CompoundingCed's Dec 2022 Review

It was an uneventful end to the year portfolio-wise. While the market has no regard for arbitrary time periods (like a calendar year), I’m glad to turn the page on 2022.

In reflecting on 2022, the question of how one could have avoided the plunge inevitably arises. I’ll be the first to admit that it’s not a good idea to ignore valuations when investing. While it’s easy to advocate exiting when the market is over-valued, it is less easy in practice. In my view, there are 2 main difficulties.

The first difficulty lies in determining what is considered over-valued. Even after a 70-80% plunge, there are people who view our companies as over-valued. (I think a couple companies are still expensive.) As Saul’s track record has shown, should you decide to sit out seemingly over-valued phases of the market, you could miss the opportunity for great wealth creation. Howard Marks reminds us that “Being too far ahead of your time is indistinguishable from being wrong.”

The second difficulty is maintaining sanity holding cash when asset prices around us are rising. Do not underestimate the toll of looking stupid or coping with FOMO day after day for months and years on end. This can be just as damaging to your mental well-being as dealing with a bear market.

I don’t have a good suggestion (otherwise I would have used it in Q4 2021!) but one solution could be to gradually take money off the table in a bubbly market.

How do we define a bubbly market? In looking back to the build-up to 2021’s ATH, a clear sign was the presence of all 3 of these:

  • prices running beyond valuation for many of my companies
  • localised ATH for the S&P 500 and Nasdaq P/E ratios
  • Plenty of street chatter on stock investing.

As this is not the right forum to discuss portfolio management (thanks Saul for the latitude), I shall leave this thought here. If you wish to continue this discussion, you can find me on Twitter.

Moving on, one thing I could have done better in my valuation work was in my forecast of forward growth rates. In some cases, I assumed future revenue growth rates to be higher and more enduring than they actually turned out to be.

For example, Sea Limited was a company that until Q4 2021, was still posting over 100% YoY growth rates, and had been doing so for the past 14 quarters (over 3 years). I did not expect triple-digit growth to continue, and instead assumed a gradual tapering (like 80% the next year and 60% the following year). We now know what actually happened. Within 3 quarters from the peak, growth had fallen to 17% YoY.

While Sea is an extreme example, it serves as a reminder that I should 1) be more critical in analyzing how revenue could be impacted under a stressed economy and 2) where appropriate, apply more conservative assumptions in my valuation model.

On a penultimate note, this community has been invaluable in helping me maintain sanity during this turbulent period. I found solace knowing I was not walking alone. You also make me feel more confident we can recover from this mess of a year. So thank you.

Lastly, in spite of the pain we have suffered this year, spare a thought for the many less fortunate folks out there. Even in down years, I make a small(er) donation to certain causes. Do consider making a small donation to causes that you are most passionate about.

Have a great 2023!

Follow me @CompoundingCed in Twitter for more sharing.

Areas of Improvement for 2022

This section is a reminder to myself.

After reviewing my 2021 decisions, the area where I didn’t do well was in portfolio allocation.

My mistakes were:

  • Too small allocation to fundamentally stronger companies.

(For e.g. I only had 2.4% in DDOG at one point)

  • Adding to fundamentally weaker companies as their prices fell.

(For e.g. I added to FUBO a few times as prices fell)

  • Initiating try-out positions with too high allocation.

(I would typically start with 5% allocation. On hindsight, this seems too high.)

YTD Returns


Jan 2022 -21.4%

Feb 2022 -24.6%

Mar 2022 -22.8%

Apr 2022 -37.9%

May 2022 -51.5%

Jun 2022 -51.2%

Jul 2022 -46.7%

Aug 2022 -44.2%

Sep 2022 -49.1%

Oct 2022 -51.8%

Nov 2022 -56.3%

Dec 2022 -58.5%

Monthly Activity: It was a quiet month. There was no activity for the portfolio.

There are new thoughts on Tesla in the individual company section below. Otherwise, every company write-up remains the same as last month’s update.

These are my 8 holdings at the end of the month. At the time of writing, my stronger positions are GTLB and GLBE. Weaker ones are S and CRWD. This could of course change next quarter.


Company      Dec 2022 Nov 2022

Gitlab        10.5%     8.7%

Tesla**        9.2%    11.8%

SentinelOne    8.2%     7.8%

ZScaler        5.6%     6.3%

GLBE           5.0%     5.0%

Cloudflare     3.9%     4.0%

BILL           2.7%     2.9%

CRWD           2.2%     2.3%


Cash          52.6%    51.1%

**Discussion of this company is OT for the board. I am including it for completeness. Please contact me off board if you wish to discuss this company.

Medium Allocation Companies (5-10%)

Gitlab

Gitlab had another great quarter. In Q3, Gitlab achieved

  • 69% revenue growth YoY

  • 89% gross profit margin and improving non-GAAP operating profit margin of -19% (vs -36% in the same period a year ago)

  • FCF margin improved to -3% (from -15% in the same period a year ago)

  • Customer (>$5k ARR) growth was 59% YoY and Customer (>$100k ARR) growth was 49% YoY.

Growth is slowing, but not at a worrying pace. Q4 revenue growth should come in at close to 60%. While it is still early days for CY 2023 guidance, the company said it was “comfortable with the Street estimates, which have us growing revenue over 40%.”. I take this to mean it can hit 50% growth next FY. Margins are improving at a good clip while the company expects to be FCF breakeven by CY 2024.

Call notes:

”We’ve had great gross retention. It’s been about the same for the last 4 quarters. So no major uptick there. And then also, we aren’t seeing the sales cycle elongate that actually shrank again this quarter, but we are seeing more scrutiny on deals.”

On why the company can expand when headcounts are being reduced:

“It’s a bottoms-up land when we land a new customer, it’s typically 50 to 100 licenses. In some cases, they have thousands and thousands of engineers and expand over time. And that’s why the cohorts are still expanding.”

“On net dollar retention rate, the #1 reason why they’re expanding is seat expansion. The second is for tier upgrade to Ultimate. And then the third is increased yield from the customer.

When you have a mission-critical platform and everybody needs to basically drive quicker time to value, you’re seeing a move to a platform, and those returns are paying off for those companies.

Under a different market sentiment, I have no doubt this stock will be flying. For the past few earnings, the stock has popped ~20% post earnings release (only to be beaten down by sentiment in the weeks that follow). I’ll be happy with a 10-12.5% stake in this company.

Tesla

**Discussion of this company is OT for the board. I am including this for completeness. Contact me off board if you wish to discuss.

How quickly things change! A couple months back, Tesla was still the market darling. Now worries abound after a delivery numbers miss. I share some thoughts here https://twitter.com/CompoundingCed/status/1610513250487275524?s=20&t=Rm_Bf0hv4DvvwlvBnbYpDA

After a weaker than expected Q2, Tesla did very little wrong in Q3.

  • Revenue grew 56% YoY to $21.5b

  • Non-GAAP operating profit improved to 18.9% (from 18.0% in Q3 2021)

  • FCF margin improved to 15.4% (from 9.6% in Q3 2021)

  • Model S/X deliveries up 101% YoY

  • Model 3/Y deliveries up 40% YoY

  • Global vehicle inventory: 8 days

It was a very bullish call:

“As our factories ramp, we’re looking forward to a record-breaking Q4. So it really, knock on wood, it looks like we’ll have an epic end of year. So Q4 is looking extremely good.”

“On the production ramp**, Giga Berlin achieved another milestone of 2,000 cars made in a week with very good quality and is ramping rapidly**. Giga Austin or Giga Texas should reach this milestone very soon. And in fact, just yesterday, we extrapolated yesterday’s hold rate, it would be 2,000.”

There was some commentary on supply chain issues:

As we look ahead, our plans show that we’re on track for the 50% annual growth in production this year, although we are tracking supply chain risks which are beyond our control. On the delivery side, we do expect to be just under 50% growth due to an increase in the cars in transit at the end of the year, as noted, just above.”

“This means that, again, you should expect a gap between production and deliveries in Q4, and those cars in transit will be delivered shortly to their customers upon arrival to their destination in Q1.

This was the reason cited why share price dropped after results were announced. I don’t see how a difference in delivery timing is a huge issue.

There had been growing calls for share buyback on Twitter and Musk took the opportunity to address this:

“Even in the downside scenario next year, even if next year is – was a very difficult year, we still have the ability to do a $5 billion to $10 billion buyback. This is obviously pending Board review and approval. So it’s likely that we’ll do some meaningful buyback.

I don’t think Tesla needs to do a buyback at this stage in its growth and shared my thoughts here: https://twitter.com/CompoundingCed/status/1581974389259898880?s=20&t=cHfviQeEcaekN5CfW5lFCA

There was some chatter about Tesla’s valuation (Musk: “I see a potential path with Tesla worth more than Apple and Saudi Aramco combined.”) but that’s unnecessary noise as far as I’m concerned.

Tesla is still a high conviction company right now because of the visibility of its runway and its ability to execute in what is a notoriously difficult industry. I’d be happy to add if the market continues to throw up silly prices, up to a max 15% position.

My thoughts on Musk are here: https://bit.ly/3M05B5U

My write-up for the company is here Tesla Inc | An Investment Pilgrim's Journal

**Discussion of this company is OT for the board. I am including this for completeness. Contact me off board if you wish to discuss.

SentinelOne

Q3 results were decent but not great.

  • Revenue grew 106% YoY but only 13% QoQ.

  • Gross Margin improved to 71.5% (from 66.8% in the same period a year ago)

  • Operating margin improved to -43.0% (from -69.1% in the same period a year ago)

  • FCF Margin worsened to –56.2% (from -37.8% in the same period a year ago)

  • Customer growth also strong: large customers (>$100k ARR) growing 117% YoY and 28% QoQ.

This was its weakest QoQ growth since publicly publishing results. The company is guiding for 8% QoQ growth in Q4 and expects Q3 weakness to persist. Continued QoQ growth in the low teens will see YoY growth come down rapidly from its current triple-digit growth rates.

Given where the other companies are, I can accept a 50-70% growth for next FY, but my (unsubstantiated) sense is it will be punished for such a guide come Q4.

Call notes:

We’re seeing higher cost consciousness and prudence around IT budgets. Enterprises are striving to enhance their security posture while also preserving cash. As a result, we are experiencing longer sales cycles and purchase delays, particularly among larger deals.

“In light of persistent macroeconomic uncertainty, we’re sharpening our focus on cost management and are calibrating our investments with the pace of growth.

We expect the macro conditions impacting growth in the third quarter to persist in Q4.

There was good information on MSFT Defender as a competitor, their strength in Singularity Cloud vs endpoint competitors and data offerings in XDR projects. For brevity, I shall not post them here on my portfolio review; I encourage you to read the call transcript for more information on these.

This company is a good reminder of how quickly things can change with our high-growth companies (or with any company). Just a quarter back, I said that this was a high conviction company after its monster Q2 and sustained high growth rates.

I added 2% to my position a few weeks before the call. I won’t be adding to the company and will monitor to see how the macro situation develops in relation to my cybersecurity companies.

ZScaler

All things considered, I thought ZS posted a decent-to-good quarter but the market liked it less than I did.

  • Revenue grew 54% YoY and 12% QoQ.

  • Operating margin improved to 11.8% (from 10.4% in the same period a year ago)

  • Customer growth was weak: both customers (>$100k ARR) and (>$1m ARR) grew 6% QoQ.

Call notes:

“Our business value message is resonating in this challenging macro environment and more customers are willing to adopt our broader platform to consolidate multiple point products, increasing our average deal size. As a result, we are actively working on more large, multiyear, multi-pillar opportunities than ever before, to align to the increasing deal sizes in each of our geo theaters.

Our Q1 results exceeded our guidance on growth and profitability even as we manage through additional deal scrutiny and longer reviews.

In our opportunity pipeline, we’re actively working on more multiyear and multi-pillar opportunities than we historically have. While good for our business, larger deals take longer to close as customers introduce more checks and reviews.

I didn’t like that customer growth was so much weaker compared to previous quarters. However, given the macro situation, I can accept a likely high 40% growth for ZS in its FY.

I’m happy with my medium allocation for now. I’m unlikely to do much with this.

Global-e Online

GLBE facilitates cross-border e-commerce.

It aims to make international transactions as seamless as domestic ones.

Services include

  • interaction with shoppers in their native languages

  • market-adjusted pricing

  • localized payment options

  • compliance with local consumer regulations and requirements such as customs duties and taxes

  • shipping services

  • after-sales support

  • returns management

The company solves a pain point for merchants as huge upfront costs and efforts are needed to offer cross-border sales.

According to Forrester, brands typically see around 30% of e-commerce traffic being international but in terms of actual sales figures, no more than 5-10% come from international shoppers.

Q3 results were very good IMO but share price suffered following the release due to lowered guidance (from 74% YoY growth for the year to 67%)

  • 79% YoY revenue growth

  • Gross margin improved to 41.5% (from 38.6% in the same period a year ago)

  • Operating margin was flattish at 11.5% (compared to 11.5% in the same period a year ago)

The lowered guidance in and of itself doesn’t worry me. Q4 is still expected to come in at over 70% YoY growth. However, there are headwinds to take note of, as one would expect for a company reliant on e-commerce. More in the notes below.

Call notes:

“In order to err on the side of caution, we have decided to slightly lower our GMV and revenue forecast for 2022 by 2.5% and 2% at the midpoint of the range, respectively, in order to take into account 2 extraordinary factors which we anticipate will have an unusually large adverse effect on our Q4 results. First is the effect of the unusually large foreign exchange swings, which worsened through the third quarter and into November, especially those of the U.S. dollar vis-à-vis other major currencies. The other factor is the go-live of a very large merchant, which was originally planned for Q4, but at the last minute was postponed to Q1 of 2023.

While the overall e-commerce market growth has slowed down in 2022, our cross-border opportunity remains massive as merchants are continuing to put direct-to-consumer in the front-end center of their strategy which results in cross-border direct-to-consumer continuously gaining share over other channels and growing.

“However, in Q3, what we started to see, especially in the second part of Q3, is also some slowness in APAC region, mainly Australia and New Zealand that we’ve seen a decrease in consumer spending, while U.S. is still holding relatively strong. So still, we see growth. When we look at our existing merchants, we do see growth, but it is a softer growth than what we’ve seen in previous quarter, but this was basically already built in and this trend is starting even prior to reporting our Q2 results.

“As we said, although there are obviously some headwinds and a lot of volatility, the segment that we focus on, which is cross-border and even more important, the direct-to-consumer is still growing very, very fast. We expect to continue the fast growth into next year. And we think that taking into account the fact that the market is huge, and we are just starting to tap into it, we will be able to grow fast for the next few years. And then this is our target.

The company also gave an update on its Shopify partnership: “We do believe that on the growth rate, the main effect would come on in 2024 onwards as the bulk of of merchants, I would say, launch some time and start along sometime within late Q3 – late 2023 and affect our 2024 growth rate.”

Given the more volatile nature of e-commerce revenues compared to SaaS companies, I’m happy to maintain a low-ish allocation.

Low Allocation Companies (0.1-5%)

Cloudflare

Cloudflare started to show weakness in Q3 but I somehow didn’t feel that disappointed after reading the call notes.

Q3 Results:

  • Revenue growth was 47% YoY to $254m

  • Non-GAAP operating profit margin improved to 5.8% (from 1.3% in the same period a year back)

  • FCF margin improved to -1.8% (from -23.1% a year ago)

  • Paying customer growth was 18% YoY.

  • $NRR was 124%

Call notes:

On their NRR: “We will continue to be dissatisfied until it’s over 130%, and we believe that it’s still very achievable as we add seats and storage-based products like Zero Trust and R2.

Some weakness was starting to show in the results: “We saw a higher level of churn in our pay-as-you-go customer base, primarily due to more customers shifting down to our free customer tier. We think this is a function of a more challenging macro environment.

“In the quarter, we observed an increase in our sales cycle and expect similar sales dynamics to continue, leading to longer lead time deal closures. We are cognizant of the increasingly cautious environment and have factored this into our outlook.

There was also some good news: “Our win rates against Zscaler and Palo Alto Networks continue to be very strong. Our product in that space competes extremely well with them. I think that Zero Trust is very much going to be the story of the next few years to come.

Putting things in context: “We are talking about a subscription-based model. So a lot of the things we see in the third quarter and we’ll see in the fourth quarter are the impact of when we started to talk about the macro climate going to change. So when we give guidance for the fourth quarter, it’s less the in-quarter impact of the business. It’s just a flow-through of what already has happened.

We, of course, for sure not assumed an improving of the macroeconomic environment. And with an outlook in Q4 and Q1, there’s nothing that signals that it’s going to get better anytime soon.

The CEO took the opportunity to stress the strength of their subscription business in times like these:

“I think that if you are a usage-based, a purely usage-based model, it is a place where people are looking for areas to save money. Similarly, if you are a seat-based model, as you’re seeing some companies do layoffs or, at a minimum, not expand their seats, that is something that is challenging in the current environment.

“I think we are fortunate that today, most of our revenue is not usage-based and not seat-based. And so while we are adding products that are in both of those categories, and we think that over time that, that will be an expansion driver for us, that today, we’re not seeing that downward pressure from people trying to rationalize or consolidate their bills.

The CEO received a question on customers moving to the free tier and why NET wouldn’t “raise the floor on that so you can hold on to the paying customers?”

CEO: “I think that what we see as the value from that pay-as-you-go business is that those customers, whether they pay us something or not, end up being our biggest advocates and our biggest champions inside whatever large organization that they operate at.

“So if you look at who are our largest customers and you go down the top 10 customers, almost all of them came to us originally because some technical leader inside that organization used Cloudflare’s pay-as-you-go services, fell in love with us, understood us and was able to adopt us as part of that. And so I think that, that benefit is so substantial to us that we always want to make sure that we’re treating those customers well.

“They may go from paying us $20 a month to not paying us something because gas prices went up**, that isn’t something that we’re trying to optimize for. What we’re trying to optimize for is that those customers love us, they understand us and they take us to work.** And so as they do, that’s how we’ve been able to close so much of the Fortune 500. Behind almost every 1 of those Fortune 500 wins is a pay-as-you-go customer who advocated for us internally, and that is our secret sales force.

I thought that was a fantastic example of long term thinking by the company’s leadership.

There is no doubt the company is facing some headwinds in the current environment. However, I didn’t come away from the call feeling like the decline would be drastic, compared to say SNOW or DDOG. My expectations are for low 40% growth in this challenging period, which is not a drastic decline from the 50+% it was posting before.

Following the 20% decline in share price after results was announced, I added a small 1% allocation.

BILL

BILL is one of my two latest positions. I’ve held back for quite a long time as I was worried that the boost it received in FY 2022 from transaction revenue would be hard act to follow in FY 2023. Following the Q1 call (FY starts in July), I was pretty pleased with what I read, so I initiated a position.

Q1 Results:

  • Revenue growth was 98% YoY and 15% QoQ

  • Non-GAAP Gross Margin improved to 85.8% (from 82.7$ in the same period a year ago)

  • Non-GAAP operating profit margin improved to 4.0% (from -16.8% in the same period a year back)

  • FCF margin improved to 5.2% (from -21.9% in the same period a year ago)

  • Customer growth was 36% YoY (not including Divvy and Invoice2go).

  • Gross take rate increased to 0.24% (from 0.17% in the same period a year ago)

In spite of the weakening macro, the company guided for a pretty strong Q2 (54-56% YoY growth) and raised guidance for the full year from 56% to 61%. They were not assuming a severe economic downturn (which is anyone’s guess whether it happens).

Call notes:

“Our second priority in fiscal 2023 is to further scale our go-to-market ecosystem by offering more of our platform solutions to our current partners as well as acquiring new relationships.

For the first time, we are now issuing virtual cards on behalf of an existing FI partner. This partner adopted the Bill solution because of our supplier enablement momentum and processing expertise.

Our third priority is to drive ongoing payment adoption and innovation across all channels. Recently, we made it simpler for Canadian and U.K. suppliers to choose to receive payments in their preferred currency via our network, driving higher FX adoption and more engagement. In the near term, we plan to offer this option to suppliers in other countries that receive cross-border payments for us, further expanding our reach.

During Q1, Bill stand-alone TPV per customer, excluding the FI channel, declined by 3% sequentially. In Q4, we saw mid-market businesses beginning to moderate their spending, and that trend is now visible with our micro and SMB customers as well.

In the near term, the macro environment appears to be increasingly challenging for businesses. We anticipate the trends we’ve observed with businesses moderating their spend will continue throughout fiscal 2023. And we expect that this will translate into lower year-over-year payment volume growth in the quarters ahead.

At the same time, in this environment, the value proposition of our platform is resonating more than ever with SMBs, and we have seen strong engagement from existing customers continued high retention and healthy new customer demand. Now more than ever, businesses need our solutions to navigate the uncertain environment, and we believe this is an opportune time for us to invest in our business. We believe we can accelerate the positive impact we’re having for SMBs globally while monitoring the external environment and proactively balancing growth and non-GAAP profitability.”

In the near term, we don’t necessarily expect the same level of monetization expansion as our volume between issuers is going to be more stable in the forward quarters. And over the next few quarters, I’d say the near term, really, we’re expecting lower expansion in that take rate, perhaps even lower than historical averages given the macro environment.

BILL is not that hard a business to understand. But it’s hard to get a handle on how revenue growth will turn out with the uncertain macro environment. Transaction volumes will be hit for sure. What is less sure is the rate at which they sign up new customers and how many services customers sign up for.

While the value BILL provides its customers is undeniable – I don’t think any of them will go back to pen and paper – SMBs might hold back on digital transformation in the current environment. In spite of the very strong guide for FY 2023, things can change rapidly in the SMB space. As such, the most I am comfortable with this company is a 5-7.5% position. I initiated with a 2.5% position and will look to add into price weakness.

CRWD

I re-initiated a position in CRWD a few weeks before earnings. I exited my CRWD position in 2021 over concerns of slowing growth. Seeing its performance in 2022 and how other companies have performed, I then accepted that slowing growth for its size was inevitable and it was doing as well as any of my other portfolio companies. Then came the weak guide during Q3 results announcement…

In Q3,

  • Revenue growth was 53% YoY and 8.5% QoQ

  • Non-GAAP operating profit margin improved to 15.4% (from 13.3% in the same period a year back)

  • FCF margin was rather flat at 30.0% (compared to 32.3% in the same period a year ago)

  • Customer growth was 44% YoY

  • ARR grew 55% YoY.

This was a great set of results. What was disappointing was the forward guide for next FY. The company guided for low-to-mid 30% growth, which would be a larger than expected deceleration from this year’s mid-50% growth. Given all the talk about the strong demand for cybersecurity products leading up to Q3 results, this was shocking. In reality, the company is probably being conservative and will achieve high 30% to low 40% growth, but the guide rattled investors.

My plan was always to initiate a position at 2.5% and then evaluate as Q3 and Q4 results reveal more about the next FY. I’m glad I didn’t rush into a 5% position (the reminder at the top of the review helped!). As things stand, it is unlikely I will add more and even more unlikely I will make this larger than a 5% position. I will also consider the sum of my S+ZS+CRWD position and I don’t wish to make it larger than a 20% position (currently at 16.4%).

Previous Updates

Jan 22: CompoundingCed's Jan 2022 review

Feb 22: CompoundingCed's Feb 2022 Review

Mar 22: CompoundingCed's Mar 2022 review

Apr 22: CompoundingCed's Apr 2022 review

May 22: CompoundingCed's May 2022 review

Jun 22: CompoundingCed's Jun 2022 review

Jul 22: CompoundingCed's Jul 2022 review

Aug 22: CompoundingCed's Aug 2022 review

Sep 22: CompoundingCed's Sep 2022 Review

Oct 22: CompoundingCed's Oct 2022 Review

Nov 22: CompoundingCed's Nov 2022 Review

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