No we’re not crazy!
We still get a lot of people who think that we are sort of demented because we are investing in these very high growth and high valued SaaS stocks that just don’t fit the model of the kind of stocks that they are used to investing in. They think that these stocks are an illusion and that they will collapse any day now. They are sure that our investing in companies growing rapidly with little if any current profit must be terribly risky! Then they are appalled and frustrated when our “terribly risky” portfolios either don’t crash and burn, but keep rising instead, or temporarily crash, but even at their bottoms, are ahead of the market by a large margin, but as I said above we are investing in a different world. I’m afraid they just don’t really understand the model of these companies and what is going on with them.
First of all, these companies are growing very, very, VERY, rapidly. Stop and think carefully about this next thought: If you think about it, the kind of companies that we are investing in now never existed before! Ten years ago I searched for companies growing at 15% or 20% a year, and I’m sure that you did too. And 25% growth 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. They have very high revenue growth year after year. I’m talking about 45% to 90% per year for most of them, but some even higher. I just looked at my top six positions which currently make up 90% of my portfolio, and they had an AVERAGE revenue growth rate of 70% this last quarter!!! That is NOT a misprint! An average revenue growth rate of 70% for the six of them !!! And these aren’t tiny penny-stocks. They have run rates close to a half-billion dollars on up… and they are still growing that fast. Does traditional EV/S valuation still work for a company growing at 70%?
Secondly, these are also very low capital intensive and very high gross margin companies (gross margins of 70% to 92%, for the most part). The reason for that is that they lease software on subscriptions, which is by its nature low capital intensive and high gross margin. And in general, those high gross margins continue to rise higher as the companies grow larger, as they have a bigger revenue base to absorb any cost of developing the software, and as they have more and more customers who simply renew their subscriptions, or increase their spend, without much additional sales cost. For an investor it’s like a dream come true.
That brings us to point three: The revenue of our companies is almost all recurring, because it’s on those software subscriptions, which have become an integral part of their customer’s businesses, and thus largely locked in. It’s not at all like selling refrigerators, or cell phones, or microchips, or in the old days like selling software. With our companies you KNOW that next year’s revenue will be greater. The only question is by how much? 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. Does traditional EV/S valuation still work for a company like that?
Fourthly, before we leave those subscriptions, let’s note that because they are subscriptions, our company’s actual revenue is considerably more than what they can recognize and thus considerably more than what you see in their quarterly reports. If they SOLD something they could recognize all the revenue in the quarter they sold it. With subscriptions, even under ASC 606, our company can only take a relatively small part up front, and the rest over the lifetime of the subscription, even if the customer paid it all up front, and if our company already has the money in the bank. Does traditional EV/S valuation still work for a company like that?
Fifthly, they are land-and expand companies, meaning that 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?
And think a little more about how low capital intensive our companies are. In order to expand sales they don’t have to go out and build or expand their factories! They don’t have any factories! (Think how car companies are always struggling with their factories, or chip companies with their overseas suppliers.) If our companies have more demand, they just lease more of the same software to more people. They can double their sales, or quadruple them, with almost no capex expense.
Does traditional EV/S valuation still work for a company like that?
Of course a company growing revenue 70% per year, with 92% recurring revenue, 82% gross margins, and a 130% dollar-based net retention rate is worth much, much, more than an old model company, with fairly low revenue growth, low gross margins, and with little or no visibility into revenue for the next year and beyond, but the same enterprise value, and the same current revenue! No wonder our companies get valued at much higher EV/S!
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 valuation, puts sales (revenue) as the denominator. But that’s silly! On $100 million of sales, Alteryx, with gross margins of 92%, keeps $92 million, while a grocery chain, with gross margins of 10%, keeps $10 million on the same $100 million of sales, or a normal S&P company with gross margins of 30% keeps $30, but to calculate EV/S you put the same $100 figure in the denominator for all of them. It’s nonsense! 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.
Now, do you still think that traditional EV/S valuation works for companies like ours?
And now, 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 70%, will have $170 of revenue instead of $100, and with its 82% gross profit margin, will keep $139 toward covering operating expenses.
This is while our conventional company growing revenue at a very respectable 20% , will have just $120 of revenue, and with its 30% margins it will keep just $36 towards operating expenses.
So now we have $139 gross margin versus $36 gross margin… just one year later! Now, do you still think that traditional EV/S valuation where you put the same $100 in the denominator, works for companies like ours?
The difference in compounding is enormous and grows each year. If we go just one additional year, our SaaS company will have $289 in revenue and will keep $237… while the conventional company will have revenue of $144 and keep $43.
Look at that again!
Both companies started two years ago with revenue of $100. Now our company is taking home $237 in gross profit(!) , while the conventional company is taking home $43!!! Just two years later!
Now, do you still think that traditional EV/S valuation, where you put the same $100 in the denominator, works for companies like ours?
I won’t trouble you with the calculation for the third year, but our SaaS company growing at 70% will keep $403 in gross profit, which is almost eight times the $52 the conventional company will keep in gross profit. That gives you an idea of the enormous power that compounding the combination of high growth and high gross margins has (and that our companies are blessed with).
And of course I know that our company’s growth rate will decrease with size, but I’m just trying to illustrate the effect of compounding here.
And for those who will maintain that companies can’t maintain high revenue growth for three years, Alteryx has been 59%, 53% and 55%, the last three years, and is increasing it this year, the fourth year, where its first three quarters averaged 58%.
To summarize
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 almost 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).
Again!
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, as well as their dollar based net retention rate, 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 I know that a lot of our companies aren’t yet making any net profit, but any company with 72%, 82% or 92% gross margins can make a large 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. Actually, I’d rather they keep grabbing all those greenfield customers now, while they can, before someone else comes along who could grab them, because revenue will keep flowing from those customers pretty much forever on a figurative timescale. However for me personally as an investor, I strongly prefer that my companies show that they are at least working towards reducing losses and making a profit, as that implies that their business model is successful and that they don’t have to spend an excessive amount of money to acquire new customers.
Look, there has been a revolution in the world of business, and especially in the world of software. As recently as five or six years ago, with the exception of perhaps one or two companies, a company selling software would sell a customer a perpetual license to use it. Then they’d charge for updates that the customer might have to install in each of their hundreds of computers, and they’d charge for service, and they’d try to sell the customer a new updated version of the software in two or three or four years. The customer might decide to skip the next version and just wait for the one after if he’s happy with the current one. Think Microsoft and all those Microsoft Office and Word versions you had to buy. It was the same for big companies with their software.
This procedure was bad for both of them. It was terribly inconvenient for the software customer, and there was no visibility into the future for the company selling the software.
There was little if any recurring revenue.
For an investor, encountering a growth company that had even a small percentage of its revenue recurring was a major find. The only companies that had most of their revenue recurring were slow or no-growth utility type companies. Think: the electric company!
There was little or no recurring revenue because the customer who bought a perpetual license for a version of the software this year might not buy an updated version for 4 or 5 years. All you had that was recurring revenue were service contracts, and not every customer took a service contract.
It was the same with dollar-based net retention rate. There was simply no such thing. You were essentially making a one-time sale with the hope of making another sale in a few years.
As an investor, PE and profit was all you had to go on (besides hope).
Finding a company that was growing revenue at 20% per year was great. NO companies had revenue growth of 40% to 60% on a regular basis. It was unheard of! It was something you couldn’t even imagine, except perhaps for a tiny company growing off a very small base, or as a one-time occurrence. And 70% or 80% growth??? It was a fairy tale.
But then an incredible new world came along in which data, and Internet usage, and Cloud usage, and software usage, have all hit an inflection point and taken off, literally exploded in their usage. What these software companies are selling is actually needed by every company currently, in every field, whether it’s a bank, a grocery chain, an insurance company or an auto manufacturer. It’s not going to go away. Every company needs software now, needs the internet, needs a website, needs ecommerce of some sort, needs security against hacking, needs to be able to analyze and visualize data, to analyze customer patterns, needs… well you get the idea.
And something amazing called SaaS was developed. It stands for Software as a Service: Instead of selling the software on a perpetual license, you, the software company, lease the customer your software, and the customer makes monthly payments “forever.” You have visibility for the first time in your company’s life, and your customer doesn’t have the large upfront outlay of cash. These monthly payments you are getting are recurring revenue.
You can update your software monthly, weekly, or even daily using the Internet, which keeps your customer very happy and very hooked, and keeps him renewing his lease contract every three or so years. He doesn’t need to install your update individually on 1347 different computers in his business. Your software becomes an integral and essential part of your customer’s business. You can sell the customer additional programs, with new bells and whistles that your R&D department just perfected, or sell to additional departments in the same customer company, and your revenue from this customer will be higher next year than it was this year (dollar-based net expansion rate). This is referred to as land and expand.
Because of increasing spend by existing customers, and because of increasingly high demand for what you are selling from new customers, our companies may see revenue grow by 40%, 50%, or 60% at least, each year. This means that their revenue will quadruple or even quintuple in four years, or five at most.
Their margins rise with time because their monthly S&M charges for the recurring part of their revenue are miniscule compared to what they paid for the initial sale. They can make all their updates in the Cloud and it is even cheaper, and cheaper for their customer too, as the customer doesn’t need to buy all that computer hardware.
This is still early innings. All companies out there need what our companies are selling but most of them don’t have what they are selling yet. They want to go all out and sign up as many of these companies as possible before credible competitors emerge on the scene. This means increasing S&M expense now. You know that while a dollar of S&M expense spent today is mostly expensed against your current earnings, it will bring in (expanding) revenue almost forever in the future. This incredible opportunity also means spending on R&D so you continue to have the best products to sell. But this is all new and greenfield, and the imperative is to sign up as many customers as you can, as rapidly as you reasonably can while still providing good service, and not worry about current profits.
Just think about this revolution for a minute. Every good-sized company now uses more and more software every year. They all want to be part of the cloud, they all need what our companies are selling, and most of them don’t have it yet. The opportunities are enormous, and once the software is incorporated in the customers business it becomes harder and harder to change providers… really a pain for the customer and a risk of all kinds of disruptions to their business if they tear it out, so they will need a really, really, good reason to change.
So our software companies have mostly recurring revenue, and not only recurring, but expanding recurring revenue as the old customers increase their spend (dollar-based net retention rate), and new customers sign on. This means that each year our software companies add lots of new recurring revenue. And they are growing at rates that will quadruple their revenue in four years. (Actually 50% compounded for four years will quintuple their revenue in four years, but I’m being conservative 
)
And that’s why I buy SaaS companies, that are growing revenue at rates I couldn’t have imagined a few years ago, and it’s why I don’t worry about them not making a profit now. My other criteria are still there: rapid revenue growth, recurring revenue, lack of debt, insider ownership, a moat, not capital intensive, not hardware, doing something really special, etc, etc, but I’m taking advantage of this new world.
People who are looking for conventional companies with PE’s of 15 or 20, and with 10% or 20% growth, are investing in the S&P and growing their portfolios at perhaps 12% per year, while we are growing at…. …Well, I’m up 300% percent in just under three years of doing this.
To Conclude:
You say:
How terrible. This company has EV/S of 20! How horrible! How overpriced! That’s so much higher than the EV/S of the companies I’m used to looking at!
Well duh! What do you expect? The company has 85% revenue growth and 72% gross margins, and almost all of its revenue is recurring, and it has a dollar based renewal rate of 130%. Of course it has an EV/S of 25.
Of course a company that is leasing a software solution that every enterprise on the planet needs, and that the vast majority don’t have yet, and that all those companies will keep indefinitely once they install it, will have a higher EV/S ratio than a company selling a product that anyone can put off getting a new model of, or stop buying for the duration of the recession, etc. (You can live another year with your old cell phone, or computer, or car, or raincoat, or refrigerator, or kindle, or ski jacket, or your old factory, or whatever, but once you lease this software, you keep leasing it indefinitely, no stopping for a year.)
And of course, of course, of course, companies that have ALL these features, companies with 70-90% gross margins AND a subscription model with recurring revenue AND 125% net retention rates AND growing revenue at 50% to 90%, AND selling products that all enterprises need …are going to have very high EV/S rates.! What else would you expect? And I don’t know what is high, but I will never sell out just because the price has gone up, and because I think the EV/S is too high. I just don’t know where these guys will ultimately end up.
I hope this helps.
Saul
A link to the Knowledgebase for this board is in the Announcements panel that is on the right side of every page on this board.
For some additions to the Knowledgebase, bringing it up to date, I’d advise reading several other posts linked to on the panel, especially “How I Pick a Company to Invest In,” and “Why My Investing Criteria Have Changed,” and “Why It Really is Different.”