ZS at 100x? a thought experiment

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Austin

Will you make the DB publicly available? :blush:

This is my first post on this board so I hope this is a small contribution. This is a snippet from a post GKesarios on Jun 28, 2014 which speaks to owning high P/S stocks. As context, I own many of the SaaS stocks here, but I find this interesting to remember.

<I?When investors buy stocks with high P/S ratios, those stocks need to grow revenue at least 30%-40% on a yearly basis for many years into the future. This is because investors are paying a big premium today for growth that is expected to happen in the future. But, with any deviation from future growth expectations, the premium paid today may no longer be deserved. As a result, and because an irrationally high P/S ratio cannot be maintained by an increase in revenue growth, the stock is likely to collapse.

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When I bought SHOP I could have bought it for 35x sales and I would still have 5x on it.

Was it overvalued?

The multiple was meaningless tripe at the time. So why is it meaningful now?

Tinker

Why doesn’t MF have an edit feature. Doh!

The post again…

Saved your post in my eternal note database.

Austin

Will you make the DB publicly available? :blush:

This is my first post on this board so I hope this is a small contribution. This is a snippet from a post GKesarios on Jun 28, 2014 which speaks to owning high P/S stocks. As context, I own many of the SaaS stocks here, but I find this interesting to remember.

When investors buy stocks with high P/S ratios, those stocks need to grow revenue at least 30%-40% on a yearly basis for many years into the future. This is because investors are paying a big premium today for growth that is expected to happen in the future. But, with any deviation from future growth expectations, the premium paid today may no longer be deserved. As a result, and because an irrationally high P/S ratio cannot be maintained by an increase in revenue growth, the stock is likely to collapse.

To finish my post, I think ZS’s expectations could be too high to hurdle at 100 x’s P/S. Nothing wrong with 100 P/S but market expectations could smash the price.

Mark

If the business model is so compelling for saas companies, why haven’t they shown up in Salesforce yet at $13 billion in revenue?

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There was a lot to learn from The Gorilla Game that is as valid today as it was then.

In particular, there was and is a lot to be learned from Moore’s books. The Gorilla Game itself is a bit of an aberration in which he somehow got talked into or talked himself into applying his perception to investing … and did so right at a time when a really abnormal investing environment made just about any theory likely to step in a hole. It is possible that feeling that a company was a Gorilla helped people to ignore all valuation discussions, but people seemed very good back then at ignoring valuation discussions for companies that couldn’t possibly be considered gorillas since they had yet to develop a business plan that even made money.

This is really a very, very, very different environment than we have today. The companies which are interesting us have real revenue growing at dramatic rates … a context which is likely to push the boundaries of traditional valuation metrics which are derived from companies with far, far less dramatic growth.

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It is because at its present marketcap it has eaten up a relatively large chunk of its opportunity and will never hyper grow again.

At the same time it is likely to grow at 20% a year for years to come and some day churn out tons in dividends when it stops growing, which may be years from now.

Compare that to CRM at $3 billion marketcap w hyper growth. Willing to pay a much higher multiple? We sure did for SHOP.

These multiples just are not cross comparable. It comes down to what your willing to pay for forward business adjusted for risk and that differs substantially by business and maturity of business.

Tinker

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What I am reading on here is saas is a goldmine business model that leads to substantial profit margins for sellers of saas. Yes software companies always have high gp. But the biggest saas company out there does not have substantial net profit. So I have concern over paying huge numbers in hopes the Zscalers out there are going to have 20% net profit some day. It’s not working that way for crm.

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12x,

Yes software companies always have high gp. But the biggest saas company out there does not have substantial net profit. So I have concern over paying huge numbers in hopes the Zscalers out there are going to have 20% net profit some day.

I think this is a really good point worth considering. Let me state that it is one of the reasons I like Arista (ANET) even though not a SaaS company. Net profit after taxes that goes to the bottom line is 30% of revenue. Operating Margins are typically around 37%. There are very few companies who are operating at that level.

I, too, have reservations about net profit levels upon maturing. I think that is key to understand, or try to glean, as well. That is, what businesses will exhibit exceptional margins down the road. One that does seem like a great candidate is Zscaler…hence the current valuation I guess.

A.J.

SaaS is a superior business model with increasing returns as more volume increases utilization of the hardware and software necessary to handle it and thus why an Amazon and a Microsoft are now virtually unstoppable because no one can match their scale.

Look at Zscaler. The more customers they get the lower their fixed unit costs. Hardware is such that new customers may have practically zero marginal cost until such time as you fill up the node and then need to fill that up.

The value of each new customer is so great that it would be malpractice to not spend money to capture them all. With Zscaler, that has so little churn, such high switching costs, and such high lifetime value per customer they are doing something with economics that probably has not been seen since Microsoft. Certainly better than Palo Alto.

No, Zscaler is not another Microsoft but its economics of customer value per cost is very comparable. Thus Zscaler making a profit is a result of management underfunding sales and the market over demanding their product. They should scour the Earth and disrupt the market as it will better every businesses’s business and lock them in to Zscaler (I mean, not impossibly, but practically).

Salesforce is the same way. You get in the Salesforce CRM system you are not going to leave. In fact Salesforce looks undervalued here. So does Elastic (but yes, Elastic’s market cap is ~20% greater than Yahoo! lists. There should be 85 million shares counted is $7.225 billion, but at $5.5 billion market cap (as Yahoo! lists) that stock release fear appears to be a real thing.

Tinker

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“My point is that the metrics that Graham and Dodd used in Security Analysis have changed radically.“

On the end, the value of a business has to relate to the value it provides and will be providing. One would value a given business potential from what s/he can see now and ahead. SaaS will not be valued like a Nucor or a consumer business. Different kind of businesses will be valued differently. That is nothing new. The attractiveness of the SaaS business model does not mean it cannot be overvalued.

How would you valuate a ZS or ESTC or AYX or any such high growths? What would you look at if the high P/S or EV/S doesn’t tell you much or anything? Or not as much as one might think? I guess that at the initial stages of high growth, these simply cannot be valuated especially when they come off from relatively small bases. They have to reach some more stable periods in their growth to really see if there is a flywheel that can last or not. We should distinguish momentum with genuine epochal growth.

It is hard to call that value when most of these could get cut by more than half in a very short period of time. Or could that be a mistake from the market? It could be in the long run. In the shorter run, who really knows?

tj

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Hey guys, this has gone into 30 posts in the thread, and everyone has said what they have to say about it three times at least, and then explained it another time or two. No one has to have the last word! Let’s just let it go and stop kicking a dead horse.
Thanks for your cooperation,
Saul

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“This time it is different” is a notoriously bad way to think … but, it is also obvious that one kind of business and another kind of business are not appropriately evaluated by the same metric and standards and one of the things about SaaS businesses is that it is in some ways a new business model with which we have as yet somewhat limited experience.

Clearly, selling hardware and software are very different businesses because one has to manufacture each unit of the hardware while much of the expense of the software is upfront. I say much since enterprise level software … as opposed to something shrink wrapped … can often include some enhancement as a part of each sale. Back when I was first selling my ERP software I could make some money on the hardware as well since the medium sized companies I was selling to had limited IT departments and one needed something mini-computer-like to support many companies. Now, the same number of users can be comfortably supported with better performance on a PC running Linux.

The genius of SaaS is that while one forgoes the big paycheck at time of sale, each sale turns into substantial recurring revenue for a significant period of time. Moreover, it is attractive to the customer because it eliminates the big up front cash outlay to purchase the license and often eliminates the cost and hazards of managing one’s own hosting (SaaS licensing can be used for on prem installations, but most often is not).

SaaS does not eliminate the need for customer-specific modifications, but it provides a huge incentive for the software company to think about better design. Pre-SaaS, many software providers were either “over the transom”, i.e., the customer was responsible for all customization or, if the provider did the customization, that was often done at minimal cost to create a unique implementation for that one customer unless the feature was one that was a good candidate for inclusion in core product. With SaaS, there is a strong motivation for the software provider to think in terms of a unified implementation with “switches” to invoke different behaviors for different users so that a single unified product was providing as much of the functionality as possible for all customers.

Which said, done right the SaaS business model enables extremely rapid company growth … as we have seen for some of the companies we discuss here. As we have seen, this strains our valuation models. I would like to suggest that this is exactly because of the rate of growth. We have seen that some traditional valuation metrics are invalidated by different business models, e.g., the Amazon keep investing the potential profits in growth so that P/E remains low despite enormous success. The inherent problem of an extremely high growth company is that a huge part of the “valuation” that the market provides is based on expectation, not performance. So, when those expectations are met, then the expectations continue to grow, but if the expectations are not met, even by a little, there can be a huge … technically disproportionate … contraction of expectations and thus of price.

At times, we have talked about the silliness of quarterly earnings reports and their impact, especially since analyst’s expectations are often based on little real knowledge. But, with these companies we would almost wish for monthly updates so that we could more rapidly adjust our expectations. And yet, even then, much of the reaction would be lacking in understanding of what was actually happening with the company.

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tl;dr

Let’s drop it like Saul asked. No more posts on this please.

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Mark,
" . . . the stock is likely to collapse."

There’s a significant difference between the stock getting rocked in a sell of and the company itself collapsing. During the dot com bust around 2000 many of the companies that were selling at nose bleed prices (multiples, whatever) were nothing but stories. They had ideas, but no or only minimal product/service offerings.

Not every SaaS stock is different from that. But, the ones discussed here get vetted from a bunch of different perspectives, both from their financials as well as the products/services they offer. These are real companies with real customers and real products/services. None of that will evaporate if the stock price takes a hit.

These stocks are volatile, if you’ve no stomach for that, then these are not good investments for you. Nothing is worth making yourself sick. I’ve watched my portfolio drop a lot in a single day. I’ve watched it erode for weeks at a time. But at the end of the year 2017 I was up over 80%. EOY 2018 up over 40%. Within the last few days, 2019, up over 50%.

I can handle the roller coaster.

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Spot on Tinker. IMO, the same goes for Mongo. They are unstoppable (save for the possibility of management screw up - which seems unlikely). They will be around and growing for the next ten years at least. As I’ve mentioned, we’ve seen this movie before, if you’ve watched this space Mongo is comparable to Oracle in the early 80s.

It will never displace relational technology completely. There are too many use cases that are perfect for the relational model. But the document db paradigm is growing and Mongo is way out in front. As more and more specialized data types are developed, Mongo will be the primary storage, retrieval and manipulation service.

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