Are cloud computing companies offering a second bite
Are cloud computing companies offering a second bite at the cherry?
On 18 December 2022, Jason Lemkin posted a blog titled “Right Back to Where We Were 3 Years Ago.” It caught my attention or those of us who have been following the performance of software-as-a-service (SaaS) cloud computing companies. It tells us, quite clearly, that the impact of the ‘pandemic pull-forward’ of demand for software consumption is completely removed from the 3-year performance number.
To us, it means that it is time to ask a simple question: is the market giving us a ‘do-over’, meaning that we can now access companies at something similar to ‘pre-pandemic’ levels, or is the jig up and the cloud business model doomed to fade away into the sunset?
SaaS companies have evolved significantly since 2019
In Figure 2, we wanted to look at valuation over the same period. Even if the share price performances of the underlying companies have run up and then fallen back in most cases—leading to the observed performance of the BVP Nasdaq Emerging Cloud Index—we have not been seeing companies reporting widespread negative year-over-year revenue growth. Instead, we’ve tended to see the revenue growth ranges shifting downwards, with the median figure for the Index now closer to the 30% level, whereas it was higher than 40% for a period of time ending roughly one year ago.
If prices have dropped but sales have continued to grow, it’s possible to see that the valuation opportunity at present is better than it was in December of 2019, 3-years ago. In Figure 2, we see that the price-to-sales ratio was 7.0-8.0x during this period, whereas presently it is below 4.5x. We agree that these stocks should be less expensive today, in that the risk today is higher and the cost of capital is also higher. We can’t know with certainty if the current price levels perfectly encapsulate this risk, but it is simply important to know that the risk does look like it is being accounted for.
In our opinion, within software-as-a-service companies, one must always marry looking at valuation with looking at revenue growth. Many of these firms, as yet, do not carry through positive net income to the bottom lines of their income statements, so if one can look at a reasonable fundamental, sales seems to make the most sense at this point in the development of the megatrend. We do view this as a megatrend, which means the time horizon we are thinking about is not the next 12 months or couple of years, but something that should unfold over a decade.
Growth, on the other hand, has come down more slowly than valuation. Now, this is ‘revenue growth’, not earnings growth or cash flow growth, but we note that companies are still growing, and some are still delivering results ahead of Wall Street’s expectations. If the Nasdaq 100 is growing something close to 10% and the BVP Nasdaq Emerging Cloud Index is growing something close to 30%, is this a worthwhile trade-off? The Nasdaq Index represents, predominantly, proven, established businesses, with some of the world’s most valuable companies, measured by their market capitalisations, getting the top weights. This risk profiles of these groups of stocks should be quite different, but if we are able to think not of the next 12 months but rather the next 10 years, does the difference in risk potentially make sense?
We do feel comfortable to conclude there is a better chance to make sense at the present valuation trade-off than it did at the near-term market high observed in November 2021, even if it’s impossible to know the future with certainty.
Where the rubber meets the road: what do SaaS companies do?
In our opinion, no discussion of cloud computing or SaaS companies is complete without giving some treatment to what the companies do. SaaS is just a business model—a way to provide/consume software that competes with other ways to provide/consume software. Do people prefer subscription models, or would they want to go back to a world where they need to buy a DVD and physically hold and use their own copy? If the software is necessary and valuable, and the company can execute their strategy, we have confidence in the long term. If, on the other hand, the software is discretionary and more ‘nice-to-have’ than needed, then there could be more risks. We see the following functional groupings as a starting point:
Cybersecurity: companies like CrowdStrike, SentinelOne, Cloudflare, Zscaler and Darktrace focus on cybersecurity. Subscribing to cybersecurity protection makes sense because we know that the attackers are always evolving. Stagnant protection would eventually lead to limited protection. Many SaaS cybersecurity firms are not necessarily trading at single digit price-to-sales multiples, but it’s also the case that cybersecurity has received massive attention from investors in 2022, largely due to the Russia/Ukraine conflict.
Software development: companies like Twilio, Atlassian and New Relic are involved with running platforms useful to software development. Twilio and Atlassian have faced challenges in their share price performance during their most recent quarterly earnings reporting periods. However, we believe that the service they provide for software development remains critical.
Business services: a company like Bill.com is very interesting, in that it is an example of a service that helps small and mid-sized firms manage their expenses. It’s a good case to remember because companies will tend to employ services like this to create efficiencies and save costs and time. We couldn’t ever say this company (or others like it) would be immune to recessionary pressures, but we find it important to note that it also may not be the first subscription to cut either.
Cloud computing and software-as-a-service companies do not have long histories of operation where we can look back at their performance during the Global Financial Crisis of 2008-09, and we’d have to assume that, if they were around in 2001 and 2002, their performance as the ‘tech bubble’ burst would have been significantly negative. To say these companies are completely resilient to recession is not a thesis that has been proving out in 2022. However, we’d note that their revenues are still growing, so it’s not the case either that these companies immediately reverted to negative revenue growth and collapsing fundamentals. If people view this as a megatrend, as we do at WisdomTree, the current period in the coming months could be a much more interesting entry point than anything we have seen recently, even if near-term performance could still be challenging.
On 18 December 2022, Jason Lemkin posted a blog titled “Right Back to Where We Were 3 Years Ago.” It caught my attention or those of us who have been following the performance of software-as-a-service (SaaS) cloud computing companies. It tells us, quite clearly, that the impact of the ‘pandemic pull-forward’ of demand for software consumption is completely removed from the 3-year performance number.
To us, it means that it is time to ask a simple question: is the market giving us a ‘do-over’, meaning that we can now access companies at something similar to ‘pre-pandemic’ levels, or is the jig up and the cloud business model doomed to fade away into the sunset?
SaaS companies have evolved significantly since 2019
In Figure 2, we wanted to look at valuation over the same period. Even if the share price performances of the underlying companies have run up and then fallen back in most cases—leading to the observed performance of the BVP Nasdaq Emerging Cloud Index—we have not been seeing companies reporting widespread negative year-over-year revenue growth. Instead, we’ve tended to see the revenue growth ranges shifting downwards, with the median figure for the Index now closer to the 30% level, whereas it was higher than 40% for a period of time ending roughly one year ago.
If prices have dropped but sales have continued to grow, it’s possible to see that the valuation opportunity at present is better than it was in December of 2019, 3-years ago. In Figure 2, we see that the price-to-sales ratio was 7.0-8.0x during this period, whereas presently it is below 4.5x. We agree that these stocks should be less expensive today, in that the risk today is higher and the cost of capital is also higher. We can’t know with certainty if the current price levels perfectly encapsulate this risk, but it is simply important to know that the risk does look like it is being accounted for.
In our opinion, within software-as-a-service companies, one must always marry looking at valuation with looking at revenue growth. Many of these firms, as yet, do not carry through positive net income to the bottom lines of their income statements, so if one can look at a reasonable fundamental, sales seems to make the most sense at this point in the development of the megatrend. We do view this as a megatrend, which means the time horizon we are thinking about is not the next 12 months or couple of years, but something that should unfold over a decade.
Growth, on the other hand, has come down more slowly than valuation. Now, this is ‘revenue growth’, not earnings growth or cash flow growth, but we note that companies are still growing, and some are still delivering results ahead of Wall Street’s expectations. If the Nasdaq 100 is growing something close to 10% and the BVP Nasdaq Emerging Cloud Index is growing something close to 30%, is this a worthwhile trade-off? The Nasdaq Index represents, predominantly, proven, established businesses, with some of the world’s most valuable companies, measured by their market capitalisations, getting the top weights. This risk profiles of these groups of stocks should be quite different, but if we are able to think not of the next 12 months but rather the next 10 years, does the difference in risk potentially make sense?
We do feel comfortable to conclude there is a better chance to make sense at the present valuation trade-off than it did at the near-term market high observed in November 2021, even if it’s impossible to know the future with certainty.
Where the rubber meets the road: what do SaaS companies do?
In our opinion, no discussion of cloud computing or SaaS companies is complete without giving some treatment to what the companies do. SaaS is just a business model—a way to provide/consume software that competes with other ways to provide/consume software. Do people prefer subscription models, or would they want to go back to a world where they need to buy a DVD and physically hold and use their own copy? If the software is necessary and valuable, and the company can execute their strategy, we have confidence in the long term. If, on the other hand, the software is discretionary and more ‘nice-to-have’ than needed, then there could be more risks. We see the following functional groupings as a starting point:
Cybersecurity: companies like CrowdStrike, SentinelOne, Cloudflare, Zscaler and Darktrace focus on cybersecurity. Subscribing to cybersecurity protection makes sense because we know that the attackers are always evolving. Stagnant protection would eventually lead to limited protection. Many SaaS cybersecurity firms are not necessarily trading at single digit price-to-sales multiples, but it’s also the case that cybersecurity has received massive attention from investors in 2022, largely due to the Russia/Ukraine conflict.
Software development: companies like Twilio, Atlassian and New Relic are involved with running platforms useful to software development. Twilio and Atlassian have faced challenges in their share price performance during their most recent quarterly earnings reporting periods. However, we believe that the service they provide for software development remains critical.
Business services: a company like Bill.com is very interesting, in that it is an example of a service that helps small and mid-sized firms manage their expenses. It’s a good case to remember because companies will tend to employ services like this to create efficiencies and save costs and time. We couldn’t ever say this company (or others like it) would be immune to recessionary pressures, but we find it important to note that it also may not be the first subscription to cut either.
Cloud computing and software-as-a-service companies do not have long histories of operation where we can look back at their performance during the Global Financial Crisis of 2008-09, and we’d have to assume that, if they were around in 2001 and 2002, their performance as the ‘tech bubble’ burst would have been significantly negative. To say these companies are completely resilient to recession is not a thesis that has been proving out in 2022. However, we’d note that their revenues are still growing, so it’s not the case either that these companies immediately reverted to negative revenue growth and collapsing fundamentals. If people view this as a megatrend, as we do at WisdomTree, the current period in the coming months could be a much more interesting entry point than anything we have seen recently, even if near-term performance could still be challenging.
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