We recently added back Microsoft as a LTBH position and we are now adding Alphabet as our second FAANG. We understand our editorials are often behind paywalls on Forbes and Seeking Alpha, and so we have copied the article from April 28th below.
Article on GOOGL Begins Here:
If an investor were to believe market price action this week, it would appear Facebook had strong earnings while Alphabet stumbled. Yet, the opposite is true. Primarily, it was strength in retail ads that led to Alphabet reporting healthy growth of 23%. Meanwhile, Meta Platforms (Facebook) reported revenue growth of 9.7% and is guiding for roughly 0% growth from $28.5 billion in Q2 2021 to $29 billion, at the midpoint for Q2 2022. This analysis looks at why Alphabet is able to provide higher revenue guidance despite 80% of its revenue coming from ads while Facebook is guiding for flat growth.
Notably, Q2 is particularly hard because there are three heavy macro headwinds: supply chain issues, Ukraine-Russia situation, and the transition that Apple has forced with changes to attribution and measurement on iOS. When you add the one-time event of Covid, which plummeted ad spend in Q2 2020, only to lead to a surge in ad spend the following year Q2 2021, the hurdle to clear for revenue growth is at a historic high. We believe those ad-tech stocks that can show top line growth right now are providing important clues for when macro headwinds clear.
BACKGROUND:
The ad-tech industry remains in a whirlwind of changes following iOS privacy changes that limit third-party tracking on Apple mobile devices. I am hyper focused on identifying who the winners and losers will be following these changes, as it will determine who will lead ad-tech going forward. This issue is important because it impacts leading FAANG ad-tech companies, such as Facebook (Meta) and Google (Alphabet). Wall Street particularly likes ad-tech’s bottom line, and will aptly reward those stocks that can capture more ad spend.
In the below analysis, I review Google’s Q1 2022 results and focus on its ad platform (I am ignoring Google Cloud for now) and look for hints if Google is being impacted by the recent iOS changes. You’ll find that Google has held up well relative to other app-based advertising platforms, such as Facebook, following the changes to third-party identifiers. This is because Google has a first-party data advantage, which is critical during a time that attribution and measurement is limited by third parties. I explain why in more detail below.
Google’s Q1 Ad Growth Remains In-Line
While the market is still digesting the macro headwinds previously mentioned – supply chain and Ukraine-Russia; the third headwind of attribution and measurement changes is the headwind that investors should pay most attention to as it leads to a material change in story for ad-tech companies. Meanwhile, the other two headwinds will resolve in time.
Q1 earnings are provide valuable data of who is most and least impacted. Two critical data points will be Facebook’s and Google’s Q1 results, as most of their sales come from mobile ads. Google recently reported that sales grew 23% YoY to $68 billion, which were in-line with estimates.
Furthermore, Google’s Search business slightly outperformed and grew 24% YoY to $40 billion. This follows the outperformance in Q4 as Search sales grew 36% YoY in Q4 while total Q4 sales grew 32% on a year-over-year basis. It may appear that Alphabet’s search revenue is slowing from 30% in the year-ago quarter, but the deceleration in search revenue is due to the tough comps, and relative to Facebook, is outperforming.
The strength in Search highlights the advantage that having first-party data provides. This is because Search is primarily done on a browser, allowing Google to capture valuable first party data from ownership of Google Chrome, Google Search and also from Android OS. Moreover, Google is releasing new products, such as Topics API, which enables behavioral targeting. This is a direct shot at Meta Platforms, who is known to be quite competitive on behavioral targeting through taxonomies.
However, while Search remained strong, both YouTube and Google Network sales underperformed during the quarter. For instance, YouTube grew sales just 14% YoY to $7 billion, a steep slowdown from the 25% and 49% YoY growth rates from last quarter in Q4 and Q1 2021, respectively. Google Network sales increased 20% YoY to $8 billion. This also represented a deacceleration from the 26% YoY growth rate in the prior quarter.
In aggregate, total ad sales increased 22% YoY to $55 billion, a deacceleration from the 33% YoY growth rate in the prior quarter. It is notable that despite the headwinds in YouTube and Google Network, Google’s sales vastly outpaced Facebook’s Q1 revenue growth. As shown below, Google’s ad sales grew nearly 3x faster than Facebook’s 7% growth.
I believe this outperformance was driven by Google’s first-party data advantage. Moreover, YouTube revenue was the biggest laggard during the quarter and YouTube sales grew 14% YoY to $7 billion during the last three-months (fun fact: YouTube is larger than Google Cloud). The slowdown in YouTube may suggest that ads have been impacted by iOS changes, but its important to consider that YouTube grew sales 49% YoY in the year-ago quarter, leading to a tougher comparable base period.
During the Q1 call, Google’s management team explained that the tough comp and “modest” growth from direct response advertising had also impacted the segment, but noted that brand advertising remained an area of strength. The diversification across content types and ability to offer at true omnichannel strategy across mobile, browsers and CTV likely contributed and suggests that brands have shifted ad budgets to YouTube, likely due to its ability to measure ROI at the expense of competing platforms.
Google also reiterated this point during their Q1 Conference Call when CBO Philipp Schindler explained that being able to fully measure what users do after they click on an ad is critical to measuring ROI. He added that “Measurement is also obviously a key component to success [in CTV], and we want to make sure that advertisers can fully measure their YouTube CTV video investments across YouTube and YouTube TV for an accurate view of true incremental reach and frequency and so on.”
CBO Schindler’s comments highlight the importance of measurement, a key aspect of digital advertising that has been challenged following the changes to iOS cookies. If advertisers cannot measure ROI, they tend to limit their ad expenditures, so its critical that ad platforms find solutions to measure ROI in order to sustain growth.
Perhaps the most important comment during the Q1 Conference Call was a statement by management that Google continues to see strength in Retail, reiterating comments made during the Q4 2021 Earnings Call that retail (e-commerce) continues to be strong.
This brief statement is very important, as it adds support that Google will not be as impacted by the iOS changes. Given the signal loss from iOS changes, e-commerce has been one of the hardest hit verticals. Google’s strength here is likely due to its first-party data advantage.
Here is what Facebook CFO David Wehner said about Google’s strength in the retail vertical during Facebook’s Q4 2021 Conference Call:
“e-commerce was an area where we saw a meaningful slowdown in growth in Q4. … But on e-commerce, it's quite noticeable — notable that Google called out, seeing strength in that very same vertical. And so given that we know that e-commerce is one of the most impacted verticals from iOS restrictions, it makes sense that those restrictions are probably part of the explanation for the difference between what they were seeing and what we were seeing.”And so given that we know that e-commerce is one of the most impacted verticals from iOS restrictions, it makes sense that those restrictions are probably part of the explanation for the difference between what they were seeing and what we were seeing.”
Google’s statement that it continues to see strength in retail suggests that it is not as impacted from the iOS changes relative to app-based peers such as Facebook. Importantly, Search is often based on a web browser (Google Chrome), allowing Google to capture first party data and limiting the signal loss from the removal of cookies on mobile based apps.
Our thesis is that in this new cookie-less world, owners of first-party data will outperform going forward. We expect that Google will remain strong given its ownership of first-party data on both its Search platform and also its YouTube platform. However, Facebook will likely continue to struggle here due to its reliance on third-party data and not owning “the real estate,” or essentially the device and/or operating system while needing to collect data from this device in order to support its high ARPU.
Conclusion
Notably, Q2 is particularly hard because there are three heavy macro headwinds: supply chain issues, Ukraine-Russia situation, and the transition that Apple has forced with changes to attribution and measurement on iOS. When you add that the one-time event of Covid, which plummeted ad spend in Q2 2020, and later led to a surge in ad spend the following year Q2 2021, the hurdle to clear for revenue growth is at a historic high. We believe those ad-tech stocks that can show top line growth right now are providing important clues for when macro headwinds clear.
Maintaining focus can be really tough when the market is penalizing tech stocks across the board. How do we determine which ones to trim/exit and which ones to add/enter? Despite it being counterintuitive, usually the best entries are made when the market is in a state of fear.
My first instinct is to protect our stocks with the highest allocations with a few of these certainly in the cloud category. I am less concerned with near-term price action and much more concerned with how the fundamentals mesh with the current macro environment. If a company has a strong report (AMD, Datadog) then I don’t stress market moves as fundamentally these companies are showing strength. It’s not an investor’s job to control the market or change positions based on 6-month price action. That’s why we haven’t changed positions such as AMD or Datadog. I’m using them as an example because they already reported.
The I/O Fund is positioned for an ad-tech rebound in H2. We’ve published quite a bit on this. We understand this requires a bit of speculation and we have been keeping our members up to date on this over the past few months with this research here and here. Ultimately, ad-tech valuations are well below the median in 2018 and 2019.
Strong growth in ad-tech is often awarded a 10 Forward EV to Revenues. The bottom line can fluctuate depending on how much a company is investing in growth, yet rarely does ad-tech have cash flow issues at scale. Snap and Roku are certainly at the scale where the path to profitability has been proven. Ultimately, we believe there is alpha here due to the market over-reacting to macro which is why we own ad-tech positions. There are many more ad-tech positions than the ones we own for investors to consider.
This analysis goes over cloud as what happened last Friday to Bill and Cloudflare caused me to shelf a deep dive on ad-tech post-earnings in favor of a cloud overview of our holdings. Many cloud companies have not been public during a rising rate environment (2017- early 2019). With the FOMC decisions being out of a tech investor's control, we have been forced to evaluate our cloud stocks to look for expanding margins and positive cash flow. There was some evidence last week that the market’s appetite for growth in this category has changed if the growth doesn’t contribute to the bottom line. I understand there is a relief rally today but my job this week has been to make sure fundamentally our cloud stocks can withstand macro pressure.
It’s true that cloud is deflationary but it’s also true that cloud can have profitability issues. As you saw last Friday, cloud is quite resilient in terms of growth, due to being deflationary, but those weak bottom lines may be questioned over time. Cash came easy over the past decade, and as cloud investors, we need to reframe our thinking on what constitutes an attractive cloud stock.
For long-term cloud investors that hold sizable allocations, like the I/O Fund does, I believe the following has to be answered:
1. Is there something inherent to the product that weighs on margins? If so, these companies have an additional hurdle beyond rising rates that must be resolved.
Cloudflare could fall into this category due to CapEx (something to monitor – we closed this position for now). The CapEx went from 9% in the current quarter to 12% to 14% for the year, and the market is likely assessing the cost it requires to become the fourth cloud provider.
Twilio falls into this category until Segment and other products can improve its core product gross margin (I believe it will and we will layer back in when it does). I expand on this more below.
2. GAAP operating margin versus Non-GAAP operating margin; this is where stock based compensation can affect a company’s GAAP profitability and companies that recently went public or had an acquisition often see an impact. There are also many cloud companies that invest their cash to grow rapidly, yet the leniency for “growth at any cost” may shift substantially.
3. Free cash flow is probably the most important in a rising rate environment for a sector that is often unprofitable and/or must spend heavily for growth. Below, we examine our top cloud holdings on the basis of their ability to become free cash flow positive.We need to recognize that the innovation cycle is such that venture capitalists exit through public offerings and there is often no path to profitability at the time a tech companies goes public. When you couple the historically loose FED policy we’ve had, it compounds the issue of figuring out which companies can become profitable and sustain in a slowing economy. Cloud will be put to the test the longer interest rates remain elevated and/or slated to rise, and I believe this will catch tech investors off guard because the sector has treated them so well. These relief rallies also do not help to distinguish which are fundamentally stronger as the price action reflects more of a rising of all boats.
Our Cloud Stocks
SentinelOne
SentinelOne is a company where we like the product very much. However, there is no denying that this company has weak margins albeit the margins are improving quite rapidly.
SentinelOne leads the cloud category in growth at 120% last quarter. In the previous quarter, SentinelOne accelerated to 128%, up from 121%. The company is expected to report $74.7 million in revenue for growth of 99.5%, assuming they come in at this number, that would be a deceleration in revenue.
Full year revenue is expected to be $370 million, up 80%. The 1-year forward for fiscal year 2024 ending in January is expected to be $605 million, up 64%. The main key metric that forecasts strong revenue growth is that ARR was up 123% year-over-year. This is a highlight from the last earnings report.
SentinelOne has a particularly weak operating margin of (108%) last quarter. The adjusted operating margin was at (66%) compared to (104%). The management guided for (85%) this quarter. The company emphasized this is improving with a full year adjusted operating margin guide of (55%) to (60%) for full year.
I believe this improvement in the guide is why the stock recovered after hours the evening of its earnings report. Will SentinelOne be able to provide a meet/beat on operating margin in the upcoming quarter and a meet/beat for the full year guide? This must happen and we also need revenue to remain strong.
We covered here in the Q2 2022 webinar how cybersecurity budgets are indicated to grow this year over 2021.
Management seemed to be quite sensitive to understanding this is key as it was the second thing they mentioned in the opening remarks:
I'm pleased to share that we ended the fourth quarter with double-digit year-over-year improvement in both our gross and operating margins. Our gross margins expanded 12 percentage points year-over-year, and our operating margin improved 38%. This progress reflects our growing scale and increasing efficiency.
The number of shares owned by institutions and the percentage of shares owned by institutions is also high at 92% (compared to Cloudflare at 80%). However, the number of institutions has declined by about 13%.
For SentinelOne, weighing on operating margin is also sales and marketing expenses at 64% of revenue and R&D at 65% of revenue. Compare this to Crowdstrike with S&M at 38% of revenue and R&D at 24% of revenue. To be clear, Crowdstrike has a better bottom line than SentinelOne. The operating margin has been at (10%) over the past few quarters and is at (5%) in the most recent quarter.
SentinelOne’s free cash flow has been improving but certainly needs work, which is common for a company that has not reached scale. The company reports cash flow of ($7.1) million improving from ($25.6) million in the same period last year.
SentinelOne has $1.67B in cash and the company burns about $400M so that’s three years. If we assume the margins improve, and the company reaches profitability by 2025 (analyst consensus believes this will happen) then the negative free cash flow should not hinder the stock. We had discussed why SentinelOne is similar to Crowdstrike at this stage of growth here.
Notably, last year, SentinelOne was weakest in Q1 and they’ve mentioned strong seasonality in Q4.
“The strength of our performance was broad-based, coming from a healthy mix of new customer additions, existing customer renewals and upsells. All of this was further magnified by the strong underlying seasonality of our fourth quarter.”All of this was further magnified by the strong underlying seasonality of our fourth quarter.”
Here was their comment about the upcoming Q1 quarter:
“Our ARR and revenue growth track very closely. Our revenue guidance for Q1 implies that we should be at or better than typical Q1 net new ARR seasonality, which has been down between 25% to 35% sequentially in the past 2 years.”
Here was our comment about Q1 following the last earnings report:
“Total ARR is nearing $300 million while annual revenue for the upcoming fiscal year 2023 is guided at $368 million, with ARR suggesting this guide could be easily met over the next four quarters. Most importantly, customers over the $100K range are growing at a rate that is double overall customer growth at 137% and 70%, respectively.
The overall customer growth represents a slowdown from 79% YoY to 70% YoY while larger account growth was fairly flat at 141% in Q3 to 137% in Q4.
The company guided for Q1 revenue of $74.5 million, compared to revenue in Q4 of $65.6 million. This is important because management has stated in the past, Q1 revenue was down sequentially by 20% to 25%. “Our revenue guidance for Q1 implies that we should be at or better than typical Q1 net new ARR seasonality, which has been down between 25% to 35% sequentially in the past 2 years.”
Notably, the I/O Fund is unable to track where the ARR was down “for the past 2 years” but the sequential growth is headed in the right direction. The numbers we have show Q1 FY2021, net new ARR declined 37% QoQ to $8 million yet in Q1 FY2022 it grew +8% QoQ to $30 million. This year, the sequential growth will be +13.5%.
Higher ARR sequentially for the upcoming Q1 is likely driven by the record number of 100,000-plus deal and a record number of million-dollar plus deals. International is another area of strength as the company saw revenue grow 140%. This represents 31% of revenue – so something to watch closely as a near-term driver.”
Takeaway: No changes to our position right now, if there is a meaningful change to operating margin, we will update you.
MongoDB
MongoDB had an acceleration in revenue from 50.1% in Q3 to 55.85% in Q4. The market rewarded this earnings report with an increase in price, moving from $280 to $338 on the report. At the beginning of April, the stock price was nearly flat YTD.
There was an acceleration in revenue for FY2022 to 48% year-over-year, up from 40% growth in FY2021. Looking forward, FY2023 revenue growth is expected to be 35% year-over-year.
Key metrics supporting future revenue growth include customers over $1 million in ARR growing 67% and customers over $100,000 growing 34%. Atlas customers outpaced total customer growth at 35% compared to 33% growth, respectively.
MongoDB has a 72% gross margin and GAAP operating margin of (29%) due to stock-based compensation, or a loss of $78.6 million. The adjusted operating margin is (0.49%) or essentially a loss of $1.3 million. The net margin is (32%) or a loss of $84.4 million with adjusted net margin of (2%), or a loss of $6.3 million.
With that said, MongoDB is cash flow positive. It needs to remain cash flow positive for the market to be confident in its valuation. I do believe where Cloudflare was penalized was the surprise to the downside in cash flow. This is a marked change to how the market treated cloud companies in the past.
MongoDB has $474 million cash on its balance sheet with operating cash flow of $22.3 million and free cash flow of $16.8 million. This represents a free cash flow margin of positive +6%. The company holds $1.2 billion in debt.
The difference between MongoDB’s GAAP EPS and Non-GAAP EPS is primarily due to SBC. Here we have a forward GAAP EPS of ($1.22) and Adjusted EPS of ($0.10). Overall, MongoDB has improved it’s adjusted EPS as it was typically in the ($0.20) range.
MongoDB’s catalyst for growth is Atlas, which we covered in a deep dive here. We also covered how this company fits into our Big Data and Analytics positioning here. We are more likely to hold a cloud stock that falls into the Big Data theme and/or cybersecurity due to seeing evidence of growth in these markets. Primarily, Microsoft pointed towards the following trends in the recent earnings report, which we covered here:
Starting in September, we began to position for Big Data, Analytics and ML. Microsoft has grown their Cosmos database (DB) transactions and data volume by 100% year-over-year for the third quarter in a row. Synapse data volume has also doubled. Monthly machine learning inference requests increased 86% year-over-year. for Big Data, Analytics and ML. Microsoft has grown their Cosmos database (DB) transactions and data volume by 100% year-over-year for the third quarter in a row. Synapse data volume has also doubled. Monthly machine learning inference requests increased 86% year-over-year.
As stated above, MongoDB’s cash flow margin is what can keep the stock strong given stock based compensation is weighing on GAAP operating margin. We want a meet/beat on revenue, strong Atlas growth (bonus for acceleration) and we must continue to have a healthy, positive cash flow margin.
Analyst consensus has MongoDB reaching profitability on an adjusted basis by calendar year 2023.
Snowflake
Snowflake is seeing a deceleration in revenue yet is reaching adjusted profitability this year.
The company is expected to report revenue of $412 million, representing growth of 80%. The previous quarters the company reported revenue growth of 101% in Q4, 109% in Q3, and 104% in Q2. For the fiscal year 2023 ending in January, the company is expecting revenue growth of 67% for revenue of $2.03 billion. Analyst consensus shows revenue of $3.17 billion, or growth of 56% for fiscal year 2024.
There has been an outflow of institutional shares since December with a 30-day change from 330 million shares to 305 million shares.
As Snowflake continues to grow revenue, the losses are narrowing. When the company reported roughly $300 million revenue, the GAAP operating losses were around $200 million. The company is now reporting a little over $400 million in revenue with GAAP operating losses of about $150 million. What you don’t want in this environment is an inverse relationship to where losses increase as revenue increases.
Snowflake is steadily improving its margins from 58% gross margin a year ago to 65% gross margin in the recent quarter. The company has improved its GAAP operating margin from (90%) a year ago to (40%) in the recent quarter. The company has a positive adjusted operating margin of 5% and has stated they will end the year with a positive 1% adjusted operating margin. They have to deliver on this promise to maintain a category-high valuation.
Revenue grew 64% to $126 million and customers over $100K grew 41%. Analyst consensus on revenue was for $127.4 million. The company reported EPS of (0.19) and analysts were looking for (0.20).
However, free cash flow for Confluent is a blemish at ($58.4) million, or 46% of revenue. Adjusted operating margins are at (41%) and GAAP operating losses of (88.4%). Adjusted gross margin is 69.7% with employee bonuses and employee stock purchase plans hurting the operating margin. FCF is to be the lowest in Q1.
Confluent has cash and marketable securities of $2.0 billion with cash of $1.05 billion.
Adjusted operating margin is expected to be (38%) on revenue growth of 44% for FY 2022.
We all know how the market feels about those margins right now – Confluent was not alone in the AH bloodbath.
On a positive note, Confluent Cloud is ripping at 180% YoY growth. This has led to RPO accelerating to 96% YoY. The company signed an 8-figure deal that was not recognized in Q1. Cloud net retention rate is 150%.
Analysts on the call were excited about the net new add in customers and the company reiterated its goal of positive FY2023 operating margin.
Note: We believe the negative free cash flow margin is too steep for Confluent to be a high conviction company at this time. We very much like the Confluent Cloud growth and will look for the more normalized growth rate once it scales. If Knox asked me where to raise cash in cloud, I would choose Confluent although we do not have all earnings reports yet.
Datadog was down after putting up a solid report and we bought a small tranche following the earnings report.
The company beat and raised on all accounts. Customers over $100K grew were up 54%, growing from 80% of revenue to 85% of revenue. The company also said the magic words: “36% free cash flow margin” in Q1 with a TTM cash flow margin of 28%. Free cash flow (FCF) grew from $250 million in Q4 to $335 million in Q1.
The company was expected to report 70% revenue growth and instead reported 83%, with revenue up 11% sequentially. Guidance also impressed at $378 million at the midpoint, or 62% growth. That should be enough to keep Datadog in the top 5 on forward growth in the cloud category. FY2022 guidance raised to $1.61 billion for growth of 56.4% at the midpoint, up from $1.53 billion.
They said the other magic words which is that “dollar based net retention rate continued to be over 130% as customers increased their usage and adopted newer products.” During covid, this DBNRR wouldn’t be as meaningful as many cloud companies were at the 130 mark but Datadog proving itself best-of-breed here by maintaining this level for 19 consecutive quarters.
Datadog’s strength is cross-selling or standardization, which we’ve covered in detail. Number of customers using 2 or more products increased to 81%. The company signed its largest contract in terms of ARR (they said it was 8-figures with a next-gen fintech company). There were examples on the call of customers consolidating monitoring tools from 5 products to 10, and from 1 product to 6.
Notably, on top of accelerating revenue growth YoY from 51% in Q1 last year to 83% in Q1 this year, Datadog also improved operating margin from 10% to 23% in the current quarter.
Note: Datadog is the strongest cloud company on the market if you look at the relationship between the top line and the bottom line.
Twilio
We covered Twilio pre-earnings here and also post-earnings here on the forum. We ultimately trimmed our position due to the reason stated post-earnings: “Analysts asked if increased costs in core product could affect gross margin and/or user fall-off. This comment is probably the most concerning to me. Lots of questions on Gross Margin, which the main concern being any fluctuations here if there's pricing pressure from telcos.”
Ultimately, we will layer back into Twilio when we see the software business help to sustain the gross margin.
Here is what was asked on the call:
Michael TurrinMichael Turrin
Gross margin saw a meaningful improvement sequentially. The prepared remarks still referenced just some near-term fluctuation potential. Just in sort of adding some more context around that. I guess the question is just why wouldn't that be at least somewhat bottoming if we're looking at sort of a point in time where U.S. growth is moderating? Some of these 10DLC impacts are playing through. Are you at all comfortable that gross margin can at least remain around a similar ZIP code regardless of our messaging mix plays through? Or anything else you could just provide to help us think through normalization of what these fluctuations can look like?. I guess the question is just why wouldn't that be at least somewhat bottoming if we're looking at sort of a point in time where U.S. growth is moderating? Some of these 10DLC impacts are playing through. Are you at all comfortable that gross margin can at least remain around a similar ZIP code regardless of our messaging mix plays through? Or anything else you could just provide to help us think through normalization of what these fluctuations can look like?
Khozema ShipchandlerKhozema Shipchandler
Yes. That's a good question. I mean I think with respect to the gross margins in Q1, we are obviously happy with them improving to 53%. I think, Michael, the thing I'd encourage you to keep in mind is that just the size and scale of our messaging business is what tends to drive it. And so that's why we're kind of signaling some level of fluctuation in gross margins in the near term. I think it'll be in the ZIP code. I mean I'm not going to be prepared to call the bottom or anything like that. But I'd also remind you that we like the messaging business a lot. And while it does carry that lower gross margin, it also generates a lot of gross profits that we reinvest back into the business.And so that's why we're kind of signaling some level of fluctuation in gross margins in the near term. I think it'll be in the ZIP code. I mean I'm not going to be prepared to call the bottom or anything like that. But I'd also remind you that we like the messaging business a lot. And while it does carry that lower gross margin, it also generates a lot of gross profits that we reinvest back into the business.
If you go back to Q1 of 2020, Twilio’s growth rate in customers was about 23.5% from 190K customers to 235K customers. The most recent year-over-year growth was 14% from 235K customers to 268K customers. The company does not break out the growth rate but the presentations provide number of customers. This would imply some churn due to increased fees passed onto customers on the core product.
In terms of margins, the company guidance missed expectations at adjusted EPS of ($0.23) to ($0.20) compared to consensus of ($0.13). The forward growth of 27%-29% is to be expected during this pivot. I want to emphasize the management has been preparing for the core product to hit saturation essentially which is why we want to remain invested to participate in this management team bringing API-driven marketing to marketing departments. Twilio certainly is consumer-facing and thus what we are seeing with ad-tech affects Twilio, as well. This is unique from more deflationary cloud products at the enterprise-level.
Cloudflare
We covered Cloudflare this week for the free newsletter, which will hit your inboxes soon. The stock hit our stop and here is the main thing that drove our decision on fundamentals.
At the time the low-cost R2 cloud storage service was launched, Cloudflare’s CEO has stated “we’re aiming to become the fourth major public cloud.” Big Tech has the advantage of strong margins and quite a bit of cash on the balance sheet to build out cloud infrastructure. For this ambition to materialize, not only must Cloudflare build more Points of Presence (PoPs) but the company must also undercut AWS on egress fees, for example, in order to remain competitive.
In the current quarter, network capex was 9% of revenue. For the full year, the network capex is expected to increase to 12% to 14% of revenue. I believe this is a primary reason Cloudflare’s valuation could come under pressure.
Here is what the company said on the call:
I think the thing which is powerful about as we build out more POPs is that counterintuitively, because of the design of our network and because of the efficiency of our network that both Thomas and I just alluded to, it actually drives our cost down over time rather than driving it up. It takes a certain amount of servers in order to process a certain number of requests. So your CapEx is actually driven by the amount of usage of your service more than anything else.
What is powerful is because we have done the hard work on the networking and software side to make it so that any server, anywhere can handle any request, that means that as we continue to expand our network out that we're able to directly interconnect with the various ISPs and eyeball networks around the world and drive our cost down for things like bandwidth, co-location and other variable costs that are part of our business.
At this time, revenue growth is not an issue for Cloudflare as it’s been quite robust for many quarters. The company reported 54% revenue growth beating estimates by 6% with 49% growth expected next quarter. The company raised full year revenue guidance to $957 million, at the mid-range, for growth of 46%.
There is additional supporting evidence that growth is not an issue for Cloudflare, including remaining performance obligations (RPO) up 57% year-over-year and dollar based net retention up 400 bps YoY. Customers paying over $100K increased 63% year-over-year to 1,537. This outpaced total customer growth of 29%. Notably, the >$100K segment was a deceleration from 71% in the previous two quarters.
Large customers contributed 58% of revenue. There was solid growth in the >$500K customer base of 68% year-over-year growth and >$1 million customer base grew by 72% year-over-year.
The company has a gross margin of 77.80% but had a GAAP operating margin of (18.90%) and adjusted operating margin of 2.30%. The primary difference being stock based compensation which doubled to $34 million in Q1, up from $18 million in the year-ago quarter. The market has not been very friendly to companies diluting GAAP operating margins due to SBC, and we see evidence this may have impacted Cloudflare.
Similar to the note about network capex, the company is stating they will not see improvement to operating margin in the near term. I believe this could put pressure on valuation if cloud peers are able to improve operating margin during the current macro environment.
Here is what management said:
“We intend to grow our operating expenses in line with the revenue staying here or at breakeven and reinvest excess profitability back into the business to address the enormous opportunity in front of us.”We intend to grow our operating expenses in line with the revenue staying here or at breakeven and reinvest excess profitability back into the business to address the enormous opportunity in front of us.”
Free cash flow was negative $64.4 million (30% of revenue) in comparison to a negative $2.2 million (2% of revenue) in Q1 2021. Of this, $30 million was due to a unique withholding tax payment in the recent quarter. This would still show a marked decline in free cash flow from last quarter during a time when the market is especially sensitive to cash flows. The company reported positive free cash flow of $8.6 million in Q4 2021, and it was the first positive free cash flow quarter since the company became a public company. Management stated they will be cash flow positive in the second half of the year while the first half of the year will have negative free cash flow due to the investment in network and redesigning of physical offices post Covid-19.
The company had cash and available-for-sale securities of about $1.7 billion, out of which cash is $152 million.
Clearly, many investors like Cloudflare and the company is not without merit by any means. Rather, I can’t rely on cash flow improving in H2 and/or CapEx not rising beyond the current 12% to 14% to personally maintain conviction in the current environment.
For costs inherent to the product, my personal choice is Twilio as I can see the product road map a bit more clearly on Segment/software side and how this can expand the company’s gross margin.
Asana
Please note, Asana is a small 1% position and we covered the company’s financials here and the unexpected rise in expenses. We will update you on the next earnings report. We hold the stock because the product should be deflationary (more than most).
We are eyeing a LTBH position for Microsoft. As many of you remember, we’ve owned Microsoft in the past following a spree of analysis published in 2018-2019.
In our latest Q2 webinar, I discussed why reducing cloud costs is a key trend for 2022 and beyond. Most investors on our site agree that cloud is a critical trend to have in a portfolio as it increases productivity and reduces costs. This is especially true for software-as-a-service whereas cloud infrastructure as-a-service does not always result in lower costs compared to on-premise servers.
The overall cost savings and/or overhead can often rely on the size of company, where it’s a no-brainer for startups to rent servers as they don’t have the budget to own servers and manage an IT department. However, we’ve pointed out in an analysis and on our webinar that companies of Dropbox, Asana or Datadog’s size are seeing a hit to their margins. If you add up the cloud infrastructure, platforms and software costs across a company, it can often become costly to manage and deploy a full cloud stack.
To put it simply, Sayta Nadella said in yesterday’s call: “More value for less price means you win.” In the same breath, he also said: “Most businesses are not looking to their IT budgets or to digital transformation for budget cuts.” These two statements echo my first point in the webinar which is that both are true: increase in cloud spending and wanting to lower costs. This is differentiated from budget cuts, such as headcount. Most importantly, our slides showed that despite Gartner’s forecast for 2020-2021 shifting by $100 billion to what became actual spend (or essentially a pull forward). Pull forward might not be the right term, however, as cloud growth is not slowing down as a result, instead it’s predicted to be a tick higher from 2019 to 2022, if we remove the anomalous 2020-2021.
Therefore, we wanted to emphasize that the trend towards reducing costs should not be confused as being prohibitive to the trend for cloud adoption, rather, it can offer investors an edge if they identify what companies serve both needs.
As you can see from our portfolio, we are best-of-breed investors and I do not believe Microsoft is a best-of-breed company, rather they aggregate cloud services to help drive down costs. This is especially attractive for the Fortune 500 whereas startups, SMBs and mid-sized enterprises are likely to seek out and manage a larger portfolio of cloud services from various vendors. We can easily evidence this by Microsoft’s Fortune 500 penetration with 95% using Azure, which was achieved through hybrid computing where Microsoft was first-to-market on serving a mix of on-premise, private and public clouds for their large enterprise customers. Secondly, as this analysis is about, Microsoft is undercutting other services on price to win the aggregate, long-term contract.
Microsoft is using the term Tier 1 workloads to not exclude those outside of the Fortune 500, and the company stated the following in terms of deal size: “The number of $100 million-plus Azure deals more than doubled year-over-year. “
As stated on the I/O Fund Wire, Azure growth of 46% is performing quite well given the tough comps it has overcome, and Microsoft’s best financial metric during this tech selloff is that commercial bookings increased 28% this quarter following 32% increase last quarter. I would look for Azure to remain elevated against AWS and Google Cloud for those two reasons – hybrid cloud leader which attracts large enterprises and its ability to reduce costs with its tech stack.
Despite overall revenue softening from 20% to 18%, Azure remained flat at 46%. This is quite remarkable considering Azure has overcome incredible growth over the past two years. Operating income was up 19% and EPS up 9%. The lower overall revenue guide is driven by gaming and Office 365, both expected to be lower by single digits. Azure growth is also guided to be sequentially lower yet Intelligent Cloud is a stronger-than-expected guide at $21.1 billion and $21.3 billion. This is what is meant by the analyst on the call when they stated: “
Starting in September, we began to position for Big Data, Analytics and ML. Microsoft has grown their Cosmos database (DB) transactions and data volume by 100% year-over-year for the third quarter in a row. Synapse data volume has also doubled. Monthly machine learning inference requests increased 86% year-over-year. Takeaway: Let’s hope this translates well for our larger holdings MDB and SNOW, and our placeholder on CFLT. This was also covered in the Q2 2022 webinar.
According to our research, cybersecurity is the top tech vertical for increased spending from 2021 to 2022. Microsoft is increasingly becoming a cybersecurity company, as well, with $15 billion in revenue and growing at a rate of 45%. Microsoft was careful to build a multi-cloud product and is the only Big 3 cloud vendor to be multi-cloud on security right now.
On a side note, not only does Datadog, SentinelOne and Cloudflare participate in cybersecurity here but they also reduce costs through standardization and/or eliminating object storage fees.
Catalysts
There are a few reasons Microsoft can continue to do well, in addition to its proven strategy to onboard large enterprises and lock them in by optimizing workloads for Azure and its broader suite of cloud platforms and services. The first reason is that I believe Microsoft will own the edge. The company is closely partnered with many telecoms and has the most data centers in the world. Another reason is that when more enterprises adopt AI/ML, whether it’s automation, super computers and/or other use cases for training and inference, it will a natural decision to use Microsoft if they’re already optimized for Azure. In other words, Tier 1/Fortune 500 are likely to be the largest customers for AI/ML. Power Automate was up 72% year-over-year, surpassing $2 billion in revenue, although not vendor agnostic like UiPath. Third, the company ranks with Nvidia and Unity for inroads to the Metaverse as it owns many gaming publishers now and is the most widely used VR headset (HoloLens). The company also has Teams to introduce Metaverse-like qualities to business meetings. It will be industrial that drives forward 3D worlds (not consumer) and Microsoft is auspiciously positioned.
These catalysts matter a little less when macro is so tough but worth mentioning as to why investors should look beyond Azure growth when it comes to Microsoft.
This article was originally published on Forbes on Apr 7, 2022,11:53pm EDTForbes on Apr 7, 2022,11:53pm EDT
Last week, we discussed signs of improvement at key automotive semiconductor suppliers and why this was affecting ad-tech stocks. Supply chain issues are causing a ripple effect due to automotive being a significant category of ad spend and due to low inventory, advertising budgets are being slashed. As stated in last week’s analysis, our expectation is that supply issues will ease by Q3 causing both automotive and ad-tech to rebound.
Specifically, it’s the extremes of seeing a $300 billion drawdown in inventories in Q2 2020 followed by the largest increase on record of inventory levels in Q4 2021. We believe this sharp rebound helps highlight that production is catching back up with demand.
Supply Chain Impact to Roku Stock and Ad-tech Going Forward
Below, we discuss why Roku stock could be set to rebound when supply chain issues begin to ease due to extreme oversold conditions based on transient headwinds. We also discuss more in depth the supply chain rebound we are forecasting for some time around the second half of 2022.
Source: U.S. Bureau of Economic Analysis (I/O Fund)
While supply chain constraints are expected to remain tight in 2022, there are numerous signs that the bottom is in. For instance, aggregate inventories rebounded strongly in Q4 2021 and have made up most of the decline from production halts during Q2 2020. Moreover, inventories relative to aggregate sales are at multi-year highs. The rebound in aggregate inventories suggests that supply chain constraints are normalizing for the broader economy.
Connected-TV (CTV) is particularly exposed to automotive advertising budgets, and a rebound in automotive inventories will be a tailwind for CTV ad-tech companies such as Roku. Automotive ad spend was just 15% of its pre-pandemic levels, largely due to the shortage of automotive inventories.
During the Q4 earnings call (02/17/22), Roku’s management explained how automotive was ‘soft’ during the quarter, yet they expect this to be a temporary trend. Roku CFO Steve Louden made a good point during the Q4 call, stating that automotive manufacturers are much stronger today than they were at the start of the pandemic, meaning that these brands have increased capacity to market their brands going forward.
For instance, if the top two automotive ad spenders (Volkswagen and Toyota) grow their topline by the midpoint of their respective guides and if their sales and marketing margins normalize to pre-pandemic levels, then aggregate ad spending could rise by about ~25% YoY in 2022, up from the ~6% YoY rise in 2021. Rising ad spend from these two leading manufacturers will likely spur marketing investments from peers.
Despite lower growth in Q1, Roku reiterated full year 2022 growth in the mid-30s. Going into the report, analysts were expecting 36% annual growth. The ad platform missed analyst expectations at $703 million compared to $732 million expected.
EBITDA was a miss with company guiding for $55 million compared to the consensus for $79 million in the upcoming Q1 quarter. The company plans to spend $1 billion on operations, which translates to investments in headcount, The Roku Channel (which is producing originals), and the Roku TV program (which means growing operating system market share).
The $1 billion in expenses is not overly concerning although it’s certainly an adjustment in expectations as the Street may have believed that Roku’s earnings were quickly scaling, but this was impacted by a slowdown in expenses during covid, and now those expenses need to ramp in the upcoming year to remain competitive.
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I/O Fund Financial Analyst Bradley Cipriano stated in a research note to our clients that Netflix's operating expenses ramped nearly $1 billion YoY when it passed $3 billion in revenues in 2011, which Roku is nearing. Viewed differently, the expected revenue growth in FY2022 of $830 million will be accompanied by a $1 billion rise in expenses, meaning that each $1 of expenses will drive just $0.76 of revenue, which is the lowest value in Roku's history. This suggests that growth is much more expensive than in prior years.
However, this is likely due to the slowdown in investments made during 2020 and 2021, and the three-year average for the above metric is 1.08x (including FY2022), meaning that each $1 of expenses resulted in $1.08 in revenues. This is above the prior three-year average of 1.04x (2019-2017), highlighting that over a longer time frame, Roku is in fact demonstrating leverage, albeit it is lumpy. FY2021 and FY2022 also includes the Player gross loss headwind that wasn't the case in prior years, and adjusting for this, the three-year average would be even higher. The takeaway is that the rise in expenses seems in-line with historical trends once we account for COVID.
The lower EPS this year is a headwind to the company's valuation, but it is expected to be profitable in FY2023. The company should be cashflow positive in FY2022 and with $2.1 billion in cash on balance, likely should not need to dilute shareholders despite the losses. There is also some leverage to improve earnings as there were $82m in one-time expenses during the most recent year.
If we widen our view, we will see that 2020 was the first year Roku was EBITDA positive and the company is expected to remain EBITDA positive this year. Most importantly, Roku has leverage with a gross profit of $1.4 billion and they are choosing to spend for top line growth.
Overall, Roku is a more complex product story because the strategy is to conquer from many angles. It’s an ad exchange, it’s a content channel, it’s an operating system and it’s a hardware player. It also owns the best first-party data available on CTV ads and I tend to stick with the data in terms of ad-tech. So, that’s primarily the reason we own Roku and continue to own Roku.
Regarding Roku’s recent price action, we look for dislocations within the markets and we believe transitory supply chain issues have caused the dislocation seen below in Roku’s valuation and its forward estimates. Most of tech has seen a dislocation between January-March, although Roku’s dislocation is particularly steep.
Regarding Roku’s recent price action, we look for dislocations within the markets and we believe transitory supply chain issues have caused the dislocation seen below in Roku’s valuation and its forward estimates. Most of tech has seen a dislocation between January-March, although Roku’s dislocation is particularly steep. (I/O Fund)
What is most striking about the divergence above is that the current selloff has provided a much cheaper stock than during the pandemic when many businesses were shut down entirely and ad budgets halted.
Despite strong growth estimates in the second half of the year, the forward PS on Roku reached 4x, which we consider to be extreme to the downside. We took this opportunity to begin building up Roku and other key ad-tech allocations. We also believe that Q4 2021 will likely represent a ‘bottom’ in automotive supply constraints, and that ad spend from automotive manufacturers will rebound going forward as supply chain constraints begin to ease.
More Data Supports Supply Chain Issues Easing in Q3
The surge in raw materials and work-in-process inventory at major auto manufacturers adds further support that auto companies are positioned to quickly ramp production. As shown below in Chart 8 and 9, both aggregate automotive raw materials and work-in-process inventories have increased to a five-year high relative to total inventory.
Chart 8. Aggregate Automotive Raw Materials to Inventory Ratio
Source: Auto manufacturer filings (I/O Fund)
Chart 9. Aggregate Automotive Work-in-Process to Inventory Ratio
Source: Auto manufacturer filings (I/O Fund)
What this trend shows is that automotive manufacturers have high levels of working capital stored in near-complete inventory. Once semiconductor supplies arrive, we should expect automotive manufacturers to quickly convert this inventory into finished goods. A build in finished goods inventory should also lead to a strong rebound in advertising budgets from the automotive industry.
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Since the semiconductor shortage is a systemic issue, we should expect auto manufacturers to ramp spending at the same time. Furthermore, auto manufacturers will likely look to quickly offload their inventory to avoid oversupply and capture market share. This trend should help drive demand for ad spend going forward.
Notably, the timing of this ramp remains unknown, with some auto executives expecting H2 2022 to be a return to normal, and others forecasting a longer horizon. We discussed this trend in more detail in last week’s analysis.
Chart 10. Aggregate Automotive Finished Goods to Inventory Ratio
Source: Auto manufacturer filings (I/O Fund)
Automotive semiconductor OEMs report rising inventories and increasing capex
IHS Markit estimated that North American vehicle production in 2021 increased just 1% YoY to 13.1 million. In 2022, vehicle production is expected to rebound and increase 13% YoY to 14.7 million units in 2022 but remain below the 15 million vehicles produced in 2019.
Nonetheless, the rebound in production should support a rebound in ad spend going forward.
While there remains considerable uncertainty due to the cadence of the ramp in vehicle production, there are signs of improvement from key automotive semiconductor suppliers.
For instance, Infineon Technologies, a key supplier of inverters for automotive applications, stated during their latest earnings call (02/03/22) that “the December quarter was the first one in a while where we did not experience [supply] disruptions”. Management added that tightness remains in securing foundry supply, but that wafer supplies are expected to materially improve in the second half of 2022.
The below charts highlight how raw material inventories have been rising for key automotive semiconductor suppliers, a trend that supports a rebound in supply going forward.
A rise in raw materials signals that companies are expected to ramp production in the near term. Furthermore, these automotive semiconductor suppliers have also ramped capacity, as aggregate capex for the group increased 29% YoY to nearly $8 billion. A rise in capex signals that management is increasing supply capacity in anticipation of future demand growth. The concurrent rise in raw materials and capex signals that supply will improve going forward, suggesting that we are nearing a trough in semiconductor imbalances in the auto industry.
Chart 11. Recent Trends in Raw Material Inventories for Automotive Semiconductor Producers
Recent Trends in Raw Material Inventories for Automotive Semiconductor Producers (I/O Fund)
Chart 12. Recent Trends in TTM Capex from Automotive Semiconductor Producers
Source: Company filings (I/O Fund)
We believe that 2021 will likely represent a ‘bottom’ in automotive supply constraints, and that ad spend from automotive manufacturers will rebound going forward as supply chain constraints begin to ease. However, semiconductor supply is expected to remain tight throughout 2022, which is the main bottleneck impacting the ramp in auto production. With record levels of idle work-in-process inventory, we believe that auto manufacturers will quickly ramp ad spend to turnover their inventory once semiconductor supply reaches them. With semiconductor OEMs reporting a ramp in both capacity and raw materials, we believe that automotive ad spend will be a tailwind for ad-tech going forward, with a significant ramp in H2 2022 and into 2023.
Roku has been a strong and steady performer in terms of revenue growth and improvement in the bottom line since going public. In six years, Roku has been able to grow its revenue 850% from $398 million in 2016 to an estimated $3.72 billion for FY2022. The Trade Desk will have grown 687% on a lower revenue base while trading 3X higher.
Even with increased spending of $1 billion, it’s important to consider that the company has leverage in its business model. Critics will point out that TTD has a much better operating margin – but time will tell if Roku has chosen the correct strategy to own the real estate. To me, this is arguably the better business model considering the average consumer owns their connected TV for seven years. If so, the current valuation for Roku is too low compared to its forward growth, which made it a buy in Q1.
Financial Analyst Bradley Cipriano, CFA, CPA at I/O Fund, contributed to this analysis.
Please note: The I/O Fund conducts research and draws conclusions for the Fund’s positions. We then share that information with our readers. This is not a guarantee of a stock’s performance. Please consult your personal financial advisor before buying any stock in the companies mentioned in this analysis.
This article was originally published on Forbes on Apr 1, 2022,01:24pm EDTForbes on Apr 1, 2022,01:24pm EDT
Aggregate Inventories Have Recovered but Auto Inventories Remain Under Pressure:
Supply chain issues have been a well-publicized event that has been hard to predict. While there have been improvements in supply chain management since the harsh production halts enforced during the pandemic, semiconductors continue to be a bottleneck in numerous industries, especially automotive.
Furthermore, the semiconductor bottleneck has had a ripple effect and has impacted industries outside of automotive production, such as ad-tech. In fact, ad-tech has been one of the most beaten-down industries due to the supply chain crisis. This is because automotive is a significant category of ad spend, and without inventory to sell, advertising budgets have been slashed. Nonetheless, we expect that this is only a temporary concern and that ad-tech will rebound in 2022 as supply chain issues begin to normalize. We especially look for discounts in tech that stem from a transient yet external issue outside of any individual company’s control.
The I/O Fund team went beyond relying on management commentary and studied the data to better understand the supply chain bottleneck. We found that aggregate inventory levels have generally recovered, but automotive inventories remain under pressure. I/O Fund Financial Analyst Bradley Cipriano notes that an analysis of automotive inventory composition suggests that the supply-chain issues have likely bottomed and will improve going forward.
The I/O Fund chose to be aggressive during the Q4 earnings season between January and March by building ad-tech positions for this reason. We expect that improving inventory trends will lead to a sharp rebound in automotive advertising in the back half of the year, driving topline growth for the ad-tech sector. We discuss why we believe that the supply chain crisis will ease around H2 2022 below.
Supply Chain Management: Aggregate Inventories Have Recovered but Auto Inventories Remain Under Pressure
The pandemic began in early 2020 and resulted in a whipsaw effect that impacted both supply and demand. With governments enforcing strict shelter in place orders, production of goods declined in 2020 but consumers still demanded goods. Government stimulus further bolstered demand and there was less of a contraction in total demand than there otherwise would have been. This dynamic led to the supply shortage that many sectors have been working through.
Since inventories are essentially the difference between production and sales over a period of time, the dynamic of reduced production but increased demand led to a sharp reduction in inventories in 2020 and 2021. As shown below in Chart 1, changes in private inventories, which is a measure of the value of the physical volume of inventories that businesses maintain to support their production, materially declined in Q2 2020. In fact, the $300 billion drawdown in inventories in Q2 2020 was the steepest drawdown in history.
However, while Q2 2020 represented the steepest decline on record, Q4 2021 represented the largest increase on record, as inventory levels bounced back by over $200 billion. This sharp rebound helps highlight that production is catching back up with demand
Chart 1. 50-year Trend of Changes in Private Inventories
Source: U.S. Bureau of Economic Analysis – I/O FUND
Source: U.S. Bureau of Economic Analysis – I/O FUND
In Chart 3 (below), inventories are also rising relative to sales, suggesting that there has been a build in inventory levels. Furthermore, the metric is above the five-year average, implying that inventories are not tight on a systemic scale.
Chart 3. Five-Year Trend of Private inventories to Final Sales
Source: U.S. Bureau of Economic Analysis – I/O FUND
While the above charts highlight that there has been a strong recovery in inventory levels in the economy, it fails to take into account the types of inventories. Specifically, despite the recovery in aggregate inventories, automotive inventories have fallen to all-time lows.
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The below chart from the U.S. Bureau of Economic Analysis shows that auto inventories have declined to a record low and are hovering just above 0.Without much inventory to sell, there is little incentive to spend on advertising, which has negatively impacted ad-tech.
Chart 4. Domestic Auto Inventories
U.S. Bureau of Economic Analysis – I/O FUND
Chart 5. Domestic Auto Inventories to Sales Ratio
Source: U.S. Bureau of Economic Analysis – I/O FUND
Data from Dentsu’s Global Ad Spend Report highlights how automotive spending is still below 2019 levels. As shown below in Chart 6, global automotive ad spend declined 16% YoY in 2020, and rebounded just 12% in 2021, meaning that global automotive ad spending was still ~6% below its pre-pandemic levels. Since automotive advertisers spend an outsized amount of their budgets on TV ads, ad-tech companies exposed to connected TVs have been especially impacted by the soft recovery in auto ad budgets shown below. As I’ll discuss in more detail below, we believe that automotive ad spending has bottomed and will be a tailwind for ad-tech going forward.
Chart 6. Automotive Global Paid Search Ad Spend
Source: Dentsu Global Ad Spend Report – I/O FUND
Curiously, despite the fact that auto inventories are at record lows, automobile manufacturers’ inventories are also at an all-time high. As shown below in Chart 7, total inventory levels in the automotive manufacturing industry have surged throughout 2021 and into 2022.
Chart 7. Automotive Total Inventories
Source: U.S. Census Bureau – I/O FUND
These disparate trends are driven by the well-publicized semiconductor bottleneck. As Chart 7 highlights above, automotive manufacturers have large amounts of nearly completed inventory that is sitting idle until semiconductor supply arrives.
Once the supply of semiconductors arrive, automotive manufacturers should be able to quickly ramp and turn work-in-process inventory into finished goods that can be sold. Moreover, this should also drive demand for advertising as auto manufacturers look to quickly convert their inventory into cash.
Fortunately, there are signs of improvement for supply chain issues, specifically from the automotive industry. For instance, Volkswagen Group’s management team explained on their Q4 call that they “expect semiconductor supply bottlenecks to continue in 2022, but gradually improve in the second half of the year” (03/15/22).
General Motors echoed similar sentiment during its Q4 earnings call. GM CEO Mary Barra stated that “by the time we get to third and fourth quarter [of 2022], we're going to be really starting to see the semiconductor constraints diminish” (02/01/22).
However, this sentiment was not shared by all automotive executives. CEO of Stellantis, maker of Dodge RAM, Fiat and other brands, stated on the company’s Q4 call (2/23/22) that the size of the automotive market will be driven by the supply of semiconductors, adding that “hopefully, things will get a little bit better. But we believe it's going to be very slow. It will take time. And 2022 is not going to be from that perspective, the year where we can say we are back to normal. We don't think that will happen”
Looking forward, automotive manufacturers have outsized raw material and work-in-process inventory that will help them quickly ramp production once semiconductor supply improves. The timing of this ramp remains unknown, with some auto executives expecting H2 2022 to be a return to normal, and others forecasting a longer horizon.
Next Tuesday, we will discuss the signs of improvement at key automotive semiconductor suppliers and what this means for ad-tech including one strategic bet the I/O Fund made in ad-tech during the January-March selloff.
Bradley Cipriano, Financial Analyst, CFA, CPA at I/O Fund, contributed to this analysis.
Microsoft, Tesla and Apple reported last week (week of 01/24/22) and results came in strong across the group. Investors needs to stay aware of what these companies are doing as they can impact numerous industries, such as semiconductors, cloud and even financial/insurance markets.
Microsoft, Tesla and Apple strong results will likely be a tailwind for the broader technology complex. For example, Tesla, Microsoft and Apple are ramping capex, which will benefit key industries such as semiconductors.
As shown below, Microsoft has ramped capital expenditures, which has been driven by its expansion of cloud computing. This is a strong tailwind for cloud companies, and highlights that cloud remains an area of hyper growth.
Watch the video below for a quick recap of Microsoft, Apple and Tesla's latest earnings release and the impact that they have on the broader market.
A trend that we are watching closely at I/O Fund, heading into 2022, is the memory market. Memory storage is struggling to keep pace with the explosion and data that's being created in the cloud environment so 2022 might be a big year as new technologies hit the market. Tech Analyst Bradley Cipriano touches on what these new technologies are and who's likely to benefit in 2022.
A major new technology is 3D NAND. Key players that have innovated around this technology are Micron and Samsung.
The chart below displays the TTM Capex of prominent companies in the memory market, highlighting that investments are being made now in anticipation of strong demand in the future.
For more on the memory market and to hear about what specific companies are doing to measure up, take a look at our newest YouTube video.
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.
This article was originally published on Forbes on October 29, 2021, 12:07am EDToriginally published on Forbes on October 29, 2021, 12:07am EDT
Microsoft has taken the coveted top spot as the world’s largest company by market capitalization – passing even stock market darling Apple. Microsoft was nearly left for dead, like peers IBM or General Electric, as one of the leaders from previous decades that couldn’t innovate fast enough to keep up. The period after the dot-com bubble and then the financial crisis of 2008 were difficult years for Microsoft’s stock as the company greatly lagged its peers in gains.
Source: YCharts: Microsoft, Alphabet, Apple and Amazon Stock performance 2014-2020
This trajectory began to change when Satya Nadella, formally of the Azure division, became CEO in 2014 after working his way up through the company over the course of 19 years to president of the cloud business. The stock is up nearly 800% since the new CEO took over. Nadella’s multi-decade cloud experience and intense focus is what has helped Microsoft climb out of the hole that Bill Gates and Steve Balmer following decades of fighting open-source communities and anti-trust issues.
Source: YCharts: Microsoft, Alphabet, Apple and Amazon Stock performance 2014-2020
We’ve analysed earnings calls to see how Microsoft’s cloud focus compares to a company like Alphabet, which is diversified across many sectors, such as advertising. The contrast is remarkable in terms of how determined Microsoft’s management is on staking their ground on cloud computing with nearly every statement in the hour-long calls tying back to this sector.
Amazon Web Services could arguably be the hardest competitor in technology and Microsoft accepted this challenge despite AWS having a nearly four-year head start. Growth rates for both companies’ cloud divisions are in the 35% to 40% range.
Since 2018, we’ve covered in detail Microsoft’s hybrid cloud computing strategy and why we thought this strategy would be enough to propel Microsoft’s stock past its peers. Nearly three years after our coverage of this hybrid strategy began, we are now looking to the bellwether to analyse what trends we should pay attention to next across the cloud ecosystem.
Why Microsoft Azure Has Doubled Its Market Share
According to Gartner, cloud growth will remain robust next year on already large numbers. Public cloud services forecast on end-user spending will reach $482 billion in 2022, up from $396 billion in 2021 for growth of 21.7%.
Cloud IaaS will outpace this growth at 32.9% from $91.5 billion to $121.7 billion. Gartner also points out that public cloud spending will exceed 45% of all enterprise IT spending, up from 17% in 2021.
Amazon Web Services, Azure and Google Cloud are the top three IaaS players in the market with Azure nearly doubling its market share from a low of 11.2% in 2018 to 21% in the most recent quarter. We can see that despite this growth, AWS has not given up any turf and has remained level at 32% market share while the overall cloud IaaS market has grown substantially over time, affording others such as Azure an opportunity to capture this growth.
Primarily, it’s hybrid cloud computing that has helped drive Azure’s market share. We first covered this in 2018 and expanded on Microsoft’s strategy in 2019 when we stated:
“Investors should pay close attention to hybrid cloud when looking at Microsoft. Looking at it carefully will give them perspectives about how the company is positioned to set itself apart from other cloud companies like Amazon and Google.
Hybrid cloud is a technology which enables companies to store some of their data on their own servers while simultaneously sending other data to the private and public cloud. Companies love hybrid cloud because it is cost-efficient, transparent, and safe. Azure’s strength in hybrid computing has made it the main player in the industry. The product is used by 95% of Fortune 500 companies.”
Satya Nadella pointed out another important key aspect as to why Microsoft’s stock price has done well in the current environment where there are inflationary fears: “Digital technology is a deflationary force in an inflationary economy. Businesses – small and large – can improve productivity and the affordability of their products and services by building tech intensity. The Microsoft Cloud delivers the end-to-end platforms and tools organizations need to navigate this time of transition and change.”
I made this point over two years ago prior to the pandemic when the market was greatly doubting cloud and I said the following: “My prediction is this may be one of the last cycles when tech is considered less safe than value stocks. As the market will find out (the hard way), cloud software is actually very safe. It is insulated from trade wars and overseas manufacturing issues. It reduces costs for enterprises, which is ideal for a recession. Cloud software is at the beginning of a rapid growth cycle compared to its counterparts in tech — such as mobile, e-commerce and advertising — which are reaching saturation, are finding themselves in the cross hairs of anti-trust and are susceptible to consumer spending changes.”
Microsoft acquired Github in 2018, which helped Microsoft address its weakness of a poor reputation in open-source communities and lacking in developer relationships. Developers help determine the cloud IaaS service an enterprise or SMB customer will choose, so in-roads into this community via an acquisition has likely helped Microsoft hedge the developer favorite, AWS.
4 Key Trends from Microsoft Ignite 2021
As one of the bellwethers for cloud, Microsoft is a key company to monitor for trends that are leading the market. At Ignite 2021 Satya Nadella said, “we’re moving from a mobile and cloud era to an era of ubiquitous computing and ambient intelligence.” This next growth phase includes four key trends.
The first is the hybrid work-from-home trend with 73% of employees wanting flexible remote work options and 67% want more in-person connections. Microsoft believes the future will support both a collaboration between the physical world and digital world. Microsoft Mesh, which the company calls the Metaverse platform, can be embedded in Teams. Mesh introduces 2D and 3D meetings with personalized avatars that use AI to imitate movements even when the camera is off. Organizations can also create virtual spaces that resemble the physical office environment.
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Microsoft Loop is a new collaboration app that will expand Office. Through Microsoft Teams Connect, the company plans to make cross-organization communication easy and secure when there are meetings outside of an organization.
The second trend Microsoft pointed towards in the keynote is hyper-connected businesses. This refers to a “business process transformation” where supply and demand is informed by data and AI to help improve outcomes, such as the supply chain issues the market has experienced this year. At Ignite, the company announced Azure OpenAI Service with a video clip that showed how real-time summaries can be generated during the WNBA play-off. This will help content editors choose the right content in a few seconds using AI. Notably, Microsoft introduced the world’s first AI supercomputer five years ago during Ignite 2016 and today has some of the most powerful AI supercomputers in the cloud.
The third trend for the next phase of growth is that digital business will drive multi-cloud and multi-edge infrastructure. The company has already partnered with telecom operators like AT&T, Verizon, Telefonica, BG, Telstra, and SingTel to use its cloud services. Earlier this year, AT&T decided to move its 5G network to Microsoft Cloud. 5G and the Internet of Things could get a further boost recently as the Infrastructure Bill has been passed. The bill is expected to cost $1.2 trillion over eight years, which includes $110 billion for roads, bridges, and infrastructure, and $65 billion for broadband.
The final trend is the requirement for strong end-to-end security. The pandemic has increased digital transformation and with every business being operated remotely, the complexity has increased. According to the company, Cybercrime costs about $6 trillion per year and is expected to reach $10 trillion by 2025. In the earnings call Satya Nadella mentioned, “Our goal is to help every organization strengthen its defense through the zero trust architecture built on end-to-end solutions that span all clouds and all platforms. We analyze over 24 trillion signals across email, endpoints, and identities each day and translate this intelligence into innovative features to protect our customers.” The company has nearly 650,000 customers using its security solutions, which is up 50% YoY.
Microsoft Fiscal Q1 FY 2022 Report
The company’s revenue in fiscal Q1 FY 2022 increased by 22% YoY to $45.3B, which beat the consensus estimates by 3%.
All the three business segments showed promising growth. Revenue in the Productivity and Business Processes segment increased by 22% YoY to $15B primarily helped by the growth in Office products and LinkedIn revenue. Intelligent Cloud segment revenue increased by 31% YoY to $17B, it was primarily helped by the 50% YoY growth in Azure & other cloud services. The Personal Computing segment increased by 12% YoY to $13.3B.
Total cloud revenue growth was 36% YoY to $20.7B in comparison to Amazon Web Services 39% YoY growth to $16.1B. Notably, Microsoft does not break out Azure revenue.
78% of the Fortune 500 companies use the company’s hybrid offerings. This quarter GE Healthcare and Procter & Gamble migrated their critical workloads to Azure.
The company also updated in the earnings call that GitHub has 73 million developers. 84% of the Fortune 100 companies use GitHub.
LinkedIn has nearly 800 million members and hiring on the platform rose 160% YoY. LinkedIn revenue grew 42% YoY.
Microsoft Teams is also growing steadily. 138 organizations have more than 100,000 users of Teams. Due to the hybrid work environment Teams chats increased 50% YoY. Schlumberger, Westpac, and SAP have chosen Teams Phone in this quarter. Microsoft 365 subscribers reached 54.1M at the end of the quarter.
The company had a free cash flow of $18.7B. Net income grew 48% YoY to $20.5B and adjusted net income grew by 24% YoY to $17.2B. Earnings per share came in at $2.71 and adjusted earnings per share came at $2.27, which beat the consensus estimates by $0.19.
Management’s revenue guidance for the next quarter is $50.6 billion across all three segments, which represents year-over-year growth of 17%. The analysts’ consensus is $50.47 billion with adjusted earnings per share of $2.31.
Conclusion:
Microsoft’s strategic bet on cloud became clear when the company placed the president of the cloud division as CEO. There is a stark change in terms of Microsoft’s performance as a public company since 2014 and we believe this new era where Microsoft leads could be just beginning. Apple must contend with consumer sentiment (and China) and must also break into new markets to maintain growth, Alphabet is spread thin across many segments with little overlap, and Amazon’s e-commerce weighs on AWS profits. Meanwhile, Microsoft’s singular focus provides a rare pure play at a $2.5 trillion market cap while cloud is setting up to capture gains from artificial intelligence.
Royston Roche contributed to this article
Please note: The I/O Fund conducts research and draws conclusions for the Fund’s positions. We then share that information with our readers. This is not a guarantee of a stock’s performance. Please consult your personal financial advisor before buying any stock in the companies mentioned in this analysis.
Despite Bitcoin’s recent decline, volatility is actually decreasing and the asset is beginning to stabilize in terms of historical performance. The last crypto peak to trough in 2019 saw a decline of 84% in price while this sell-off’s peak to trough was 55%It took three years to recover the all-time high from 2017 for Bitcoin yet the I/O Fund thinks Bitcoin will recover its current all-time high quicker this time as the long-term pressure for Bitcoin is up.
Naturally, with the steep drawdown of 55% (yet the very promising future of crypto – see our price targets below) we were wondering how crypto trading apps are faring after the Q2 sell-off now that Coinbase and Robinhood have gone public, two of the biggest names in the space. Below, we highlight data that is offered by Apptopia (and is also available on the Bloomberg Terminal) to show that in some cases crypto trading apps are down sequentially while others are down even year-over-year. Robinhood is stock trading app too, of course, yet we think any Q3 declines will be largely contributed to crypto trading. We also discuss Voyager, a company we have done a deep dive on before and currently hold a position in.
Two Popular Crypto Trading Apps Went Public in Q2
The I/O Fund figured it would be a good idea to check on the health of crypto trading apps to see how the asset class underperformance may have affected crypto trading apps. When Bitcoin and crypto go through a rally there will be a correlation with the crypto trading apps, yet how much of a fall-off do crypto apps see when there is a sell-off?
Coinbase and Robinhood seized the crypto rally to go public as the companies posted 1080% growth and over 309%+ revenue growth, respectively in the March quarter. You’ll see below in the downloads and sessions that there was unusually high activity during the period the two companies went public.
Coinbase was listed on April 14th at $381. The shares were off to a good start on the day of direct listing, but the shares sold drastically a month later. Lock-up periods are standard for Initial Public Offerings (IPOs). However, Direct Listings usually don’t have lock-up periods. There could be exceptions like Palantir, which despite the direct listing, had lock-up restrictions. Coinbase, which did a direct listing, did not have lock-up agreements. This is important because shares can come under pressure following a soft quarter.
Robinhood shares were listed on July 29th at $38, which was at the lower end of the offering range. The shares peaked at $70.39 and are currently trading above the IPO price at $47.15. Many IPOs have 180 day lock-up periods yet Robinhood has a partial lockup schedule. In Robinhood’s case, 15% of the employees were able to sell their shares on the day of the company’s listing. The next 15% of the shares will be eligible for sale on October 27, 2021. There is mention of a final lockup expiring on December 1st in the amended S-1 filing here. There will likely be volatility during this period as insiders tend to sell after lockups expire. A soft quarter or two could exacerbate this. Doge Coin also peaked around $0.60 and is now trading around $0.20. Per Robinhood’s financials, this coin drives 62% of Robinhood’s crypto trading activity.
Quick Glance at Q2 Financials for Crypto Trading Apps:
Before we look at the current downloads and sessions for Q3, we want to review the Q2 financials for Coinbase, Robinhood and Voyager Digital.
Coinbase reported $1.3 billion in revenue in 2020 compared to $533.7 million in 2019 for growth of 143.6%. Revenue growth in Q2 was impressive at $2.2 billion compared to $186.4 million for 1080% growth. A similar trend was seen in H1 2020 compared to H1 2021 for 936% growth. Net income grew in line with the top line at net income of $1.6 billion and adjusted EBITDA of $1.15 billion compared to a net income of $32.3 million and adjusted EBITDA of $61 million for the same period last year.
Retail Monthly transacting users (MTUs) rose to 8.8 million in the recent quarter when compared to 2.8 million at the end of December 2020 and 1.5 million for the 2Q 2020. Verified users were 68 million. Absent a rally in Bitcoin and crypto, these will be tough comps to clear in future quarters this year. The data from July showed that retail MTUs came at 6.3 million. The management expects MTUs and total trading volume to be lower in the third quarter when compared to the second quarter with the company stating, “as volatility and crypto asset prices are highly correlated with trading revenue, the crypto market environment heavily influenced our Q2 financial results” citing declines of 45% in Bitcoin and Ethereum.
Coinbase emphasized they have 9,000+ institutional customers and 160,000 ecosystem partners. Trading volume is primarily driven by institutions at $317 billion compared to $145 billion from retail (about two-thirds) with trading volume at 24% for Bitcoin, 26% Ethereum and 50% other crypto assets. In terms of assets on the platform, the mix is more equal at $88 billion for retail and $92 billion for institutions with 47$ Bitcoin, 24% Ethereum and 25% other crypto assets.
The company derives its major revenues from the transaction revenue. This is correlated with the trading volume. The company plans to reduce the focus on the transaction revenue since it’s volatile and focus on the subscription & services revenue in the long run. The subscription & services revenue include custodial fees, blockchain rewards which includes staking revenue, earn campaign revenue, interest income and other subscription & services revenue. The third classification of revenue is other revenue which includes crypto asset sales revenue and corporate interest income.
Robinhood grew Q2 revenue by 131% YoY to $565.3 million. Revenue growth has been strong yet may have peaked in Q1 as growth has been slowing down. For the full year 2020 it rose by 245% to $959 million and in the 1Q 2021, it was up 309% to $522 million. Transaction-based revenue grew by 141% to $451.2 million, net interest revenue grew by 69% to $67.7 million, and other revenue grew by 177% to $46.5 million. Looking deeper into the transaction-based revenue, options revenue grew by 48% to $165 million while cryptocurrencies revenue increased to $233 million from $5 million in the same period last year. The equities transaction-based revenue dropped 26% to $52 million.
As stated above, Dogecoin accounted for 62% of crypto trading in Q2, which was up compared to 34% in the first quarter. Due to the price decline in this asset, it’s unlikely Q3 will comp well with Q2 partly due to this alt-coin.
Operating expenses increased 169% to $500.7 million. Notably, technology and development expenses increased 248% to $156.3 million and operations expenses rose 232% to $101.1 million. Due to the strong trading activity, the company procured additional cloud infrastructure, which increased technology expenses. Operations expenses were high due to the increase in the headcount of customer support staff.
The company also recorded stock-based compensation in the current quarter and expects to record a charge of $1 billion in stock-based compensation for RSUs related to the IPO in the third quarter. It reported a net loss of $502 million in the recent quarter and adjusted EBITDA of $90 million. In contrast, the company reported a net income of $58 million and adjusted EBITDA of $63 million in the same period last year.
According to the management, due to the seasonal nature of the business, trading activity has been generally strong in the first half of the year. On similar lines, they expect lower trading activity in the third quarter. The sessions and downloads confirm that Q3 will be much softer than Q2. At the end of June 2021, the company had about 22.5 million net cumulative funded accounts compared to 18 million at the end of March 2021 and 12.5 million at the end of December 2020. The customer growth has been strong due to the strong word-of-mouth referrals yet appears to have declined for Q3 (see below).
The company earns the majority of its revenues from payment for order flow (PFOF). This is a method in which the brokerages like Robinhood receive compensation for routing orders to market makers. The transaction-based fees represent 81% of the total revenues of the 1Q 2021 and 80% of the 2Q 2021. Notably, there are conversations going on in Congress about the risks and SEC might consider banning or putting restrictions on payment for order flow.
Similar to its peers, Voyager Digital demonstrated strong revenue growth in the first half of the year. The earnings release for May shows Q3 FY 2021 revenue came in at $60.4 million, up from $3.6 million in the previous quarter fiscal Q2, representing 21,000%+ growth (yes, you read that right). Fee revenue was $53.7 million and interest revenue from custodians was $6.7 million. Operating profit was $30 million for the 3Q FY 2021. There was a press release in July that showed revenue for fiscal Q4 ending in June in the range of $103 million to $107 million, up from less than $1 million in revenue in the year-ago quarter. Sequentially, this represented over 65% growth. Total funded accounts have exceeded 665,000, and total verified users are more than 1.75 million. You can read our full analysis here.
According to Steve Ehrlich, CEO and Co-founder, "Our June quarter reflects continued growth of our platform, with revenues up more than 65% from the March Quarter. Although we have seen a significant decrease in crypto market volume since mid-June we continue to see significant net new funded account growth, net asset inflows, and consistent basis points on spread revenues on our platform continue through today."
The Impending Question is Performance in Q3 and Subsequent Valuations:
Crypto trading apps may be the hardest vertical in tech when it comes to forward guidance as crypto is extraordinarily volatile and trading volumes can greatly fluctuate. 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, that companies often report various key metrics, such as monthly transacting users (MTU) rather than downloads or sessions. Therefore, Apptopia provides an important glimpse on app activity, however, we are not making predictions on what Q3 earnings will report rather we track the overall trend.
Coinbase’s provided a glimpse for July, stating that retail MTUs were at 6.3 million compared to 8.8 million in the previous quarter. The company stated they believed total trading volume would be lower in Q2 compared to Q3. Apptopia data is showing roughly 5 million downloads with still two weeks to go in the quarter or a decrease of roughly 60% if we factor in the additional two weeks that remain in September.
Here is a glimpse of the sessions which show a similar trend as downloads are indicating more of a 40% decline (roughly speaking if we figure a total of 550,000 with the remaining days). In both cases, Coinbase is doing well year-over-year although the growth has tapered off from the 900% to 1000% range to what may be more in the 100% to 200% range year-over-year. According to analyst consensus, there have been 8 downward revisions with revenue estimated at $1.46 billion in the upcoming quarter down from $2.23 billion in the previous quarter. EPS estimates are currently at $1.4 billion compared to $6.78 billion.
Robinhood did not provide guidance but issued the following statement in August: “For the three months ended September 30, 2021, we expect seasonal headwinds and lower trading activity across the industry to result in lower revenues and considerably fewer new funded accounts than in the prior quarter.” In this case, it’s looking certain that Robinhood will report a steep sequential decline and the company is on track to also report a decline year-over-year unless there is a catalyst in the next week or so.
Sessions look stronger than downloads with Robinhood showing slight year-over-year growth. The number of upward or downward revisions available is not available for this newly public company, yet the revenue estimates are at $427.3 million compared to $565 million last quarter. EPS estimates are at ($0.34) compared to $0.18 last quarter.
Voyager released an update for the quarter ending in June but did not offer forward guidance on the press release. Year-over-year is still extraordinarily strong and Voyager is also the strongest app between the three in terms of downloads sequentially, as well. We discuss the key differences between Voyager and Coinbase in a previous analysis here
The Investors Presentation shows an increase in verified users from 1.75 million reported in fiscal Q4 to 2 million on September 7th. Sessions show similar information as downloads, which is very strong year-over-year activity with a decline sequentially although much less impact compared to its peers. Voyager Digital is listed on the OTC market and does not have analysts covering it at this time.
Conclusion:
We don’t expect crypto trading apps to maintain peak traffic, yet as the market attempts to price these apps with no forward guidance, we could see some volatility. Because we track Bitcoin and other alt-coin holdings very frequently, we performed this research to check on the health of Voyager Digital, another holding at the I/O Fund. Due to its strong retention and rock-bottom valuation, we will continue to hold Voyager. The issue we see with Coinbase and Robinhood at this time are the lockup expirations (or having no lockup for Coinbase) combined with the sequential weakness and the likelihood the two companies can’t provide adequate forward guidance. We are in the early days for crypto so anything could happen, and stories can certainly strengthen. However, absent a strong bitcoin rally, Q3 looks weak for the bigger players yet comparatively strong for the small cap Voyager.
As for Bitcoin, the I/O Fund has been covering this asset for the public markets since 2019 when we added a position alongside other tech stocks to a portfolio when we called for a market cap of $1 trillion. We did not budge on this target even when the asset dropped from the $10-$13K region to the $4K and $7K region. Today, our price target is $120,000 to $160,000. We are not financial advisors, rather we perform deep drive research for our own positions and share our conclusions. Our first published piece on crypto was in 2013 when I published a guest blog from Chris Larsen of Ripple on my early-stage tech blog (now archived). Here is a snapshot of our trading history during the most recent sell-off. These are verified through real-time trade notifications sent to our members at the time of the trade.
In early 2021, we warned our readers that a top was forming in Bitcoin. With our initial downside targets showing a likely bottom in the$37,000-$22,000 region, we cut our position in half, alerting our readers that Bitcoin was in a complex topping process, and to be prepared. However, we also stated, and still believe, this drawdown is part of a much larger uptrend. This last point is key.
As stated in the article, Beth Kindig and I/O Fund currently own shares of Voyager Digital and Bitcoin. This is not financial advice. Please consult with your financial advisor in regards to any stocks you buy.
Royston Roche contributed to this article.
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 affect a stock beyond downloads or sessions. Gross margins, EPS beat or miss, etc, will not be reflected by downloads or sessions alone. We pull data to reduce risk in positions we already own and share the publicly available information with our readers. Please consult your personal financial advisor before buying any stock. You can read Apptopia’s response to the SEC action with AppAnnie and how the company provides quality information for the public markets.read Apptopia’s response to the SEC action with AppAnnie and how the company provides quality information for the public markets.
