For those worried about whether our SaaS stocks will come back and why they are valued at such a higher EV/S than Walmart and General Motors, I thought that this was a very appropriate time to pull this from my June End of the Month. Even if you’ve read it already, rereading it might soothe your jangled nerves. It worked for mine.
AN EXPLANATION OF THE VALUATION OF OUR STOCKS
I’m sure that some of you have wondered why our companies are valued so much higher than conventional companies. There’s been a lot of discussion and worry on the board (which is a good thing, and a lot better than if there was no worry). Here’s a more detailed explanation of their valuation expansion. It has occurred because other investors (and the market) have gradually come to realize the facts I explain below. I’ve tried to make the explanation as clear as possible, and I hope that it makes good sense to you.
The kind of companies that we are investing in now never existed before! Look, ten years ago I searched for companies growing at 15% or 20% a year. And 25% was a dream come true. Now I don’t even bother looking at a company with 20% or 25% revenue growth.
We are investing in a new model of enterprise. Our companies have very high revenue growth year after year. I’m talking about 40% to 65% per year for most of them, but some even higher. These are also very high gross margin companies (70% to 92% for the most part). Their revenue is almost all recurring, on software subscriptions and thus largely locked in, and their dollar-based net retention rates are generally greater than even 120%. This means that last year’s customers buy a lot more this year than they bought last year instead of having an attrition rate, or forbid-the-thought, being companies whose customers make one time purchases, or companies that sell hardware, and thus don’t even have ANY revenue guaranteed next year at all. I’ve never seen companies like ours before. Have you?
Think how different this is from companies that sell “things” and have to go out and sell them again next year to the same people or different ones. And think how low capital intensive our companies are. No factories that have to be built or enlarged to expand sales! Just lease more software.
Of course a company growing revenue 50% per year, with 95% recurring revenue, 92% gross margins, and a 130% dollar-based net retention rate is worth a much, much, higher EV/S than the old model of company, with fairly low revenue growth, low gross margins, and with little or no visibility into revenue for the next year and beyond!
And revenue which has very high gross margins is worth more per dollar of current revenue (in other words, it’s worth a higher EV/S) than lower gross margin, revenue. WHY? Let me explain it to you.
EV/S, which is traditionally used for evaluation, puts sales (revenue) as the denominator. But that’s silly! On $100 million of sales Alteryx, with gross margins of 90%, keeps $90 million, while a grocery chain, with gross margins of 10%, keeps $10 million on the same $100 million of sales. Revenue by itself doesn’t tell you much of anything. It’s the gross margin dollars which ought to go in the denominator, not total revenue.
Let’s consider an extreme example for clarity of understanding: I’ll take a hypothetical conventional company and compare it with an equally imaginary one of our SaaS companies:
Let’s say that our conventional company has a 23% gross margin. That means it keeps $23 out of every $100 of revenue to cover operating expenses and profit. And let’s say our SaaS company has a 92% gross margin. That means that it keeps $92 out of that same $100 of revenue. (I said it would be an extreme example, but Alteryx had a 92% gross margin last year, and a 55% rate of revenue growth).
Almost by definition, the high gross margin company is worth four times as much as the conventional company FOR EVERY MILLION DOLLARS OF REVENUE, because it keeps four times as much of every dollar of that revenue as gross profit. (It’s not the revenue that counts, its what you keep out of it. For example, a grocery chain may keep only 5% of its revenue.)
Thus, it’s totally normal for the SaaS company, with high gross margins, to have an EV/S ratio four times as high as the conventional company, even if they were growing at the same rate. The high margin company SHOULD have an EV/S ratio four times as high! (And, for example, if you were comparing it to a conventional company whose gross margins were 31%, our SaaS company should have an EV/S three times as high, etc.)
Note that that is WITHOUT even taking into account the higher rate of growth, which compounds, and without taking into account the recurring revenue.
WHY is the RATE OF GROWTH of revenue important for comparing EV/S? There’s a heck of a good reason! Next year our SaaS company growing at 50%, will have $150 of revenue instead of $100, and with its 92% gross profit margin, it will keep $138 toward covering operating expenses.
Let’s say our conventional company is growing at a nice steady respectable 10% per year. Next year, it will have just $110 of revenue, and with its 23% margins it will keep just $25 towards operating expenses. So now we have $138 versus $25… one year later!
The difference in compounding is enormous and grows each year. If we go just one additional year later, our SaaS company will have $225 in revenue and will keep $207… while the conventional company will have revenue of $121 and keep $28.
Look at that again! Both companies started two years ago with revenue of $100. Now our company is taking home $207 in gross profit , while the conventional company is taking home $28!!! Just two years later!
I won’t trouble you with the calculation for the third year, but our SaaS company growing at 50% will keep $310 in gross profit, which is ten times the $31 the conventional company will keep in gross profit. That gives you an idea of the enormous power that the combination of high growth and high gross margins (that our companies are blessed with), has.
And for those who will maintain that companies can’t maintain 50% revenue growth for three years, Zscaler was over 50% the last two years, and at 59% and 65% the first two quarters of this fiscal year. Twilio was 66%, 44% and 63% for the last three years, Alteryx has been 59%, 53% and 55%, etc, etc, etc.
If the conventional company is trading at an enterprise value of let’s say, four times its revenue, isn’t our SaaS company worth four times THAT! Or six times that, … or who knows, ten times that?
Remember that in two years the SaaS company will be taking home 7.4 times as many dollars in gross profit as the conventional company, and 7.4 times an EV/S of 4 gives you an EV/S of about 30. That’s what many people simply don’t get. You don’t even have to look at that 10x three-year example, which would justify an EV/S of 40.
You can argue that the rate of growth for the conventional company should be 13% instead of 10%, or that it should have a gross margin of 28%, or 35%, instead of 23%, and that will change the numbers slightly, but it won’t change the story at all.
And in our defense, my example used 50% revenue growth, but as of the end of May, when I made up this example, Okta was the only stock in my portfolio with revenue growth that low last quarter. All the others were above it. In fact, the percent rates of growth of revenue for my companies in the previous quarter were 50%, 51%, 56%, 55%, 59%, 65%, 71%, 81%, and 108%. Thus using 50% for our SaaS companies in the calculation was no exaggeration. In fact, it was actually being quite conservative. And five of my nine companies had gross margins over 80%, and two others were over 75%.
Now let’s consider that our company has almost all recurring revenue, and a dollar based net retention rate of 130%, which means that it is enormously more certain that our SaaS company will have increased revenue next year than that the conventional company will even have the same revenue next year. How much is that worth in increased EV/S? Is that security of our revenue worth another 30% tacked on? Or 20%, or 40%. I don’t know. But it becomes clear that, by simple arithmatic, the reason that our SaaS companies are exploding in EV/S is that the market is starting to do the same arithmatic that I just did.
We have Factor One – A company with a higher gross margin takes home more dollars out of each $100 of revenue, and thus, by definition, is worth a higher EV/S, even without considering the higher rate of growth.
Then Factor Two, even more important. Companies with high rates of growth of revenue will compound that revenue enormously in just two or three years, and combined with the high gross margins, that will produce hugely more gross profit dollars than a conventional slower growing company that started with the same revenue.
That our companies have an even greater EV/S (EV divided by current sales), flows by definition from that, when compared to a conventional company with the same revenue!
Finally Factor Three, which is perhaps less easy to quantify, but a large percentage of recurring revenue, and a high dollar based net retention rate, gives much more security to the revenue and to its potential increase, and thus would warrant an even further increase to the EV/S in some investors’ eyes (like mine).
To summarize the summary,
The huge, even enormous, relative number of gross profit dollars that our companies have, and will have in the future, for each current dollar of revenue, because of their growth rates and high gross margins, compared to the relatively small amount of gross profit that a conventional company has, and will have, for the same current dollar of revenue, is what gives our companies the much larger EV/S ratios. Simple as that!
And don’t bother telling me our companies are not making any profit. Any company with 75%, 85% or 95% gross margins can make a profit whenever they decide to! All they need to do is slow down their enormous S&M spending, whose purpose is to grab every new customer they can grab while the grabbing is good. Personally, I’d rather they keep grabbing all those customers now, because revenue will keep flowing from them for the indefinite future.
So this is an entirely different set of facts we are dealing with. That’s how I see it anyway. And I hope that I made it clear for you.
ON MARKET TIMING
Let me remind you that I’m no good on timing the market, and I don’t try. If I did, I would have exited all my positions at the end of April 2017, when I was up 26% in four months and my portfolio had already beaten my total results of the previous two years (combined!). It was clearly time to get out and wait for the pullback that never came!
Picking good companies makes much more sense to me than trying to pick good companies AND trying to time the market too. I have stocks in a small group of remarkable companies, in which I have high confidence for the most part. I feel that they mostly dominate their markets or their niches, they are category crushers or disruptors, they have customers that absolutely need them, they have long runways, and they will have great futures.
All enterprises, whatever industry they are in, use more and more software, want to use the cloud, AI, big data, and the rest, and they need the software that our compaies are leasing. Most of our companies provide the picks and shovels for enterprise companies switching over to the cloud, and the enterprise companies NEED what our companies have to offer.
Again, good luck and good investing to you all,