This article was originally published on Forbes on Jan 4, 2024,11:27am ESTForbes Forbes on Jan 4, 2024,11:27am EST
The Nasdaq 100 capped off 2023 with a return of +53.8%, erasing 2022’s losses and recording its highest annual return since 1999. This year had countless winners, but 5 stocks surprised and shocked the market with significant outperformance relative to the broader indices.
We think it’s important to pause and draw some parallels around the stocks that performed well in 2023 to form an opinion on what might perform well in 2024, as well as identify common themes that are seeing high levels of investor interest, such as AI.
Below, we review five top stocks of 2023, selected based on their price action and strong fundamentals. Choosing a top 5 means many great stocks were left off this list, yet this sample helps to form conclusions around how 2023 shaped up as a different trading environment from years past.
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Nvidia
It wouldn’t be a top 5 list without Nvidia, with shares surging past a $1 trillion valuation as the company rapidly became the face of the AI revolution taking the market by storm. One phrase from CEO Jensen Haung sums it up nicely: Generative AI is the largest TAM expansion of software and hardware that we've seen in several decades.
Nvidia has added $800 billion in market cap this year as data center revenues continue a streak of triple-digits YoY growth due to soaring AI chip demand. Data center revenues have risen from a record $4.28 billion in Q1 this year to $14.51 billion in Q3 – a 217% increase in just two quarters. Total revenues for the data center are projected to reach $46.6 billion this year as Nvidia is expected to ship at least 550,000 of its highly popular H100 GPUs.
Source: Twitter
Regardless, the market has rewarded Nvidia handily for building an AI GPU empire so strong, every major cloud provider, from Amazon to Microsoft to Google to Oracle and others, are all scrambling to secure supply. Revenues for fiscal 2024 are projected to increase 118% YoY to $58.9 billion, followed by another 53% YoY increase to $90 billion for fiscal 2025, and it’s this growth at such a scale that has driven Nvidia’s outsized returns this year. The Street is also rewarding Nvidia’s strong margins and FCF generation, as it had the best cash flow margins of the Magnificent 7 in Q3: a 40.5% operating cash flow margin and 39.8% free cash flow margin.
2023’s market has seen very narrow leadership, and Nvidia has been one of the de facto leaders within that narrow leadership.
The I/O Fund was early to this year’s move in Nvidia with a bold analysis in 2021 that claimed Nvidia will surpass Apple in valuation. In January of 2023, Beth also stated Nvidia was a top pick for 2023. Later, it became one of the best performing stocks of the year. Sign up Nvidia will surpass Apple in valuation. In January of 2023, Beth also stated Nvidia was a top pick for 2023. Later, it became one of the best performing stocks of the year. Sign up today to stay on the leading edge with Nvidia and get an update on the long-term thesis in the coming weeks, with details on how Nvidia will close-in on the next trillion in market cap.
Meta
Meta’s 194% rally sees it join the top 5 list, as its turnaround story has been nothing short of remarkable in 2023. Financials and margins are rapidly improving, while Meta continues to invest and make progress in advancing AI.
Even though Meta’s LLaMA 2 large language model has made headlines for its performance and its tie-ups with Amazon’s AWS and Microsoft’s Azure, the force behind Meta’s rally lies within its financial recovery. Meta recorded one of its best days in more than a decade in February as the market rewarded a revenue beat and a positive outlook for Zuckerberg’s ‘Year of Efficiency,’ which the company would go on to do just that.
Acceleration in ad impressions in 2023 provided a needed lever of growth as pricing remained weak relative to 2022, and Meta returned to growth in Q1 with revenues up 2.6% YoY. It has since seen revenue growth accelerate, posting 23.2% growth in Q3 ahead of a forecasted 21.1% for Q4.
Source: YCharts
The Year of Efficiency is paying off, as Meta demonstrated substantial improvement in operating leverage. Gross margins expanded from 74% in Q4 last year to 81.8% in Q3, and a hyper-focused approach on cutting expenses saw operating margin more than double over 9 months, from 19.9% in Q4 to 40.3% in Q3. Net margin also expanded significantly, from 14.5% to 33.9%. Driving this rapid of a recovery in the bottom line combined with a 20-percentage point reacceleration in revenues at a >$120 billion annual run rate is what marks 2023 as an especially strong year for Meta.
Palo Alto Networks
Palo Alto returns to the top 5 list after being featured in last year’s edition, with shares up 111% as cybersecurity has been one of the strongest sectors this year. Palo Alto’s stance as a one-stop cybersecurity shop offers what we previously called the “best of both worlds” – it has potential to accelerate revenue growth from its platform approach, and has an enviable bottom line.
The market has rewarded Palo Alto for its shift to become “firmly GAAP profitable,” a key differentiator from a majority of other cloud stocks. Gross margin expanded 440 bp to reach another record level at 74.8% in the most recent quarter. Operating margin increased 1050 bp from 1% a year ago to 11.5%. This strong increase in operating leverage has greatly benefited Palo Alto’s bottom line, with net margin at two consecutive quarters above 10%.
Source: YCharts
Palo Alto is reporting strong underlying metrics, especially with its next-gen offerings. Next-Gen Security ARR increased +53% YoY to $3.23 billion, and SASE ARR increased +60% YoY. Palo Alto witnessed very strong growth in multi-module customers, with +155% YoY growth in those adopting 5+ modules, and +59% YoY growth in those adopting 3+.
We discussed in early October how cybersecurity will be the next industry disrupted by AI, and the market is already looking to select the frontrunners in this trend. Palo Alto and peer CrowdStrike, an honorable mention on the list, are two of the market’s favorites in 2023 stemming from GAAP profitability and strong cash flow.
Duolingo
It might be the odd one out on this list for many tech investors, but Duolingo (DUOL) is not to be ignored: it has proven this year that it’s a textbook growth stock, boasting a 219% return. It’s also hard to argue with the strength of Duolingo’s growth flywheel, as active user metrics, paid subscribers, and bookings grow at a blistering pace.
Source: Duolingo
MAUs increased 47% YoY to 83.1 million, the third straight quarter with growth above 47%. DAUs rose 63% YoY to 20.3 million, the fourth quarter in a row with growth above 62%. Paid subscribers also rose 60% YoY to 5.8 million. Bookings growth has accelerated each quarter this year, from 37% in Q1, to 43% in Q2, and now to 49% in Q3.
Revenue is on the verge of breaking $500 million on a TTM basis, and bookings have topped a $600 million annual run rate. While it is easier to see hypergrowth at a smaller scale of revenue, Duolingo is showing no signs of slowing – very few hypergrowth stocks, if any, can say the same this year.
One other factor behind Duolingo’s stellar year is a shift to two consecutive quarters of GAAP profitability, and strong expansion in adjusted EBITDA margins. GAAP net margin in Q3 was 2%, and though it is razor thin, the market is looking forward to how revenue hypergrowth will translate to increased operating leverage, and ultimately, a strong net margin expansion. Adjusted EBITDA margin was above 16% in both Q2 and Q3, up from the 2% range last year – a hint of what the Street is anticipating for the bottom line.
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Palantir
Palantir rounds out the top five as another Street favorite in AI, with the company’s Artificial Intelligence Platform (AIP) driving an acceleration in growth. Palantir is seeing strong growth in its US commercial segment due to AIP, which launched in June and has since seen remarkable growth. A shift to GAAP profitability and an ensuing four consecutive quarters with GAAP profits cemented its spot as a top tech stock with a 167% rally this year.
Source: YCharts
Palantir nearly tripled the number of AIP users in the past quarter, with over 300 organizations using the new product in the last 5 months. Palantir can “more aggressively invest” in AIP and other AI products without sacrificing margins due to its GAAP profitability, a key differentiator from a majority of cloud AI plays, who are investing in growth at the expense of margins.
The US commercial business accelerated in Q3, rising 52% YoY and 19% QoQ, due to the “rapid expansion of AIP at both our existing and new customers.” This acceleration in a key segment combined with strong adoption of an AI model has sparked optimism, with shares adding +34% in November before pulling back in December.
The market is forward looking, and in Palantir’s case, the market is looking forward to a revenue reacceleration in 2024, another catalyst for the rally Palantir has enjoyed this year. Revenue growth is poised to accelerate in Q4 and through 2024, boosted by AI demand, reacceleration in Palantir’s US government segment, and continued strength in the US commercial side. Palantir is projected to report 18.5% YoY growth in revenues in Q4, the highest in five quarters, and 2024 is expected to see a marked acceleration — current projections point to a 320 bp acceleration in Palantir’s revenue growth rate to 19.7% YoY.
Conclusion
Looking back at 2023 is important as it often provides clues for tech investors as we move forward into 2024. Winners keep winning, and that is one reason we like to reflect on the clear winners from the previous year.
The stocks above have proven they do not need good or easy conditions to perform well. It can be hard to have a repeat year as often investors will take gains, and there’s certainly gains to take in the five stocks listed above. Therefore, we are searching for patterns rather than attempting to exactly repeat 2023. This pattern is expanding margins, strong cash flows, shifts to GAAP profitability, and any hint or sign of accelerating revenue growth.
The most exciting products and the most rewarding tech stocks on the market today are the ones that challenge Big Tech. This is because the market will often underestimate the ability of an agile team to disrupt the incumbents despite substantial evidence that this is exactly what the tech industry is built to do.
What’s remarkable about Cloudflare is how the company has leveraged its content delivery network footprint to simultaneously be a leader in application and website security, then to further innovate with Zero Trust security combined with SASE network connectivity, and more recently to leverage the elimination of egress fees for object storage to attract developers. The latter is the most exciting as Cloudflare has already proven its ability in driving down costs and will now take on AWS head-to-head.
However, in light of Cloudflare’s impressive price movement this year, the company is now priced to perfection. When looking at its peers with similar or higher growth rates, which we discuss below, Cloudflare could see a 35% cut in its price to 40X forward sales and the company would still be fully valued.
Below, we look at the products driving Cloudflare to trade at a higher valuation and whether it’s a valuation the company can sustain.
Cloudflare’s Core Products:
Cloudflare is a well-known company that owns a predominant share of the CDN market. Content Delivery Networks contain a cached copy of website content on multiple servers located across the world to help improve page loading times. When a person visits the website, it will provide the content from the server closest to the end-user, which helps increase the delivery speed of the content. When a website is hosted on a server in the United States, the person browsing the website from any part of the globe, like Asia or Europe, will receive the content from the nearest location instead of the server in the USA. The Fastly outage this year shows the prominence of these CDN providers to where one outage can create downtime for sites, such as Amazon, Reddit and the New York Times.
According to data from W3Techs, 81.2% of all websites that use a CDN or reverse proxy rely on Cloudflare. We had discussed in a podcast earlier this year that Cloudflare is strong in the small to medium-sized business (SMB) category and offers free entry-level services. The penetration among SMBs is one reason why Cloudflare has an estimated annual revenue of $648 million this year with over 1 million customers compared to the enterprise-focused Akamai at $3.48 billion with roughly 50,000 customers. The overall revenue is low for its high customer count compared to Akamai partly because of the free-entry level.
According to Intricately, the cloud Content Delivery Network market is expected to grow at a compounded annual growth rate of 28% between 2020 and 2025. Cloudflare has the highest number of customers (this data includes free users). As of June 2020, Amazon Web Services has the highest share among enterprise customers with Cloudflare is in second place. Among the SMB customers, Cloudflare is leading all the other players. Cloudflare also has a better overall rating when compared to Fastly and also compared to Amazon Web Services in the Gartner Peer Insights.
The company has a large free customer base. In addition to the benefit of converting the free base to paid services it can use the free base to test the features before they are launched.
The free user base was mentioned by management in the earnings call,
“One of our secret to success is our broad customer base that we have millions of customers, many of whom use our services for free means that we have an eager pool excited to test new features before they're released.While traditional B2B companies have extensive QA team, we regularly ask volunteers from our community to be our earliest alpha testers. Our iteration cycles can then be extremely fast. And by the time a feature makes its production at one of our enterprise customers, it's full of proof, having been through the paces under real network conditions.”
Cloudflare has built a large footprint, which means the company already owns a large portion of the TAM for CDNs. The 81% footprint is impressive but one could argue this leaves little room for growth. Cloudflare’s potential in a largely-commoditized CDN market will come from the “extremely fast” iteration cycle. There’s ample evidence the company can execute as it now owns a large portion of the application and website security market, especially for DDoS attacks (distributed denial-of-service).
Because Cloudflare has a large global presence of servers and data centers, it’s particularly well suited for analyzing traffic to determine security risks. The company is able to analyze and detect attacks by running a background program known as a daemon on every server in every data center. The scans are shared as threat intelligence among the servers in each data center without affecting the latency of the CDN.
Cloudflare is able to mitigate at optimal locations in the tech stack, for example at L4 inside the firewall or at L7 inside the reverse proxy with a 403 error page. The company is advanced at preventing L3 DDoS attacks, which targets network equipment and infrastructure. The benefit of having access to more of the stack for security purposes is that CPU consumption and intra-data center bandwidth remains relatively unaffected. It’s also autonomous so Cloudflare is not using manual employees for this process.
DDoS attacks are essentially bots that send millions of requests to overload servers and to shut down a specific website by targeting its IP address. Often times, these bots are run from devices infected with malware and operated remotely by an attacker. Cloudflare recently detected and mitigated a 17.2 million request-per-second DDoS attack, which was three times larger than any previous DDoS attack on record. This is two-thirds the average rate per second that Cloudflare had served in all of Q2.
DDoS is one example of what the company offers and certainly Cloudflare has other security and network offerings based on their large footprint. They can also cross-sell security and CDN customers with WAN-as-service, or Magic WAN, which connects office networks through the local area network. The company also offers application delivery controllers located centrally within a customer’s infrastructure for Layer 3 through Layer 7 security for applications and APIs.
Cloudflare’s Move into Zero Trust
Across Cloudflare’s security products, an important one to focus on moving forward is Cloudflare One, which is a Zero Trust network-as-a-service. Zero Trust is gaining increasing acceptance due to rising security threats from data not being stored in one place. Secure access service edge (SASE) is a cybersecurity concept that utilizes Zero Trust to identify users and devices to deliver secure access to specific applications or data. The need for this has grown due to remote teams as SASE allows policy-based security no matter where the user, application or device is located.
Zero Trust Security is built on the premise that no one should be trusted within or outside the network. In the traditional security systems, it is difficult to obtain access from outside the network while those located inside the network were trusted. With Zero Trust, these trust assumptions are removed with tools such as multi-factor authentication, giving access for a limited time and to also verify, authorize and to have a continuous check on all the data points that are given access.
In the earnings call, the company’s CEO assured that the company’s proxy infrastructure could be used for both reverse proxy and forward proxy. He stated, “but it turns out that it's as easy to make the traffic flow one way through the pipe as it is to make it flow the other way through the pipe.” Its proxy has security features built-in and also has the capacity to increase customer’s traffic.
Earlier this year, the I/O Fund covered the launch of Cloudflare One, and the management’s belief in the shift from a traditional hardware-based security approach to a modern zero trust approach, and the company’s confidence to be a leader in making that transition.
Cloudflare One has been getting a good response from customers due to mitigating attacks and improving overall performance. On the earnings call, the company discussed a Fortune 500 pharmaceutical company which was using Cloudflare One that signed a $600,000 expansion deal to increase the total contract value to over $2 million. Another large European software company signed a three-year deal worth $600,000. According to October numbers, Cloudflare signed a social network company which has a contract value of more than $1 million annually. Another video conferencing company also moved to Cloudflare which has a contract value of about $8 million.
Due to the increasing hybrid work conditions, Cloudflare has announced new cloud firewall functionality for distributed environments to overcome the issues with traditional firewalls. The company’s rating on TrustRadius and also on capterra shows that it rates higher than Zscaler, which has also performed well in the market.
Cloudflare R2 storage
Cloudflare began to lead its cloud peers when the company announced its R2 storage product on September 28th, 2021. You can see the dark purple line start a sharp rise upward following the start of October.
R2 storage allows unstructured data to be stored without egress bandwidth fees, which are charged when developers retrieve data from a cloud provider like AWS. The egress fees are essentially a tax without any value. Markups are as high as 7900% in the United States region when calculating what AWS charges. This is an 80X bandwidth markup and was detailed here by Cloudflare’s management.
Eliminating egress fees with R2 Storage places Cloudflare in direct competition with Amazon’s S3. Cloudflare’s motivation is to win over developers and their loyalty.
In the words of Matthew Prince, “We want developers to keep developing, not worrying about their storage bill. Our aim is to make R2 Storage the least expensive, most reliable option for storing data, with no egress charges. I’m constantly amazed by what developers are building on our platform, and look forward to continued innovation as we expand the tools they have access to.”
Primarily, Cloudflare is hoping to attract developers for its Workers product, which is a serverless compute service for developers to build applications and deploy code at the edge. This removes the need for developers to maintain servers or spin-up containers. The cloud service provider (in this case, Cloudflare) provisions, scales and manages the infrastructure required to run the code. Cloudflare wants developers to choose them over the larger cloud providers because of their location at the edge. This is ambitious as most developers are accustomed to AWS, Google Cloud and Microsoft Azure, all three of which also offer serverless at the edge with plans to aggressively expand, such as AWS Lambda and its extension Lambda@Edge.
R2 Storage will help Cloudflare grow its addressable market and will help the company compete as a best-of-breed player in the trends towards multi-cloud. In response, Amazon has lowered prices by up to 31% but this may not be enough if Cloudflare plans to get rid of egress fees entirely. When Cloudflare announced R2 storage, the company’s co-founder and CEO, Matthew Prince, tweeted, “Why R2? Because it’s S3 minus the one most annoying thing: egregious egress.” The product will be launched soon and has a waitlist for customers.
Notably, the outcome from Cloudflare’s R2 Storage, and also the Bandwidth Alliance, which is a consortium of cloud providers who address bandwidth pricing issues, could end up forcing Amazon to drop its egress fees rather than lose customers. Also, as an investor, it’s not clear how much R2 Storage will contribute to Cloudflare’s top line considering the markup will be eliminated. Regardless, the market has rewarded the company for taking on AWS and my hunch is developers will support the cause regardless of AWS’s response.
Cloudflare has done well since its initial focus on the CDN and web security market, increased its TAM with Zero Trust Security, and now adds object storage as a way to attract developers for products like Workers. It is interesting to note that Amazon successfully grew by targeting companies that had good margins with a famous quote from Jeff Bezos, “Your margin is my opportunity.” Now, companies like Cloudflare are doing what Amazon did in its early days by toughening the competition. Amazon’s AWS is a profitable powerhouse, and if Cloudflare can disrupt this, it could be another game-changer for the company.
Financials
The market is excited about how Cloudflare has performed post-Covid as it’s clear the company did not need the one-time bump from 2020 as growth has been stable throughout 2021. Cloudflare decelerated in the most recent quarter —- but not by much; from 54% revenue growth last year to 51% revenue growth in the most recent quarter. The guide for next quarter is also a slight deceleration from 50% revenue growth last year to 47% this year.
The company’s revenue growth was partly helped by growth in large customers with annualized revenue greater than $100,000. We also noticed a similar trend of large customer growth in the last quarter. The company exited the 3Q with 1,260 large customers, a net addition of 172 in the recent quarter for 71% growth. The company had 132,390 paying customers, which represents total customer growth of 31% YoY.
Cloudflare has also demonstrated its ability to be profitable. The company reported break-even adjusted earnings per share, which beat estimates by $0.04. The gross profit margin improved to 78.2% compared to 76.3% in the 3Q 2020. Adjusted gross margin improved to 79.2% compared to 77.3% in the 3Q 2020.
Adjusted net income came at $1.4 million or $0.00 per share compared to an adjusted net loss of $7.3 million or ($0.02) per share in the 2Q 2021 and adjusted net loss of $5.8 million or ($0.02) per share in the same period last year.
Net cash flow from operations was negative $6.9 million compared to a positive $2.0 million for the 3Q 2020. The company had cash and investments of about $1.8 billion at the end of the quarter, including about $790 million of net proceeds from the convertible note issuance in August.
The dollar-based net retention was 124%, the same as the 2Q 2021 and higher than the 3Q 2020 that was 116%.
The company’s revenue guidance for the 4Q is $184 million to $185 million, represents an increase of 46% to 47%. The adjusted earnings are expected to be between ($0.01) to break even. The full year revenue guidance is $647 million to $648 million, representing an increase of 50% and adjusted earnings per share are expected to be between ($0.06) to ($0.05).
Valuation:
Cloudflare has an eye-watering valuation of 47X EV to 1-year forward revenue. As a tech growth portfolio, the I/O Fund is certainly not the valuation police as we often find our best winners carry high valuations if a company is executing against the competitors.
However, it’s the growth rate of Cloudflare that makes me question if this valuation is appropriate. In regards to Cloudflare’s high-valued peers, we see that Cloudflare has one of the lowest revenue growth rates at 51% in the most recent quarter and free cash flow isn’t a strong factor here either. As mentioned, the only other stock on our list carrying this 1-year forward valuation is Snowflake, which had nearly double the growth.
Cloudflare’s analyst consensus for next year is revenue of $886 million with 20 analysts providing estimates. This represents growth of 37.2%. The analysts covering the stock are modeling Cloudflare to be profitable next year with $0.02 EPS. At this valuation, investors should feel confident there will be a beat and raise to at minimum 50% growth although the data above suggests revenue growth must be in the 60% range to be in the top 10 for valuation.
Conclusion:
By the sweat of its brow, Cloudflare has expanded a commoditized content delivery network footprint to become a leader in website and application security, and is not standing still with products such as Zero Trust and R2 Storage. However, being a great company is sometimes confused for a great stock. At the current valuation, Cloudflare has no room to explore these new markets and find its footing.
I have no doubt the company will execute, how it goes about this and if the timing of execution can meet Wall Street’s often unrealistic standards of quarterly perfection is the risk that investors take. This is certainly one to watch, or one to hold if you’re already in the stock, but to enter as of October requires hardened conviction in Cloudflare surprising to the upside on the 37% forward growth estimates for FY2022. We prefer to wait from the sidelines for a more attractive entry.
Please note: The I/O Fund conducts research and draws conclusions for the company’s portfolio. We then share that information with our readers and offer real-time trade notifications. This is not a guarantee of a stock’s performance and it is not financial advice. Please consult your personal financial advisor before buying any stock in the companies mentioned in this analysis. Beth Kindig and the I/O Fund do not own Cloudflare and there are no plans to enter the stock in the next 72 hours.
Two years ago, the I/O Fund wrote about Apple’s mobile privacy changes and kept our newsletter readers aware of these changes as they rolled out. Going into earnings, we are seeing headlines that Facebook may be affected. We think when Big Tech goes up against Big Tech, that investors should watch the outcomes closely. Our stance for the past two years is that Apple owns the real estate on iOS, and everyone else is renting. The hierarchy is straight forward yet many critics question Apple’s decisions, often feigning concern for the impact to small businesses. We do not think Facebook cares about small businesses at all, per se, but rather about ad dollars.
This upcoming quarter will be the first full quarter to reflect the change. Some models suggest about 7% decline if 20% of iOS users opt-in. The opt-in rates quoted here match what is being reported (about 1 in 5 users opt-in for Facebook to track them). Flurry also stated about 20% were opting in. Meanwhile, according to Bloomberg, some agencies are reporting that companies went from spending “nearly all” of their budget on Facebook to more around two-thirds or half of their budget due to the iOS tracking changes.
The reality is that Apple built the ecosystem and it’s theirs to monetize as they see fit. In this equation, consumers matter too, and data should not have been collected without permission in the first place. Although we’ve been covering privacy concerns since 2014, we specifically called out Facebook in 2018 during Cambridge Analytica to discuss the various ways Facebook was collecting data without permissions.
We’ve also maintained that Apple is running out of near-term growth markets so it makes sense they’re looking for ways to expand their revenue. Below is a snapshot of Apple’s growth pre-Covid in 2019. Due to an increase in time spent indoors, even sleepy segments like personal computers exploded overnight. However, these segments could return to pre-Covid levels (or even lower if consumer hardware saw a pull forward). This helps us to understand Apple’s motivation taking back its real estate. My only question is … why didn’t Apple do this sooner?
Pictured below: 2019 revenue for Apple and it’s iPhone segment
Below are excerpts and links to our previous analysis, which was written for our free newsletter subscribers over the past few years.
Governments Won’t Be Able to Stop Facebook and Google — But Apple Could
In April 2018, Congress tried to piece together how Facebook’s platform works. It ended up being a disaster. Anyone who works in the mobile-ad industry knows that the mobile device, notorious for its massive data leakage, could be used to collect thousands of data points daily to reveal personal thoughts, behaviors and political preferences.
When Facebook CEO Mark Zuckerberg answered a question on how Facebook makes money — “We sell ads, senator” — he wasn’t fooling the ad industry. It’s well aware that Facebook sells audiences and identities, as the company’s ads would be worthless without extracting data points from the mobile device and aggregating them for targeting.
This isn’t your typical targeting of pizza (or beer) ads during football games. This targeting knows you better than you know yourself, as it monitors your actions with data science and look-alike modeling.
The only force that can stand up to the complex tracking methods used by Google and Facebook will be an opposite, yet equal, force. It will not come from governments, which think that paying for search results is the problem. Rather, the problem is the pervasive code and software that continually tracks people, which no competitor can compete with.
Turns out, there is an opposite and equal force in magnitude that has chipped away at the anti-competitive tracking that occurs in the browser with Intelligent Tracking Prevention (ITP). Yet it has not done so on the leakiest device of all: mobile. And that would be Apple.
Facebook and Google aren’t the only companies that track users on mobile and browsers. They simply have software and code in more places. For instance, Facebook’s software is in 32% of the top 500 app market — and up to 800,000 applications. They track billions of non-Facebook users with software that can track you whether you have navigated one of their digital properties or not.
There is no way to opt out of Facebook or Google from tracking you, as their tracking is simply everywhere. In fact, security experts, including Bruce Schneier of the Berkman Center for Internet and Society at Harvard, call such tracking outright surveillance.
The incredible depth of information those giant companies have on mobile and internet users is the “moat” that generates unprecedented cash flow in advertising.
Advertising Stocks Face New, Major Challenge with Apple’s iOS 14
Excerpts:
Tim Cook has publicly criticized [Facebook with its software development kit “Audience Network” installed in 300,000 applications on iOS and Android combined and has seen nearly 200 billion downloads. Google’s AdMob is even worse with installation in 1.5 million applications and 375 billion downloads. (Now consider that users did not authorize or download this software on purpose!)
[Despite Apple’s privacy advertisements] what happens on the iPhone most certainly does not stay on the iPhone. Mobile has become a free-for-all in data collection over the past ten years. The device leaks volumes of information through software development kits (SDKs) installed inside every application. Most applications have 18 SDKs, which extends beyond Facebook and Google to include a mix and match of ad software companies although the most pervasive being Google and Facebook who are inside the far majority due to the depth of their data for cross-targeting.
The concept of Apple pioneering privacy at the client level is not new. Apple began to restrict tracking on the Safari browser through iterations of Intelligent Tracking Prevention (ITP) from 2017 to 2019. As I covered previously in depth, Apple implemented strict requirements, such as having a relationship with the customer within the last 24 hours to place a cookie, and companies have continued to find loop holes.
Unlike cookies on the web, where there is a tag on the browser, mobile identifiers have much stronger tracking capabilities. Apple’s IDFA enables the following: user tracking, marketing measurement, attribution, ad targeting, ad monetization, programmatic advertising including DSPs, SSPs and exchanges, device graphs, retargeting of individuals and audiences.
What investors may not realize is these advertising cash machines are largely dependent on tracking software for the high CPMS (cost per thousand views) and CPIs (cost per install) they charge because they can track actions on a granular level even days after a mobile user has seen an advertisement. The mobile users are not aware they are being tracked by many companies they do not have a first-party relationship with (but the developer or publisher does). These developers and publishers must now obtain permission. Without permission, the inventory on mobile becomes less valuable.
Mobile applications, such as Spotify, Uber, Lyft, and mobile gaming, for example, are also dependent on the ability to track and identify cohorts for user acquisition. This is one reason we see the top line grow rapidly in ridesharing at the expense of the bottom line; these companies are crunching customer acquisition costs and lifetime value (LTV) across specific demographics and then using lookalike modeling to target the demographics with the best LTV.
Facebook’s Surveillance-Like Software is Called Audience Network
The betrayal was two-fold. On one hand, a first-party data company boldly entered the third-party data marketplace to broker data, risking the trust of its social media users. Secondly, Facebook did everything in its power to make sure social media users would not find out. Audience Network, which fuels a substantial portion of Facebook’s revenue from the social network, has not been disclosed to the public to this day. It is eerily absent from PR releases and discussions around privacy. Unless a Facebook user was a detective, they would have no reasonable way to know that Facebook operates Audience Network and is selling private data across hundreds of thousands of applications at an estimated 40% of the app market.
Built in 2012, Audience Network went live in 2014, and caused Facebook to stage a remarkable turnaround on the stock market. Facebook has posted consistent returns ever since. This is in marked contrast to the years prior to Audience Network, between 2012 and 2014, when Facebook faltered quarterly, often losing 50% of its stock value due to frequent, disappointing earnings.
Disclaimer: Beth Kindig and I/O Fund does not own stocks mentioned in this article. This is not financial advice. Please consult with your financial advisor in regards to any stocks you buy.
There are three important trends we weave together in this report to draw conclusions around potential winners in big data and analytics. We’ve recently covered MongoDB, Elastic, and we’ve discussed Confluent. What do they all have in common and why are these companies important right now? That’s what we aim to answer in this write-up.
Before we go into where we are with big data and analytics right now, I’ll quickly touch on cloud IaaS and especially why hybrid and multi-cloud are leading this space and why investors should not be concerned with tech giants that offer competing products in the data and analytics space.
When we talk about Big Data, the main driver is machine learning, which is performed through supervised learning with the use of historical data, or unsupervised learning, with clustering models and associations to identify rules. There is also reinforcement learning that is trained from feedback. Here are the three trends we are going to weave together to form a full picture of Big Data and Analytics.
The migration to the cloud — but more specifically multi-cloud and hybrid
Why multi-cloud drives demand for best-of-breed, i.e., generally speaking, we do not need to be overly concerned when tech giants that offer competing products
How Apache Spark helped catalyze the AI/ML market with efficient data processing
How we plan to invest right now given that #2 and #3 are prepping the market for us
Hybrid and Multi-Cloud are Driving the Cloud IaaS Market:
For cloud IaaS, we don’t want to only focus on CAGR but also the budget allocation that cloud IaaS is capturing. According to IDC, the IaaS market will reach $112.9 billion at a CAGR of 11.3% through 2025 and will account for 66.1% of total compute and storage infrastructure spend. Two-thirds of IaaS spend is on the public cloud.
To compare, the on-premise market (i.e., not hybrid) will grow at 0.3% CAGR for a total of $57.9 billion. According to the most recent Denodo survey, hybrid cloud drove 35% of the workloads worldwide. Private cloud expanded from 16.6% of workloads to 24% percent of workloads worldwide. Meanwhile, the public cloud had flat growth.
Hybrid cloud is a mix of public and private clouds or a mix of cloud and on-premise. Enterprise companies that choose hybrid deployments are motivated to not share intellectual property or data with a vendor, known as data residency, plus other security implications that come with storing data on another company’s servers. Other companies find moving to the cloud to be time and resource-intensive and prefer to keep some workloads on the servers they own.
Recently, a report came out that repatriation, or moving some workloads back to on-premise, has resulted in quite a bit of cost savings for companies like Dropbox, Crowdstrike and Zscaler, who use hybrid approaches. The report is quite surprising as the conclusion is that $100 billion to $500 billion in market value is lost on cloud deployments in terms of margins. One use case that is detailed is Dropbox, a company that reported savings of $75 million in two years after repatriation, which in turn, helped the company’s gross margins increase from 33% to 67%. Meanwhile, companies like Asana and Datadog spend about 60% of their revenue towards committed cloud spend. This report, among others, shows why hybrid is likely to be the chosen deployment for many enterprises into the near future.
We had previously formed a Microsoft thesis in 2018 based on the trend towards hybrid cloud and why a focus on a hybrid strategy for governments and enterprises was important to Azure’s growth rate. Microsoft is especially well suited to serve the hybrid market because of the company’s deep roots with on-premise enterprise software. When the I/O Fund first covered hybrid cloud as a major driver of cloud IaaS in 2018, Amazon’s AWS did not even have a publicly available hybrid product. The company later publicly released Outposts in 2019 to compete with Azure. If you want more information about how these two compete on hybrid on-prem deployments specifically, the in-depth analysis I published in the past is found on Seeking Alpha and also Forbes.
Multi-cloud refers to using more than one cloud provider, which is usually done to avoid vendor lock-in and to choose best-of-breed products. It also helps to avoid downtime should one cloud provider go down or become overwhelmed with demand.
Multi-cloud is the dominant strategy today and is used by 80% to 90% of organizations. In 2019, Gartner stated 81% of respondents were using two or more cloud providers. The top reason was to avoid vendor lock-in by the “megavendors.” Therefore, this is why investors should not be concerned with tech giants offering competing products in the data and analytics space. The far majority of companies are taking strides to avoid vendor lock-in as multi-cloud technically requires more work yet increases agility and flexibility. The end result is these companies will use best-in-breed products.
According to IBM, 98% of companies plan to use multiple hybrid clouds and 85% operate in multi-cloud environment. There is substantial evidence that organizations are preferring a mix of cloud providers. Most importantly to our thesis and this particular analysis, only 40% use management tools and/or have implemented DevOps practices. The migration to the cloud was happening slowly over time and this migration is under-served in terms of management tools, data and analytics. This would be a sufficient tailwind on its own yet we also have the additional tailwind of data-intensive industries that are moving into machine learning.
The motivation behind cloud IaaS growth and especially hybrid and multi-cloud growth is partially driven by the need for analytics, and also newer trends, such as stream processing. Stream processing is a continuous stream of events that is processed in real-time as it’s received. This allows applications to respond to events as they occur. It combines real-time analytics, inferencing and monitoring to achieve things like optimizing transportation routes, understanding traffic patterns, anomaly detection in cyber security, making real-time predictions powered by machine learning, and even location-based advertising.
In terms of architecture, we’ve covered how microservices and containers are also driving the multi-cloud trend as microservices often span multiple clouds. You can find this write-up here on Forbes and also here on Medium, where we discussed a background on Google Cloud and how the company was the first to automate orchestration across containers. This write-up provides a great overview of where the major cloud IaaS providers are today and where they might go next strategically speaking.
Big Data and Analytics will Explode because of AI/ML Applications
There is an oft-quoted statistic that 90% of the world’s data was created in the last two years – and this stat is from 2018. The world produces 44 zetabytes of data across the digital universe as of 2020 and there is expected to be 200+ zetabytes of data in cloud storage by 2025. Each zettabyte has 21 zeroes or is 1,000 bytes to the 7th power. By these estimates, we can expect to see up to 5X growth specifically in data centers. Statista places the number at 181 zetabytes by 2025 up from 64.2 zettabytes in 2020.
In regards to data integration in the cloud, this spans from data lakes, to ETL pipelines, cloud data warehouses and object storage. Data fabrics and data virtualization is key to both hybrid and multi-cloud strategies.
Here's how Datadog’s CEO describes what is going on in terms of big data in the most recent earnings call: “it's almost a given that there will need to be a different way of charging for capturing some of the value provided to customers that can't just be attached to the straight volumes of data that are being exchanged because those volume of data are exploding exponentially while our customers' revenues are not going to explode exponentially.”
Generating the data is not the issue (clearly), and distributed data storage has been largely solved with Hadoop. I think it’s worth going through what Hadoop is and how it came about, and then we can look at how Apache Spark helped accelerate data processing, including for Machine Learning. Notably, most open-source projects are not “easy” and this is why companies do well that simplify how to work with Apache Spark and other frameworks, like Kafka.
Background on Hadoop and Data Storage:
Hadoop became instrumental in helping companies store large amounts of structured data, semi-structured and unstructured data through distributed storage and compute. The result was that data storage became cheap enough to retain any/all data that was generated rather than only the essential data due to its distributed file system. The distributed file system was designed to store and process billions of search engine pages across thousands of nodes. The project was created in 2006 by a team of engineers at Yahoo, who had worked previously on a search engine in the early 2000s with the goal of indexing 1 billion pages.
You can think of search engines as some of the first projects that needed to utilize Big Data. The original search engine project “Nutch was limited to 20-to-40 node clusters, and for this amount of data, more clusters were needed. At Yahoo, the team separated the distributed computing parts from Nutch and renamed the project Hadoop, which successfully worked on thousands of nodes. Parallelism was key for the data processing model as Yahoo’s algorithm would need to be run on multiple nodes at the same time and it had to scale linearly. It was then released in 2008 as an open-source project with up to 4000 nodes with distributed capacity with contributors such as Facebook and LinkedIN.
Distributed systems and parallel computing didn’t begin with Yahoo, of course, it began with Google. The paper “MapReduce: Simplified Data Processing on Large Clusters” is considered a defining moment in how programming models handled large data sets. MapReduce was a key moment because it was specifically designed to handle Big Data in terabytes and petabytes due to its framework for parallel computation using a key-value pair.
By 2012, Hadoop’s clusters were up to 42,000 nodes and the number of contributors had reached nearly 1500. Apache Hive is a ETL and data warehouse tool that uses SQL, but Hadoop can manage and process large volumes of data that are structured, unstructured or semi-structured data depending on the database that is chosen. Therefore, you can use many tools with Hadoop, such as Spark.
Background on Apache Spark and Data Processing for Machine Learning:
In 2014, Apache Spark was released which took over the MapReduce model primarily because of its speed. By working with data in-memory, the parallel processing framework can push queries 100X faster and on-disk queries run 10X faster. After the extract, transform and load the data (ETL) process, with Spark you can run a training algorithm on the same in-memory data. This helps Spark reach peak performance over competitors for ETL and relational queries, but also for machine learning. Spark’s goal was to become (and now remain) the general platform for distributed programmers where many specialized systems have one interface and one system to install and manage. Apache Spark also reduces code volume by using APIs for Scala, Java and Python. The framework offers a unified API for fault-tolerant stream processing, which reduces the number of APIs to learn. Spark ML and SparkML are the two APIs that are offered for machine learning pipelines.
Hadoop helped solve some of the data storage issues and reduced the cost for expensive storage and compute. Therefore, the next issue is who can work with these databases and can this be simplified. Apache Spark simplifies who can work with the framework by supporting libraries, which can be executed to interact with data shared across many libraries. The data processing engine is extremely fast because it processes and keeps the data in-memory without reading or writing to disk. This has resulted in Apache Spark becoming popular for machine learning and AI applications with the support of Apache’s very large community of contributors.
Overview of Public Companies in the Big Data and Analytics Space
Databricks and Snowflake:
I’m starting with Databricks and Snowflake simply because we discussed Apache Spark in this analysis. The founders of Apache Spark are from Berkeley and later went onto become the founders of Databricks. We covered this company in-depth on our Snowflake analysis because we feel this is Snowflake’s strongest competitor (i.e., not traditional SQL warehouses or Big Tech). Databricks is not public right now but plans to go public soon.
Here is a summary of the explanation we published in April as to how these two companies compare:
The major difference between Snowflake and Databricks from a customer standpoint is that Snowflake is laser-focused on the public cloud/cloud native while Databricks is differentiated in that it can build information pipelines across silos, including on-premise and hybrid architectures. As we know from this analysis, hybrid is key moving forward.
Snowflake's main value proposition is to reduce the time required to prep and monitor data so that a customer does not need to manage software or hardware. Even if a team has the technical skills, they may not want to spend the time required for Databricks, which is perhaps one reason why Snowflake is reporting decent growth in the Fortune 500 and other key accounts.
The architecture of a data lakehouse allows for business intelligence and machine learning through a more open paradigm. The idea is to combine the best of data warehouses and data lakes to span unstructured and semi-structured data while keeping costs low. By combining both, teams can move faster and without duplicating the data. This is a key benefit to Databricks DeltaLake, and this is especially important for data analytics and machine learning. With that said, Databricks is more advanced and expert-level.
I want to point out that Snowflake is very clear as to why it's done well – which is that it handles migrations to the public cloud from legacy on-premise systems better than the competitors. Snowflake's priority is to compete with other SQL databases right now, although the company will need to eventually compete with Databricks. Management has discussed rolling out support for unstructured data, for instance, but no timeline has been set.
Looking longer-term, what Snowflake needs to answer is how will it compete with Databricks on machine learning? Databricks is superior here for ML as it’s built on top of Apache Spark and supports Spark, Python, Scala and also SQL. This was discussed in the thread on the forum here.
The forum thread points out that Databricks is more complex to upload the data, monitor and manage, but there are benefits to going through this hassle. One of the primary benefits is support for Python and Scala, which are programming languages for machine learning. For now, you must use an outside vendor or tool as connectors or integrations in order to support these programming languages and libraries with Snowflake. It’s also worth mentioning that Databricks is cheaper for processing a lot of data at petabyte scale.
Growth is the great equalizer when comparing products and my preliminary understanding is that Snowflake is growing much faster than Databricks and expects to continue to outpace the competitor. I will need to look into Databrick’s financials and see an earnings report or two to determine more about the competitor’s sustained growth rate.
What I find to be very intriguing is what Snowflake will do to compete on ML. This gap in product capability is not lost on the Snowflake team and management. Being laser-focused on the public cloud/cloud-native lends itself well for Snowflake to compete here theoretically, yet its laser-focus on SQL is getting in the way strategically speaking. The company is aware of this and plans to roll out support for unstructured data.
We have two strong products here yet the valuation on Snowflake is stretched and I imagine Databricks will be, too. It’s rare to see a company sustain higher than a 40 or a 50 forward P/S for an extended period of time. Right now, Snowflake is at a 79 forward P/S.
MongoDB:
Big Data applications require a flexible data model, which NoSQL supports. MongoDB is a database that can handle unstructured and semi-structured data, whereas SQL competitors require data to be structured and stored in tables. The predefined schema of the relational database is correlated due to common characteristics. SQL is well-supported as the original database management type yet NoSQL is also reaching critical mass.
The reason NoSQL has risen in popularity is because as data grows, there are more data types to work with outside of Excel spreadsheets/CSV or tabular structures. MongoDB and its competitors are a good choice for Big Data because NoSQL databases can process unpredictable and unstructured data. The most popular types of NoSQL databases include graph, key-value pairs, columnar and document.
Moving forward, we think NoSQL is going to take more market share, simply because it saves steps when dealing with Big Data as the unstructured data does not need to be converted and this is preferred for some machine learning models. This is why NoSQL is used by companies that generate the most data, like Amazon, Facebook, LinkedIN and Google. The extra bonus is that the JSON documents in NoSQL databases can be prepared for machine learning. Because you do not have to define a schema, this allows data to be directly loaded from any new source without changing lines of code. SQL is used in training machine learning models with most of this data coming from on-premise servers. Therefore, the migration to the cloud and various types of data that are generated is also helpful for companies like MongoDB in growing market share. This is because the cloud produces various forms of data.
MongoDB has a query language and secondary indexes for specific values to filter, sort and aggregate data. The leading NoSQL database also allows for the storage and retrieval of trained models as JSON documents. In this case, you can query MongoDB to pull up a previous model.
In the multi-cloud trend, MongoDB is a leader here as the company was the first cloud database to run applications simultaneously on all major cloud providers. The multi-cloud clusters allow developers to deploy applications across multiple cloud providers without having to manage the complexity. In addition, the technical team at MongoDB maintains that you can forego Hadoop and Spark, which requires complex functions and logic, and instead rely on Tensorflow.js, MongoDB and a browser for the same level of machine learning but with less complexity. In an example, a MongoDB representative was able to write a ML program with 88 lines of code. With that said, NoSQL requires more expertise than the universal language of SQL.
The takeaway is that Big Data companies prefer NoSQL for many reasons, and we think in the era of ML and AI, that more companies will lean towards having similar requirements as Big Data companies. This isn’t to say that SQL isn’t alive and well due to the sheer amount of support for structured data across various database systems. Financial transactions for instance fit well into SQL. This is not a “SQL will die” discussion, instead it’s a “NoSQL may see a bigger market thanks to big data and the sheer amounts of unstructured and semi-structured data that will continue to grow” discussion.
Although the SQL and NoSQL debate has lingered for some time with SQL being the leading database today, requirements may change and we think MDB is positioned well for this shift.
Also, refer to the fact that MongoDB is fifth in terms of database market share yet is tied for first place for most wanted database skills among software developers. Notably, MySQL and Oracle are the top database systems globally yet MySQL is fifth in terms of most wanted database skills. The demand for talent is typically an important indicator of where we are now and where the puck is going.
The founding team of Apache Kafka worked at LInkedIN before leaving to start Confluent. Apache Kafka is used by thousands of companies for message streaming, such as LinkedIN, where a publish/subscribe model allows applications to share and create data in a serverless and microservices architecture. What Kafka solved for is the ingestion of events data in real-time and with low latency.
At the time that Kafka was developed, LinkedIN was ingesting 1 billion events a day. The company is now ingesting 1 trillion per day. Kafka does this through a log that writes messages to a topic and is able to retain messages for a long time. Kafka is also used in stream processing by parallelizing the pipelines. Kafka Streams were built to increase simplicity while retaining the same amount of performance as a Spark streaming job.
As with Spark and other open-source projects, there is a marketplace for making the frameworks easier to use. Confluent Kafka opens up the amount of data that can be integrated, for example, to combine transactional data (orders, inventory) with sentiment-driven data (likes, page clicks). This helps with predictive analytics and also machine learning because the “data flow” allows for algorithms to work as they are intended to. This is what is meant by the title slide of the S-1 filing “Set Data in Motion.” In order for data to be in motion, Confluent’s platform connects data from many different sources.
The end result for Confluent is that the company allows large amounts of data to be moved very quickly. This is needed for machine learning algorithms that are very data hungry. Kafka can be paired with Apache Spark and Apache Samza to route data and then load it into ElasticSearch, for instance, so it’s a bridge (or a nervous system according to Confluent’s marketing department).
The goal of Confluent is to reduce operational complexity. In the case of Kafka Streams, this is done by not requiring a cluster to be spun up, offering a single framework for streams of events, and reducing the number of pieces in a stream architecture. Confluent Cloud is growing rapidly at 200% year-over-year, primarily driven by event streaming.
Please note, that Confluent is on a partial lockup schedule. The partial lockup dates are 15% on the day of the IPO (June 24th), 25% on the second day of trading (August 09th) after the Q2 earnings, with the remaining at the earlier of the second day of trading after Q3 earnings and 181 days of the IPO.My note: Already up to 40% of the shares have already been released by the eligible employees. The full lock-up expiry is between November and December..
Elastic:
Elastic is a best-of-breed search company that has other benefits, as well. Elasticsearch is the core product that allows for the searching, storing and analyzing of data. This allows developers to build search features that pair Uber passengers with drivers, recommend grocery items on Instacart based on your history, match online data profiles for Tinder, or log events for Fitbit at a rate of 250,000 logs per second. In addition to searching and storing data, Logstash and Beats are ingestion tools to ingest data from applications and to query external systems. Kibana is an open-source tool for visualizing the data. We’ve covered Elastic Stack in more detail here.
Since 2018, the Elastic License has been free and open source with paid proprietary features. As Bradley detailed in this write-up, Amazon began to profit from Elastic’s open-source software and did not contribute back. According to Elastic, over 90% of new downloads choose Elastic’s License. As of January 2021, the company dual-licensed Elasticsearch and Kibana under SSPL or “Server Side Public License,” which requires Amazon or any others to publish modifications and the entirety of their source code. We think the multi-cloud trend is one reason that Elastic has been able to overcome Amazon as the primary driver is to avoid vendor lock-in. Notably, Elastic is cloud neutral so it does not rely on any specific external services for machine learning like AWS’s OpenSearch. Basically, this goes back to the points we made about multi-cloud earlier in this analysis.
We also discussed Elastic’s move into XDR is important because security is a primary concern for those who are on multi-cloud deployments. The SIEM and XDR space is not without its competitors yet it could be Elastic’s combination of already having ingestion tools for thousands of applications and sensors that lends itself well to monitoring and detection. SIEM is security, information and event management while XDR stands for extended, detection and response (XDR). SIEM was first used as a compliance product and often works alongside endpoint and network security products in order to offer a narrower yet deeper set of activity. This last piece has become critical over time. For Elastic’s product, XDR builds on the SIEM and EDR (endpoints) combination for more accuracy and applies machine learning models to detect anomalies.
Where there is data, there will be new opportunities for growth as the AI/ML landscape goes from nascent to mature (i.e. not all uses cases have arrived for big data and analytics companies). Due to Elastic being essentially a pretrained model for extracting keywords and synonyms and “term co-occurrences”, it lends itself well to natural language processing (NLP). With Elastic, terms can be filtered by significance and offer out-of-the box shortcuts to Python with its REST API. Cognitive search is a new form of search that uses AI to improve search queries and to extract information from multiple data sets. Cognitive search can combine a traditional search engine with NLP to extract more useful information since keyword search is limited in the variety of data that can be searched. Cognitive search uses machine learning algorithms for its greatly improved search results and will be a $6 billion market by 2025. We think it's impressive that Elastic was named a Leader in the Gartner Magic Quadrant for cognitive search in the first year it was added as a new entrant, blowing past Microsoft, AWS and even Google.
Conclusion:
I wanted to cover Big Data and Analytics broadly and horizontally rather than vertically by company because it paints a better picture of what we are positioning forand why. It’s easy to get lost in the jargon when discussing companies individually especially with technical companies like these. But what really separates each of them? We think the side-by-side comparison can be more conducive at times when setting up a microtrend.
We had a few goals with this analysis that I hope we accomplished:
Bring to your attention this trend (and the common thread) and pull-out names from the general “cloud” list to discuss why they may have a unique catalyst. There will be many winners in this space and we are limited in terms of number of positions we can enter. It’s easy to get caught up in “stock picks” yet we also want to offer you microtrends to help inform your individual portfolio decisions.
We think big data and analytics from best-of-breed companies could become a solid post-covid cloud play due to the sheer number of companies that migrated to the cloud yet have multi-cloud and hybrid deployments
Third, I want to make sure and elaborate on where the MongoDB, Confluent and Elastic positions are coming from that the I/O Fund recently entered. We offer deep dives on companies but we also want to anchor our readers with the underlying microtrends that we are investing in. For instance, Snowflake is a great choice, yet the valuation is high and that range above 50 has not treated us well in the past (i.e., personal choice). Perhaps for your investment profile, you prefer Snowflake right now, etc.
This is a big space and it’d be impossible for me to cover everything but we pulled out the critical pieces. We think it’s important to simplify the key drivers of a microtrend and illustrate the ways that specific companies are serving the trend. You can expect to see MongoDB and perhaps Confluent added to the LTBH portfolio as the thesis should take about 3-5 years to fully play out. The main thing to know is this means we will have to remove a name or two from the current LTBH portfolio. We will keep you in the loop as we weigh these decisions.
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UiPath’s core product is UI-based automation and they’ve recently acquired Cloud Elements to add API-based automation. The software robots are able to work across programs in the background, build applications, send emails and interact with chatbots. Although making AI/ML actionable is UiPath’s sweet spot, the trend towards low code/no code is also a tailwind for UiPath. We know the AI-bellwether Nvidia has led the market this year, which helps us gauge where we are in the AI cycle as semis must move first. Therefore, Nvidia helps provide evidence that we are early to UiPath (unlikely automation moves exactly in sync with GPUs) and the goal will be to remain invested through the ups/downs as the story unfolds.
I had posted on the forum my thoughts on the decelerating revenue and why the unique business model and change in billing terms is causing the top line to look weaker than the company actually is. Management emphasizes to focus on ARR and we break down why that’s important. Although a change in billing terms can be seen as a weakness, we don’t think this is the case as the change in terms could open up the company to more customers who aren’t willing or able to pay up front. We had outlined in our original analysis that UiPath is an expensive product with a customer concentration at the enterprise level. Customer growth above $1 million was up 100%, therefore, UiPath is showing strength in its core customer base. However, UiPath is now ready to invest at the citizen developer level in the Studio X product.
Earnings Overview
This section posted on the forum Thursday, September 16th:This section posted on the forum Thursday, September 16th:posted on the forum Thursday, September 16th:
UiPath beat and raised guidance, so there was no issue here. Rather the issue is the company’s growth is decelerating and this is raising some question marks as to how long the deceleration will continue. The market is forward looking, and in this case, the market is pricing in lower growth. The guidance does not fully illustrate the deceleration in licensing and deferred revenue. We break this down for you below.
First, I want to talk about UiPath’s unique business model which is to license software robots and then charge for support and maintenance. Here is the difference as outlined in the S-1 filing:
Licenses:
We sell term licenses which provide customers the right to use software for a specified period of time. From time to time, we also sell perpetual licenses that provide customers the right to use software for an indefinite period of time. For each respective type of license, revenue is recognized at the point-in-time when the customer is able to use and benefit from the software, which is generally upon delivery to the customer or upon the commencement of the renewal term.
Maintenance and Support:
We generate maintenance and support revenue through technical support and the provision of unspecified updates and upgrades on a when-and-if-available basis for both term and perpetual license arrangements. Maintenance and support for perpetual licenses is renewable, generally on an annual basis, at the option of the customer. Maintenance and support represents stand-ready obligations for which revenue is recognized ratably over the term of the arrangement.
The reason the company emphasizes ARR as the key metric to focus on is because it accounts for UiPath’s upgrade-heavy business model and it shows the strength from retention. Expansion revenue is essentially what drives UiPath rather than yearly subscriptions alone (revenue). Once a company licenses software robots from UiPath, they are more likely to license more software robots over time and to need more maintenance and support. This upgrade cycle is unique from other cloud companies that have only specific cohorts they can upgrade and are more focused on yearly subscriptions (i.e., Pro Plan to Enterprise Plan, etc.).
Management at UiPath is communicating that the ARR forecast is more important than the revenue forecast as it accounts for the upgrades they are expecting. The dollar based net retention rate for the company is very high at 144%. Evidence of the expansion revenue model is also seen in the company’s lifetime value which is 233X for the top 25 customers and 62X for the top 100 customers. UiPath’s customers are enterprise customers with large budgets, which is why we saw the $1 million+ ARR cohort up 100% this quarter and those accounting for $100,000+ ARR up 59% this quarter.
Why UiPath Sold Off Despite a Beat:
Given what analysts know about Q3 guidance, the current projections for fiscal year 2022 is at 44%, which is down from 81% in the last fiscal year. We’ve included the analyst projections for the following year, which right now are at 34% growth to $1.17 billion.
However, the ARR hints towards stronger revenue growth in the future. For fiscal year 2021, revenue of $608,000 exceeded ARR of $580,400. This year, we are seeing ARR slightly outpace revenue if we based revenue projections on analyst consensus. While revenue is forecast to grow 44% this fiscal year, ARR is forecast to grow at 51%. Historically, UiPath’s revenue exceeded ARR.
Another explanation for why we are seeing the lapse between ARR and revenue is that the CFO mentioned a change in terms of how the company bills. In the past, the company billed multi-year deals all at once, and instead, they are shifting towards billing annually. The management stated the reason is that it allows more upgrades as their customers’ needs change and it results in less up front from their customers. In the example provided, instead of buying 10,000 robots at once, they would buy 1,000 and then 5,000 and then 10,000 with the new billing structure with the revenue realized across three years rather than realized in one year.
Here is the quote about the difference between revenue guidance and ARR: “So when I talk about an annual ramping contract, one of the things that is really positive for us is digital transformation is a long-term trend. And what has happened with the strength of UiPath’s platform is automation is a staple for the long-term requirements for customers to transform the way they work in digital transformation. So what that means is instead of buying simple annual contracts, what we see a larger demand for is getting larger term commitments from some of our customers. But the way they look at that is instead of buying 10,000 robots today, they may buy 1,000 robots today, 5,000 next year, 10,000 in year three. And those – the license deliveries would happen into those years as we go down.
And so, one of the things that we look at is that we like that because that is better ROI for our customers. And I – when we think about the impact on financial metrics, two things. One is remember, we – and I repeat this, we really drive our company to ARR. From an ARR perspective, there is no impact that is there. Based on the way the contracts are structured, if license delivery happens in the out years, then that does have – that creates variability in revenue because we only can recognize the revenue upon delivery of the license. And so that is kind of the way that I think about it from a modeling perspective on revenue. But again, I stress ARR really, there is no impact, and that’s how we drive the business.”Based on the way the contracts are structured, if license delivery happens in the out years, then that does have – that creates variability in revenue because we only can recognize the revenue upon delivery of the license. And so that is kind of the way that I think about it from a modeling perspective on revenue. But again, I stress ARR really, there is no impact, and that’s how we drive the business.”
This change in how customers are billed likely led to lower licensing revenue in the current quarter of 20% growth compared to 72% growth from the fiscal year (not apples-to-apples comparing Quarterly to Fiscal Year but helps provide color). This is down from 57% last fiscal quarter ending in April. We see evidence that those licenses will be recognized in future quarters not only in ARR but also in support and maintenance growth, which is recognized ratably and grew 74% year-over-year compared to 79% in the quarter ending in April. In other words, customers aren’t falling off or downgrading rather they are paying for licenses across many years rather than pre-paying.
Expanding on Earnings:
UiPath reported revenue of $195.5 million compared to the consensus for $184.3 million. This represents 40% growth year-over-year compared to 65% growth in the prior quarter. EPS also beat at $0.01 compared to a consensus of ($0.05) EPS. UiPath has a total of 9,100 customers with 600 added in the recent quarter. The company also has 4,700 partners after adding 400 in the most recent quarter. The Partner Network is part of our thesis on UiPath and we think this number carries significance in terms of a defensible position. This quarter, the company highlighted its partnerships with Alteryx and Smartsheet.
The company’s adjusted gross margins are at 86% in the most recent quarter with adjusted free cash flow at a loss of $3.5 million. As stated, licensing revenue slowed down with the revenue mix being $95.5 million in licenses compared to $79.5 million in the year-ago quarter. Maintenance and other Support was at $90.3 million compared to $51.9 million in the year-ago quarter.
We believe the management is correct in focusing on ARR. As stated above, revenue typically exceeds ARR. Therefore, if we draw conclusions based on the historic performance of the company, the revenue growth would be above 60% in this quarter and above 51% in future quarters. In addition, net new ARR was up 33%. We will need to see how long it takes before the company absorbs the change in billing terms, but due to where we are in the AI cycle, we prefer to be patient. If this was cloud software, which is moving towards consolidation, we would be more concerned. Hopefully, the above section explains why we are not concerned at this time.
Guidance came in higher than expected at revenue of $208 million at the midpoint compared to consensus of $206 million. The guide in ARR was at 54% next quarter and at 51% growth for the fiscal year. When asked if the raised guidance was from a demand signal, the company pointed towards their Net Retention Rate, which remained robust at 144%, indicating that demand for their products has remained strong.
From my perspective, UiPath has very few comparables on the market but we can lump the company in with cloud software with the understanding that cloud software’s growth reflects a mature market while UiPath’s does not. Forward fiscal year P/S is at 32 based on $874 million consensus estimates for this year and 1-year forward is at 24 if based on consensus estimates of 1.17 billion. We think this is a reasonable valuation for a company that is at the forefront of automation, which is one of the least-hyped yet most practical commercial uses for AI and ML. However, the full lockup is next month and we had stated in our initial coverage on UiPath and reiterated across other analysis that even the most quality companies come under pressure from insiders and early investors needing an exit.
Of the companies pictured above, ZS, TEAM and NET have similar forward revenue growth and we can see they are fetching much higher valuations. It will be interesting to see how this unfolds if UiPath’s revenue does indeed catch up to ARR and enterprise customer growth.
Product Catalysts:
The focus of this update has been primarily on the financials as we’ve written a deep dive on the product, which you can find here.
UiPath has a few catalysts this fall, including releasing attended robots for the Linux operating system and also for Mac users. Mac OS users make up roughly 17% compared to Windows, there is a higher concentration of Mac users among citizen developers and also in enterprises in the tech industry. Linux makes up a very tiny portion of overall operating system market share at less than 2% yet dominates cloud infrastructure at 90% penetration. In 2021, 100% of the world’s top 500 supercomputers ran Linux. Here are the releases the company has planned including a web-based version of StudioX:
Now, we continue to invest in StudioX as a major tool to foster the community of citizen developers. We are going to extend it also to be available multi-platform. So, you will expect quite a bit of investment from us in the coming few quarters. It’s – right now, we are doing really a major advance into multi-cloud and multi-platform. And we are launching Linux-based robots. We just announced yesterday the public review available. We are launching Mac support. We are going to launch early next year, the web-based StudioX that will make it even easier to adopt. But overall, we really believe that it’s important to have a suite of tools that cater to a large array of options from professional developers to citizen developers and to all business users.
Conclusions:
The lockup for UiPath happened in tranches after the first fiscal quarter results and also following the second fiscal quarter results, per the S-1 filing, with some restrictions. The full lockup with no restrictions occurs on October 18th. This is likely weighing on shares more than anything in the current ER as some shares were up for lockup expiration at the time of fiscal Q2. Participating in IPOs rarely works out in the first few months of the listing unless you’re actively trading, which we stated clearly in the original write-up on UiPath. However, we decided to add this to LTBH to show our seriousness in building AI positions.
With that said, we will likely hold off on Confluent until post-lockup. You’ll get this analysis soon to set the stage for why we are building MDB, ESTC and eventually CFLT as a package as we think there’s an important trend bubbling beneath the surface. Keep an eye for this deep dive end of next week.
If you own Zoom, why are you invested in the company? That’ll be a key thing to answer as the market is clearly doubting the company. I know exactly why we are in the stock. Before I review our thesis and why the earnings report was stronger than the market is pricing in (again, for our purposes), I want to begin with the bad news.
The bad news is that the online business is declining and management is being very conservative in regards to their guidance because they’re unsure of how to forecast the churn and lower signups in the individual and small account category. Zoom uses the words online business to refer to the small accounts that sign up online. They use the words channel and direct to refer to the enterprise sales that require their sales team.
The annual forecast of 51% revenue growth places Zoom in the top tier of cloud stocks this year in terms of growth – and that’s especially impressive considering their 300%+ quarters last year. Some are referring to this as a pull forward but that’s not accurate. A pull forward refers to business you would have secured at one point yet it comes earlier or consolidates into a single quarter or time period. What Zoom experienced was a leap from enterprise to consumer during Covid with consumer not being its core business. This is not a pull forward because consumer was a bonus or unexpected use case for the product. It reminds me of Nvidia’s use case with crypto mining, which the market had a severe reaction to, even though crypto mining was not in Nvidia’s product road map.
There are some reports that point towards a deceleration across accounts as the issue. Well, yeah … it has to decelerate from 300%+ but what’s the deceleration referring to exactly? The write-ups will say something like “User growth exploded for Zoom throughout the pandemic, with the number of customers with 10 or more employees skyrocketing 458% from 66,300 in fiscal Q2 2020 to 370,200 during the company’s fiscal Q2 2021. That growth, however, slowed in Q2 2022 to 36%, with the company reporting 504,900 such customers.”
That looks scary yet the revenue growth in Q2 2022 of 51% is not a problem as it was carried by the critical enterprise segment. I review those numbers below. Believe it or not, some enterprise segments actually accelerated from last year. You wouldn’t know that from the earnings reaction.
However, let me be really clear that the reason the market is spooked is the fiscal year guide, and subsequently what it means for Q4’s growth and beyond. The confusion around the current quarter is mainly journalists trying to figure out what’s causing the sell-off and thinking it was something in the current quarter’s ER so you’ll see those quotes like what I pasted above.
Here's the question on the earnings call that caused the sell-off Tuesday:
So, I look at your implied guide for Q4. It seems like you're guiding it to decel to around 12% or so, plus or minus from 30% or so in Q3 with a similar compare I would argue. Now, it seems like it'll actually be down potentially sequentially from Q3. So, can you elaborate on why that might be the case? You talked about online issues. How long do they last, for example? And if we go to like 10% to 12% growth in Q4, should we accelerate afterward if we — the compares get easier, how should we think about next year? –. It seems like you're guiding it to decel to around 12% or so, plus or minus from 30% or so in Q3 with a similar compare I would argue. Now, it seems like it'll actually be down potentially sequentially from Q3. So, can you elaborate on why that might be the case? You talked about online issues. How long do they last, for example? And if we go to like 10% to 12% growth in Q4, should we accelerate afterward if we — the compares get easier, how should we think about next year? –Shebly Seyrafi, FBN Securities
Here was the answer from management. Notably, Zoom calls the individual accounts the “online segment.”
“Yes. So, in terms of what you're seeing in Q4, it is continued uncertainty around headwinds in the online segment, absolutely, it’s driving that. And we're — in terms of what that implies for next year, we're not ready to give FY'23 guidance today, unfortunately. So we will be prepared to do that when we get on the Q4 earnings call and, of course, we'll have a lot more earnings at that point to share with you, but that is what – exactly what continues to drive that in Q4.” – Kelly Steckelberg, CFO Zoom it is continued uncertainty around headwinds in the online segment, absolutely, it’s driving that. And we're — in terms of what that implies for next year, we're not ready to give FY'23 guidance today, unfortunately. So we will be prepared to do that when we get on the Q4 earnings call and, of course, we'll have a lot more earnings at that point to share with you, but that is what – exactly what continues to drive that in Q4.” –Kelly Steckelberg, CFO Zoom
My read on the situation is that management doesn’t know what to expect right now. It was an unexpected situation last year and unwinding from that is hard to model. Please also note, that Zoom has what’s called “front-weighted seasonality” which means contracts renew more in the first half of the year than the second half of the year. This is technically a headwind to Q3 and Q4 although that was already taken into account with the guide.
So, where does that leave us considering Zoom is a LTBH position but nearly 5% allocation? As annoying as this may be, I don’t see any change to the thesis we set out for Zoom. There is confusion about the company’s revenue segments and how they’ll unwind but this earnings report saw accelerating growth in enterprise. Therefore, at most, I see us taking the allocation down to 3% and then back to 5% on a breakout. The reason is we will keep the 3% minimum is that this company is rare and special, I’ve already made that case many times.
Cash is the great equalizer in terms of product-market fit; if you knew nothing else about product, that’ll quickly communicate to you the relationship a tech company has with its customers in any given market. Cloud isn’t ad-tech, where it’s this cash efficient either, which makes Zoom’s cash even more rare. Why is Zoom able to keep costs so low while growing this rapidly? I expand on this below.
I want to point out that Knox has done an excellent job with this position as the highest entry he’s guided was in the mid-$300s with the high-$200s in May. He was extremely clear when Zoom became overextended into the $400s and even $500s, that we were not buyers. Therefore, we are about a 10%-15% drawdown from our last entry. It’s not only our wins that make a portfolio but it’s also avoiding the losses. We take both very seriously.
Enterprise > Consumer
Consumers turned to Zoom during Covid because the product is easy to use and has a viral mechanic, which is the easy-to-share URLs that allow a frictionless video call without logging into accounts or downloading software.
Zoom is clear on who and what they are. The Five9 acquisition that we covered in-depth here expands their enterprise footprint from employee communications to customer communications for call centers.
Channel and Direct Business drove the revenue results this quarter and the company clearly stated they expect this growth to be “robust” into the future. The company grew revenue by 54% year-over-year to $1.02 billion, exceeding guidance of $990 million.
Enterprise customers that spend more than $1 million dollars in ARR grew by 77% year-over-year. Zoom also reported 131% year-over-year growth in accounts with greater than $100,000 in trailing twelve months of revenue. This was an acceleration from 112% growth in the year-ago quarter.
The Net Dollar Expansion rate for customers with more than 10 employees was above 130% for customers. This is contributed to an increase in spend and upsells on Zoom Phone and Zoom Rooms.
Zoom Phone grew customers by 241% year-over-year and the company “set a record for the largest Zoom Phone deal to date twice in the same day.” There are now 26 customers with more than 10,000 seats. The incremental revenue was driven primarily by new customers. The company is growing Zoom Phone seats at a rate of 1 million per 8 months.
Here's an important excerpt from the call: “In addition to these great customer wins, we also closed another strategic channel partnership with Telkomsel, the largest cellular operator in Indonesia, which is the world’s fourth largest country by population. Telkomsel understands and wants to support their 170 million subscribers’ need for seamless and reliable virtual meetings to thrive in the digital workplace era. They will be leveraging the power of Zoom’s Developer Platform and ISV Partner Program to deliver a fully integrated solution via their CloudX offering for the Enterprise segment and Zoom native apps for the Consumer segment.”
Signing one cellular operator can make up for a lot of online accounts. Telkomsel’s CloudX is unified communications and a contact center solution. As noted in past analysis, Zoom also has partnerships with British Telecom, Lumen Technologies, and Orange Business Services. Zoom’s Distributor Partner Program includes Carahsoft Technology Group in the U.S., Nuvias Unified Communications in Europe, eLink Distribution AG in DACH, and West Telco in LATAM and EMEA, Avant Communications and Intelisys.
Zoom’s Cash
There’s no doubt that Zoom’s bottom line is exceptional with operating income of $1.5 billion expected in fiscal year 2022 and adjusted EPS of $4.75 to $4.79.
We can also see that Zoom’s earnings turn into cash, highlighting the high quality of its results. For instance, YTD FCF increased 45% YOY to $909 million, which is impressive considering YTD earnings were $544 million. Zoom’s cashflows are higher than its earnings, which improves the quality of recently reported results.
The firm’s cashflows are largely driven by pre-payments from enterprise customers, which are stored in deferred revenue. Deferred revenue was a healthy $1.15 billion as of Q2, up 62% YOY, and signaling that enterprise customer growth remains strong. As discussed above, a lot of the uncertainty in management’s guide comes from smaller accounts (online accounts), so it is good to see that Enterprise has amble cash support for future sales.
We can gain further confidence that Enterprise is performing strong by scaling deferred revenue to expected H2 enterprise sales. Zoom disclosed on the Q2 call that 40% of its sales are from monthly payers (online accounts), which do not prepay revenues and as a result, do not drive deferred revenue. Last year, around ~40% of Zoom’s H2 sales were from monthly payers.
By stripping out the 40% monthly payers from the H2 guide, we can see that enterprise sales are expected to increase to ~$1.2 billion in H2. Considering Zoom’s $1.15 billion deferred revenue balance, the company’s H2 enterprise sales are 94% supported by pre-payments of cash (deferred revenue), up YOY from 72% support in the prior-year quarter. Viewed differently, Zoom’s enterprise sales are performing stronger than they were last year. If you believe that Zoom’s story is driven by Enterprise (we do), then this is a great trend to see.
However, it also means that any raises or beats for Q4 will require online payments to come in stronger than expected since enterprise is accounted for in the deferred revenue balance.
Hybrid Work-from-Home
As stated above, Zoom Phone is the most prominent product that can drive future revenue growth as the telecom and cellular operators embrace cloud-native. Quite a bit of this will be driven by the developer platform that Zoom has launched and Zoom Apps.
However, hybrid work-from-home is not to be overlooked. Zoom Rooms and Zoom Events are the two products that fall into hybrid WFH.
According to Gartner, by the end of 2021, 32% of workers worldwide will be remote while 51% will be working in a hybrid environment. As you can see from the chart below, Gartner sees this increasing from 50% to 60% in the United States with more percentage increases in India and Western Europe. Zoom Rooms facilitates this by allowing office conference rooms to connect with the remote employees.
Zoom Events capitalizes on the event industry which is one of the last to resume after Covid. It’s not hard to imagine that events will end up being hybrid too, moving forward, to help reduce travel and maximize the number of attendees. Right now, 73% of event planners believe hybrid will be more common in the future.
Conclusion
I’ve been here many times where the wrong revenue segment is driving a market reaction. Zoom is not a consumer story and the current earnings results are showing robust enterprise sales. Regardless, I won’t sugar coat anything with my readers and Q4 is a gamble right now. That’s the issue and why we saw a 16% decline the day after earnings.
I’ve laid out why we will remain in our position so you can make an educated decision for yourself. We also offer backup with Knox’s entries and so you’ll know when the company is rev’ving up again. We won’t blink an eye when the charts say the timing is right to increase allocation. In my opinion, the chances are incredibly high that Zoom becomes the leading cloud-native communications company globally. Notice I’m not saying the leading web conferencing app and notice I’m not saying “one of the leading.” It’s a big TAM, it’s a sharp team, it’s an incredible product, and they’ve got a pile of cash – that’s all I got for ya.
Every management team has a style and Wall Street (and/or the NLP machines – these two terms becoming synonymous) often penalize management teams that are more forthright. I actually like these teams better because I’m setting up for many quarters or many years for an investment. I’d rather hear the issues upfront so I don’t have to dig around for them like a detective. Roku is a management team that I can simply kick back and listen to the call because they tell you exactly the risks and the opportunities. The market, however, prefers more of a sugar high and Roku management isn’t great at dishing out sugar highs.
The words “tough year-over-year comps” came up a lot in Roku’s call. It would be easy to focus on those words and assume Roku is in a tough spot coming out of the increase of usage from last year. Meanwhile, I think Roku is as strong as ever. Remember that we are invested in the Pay-TV ad dollars trend. Those who question Roku think we are invested for the cord-cutting trend. The cord-cutting trend began around 2005. The Pay TV ad trend began in 2017 and started to contribute meaningful revenue in 2018. This is critical to understand.
If Roku were only a cord-cutting stock, the 1.5 million net adds could be a concern although it’s still 28% year-over-year. This is why there is market weakness right now. Essentially, Roku is experiencing the same pull forward that Netflix warned about, which is that the customers interested in streaming and converting from cable did so during Covid.
Global User growth does need to get sorted, and I fully expect the management to figure this out. Just remember, that some of the best global stories come from the best domestic stories. Meaning, the teams doing well in the United States are the ones who expand to do well globally. We do have Magnite as a global CTV company but their angles are slightly different, which I covered in the LTBH webinar. Right now, Roku has expanded to Canada, Mexico, Brazil, Germany and UK.
Let me quote Anthony Wood on just how unafraid of Google he is:
We've been competing with large companies, including Google in our space for since we started, and we compete extremely well. And the primary difference in the way we compete versus Google as we built from the beginning, a software platform designed specifically for TV, whereas they take their phone, operating system, Android, and they ported it to TVs. So if you look at the history of computing platforms, whether it's windows on PCs, or Android on phones, or Roku on TVs, purpose built, operating systems traditionally have always won in terms of market share. And it's because, when you build something from the ground up for a new user environment, for new business models, it's just more effective. And so that's really the kind of where the source of our competitive advantage come from. And it's working well for us and has worked historically, you know, we compete extremely well, we're the number one streaming platform in the US by a pretty wide margin., a software platform designed specifically for TV, whereas they take their phone, operating system, Android, and they ported it to TVs. So if you look at the history of computing platforms, whether it's windows on PCs, or Android on phones, or Roku on TVs, purpose built, operating systems traditionally have always won in terms of market share. And it's because, when you build something from the ground up for a new user environment, for new business models, it's just more effective. And so that's really the kind of where the source of our competitive advantage come from. And it's working well for us and has worked historically, you know, we compete extremely well, we're the number one streaming platform in the US by a pretty wide margin.
You can apply the same thought process to Samsung.
In the meantime, keep an eye on ARPU becoming disjointed from user growth. For instance, this quarter it was up 46% year-over-year.
Five-year trend in ROKU’s ARPU metric
Sequential growth in APRU over last 5 quarters – note that 2Q21 was the fast pace of QoQ growth since ROKU went public.
ROKU’s YOY growth in ARPU – YOY growth has accelerated for 4 consecutive quarters
The thing to ponder is why is ARPU going up so much? Here’s why I think this is happening:
The most important statement Roku made in this earnings call was in regards to signing all 7 major advertising agencies and the transition of Pay TV ad dollars. The company is talking about signing upfront contracts for television advertising.
This is a long quote so bear with me bc it’s important on what they’re saying.
Regarding your question about the upfront, it was a pretty transformative upfront season for us. We closed it several months earlier than we have over the last couple of years concurrent with traditional TV networks. I think that's an indication that streaming has arrived as a first-class citizen in the way brands think about allocating their annual budgets, because it deals with all seven major agency holding companies and more than double commitments in terms of dollar basis. it was a pretty transformative upfront season for us. We closed it several months earlier than we have over the last couple of years concurrent with traditional TV networks. I think that's an indication that streaming has arrived as a first-class citizen in the way brands think about allocating their annual budgets, because it deals with all seven major agency holding companies and more than double commitments in terms of dollar basis.
So it's definitely coming out of the pandemic, increased urgency by marketers to follow audiences, especially amidst steep ratings declines. Nielsen reported a 29% decline among adults 18 to 49 year-over-year. But it's also a function of our scale and our capabilities, including one view which played a pretty prominent role, our ad platform, our DSP, and our data. And this upfront season as well, our ability to offer originals exclusive content, the performance of that content in the time since as well as our new brand – branded content studio offering really resonated with brands and stuff, it not just brought in a significant uptick in dollars and earlier commitments. It also brought in a significant new set of advertisers who had not yet committed with us in the upfront. Over 42% of our advertisers were first-time upfront advertisers with Roku. So overall, we're extremely pleased with how we did the upfront and also think it's a good Harbinger for how we'll perform throughout the year during the scatter period. Thanks for the question. But it's also a function of our scale and our capabilities, including one view which played a pretty prominent role, our ad platform, our DSP, and our data. And this upfront season as well, our ability to offer originals exclusive content, the performance of that content in the time since as well as our new brand – branded content studio offering really resonated with brands and stuff, it not just brought in a significant uptick in dollars and earlier commitments. It also brought in a significant new set of advertisers who had not yet committed with us in the upfront. Over 42% of our advertisers were first-time upfront advertisers with Roku. So overall, we're extremely pleased with how we did the upfront and also think it's a good Harbinger for how we'll perform throughout the year during the scatter period. Thanks for the question.
In the LTBH webinar, I went over OneView and how Roku will be monetizing audiences outside of Connected TV and onto mobile and desktop. You can find this on our Roku and Magnite LTBH webinar around minute 28:00. That slide in the webinar is important to revisit if you’re wanting more information about Roku’s strategic advantage as a Pay TV/CTV ad exchange that can monetize beyond its own audience numbers. This is technically Roku becoming a demand side competitor by leveraging first party data. By focusing on Roku’s audience, we are only seeing half the picture (Roku’s position on the supply side). By “demand side,” I mean the side of the ad transaction for advertisers. By “supply side,” I mean the side of the transaction for publishers. In this case, Roku is moving onto the other side to work directly with advertisers. This is a critical change in their story that began with OneView although it’s not surprising or unexpected as strong first-party data ad players who own the stack typically move in this direction (Facebook, Google).
There are other microtrend stats the management discussed that confirms our understanding of where we are in the trend for a Pay TV ad stock (i.e., remember, we are not invested for cord-cutting although it’s a nice-to-have. Similarly, we are in Fubo for live sports and the synergies with sports betting — not the cord-cutting trend that began with Netflix). The first is that Nielsen reported a 29% decline for traditional TV networks among 18 to 49-year olds. The second statistic is that only 39% have a streaming TV service. Roku echoed what we have published in the past, which is that “it’s all going to move towards streaming.”
The Roku Channel is also growing steadily with management stating, "In Q2, we continued to drive robust growth of The Roku Channel with streaming hours more than doubling year-over-year."
Financials Overview
By Bradley Cipriano
Roku’s Q2 sales increased 81% YOY to $645.1 million, beating consensus estimates by 4%. Revenue was driven by a 46% YoY increase in ARPU (now at $36.46) and a 28% YoY rise in active accounts (now at 55.1 million). The firm’s platform sales surged 117% YoY to $532.3 million, an acceleration from the 101% and 46% YoY growth rates in Q1 2021 and Q2 2020, respectively. In fact, this represented the fastest pace of YoY growth since 2017, demonstrating ROKU’s ability to scale its ad business. Importantly, we believe that ROKU is still in the early stages of scaling its ad platform, as the international market remains untapped.
Offsetting ROKU’s platform sales, its player sales increased just 1% YOY to $113 million. However, we note that this number is somewhat subdued as ROKU decided to absorb cost increases (due to a tight supply environment) instead of passing them onto the customer with higher prices. Since ROKU absorbed the price pressures, it reported a -$7 million gross loss in its player segment during this quarter. Importantly, ROKU operates its player segment close to breakeven, as management prioritizes user growth as it scales its ad platform. This is a wise decision by management, considering the acceleration in its ad platform discussed above.
The math also shows that this strategy is sustainable. For instance, ROKU lost $7 million selling its players during the most recent quarter. Considering ROKU nets ~$19.12 per user per year, ROKU can make up the $7 million gross loss in the next twelve months with just ~350k active accounts.
Since ROKU added 1.5 million accounts during the latest quarter, it will easily be able to offset this relatively benigngin loss going forward. Unfortunately, management expects the negative gross margins in the player segment to persist into 2022, which will eat into the firm’s profitability.
On the bright side, ROKU’s platform gross profit rose 149% YoOY to $345 million, easily offsetting the negative margins in the player segment. Consolidated gross margin improved 1,120 bps YoOY to 52%, well above the trailing 3-yr average of 46%. These results flowed down to ROKU’s bottom-line, as 2Q21 EPS increased from a loss of -$0.35 in 2Q20 to a profit of $0.52 as of the latest quarter, which also beat the Street’s expectations by 351%.
However, we believe that ROKU’s current earnings are temporarily inflated. This is because the firm made cost cuts last year due to COVID-19, and management disclosed that expenses will rise going forward as these cuts are unwound to support future growth. Furthermore, ROKU has spent $98 million on media content acquisitions this year, instead of developing this content in-house. This approach temporarily juices earnings since the $98 million acquisition costs are initially capitalized and expensed over-time. If ROKU had developed this media content in house, it would have incurred the expenses more immediately.
ROKU also allocated $47 million of the $98 million of content acquisition costs to goodwill, rather than to media assets. This trend cosmetically inflates ROKU’s earnings growth going forward because goodwill is never expensed to the income statement (it is instead tested for impairment) and hence, distorts the true costs of acquiring the content. Nevertheless, ROKU acquiring media content is akin to a drug manufacturer acquiring a bio-tech firm with solid Phase 3 results. The media acquisition allows management to quickly ramp ROKU’s original media content and to remain laser focused on its ad platform, which is crucial to ROKU’s success.
Looking forward, ROKU guided Q3 sales to $680 million at the midpoint, representing a 50% YOY growth rate which was 5% above consensus. Similarly, 3Q21 EPS was guided to be ~$0.06, above initial expectations of a -$0.22 loss. We expect ROKU to continue to report strong topline growth, especially considering its untapped international opportunity. For example, ROKU has been selling its players to international markets such as Canada, the UK, France, Ireland, Mexico, Brazil and will start marketing its players in Germany in H2 2021.
Magnite Summary:
Roku critics point towards lack of global growth and market penetration. My personal thoughts are that global is way too early to call right now and that Samsung and Google will likely have its hands full competing with Roku long-term in emerging markets. However, Magnite provides exposure to global CTV ad dollars and this has been clearly laid out in our thesis both in our written reports and our LTBH 1-hour webinar. Magnite is our global CTV pick, essentially. With that said, the long-term growth rate of 25% from the company seems low and it’s my hope that the company is setting expectations correctly and plans to easily beat this guidance following its string of acquisitions.
The one thing about ad-tech companies like Magnite is that they use a lot of jargon in their earnings calls. I’ll help simplify the main points before we go into the financials.
Magnite is exposed to desktop revenue, reported under OLV revenue (online video). Therefore, it’s a big win for Magnite that Chrome is pushing out the removal of third-party cookies to 2023.
On the product front, Magnite is now an ad server on top of being a Supply Side Platform (SSP). Strategically, this allows Magnite to compete with FreeWheel and Google and helps them maintain their position “as the largest independent programmatic CTV marketplace.” The SSP allows for programmatic and private market place bidding while the ad server stores the creatives and serves the ads. The SSP facilitates the selling/bidding (auction) while the ad server actually manages, stores and serves the ads. SpringServe is the acquisition that resulted in an ad server for $31 million. The acquisition came from SpotX’s option to buy.
Here’s the flow when you visit a website or watch a connected TV app/show: The page or app calls the ad server, a bid request is sent to the SSP, the SSP auctions off the space to demand-side platforms and ad networks, the winning bid sends its creatives to the ad server, the ad appears on the site you’re viewing or the connected TV show you’re viewing.
In this case, Magnite now owns the full stack. The goal is to give small-to-medium sized publishers even less of a reason to work with FreeWheel and Google.
Overall, management continues to echo our understanding of Magnite’s positioning. They pointed towards India and Asia as markets the company is focused on. The company also repeated it’s discussion of private marketplaces and why an independent SSP on CTV can do well here compared to a public auction marketplace.
I’ve gone into detail on this point in the past, so I won’t elaborate fully here other than to paste this quote:
“With the traditional TV upfront season recently concluded, I’d like to clear up confusion regarding how we participate in these upfronts. Direct-sold and upfront refers to who is doing the selling, but direct and upfront deals increasingly include programmatic media spend commitments, because buyers and sellers want to realize the workflow efficiencies and targeting gains that programmatic provides.
So, how do we participate in upfronts and direct-sold CTV? First through private marketplaces, where our platform serves as the pipes that connect buyers and sellers. As you may recall, a substantial majority of our CTV revenue comes from PMPs. In supporting PMPs, our textures as a self-service productivity and workflow tool to efficiently execute CTV campaigns. We also participate in direct-sold inventory through our managed service business, which provides demand facilitation and serves as a great onboarding source to get buyers into the programmatic ecosystem.”-CEO of Magnite on Q2 earnings call
“However, Connected TV inventory is unique as the inventory is premium and goes for $25 to $40 for placements on a private marketplace. This means that publishers will work with maybe one or two SSPs total as the private marketplace does not result in higher bids because the pricing is already agreed on.
SSPs and DSPs especially come under pressure because they don’t own the audience. However, Magnite is leveraging a few key strengths, such as becoming the primary independent SSP in the Connected TV arena. On the earnings call, the management stated that it would be hard for other SSPs to compete at this point, given the unique private marketplace environment of Connected TV. This is due to Magnite’s acquisition strategy, and we see the effects of this in the Disney partnership, where Magnite is the obvious choice on the supply side.”
The takeaway is that investors in Magnite, like ourselves, should understand that the bids occurring on private marketplaces is partly why Magnite can do well in the CTV environment whereas display ads online became highly competitive in an open marketplace.
Financial Analysis:
By Bradley Cipriano
In the prior quarter (1Q21), MGNI reported results that were underwhelming when compared to ROKU’s strong 1Q21 print. However, during the 1Q21 Conference Call, CEO Michael Barrett explained that growth had started to rebound in Q2 and that “all was well”. CEO Barrett’s comments were confirmed when the company reported 2Q21 results on 08/05/21, as 2Q21 sales increased 170% YOY to $114 million, 22% above the consensus estimate.
However, due to the impact from recent acquisitions, reported sales are not comparable to the prior year. As a result, MGNI also disclosed that adjusted pro-forma quarterly sales increased 79% YOY to $100 million, which assumes that acquisitions were closed last year and also adjusts for traffic acquisition costs (TAC). On a segment basis, CTV pro-forma sales increased 108% YOY to $34 million, while on-line video and display pro-forma sales increased 60% YOY to $66 million. Due to nuances in GAAP accounting following MGNI’s recent acquisitions (discussed below), we believe that adjusted pro-forma sales are the best metric to use to measure MGNI’s true growth rate in the near term.
MGNI’s financial results continue to be tough to analyze from a financial perspective. This is due to all the moving pieces, as the company has made a series of transformational acquisitions in the past year and a half, which has complicated YOY comparisons. Nonetheless, these acquisitions have positioned MGNI to benefit from the rise in connected TV (CTV) ad spend and the industry-wide migration from direct ad sales to programmatic ad auctions.
For instance, MGNI recently closed its $1.2 billion acquisition of SpotX on April 30th, 2021. MGNI stated that “following the Telaria Merger and SpotX Acquisition, we believe that we are the world’s largest independent omni-channel sell-side advertising platform, offering a single partner for transacting globally … and the largest independent programmatic CTV marketplace … allowing buyers access to a global, scaled, independent alternative to "walled gardens," who both own and sell inventory and maintain control on the demand side”. We had also discussed back in April that the SpotX acquisition will allow MGNI to rapidly expand internationally, which should support increased growth and margins going forward.
While the SpotX acquisition positions the company to succeed in the CTV ad market, it also unfortunately complicates MGNI’s accounting. For example, SpotX recognizes sales on a gross basis, while MGNI had previously recognized most of its sales on a net basis (net of TAC). As a result, the company has reported an adjusted pro-forma growth rate to help investors better gauge MGNI true topline growth rate.
Moreover, since SpotX recognizes sales on a gross basis, this can artificially dampen MGNI’s reported gross margins, as the topline is inflated while gross profit remains static. As well, accounts receivables are accrued on a gross basis, which makes MGNI receivables balance appear severely outsized relative to sales. A ballooning receivables balance can signal that a company is pulling forward sales, which is a negative trend and something investors tend to avoid. We suspect that MGNI’s complex accounting is having a temporary negative impact on MGNI share price, due to a subdued gross margin and an inflated receivables balance. However, these concerns will likely dissipate as MGNI’s results start to annualize and the Street gains a better understanding of MGNI’s future growth prospects.
At the moment, the Street is dependent on management’s adjusted, pro-forma metrics. Looking forward, management guided for 3Q21 sales (excluding TAC) to be $115 million at the midpoint, representing a 15% sequential rise in sales (89% YOY). Management also guided for 3Q21 CTV sales of $43 million at the midpoint, which represents a robust 27% QOQ growth rate (307% YOY).
During its Q2 Conference Call, management explained that its long-term expected growth rate (ex-TAC) will be ~25% with 30% to 35% adjusted EBITDA margins.
As a comparison, TTD reported that its Q2 sales grew 101% YOY to $280 million, while the company guided for Q3 sales to grow 31% YOY (1% QOQ) to $282 million with a 35% adjusted EBITDA margin. TTD did not provide long-term guidance.
Vuzix committed the two cardinal sins for an earnings report — which are: 1) a big miss and 2) vague guidance.
Before I go into those issues around the earnings report, I want to point out that the company is actually on the right track. This is a technology that had zero adoption for decades and our report outlined that the medical industry is likely the right industry for Vuzix to see early adopter traction. You can read our previous coverage here where we point towards the medical industry as a main driver: https://io-fund.com/premium/ar-vr-h2-2021-update-and-vuzix-deep-dive
The company reported 240% growth in surgical eyewear sales in the most recent quarter. The earnings call listed many medical corporations and hospitals who are using Vuzix and will continue to buy more from the company. This market is expected to be in the $6 billion range by 2025. If Vuzix owns 8% of the market, that will be $500 million in revenue. It’s looking like that will be reasonable for Vuzix as they are doing well in this this industry in terms of early adoption. Perhaps it’s contrarian right now in the face of a terrible earnings report, but I believe the medical industry and manufacturing are (indeed) moving forward on augmented reality and will require hardware (smart glasses) for this rather than a mobile phone (Apple’s iOS).
We were very early to Unity with coverage at IPO regarding its augmented reality potential. As I write this, the company reports today. If you’re a Unity investor, you’ll need to ask yourself if it’s for AR gaming or AR enterprise. I’d say at least 50% of Unity’s story is for AR enterprise. If you agree with me (read my report here), then keep in mind, enterprise AR will not be displayed or utilized on a mobile phone. As you know, we plan to revisit Unity after we get more information on how IDFA affects the company as gaming is primarily driven by app downloads on iOS. So far, most companies are saying the impact has been delayed so not sure what we will get today AH.
My concern with Vuzix is not its long-term potential. I think the company will be firmly on the map after a few quarters. AR enterprise is a viable market for tech investors to consider, and as I’ve stated in this intro, AR enterprise requires glasses. Snap has a loophole with Apple’s iOS which is why we recommended this one many months ago but what you’re seeing with Snap now will eventually be seen across the entire AR market.
There is no way around the fact that AR will require hardware. That’s not my concern with Vuzix, rather it’s whether we are parking our money in a stock that won’t give us gains in the next 5 months. This is because we have to compete on performance. Therefore, if we close Vuzix, we will likely re-enter early next year. Right now, we are not closing Vuzix rather it’s up to Knox and his chart work (he is laying out a plan for the forum). My understanding is that his thoughts are that he prefers to catch the company on an uptrend.
Vuzix Earnings: Unpacking the Disappointment
I actually don’t mind if a small cap stock that is taking on a sizable TAM has a big miss as long as the key metrics I’m tracking come in strong. Smart glasses grew 21% and as stated the industry where Vuzix is likely to see the most sales were up 240%. Medical sales makes up 25% of revenue.
The company’s official reported that the sales of smart glasses for the three months ended June 30, 2021, rose 21% in the period to $2.8 million led by a 22% increase year-over-year in unit sales in the M400 smart glasses and a 77% year-over-year increase in Blade smart glasses revenues.
There was certainly an increase in expenses with R&D up 50% and sales and marketing up 164%. This is despite engineering services declining from $600,000 to $300,000 (we aren’t invested in the company for engineering services so no matter to us on this).
What bothers me is a lack of guidance. As an investor and shareholder, I’d like some idea as to what a company is expecting in terms of sales. This is all we got:
Christian Schwab
Hey, good afternoon guys. Thanks for the slide presentation. I guess when I'm looking at Page 4 of the slide presentation and in the commentary and the prepared comments, I'm just trying to figure out, can you give us a range of revenue outcome that you expect for the year in 2021 and what type of growth rates we should really be thinking about in the second half of 2021 versus the second half of 2020?
Grant Russell
Yes. 2021 should continue to see consecutive growth as we move from our second quarter. Some of the business in the second quarter was timing related, frankly. That said, none of the SaaS-based software that we expect ultimately will start to add to the revenue stream. I would count in a second, especially in the third and fourth quarter of this year, even though some might be there. So you're probably going to be a little bit softer match. I think it's right in line, Christian, with the numbers that we discussed in the past. I think you look at the 3 million to 4 million units for the kind of a numbers, and then more in the fourth quarter.
Christian Schwab
Okay. Okay.
Grant Russell
That’s hard forecast there. Sorry.
Christian Schwab
Yes. No, I appreciate that. I guess if we sum up those numbers, I mean, could Q4 be big enough to do $20 plus million this year? Is that a little bit too optimistic and it may take too many things going in the right direction right now?
Paul Travers
It would take some things going in the right direction. I mean, it's not impossible to see that some of the business we had could do that, but I mean, I can't, we certainly would not give that advice right now, because there's question marks on the timing for it. And unfortunately, this industry is zero down. It's coming. You can see it, our business continues to grow and move forward. And the size of some of the things that we're talking about are getting bigger and bigger without doubt. It's only a question of, is it this month, the next month, in and out based upon the timing. Yes. It could be there Christian, but we'd have to really work to make that happen.
Knox has been pretty clear on the forum that small caps are out of favor. When this sector is out of favor, it can be brutal. When the sector is in favor, investors run around withbe in a state of FOMO. We want exposure to some small caps because there is outsized reward when you do well in this category. We don’t see any nefarious issues here with Vuzix and we don’t think this quarter defines the opportunity. With that said, we are using purely technicals at this point to determine if we remain or exit the position. We do this with most momentum stocks and I’m stating this as more of a reminder than anything unique to Vuzix.
Please note, this is a Forbes article to be published Monday morning.
Fubo reports Q2 earnings on Tuesday, August 10th, which is a seasonally low quarter for live sports in North America. According to data from Apptopia, the company had a slower start to the quarter in terms of sequential downloads and DAUs, yet the traffic picked up considerably in the back half of the quarter. This is good news as management raised guidance for both the quarter and the year on May 11th and the app data downloads and DAUs support a strong June.
The I/O Fund has written on Fubo in prior quarters to make the point that live sports is an especially coveted audience in media. Our contention is that as long as Fubo can continue to grow its audience with demonstrable key metrics, the market will eventually acquiesce and reward the stock. Below, we revisit these key points and why Q2’s strength in June is important to our thesis.
Our Thesis on FuboTV
First and foremost, we see live sports OTT as an investable trend as the live sports audience is the most coveted audience across media. According to a March 2021 press release, Fubo offers “42 of the top 50 Nielsen-ranked networks across sports, news and entertainment channels” plus more than 30,000 movies and TV shows on-demand. The company also has the exclusive rights to the South American Qatar World Cup 2022. In this case, the rights to Thursday night football being owned by Amazon pales in comparison to the 3.5 billion soccer fans globally that Fubo can capture with the World Cup. With live sports, investors must think big — including beyond the sports teams they personally watch.
We think investors who are overly concerned with the high and low season of sports is missing the bigger picture as to the potential Fubo has demonstrated in capturing this audience. The NBA playoffs likely increased viewership for Fubo in June. Fubo offered options for the Olympics, such as NBC, USA Network and the Olympic Channel. On that note, we see evidence in the app download data presented below that July continued to be strong, likely from the Tokyo Olympics.
Despite Fubo being centered in an important trend, the company’s negative gross margins are certainly a blemish in the financial reports. Our investment thesis allows Fubo time to execute on the product road map to improve its margins through sports betting. We covered this in-depth in our first Forbes article on Fubo when we maintained that by combining live sports viewership with free-to-play, and later sports betting, that Fubo will be in much better financial shape over time. In fact, we think the cross-sell between the programming and the betting will be key to Fubo taking a leadership position as more states open up betting.
On that point, we think DraftKings is the weaker of the two stocks as the company’s bottom line is worse than Fubo’s. It’s true that both companies have to figure out user acquisition; Fubo has chosen programming while DraftKings has chosen growth marketing. Wall Street has mistakenly priced DraftKings to be stronger because their line item for these costs is further down the income statement, when in fact, DraftKings spends more than Fubo for their audience and has worse operating margins. In this is (indeed) a market oversight, then there’s quite a bit of room in Fubo’s valuation.
Fubo’s earnings report will provide a better understanding of when the free-to-play and betting app will launch. The last earnings report indicated the app could be available as soon as Q4. We see some indication that Fubo is preparing for a successful launch, such as the market access agreement with Cordish Companies to open up sports betting for Fubo in Pennsylvania.
Review of Q2 Numbers
Despite the short seller reports that were published in December, Fubo has become one of the strongest tech companies post-Covid in terms of reporting blowout earnings in both Q4 2020 and Q1 2021. On May 11th, the company went on to report 105% year-over-year growth and 8% sequential growth for 590,430 MAUs with subscription revenue increasing 131% YoY to $107.1M. Net subscriber additions were approximately 43,000 versus a loss of 28,000 in the same quarter last year, which the company achieved while reducing sales and marketing as a percentage of revenue. Monthly ARPU increased 28% year-over-year and advertising ARPU was up 57%. Paid and trial users streamed more than 228 million hours, up 113% YoY. MAUs on average watched 129 hours per month, up 8% YoY.
This led to the company increasing its end-of-year subscriber guide to 830k – 850k, up 53% YoY at the midpoint and an increase from the prior guide of a 40% YoY rise.
The I/O Fund uses app data primarily to see if a company is trending up or down. We do not use app data to predict exact numbers. Please also note, Fubo reports audience size in terms of “Subscribers” while Apptopia tracks “DAUs” or “daily active users” and “Downloads.” Therefore, Apptopia provides an important glimpse as to the direction of Fubo’s growth trend, however, we are not making an earnings call on number of Subscribers.
As shown in the Chart below, Fubo’s DAUs were higher in June than in May, likely due to the NBA playoffs. Notably, Fubo’s DAUs continued to grow into July and August as a result of the Olympics, supporting the firm’s strong growth projections. With the NFL football season on the horizon, we would expect steady growth in year-over-year DAUs to continue into Q3 and Q4 2021.
According to Q2 data from Apptopia, Fubo’s download growth accelerated 235% YoY to 1.25 million downloads during Q2 2021, well above our initial calculation for Q2 published in Forbes of a 181% YoY growth rate back on May 12th, which at the time only included data from 46% of the Q2 quarter.
It is great to see that Fubo’s downloads accelerated in the back half of Q2 2021. The chart below illustrates how FUBO’s daily downloads have been trending up since the end of Q2 and into Q3. Unsurprisingly, DAU growth followed the growth in downloads, increasing 182% YoY (more on this below).
Source: Apptopia
Source: Apptopia
As shown in the chart above, Fubo will likely report a sequential decline in downloads in Q2, however, Q2 has historically been a weaker quarter for user growth due to the seasonality of sporting events. This assumption is supported by 2019 (pre-COVID) data, as Q2 2019 downloads also fell on a sequential basis. Importantly, Q2 2021 downloads only declined 8% QoQ, which is well above the Q2 2019 (pre-pandemic) sequential decline of 37%.
Daily active user (DAU) growth has followed a similar trend as downloads. Back in May, we had initially anticipated a 172% YOY growth rate in DAU by extrapolating Apptopia data. With more complete data on the quarter from Apptopia, we anticipate that DAU growth accelerated in the back half of the year, growing an estimated 182% YOY.
Source: Apptopia
Notably, Apptopia’s data shows a roughly 8% sequential decline while Fubo is guiding for slight sequential 2% growth. Apptopia does not track Roku numbers and this may be partly why there is a 10% gap. Roku owns 1/3 of the Connected TV market in the United States. The main takeaway from the data is that Fubo ended the quarter strong and performed well after management raised guidance. This is what we want to see from Fubo – growth year-over-year despite being a seasonally low quarter.
Therefore, we see the trend is up and this is the most pertinent takeaway. As noted, the expectation is not that these will be identical numbers between what Apptopia provides (DAU and Downloads) and Fubo’s Key Metric (Subscribers). Rather, we are using the app data going into earnings similar to checking a person’s vital signs. We like what we see, particularly in the June quarter, as Fubo continues to clear hurdles.
What if Fubo has a slight miss? We will remain with our position as we don’t expect perfection as this stage in tech growth. Instead, we are looking for exactly that(growth) and we see evidence for growth in Q2 and this growth continued into the first month of Q3.
As stated in the article, Beth Kindig and I/O Fund currently own shares of FUBO. This is not financial advice. Please consult with your financial advisor in regards to any stocks you buy.
Please note: The I/O Fund does not make earnings calls and we do not "play earnings." There are many things that can be reported to shake a stock beyond user growth. Gross margins, EPS miss, etc, will not be reflected by user growth alone. We pull data to reduce risk in positions we already own. We then share that information with our readers. Please consult your personal financial advisor before buying any stock.
