SaaS Valuations COVID-19 Edition: Zoom Is (Literally) Off The Charts
The COVID-19 pandemic is disrupting our lives in an unprecedented way. The humanitarian crisis we are going through will have long-lasting ramifications on healthcare, the economy and our society as a whole.
There are already very obvious impacts in public equities:
- Travel and hospitality, non-essential retail, live events and offline entertainment are all coming to a halt and are being hammered.
- Telehealth, video-conferencing software, online delivery services and online entertainment appear poised to thrive and are surging.
But the pandemic could pose a challenge to many industries in more subtle ways. In an economic slowdown, with the vast majority of the world expected to be sheltering-in-place for at least another month, software businesses are not going to be immune to the virus.
Volatility has reached levels not seen since the Great Recession. Market sentiment is likely to prove to be challenging. SaaS companies could see longer sales cycles in a COVID world. Many may have to offer flexible contract terms and pricing.
As explained recently by Gavin Baker on Patrick O’Shaughnessy’s podcast:
If budgets are going to get cut, software is going to get hurt. I don’t see any way around that. […] In a world where first lien debt holders are not being paid, I’m not sure if software bills are going to be paid on time and in full. […] If you have zero revenue, are you actually going to pay all your software bills?
According to Germain Brion, SVP of Global Sales of Chargebee:
Sales teams acknowledge the current sentiment prevalent in the market and make the necessary changes to tackle this unpredictability.
Software companies working with small-and-medium sized businesses could see their customer relationships challenged and software bills being cut. If so, only those with strong balance sheets will be able to weather the storm and go through this turbulent time unscathed.
On the flip side, some companies are going to benefit immensely from the COVID world we now live in. Software companies that enable and enhance work-from-home are struggling to keep up with demand. They could see the existing secular trend accelerate and catapult them forward – though things will normalize once we exit months of sheltering-in-place.
As most of you already know, I’m a business-focused investor. If the underlying business of a company is likely to survive this crisis, the current market meltdown is nothing more than a once-in-a-lifetime opportunity to accumulate shares of outstanding companies at a (more) affordable price.
As the market digests the new paradigm we live in and its implications, let’s review where valuations of software companies currently stand.
Most SaaS companies have dropped 40% or more
While some work-from-home plays managed to perform better than the market such as Zoom, Adobe (ADBE), Okta (OKTA) or DocuSign (DOCU), many software companies have suffered huge drawdowns of 40% or more from their previous highs.
Source: Google Finance 4/3/2020. Chart by App Economy Insights. In the chart: Five9 (FIVN), Veeva Systems (VEEV), Atlassian (TEAM), Okta, DocuSign, Everbridge (EVBG), Zoom Video, Adobe, Zscaler (ZS), Datadog (DDOG), ServiceNow (NOW), salesforce.com (CRM), Dropbox (DBX), Axon (AAXN), Box (BOX), BlackLine (BL), MongoDB (MDB), Zendesk (ZEN), Wix.com (WIX), Shopify (SHOP), AppFolio (APPF), Splunk (SPLK), Slack (WORK), CrowdStrike (CRWD), HubSpot (HUBS), Twilio (TWLO), Workday (WDAY), Alteryx (AYX), The Trade Desk (TTD), Appian (APPN), Paylocity (PCTY), Paycom (PAYC), Elastic (ESTC), New Relic (NEWR), Yext (YEXT), Zuora (ZUO), PagerDuty (PD), 2U (TWOU).
Several categories emerge:
- Laggards that had their own issues well before the pandemic started. That includes companies like CrowdStrike, PagerDuty, Zuora, and education technology company 2U.
- High flyers that were on an upward trajectory for months and had a lot of expectations baked in their valuations, with much more room to fall. That includes companies like Shopify, MongoDB and Alteryx.
- SMB software providers that are likely to suffer more in the coming months due to budget cuts or challenged sales cycle. That includes companies like Paycom, Paylocity, and HubSpot.
To be able to put these drawdowns in context, we have to look at the underlying performance of these businesses and where their valuations stand.
Winners of the Rule of 40 remain sparse
I have shared before the rule of 40 map, breaking down my methodology and showing how to pit the performance of SaaS businesses against one another through the lens of sales growth and operating profit.
I’m using the operating margin of the past 12 months. This is meant to better reflect the performance of companies that have some seasonality to their sales and marketing or R&D investments. Some analysts like to use free cash flow margin or operating cash flow margin, which can result in slightly different results.
As illustrated below, with the most recent data pulled from Yahoo Finance, only a few SaaS companies manage to satisfy the rule of 40, that Bain & Company defines as “the principle that a software company’s combined growth rate and profit margin should exceed 40%.”
Let’s look at the map and see what we can learn.
Bubble size based on market capitalization as of 4/5/2020.
Out of the 37 SaaS companies selected:
- 21% have an efficiency score above 40
- 30% have an efficiency score between 20 and 40
- 49% have an efficiency score below 20
It has been very helpful for me to realize where some of these companies end up appearing on the map. Most of them have yet to turn a profit, but they all have very different stories once you look at their profitability respective to their sales growth.
I identified three categories of interest before and have updated them accordingly:
Source: App Economy Insights
1. Proven winners:
Paycom Software, Adobe and Veeva Systems are outstanding performers. The three of them are still growing their sales above 20% most quarters while delivering outstanding profit margins above 20% as well.
2. Scaling champions:
Many of my favorite and most successful investments end up being very close to the center of the map. They are in a phase focused on the scalability of their business: continued very high sales growth around 40% with profitability close to equilibrium. That includes companies like The Trade Desk, and others falling just short of the Rule of 40 such as Shopify, Salesforce, HubSpot, and AppFolio. Several of them are among the best performers of the App Economy Portfolio.
3. Super-fast growers:
I had not fully realized how astonishing the current growth of Zoom, Alteryx, Datadog and CrowdStrike really is. They stand out on the map, with Alteryx presenting the most impressive margin profile. These companies are emerging forces in their respective fields and likely to deliver outstanding returns for the years to come. They present a riskier profile since there are more uncertainties around the sustainability of such an impressive growth.
Laggards (efficiency score under 20):
Companies like DocuSign, Splunk or even Zendesk are not growing fast enough when you consider their current profitability. Things could improve over time, but they are clearly lagging behind their peers. They present a good opportunity only if you think they can turn things around over the long term or if they offer a good entry point.
With the exception of CrowdStrike, still in its first year since becoming public, companies that score above the 40% efficiency threshold have completely crushed the market over the years.
Now that we have identified who the winners are and where they are positioned on the map, the next step is to understand their corresponding valuation and to what extent you have to pay up for excellence.
Zoom is (literally) off the charts
Bubble size based on market capitalization as of 4/5/2020.
Given that the vast majority of these software companies have yet to turn a profit, the only way to pit them all against a comparable valuation metric is to use Enterprise Value to Sales ratio.
I always enjoy updating this chart and seeing it come to fruition. I added a trendline to illustrate the correlation between efficiency score and valuation.
Before considering whether a company is overvalued or undervalued, it seems relevant to compare it to similar performers. If we assume that the trendline represents what a “fair” valuation could be among this set of SaaS companies, the companies that are overvalued are above the trendline, while the companies that are undervalued are below the trend line.
Here are some important thoughts to keep in mind:
- While the future pain or gain coming from the COVID-19 pandemic has yet to be reflected in these companies’ growth and profitability, it is reflected in their valuation multiples.
- Before assuming that a company is a good or bad investment, you may want to consider how the market has already baked in its future performance.
What to look for to separate the wheat from the chaff
Investors have to look at the nature of the underlying business of a company before jumping to a conclusion as to whether or not it is cheap or expensive.
Some of these businesses are about to go through troubled times, and only those with strong balance sheets and access to liquidity will be able to come out stronger on the other side.
I think most investors need to avoid thinking too short term in their trading. You don’t have to buy shares of a company just because it should have a strong earnings report next week. Most of the time, a company that is suffering from negative sentiment presents a much better investment opportunity for the long term.
I always cringe when I see investors reach a conclusion about the validity of an investment simply based on a valuation metric.
Zoom Video is a perfect example. There is no software company in history that saw a growth in usage the way Zoom did over the past few weeks. Zoom was the Stock Idea of the month in February in the App Economy Portfolio service. The stock is up almost 70% since then. If I believed Zoom was a sound investment two months ago, I obviously believe it still is today after being adopted by 190 million new users.
What matters most is for investors to recognize the inherent risk attached to elevated expectations and astronomical growth. Your portfolio allocation should be managed appropriately. Always remember you don’t have to go all in. To quote Tom Engle: “If this company is the next great growth stock, a little is all I need. If it’s not, a little is all I want.”
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The rise of the App Economy is disrupting many industries: retail, entertainment, financials, media, social platforms, healthcare, enterprise software and more.
While keeping in mind some of the best recommendations from experienced gurus of Wall Street such as Warren Buffett, Peter Lynch, Burton Malkiel or Philip Fisher, I am trying to beat the S&P 500 index by a significant margin.
Here are some of the trends reflected in the portfolio:
Disclosure: I am/we are long APPF AYX CRM HUBS MDB PAYC SHOP TTD ZUO. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.