Tactics: A guide to taking advantage of extraordinary valuations in the software/cloud space
It would be difficult to ignore the massive valuation implosion of most software equities over the past 3 months. In Part 1, I outlined my thoughts regarding valuation and why I thought this decline provides a good time to invest in the high-growth IT space. In Part 2 below, I outline some of the themes I consider in looking at specific companies and their shares. The fact is that the shares of almost all Information Technology (IT) companies have seen their share prices plummet, but particularly those companies whose enterprise value/sales (EV/S) had been higher than average; investors have suddenly chosen to disregard fundamentals and specific positive announcements from the companies. The past 3 months have been one of the worst times to be an investor in high growth shares - and yet as bad as this decline has been for IT investors, the valuation implosion has presented one of the more significant opportunities to buy both the highest growth names and some fallen angels at what I believe will prove in time to be bargain valuations.
In the previous part of this article, I explained what has been happening during this great rerating of share prices and valuations, why it happens, and how it might end. I proposed a conservative strategy to buy the ETFs that in whole or part reflect the sector for those readers who had not the willingness to deal with the volatility inherent in this space; I suggested the most appropriate ETFs would be the (CLOU) and the (IGV).
But I imagine the majority of readers/subscribers are interested in investing in individual stocks. For those investors with a long-term outlook and the sangfroid to deal with the current negative sentiment, I will suggest some tactics to utilize in considering the construction of a buy list at this point. I think readers/subscribers would be much better off with a portfolio of these opportunities rather than attempt to cherry-pick two or three and try to call their bottom.
Before starting on some specific recommendations, I want to suggest a couple of thoughts about methodology and valuation. There are two basic ways that analysts use to set price targets for shares. One of those is to use comparables. I have never been comfortable with that methodology. Finding a comparable always risks looking at the wrong comparable. This often happens when a covering analyst who specializes in a particular business segment attempts to use that segment as a comparable for a company that really doesn't fit.
The better approach is to use what is called a discounted present value (DPV) analysis, which discounts the sum of future free cash flows back to the present using some kind of assumed discount rate, most often the weighted average cost of capital. This approach, however, requires analysts to present a multi-year estimate of free cash flow, and that is often a highly fraught undertaking. Many analysts do not have confidence in their estimates and use comparables because it is much easier and requires fewer assumptions. However, I use DPV, and it is why I present a Compound Annual Growth Rate (CAGR) and an estimated free cash flow margin for all of the recommendations I publish. What follows is not a comprehensive guide; for example, I do not address the FAANG names or other large-cap investment choices. That said and because of the rather indiscriminate nature of this decline, I believe that when a reversal sets in, it will tend to lift what had been all the highly valued IT names rather equally. Eventually, discernment will set in.
Try not to overthink stories
Perhaps the most important concept to consider at this point is not to overthink stories. Many readers will be tempted to imagine a story has changed because the value of its shares has imploded, something that challenges this writer on occasion. Many subscribers write to me to question if stories are intact, after such shocking declines. I get it.
Other readers see discussion boards that evaluate the investment merits of individual companies. Often these boards provide valuable insights, but sometimes they can focus on a single metric to the exclusion of attempting to provide a holistic picture that includes positives and negatives in assessing the outlook for a company. For the most part, the operational outlook for even the most devalued companies hasn't changed for the negative. Indeed, I would argue that the current outlook, regardless of the share price, has tended to improve for most IT companies which saw peak share prices in early November.
Most analysts at large brokerages are obliged to reduce price targets in response to share price changes. In other words, rather than being changed in anticipation of company fundamentals, price targets are set to reflect the current level of share prices and the current level of market valuation. In this environment, looking at a reduced price target may suggest issues with the fundamental prospects for a company, but the reality is quite different. Some of the most vivid examples of shares prices imploding without a changed outlook have been in FinTech.
The fact is that regardless of the share price, the technology of evaluating loans and providing end-customers with digital experiences is one of the more seminal events in the financial services industry in several decades. Financial institutions can either enthusiastically adopt the new paradigms in evaluating credit and in providing their customers with a complete package of digital experiences or they will cease to be relevant and lose market share.
Upstart (NASDAQ:UPST) is perhaps the "poster child" for overthinking a story. In the course of less than one year, Upstart shares have emerged from the wilderness to become an investment darling last summer and then have seen more than 75% share price implosion. Upstart's share price implosion really began after it reported Q3 results on November 9th, 2021 although there had been two analyst downgrades before that point. For the record, the company's revenues reached $228 million that quarter, which was 2.6X above the revenues it reported in Q4-2020 and sequential growth of 17.5%. At the time, this level of sequential growth, which actually is an annual rate of 90%, was said to be disappointing and the beat of 8% above the company's prior forecast was said to be inadequate.
As it happens, the company's EBITDA for Q3 was almost double the level it had forecast when it gave guidance. In the quarter, the company originated 363k loans, compared to 123k in Q4-2020 and 287k in Q2. And its adjusted net income margin rose to 25%. But the issue was that there were numbers and estimates on some investment boards considerably greater than those the company achieved, and momentum investors felt jilted because the percentage beat was smaller than in the past and the raise in guidance was below the increases in that metric the previous two quarters.
Upstart now forecasts that full-year revenues will be about $775 million, with adjusted EBITDA margins for the year now forecast to be around 25%. The company's free cash flow margin last quarter was 18%, and its free cash flow margin for the first 9 months of the year was 34%. At this point, consensus numbers are that the company will achieve revenues in 2022 of $1.2 billion.
Just from a financial perspective, it is obvious that Upstart shares have seen an enormous valuation compression. While $1.2 billion is growth of 48%, the estimate will probably turn out to be low simply given how these out-year consensus forecasts are constructed, and the track record of Upstart in terms of exceeding forecasts since it has been a public company.
The current investment issue which apparently has precipitated the last down leg in the shares had to do with delinquency rates. It is probably worth parsing this issue a little more thoroughly. Upstart's platform uses AI technology to underwrite loans. To restate the obvious, AI is just a piece of software that allows users to plug in parameters to achieve certain pre-determined levels of risks and returns. It can be used to minimize defaults, it can be used to maximize yields, or more likely to maximize risk-adjusted yields. It is almost certainly going to improve on the results of FICO scores in terms of its predictive capabilities, and when used repetitively, or "trained" as it is called, it will become increasingly accurate. Absent some exogenous event, i.e. some kind of colored swan, it will simply allow users of the technology to map their requirements more closely onto a body of loan applications. But to repeat, it will not eliminate default/delinquencies unless it is tasked with solving for that, to the exclusion of yields.
There is a service called KBRA which evaluates many kinds of asset-backed securities, including the pass-throughs that Upstart offers. Readers can link to the report. Little more than a month ago, the analyst at Wedbush, David Chiavenni initiated his coverage of Upstart with a hold rating and a $160 price target. At the time, he called out what he described as a spike in delinquencies that were indicated in the KBRA report and said that until this spike was seen as transitory he could not recommend the shares. Recently, the analyst lowered his price target to $110.
This was really not because of any new information, but because comparables that the analyst uses in valuing the shares had declined sharply in their valuation. But he once again cited the KBRA report about delinquencies as an issue in valuing the shares. I believe there to be some significant issues with hanging a recommendation on the KBRA report that a careful reading will make apparent. Firstly, the latest delinquency rate ticked down a little, and so far as it goes, the delinquency rates have bounced around and are certainly not at a peak although they are higher than in the past.
But having seen that, it turns out that the current asset pass through pool minimizes exposure to the lowest rated loans, i.e. those classed C and D credits, and, as a result, the net yields provided to investors have been lower than the prior (2020) asset security sale. Overall, net of delinquencies and servicing fees, investors, are still receiving a net 16.75% return, according to KBR. The total delinquency rate for the current trust is essentially the same as the delinquency rates for the prior 2 trusts.
But even more telling, at least to me, is that one of the banks that is a sale sponsor, FinWise, recently dropped all FICO requirements from its evaluation of loans analyzed by Upstart's technology. Further, FinWise does not receive any fees, whatsoever, unless the loans it sells to investors perform at some predetermined level.
It seems highly unlikely, at least to me, that FinWise would eliminate the use of FICO scores from its evaluation of loans that the Upstart technology has analyzed, unless its experience with those loans has been at least as expected. Yes, Upstart's delinquency ratios have seen fluctuation, but the concept that the risk of its technology is causing spiking delinquencies seems rather overblown, to say the least. So what are Upstart shares worth?
One of my issues with the Wedbush methodology, and its $110 price target is that the analyst has chosen a price target based on looking at the company as a neo bank. Whatever else Upstart is, it is not a neo-bank or anything like a neo bank. Upstart is basically a software company with a consumption-based model. But the most appropriate methodology to value Upstart, or any other stock would be to use some kind of a discounted present value model.
Of course, such models require multiple assumptions, and that is why I choose to rarely publish the results of such an analysis. In the case of Upstart, and using a $1.4 billion revenue estimate for 2022, with growth of 52% in 2023, 40% in 2024, 33% for 2025, and 25%/year for the next 3 years, 20% for 2 years and a terminal growth rate of 5%, coupled with a 25% free cash flow margin throughout the period, and a weighted average cost of capital of 8.5%, the result shows a current DPV more than 2.5X above the current price of the shares. Readers, of course, may substitute different assumptions, and will then get different results. But I actually believe my estimates are quite conservative, especially that for the company's projected free cash flow margin.
It is extremely difficult to accurately forecast anything, let alone the revenues and free cash flow margin of a company through 2030. The estimates I am using imply that at the end of the forecast period, the company will have more than $10 billion of revenues and will be generating $2.5+ billion in free cash flow consistently. Given that Upstart's enterprise value currently is less than $8 billion, it should be obvious why its DPV is so far greater than its current share price.
Shares of Affirm (NASDAQ:AFRM) have been tracking a similar share price pattern to those of Upstart, and wound up the week of January 21st, down almost 17% and down by 68% since the shares reached their high point on November 4th. It may be difficult to accept, but the reality is that nothing has changed in the outlook for the company's operational performance since November 4th. I confess that at that time, I thought the valuation was a bit frothy, but now…68% has taken valuations from frothy to compressed.
Unlike Upstart, Affirm does fund the credit it advances from its own balance sheet. In turn, it sells tranches of loans to investors. These notes are called securitization trusts, and the company raises capital for the credit it extends to its customers with what it calls funding debt. In an effort to assuage investor concerns, Affirm has actually prepared an analysis of its securitization offerings that was released late last week. The net of the December securitization data shows positive credit trends with delinquency rates plateauing and the non-interest-bearing credits showing very favorable trends. That along with an upgrade from the Stephens & Co. analyst has not impacted the fall of the shares.
For those unfamiliar with the company. Affirm is the leader in what is known as the buy now/pay later (BN/PL) space. Simply put, BN/PL offers consumers the option to pay for their purchases over time. Most typically, purchases are paid for in 4 equal installments, but Affirm's version of BN/PL offers a multitude of flavors and offerings.
Affirm's technology utilizes AI, in the same manner that it is utilized by Upstart in order to evaluate the credit of buyers. BN/PL has been a solution whose acceptance has been rapidly rising, not just for those with marginal credit, or credit history, but for most younger consumers, as an alternative to the use of high-interest credit cards as a payment alternative for any significant purchase.
Younger consumers are well aware of the sky-high interest rates that some credit card debt carries, and the numerous fees and inconveniences associated with that form of borrowing. BN/PL is just viewed by many of these younger consumers, regardless of their credit situation, as a better way to consummate a transaction. There are loads of alternatives in the space, and many observers/investors think there is little differentiation in terms of what is offered by the companies in the space.
In my view, this is quite inaccurate as none of these alternatives is anywhere near as technologically enabled with real differentiators when compared to Affirm.. A few months back, Block, Inc. (NYSE:SQ) bought an Australian company in the space, Afterpay. PayPal also offers a BN/PL service. Both Mastercard (MA) and Visa (V) are in the process of entering the space.
So what makes Affirm special? Its technology. Part of that is the use of AI, but part of it is also the flexibility of Affirm's platform. Almost all Affirm alternatives allow end-users to split the payment for a purchase into 4 installments which are paid over 2 months. For many consumers and some merchants that offering is sufficient. But Affirm goes far further in expanding payment options for consumers and merchants. Merchants can select numerous options to offer credit with the Affirm platform. They can choose different lengths of repayment terms, they can offer promotional interest rates, or even "0%" rates. They can basically provide rules that the Affirm engine uses to make unique offers to different buyers for different products. It is a very flexible solution, and as a result, the company has a number of unique and strong partnerships.
The company actually launched its most flexible credit offering that it calls Adaptive Checkout at the end of September, and it is a significant differentiator and provides Affirm with a significant competitive moat. My process requires that I at least try to do a deep dive in what makes my own recommendations unique and while that isn't influencing share prices and valuations these days, at some point, in the not distant future, investors will return to looking at the specific merits of individual companies more than macro trends.
What has happened in this meltdown is that investors have ceased paying much attention to the news and progress of individual companies, and have focused their attention pretty much exclusively on interest rates, and most recently the risk of a recession. I think Adaptive Checkout is a big deal, but it seems to me that investors, in their desire to move to what they perceive to be de-risked investments, have ceased to have interest in the specifics of the outlook for Affirm along with many other companies.
Affirm has a partnership with Shopify (SHOP), and Shopify began offering Shop Pay this past summer. In addition, Affirm has partnerships with Walmart (WMT), Target (TGT), American Airlines (NASDAQ:AAL), Apple/Canada (AAPL), and Peloton (PTON), amongst well-known sellers. Even Hammacher & Schlemmer, a large catalog merchant with a flagship store in NYC, offers Affirm as a payment option. Recent partnerships include that with Michael's as well as agreement with Verifone (VERI), which offers e-commerce and card-present payment solutions.
At one time, Peloton was a substantial customer. Its share of Affirm's business has steadily declined and was below 8% last quarter. Affirm's forecast has included steadily diminishing contributions from Peloton and regardless of the actual situation with that company, its influence on Affirm's current results and guidance is not going to be substantial, I believe.
Of course, the news that drove the shares to their peak valuation was the announcement of an exclusive partnership with Amazon (AMZN) for BN/PL solutions. This is an exclusive partnership that goes through January 2025, and as part of the agreement, Amazon got warrants to purchase up to 7 million Affirm shares for $.01 as well as a warrant for an additional 15 million shares at a strike price of $100. Just precisely what the revenue potential of that agreement might be is difficult to know.
Affirm's revenues over the next 12 months are estimated to be about $1.6 billion. That amount excludes any estimate for the contribution of the Amazon partnership whose results won't be forecast by the company until fiscal Q3, or the quarter ending in June 2022. Based on my revenue estimate, Affirm's EV/S has contracted to less than 10X. I have used a 3-year CAGR of 52% in looking at valuation, but that is likely to be exceeded. In any event, the shares are valued at far below average for the company's growth cohort.
Does this mean that Affirm will suffer from a higher interest rate environment? There are some analysts who have made that call in whole or part, and perhaps it would be something to be debated if the valuation of Affirm hadn't imploded. Affirm is likely to pay more to raise money through its securitization trust sales. It is equally likely to charge its various partners, and end-users more. It is not as though Affirm's price for credit exists in a vacuum; if interest rates rise, then all borrowers are going to pay more for credit. The question is that of net spreads. In a full-employment environment, Affirm's credit losses, which the CFO acknowledged were figured with an excess of conservatism last quarter, are likely to remain at modest levels.
I have yet to hear anyone suggest that the use of AI models as a tool to analyze credit doesn't improve the performance of loans, and that really shouldn't be some new and existential issue. Needless to say, Affirm's growth rate has been prodigious, particularly as the partnership with Shopify has brought it thousands of merchant partners. The number of active merchant customers actually rose by more than 3.5X sequentially last quarter. To a certain extent, year-over-year revenue comparisons are not meaningful given the nascent state of the company's business in 2020 as well as the influence of the pandemic on many business metrics. Finally, the revenue and profit opportunity inherent in the company's Debit + card are just now coming into focus.
As mentioned, my own estimate for 12 month forward revenues is $1.6 billion, which does not include any potential contribution from Amazon, or the Debit + card. It can be difficult to handicap the full potential of partnerships such as that which Affirm has with Amazon when little is known about the specifics of the business relationship between the 2 companies and how the relationship might evolve over time.
With the most recent share price compression, Affirm shares have reached an EV/S of just above 8X. Despite the fall of most other high growth names, the fall of Affirm has been so substantial that it now has a 50%+ discount compared to average for its growth cohort. And it has a huge upside in terms of its DPV value (well more than 2.5X), depending, of course, on its path to profitability and cash flow generation.
Affirm hasn't yet generated free cash flow, and the costs of initiating some of its new partnerships, particularly that with Amazon in terms of infrastructure and data science, will inevitably be relatively substantial. But that said, the company reported a break-even result in operating cash flow last quarter, even after adjusting for the increase in accounts payable. The leverage in the business or the unit economics which is the term most commonly used these days for Affirm has been and is likely to remain very substantial. The story has gotten better while the valuation has imploded; that to me is a formula for a good investment.
nCino (NCNO) is substantially different from either Upstart or Affirm but just as disruptive in its own way. The company went public back in the summer of 2020. The company's operating progress has been consistent and positive although I imagine that reported revenue growth, which has been hovering in the mid-30% range for most of the past year, is probably below the more optimistic expectations that some investors and analysts may have had for sustainable growth. On the other hand, the company's backlog (Remaining Performance Obligations) has shown exceptional growth and was up 58% year on year. Backlog, at current levels, now represents more than 2.6 years of current revenues.
nCino is a relatively small company with revenues just now crossing the $300 million run rate. Basically, the company offers its users what it calls a Bank Operating System. The operating system has been built on the Salesforce (CRM) platform. The company offers a variety of solutions all of which are designed to help banks achieve a digital transformation and to offer their customers a digital experience.
Essentially, using the nCino solution, its customers are able to offer clients an all-digital experience for onboarding, account opening, loan underwriting, document preparation, closing, and e-signature. There are several other solutions available on the platform including a customer engagement product, an asset financing/leasing solution, and a Treasury management and onboarding product which is targeted at helping bank customers optimize the risk adjusted return on their cash and equivalent holdings.
In my opinion, banks are going to move rapidly to provide their own customers a digital space experience, or they are going to be out-competed and will lose market share. The issue nCino usually faces isn't overall demand, but the make/buy decision that banks have to make between adopting technology such as that of nCino or trying to build their own solutions in the same space that do the same things.
For the most part, until recently, nCino's bank and credit union customers were medium/medium-large institutions. On the upper end of the customer range have been institutions such as KeyBank, Fifth Third Bank (FITB), Banco Santander (SAN), and TD Bank (TD). Not all of these banks have all of the components of the solution.
Most recently, nCino announced that Wells Fargo has chosen its commercial lending solution. The Wells Fargo (WFC) transaction was one of the larger wins for nCino and it is one reason why the growth in backlog has been so much greater than the growth in revenue over the past couple of quarters. What's significant about the Wells Fargo transaction, at least to my mind, is that Wells Fargo is one of the larger banks in the US with extensive internal software development capabilities. I think that to the extent that the Wells Fargo deployment achieves its objectives, the likely competitive advantages that will accrue to Wells can positively impact the selling opportunities. But it suggests that even the largest banks are targets for using nCino software, even if they have the capability for internal development
The company added to the scope of its platform by acquiring SimpleNexus, which is a mobile-first, digital loan application platform whose customers include some banks, but primarily independent mortgage banks. It is very much congruent with the other offerings of nCino, and there should be substantial cross-selling opportunities as well as opportunities to improve the mobile and point of sale capabilities of the nCino platform. SimpleNexus had reported revenues of about $41 million in the year ending 9/30, but its revenue run rate had reached $54 million at the time the merger was announced, and it reported a net revenue retention rate of 183%.
As mentioned, my process is very much weighted toward a combination of the relative EV/S ratio coupled with a free cash flow margin. Until recently, using that kind of process made it impossible to recommend nCino, regardless of the opportunities it has to materially disrupt the banking space. But now, after adjusting for the impending merger and the slightly faster growth rate of the combined company, the EV/S ratio has fallen to just 10.6X, the lowest such ratio since nCino has been a public company by a substantial margin. Using a 33% CAGR, which is consistent with recent revenue growth results, but substantially less than the recent trends in bookings growth that I highlighted above, nCino shares have about an average valuation compared to other IT names with similar growth. Its current free cash flow margin, which I estimate will be about 5%, is also about average.
Before the substantial rerating of growth names, the news of the large win at Wells Fargo, and the acquisition of a fast-growing mobile platform in a strategic adjacency would likely have had a substantial positive impact on nCino shares. But the fact it hasn't presents investors for the first time since the company went public with an entry point that should produce substantial returns using a model based on DPV.
Shift4 (FOUR) is a payment processor/merchant acquirer and may be considered part of the fintech space. Shift4's primary focus has been in verticals of restaurants, hospitality, specialty retail entertainment/sporting venues. It has a significant market share of greater than 30% in the restaurant payment space with more than 125,000 users. Its end-to-end platform has resonated with users, and its new integrated restaurant solution is seeing strong traction. Shift4's business to some degree or the other has been correlated with the degree of the shutdown of travel. Its current growth is coming against very constrained comparisons. But the company, because of its end-to-end solution, continues to gain market share and to grow its overall customer base at rates in the mid-20% range. FOUR's EV/S ratio, based on my updated estimate for 4 quarter forward revenue of $730 million (that's net revenue excluding pass-through network fees), is 5.7X. Needless to say, that is way below average for the company's low thirty percent growth cohort. FOUR is already profitable and generating free cash, and it has excellent unit economics compared to many other businesses in this space. Its shares have fallen by more than 60% in the past 7 months. Its decline started sooner because the company has been thought to be a "reopening" trade, and when reopening was postponed because first Delta and then most lately Omicron, the shares reflected that concern.
Follow the major themes in the IT space that resonates with users
Over the years, there have been a variety of themes that resonated with IT buyers. Relational databases became de rigueur more than 30 years ago, and soon thereafter ERP became a priority. Then, in succession came client/server architecture and its child, the thin client, along with the emergence of SaaS models and the cloud. Along the way, there has been the continuous refinement and enhancement of solutions in the cyber-security space from anti-virus, firewalls, next-generation firewalls, and now zero trust and advanced end-point threat detection and remediation. The largest returns over the years have been earned by investors who focused on the overarching trends IT and weren't obsessively concerned with the fact that as software companies grow larger, their percentage growth, at least on an organic basis, tends to decline. Today, I count 4 major themes in IT (although there are other worthy candidates) that should be the heart of any high-growth portfolio construction: 1) Digital Transformation, 2) Cyber Security, 3) Artificial Intelligence, and 4) Automation.
If readers obtain only one understanding from this article it should be that digital transformation is the most powerful trend in IT in decades; digital transformation allows some users to differentiate what they do from what others do. Companies compete on which can offer their customers the best digital experience. And companies enhance the productivity of their employees by providing them with digital transformation tools. Software spending still gets recorded as a cost on the books of buyers. But those expenditures have become necessary to generate revenue and stay competitive. And that is one of the things that really was not part of the software dialog until the last few years. The mantra of facilitating digital transformations is a universal one. But not all companies that say that they facilitate digital transformations are of equal significance.
Here is a partial list of some vendors that I believe are really reaping outsize benefits from the strong theme of digital transformation. Braze (BRZE) really is bringing a set of digital transformation solutions to the customer engagement space. Confluent (CFLT) is a company whose métier of allowing users to adopt a paid version of Apache Kafka to capture the benefits of "data in motion integration" is one way for users to adopt applications that promote digital transformations for users.
I just reviewed above how nCino is fostering digital transformations for its bank clients and now for mortgage bankers. Pega's (PEGA) low-code/no-code solutions are allowing its users to build customer experience applications that enhance a digital transformation strategy. ZoomInfo (ZI) is the most complete digital experience offering that can automate the B2B sales process.
Snowflake (SNOW) the pride of Bozeman, Montana, is a key enabler of digital transformation solutions through its offering of Data Cloud that enables customers to consolidate their data from multiple clouds into what is called "a single source of truth." It has become a poster child for company's looking to embark on a digital transformation journey.
That said, even after a fall of 36% from its November high, Snowflake shares are still valued beyond a level that I could recommend for purchase, with the absolute highest EV/S ratio at 43X of any company whose fortunes I follow. Snowflake is likely the single best long-term growth story in the software space, and I would like to recommend it. And its growth metrics are fantastic.
I typically use the latest sequential quarter growth in estimating revenues for the next 4 quarters. Last quarter, Snowflake's sequential revenues rose by $62 million, or 23%. In the prior sequential quarter, revenues rose by $43 million or 19%. The company's backlog has grown from $1.3 billion to $1.8 billion since the start of the year and stands 94% higher than it was 12 months ago. The net retention rate has actually risen to 173%.
So, based on that background, my forecast for 4 quarter forward revenues stands at $2+ Billion. But with an estimated 358 million shares outstanding (the estimate used by the company in its latest quarterly presentation), my EV/S estimate is 43X. Even with a 3-year CAGR estimate of 74%, the valuation is still at a substantial premium. I believe the shares need to be at something closer to 30X EV/S to make sense using my process of growth + free cash flow.
As mentioned, just about every software vendor who isn't moribund says that they are in the business of facilitating digital transformations. And these days, many customers actually have digital transformation officers who have an important role in the C-suite. The above is not intended to be an exhaustive list of all of the companies that have tied their solution offerings to the digital transformation paradigm. But these are some of the best companies, and their valuations have been eviscerated. But not all companies that offer their customers digital transformation solutions are necessarily considered to be in that space.
I consider Global-E (NASDAQ:GLBE) to be a digital transformation name and recently initiated my analysis of the company when the shares were $70 less than 4 months ago. They have now fallen by more than 50% without any negative change in the company's outlook. Global-E is the leader in the cross-border e-commerce space, and it is Shopify's partner to facilitate D2C commerce internationally. The company recently acquired Flow Commerce to facilitate its reach into the SMB space. At the time the transaction closed, Global-E and Shopify announced a deepening of their strategic relationship. After adjusting for the revenues brought in by the acquisition, paid for partly in cash and partly in shares, my estimate of the company's EV/S based on a 2022 revenue estimate of $370 million, is now about 12X. The company's growth has been very strong (more than 70% last quarter), and the impact of its relationship with Shopify has yet to significantly impact the business. Its business mix has been changing to higher margined revenues (less pass-through shipping and more software) and I have projected a small level (3%) of free cash margin for the next 12 months
It is hard to imagine a higher IT spending priority than cyber-security. It has been a trend for years now and that hasn't changed and is unlikely to change any time in the near future. The issue for users is that not having the best cyber-security available, and then getting hacked, is really a ticket to both corporate and career oblivion. Normally, the best in category companies sport a premium multiple. That has become less so now, than before the great re-rating. Not that the cyber security names are really cheap. But given the growth they have enjoyed, their highly profitable business models that include very strong net expansion rates, and their ability to continue to grow at hyper-rates for many years, their valuation is far more reasonable than it has been in quite some time. Again, there are plenty of cyber-security names from which to choose, but at this point, with valuations compressed, I think it makes the most sense to choose the 3 category leaders:
Crowdstrike (CRWD), the leader in advanced endpoint security based on the newest AI technologies. Zscaler (ZS), the leader in security for the cloud (Zscaler internet Access) based on what is often referred to as a zero-trust architecture as well as Zscaler Private Access, designed to secure access to applications hosted in user data centers, and Okta (OKTA), the leader in identity management, both for enterprises and for business to consumer applications, whose recent acquisition of AuthO is apparently accelerating organic growth and the acquisition of larger, enterprise users.
Artificial intelligence is used by most enterprise software vendors these days. I have outlined earlier how the use of AI models is the major component of the technology that is being used by both Affirm and particularly Upstart to substantially disrupt the process of credit evaluation for consumers. AI is also being used by cybersecurity vendors as a technology to detect anomalies that are potential security issues. Braze uses AI to determine the best ways to mount campaigns for its clients. Alteryx (AYX) has recently become far more invested in the use of AI as part of its analytic solution. It has made a couple of strategic acquisitions in the space and most recently announced the acquisition of Trifacta. The Alteryx Intelligence Suite is perhaps the first desktop application that incorporates machine learning as part of an analytics solution.
Mention should be made of tools that automate the creation and implementation of the software itself. The fact is that the software space itself is short of talent, and needs to automate many of its own processes. A few companies stand out with regards to the use of automation to enhance the productivity of software professionals. Perhaps the most visible company with an automation solution is UiPath (PATH), a company with an awkward name, but a leader in what is described as Robotic Process Automation. UiPath used to be too expensive for me, but a fall of 59% since its high back in May of 2021 coupled with growth in the 50% range, have brought about a far more palatable valuation; although still not absolutely cheap, particularly given its lack of free cash flow. Currently, I project that UiPath has a forward EV/S of a bit greater than 12X which is below average for its growth cohort in the low 40% range.
The DevOps space is all about the automation of the software development process. Two names stand out to me. One of them is GitLab (GTLB), the leader in the space, and JFrog (FROG), whose liquid software development stands out as a unique way of automating the release of various software versions. In addition, the workflow management space is all about automation and improving the productivity of workgroups.
Atlassian's (TEAM) Jira is amazingly popular as a communications tool to facilitate task management, but the three standouts in the space are Asana (ASAN), Monday (MNDY), and Smartsheet (SMAR). The use of the functionality offered by these vendors to enhance the productivity of workgroups is substantial and this technology is becoming standard at a whole host of enterprises.
The fact is that most software is designed to automate and simplify manual processes, and that is true for Alteryx, Pega (PEGA), ZoomInfo (ZI), and many other IT participants. That might suggest that the current implosion of valuations, based on concerns of inflation and higher rates is off base. While I never would suggest that inflation is a good reason to buy equities, the fact is that if inflation is a concern, then the automation of manual processes that can be achieved by software will be a demand tailwind unique to the space.
Focus on Business Models
One investment consideration that may surprise many readers is just how many software companies are quite profitable and are generating very high free cash flow margins. It has been said and written that part of the pivot of portfolios from growth to value has been because of the fact that some IT companies burn cash or aren't generating current profits or free cash flow. But many software vendors have exceptional free cash flow margins and are hugely profitable. I tend to doubt, as I have mentioned, that the causes of the pivot really are profitability concerns.
And so far as it goes, I haven't really seen any correlation between the share price performance of IT names with or without strong free cash flow margins. One valuation metric that I use is to relate growth to free cash flow margin. While there is some correlation, the actual R2 value is only about 9%.Despite such a low level of correlation, I believe that it is important to evaluate IT companies not only based on their growth but also based on the profitability of their models. When I use a DPV model, I of course have to make estimates for free cash flow for several years. The level of free cash flow is of critical importance in determining what might be a "fair" valuation, and in reality, the change in free cash flow estimates has far more impact on a "fair" value than a change of 1% or 2% in the weighted average cost of capital.
The IT space has been one of acquisition and consolidation from time out of mind. Those companies who enjoy strong free cash flow margins are going to be able to fund acquisitions that significantly enhance their competitive position and accelerate their growth.
One example might be that of Crowdstrike (CRWD). Some commentators have expressed the view that Crowdstrike is going to see falling growth. While last quarter's sequential growth reaccelerated, Crowdstrike is a sizable company with revenues likely to exceed $2 billion over the next 12 months. It would be surprising if growth in percentage terms didn't start to slow at that scale. But Crowdstrike is an incredibly profitable company, with a current free cash flow margin of greater than 40%. The company has more than $1.9 billion of cash on its balance sheet. With free cash flow running at more than $500 million/year and rising rapidly, I think that the odds are very high that CRWD will make strategic acquisitions that will serve to buoy its growth rate for a long time into the future. While it isn't really feasible to factor in the value of free cash flow in facilitating acquisitions and in minimizing the weighted average cost of capital, it is something more important than is often appreciated.
In terms of recommendations, there are a number of outstanding IT vendors with elevated free cash flow margins that I find attractive. Some IT vendors of note with exceptional free cash flow margins whose businesses are also growing rapidly and who enjoy strong outlooks for continued growth include Crowdstrike (CRWD), Doximity (DOCS), Zscaler (ZS), DataDog (DDOG), ZoomInfo (ZI), the Trade Desk (TTD), Jamf (JAMF), and Dynatrace (DT).
Some fallen angels to consider
One question to consider, is whether or not to look at fallen angels, when just so many category leaders have been dramatically impacted in this valuation compression. I typically allocate a percentage of my portfolio to these kinds of names. Not all of them will work-the number of failed turnarounds rivals and perhaps exceeds the number of hot dinners I have enjoyed. But who's counting. Often, the patience required for a turnaround to work, or alternatively for one of these fallen angels to get sold to either a P/E or strategic buyer is just too great.
I have recently written about one potential turnaround, that of Alteryx (AYX). The signposts are suggesting that the company's business is improving. As it happens, the company did indeed pre-announce that its results exceeded prior projections. It has made a highly strategic acquisition, i.e. that of Trifacta. And other metrics are certainly pointing in the right direction. But in the last weeks, investors have not really been focused on fundamentals, and certainly not on any positive fundamentals.
The poster child for fallen angels as I write this is DocuSign (DOCU). The combination of value compression and weak guidance has sent the shares down by no less than 54% in the last 2.5 months, most of the fall happening when earnings were announced on December 2nd. The company had been achieving revenue growth of greater than 40%, but the growth of its billings metric plunged to 28%. The company attributed part of the decline in its growth rate to a lessening of pandemic related demand tailwinds, but a significant component of the growth slowdown has been ascribed to a material weakness in the company's sales motion, with many salespeople becoming order takers/harvesters, rather than prospectors/hunters.
Notably, the CEO, Dan Springer, has been buying shares. He obviously believes that he and his team will fix the problems of a flawed selling motion. Further, despite the depressed growth rate, DocuSign is a very profitable company these days. That said, despite the decline in the share price, on an EV/S basis, and using current growth (28%) as a CAGR estimate, the shares aren't dramatically cheap. Based on my estimate of 4 quarter forward revenues of $2.455 billion, my estimated EV/S is now 9.6X. But because of the overall bloodletting across the IT universe, that EV/S ratio is actually still a bit above average for the high 20% growth cohort.
One fallen angel whose shares really do not reflect its actual turnaround is Nutanix (NTNX), the leader in the hyper-converged space and some adjacencies. The space is still growing rapidly, and the company is winning the market share battle. Its EV/S has compressed to just 3X, and it is on the cusp of turning the corner to positive free cash flow generation.
Another very fallen angel is Wix (WIX). Wix fell out of favor along with several other comparable names that can be used by businesses to create websites. Demand picked up a bit last quarter but is still quite constrained. Of course, with the share price decline of 67% in the past 6 months, the level of growth to satisfy investors has probably compressed as well. Wix does generate cash, and its EV/S ratio is now below 5X.
Another fallen angel is Fastly (FSLY). Fastly has been a leader in edge computing. Shares fell sharply earlier this year after an outage constrained revenue growth. Some recovery was seen last quarter, and I imagine the recovery has continued.
Finally, while JFrog (FROG) has not seen its business implode, or hit a speed bump, the way others in this list have, it shares reflect extreme investor disenchantment with its prospects. FROG participates as a competitor in the DevOps space with a set of offering. Its most widely known offering, and its key differentiator, is known as "versionless software." Despite the overall valuation compression of all IT stocks, the fall in FROG shares has been so extreme that it is now selling at below an average EV/S ratio for its mid-high 30% growth cohort, despite the fact that it already has a substantial free cash flow margin.
In my opinion, investors should not commit more than 10%-15% of a high-growth portfolio to turnaround stories no matter how attractive they seem. It is highly unlikely that all 6 of these turnarounds will actually turn around, and even if they do, it can take quarters before investors acknowledge the legitimacy of a turnaround. My recommendation, to the extent that readers are tempted, is to buy a basket of turnaround stories with the understanding that one or two can be spectacular, and the others will produce just average returns at best. Recognize that for turnarounds to work, they will have to start exceeding consensus expectations and do so consistently. Not everything is about EV/S analysis, but some judgment is also required as to when a fallen angel might start realizing its inherent potential.
Wrapping up!
The recommendations in this article are not meant as all-inclusive. I have chosen to look at a few themes, and recommend stocks that in my opinion are illustrative of those themes. That doesn't mean there aren't other names that I like but I just didn't have space to cover them in this article.
Is this a clarion call to buy all of these stocks now? No. It is evident the risk-off sentiment is still alive and well, despite some brief rally attempts; nonetheless, today's levels for most IT shares will be seen as attractive in future months and years. I would enter these names gingerly with a disciplined approach as to price and position size. I would not buy an entire position to start, no matter how tempting it might appear. And patience is going to be required. Equity prices decline and do so in the absence of any significant bad news.
I do not have a crystal ball that tells me when there is a market bottom, or when investors start paying attention to fundamentals rather than perceptions of the influence of economic macros. I do believe many IT companies have unusually attractive valuations. But having an attractive valuation and benefiting from positive alpha can diverge for a time. For investors with a longer-term perspective, this decline presents rare opportunities to accumulate the shares of leading companies at exceptionally low prices and valuations.
