A few weeks ago, I made an attempt to analyze and compare non-profitable, fast growing tech companies with the following attributes:
- Fast revenue growth
- Lack of positive EPS
- Lots of recurring revenue
- Light capital business model
Here’s my previous post:
Now, it’s been almost 2 weeks and I’ve had some time to think and do some additional evaluation. We’ve also had some of these companies report earnings. My thinking on how I should make investment decisions with such companies has evolved. The main change for me has been that I now shy away from companies that I believe have trouble scaling. My thinking on this seems very aligned to Tinker’s thinking. With MULE, NEWR, BL, and TLND (all of which were companies in my portfolio or on my list to evaluate), I have concluded that the complexity of selling and implementing their offering to customers may well limit the rate of customer growth and therefore revenue scalability and stock price appreciation. I realize that there may be some exceptions but I am now focusing looking at companies that I believe are on their way to scaling. The companies on this list are SHOP, SQ, HUBS, WIX, and TWLO. I already own them all and the next step is to evaluate them further for evidence that scaling is well underway. Why? Because I believe that scaling is an indicator that accelerated growth can continue and target market domination can occur.
Last night, NEWR reported their results. I see some things that I don’t like and that point to the validation of the hypothesis that their ability to scale is limited. What did I see?
The first warning sign is that revenue growth continue to decelerate. The q/q growth rate for the past 6 quarters was the following:
Q/Q Revenue Growth Q1 17 54% Q2 17 48% Q3 17 44% Q4 17 40% Q1 17 37% Q2 17 (E) 30%
Don’t like that deceleration.
Next, let’s look at customer acquisition for the past 5 quarters:
Customers Cust Added Seq Growth Y/Y Growth Q4 2016 13518 Q1 2017 14048 530 3.9% Q2 2017 14538 490 3.5% Q3 2017 14915 377 2.6% Q4 2017 15216 301 2.0% 12.6% Q1 2018 15400 184 1.2% 9.6%
They should be adding more and more customers each quarter. That would be evidence that scaling is working. If you compare the sequential growth in customers to other companies in the peer group, it looks pretty terrible. For me this is the nail in the coffin. It caused me to sell my small position today.
Now let’s look at MULE. Here’s recurring revenue growth:
Y/Y Recurring Rev Growth Q1 2016 90.9% Q2 2016 77.1% Q3 2016 70.4% Q4 2016 63.0% Q1 2017 61.7% Q2 2017 54.8% Q3 2017 (E) 44.3% Q4 2017 (E) 39.4%
While the 39% growth in recurring revenue is still very strong, the deceleration has been consistent. Now, there are some things that give some hope. The guidance may well be lowballed by management. Also, management said that there were deals that moved from Q2 to Q3 or Q4, and they said that none of the deals were lost. This tells me that high growth may continue. However, there were 2 things said on the conference call that give me great concern. First, sales take 6-12 months to close. Implementation of new customers can take a year. This is a severe limitation to scalability.
Now let’s like at customer additions:
Cust. # Added Growth (seq) Growth (y/y) Q2 2015 655 Q3 2015 716 61 9.3% Q4 2015 758 42 5.9% Q1 2016 839 81 10.7% Q2 2016 946 107 12.8% 44.4% Q3 2016 994 48 5.1% 38.8% Q4 2016 1071 77 7.7% 41.3% Q1 2017 1131 60 5.6% 34.8% Q2 2017 1170 39 3.4% 23.7%
While not as bad as NEWR, these numbers don’t inspire a lot of confidence that they can scale. In particular, I don’t like the customer acquisition over the past year. Revenue growth has been strong and it appears it has come mostly from the strong and steady increase in spend per customer and strong customer retention. These are great (see below).
Avg Recurring Rev pre Cust ($000) Dollar-based Retention Rate Q2 2015 $89 1.12% Q3 2015 $99 1.16% Q4 2015 $105 1.21% Q1 2016 $115 1.25% Q2 2016 $125 1.22% Q3 2016 $136 1.20% Q4 2016 $143 1.17% Q1 2017 $152 1.16% Q2 2017 $164 1.16%
These numbers are impressive and will probably allow (assuming they continue) MULE to continue to grow revenue rapidly for a while. I still own a substantial position in MULE and after the post-earnings release selloff, I am inclined to believe that the shares will recover and even continue the growth. However, I see a company that’s more likely to achieve scalability as a better place for my investment dollars for the long run. So I’ve held on for now but I will look to sell these share should I see an opportunity and I need cash.
Next, let’s look at TLND. Here’s the recurring revenue growth:
Rec Rev GR (y/y) Rec Rev GR (1YR) Q1 2016 39.9% Q2 2016 39.5% Q3 2016 41.4% Q4 2016 43.2% 41.1% Q1 2017 42.5% 41.7% Q2 2017 42.9% 42.5% Q3 2017(E) 37.6% 41.4% Q4 2017(E) 36.7% 39.7%
Growth is strong and not decelerating or accelerating, assuming TLND beats their guidance. For Q2 2017, the CEO noted on the earnings call that y/y recurring revenue growth would have been 46% (instead of 43%) if not for currency headwinds. Thus, in looking at revenue, there is no evidence yet that scalability is limited. We will need to watch this going forward as the company grows larger.
Now let’s look at customer number growth. TLND has more than 1500 customers, but they find it more relevant to report the number of customers who spend more than $100K per year. Here are those figures for the past several years:
Cust Added Seq Growth Y/Y Growth Q1 2015 100 Q2 2015 110 10 10.0% Q3 2015 122 12 10.9% Q4 2015 138 16 13.1% Q1 2016 162 24 17.4% 62.0% Q2 2016 186 24 14.8% 69.1% Q3 2016 221 35 18.8% 81.1% Q4 2016 224 3 1.4% 62.3% Q1 2017 259 35 15.6% 59.9% Q2 2017 291 32 12.4% 56.5%
Aside from one bad quarter, the growth figures look very strong. I don’t see any red flags yet to suggest that TLND has trouble selling their offering even to organizations with large big data budgets. Perhaps, I’ve misclassified TLND as a company that’s not scalable. We need to continue to monitor for going pains.
Other business metrics look solid as well so I’ve decided to keep my position in TLND.
I never bought any BL due to concerns about high customers acquisition costs, high on-boarding costs, and scalability challenges.
Next I will spend some time looking at SHOP, SQ, TWLO, and HUBS which are all companies that I think have shown that they can be scalable.