WSM's portfolio review end Jan 2023

[wsm007]

Well we seem to be off to a good start, at least. It was my first month in the green in what feels like forever. Let’s hope the Fed doesn’t spoil it later today…

Here’s what I did in January:

I sold most of my SentinelOne shares and reallocated it to my top 4. My thinking about S has changed a bit after looking at someting which does not often get looked at in detail on this board (and almost all of our companies exclude this from their commentary), namely gaap operating profits and SBC. Now why look at that? Because SBC is a cost to someone and it needs to be taken into account in one’s thinking in some way (I think we all agree on that - we just have passionate debates about whose cost it is). So, either you include it in your thinking by thinking through the dilutive impact of SBC (i.e. you think about it as a direct cost to shareholders, which it is, actually). Or you incorporate it into a company’s expenses as GAAP dictates, which makes hiding the ball more difficult for management teams and makes comparing companies easier.

First, dilution: S’s weighted average share count was up 7% in the last 4 quarters. That’s quite a lot. More than most companies we follow I believe.

Next, gaap operating margin (so this includes expensed SBC according to the way GAAP requires). Here I’m comparing S to other companies in my portfolio, but I’m starting the comparison at the point where each company had revenues below $50m (it’s roughly $45m for all companies - that’s the first column in the table below):

So vs my other portfolio companies, at similar stages of growth (i.e. the 6 quarters starting on the one in which each one had revenues of ±$45m), S is in a league of their own ito how opex & SBC intensive the business model is: with a negative 90% gaap operating margin last Q (vs better for all of the others).

Now normally that wouldn’t need to be an issue per se. But in our current environment where profitability has become relatively (vs 2020-2021) more important than growth that’s a big deal. So to offset that negative, revenue growth really must be flying, like SNOW’s was at that point in time. However, I’m not sure that S is in that spot - we all expect that revenue growth will slow, and management said the same thing.

Now I don’t think S will crash and burn - I’m not going on an S bashing here. The company is founder-led, they’ve got more than enough cash on hand to easily handle the cash burn for many moons, their revenue is still growing exceptionally fast and they are improving their operating margins each quarter. I still believe all of those things. And it is really cheaply valued. However they may be forced to guide lower for next year than what they previously implied, or they may only just miss the implied ARR growth for this coming quarter (they did last quarter) or they may not be able to pull the breaks on opex fast enough (especially SBC may be expensive for them as their share price has tanked so much).

So I simply came to the conclusion that I do not want such a big position in S at the moment as I had prior to this. I think the stock could really take off given its exceptionally low valuation relative to its growth - but I’m not as sure as I was before. And I’m more sure about my top 4 positions. Hence I significantly lowered my position in S, however what I retained is leveraged with options. If it does take off I should benefit a lot. I’ll wait for earnings and reassess. I’m not writing this one off.

My 2023 results

January: +7.2%

Yay! It’s a psychological win after last year. I’ll take it - volatility and all.

Portfolio composition

Company	Ticker	% of port
Snowflake	SNOW	23.3%
Cloudflare	NET	22.7%
Datadog	DDOG	21.2%
Bill	BILL	20.0%
Trade Desk	TTD	5.1%
Transmedics	TMDX	4.6%
SentinelOne	S	2.9%
Crowdstrike	CRWD	0.2%
	Cash	0.0%

Individual companies

Snowflake

Snowflake announced plans to acquire two companies in Jan: Myst, a small company, probably acquired for the talent and mobilize.net which has upward of 200 employees on LinkedIn and which helps with migrations from legacy DB’s to Snowflake. From their website:

SnowConvert from Mobilize.Net can unblock your move to Snowflake from Teradata, Oracle, SQL Server, Apache Spark and more. Our automated migration tools can reduce the effort needed to migrate SQL procedures, scripts, and tables by as much as 88 percent. Our analysis tools can help you extract all your data warehouse code and understand the level of effort—as well as any potential issues—to migrate that code to Snowflake.

I believe that Snowflake has enormous further potential to grow average revenue per customer in its G2000 base, and that many of the workflows that SNOW enables will not get cut in a downturn. My view is therefore that SNOW should continue to see outsized relative growth compared to just about any other company out there at this scale. They will also start pumping out a lot of cash simply by curtailing hiring. I’ll be watching the CF number and NRR with a lot of interest when they report.

Cloudflare

In January they won a $7.2m CISA contract and Palantir announced a strategic partnership with them. Given that Palantir’s bread and butter is Government work, this seems to bode well for Cloudflare’s inroads into winning more work as the US Government upgrades its technology and security.

I believe that we may get strong - perhaps very strong - cash-flow numbers from Cloudflare in the ER on 9 Feb. Given that they promised to get to CF positive territory this financial year and this is their last quarter to make good on that promise, I’ll be watching that FCF number like a hawk.

Bill

Nice short name. Getting used to dropping that .com Last Q the standout achievement was the huge number of new customers they managed to sign up. This quarter I’ll be watching to see how much that has translated into revenue. Last quarter subscription revenues were up only 5.3% and transaction revenues up 12.1% sequentially, with float revenue creating the nice tailwind to margins and the bottom line, fuelled by higher interest rates. I’ll be looking for a continuation of that story this quarter (and hoping that subscription revenues do not deteriorate further): relatively subdued subscription and transaction revenue being boosted by outsized float revenue falling to to bottom line for as long as the Fed holds rates high. A nice hedge in the business model. I’ll be looking for mid 60% revenue growth yoy. ER coming up tomorrow - looking forward to it!

Datadog

With Datadog the thing that became more important to me this month is the long history this company has of extremely efficient growth. It has a fantastic business model. Frictionless sales motion coupled with hugely impressive innovation cadence. No other company that I follow has managed to grow this fast this big with so little cash burn.

They have a usage-based revenue model, so will likely see some further pull-back from the 7.5% sequential growth of last Q, but should also see acceleration once “the macro” abates. For the coming ER on 16 Feb I’ll be looking to operating margins bouncing back from the relatively low 17% they hit last quarter and looking for revenue growth in the mid 40%'s.

The Trade Desk

The key thing that impressed me in the last quarter was the extent to which this company gained market share in an otherwise depressed and volatile digital ad market. While posting strong financial numbers: EBITDA margin of 41%, net profit margin of 33% and operating cash flow margin of 35% is just great. For the coming ER I’m hoping for an acceleration of growth from the 31% reported last Q, fueled by political ad spending, but will focus more on comments around market share gains, as was the case last Q.

Transmedics

Transmedics guided to $22.9m revenue for next quarter which would be a 11% sequential decline (still good for 136% yoy though) but with analysts, probably cognisant of how much management has low-balled guidance in the past, averaging $24.5m. I’ll be looking for something much closer to $30m. Let’s see. This company could be explosive and that’s probably why @XMFRob has it as such a big position. I’m very tempted to increase my position but don’t know what to reduce in order to buy more!

For those not familiar with the company, they put out a new investor deck on January 12th. Highly recommend squizzing through.

Finishing up

Things can only get better this year, right?

Good luck, all!

-WSM

Previous reviews

Dec 2022 full-year

Dec 2021 full-year

Dec 2020 full-year

[SaulR80683]

@wsm007

First, dilution: S’s weighted average share count was up 7% in the last 4 quarters. That’s quite a lot. More than most companies we follow I believe.

Hi WSM, let me suggest a different way of thinking about that. Sentinel had 7% more shares than a year ago but revenue was up 106%. That means revenue per share was only up 99.1% instead of 106%. Do you have any other companies who had revenue per share up 99% last quarter ???

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Next, gaap operating margin (so this includes expensed SBC according to the way GAAP requires).

Well, actually, SBC causes dilution but doesn’t cost the companies a penny.

GAAP counting it as an expense AND a dilution is just the way the bunch of obsessive CPAs who created GAAP decided to punish the tech companies who used SBC for being bad boys.

Look, if a company creates and gives away a share of stock, it dilutes the stockholders by a share, but it doesn’t cost the company anything. And if they give away a thousand shares it doesn’t cost the company any more than one share, which again, is zero dollars.

If the adjusted earnings are $5 million but the company gives away 100,000 shares worth $20 million, guess what? The company doesn’t actually lose $15 million. It makes the same $5 million they had before GAAP started messing with them. That’s the profit they have before capex, etc. Those 100,000 shares didn’t cost the company anything.

And that’s the reason that every one of our CFO’s says “when I give results everything after revenue will be in adjusted figures,” and why they say they use adjusted internally to evaluate how the company is doing, and why both company and analyst estimates are in adjusted numbers, etc.

Best,

Saul

[MajorFool20]

@wsm007

My thinking about S has changed a bit after looking at something which does not often get looked at in detail on this board (and almost all of our companies exclude this from their commentary), namely gaap operating profits and SBC…

First, dilution: S’s weighted average share count was up 7% in the last 4 quarters. That’s quite a lot. More than most companies we follow I believe.

Thanks WSM for the detailed portfolio review post. I am glad you brought this topic up as it is something I have been looking into recently as well during the slower month. I was debating posting a new topic on this but figured I would add my comments here.

I agree with your assessment of SentinelOne. Their stock based comp has consistently been around 40% of revenues since coming public. This is far too high for my liking. I would like to see this number closer to 20%, but ideally below. For now, I have not reduced my position like you have done - I am giving them a bit of a hall pass in the short term as I think much of this can be chalked up to their somewhat recent IPO, acquisitions, and smaller size. I fully expect this number to decrease in the coming quarters.

With that being said, I am curious if you have carried out the same exercise for your other holdings, particularly Bill? Out of all my holdings, I consider Bill to be the worst offender with regards to SBC/dilution.

Since the acquisition of Divvy closed six quarters ago, Bill has seen their SBC jump to 32% as a percent of revenue on average. Consequentially, the weighted-average number of shares has ballooned. Two years ago, in Q1 2021, Bill reported an weighted-average number of 80,216 shares. The most recent figure from Q1 2023 was 105,086 shares. This is a whopping 31% increase in share count over just the last two years!

This kind of dilution is very excessive and going to make future returns difficult if they continue at this pace. I expect much of this was driven by the Divvy and Invoice2Go acquisitions. While these acquisitions have helped fuel their revenue growth, they have come at a cost. Bill has diluted the heck out of their shareholders in the process. For this reason, I am not comfortable making Bill one of my largest positions in my portfolio.

One other thing to note - Bill broke out their diluted share count for the first time in the most recent press release - 117,191. I expect they will be including this figure on future reports. It will be a number I am watching closely, along with their SBC. Hopefully, we begin to see these figures stabilize.

Rex

[SaulR80683]

@MajorFool20

This is a whopping 31% increase in share count over just the last two years! This kind of dilution is very excessive and going to make future returns difficult if they continue at this pace. I expect much of this was driven by the Divvy and Invoice2Go acquisitions.

Whoa Rex, I have to ask the same question. Two years ago Bill had $46 million revenue in the quarter. This last quarter they had $230 million. That’s FIVE TIMES as much revenue as they had two years ago !!! 500% as much revenue !!! And you are complaining about 31% dilution in that time??? You must be kidding !!!

So they “only” have 382% as much revenue per share as they had two years ago. Almost four times as much! Wow! what a catastrophe!

Do you have any other companies with four times as much revenue per share as two years ago?

The only possibility would be Sentinel which has grown revenue from $25 million to $115 million in that quarter in the last two years. That’s 460% as much revenue.

Saul

[rhill0123]

To elaborate further on share dilution by our companies, if I squint at the data, here is how it looks:

BILL has been about 10% per year - but they have done big acquisitions in this number
SNOW around 7% per year
DDOG around 3% per year
CRWD around 3% per year
ZS around 4% per year
MELI around 1% per year (note different kind of business)
TTD around 2% per year
MDB around 5% per year
NET around 4% per year
MNDY around 3% per year
ZI around 1% per year
OKTA around 3% per year

My conclusion is, companies in our list that are middle of the road and growing in the 40-50% range, tend to do around 3-5% per year. The fast growers have been higher. BILL has been making transformative bolt-on acquisitions and is smaller than the others so I don’t think it is completely fair comparison.

So this data hopefully gives some calibration around this. If you are growing at 8-10x your dilution rate, I would say that is a pretty healthy situation, and definitely worth the tradeoff.

If you are troubled by these levels of dilution, then these kind of companies aren’t for you. There are ones on the list that are still rather fast growth but slow diluting, like MELI, TTD, and ZI. You could look at those.

Thanks,
Rob

[wsm007]

Hi Saul I don’t think we disagree. I basically said as much below: either you think through the implications of SBC in terms of what the impact is on a shareholder (which I also said is the actual nature of it, so we are agreed) - see quote below, or you think it through by expensing it as required by GAAP. Two ways of looking at this vexing equity compensation conundrum (if my rusty memory is to be trusted, I remember a couple decades ago SBC was not expensed like it is now; it was often accounted for directly in Equity - many people disagreed with that methodology too because you could “hide” management compensation outside the income statement).

My beef is more that we don’t - or rather I haven’t - looked at SBC explicitly through either of those lenses in the past. I ignored it. And that’s not correct imo and possibly led me to miss a thing or two with S.

@wsm007

So, either you include it in your thinking by thinking through the dilutive impact of SBC (i.e. you think about it as a direct cost to shareholders, which it is, actually). Or you incorporate it into a company’s expenses as GAAP dictates, which makes hiding the ball more difficult for management teams and makes comparing companies easier.

@SaulR80683

Well, actually, SBC causes dilution but doesn’t cost the companies a penny.

GAAP counting it as an expense AND a dilution is just the way the bunch of obsessive CPAs who created GAAP decided to punish the tech companies who used SBC for being bad boys.

Now I say this fully taking your point that SBC should not be considered as both dilutive and as an expense - that’s double counting. But ignoring it completely is probably not correct either. Another great investor that I have a lot of respect for - Buffett - (and who is invested in SNOW) had this to say in 2015 about ignoring SBC (p16). As you can see he is also quite passionate about it:

[…] I suggest that you ignore a portion of GAAP amortization costs. But it is with some trepidation that I do that, knowing that it has become common for managers to tell their owners to ignore certain expense items that are all too real. “Stock-based compensation” is the most egregious example. The very name says it all: “compensation.” If compensation isn’t an expense, what is it? And, if real and recurring expenses don’t belong in the calculation of earnings, where in the world do they belong?

Wall Street analysts often play their part in this charade, too, parroting the phony, compensation-ignoring “earnings” figures fed them by managements. Maybe the offending analysts don’t know any better. Or maybe they fear losing “access” to management. Or maybe they are cynical, telling themselves that since everyone else is playing the game, why shouldn’t they go along with it. Whatever their reasoning, these analysts are guilty of propagating misleading numbers that can deceive investors.

I don’t think we’re going to get to a definitive answer about the “correct” treatment here - it is almost like politics. And to be honest it is largely irrelevant which method is correct as long as one uses a method imho.

I was specifically trying to benchmark my companies with one another using a standard methodology relating to opex. The key question I was trying to investigate was the opex intensity of SentinelOne vs other high-tech companies who also employ SBC and lots of it. A previous benchmark excluding SBC showed SentinelOne being a bit better than Snowflake at a similar stage of growth, so I wanted to see what it looked like when I included SBC. I have zero issues with SBC per se. It is a necessary part of doing business especially as a tech business. But if one analyses a company and ignores SBC, it is almost like analysing a company and ignoring the tax regime. A company earning the same but paying tax on earnings in France will be valued lower than a company paying tax in Delaware. The reason of course is that corporate taxes in Delaware are significantly lower than in France.

And when I looked at S’s opex through that lens - i.e. not ignoring SBC - it looked worse than the others in my portfolio when they were about the same size. And S’s revenue growth rate is now going down.

That, and the other concerns - S potentially having to reduce guidance, the endpoint market slowing too much etc - led me to reduce my position. Not exit completely.

I still have 3% in S, and that 3% is on steroids, so I’m still very much “in” SentinelOne.