Cloud software stocks have at most times in their relatively short history traded at valuation multiples beyond the ken of many mainstream investors. This causes such investors to stay away from these stocks. Hang around the bars, trading rooms and home offices occupied by said investors and you will hear mutterings of "valuation is crazy ... will all end in tears ... I'm not buying that". And upon any given market paroxysm du jour, or at least de l'annee, when cloud stocks tumble for a moment, those same investors can be heard to say "there - you see - told you so - it ended in tears". Whereupon they don't buy cloud stocks because, well, the vertiginous drop has proven that the valuations were lunacy in the first place. Only for cloud stocks to get back up, dust themselves off and resume their moon-shot trajectory. Still without those mainstream investors as shareholders.
Now, this doom loop happens because investors have been educated to believe that software stocks are different. Hard to understand. Risky. Could go bump in the night at any moment. In fact, the best cloud software companies are safe as houses, and any thoughtful investor can understand them. In this, Part 1 of our "Cloud 101" series, we begin our journey walking you through what good looks like in the cloud.
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It's All In The Numbers.
The first thing to say about cloud software companies is that you don't need to know all that much about software in order to spot a good business. We're talking about the company here, not its stock. And we're talking about companies whose stock is listed on one of the main US exchanges, trades in reasonable volume, and ideally has a market cap of $1bn or more. In other words relatively grownup companies, not early stage stuff.
If you have a reasonable understanding of a company's financial statements, all you need to know is a little about the business model of a cloud software business in order to read the company's quarterly filings and conclude, well, company A sure is a good business and company B sure is not. The strength of the financials will tell you a lot about the strength of the product. In other words, just as you don't need to be able to strip down and rebuild an earth mover in order to assess Caterpillar stock, you don't need to be a software developer to assess software companies.
Here's what good looks like in cloud company financial statements. Obviously, like any company, you want things moving up and to the right. But below we highlight some of the details which, if you know where to look, can help you pick out the true stars.
In particular, one or two elements of cloud software fundamentals look a little different to most businesses. That's due to the comp model and due to the upfront subscription model. Learn how to analyze these in detail and you are a step ahead of most investors and a long way towards picking out the best companies.
Let's walk through the financial statements.
- Revenue - you should see solid revenue growth each year - at least 20% per annum and ideally more. If you look quarter to quarter, smooth sequential growth usually indicates some kind of self-serve, individual-customer-signup business (like Netflix (NFLX) in consumer stocks), lumpy growth indicates a heavy in-person sales process (like IBM in services). Smooth is preferable but lumpy is OK if you can see a consistent repeating pattern over the years. And ideally you want Q1 to be the big quarter, not Q4, so you aren't back-ending the risk that the company misses the year.
- Gross Margin - software companies don't have to pay away much of their revenue as a cost of sale - they don't have inventory in the conventional sense and they sell products produced by intellectual property they own. So you should expect to see a minimum of 80% and ideally up to around 90% gross margins. If it's less, there's a reason. For instance, CrowdStrike (CRWD), a stock we cover, has mid-70s% gross margin because one of its revenue lines is to provide bespoke security consulting for its customers, and being a fairly manual activity that runs at likely 30ish percent gross margin, dragging down the overall average. Sub 80% doesn't mean walk away but it does mean check what the nature of the revenue is and whether it can scale. Software subscriptions - can scale. In-person services - very hard to scale.
- Operating Margin, Net Income, EPS - if you want to understand the fundamentals of the company we suggest you cast no more than a passing glance at these line items. They won't tell you much. And that's because of stock-based compensation, which we comment on below. (Note - stocks sometimes trade on EPS but that's different to company fundamentals. We'll deal with trading and valuation drives in a subsequent post in this series). What you should look at more closely is ... EBITDA.
- EBITDA (earnings before interest, taxes, deprecation & amortization) is a concept borrowed from leveraged buyouts which is useful in assessing cloud stocks. In our research coverage we calculate it thus: (Operating Income) + (Depreciation & Amortization) + (Stock Based Compensation). That gets you back to the profitability of the company prior to paying lenders, the IRS, shareholders or the stock element of staff compensation. LBO investors use this measure as an imperfect proxy for company cashflow - in the case of an LBO the investor is typically trying to analyze roughly what cashflows the business generates absent its capital structure because, of course, an LBO will change its capital structure. When assessing cloud companies one ought to try to understand roughly what cashflows the business produces before its capital structure too. It's just that here, the main pressure on the capital structure isn't debt, it's issuance of new equity to employees.
Now, just as the tooth fairy doesn't pay for capex, as goes the famous Warren Buffett epithet, s/he doesn't pay for the stock based comp either. You pay for it, in the dilution it causes. So you need an eye on the share count too. You'll find it goes up every quarter - not like say an industrials business where it decreases most quarters due to buybacks. The market knows this and accepts it - prices it in - so whilst the comp most certainly is not free, it doesn't in and of itself hit the stock, because it has become the norm in this industry.
Look first at the following items:
- Depreciation & Amortization - you'll need this to calculate EBITDA per the above.
- Stock Based Compensation - ditto.
- Capex - including any capitalized R&D.
- Change in Net Working Capital. (This in essence measures, does EBITDA understate or overstate cashflow before capex. If the change is positive - then cashflow exceeds EBITDA - that's good. Negative - cashflow is less than EBITDA - bad.)
Now you can use another leveraged buyout concept, unlevered pre-tax free cashflow. This tells you what cashflow the company is actually producing prior to paying the IRS, lenders, shareholders and stock-based comp. The calculation is simple:
EBITDA - Capex - Change in Net Working Capital.
And now you are getting to the good stuff.
Because a well-run cloud software company will have positive EBITDA even whilst growing revenues quickly; it will have little capex (because this is an asset-light business and today you don't even need to buy much in the way of server hardware, because you can rent your compute cycles from Amazon or Microsoft); and it will often be paid upfront for the subscriptions it sells. Think back to your Buffett reading. Remember those insurance premia that generate "float" ie. low cost capital? That's what an upfront subscription payment does for a cloud stock. Provides low cost capital - for acquisitions, for paying the bills, whatever. So a good company in this group will be generating net cash even whilst its Operating Income, Net Income and EPS can be negative. That's something that's well known to specialists but it doesn't show up on a stock screener very easily.
Finally, you're going to want to check the balance sheet. You'll look at cash and equivalents, short term investments, long term investments, short and long term debt as always. Add them together and you have the net cash or net debt position - usually net cash in these growth companies. But be sure to take a look at a line called ...
- Deferred revenue. You'll usually find a material amount of this in short-term liabilities and a small amount in long-term liabilities. Deferred revenue is the liability (to deliver service) that offsets that upfront cash asset we talked about above. If deferred revenue is large vs. recognized revenue, you have a company with a high level of revenue visibility - and the converse is true. And if deferred is growing faster than recognized, you have an overall improvement trend in the quality of revenues.
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Cestrian Capital Research, Inc - 20 July 2020.