2024 Annual Letter to Investors

 
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The information set forth herein is being furnished on a confidential basis to the recipient and does not constitute an offer, solicitation or recommendation to sell or an offer to buy any securities, investment products or investment advisory services. Such an offer may only be made to eligible investors by means of delivery of a confidential private placement memorandum or other similar materials that contain a description of material terms relating to such investment. All performance figures and results are unaudited and taken from separately managed accounts (collectively, the “Fund”). The information and opinions expressed herein are provided for informational purposes only. An investment in the Fund is speculative due to a variety of risks and considerations as detailed in the confidential private placement memorandum of the particular fund and this summary is qualified in its entirety by the more complete information contained therein and in the related subscription materials. This may not be reproduced, distributed or used for any other purpose. Reproduction and distribution of this summary may constitute a violation of federal or state securities laws.

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.