Massive transformation of the Digital space and the entire business commerce model is being disrupted by the COVID crisis
Traditional metrics like Price to Sales(P/S) and Price to Earnings growth (PEG) have to be tweaked to look at revenue growth, Sales and Marketing (S&M) costs/Revenue, ARR(annual recurring revenue) and NER(Expansion, retention rate from existing clients) to identify the best of breed stocks
Investing in best of breed component and cloud providers, service and monitoring, remote work and health providers requires a different mind set
Identify the winners with potential for high growth and market expansion and pick a bundle of 4 -5 stocks for the best returns in the next 5 years
A massive transformation is taking place in the Digital space with an entire spectrum business commerce being disrupted and COVID could bring forth a sea of change in how the business will run in the future. In the olden days we had monolithic software providers wiring the internet 2.0 with a complete stack for instance an Oracle or Microsoft or IBM. Today the play has changed to best of breed providers who are working with each other to simplify client solutions as, the demand for specialized software has never been higher. In the past few years, the number of enterprise Software-as-a-Service (SaaS) companies going public has increased significantly and I believe SaaS has become the de-facto business model. While not new, its addressable market and growth seems to have caught many investors by surprise. These include component providers, cloud providers, the service and monitoring providers including software app providers and it is leading to disintermediation on a massive scale and better digital experiences and efficiencies. There are some industries like insurance or banking where the next set of products is yet to surface and a Square (SQ) could eventually force that change. I am not privy to who will be the winners but I can definitely pick up a few players who may be in the reckoning and place my bets on them with my analysis.
What is unique to this new breed of companies is, they spend a significant amount of capex upfront to capture the market but the revenue comes over a few years as they install and service the client. So traditional metrics like P/S and PEG have to be tweaked and instead we need to look at Sales growth, S&M costs/Revenue and ARR and a few other metrics. Let’s try to understand what is happening in each of these business layers and look at mission critical providers that have a strong recurring revenue model, akin an utility which you cannot stop and let go without any fuss. As an e.g BITCOIN may be an outcome short lived on hype but the underlying technology Block chain, may have a strong long-lasting impact and service industries for the foreseeable future
At the top of the list here are companies like ANET, NVDA, MDB and a host of others who are providing the mix of hardware and software for the cloud to be created and ready for consumption . These underlying components help lay out the Digital Fiber and help the service providers operate the cloud. What I would look at here is volumes and scale though a company like NVDA or ANET probably have a moat, which increases the CAP (the competitive advantage period) and ability to keep prices from dropping. When volumes or margins start dropping for these players, one would need to quickly reassess and change investments decisions at a macro level.
The Cloud providers – use the above component to create the cloud services as an e.g. AWS is a dated story and we already the winners but it does not mean they will stay at the top forever. You will have new upstarts trying to disrupt the incumbents but we are yet to see that happen.
Service and Tool providers – If you look at a company like NTNX, DDOG, OKTA, SPLK, they are providing add on tools or services to make the cloud experience user friendly and cost effective both for consumers and companies providing those services. Market share, moat and margins matter in this space.
Software App providers like AYX, PEGA, DOCU , SHOP, LVGO etc. are the final list that provides the apps that help consumers enjoy the service . Companies here provide the last mile service or information needed to automate or deliver the services.
How to invest in cloud based businesses.
Since most of these companies are less than 10 years old, many still don’t have earnings and it is difficult to use the traditional metrics like PE (price to earnings) to make investment decisions. Valuations are generally very high but one needs to focus on a few key things and look at measures that are fundamentally different. I would look at these questions –
How mission critical are the product or services offered?
Are they a leader, disrupting a model or creating a new one?
What is the TAM and SAM (serviceable market) for the products offered? Is it increasing YOY?
What is the revenue growth and are they increasing revenue YOY ?
What is the moat or switching costs? Is there stickiness – i.e. Companies cannot throw them during a downturn without disruption.
How long will Markets/clients exist and how do they stack up to competition?
What is the company plan to profitability? Are they sticking with the plan and showing progress.
Do they have a recurring revenue stream? What is the ARR (Annual recurring revenue)?
Are they able to leverage their sales and marketing to increase the DBNR ($ based net expansion)?
Are the customers are happy? What is their NPS (net promoter score)?
While analyzing these stocks, I look at sales growth over a period of time as that is the most critical factor and determines whether I should invest in the story. Look at the winners in the last decade like AMZN , APPL, ISRG, NFLX and many more and one would realize revenue growth determined the stock price trajectory and profitability followed. Profitability is important as to know when it would start but one can estimate it based on other factors, which indicate a path to profitability. Consider a stock trading at 15 X sales and growing revenue 50% a year for 3 years – this stock will trade for 3 times sales if stock price is at the same point 3 years later. Imagine if the company can grow 25% on average for 10 years and what will be the price . It’s obviously very difficult to predict growth accurately beyond a short time horizon but what one can do is Look at sales growth guidance over the next 2 -3 years
A large TAM and SAM that will grow significantly
A product that is loved and businesses keep buying more OR more number of businesses are buying (ARR and client growth)
Light asset with High gross margins
Operating margins expansion which shows path to profitability and pricing power
If you want to look for more, check the CAC (client acquisition cost) and the number of years customer will have to stick for the company to make the money back from sales or better still find the TLV (total Lifetime value). If one can estimate an X times the CAC (x being based on factors like industry, deal size , margins etc.) could be another way to analyze the investment worthiness of a company.
It’s a big change for the traditional value investor but if you can learn to change your outlook and not focus on valuation and price but instead on the foreseeable 3 -5 years and how realistically the company can make it and the probability of it succeeding . It is hard for us to sell the APPL, ORCL, ISRG and MKL and pick up AYX and NET or LVGO. The point to note is if these new age picks grow revenue and double it every two years for 3 -5 years , one would still make more money even if they fail to spot the imminent crash of high value stocks as Wall street is so attuned to QoQ numbers . Let’s take an example if one of these stocks crashes 40% and one sells the stock you would still get a good return. Assume $100 becomes $600 USD in year 4 for a growth stock with the P/S about constant and price crashes to 360 after a bad earning, one would still get a 35% return if you had picked it up as a mid-cap in year 1 or year 2 (AYX is a recent example that comes to mind and I think it has a long runway).
The basic premise is once a company has spent the costs on infrastructure and building the product or services, and the sales cost to acquire a customer , it’s just a matter of expanding the client numbers to start seeing the effect of scale as incremental cost of sales is meager and this is called operating leverage. And if this comes with little to no debt and high inside ownership jump on that bandwagon without anchoring yourself to the current price as it will eventually fetch you great returns.
I am sure by traditional metric Zoom (ZM) is probably a candidate for the dot come type of bust but what if someone told you that eventually Zoom could have as many subscribers as Netflix. It may not be unreal that in the future everyone will have a personal Zoom room, and if we do a simple math: US $10 per month x 12 months x 200 million subscribers = 240 billion dollars in revenue. If you look at Zoom with this lens then it’s a buy since at a P/S of 12, Zoom could be a 300+ billion dollar company and suddenly there is still plenty of growth yet to come.
The author is an investment analyst and runs an investment advisory and consultancy – Sequity advisors (www.sequityadvisors.com). Sequity has been developing investment strategies helping generate 25% returns consistently in the last decade for investors in the US stock markets. Sequity also mentors start-ups in the APAC region to scale up their business in emerging economies like India, Vietnam and Indonesia.