WSM's November 2022 portfolio review

Oh, my what a month again. This is the most tiring year of investing for me ever. Like a marathon where you get beaten up at each watering point…The biggest events of the month were - again - the Fed. Hard institution to fight against…

In this (fairly long) review I cover the results of the companies that reported in the month of November, as well as a fairly detailed and longer-form write-up of Transmedics right at the end, as I’m hoping to get some engagement from the group and have therefore included more information than a standard quarterly report.

2022 PORTFOLIO RETURN

Month YTD return
Jan -27.1%
Feb -23.9%
Mar -33.8%
Apr -43.4%
May -59.0%
Jun -59.6%
Jul -58.4%
Aug -54.2%
Sep -59.7%
Oct -60.3%
Nov -66.7%

Shock! Horror!…I can’t really sugarcoat the performance. I hope the rest of you did better. My portfolio hit a new low for the year, at -69.4% on Nov 9.

Now, to keep my balance, I also calculate my IRR for my portfolio over a longer timeframe. In January 2020 I changed my approach from a mix of value and growth and a highly diversified portfolio, to a focused, growth-oriented one. So that is the starting point for my portfolio measurement. From Jan 2020 to now the IRR achieved:

My port: ±19%
S&P: ±8%
BRK.B: ±12%

So, even after this massive drawdown, I’m still better off having invested the way I had than if I had put it all in an index tracker fund or bought Berkshire. Now I know that’s not everyone’s situation, but it’s mine and I take heart from that. It validates the approach for me.

POSITION SIZES

Bill (BILL)          17.5% (15.7%, 13.2%, 14.8%)
SentinelOne (S)      15.8% (17.8%, 17.6%, 15.0%)
Cloudflare (NET)     14.2% (17.3%, 18.0%, 19.5%)
Crowdstrike (CRWD)   11.5% (8.7%, 9.8%, 16.3%)
Snowflake (SNOW)     10.9% (18.5%, 13.8%, 12.3%)
Trade Desk (TTD)     9.6% (3.1%, 0%, 0%)
Datadog (DDOG)       9.1% (13.2%, 12.6%, 15.2%)
Transmedics (TMDX)   8.2% (0%, 0%, 0%)
Gitlab (GTLB)        0.5% (4.2%, 9.6%, 6.4%)
Twilio (TWLO)        - (1.2%, 0.9%, 0%)
Cash                 1.3% (0.4%, 5.0%, 0.5%)

The main changes I made this month were that I reduced my Snowflake position, reduced Gitlab to almost zero (my reasoning in last month’s portfolio write-up) and trimmed most of the others to reduce my outsized positions going into earnings. I redeployed the cash to increase Crowdstrike, Trade Desk and take a new position in Transmedics, which I discuss in detail below.

Now quickly a thought about my almost zero cash holding - it will be zero soon. If I were a genius, I would have been 100% in cash last year October/November. Why? Because that was the top for high-growth tech portfolios. We know that clearly now.

But that’s water under the bridge. Now, after being down an astonishing amount of money, should I increase my cash position? Or is this the time to not be in cash?

Varying one’s cash position is inherently a way of trying to time the market (which Saul advises against). It’s a bet on being close to either the bottom (no cash) or top (all cash). So, after not being in cash when I should have been (a year ago), is it wise to now go big on cash? I think not.

Perhaps next time round I can manage to time the market and do better - by selling some at the top. But having failed to sell at the top, I don’t now want to be selling at what I perceive to be close to the bottom. So my cash position is zero.

BILL

Bill reported on Nov 3. The number of ways they slice and dice the numbers sometimes confuses me. So for my purposes I dumb it down a bit.

Because of the various acquisitions, I also focus mainly on the last two quarters and on qoq growth. They have three sources of revenue in my dumbed down version of their business: subscription revenue, transaction revenue and float revenue (interest they get from holding customers’ cash).

Revenue came in at $229.9m, up 14.8%qoq (annualises to about 74%), or by $29.7m, which was a very respectable 9% beat to guidance.

Revenue is split as follows:

Subscription revenue grew from $55.2mto $58.1m, up 5.3% qoq, or $2.9m, so some slowness in the subscription business…
Transaction revenue grew from $139.6m 156.6m, up 12.1% qoq, or $16.9m; the transaction business grew slower than the revenue growth overall too. Also not that great
Float revenue grew from $5.4m to $15.3m, up 183% qoq, or $9.9m - this is the secret weapon that juices up their growth currently.

Bear in mind that our other SaaS companies have interest on cash balances that gets larger in higher interest rate environments too - hell Snowflake sits on $5bn of the stuff. But because it is not part of their business model like it is for Bill, they do not show this as revenue or operating income. Bill does. So imo we need to be careful to remember that Bill has a way of juicing up the numbers which one may argue is not really core to what they are doing.

Gross profit margins reached an all-time high of 85.8%, up from 84.2% in the prior quarter, which is great, but as pointed out above I guess most of this was due to the float revenue (which is probably 100% margin), which makes it a tad less great.

Operating income went from -$3.2 to +$9.2, so a $12.4m improvement. However this was a tad disappointing to me as all of the operating income improvement was simply driven by the float income increase which drops straight to the bottom line (and increases gross profit margins…), so no real operating leverage this Q.

Their FCF improved a lot and went from -$14.9m to $12m, so up $26.9m qoq, of which $10m was driven by the increase in float revenue and the rest by the rest of the business, so a bit of a positive there.

Customer adds were great with a record 14,200 customers added in the quarter - the most in history. And these haven’t really translated into much revenue yet. So this could either be Mickey Mouse customers, customers who haven’t yet ramped up yet, or customers acquired right at the end of the quarter. Not sure yet, lets see how things progress next Q, but I’m thinking those customers will contribute increasingly in the next couple of quarters as they take some time to ramp up, especially when looking at the huge cohort of customers added in the last 3 quarters (bolded):

Bill cust adds '000 Q1 Q2 Q3 Q4
2021 5.5 5.6 6 5.6
2022 5.6 8.2 11.6 11.2
2023 14.2

Guidance was very good for this environment, as a similar beat to the recent past of say 8%-9% would set them up for a 14%-16% sequential growth rate, keeping the latest quarter’s momentum intact and with it the annualised growth of 70-ish%.

Putting it all together, Bill did very well for this environment especially given that they are focused on SMB’s who just about every other company reporting called out as a reason for weakness in their own numbers. Good revenue growth, great customer adds (albeit very small, or not yet ramped), cautious commentary, arguably a good guide, relatively poor subscription growth, no real operating leverage, good FCF delivery. It ended up as my top position only towards the end of the month as I trimmed and equalised some of the others and it didn’t drop by as much as the others. It will probably remain one of my largest.

SENTINELONE

SentinelOne will report on 6 December. It’s down the most of any of my positions the last month - by a whopping 36% on no company-specific news. I’m not going to speculate too much on the why, but I guess the path that it still needs to travel to get to cash-flow positive territory plus question marks around how it stacks up against Crowdstrike and negative commentary by a bunch of companies about the SME space are to blame. I believe that the price drop is way overdone and have added as the price dropped to keep the position a top one.

Jamin Ball publishes a weekly overview of all listed SaaS companies and this graph tells the story quite plainly ito why I believe S’s recent stock price implosion is overdone. It is the second-cheapest listed SaaS company based on this metric, despite having had the fastest growth and gross-margin adjusted payback of the whole lot, a rule of 40 above 70% and an NRR that only SNOW and probably Gitlab exceeded. I recommend following Jamin Ball’s Clouded Judgment if you don’t already:


Source: Clouded Judgement 25/11

In the month S was recognised for their culture, diversity and being a great place to work by Fortune and Comparably. While certainly not something that will hit numbers in the short-term, having a good culture is great for long-term growth imo.

S also again impressed in a MITRE ATT&CK evaluation - this time MITRE evaluated their Vigilance MDR. I tried to parse the results directly from MITRE but it’s above my technical ability to properly interpret so I’ll stick to S’s blog on the subject: https://www.sentinelone.com/blog/mitre-managed-services-evaluation-4-key-takeaways-for-mdr-dfir-buyers/

The evaluation did not task the team to stop the attack but rather to just track the attackers, which they did. However S had this to say, which I think is the key to why they are continuing to do well:

"It is crucial to note, however, that a real-life application of detection and response technology and MDR services should be aimed at preventing and mitigating such attacks as quickly as possible—before the adversary can perform recon, move laterally, or steal data.

In a live scenario of this incident, the SentinelOne Singularity platform and Vigilance services would have stopped the attack from the very first detection. If set to “Protect” mode rather than “Detect-Only”, the Sentinel Agent would be equipped to autonomously kill the entire chain in an instant, without analyst intervention"

I continue to stay the course here due to my belief that cyber should prove relatively more resilient vs the rest of SaaS in this environment. This is further supported by the CEOs of Cloudflare, PaloAlto and ZScaler’s comments in their ERs indicating general cyber tailwinds, even though the relative weakness of Crowdstrike puts a question mark around whether that includes endpoint or not. Lastly, I believe S is firmly on its way to getting to break-even and beyond in the quarters and years ahead.

We’ll know to what extent they’ve lived up to my expectations tomorrow.

CLOUDFLARE

Cloudflare reported results on November 4th, and I thought the quarter was ok.

I know some people did not like what they saw, which was the following:

Revenue came in at $254m which was a beat, but a poor showing as beats go - the lowest I have on record for them.
Growth slowed to 47.6%yoy/8.3% qoq. This was their slowest growth since 2018.
FCF was not yet positive: at -$4.6m thereby kicking the fulfilment of their promise of becoming FCF positive to the last quarter of this financial year.
Gross margins dropped by 1%pt to 78%, and NRR dropped by 2%pts to 124%.

However I looked at the quarter and thought it was pretty strong for this environment. I thought the revenue growth, NRR and gross margin decelerations were relatively small and were all signalled at the beginning of the year already. CEO Prince put this in context nicely when he said in the Q3 Q&A:

I think we started to see that, as we’ve talked about on previous calls, in December of last year, and you’re seeing some of that slowness in new business now flow through and hit our top line.
[…]
The nature of subscription businesses is that if you see slowdowns in the beginning of the year, they show up in your top line later in the year.

So what he’s saying is that the current quarter revenue slowdown was apparent to them at the beginning of the year, and that is why he signalled it then already, and also why they made GTM changes. He’s saying the revenue slowdown is old news. So what’s important is what he’s signalling going forward. More on that a bit later.

Their operating margin improved to 6%, the highest since 2018.
Operating cash flows improved to $42.7m and a 16.8% margin, their best yet.

Prince was quite bullish on what lies ahead, especially as it relates to their security products:

"What I think is continuing to hold up extremely well right now, and in fact, in some cases, we’re seeing acceleration, is in the security portion of our business.
[…]
What I think, if we dig down a little further into the security business, I think especially in February of this year, when we saw Russia and then Ukraine, a lot of security companies expect that, that would be a tailwind to their business. What I think actually ended up happening was that, that tailwind did not materialize, and that the threat that the Russians are coming turned out to not be something which was showed up outside of the Ukrainian theater.

However, in the last several months, and especially in Q3, we started to see an increase in cyberattacks coming out of both Russia and other parts of the world. That drives increasing adoption of products like Cloudflare’s products at a very, very, very high velocity. So where we’ll see close rates that you can often measure in hours or days.

And so I think that, that expectation of the war in Ukraine and other political conflicts around the rest of the world leading to more security business was something that I think a lot of the industry expected would show up in Q1 and Q2, and we actually saw it show up more in Q3."

And then he went ahead and put a $5bn ARR target in 5 years on the table, and he got his brand spanking new CRO to publicly commit to the target after just a week in the job:

CEO Prince:

“Even as we achieve $1 billion, we have penetrated less than 1% of our identified market for products we already have available today.
That’s why we’re confident. We’re on the path to organically achieve $5 billion in annualized revenue over the next 5 years.”

New CRO Marc Boroditsky:

“We don’t need to invent new technologies. I see a clear path to $5 billion in 5 years simply by selling what we already have in the bag to the customers that already know us.”

That’s a 38% CAGR for the next 5 years…very strong. Add to that a pretty strong Q4 guide (for ±8% sequential growth) and strong growth in RPO and cRPO - both came in at 52% - and it looks to me like Q4 and the years thereafter will not disappoint.

On customers, I find their total customers, of which they have 156,000 less relevant as a metric as many of them are so small. They added 4197 customers in the quarter. So what - most of them are simply an interesting way for them to test their product. What is more interesting is the growth in large >$100k customers:

cust >$100k Q1 Q2 Q3 Q4 Q1 QoQ Q2 Q3 Q4 Q1 yoy Q2 Q3 Q4
2019 336 387 451 526 7% 15% 17% 17% 71% 65% 73% 68%
2020 556 637 736 828 6% 15% 16% 13% 65% 65% 63% 57%
2021 945 1088 1260 1416 14% 15% 16% 12% 70% 71% 71% 71%
2022 1537 1749 1908 9% 14% 9% 63% 61% 51%

Customer growth clearly slowed. But did it slow disastrously and/or is there a worrying trend? I see no long-term trend of slowdown. And large customers still grew by 51% yoy and 9% qoq - still above revenue growth (that is not the case for DDOG or CRWD). And >$1m customers, of which they have 75 grew faster - probably closer to 60% (they don’t give that metric each quarter and have only given it at the end of the year historically, but extrapolating the numbers gets to a rough approx). Given that they are now increasingly entering Zero Trust territory, where deals are much larger (and similar to SNOW landing a few very big customers moves the dial), I’m thinking perhaps wait a bit before concluding on this score. I give them a pass on customer growth.

And guidance? They guided for 41.8% revenue growth for next q. With a bit of a beat, that would get them close to 50% again - so no big slowdown coming of the magnitude that DDOG or CRWD is signaling (30%s). And not very far below what they’ve done historically of just above 50%.

That leaves the question mark of the day: can they pump out free cash flow? And can they do that next quarter already?

On this one I trust Prince. I think they have a lot of levers to pull to generate FCF next quarter. Their OCF is already pretty strong at 17% of revenue and Q4 was a strong FCF quarter last year so they have both cash flow seasonality and the potential to curtail opex. And they have two further levers to pull: capex and working capital. Capex has been relatively elevated, and their billing cycle has not focused on getting a lot of cash upfront from their customers in general. The CFO addressed the latter specifically in the Q&A and said that moving to annual billings is their biggest opportunity to drive increased CF. He specifically said that we will see this come through in improved FCF in coming quarters and stated that Q4 is still not a huge annual billings quarter for them (as most billings is monthly) - “at least not yet”. So my read is that they are moving in that direction and we will see some of that in the coming quarter. And just as I was writing this, they made a concrete move in that direction. By raising prices per 15 January 2023 and allowing customers to lock in the old price by moving to annual billing before then. Very smart imo: https://blog.cloudflare.com/adjusting-pricing-introducing-annual-plans-and-accelerating-innovation/

Lastly - the coming couple of quarters of a likely global recession: how will that impact them? Prince addressed this too. He said that because most of their revenue is not derived from either seat-based or usage based billing, they are more insulated than businesses with primarily seat-based or usage-based models.

I still see Cloudflare’s revenue trajectory going steady and far and ultimately producing a lot of cash.

CROWDSTRIKE

On reflection, Crowdstrike reported a bit of a disappointing set of results to me.

Revenue came in at $580m - which was their lowest beat I have on record.
Revenue growth slowed
to 53% yoy/8.5%qoq (annualises to about 39%), but net new ARR disappointed (it also disappointed the management team) by declining 9% qoq, something that has not happened in any Q3 of the last 5 years.
Margins held steady, with product GM% remaining at 78% and Op margin ticking down 1%pt to 15%.
FCF margin was strong at 30%

“Our dollar-based net retention rate was well above Q3 of last year and consistent with our Q2 performance, which was at the highest level in seven quarters. Our best-in-class gross retention rates remained at record levels above 98%.”

→ This means NRR was well above 122% (Q3 last year) and in line with >128% (Q2), driven by continued success with driving incremental module adoption. Given that they’re not losing customers (gross retention great) and they had a record NRR, it means their slowdown is due to the sales machine not managing to land new customers. And for that, they blamed the macro environment and trouble in SMB country:

Customer growth was disappointing. Customers added were the lowest in 8 quarters:

Cust adds Q1 Q2 Q3 Q4
2021 830 969 1186 1480
2022 1524 1660 1607 1638
2023 1620 1741 1460

ARR from large customers (>$1m) grew by 67% yoy and was good for roughly half of their total ARR, yet their overall revenue growth rate was only 54%. That must mean their smaller (<$1m) customers grew by ±40%. So they seem to have been very unsuccessful with smaller customers.

In addition, the US business slowed much more than the rest of the business. In the table below, I annualised the qoq growth rates per geo and in total for the past couple of quarters, to try to get a sense of the current/in quarter growth. Note that the US is 69.4% of the total revenue so is by far the most important. The annualised qoq growth slowed from 63.5% a year ago in the US to 34.9% this Q and from 60.1% a year ago to 38.9% this Q. That’s quite a deceleration.

Rev g% qoq annualised Q222 Q322 Q422 Q123 Q223 Q323
US 53.6% 63.5% 48.2% 64.2% 37.4% 34.9%
EMEA 57.5% 40.1% 113.7% 75.9% 42.2% 52.7%
APAC 67.7% 63.2% 83.3% 50.9% 66.0% 45.8%
Other 45.1% 65.0% 261.7% 53.9% 138.4% 42.4%
Total 55.1% 60.1% 65.6% 63.9% 44.8% 38.9%

An analyst asked about the reasons behind the US weakness in the Q&A, which the CFO answered quite poorly I thought, as he did not provide an answer…

Still, management were bullish, especially wrt their larger customers:

We believe cybersecurity investments is resilient and is prioritized, especially among the world’s largest organizations as represented in our $1 million-plus customer cohort

Their guidance was not great imo, except for fcf:

  • Net new ARR to be up to 10% lower in Q4 than current Q.
  • No budget flush anticipated for Q4. This was a big one; one of the analysts called it “like telling a kid Santa Claus isn’t coming for Christmas
  • Significantly slowing the pace of new hires from Q4
  • Net new ARR in 2024 flat; implying low/mid 30% growth for next year
  • They see a clear path to 30% FCF margin for next year

So with enterprise customer ARR growth of 67% and NRR and gross retention at record levels, what, from that starting point, could cause such a level of ARR softness going forward? I only really see two possibilities:

  1. they are expecting a big NRR deceleration, driven by a combi of
  • large customer behavior slowing in aggregate or
  • losing a couple big customers or
  • a couple big ones decelerating big time next q
  1. they anticipate not acquiring sufficient new customers. And to move the needle that much it would again need to be a failure to acquire big ones, or a huge failure to acquire small ones.

Given the NRR and gross retention trends and level (high and improved) I can only really see 1 being the big driver if they are, for example, disproportionately exposed to big tech companies. Endpoints probably correlate with employees and hiring has slowed across the board for big tech. The layoffs and slowdown in hiring will only hit next q, so that is certainly possible.

But it also leaves a strong possibility that they are simply losing the new customer acquisition game given the relatively poor new cust adds this q - possibly driven by the fact that they are now fighting on two fronts: on the top end vs MSFT and PANW and on the bottom vs S. Hence they got a new CMO in September to work on “top of funnel”.

Given the above, I don’t quite follow their narrative of blaming a lot of the weakness on SMB’s and macro, as they would need a lot of softness in the enterprise market to justify the anticipated ARR slowdown. I decided to trim CRWD a little more.

SNOWFLAKE

Snowflake’s results on 30 November was interesting. The CEO ploughed through the prepared remarks as if on a military mission, and thereafter most of the Q&A was answered by the CFO. It was businesslike without any cracks.

Revenue came in at $557m or 67% yoy growth/12% qoq which was towards the lower end of their historical beats (they guide on product revenue), but not worryingly so.
Margins held and even improved: product GM stayed at 75%, operating margin improved to 8% from 4% in the prior q and 3 % in the prior year, and FCF margins stayed at 12%.
NRR slipped a bit, to 165% from 171% but to be honest this is to be expected as this is an insanely high NRR and the CFO has guided that this will come down for many quarters already.

But it was in the GTM machine that things were really impressive. In the past I fretted about the efficiency of their sales machine, and I must say that this part of their business fired on all cylinders. In the same league as Bill ito their success with customer growth.
Customer adds were strong, >$1m ttm customer adds were strong and G2K customer adds were massive - they added 28 G2k customers, double what they did in Q2 and just one less than what they added in the prior 2 quarters together:

Cust added Q1 Q2 Q3 Q4
2022 393 458 426 528
2023 378 486 484
Cust >$1m ttm Q1 Q2 Q3 Q4
2022 104 116 148 184
2023 206 246 287
G2000 add Q1 Q2 Q3 Q4
2022 11 29 19 24
2023 15 14 28

Given the importance to them of adding quality customers, this is an A+ performance in this environment.

Also, sales efficiency continued to improve, as measured by the number of G2K customers added for each 500 sales employees, after a bit of a dip earlier this year. This is impressive given how much the sales machine has expanded over this time: by 57% yoy from 1,672 employees a year ago to 2,625 this Q.

G2000/500 S&M empl Q1 Q2 Q3 Q4
2022 3.8 9.2 5.7 6.3
2023 3.3 2.9 5.3

All in all, this is a powerhouse of a company that is just continuing to power ahead. I will likely increase my position.

THE TRADE DESK

The trade desk reported numbers on 9 November that bucked the trend of disaster which other ad-tech companies seemed to have reported almost universally. And therein lies the biggest take-out for me for this company: they are massively gaining market share currently.

CEO:

“I believe that through the first 9 months of the year, we have gained more market share, grabbed more land than at any point in our history.”

Revenue came in at $393.9 for 31% yoy growth. It was a 7% beat to guidance which is relatively low historically but still decent.

Gross profit margin held steady at 82%.
EBITDA% (which is comparable to operating margin for our non-capex heavy SaaS co’s) increased to 41% and net profit margin to 33%!
Operating CF margin was 34.8%

This is a more simple business to track than our other SaaS companies imo and it is a cash-generating, profitable beast of a company with a very strong competitive position currently grabbing market share in a huuuuuge market.

Bear in mind this is a very cyclical business from Q to Q and also from year to year: Q1 and Q3 are weak, Q2 and especially Q4 strong, and every second year, of which 2022 is one, has an election fuelled bonanza in Q4. I expect growth to pick up for this company going forward, and for Q4 to be stronger than anticipated, which is different to many others in my portfolio and one of the reasons for owning it.

For a fuller review, read @mekong22’s various write-ups on the company; he’s stuck with them for a very long time.

DATADOG

Datadog reported results that reflected belt-tightening at their customers reminiscent of the deceleration at the beginning of COVID.

Revenue came in at $436.5m, which was a low beat to their guidance - in fact it was the second-lowest % beat I have on record; the lowest was in the dreaded COVID quarter of Q2 2020.
Growth decelerated to 61% yoy, but that significantly overstates what happened in-quarter. QoQ growth was only 7.5% which annualises to 33.4% (vs 15.8% / 80.1% annualised a year earlier) - a massive decel.

Gross margin held at 80%, but operating margin contracted to 17% from 21% in Q2 and 23% in Q1.

FCF of $67.4m was good for a 15.4% margin, up marginally from the prior quarter.

NRR was still >130% but that really doesn’t say anything. Did it come down from 140% to 131%? We don’t know. But it had to be something along those lines, given that customers added came in relatively flat, same as it has for most of the last couple of quarters, and large customers added in the last 2 q’s - with >$100k in ARR - were lower than the 3 before that:

Cust adds Q1 Q2 Q3 Q4
2019 600 700 1,000
2020 1,000 600 1,000 1,100
2021 1,000 1,200 1,100 1,300
2022 1,000 1,400 1,000

→ Not much movement in those adds over the last three years…

>$100k adds Q1 Q2 Q3 Q4
2019 86 133 131
2020 75 51 98 146
2021 178 164 230 210
2022 240 170 180

Also, there was a question in the Q&A about exactly this: what was the direction of NRR, which the CFO answered by saying they don’t give that detail, and then proceeded to explain that, yes, it was down (but not as much as in COVID).

So what to make of all of this? We can see that the number of large customers as well as the total number of customers added has been relatively flat for many quarters now, resulting in a steady customer growth slowdown over the last two years from 40% yoy in Q1 2020 to 27% now. Which to me says that the massive revenue growth of the last year and a bit was probably mostly driven by a rapidly expanding NRR, which is now going in reverse as customers reduce usage.

Guidance was ok: given a roughly 5% beat they could accelerate slightly qoq.

I’m still not too sure about this one. Same as Crowdstrike I worry about the relatively lacklustre customer additions (although slightly less so than CRWD), rapid revenue deceleration and guidance which hints at mid/high 30% growth for next year - again same as Crowdstrike. Which leaves me wondering given that I’ve kinda decided to trim CRWD: why should I settle for similar growth at lower scale with about half the fcf margin? Why does the Dog get a pass but Crowdstrike does not?

Perhaps both should get a fail? It worries me enough that I may trim DDOG further.

TRANSMEDICS (TMDX)

The leadership

The CEO and founder of Transmedics is Waleed Hassanein, MD. He has been at it for more than 22 years…having founded a company myself more than 20 years ago, I know how long that is. Although in most instances such a long period of time without the company really taking off is a big red flag, in this instance I don’t think it is. It simply takes that long to get regulatory approvals and get health practitioners and insurers to buy into, and ultimately pay for, innovations in health care. I think it is a testament to the founder that he has remained resilient for so long. This really is his baby, and I would wager he is extremely careful not to stuff anything up, now that the company and adoption is finally taking off.

What they do

I’m not a medical doctor, so what follows is my interpretation of what this company does. Transmedics solves a big problem on the supply side of the organ transplant supply chain. There is a huge demand for organs, which currently cannot be met due to inefficiencies in the supply side which leads to most donated organs being thrown away. Transmedics solves this with new technology and a better supply chain for the process.

Transmedics is replacing cold storage of donated organs (organs on ice) with their OCS product as the standard of care. Their system keeps organs warm and artificially perfused (=warm blood/fluid being pumped through the organ to keep it “alive”). This results in organs staying relatively healthy and usable for much longer than keeping them on ice.

In addition, most donated hearts have historically been thrown away without even an attempt to get them transplanted. This is because most people die from heart stoppage and not from brain death, and historically only/mostly organs harvested from people dying from brain death (and hence with their heart still beating) could be used. Organs die quickly if not properly perfused and also relatively quickly when on ice. Because TMDX puts the organs on “life support”, even organs deemed not feasible in the past due to the way the person died, are now considered feasible for transplantation, resulting in an expansion of the market.

TMDX also provide the service of distributing the organs from the donor to the transplanting hospital, thereby alleviating this difficult and non-core logistical problem for the transplanting hospital.

In addition, doctors can now inspect organs pre transplantation to see if they are suitable and and also treat the organs pre transplantation with hormones etc. that increase the success of transplants.

Lastly, because organs can now be “kept alive” safely for longer, doctors and the transplanting team at the hospitals doing the transplants now no longer need to rush in to do a transplant whenever someone with the right donor organ dies (i.e. unscheduled, middle of the night), but can schedule the procedure during the day and when there is operating room capacity.

Taken together, these improvements are huge as it solves problems and reduces costs for everyone in the chain (except the donors, of course…): recipients benefit as there is now more usable organ supply and the outcomes are better, the medical teams doing the transplants now can do a procedure during the day and don’t need to get up and rush to the hospital at 3am, OR’s benefit as they can schedule the procedures and hence do more of them (and hence make more money), and health care insurers benefit as doing a transplant is cheaper than keeping patients alive with alternative care, hence doing more transplants is in their interest.

TMDX has in the last year or so gotten regulatory approval for three organs: heart, lung, liver. And they are working on providing kidney in the future.

And kidney transplants is a big deal, as there are many, many more patients in need of a kidney than all 3 other organs combined:

Source: HRSA / Organdonor.gov

Currently the main constraint on TMDX’s growth is capacity, something which they are planning on improving by a factor of 3x by the end of the year.

Also, they don’t really have competition. Their OCS machine can support lung, heart and liver (with different “fittings”) while competitors offer only one of the three.

Customer adoption

I found this article describing tests that the Mayo clinic are doing with a “heart in a box” system from Aug 2021. It is not explicitly mentioned, but the machine in the picture is one of Transmedics’ OCS machines: Organ perfusion systems a boon to heart and lung transplants - Mayo Clinic From the article:

“This system preserves a heart while it is beating, extending the time between retrieval and transplant by several hours. With the standard heart preservation technique, this window has ideally been only about three to five hours. In addition, the new system has the potential to widen the donor pool by supporting the novel use of donation after circulatory death (DCD) hearts by reviving and supporting the recovery of nonbeating hearts.”

So from a customer perspective it looks like adoption is going well.

Ok, on to the numbers.

First let’s look at the TAM to guage how much more runway is left in their current markets. Below is their Q3 revenues, their Q3 revenues annualised, and that as a % of the TAM per organ. Clearly there is a huge runway left as they are less than 2% penetrated into the current TAM. And that is before the TAM extention which adding kidneys could bring (see the graph above).

Organ Q3 Revs $m Annualised $m TAM % penetrated
Lung 1.3 5.2 2,540 0.2%
Liver 12.4 49.6 3,015 1.6%
Heart 8.2 32.8 2,470 1.3%

On to their reported financials. They only got regulatory approval for heart and liver - the two biggest contributors to their revenue - at the end of 2021, so the 2022 numbers are what I focus on.

Revenue growth is very strong, clocking in at 25% qoq in the last quarter (and 375% yoy) and in the call it was clear that they could have grown much faster if they weren’t supply and capacity constrained. Given that they are aiming to 3x their capacity in the last Q of this year, it feels like they could continue the momentum.

Revenue $m Q1 Q2 Q3 Q4 QoQ Q1 Q2 Q3 Q4
2020 7.5 3.4 7.1 7.6 2020 -55% 109% 7%
2021 7.1 8.2 5.4 9.7 2021 -7% 15% -34% 80%
2022 15.9 20.5 25.7 2022 64% 29% 25%

Gross margins have steadily inched up over the last couple of quarters and is above 70% - very strong for a non-software company:

GP % Q1 Q2 Q3 Q4
2020 65% 56% 71% 63%
2021 68% 68% 70% 72%
2022 76% 70% 71%

Operating margins have shown extremely fast improvement after in the last couple of quarters, going form -116% in Q4 of last year to -21% in Q3, and the same goes for net profit margins, going from -131% to -29% in the same time frame.

Op % Q1 Q2 Q3 Q4
2020 -107% -232% -65% -78%
2021 -92% -121% -217% -116%
2022 -59% -47% -21%
NP % Q1 Q2 Q3 Q4
2020 -72% -83%
2021 -103% -67% -174% -131%
2022 -67% -56% -29%

This is not SaaS and they carry stock. So inventory turnover is important (number of times you sell your inventory per year - the ratio between cost of sales and inventory) - i.e. are they efficient with their inventory? We want that number to be high and going up. An dit seems that the absolute number is not that great, but it’s steadily improving. Also, I would argue that in this phase of growth you want to keep a relatively large supply of inventory on hand, especially given the very high margins. Finally, the absolute inventory number has not really moved too much in the last quarters. So I’m happy with this metric.

Inventory $m Q1 Q2 Q3 Q4
2020 11.4 12.6 13.0 11.9
2021 11.8 13.0 14.9 14.9
2022 16.7 17.5 18.8
Inventory turn Q1 Q2 Q3 Q4
2020 0.9 0.5 0.6 0.9
2021 0.8 0.8 0.4 0.7
2022 0.9 1.4 1.6

In summary

This is a company growing extremely fast with a recurring revenue model and high gross margins and no real customer concentration by the look of things. They have a very deep moat/barrier to entry and strong competitive advantage relative to the existing standard of care. They bring a radically improved solution to an existing process and large global problem which saves costs and improves outcomes for all in the supply chain. They have very little competition and their market penetration into their existing product set (lung, heart, liver) is still very low (<2%). And this is before the market-expanding potential of additional organs, most notably kidney, and international expansion outside of the US. The company is founder-led, and although he does not own a massive shareholding, he does seem to have a fair bit of skin in the game with just under 2% of the shares, and 22 years at the helm.

FINISHING UP

I am finding it quite hard to handicap the results of the companies in my portfolio at this stage and to isolate which factors are transitory in nature (hell even the Fed got that wrong, right?) and macro-induced, which are down to the market that they’re in being perhaps smaller and/or more contested than I thought and which are down to execution not going as well as I would have wanted. Not a single company shot the lights out (except Transmedics).

However, having said that, I believe that success with adding customers is crucial in all markets. If your customers are not doing great, then you will feel some pain - always. But as long as you are adding customers, you should eventually be ok again when the tide turns. But if you are not adding customers you’re in trouble - always. Like Fastly was back in the midst of the go-go times of a year or two ago where nothing could seem to go wrong with SaaS companies when they weren’t adding customers. Existing customers don’t grow forever, and some always leave. So adding customers is key.

And on this score, Snowflake, Bill, the Trade Desk (gaining market share) and Transmedics did well, Cloudflare did just ok and Crowdstrike and Datadog disappointed (not vs expectations - vs their own history and in absolute terms). I intend to weight my portfolio accordingly.

Good luck, all, and may the macro smile on us in 2023.

-WSM.

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Thanks wsm! Great write up. I wanted to add some thoughts to your BILL discussion:

So for me the thing that’s now clear is that float revenue is boosting the growth at the moment. So float revenue is very sensitive to the CHANGE in interest rates. And the change in rates has been enormous over the past 6 months. Enormous in a historical record sense. Where will interest rates go from here in the short-, mid-, and long-term? I think we all know that the percentage CHANGE in interest rate increase must come down as even further 75 bps increases will mean a lower float revenue growth. But I don’t think any of us believe that 75 bps will occur more than maybe one more time. This means that float revenue growth can show big Y/Y growth for maybe 2-3 more quarters at best. After that the float revenue growth will grow only as a result of an increase in float dollars assuming that the Fed maintains the interest rate (doesn’t loosen or tighten for a while). If the Fed starts lower rates then this will be a big headwind to float revenue growth. So if we strip out float revenue BILL is maybe a 45-50% grower on the top line with margins in the low 80%s. Maybe all their recent customer adds over the past 3 quarters will keep growth in the 60-70% but this assumes that these new customers will ramp up. The next big question is whether strong customer acquisition will continue strongly: are the last 3 Qs a new normal or not? We’ll see…

GauchoRico

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Hi Gaucho,

The way I think of it is that the rising interest rates causes Bill’s customers to be more cautious and spend less money so transaction revenue goes down — but that that decrease in transaction revenue was balanced by increased float revenue.

So I would assume that when interest rates stop rising and perhaps start falling, customer companies will become much more optimistic and will spend more liberally as the economy relaxes, and that that increased transaction revenue will balance decreasing float revenue.

But that’s just my simple minded way of thinking about it.

Best,

Saul

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