Feb 5 2020 - SaaS Companies Are Priced To Perfection

Summary

SaaS companies are fully valued.

If I had to choose one, it would be Alteryx.

We take a closer look at the Rule of 40 and stock-based compensation.

When I started out in the investment business over thirty years ago, one of the first things that I learned was to differentiate between a great company and a great stock.

The Needham Growth conference last month showcased several outstanding software companies, leveraging big data and the Cloud. Most of these companies use an attractive software-as-a-service (SaaS) business model. These SaaS companies had impressive presentations and fire-side chats, espousing their scalable business models, growing customer base, land-and-expand client strategies, unique value propositions, and rosy outlooks. The twelve presenting companies on my watch-list had median revenue growth of +51%.

Most of these companies operate at a loss to grab as much of this nascent market growth as possible. These twelve high-growth software companies had a median GAAP EBIT margin of -14%, stemming from high product development and marketing expenditures and related stock-based compensation. These SaaS companies want to be the future leaders in their eventually-large market niches.

But the valuations of some Cloud software stocks are hard to justify, even with today's low interest rates. The above-mentioned group's median enterprise value/last twelve-month revenue multiple is 23x. These are revenue multiples, not earnings multiples. Most of these companies have no earnings, and are not projected to have positive GAAP earnings for a number of years. Thus, they may be great companies, but not such great stocks on a fundamental basis.

The market, however, has a different view. Growth stocks like these SaaS companies have continued to outperform Value Stocks. Value stocks (Russell 1000 Value ETF (IWD)) are up +13.8% over the last twelve months, well below the +29.5% jump in growth stocks (Russell 1000 Growth ETF (IWF)). Today's near-zero interest rate environment provides the high-octane fuel to drive growth stocks higher; future cash flows are discounted at very low discount rates, while unattractive cash and bond yields provide miserable alternatives to stocks.

Neither low interest rates nor high-and-profitless growth will continue indefinitely. At 23x revenues with heavy losses, these ultra-growth SaaS stocks will need several years of at least 30% top-line growth off of larger bases, with less proportional spending support, no inflation threat, no rising interest rates and continued economic prosperity. Moreover, these valuations assume that there will be no technological shifts or major competitors arising to challenge today's emerging SaaS stars. In short, these stocks appear to be priced to perfection. Look what happened in late 2018 when there was just a sign of the liquidity faucet being tightened. The technology-heavy Nasdaq fell by 20%.

Despite their high-valuations, the twelve stocks below were the top growth stocks that I picked out among the roughly 250 publicly-traded companies that participated at the Needham Growth conference.

Company Ticker Price EV EV/Revs Rank
Alteryx AYX 139.57 .9B 25.5x 8
DocuSign DOCU 80.63 .4B 16.1x 3
EverQuote EVER 38.18 .0B 4.5x 1
DataDog DDOG 45.26 .7B 40.8x 12
CrowdStrike CRWD 61.08 .7B 28.6x 9
Ansys ANSS 281.33 .5B 16.2x 4
Smartsheet SMAR 50.51 .9B 22.2x 6
MongoDB MDB 163.33 .3B 23.8x 7
Coupa COUP 161.73 .2B 29.0x 11
Five9 FIVN 72.71 .3B 14.1x 2
Okta OKTA 129.35 .4B 28.8x 10
Zscaler ZS 56.82 .9B 20.8x 5
Median       23.0x  

Another prism from which to view high-growth software companies is through the Rule of Forty. This rule of thumb states that a company's revenue growth rate plus operating margin should equal at least 40 (as a percent) to be a financially attractive investment. Below are two versions of the Rule of Forty - a standard version and an adjusted version. The standard version uses last-twelve-months revenue change, plus free cash flow (which is Non-GAAP EBITDA plus changes in net working capital) as a percentage of revenues. In the adjusted version, EBIT margin (earnings before interest and taxes) was used in place of the free cash flow margin. Not counting non-cash operating items is misleading; the GAAP EBIT margin better captures the full picture of the company. Thus, the adjusted version may be more meaningful, and sets a higher bar.

Company % chg in Revs FCF/Revs EBIT/Revs

Rule of 40 std

Rule of 40 adj Rank
Alteryx +73% +7%* +6% 80 79 1
DocuSign +38% +24% -24% 62 14 12
EverQuote +38% +2% -7% 40 31 6
DataDog +85%# -4% -8% 81 77 2
CrowdStrike +97% +5% -36% 102 61 3
Ansys +22% +30% +36% 52 58 4
Smartsheet +54% +19% -35% 73 19 10
MongoDB +61% -5% -34% 56 27 9
Coupa +48% +29% -19% 77 29 8
Five9 +28% +13% +2% 41 30 7
Okta +48% +18% -31% 66 17 11
Zscaler +56% +23% -10% 79 46 5
Median +51% +15% -14% 64 31  

* Q3 2019 FCF margin, LTM FCF margin of -11% had irregular working capital changes

# last six month revenues vs year-ago, due to unavailability of pre-IPO year-ago data

A primary non-cash expense that sell-side analysts exclude from their financial projections is stock-based compensation. The sell-side prefers to focus on cash expenses, as opposed to estimated non-cash expenses that may vary over time. On the other hand, stock-based compensation is an operating item that is a key component of employees' salaries, which can be clearly estimated. Stock-based compensation has a substantial impact on SaaS companies' financials.

Company SBC Revs Employees Revs/Empl SBC/Revs SBC/Empl
Alteryx .8M 0.6M 1,176 8k 7.6% k
DocuSign 0.1M 8.1M 3,023 7k 22.3% k
EverQuote .5M 4.8M 250 9k 5.8% k
DataDog .8M^ 3.6M 1,035 1k 4.9% k
CrowdStrike .0M^ 0.0M 2,078 1k 17.6% k
Ansys 9.2M 45.1M 3,900 1k 7.6% k
Smartsheet .6M 4.5M 1,489 4k 12.1% k
MongoDB .6M 3.7M 1,660 1k 16.1% k
Coupa .3M 3.2M 1,202 4k 21.0% k
Five9 .7M 8.1M 983 3k 12.2% k
Okta 2.1M 4.2M 2,116 2k 21.0% k
Zscaler .2M 3.1M 1,480 5k 17.2% k
Median       5k 14.1% k
^ annualized latest-reported quarter due to 2019 IPO, isn't comparable to pre-IPO data

An important factor in selecting these high-growth SaaS companies is the sustainability of their growth rates. A related metric is the net expansion rate. The dollar-based net expansion rate is a trailing four-quarter average of the annual contract value divided by the term of the contract, from a base of total customers that is comparable to the year-ago period. A net expansion rate above 100% is positive, as it shows that the company's land-and-expand strategy is working. The company that had the highest net expansion rate that I saw at the conference was Alteryx, with a net expansion rate that was consistently above 130%.

Alteryx provides self-service, advanced data analytics. The company's software optimizes data discovery, preparation, as well as analytics; then enables rapid deployment and actionable insights. Not only does Alteryx platform scale to handle large data sets, but automates previously complex manual processes - a key growth driver. The company has a rapidly expanding user base of analysts, data scientists and engineers.

Alteryx users love the companies' products because it saves them a lot of time and makes them more productive. Alteryx directly addresses the problem of how to make sense out of the plethora of incoming data in a time-efficient manner.

The company also has a lot of potential to increase its low average seat price by offering more specific solutions for certain industry verticals. This natural price uplift is in the pipeline, and provides a lot of upside. Furthermore, Alteryx just announced a major partnership with PricewaterhouseCoopers to provide automated data solutions to PwC's global customer base.

Alteryx is one of the few high-flying Cloud software companies that are in the black. The biggest risk lies in its current lofty revenue multiple.

DocuSign is an interesting company as well. They have built a competitive moat in the electronic signature niche. DocuSign dominates the space with 70% market share using a work-flow based model. Adobe (ADBE), with 20% market share, uses a less-sophisticated signature tagging system. For the moment, Adobe is not focusing on eSignature, as it is only 1% of Adobe's revenues.

Electronic signature should provide steady growth over several years as companies slowly-but-surely are beginning to convert from paper to eSignatures. The company is now expanding into broader work-flow solutions for front and back office workers, to provide a more complete solution for customers.

A weak point for DocuSign are the large GAAP losses despite a B annual revenue run rate in the latest-reported quarter, in part due to above-average stock-based compensation costs.

I also liked EverQuote, which provides an online marketplace for insurance shopping. The company provides consumers a free insurance shopping service, and matches them up with a quote from an appropriate carrier with one click. The carriers pay a fee to Everquote. The company's main business today is auto insurance, but also provides quotes for Medicare gap supplement insurance and other new verticals.

EverQuote's revenue multiple of 4.5x is more reasonable than its SaaS peers. On the other hand, the stock price has had a hyperbolic 7x run over the past twelve months. Also, EverQuote's business has lower barriers to entry. The company has about 6% market share in a fragmented .4B market (including online advertisers). Lending Tree (TREE)/Quote Wizard is a formidable competitor with a similar market share.

Regardless of the compelling growth stories from these SaaS companies, keep in mind that the current valuations are rich. While they can still go higher on very good news that exceed expectations, be aware of the downside on any hiccup.

I encourage you to read this previous article as an investment primer on Cloud Computing, Big Data and SaaS technology.

Disclosure: I am/we are long AYX. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.

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