Pocket Bubble

In my last post, I wrote about how tech IPOs have returned with a vengeance this year but highlighted the pitfalls of jumping into them on day one. The impetus was Uber’s IPO, which was priced at $45/share. Its stock as of this writing, on the back of a quarter that saw its largest quarterly loss ever ($5 billion, which included a whopping $3.9 billion of stock-based compensation costs, i.e. stock options given to insiders at the literal expense of common shareholders)  and a cash burn of over -$1 billion, has dropped -15% below its IPO price.
 
There is, however, one subset in recent IPOs that have performed spectacularly well which has lifted the overall valuation of its sector, and I’m not talking about plant-based meat substitutes¹: Enterprise SaaS companies.

First, here’s a chart of the Bessemer Venture Partners’ Emerging Cloud Index², which tracks the stock prices of emerging public companies involved in providing cloud software to customers:

And here’s a short list of some of the hottest enterprise SaaS names on the market, with their IPO year, current stock price, and enterprise value to sales (EV/S) multiple:

• 2015	Atlassian	TEAM	$144	29x
• 2016	Twilio	TWLO	$131	20x
• 2017	MongoDB	MDB	$144	25x
• 2018	Zscaler	ZS	$83	36x
• 2019	Zoom	ZM	$92	60x
• 2019	PagerDuty	PD	$37	20x
• 2019	CrowdStrike	CRWD	$93	45x

I use a multiple of sales rather than a multiple of earnings because most of these companies have either negative earnings or barely break even. Traditional P/E multiples are meaningless in this space. The strict GAAP accounting rules applied to subscription based software obfuscate the true economics of the business, so it’s somewhat acceptable to use EV/S as a crude substitute. But this only applies during the rapid growth phase, when recurring revenues do not match up with the upfront sales commission expenses and heavy R&D. There is an anticipation of eventually reaching profitable scale, and at scale, a la a Microsoft or Adobe, the EV/S multiple should settle somewhere in the mid-single digit, which translates into something like a more normal 20-ish x P/E multiple.

With that in mind, it’s pretty clear that the names above—taken as a whole—are overvalued. Obviously it would be unfair to label all of them as equally outrageous bubbles. Atlassian in particular has matured into a substantial positive cash flowing corporation while maintaining a 30-40% growth rate on a billion dollar annual run rate. Even so, valuation can act as a substantial headwind even for legitimately impressive SaaS companies. WorkDay (WDAY), a provider of HR and financial planning software, hit a $20 billion EV in early 2014 on sales of $500 million, an astronomical 40x EV/S multiple. And so despite revenues growing from $500 million to $1.5 billion from 2014 to 2018, shares basically went nowhere those four years.

But it appears the market is pricing in Atlassian/WorkDay-esque success for almost every company claiming to be 1.) SaaS, 2.) cloud-native, and 3.) enterprise-focused. For example: Zoom is a video conferencing app. A very slick and very well engineered video conferencing app, but still – a video conferencing app. PagerDuty is… well, basically a fancy pager. A very slick and very well engineered suite of software that facilitates integrated real-time incident response via multiple channels, but still – yeah, a pager that beeps when something has gone wrong.

They are real, legitimate products that are probably pretty awesome for end-users now in 2019. But they serve narrow functions, and so for Zoom and PagerDuty et. al. to be worth their current valuation not only requires them to dramatically grow their enterprise footprint, they must also aggressively grow horizontally within each enterprise year after year. It seems inevitable to me that they will eventually step on not just Microsoft and Amazon and Salesforce and Atlassian and WorkDay and Oracle and SAP and other established enterprise software competitors, but eventually also on each other. At which point, when (not if) their growth begins to slow even a few percentage points: watch out below.
 
And then, there’s CrowdStrike, a competitor of Cylance. You may recall Cylance was acquired by BlackBerry earlier this year. Both were founded by former Chief Technology Officers of legacy antivirus company McAfee. Both offer SaaS, cloud-native, next generation A.I. endpoint protection (read: Super Antivirus). And yet, CRWD is selling for a 45x EV/S multiple on the public market while BlackBerry purchased Cylance for a comparatively modest 7x EV/S. Meanwhile, BB is currently trading for 3x. All of BlackBerry, on track to generate over $1.1 billion in revenues this fiscal year, is valued at less than 20% of CrowdStrike, which will only book ~$440 million and be nowhere near profitability. Something’s not right.

This dichotomy implies total value destruction and transfer, i.e. not only has Cylance become completely worthless under BlackBerry, CrowdStrike will also scale into a multibillion revenue company in just a few short years³. It is almost certain that either BlackBerry’s valuation is too absurdly low, or CrowdStrike’s valuation is too absurdly high (or both). And it is almost certain that the enterprise SaaS darlings of today—as a whole—is likewise overvalued and many names will have collapsed over the next several years. Time will tell, so stay tuned. Caveat emptor.

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¹ Beyond Meat Inc. (BYND), IPO’d at $25/share and is now casually trading above $150/share, just a 700% rise over the past 3 months. They are now a $10 billion company with around $0.05 billion in annual gross profits and, of course, negative earnings and cash flows. ¯\_(ツ)_/¯

² https://www.bvp.com/bvp-nasdaq-emerging-cloud-index

³ And even if so, you still might not earn a return at today’s stock prices a la the WorkDay example above.

IPOs, Revisited

Given that Uber’s upcoming initial public offering is consuming much of the oxygen in the business press lately, not to mention the recent IPOs of Lyft and Pinterest (with Slack, WeWork, and AirBnB not far off on the horizon), it might be timely to revisit the topic of tech IPOs, which I first wrote to you about in a letter some five plus years ago¹.

In 2013, Twitter was the hottest IPO since Facebook. It debuted in November of that year at around $40/share. Revenue was $665 million and operating income was negative -$635 million. Today, revenues have grown to $3 billion and operating income has swung to a positive $453 million. But its share price as of this writing? Still ~$40/share. Even though the result has been nearly identical to that of stashing cash in your checking account, the journey has been far from it. After initially popping in exuberance to over $70/share, TWTR collapsed into the ‘teens. If we did this retrospective two years ago², the number I’d be quoting you would be $15/share.

As an added twist, TWTR shares outstanding were 588 million back in 2013. Shares outstanding as of Q1 2019 is a much heftier 768 million. For all the media attention about companies supposedly wasting money buying back record amounts of their stock, the other side of the equation is that companies, especially Silicon Valley based tech companies, are voracious issuers of stock options that often outpace buybacks. The buybacks exist mostly to prop up share prices which are then sold into the open market by insiders.

This is how it works: you’re upper management. You get stock options. When the options vest, you exercise and thereby create more inventory of stock. Then the company spends money to buy back shares, partially reducing the inventory of stock. The net effect is you have more money and the company has less. You essentially got paid by the company, just in a circuitous manner. In the meantime, the shareholder has been sneakily diluted all the while the company is trumpeting how generous its buybacks are and how shareholder friendly it is.
 
The point is, if you buy a hot IPO stock based on hype, you are probably getting suckered. Some IPOs turn out well, but most don’t. It’s simply not designed for the public to get rich off of. It’s designed for founders and early investors to cash out. It’s designed for investment banks to reap fees and dole out favors to their lucrative clientele. It’s designed to create a new type of currency (stock options) to “attract and retain” employees. As far as stakeholders go, Joe Investor is just about damn near the bottom rung of the ladder.

If you’re a long term investor, you can afford to watch and wait. Every world-beating common stock in the past decade or two, be it Apple or Amazon or Netflix at times experience dramatic declines. Twitter languished for years below 50% of its IPO valuation. Even Facebook’s IPO was widely considered a flop back in 2012³. Shares opened at $40 in May but by August it was below $20. Since then: 10-bagger. The moral of the story is, if you really like a public company, eventually you will have a chance to buy its shares. Just probably don’t do it on the first possible day (or week, or month).

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¹http://blog.incandescentcapital.com/2013/11/the-ipo-of-twitter-to-buy-or-not-to-buy.html

²And, perhaps, if it were not for a certain "Tweeter-in-Chief" ascending to the Oval Office in 2016…

³https://money.cnn.com/2012/05/23/technology/facebook-ipo-what-went-wrong/index.htm

2018 Annual Letter to Investors

 
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