document was the only record that indicated who used the company’s software. Palantir can be a divisive company that draws strong opinions from supporters and critics. Regardless of how you feel about the work Palantir does, one thing is for certain: when the stock trades on the public market, the company will dominate headlines.

Often those headlines will get it wrong in an attempt to frame Palantir in various lights. For instance, I don’t think anyone in Silicon Valley batted an eye at Alex Karp’s letter when the company exited for Denver. He stated that engineers “may know more than most about building software but they do not know more about how society should be organized or what justice requires. Our company was founded in Silicon Valley. But we seem to share fewer and fewer of the technology sector’s values and commitments.”

These sensational headlines and CEO-centric storylines can be a bit distracting. When looking at things rationally, it’s probably better that Palantir be in Denver as government is a major industry in Colorado and being centered in the country will position Palantir closer to Washington D.C. Palantir’s investors are not traditional Silicon Valley VC-firms, either. The company was likely in SF/SV to attract top talent. There is also the theory that it was Silicon Valley that turned cold towards Palantir, as voiced by a privacy and technology advocate Harrison Rudolph.

In-Q-Tel, one of the venture firms that invested in Palantir, is located in Virginia and is funded by the CIA. This group has funded many projects, including Google Maps, Gitlab, Pure Storage, MongoDB, Cloudera and FireEye – but Palantir is on a different level as the CIA was the primary customer for many years. For these other companies, the CIA was not a primary customer. In-Q-Tel does not typically disclose funding rounds, amounts or dates. However, according to CNBC, Palantir received a $2 million funding round in 2004. Other investors include Peter Thiel, Stanley Druckenmiller and Tiger Global.

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On the positive side of things, Palantir is believed to have helped with counter-terrorism, human trafficking and disaster response. On the more questionable side, the company has admitted to helping ICE deport immigrants. The company embodies taking the good with the bad. A former Marine, Samuel Reading, was quoted saying “it’s the combination of every analytical tool you could ever dream of. You will know every single bad guy in your area.” That, of course, implies having to know every good guy in the area too.

In the past, the Board has included Condoleeza Rice and former CIA director George Tenet, who said “I wish we had a tool of its power” before 9/11. The software was also allegedly used to convict Bernie Madoff.

Just when you think Palantir couldn’t be steeped in any more controversy — there’s more. In 2016, the company sued the United States Army for unlawful procurement solicitation for the Army’s internal intelligence software suite. Palantir argued the Army should be stopped from developing a risk-prone software project that would cost more than using Palantir’s software. In the end, Palantir won and the Army signed a $800 million contract over the course of 10 years.

So, why is Palantir going public now? Well, for one, it will be easier to gain corporate clients if the company becomes a stock market darling. The stock market is becoming a phenomenal source of free press and Wall Street will glamorize the company if it produces solid returns. This, in turn, will help Palantir attract more commercial customers and perhaps bury any ethical opposition.

The markets came close to burying the ethical issues around Uber. Perhaps this time it will succeed with Palantir. I also personally believe Palantir’s wide lead and lack of direct competitors (moat) will erode with artificial intelligence and machine learning. Time is of the essence to go public as AI startups need another few years before they can compete on this level.

Palantir’s Product:

Founded in 2003, Palantir is described as a company specializing in big data analytics. Palantir’s specific expertise in government intelligence and its existing ties to national security and the intelligence community differentiate its offering from competition.

Palantir will say the company does not provide the raw data, rather discovers patterns in large data sets. Investigative reporters have asserted the company helps some agencies use mass surveillance systems, and therefore, this line is blurred. Those are two of many opposing facts about this company.

The company has two platforms: Gotham and Foundry. These platforms allow organizations to combine core data with critical tools into a single platform to help users obtain actionable insights from a unified data asset. What Palantir tackles is the issue of data being siloed and ineffective for problem solving. These problems may relate to manufacturing, product development or customer experience.

The data Palantir gets is from the customer themselves and their existing databases although Palantir can crawl and scrape data that is freely available. For instance, Palantir can easily scrape public social media profiles but probably does not have access to private profiles except when the FBI issues government requests to Facebook.

The traditional deployment involves hosting Palantir servers in a customer’s data center. There is a cloud-based offering, as well, so the company can work across a range of hosting environments.

The company differs from a business intelligence solution like Tableau, Alteryx or Cloudera by answering questions that a model cannot answer. An example might be “how do we service car loans to people least likely to default” or “how do we catch fraud before it happens.” With traditional BI, it’s assumed you have the complete data set. Palantir tackles situations where a company may not have the complete data set. This is a crucial difference.

Palantir Gotham was the company’s first platform, built for government operatives in defense and intelligence sectors. The platform enables users to identify patterns hidden deep within datasets using semantic, temporal, geospatial and full-text analysis.

Here are some ways the platform is used:

Graph: This application allows data objects to be seen as nodes and edges. Users can visualize events, filter objects and plot characteristics in a logical manner.

SOURCE: PALANTIR.COM

Map: This brings geospatial capabilities to track geo-located objects and events and to create heatmaps for the density of the objects.

SOURCE: PALANTIR.COM

Object Explorer: This feature is powered by the Horizon in-memory database, which competes with Apache Spark by letting users query billions of objects. The database provides further analysis for Map and Graph data.

SOURCE: PALANTIR.COM

Browser: This enables search queries for investigations and surfaces information, runs relevant searches, displays key data points and answers analytical questions.

SOURCE: PALANTIR.COM

Palantir Foundry is the commercial offering and has four layers of tooling: Foundry Core, Data Foundation, Ontology and Workflows.

This four-step process does the following:

  1. brings volumes of data into one place,
  2. transforms the data into a format that analysts can work with and enables validation in any number of programming languages
  3. the “ontology layer” allows datasets to be turned into real-world concepts with the ability to accelerate on the company’s core ontology to reduce redundancy
  4. workflows is where it all comes together in an integrated environment for object exploration, point-and-click top down analysis, code authoring, time series analysis, data science and application development. When a user has a question, it answers it using all layers and tools available.

Palantir describes Gotham and Foundry as the “ability to construct a model of the real world from countless data points.” Unlike a SQL database, natural language is used to query data and return results in real-time rather than through strings.

The truest, closest competitor for Palantir is Semantic AI, which supplies graph-based analytical platforms to the DoD and other government agencies. As stated, I think Palantir’s real competition is being developed as we speak as machines will answer questions from incomplete data sets once the AI/ML market is built out.

Some real-world uses for Palantir include Hershey’s using the software for global food distribution and to correlate weather patterns with snack consumption. Chase Bank and other financial firms have used Palantir’s data analysis to identify troubled properties and ensure employees are not committing fraud (the employee monitoring took a nosedive — more on this below). Pharmaceutical companies use Palantir to expedite the development of new drugs – this being a substantial use case this year and perhaps why Palantir’s revenue has accelerated.

Palantir’s Financials

The company grew revenue 25% year-over-year to $742 million in 2019. This accelerated to 49% year-over-year to $481 million for the six months ending June 30th. According to a Reuters article in June, the company is expecting $1.5 billion in 2021, which looks easily achievable. The company’s annual run rate based on the current quarter is about $1 billion.

Link: https://www.sec.gov/Archives/edgar/data/1321655/000119312520230013/d904406ds1.htm

PALANTIR'S S-1 FILING

Net losses for 2019 of $579 million were flat year-over-year compared to net losses in 2018 of $580 million. On an adjusted basis, net losses in 2019 were $337 million. The losses are shrinking with H1 2020 reporting a loss of $164.7 million compared to $280.5 million in the year-ago period.

On an adjusted basis, the company was profitable in the first six months of this year at $17.2 million compared to a loss of $167.6 million in H1 2019. This improvement in operating results was driven by increasing revenue and reducing the number of engineers needed to install and deploy software programs.

Gross margins for H1 2020 are at 73% and the company spent only 42% of revenue on sales and marketing.

The company has cash of $1.5 billion and debt of $297.6 million as of June 30th.

Contribution margin is a Non-GAAP key metric that represents the revenue the company generates relative to the costs incurred. It strips out variable costs related to deploying and operating the software and identifying new customers.

You can think of it as falling somewhere between gross margins and operating margins. For comparison purposes, Palantir’s gross margins are at 72.3%for the six-month ending June 30 and the company has negative operating margins of -48.5% and negative net margins of -78%.

Source: S1 Filing

The company states the addressable market is $119 billion across commercial and government sectors. The TAM in the government sector is $63 billion and the TAM in the commercial sector is $56 billion. Within the government TAM, domestic is $26 billion and international is $37 billion.

The commercial sector is the growth story. For example, Skywise is a solution that connects in-flight, engineering, and operations data to break down siloed systems around maintenance, flight management and aircraft monitoring and safety. Palantir is partnered with Airbus who offers this solution as “the leading data platform for the aviation industry.”

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This example can extend to many industries, such as pharma for drug development data to better understand population dynamics and drug outcomes. This is for the pre-clinical and clinical stages, mapping treatment pathways, and automating reporting. Manufacturing can benefit from Palantir Foundry by managing inventory, saving on distribution costs and prevent delays while increasing sales.

There are also solutions for financial compliance, insurance, automotive and sales.

Valuation:

Palantir is doing a direct public offering (DPO), which means there will be no new shares offered and no underwriters. The goal of a direct listing is not to raise money rather to allow existing investors to sell their shares. However, unlike Spotify and Slack who did DPOs, Palantir will have a lock-up period. I find a lock-up period to be more favorable for retailers as Spotify took nearly two years to break out from its opening DPO price and Slack is taking more than a year to break out beyond its opening price. 

The company’s founders, Peter Thiel, Alex Karp and Stephen Cohen, own 30.2% of the company’s stock. Peter Thiel owns additional stock through various investment management funds that own stock, such as Founders Fund. Thiel has 28.4% corporate voting power, Karp has 8.9% and Cohen 3.1%.

There will be three classes of stock: Class A, Class B and Class F common stock – which is unusual to have three tiers. Class A will allow for one vote, Class B will allow for 10 votes and Class F will share 49.99% of the voting power for Palantir. Class F is for the founders who will retain just under 50% of the voting rights at all times. This is reminiscent of Facebook where insiders control about 70% and Zuckerberg controls 58%.

The reference price for Palantir’s direct listing is $7.25 per share, which would value the company at $15.7B. This is lower than the expected price range we saw throughout the month. Palantir was initially thought to open in a range of $10-$14, which would have given the company a $26B market cap at the midpoint. Palantir received a private valuation of $20.4B in 2015. 

At the reference price, Palantir would trade somewhere between 10.5x-15.7x FY 2020 revenue depending on the estimate. At a reasonable $1.25B FY revenue estimate, Palantir would be valued at 12.6x 2020 sales. With a more generous estimate of $1.5B in 2020 revenue, Palantir would trade at 10.5x sales.

BETH.TECHNOLOGY

The reference price does not mean Palantir shares will open at this price on Wednesday. If Palantir follows the trend of recent tech IPOs, it will open trading well above its offering price. For comparison, Snowflake (SNOW) opened 105% above its offering price, JFrog (JFROG) 62%, Sumo Logic (SUMO) 21%, and Unity (U) 44%. A $25B valuation would be roughly 59% above Palantir’s reference price, a number that is in line with this trend. 

Looking at the current IPO market, it’s very likely that Palantir will open above its reference price, but still well below the valuations we have seen in some recent IPOs. A few recent IPOs have traded at historically high valuations.  Zoom Video, Agora, Datadog and Lemonade have all hit the 50 EV/Revenues level. More recently, Snowflake opened above 100x EV/Forward Revenue and JFrog above 40x. Early indications show that Palantir will open at a more reasonable valuation. 

Below, I review the risks that may be contributing to this lower valuation.

Risks

Palantir’s biggest risk is customer concentration with the top 20 customers accounting for 67% of revenue and the dependence on government contracts at 54% of revenue. The Army’s attempt to develop a more expensive in-house solution illustrates there is a risk that government agencies eventually move away from Palantir in the future.

Reputation and social acceptance is also a risk. Tech companies often see employees engage in protests when a company contracts with the government on AI-driven war missions and privacy issues that potentially threaten human rights. Palantir’s biggest obstacle today is the work it does with ICE which pits the company’s internal employees against the CEO on social issues.

For instance, this week, Hootsuite stated the company would terminate its ICE contract due to disagreements within the company. The CEO tweeted: “We typically do not make public facing statements about specific customers or contracts. However, due to the attention around this particular case we can confirm that Hootsuite has decided not to do business with the U.S. Immigration and Customs Enforcement.”

In the past, Google ended a contract with the Pentagon when employees protested using AI for lethal purposes. Karp became controversial and challenged Google on this decision, saying it was a “loser” position.

This can backfire as Palantir may not be able to attract top talent as AI companies begin to compete from a small pool of AI developers and engineers who have proven to protest and walk-out of company projects they feel are unethical. Amazon, also, banned facial recognition for law enforcement for one year following the George Floyd protests. Therefore, Karp’s personality could be considered a risk as the tech world begins to explore and support ethical AI development.

Despite government-backing, Palantir’s products are certainly not bulletproof. The company attempted to launch a platform called Metropolis to help hedge funds with trading and to spot patterns in the markets, among other things. Metropolis, formerly known as Palantir Financial, did not succeed as hedge funds already possessed AI tools that were cheaper and the project was shut down. According to a lengthy response by Joe Lonsdale, Co-Founder of Palantir, the issue was that funds would not pay as much for the platform as other customers and the company may have been charging too much to go to mass market.

Chase Bank used the platform to monitor its 250,000 employees for fraud by mining trading data, emails and phone calls, yet this backfired when it was found out the platform had been used as surveillance for top executives. The information gathered from surveilling the executives led to a press leak (taste of own medicine, perhaps?).

There are also rumors that the CIA has been cold towards the company since the CEO chose to be more in the public eye, especially around Osama bin Laden’s death. Palantir began linking to articles asserted their software was responsible for bin Laden.

Conclusion:

To conclude, Palantir must be sensitive enough to win over commercial clients and top talent yet must not lose government contracts from being too overt. This IPO carries a great deal of speculation as there is no reason the company should not have stronger revenue growth and profits from the guaranteed government contracts. As of now, Palantir does not have product-market fit as it’s specialized and hard to scale (proven by its financials). We’ve also seen some issues with scale due to the pricing of the product, as noted by the Metropolis platform.

If you choose to be an investor, you’ll also have to get comfortable with ethical controversy as Amnesty International has now slammed Palantir’s human rights record on the eve of the IPO. Like Uber, the company is clouded by serious ethical issues. Wall Street may not care but internal employees and customers of Palantir could very well care. On that note, keep an eye out for “ethical AI” competitors in future years.

Similar to Snowflake, the headlines and FOMO can pump this company for a while, but bi-annually —- or even more often, rotations happen in tech growth. I’ve found price-to-sales revert to the mean during these rotations.

Palantir’s most promising aspect, in my opinion, is the acceleration in revenue that perhaps came from coronavirus-related research. This is something to monitor in future quarters.

Beating Smart Money & Bloomberg Video

Posted on by io-fund

I realize you have a choice in the newsletters you subscribe to and my way of saying thanks is to offer original analysis. Most newsletters will wait for breakouts and price momentum and then backfill the analysis. This creates a few issues from my perspective. The first is that conviction gets shaky when basing investments on price only as it requires a herd mentality to remain in a stock. The best gains come from getting in front of the herd. The second issue is that many tech companies go through periods of high growth yet can’t sustain this long-term unless there is excellent product market fit. Momentum investors and trend followers struggle most when it comes to FAANG-like gains because they can’t determine the true gems from those that are simply doing what most tech does (disrupt a market for a period of time).   

Case Study: Zoom Video

On a recent Bloomberg interview, I discussed Zoom Video as the stock that is “sitting right under everyone’s nose” due to growth that we haven’t seen in my lifetime or yours and likely won’t see again over the next decade.

Tech Sector Is Only Going to Grow: Beth Kindig

Access Bloomberg Video here.

This is a stock tip I released in the wake of the coronavirus shut-downs on April 3rd. There was a lot of noise in the market at that time due to the bull/bear market tug-o-war. I said, “If Silicon Valley unicorns are rare, then Zoom Video is a Pegasus.” The company then went on to accelerate from 78% year-over-year growth to 169% year-over-year analysis to 355% year-over-year growth. Keep in mind, I wrote this and maintained conviction even as the market began to question Zoom Video’s security issues.

We track institutional money flows by large volume spikes accompanied with a long candle pattern. We got out first indication that smart money was buying Zoom in bulk as indicated by the black arrow.

Case Study: Bandwidth

Bandwidth is a stock I covered on August 13th with a thesis around archaic telecom hardware becoming eradicated during and following the pandemic. I stated, “One trend I am monitoring closely for the more permanent effects is the disruption of telecom hardware systems through cloud-native communications” while spelling out why everything from SMBs to enterprises would seek to cut their telecom bills. From there, I wrote why I thought Bandwidth could out-perform long-term due to a solid list of customers, including Zoom, Google, Cisco, Microsoft, Skype, RingCentral and Square. I also discuss how Twilio is different from Bandwidth as this is a comparison that often comes up despite there being key differences at the product level.

This trend is still early yet we recently saw large institutional spikes in the stock. This is a great example as to why product-first analysis is key and how I try to give this to my free newsletter readers to help get them in front of trends the market may be overlooking.  

Notice the large volume spike below accompanied with a large candlestick.

 

In conclusion, thanks again for being a newsletter subscriber. We hope to deliver more original analysis in the months and years to come.

Warm regards,
Beth

p.s. If you’re not a free newsletter subscriber yet, you can sign up here.

Palantir

Posted on by io-fund

Details on Palantir’s Investor Day held September 9th are here.held September 9th are here.

The Economist was correct when it recently stated that Palantir is “more than a technological project, it is a philosophical, even political one.” Palantir has a mythical and esoteric reputation in the Bay Area. The name is well-known and what the company does has circulated for years, which in a nutshell, is data mining for the government.

But until now, a customer list and any level of transparency has gone against the core purpose of the company. Therefore, I was somewhat surprised at the leak in 2018 that Palantir was considering a public offering as it seemed odd the company would operate openly and transparently. In fact, about five years earlier, the CEO had said an IPO was unlikely as it would make “running a company like ours very difficult.”

Nonetheless, the company is wanting to attract more commercial accounts and going public should help facilitate this. The old adage, “you can’t sell a secret” may be hindering Palantir’s growth especially as artificial intelligence startups raise their first and second rounds. Now is a good time to make sure to penetrate commercial accounts before AI bring more direct competition.

Below, I go over some of the folklore that surrounds Palantir and then I discuss S-1 filing. We aren’t dealing with a company where one has to wonder if the company or product will be popular on the public markets. Rather, we need to drill down into valuation and decide how much we are willing to pay.

The Folklore

Palantir can neither confirm nor deny if the software was used to kill Osama bin Laden, but the CEO required a body guard as of 2013, and it was generally understood for about a decade that Palantir had only one customer: the CIA. The company then grew to have three customers: the CIA, the FBI and the NSA.

By 2015, a leaked document from TechCrunch dated in 2013 confirmed twelve government agencies were using Palantir, including the “CIA, DHS, NSA, FBI, the CDC, the Marine Corps, the Air Force, Special Operations Command, West Point, the Joint IED-defeat organization and Allies, the Recovery Accountability and Transparency Board and the National Center for Missing and Exploited Children.” Palantir’s leaked document was the first time the CIA and the FBI had databases linked rather than siloed.

Nearly twelve years after Palantir was founded in 2003, that leaked document was the only record that indicated who used the company’s software. Palantir can be a divisive company that draws strong opinions from supporters and critics. Regardless of how you feel about the work Palantir does, one thing is for certain: as the IPO approaches, the company will dominate headlines.

Often those headlines will get it wrong in an attempt to frame Palantir in various lights. For instance, I don’t think anyone in Silicon Valley batted an eye at Alex Karp’s letter when the company exited for Denver. He stated that engineers “may know more than most about building software but they do not know more about how society should be organized or what justice requires. Our company was founded in Silicon Valley. But we seem to share fewer and fewer of the technology sector’s values and commitments.” These sensational headlines and CEO-centric storylines are distracting (i.e. who, then, does know how society should be organized and what justice requires? This is fairly presumptive and one of the many dramatic sentences from the filing).

When looking at things rationally, it’s probably better that Palantir be in Denver as government is a major industry in Colorado and being centered in the country will position the Palantir closer to Washington D.C. Palantir’s investors are not traditional Silicon Valley VC-firms, either. The company was likely there to attract top talent.

Palantir’s venture firm, In-Q-Tel, is located in Virginia and is funded by the CIA. This group has funded many projects, including Google Maps, Gitlab, Pure Storage, MongoDB, Cloudera and FireEye – but Palantir is on a different level as the CIA was the primary customer for many years. For these other companies, the CIA was not a primary customer. In-Q-Tel does not typically disclose funding rounds, amounts or dates. However, according to CNBC, Palantir received a $2 million funding round in 2004. Other investors include Peter Thiel, Stanley Druckenmiller and Tiger Global.

On the positive side of things, Palantir is believed to have helped with counter-terrorism, human trafficking and disaster response. On the more questionable side, the company has helped to deport immigrants and allegedly track law-abiding United States citizens without consent (i.e. spy software).

The company embodies “taking the good with the bad.” A former Marine, Samuel Reading, was quoted saying “it’s the combination of every analytical tool you could ever dream of. You will know every single bad guy in your area.” That, of course, implies having to know every good guy in the area too.

In the past, the Board has included Condoleeza Rice and former CIA director George Tenet, who said “I wish we had a tool of its power” before 9/11. The software was also allegedly used to convict Bernie Madoff.

Just when you think Palantir couldn’t be steeped in any more controversy — there’s more. In 2016, the company sued the United States Army for unlawful procurement solicitation for the Army’s internal intelligence software suite. Palantir argued the Army should be stopped from developing a risk-prone software project that would cost more than using Palantir’s software. In the end, Palantir won and the Army signed a $800 million contract over the course of 10 years.

So, why is Palantir going public now? Well, for one, it will be easier to gain corporate clients when (not if) the company becomes a stock market darling. The stock market is becoming a phenomenal source of free press and Wall Street will glamorize the company if it produces solid returns. This, in turn, will help Palantir attract more commercial customers and perhaps bury any ethical opposition.

The markets came close to burying the ethical issues around Uber. Perhaps this time it will succeed with Palantir. I also personally believe Palantir’s wide lead and lack of direct competitors (moat) will erode with artificial intelligence and machine learning. Time is of the essence to go public as AI startups need another few years before they can compete on this level.

Product:

Founded in 2003, Palantir is described as a company specializing in big data analytics. Palantir’s specific expertise in government intelligence and its existing ties to national security and the intelligence community differentiate its offering from competition.

The company has two platforms: Gotham and Foundry. These platforms allow organizations to combine core data with critical tools into a single platform to help users obtain actionable insights from a unified data asset. What Palantir tackles is the issue of data being siloed and ineffective for problem solving. These problems may relate to manufacturing, product development or customer experience.

The data Palantir gets is from the customer themselves and their existing databases although Palantir can crawl and scrape data that is freely available. For instance, Palantir can easily scrape public social media profiles but probably does not have access to private profiles except when the FBI issues government requests to Facebook.

The traditional deployment involves hosting Palantir servers in a customer’s data center. There is a cloud-based offering, as well, so the company can work across a range of hosting environments.

The company differs from a business intelligence solution like Tableau, Alteryx or Cloudera by answering questions that a model cannot answer. An example might be “how do we service car loans to people least likely to default” or “how do we catch fraud before it happens.” With traditional BI, it’s assumed you have the complete data set. Palantir tackles situations where a company may not have the complete data set. This is a crucial difference.

Palantir Gotham was the company’s first platform, built for government operatives in defense and intelligence sectors. The platform enables users to identify patterns hidden deep within datasets using semantic, temporal, geospatial and full-text analysis. Here are some ways the platform is used:

Graph: This application allows data objects to be seen as nodes and edges. Users can visualize events, filter objects and plot characteristics in a logical manner.

Source: Palantir.com

Map: This brings geospatial capabilities to track geo-located objects and events and to create heatmaps for the density of the objects.

Source: Palantir.com

Object Explorer: This feature is powered by the Horizon in-memory database, which competes with Apache Spark by letting users query billions of objects. The database provides further analysis for Map and Graph data.

Source: Palantir.com

Browser: This enables search queries for investigations and surfaces information, runs relevant searches, displays key data points and answers analytical questions.

Source: Palantir.com

Palantir Foundry is the commercial offering and has four layers of tooling: Foundry Core, Data Foundation, Ontology and Workflows. This four-step process does the following:

  1. brings volumes of data into one place,
  2. transforms the data into a format that analysts can work with and enables validation in any number of programming languages
  3. the “ontology layer” allows datasets to be turned into real-world concepts with the ability to accelerate on the company’s core ontology to reduce redundancy
  4. workflows is where it all comes together in an integrated environment for object exploration, point-and-click top down analysis, code authoring, time series analysis, data science and application development. When a user has a question, it answers it using all layers and tools available.

Palantir describes Gotham and Foundry as the “ability to construct a model of the real world from countless data points.” Unlike a SQL database, natural language is used to query data and return results in real-time rather than through strings. To some extent, Palantir resembles Elasticsearch in its ability to use a search stack to answer complex questions. For instance, Elastic is used to pair a passenger with an Uber driver or to process billions of log events from Sprint for outages or Fitbit to validate failures and for data discovery. Kibana can be used with Elastic to visualize the data. Another company where Palantir could potentially share the customer pool is Splunk or perhaps Sumo Logic. It’s not clear though if Palantir is price competitive with these other tools to be used in their place for analysis or if Palantir’s offerings are overkill for the analysis most companies require (to justify a higher price).

The truest, closest competitor for Palantir is Semantic AI, which supplies graph-based analytical platforms to the DoD and other government agencies. As stated, I think Palantir’s real competition is being developed as we speak as it will machines will answer questions from incomplete data sets once the AI/ML market is built out.

Some real-world uses for Palantir include Hershey’s using the software for global food distribution and to correlate weather patterns with snack consumption. Chase Bank and other financial firms use Palantir’s data analysis to catch fraud. Pharmaceutical companies to expedite the development of new drugs – this being a substantial use case this year and perhaps why Palantir’s revenue has accelerated.

Financials

The company grew revenue 25% year-over-year to $742 million in 2019. This accelerated to 49% year-over-year to $481 million for the six months ending June 30th. According to a Reuters article in June, the company is expecting $1.5 billion in 2021, which looks easily achievable. The company’s annual run rate based on the current quarter is about $1 billion.

Bloomberg reported from an unidentified source that Palantir’s revenue in the second half of the year is often larger during the fourth quarter due to government contracts being finalized. According to the article, Palantir books roughly 60% of revenue during the fourth quarter. For valuation purposes, we will run three instances between $1 billion and $1.5 billion. The higher number assumes Q4 is strong and the revenue acceleration we are currently seeing will continue. To simplify things, we will offer a scenario with $1.25 billion in revenue (see below).

Net losses for 2019 of $579 million were flat year-over-year compared to net losses in 2018 of $580 million. On an adjusted basis, net losses in 2019 were $337 million. The losses are shrinking with H1 2020 reporting a loss of $164.7 million compared to $280.5 million in the year-ago period.

On an adjusted basis, the company was profitable in the first six months of this year at $17.2 million compared to a loss of $167.6 million in H1 2019. This improvement in operating results was driven by increasing revenue and reducing the number of engineers needed to install and deploy software programs.

Gross margins for H1 2020 are at 73% and the company spent only 42% of revenue on sales and marketing.

The company has cash of $1.5 billion and debt of $297.6 million as of June 30th.

Contribution margin is a Non-GAAP key metric that represents the revenue the company generates relative to the costs incurred. It strips out variable costs related to deploying and operating the software and identifying new customers.

You can think of it as falling somewhere between gross margins and operating margins. For comparison purposes, Palantir’s gross margins are at 72.3%for the six-month ending June 30 and the company has negative operating margins of -48.5% and negative net margins of -78%.

The company states the addressable market is $119 billion across commercial and government sectors. The TAM in the government sector is $63 billion and the TAM in the commercial sector is $56 billion. Within the government TAM, domestic is $26 billion and international is $37 billion.

The commercial sector is the growth story. For example, Skywise is a solution that connects in-flight, engineering, and operations data to break down siloed systems around maintenance, flight management and aircraft monitoring and safety. Palantir is partnered with Airbus who offers this solution as “the leading data platform for the aviation industry.”

This example can extend to many industries, such as pharma for drug development data to better understand population dynamics and drug outcomes. This is for the pre-clinical and clinical stages, mapping treatment pathways, and automating reporting. Manufacturing can benefit from Palantir Foundry by managing inventory, saving on distribution costs and prevent delays while increasing sales.

There are also solutions for financial compliance, insurance, automotive and sales.

Valuation

Palantir is doing a direct public offering (DPO), which means there will be no new shares offered and no underwriters. The goal of a direct listing is not to raise money rather to allow existing investors to sell their shares. However, unlike Spotify and Slack who did DPOs, Palantir will have a lock-up period. I find a lock-up period to be more favorable for retailers Spotify took nearly two years to break out from its opening DPO price and Slack is taking about a year to break out beyond its opening price.  

The company’s founders, Peter Thiel, Alex Karp and Stephen Cohen, own 30.2% of the company’s stock. Peter Thiel owns additional stock through various investment management funds that own stock, such as Founders Fund. Thiel has 28.4% corporate voting power, Karp has 8.9% and Cohen 3.1%.

There will be three classes of stock: Class A, Class B and Class F common stock – which is unusual to have three tiers. Class A will allow for one vote, Class B will allow for 10 votes and Class F will share 49.99% of the voting power for Palantir. Class F is for the founders who will retain just under 50% of the voting rights at all times. This is reminiscent of Facebook where insiders control about 70% and Zuckerberg controls 58%.

Palantir’s last valuation at $20 billion from 2015 is outdated as is the $26 billion valuation from last year. There were rumors in 2018 that Palantir was privately valued at $41 billion and this is probably closer to where it will trade on the public markets.

If we give Palantir a generous $1.5 billion in forward revenue, it’ll be trading at 20 price-to-sales at a $30 billion valuation and 27.3 price-to-sales at the $41 billion valuation. At the more reasonable $1.25 billion in current revenue, Palantir will be trading at 24 price-to-sales at the $30 billion and 32.8 price-to-sales at the $41 billion.

We can see below that trading higher than 32 forward EV/Revenues is very rare with most trading between 16 and 24.

However, IPOs have a way of pushing emotional buttons and there have been a few recent IPOs that have traded at exorbitant valuations. Zoom Video, Agora, Datadog and Lemonade have all hit the 50 EV/Revenues level.

Palantir is not profitable like Zoom Video and Datadog were at their IPOs. In fact, it’s a bit strange that Palantir has the losses it does with its vintage and guaranteed government contracts. I prefer to not pay over 40 P/S for any IPO as all of them have eventually settled under this number. I’m evaluating Snowflake next, which is a company I would value higher than Palantir due to fewer risks.

Point being, I’m a buyer in the $35 billion to $40 billion valuation on Palantir and then will respectfully wait on the sidelines. Beyond this valuation and I prefer to put my money to work elsewhere.

Risks

Palantir’s biggest risk is customer concentration with the top 20 customers accounting for 67% of revenue and the dependence on government contracts at 54% of revenue. The Army attempting to develop a more expensive in-house solution illustrates there is a risk that government agencies eventually move away from Palantir in the future.

Reputation and social acceptance is also a risk. Tech companies often see employees engage in protests when a company contracts with the government on AI-driven war missions and privacy issues that potentially threaten human rights. Palantir’s biggest obstacle today is the work it does with ICE which pits the company’s internal employees against the CEO on social issues.

For instance, Google ended a contract with the Pentagon when employees protested using AI for lethal purposes. Karp became controversial and challenged Google on this decision, saying it was a “loser” position. This can backfire as Palantir may not be able to attract top talent as AI companies begin to compete from a small pool of AI developers and engineers who have proven to protest and walk-out of company projects they feel are unethical. Amazon, also, banned facial recognition for law enforcement for one year following the George Floyd protests. Therefore, Karp’s personality could be considered a risk as the tech world begins to explore and support ethical AI development.

Despite government-backing, Palantir’s products are certainly not bulletproof. The company attempted to launch a platform called Metropolis to help hedge funds with trading, among other things. This platform did not succeed as hedge funds already possessed AI tools that were more of a complete package and the project was shut down. There are also rumors that the CIA has been cold towards the company since the CEO chose to be more in the public eye, especially around Osama bin Laden’s death. Palantir began linking to articles asserted their software was responsible for bin Laden.

To conclude, Palantir must be sensitive enough to win over commercial clients and top talent yet must not lose government contracts from being too overt. For valuation, I’ll cap it at $35 to $40 billion max.

Playing Defense With Cloud Software Stocks

Posted on by io-fund

This article was originally published on Forbes on May 27, 2020,06:47pm EDTForbes on May 27, 2020,06:47pm EDT

The main risk to cloud software during a less-than-ideal economy is downgrades and churn. Signing new customers can also be a challenge. How a company is faring will often show up in net retention rates. My guess is we will see some cloud software companies remove this metric from their Q2 earnings report or we will see previously strong net retention rates dip below the ideal thresh-hold of 100% to 106%. 

Net dollar retention rate is a key metric in software-as-a-service (SaaS) that has generated a lot of buzz over the past ten years or so. This is because it helps to predict cash efficiency for subscription-based models by calculating the inflows of revenue and upgrades minus the outflows of downgrades and churn. The benchmark that SaaS companies are shooting for is between 100%-106%. Exceptional companies report above 120%. Sammy Abdullah did a great write-up of this in Crunchbase. 

Key metrics like net dollar retention rate come from venture capital deals where the goal is to exit through the public markets or through an acquisition. This key metric is helpful to consider but it also fizzles out over time. Venture capitalists are less concerned with the long-term growth of a company as they have already exited by the time subscriptions see serious churn. 

Box is a great example for this as the company has been on the public market longer than most cloud software companies (although still a relatively short time of five years). Despite having an ideal net retention rate, the company’s revenue growth has declined. Box also had sales and marketing costs at 40-50% of revenue, which I’ll discuss in greater detail in my next article.

2U previously held the record for net retention at 144%. Revenue peaked at 44% year-over-growth in 2019 and now stands at 39.5% year-over-year growth. The stock price has correlated with this growth and the company is trading well beneath all-time highs of $98 with a current price of $35. 

Slack has a net retention rate of 143% and Zoom Video has a net retention rate of 140%. These two may be outliers this year as the work-from-home trend will help sustain both existing and new subscriptions. 

YCharts: Box Inc Revenue Annual YoY Growth

YCHARTS

Recently I published on whether we would see another dot-com crash considering the high valuations in tech despite a questionable economic backdrop. The main takeaway is that tech has many outliers in both revenue and earnings growth when compared to other industries. However, there is an imbalance in the number of cloud software companies on the market as venture capitalists have pushed for exits in recent years. 

The glut in supply will be tested by startup closures and the lack of venture funding in the Series A and Series B stage as the two ecosystems are closely intertwined. This imbalance across the board is more important than focusing on the valuation of any one company.

When I speak of the glut of inventory, I am referencing the three-fold increase in competitors from an average of 2.6 competitors per company five years ago to 9.7 competitors per company today. Companies with more than 250 employees use an average of 124 SaaS applications, while companies with up to 10 employees use an average of 26 SaaS applications.

Cloud software will be more resilient than many other categories. But there will be some cloud software companies that see an impact on one side of the equation or both sides of the equation – this means either fewer new customers new customers or more churn or downgrades in existing customers more churn or downgrades in existing customers or both.both. There are three points where weakness can occur. Notably, companies that have annual recurring revenue will be more protected.

What we know is that the economy is not as strong this year as it has been in previous years. Some will argue the market is not the economy (which is true), however, cloud software can’t stop the spiraling effects of lower IT/cloud spending and tighter budgets that follow a weaker economy. One area that companies might reduce costs is to trim down on the number of cloud software and tools they use. Unemployment could exacerbate this if the subscriptions are paid per employee.

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Lower net retention rates eventually happen to roughly half of the software companies that are on the market for three years but covid-19 may speed this up or cause churn in otherwise strong subscription models. 

Before the coronavirus, I championed cloud software at their low point in September of 2019. It seems like a distant memory now but Zoom, Twilio, Okta and MongoDB were down roughly 30% in a very short time span of one week over no major news or negative catalyst. My article’s subtitle stated, “Investors have dumped cloud stocks, which could prove to be a costly mistake” — this could not have been more accurate as cloud software led the rally off the March lows with some stocks up nearly 200% in one month. I was firm during the value rotation that these stocks would out-perform and I expanded on this as one of my top tech trends in 2020. 

Considering we are at all-time highs and many gains have been clocked, I think it’s the perfect time to identify the indicators that might help determine if a company will be resilient post-covid. This was very important when the market showed signs of indiscriminate selling and is also important now when we’ve seen indiscriminate buying. 

I consider this rally indiscriminate because many companies have withdrawn guidance. There is less information than usual to determine forward growth and valuations. Yet, we have seen massive upward moves based off very little information. With that said, many investors are feeling quite reassured right now as it’s been hard to not make stellar gains in cloud software no matter what company you picked.

I don't think the broad category of cloud software will end the year as strong as it began the year as the market will begin to see cracks in the three weak points mentioned. There will, of course, be many exceptions – this is commentary on the broader category of cloud software.

Conclusion:

Value investors like to focus on valuations as an indication for a bubble, especially since their objective is to find cheap companies. This works in some industries but it does not work in tech. This is because some of the most expensive tech companies are also the top performers with insatiable addressable markets.

Of course, what you want to avoid (at all costs) is a hypergrowth company that fails to report the expected growth rate. The market is a game of musical chairs, especially now that machines are driving the majority of the market. The only way to win at this game without having a team of Python software developers is to either be “early in and early out” or to be “early in and never get out.” 

Paul Tudor Jones is one of many money managers who believe having a great defense is more important than having a great offense. This means you should have a mindset of protecting your money rather than making money. In some cases, net retention rates will become accelerated this year. For those that don’t accelerate, I will be favoring a strong defense.

Next week, I’ll be publishing on why the advent (and now maturing field) of growth marketing may contribute to a few surprise failures across cloud software.

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.