(For this piece, Alphaville pulled the financials for 50 cloud software companies from S&P Capital IQ. Much is owed to a friend of Alphaville, whose similar efforts a few months back proved an inspiration. Do note that when comparing various metrics, this is often not an exact like-for-like comparison, due to some companies, such as Microsoft, having unconventional financial years. All numbers are from before Monday's opening bell.)
In an era of low global growth, the equities of businesses with no glass ceiling are king.
Think Alphaville favourites Tesla, Netflix and Wayfair — rocket-ship businesses that trade at multiples which suggest a distant future is all but a dead certainty.
But there's an entire sector of the US market which makes the rocket ships seem cheap: the cloud software companies. Call them the cloud kings.
In the past decade, they've had a pretty good run. Just take a look at the chart of First Trust's Cloud Computing exchange-traded fund, ticker SKYY (of course), since it launched in mid-2011:
A 179 cent return, compared to just 109 per cent for the S&P 500.
It's not just retail investors excited about the limitless futures of the cloud kings. A recent Morgan Stanley research note found that hedge fund net exposure to software companies is also near record highs:
So why the exuberance?
Delineating the cloud software space is a difficult one. There are established businesses, like $856bn Microsoft and $128bn Adobe, who have smoothly pivoted their successful suites of enterprise software products to the cloud. And then there are small-cap hopefuls such as $2.1bn Yext — a digital knowledge platform — and $1.1bn Domo — who provide business analytics tools for companies. Product types also vary. There are consumer-facing subscription brands like Spotify, and enterprise-only businesses like Salesforce. Some, like Dropbox, cater to both.
But while serving a variety of customer needs across different verticals, the kings do have one thing in common: their top lines are exploding.
Indeed, in the last financial year for each of the 50 businesses, revenue growth averaged a whopping 35.2 per cent:
Last financial year, the S&P 500 mustered just 9.1 per cent.
In normal times, high-growth companies command high valuations. But even for a cycle long in the tooth, the multiples on offer to investors are staggering.
Here's a chart of the enterprise value to sales ratio for the clouds. Yes, take your jaw off the floor, the numbers are correct:
Even the lowest multiple on offer, 3.4 times sales for $4bn LogMeIn — a remote-access provider (disclaimer: used by FT staff) — is a whole turn more than the S&P 500's average of 2.4 times sales.
At the crazier end, there's $8.2bn Zscaler, a cloud-based security company, whose shares have entered the twilight zone of 41 times sales. To put that into perspective, assuming Zscaler achieves 100 per cent margins, and no growth, you'd have to wait 41 years to recoup your initial investment.
However, when looking at the gross margins — the money left to service operations after the costs of delivering a product are deducted — of these companies, projections of massive future profits doesn't seem so far-fetched.
Over the past year, the ethereal ensemble has averaged a gross margin of 70.5 per cent:
This is down to the cost structure of these companies. As Stratechery's Ben Thompson has noted, internet businesses — such as Google and Facebook — have high fixed costs, and zero marginal costs. That means that once a business's core infrastructure is up and motoring, gross profits should flow straight through to the bottom line. Assuming, of course, that fixed costs remain relatively stable.
So high gross margins are to be expected, but among our nimbus 50, there's a problem keeping the crucial fixed costs, well, fixed.
Of our group, less than half achieved a positive ebitda margin last year. In fact, the average was -6.5 per cent:
Previously mentioned Domo was the worst offender, recording ebitda margins of -94.9 per cent. Investors don't seem bothered, it's up 107.5 per cent since its $311m IPO last summer.
Of course, many of these money-losing businesses are in their relative infancy. Of the 29 with negative margins, only five have an enterprise value above $10bn. These include $16bn Twilio, with a -14.1 per cent margin, and $42bn Workday, which turned its revenues of $2.8bn last year into -$240m of ebitda. Impressive.
“But Alphaville”, we hear software investors cry, “you're ignoring that these businesses are free cash-flow cash generative!". OK, maybe we'll give you that. Here's a chart of the cirrocumuluses' free cash flow margins last year (defined as operating cash flow minus capital expenditures divided by revenues).
So of the 50, only 13 posted negative free cash flow. Pretty good going. Yet there's a major contributing factor to this cash generation: stock-based compensation.
High-growth companies like paying staff in shares and share options. Not only because it aligns worker and shareholder interests, but also because it means not paying labour in precious cash.
But among the cloud kings, it's gone to pretty extreme levels. And in some cases, it distorts the free cash flow metric beyond all recognition.
Take $2.4bn Cloudera, a software platform for data engineering, as one example. In 2018, stock compensation accounted for 485 per cent of its free cash flow. If it paid workers in dollars, its free cash flow would have plummeted from $24m to -$93m.
It's not alone. Of the 50 businesses, 13 were free cash-flow positive, thanks solely to stock compensation. For a further 11, handing out pieces of paper to workers accounted for upwards of 50 per cent of the metric.
To illustrate, here's a chart of what we've called adjusted free cash flow, which is simply free cash flow, minus stock compensation:
Investors don't seem to care that much, clearly. But it's worth highlighting that stock compensation carries a real cost to shareholders as it dilutes their future claims over the company's cash flow.
Some businesses, such as Microsoft, use share buybacks to offset dilution. But unlike the stock compensation, share repurchases run through the cash from financing statement, so there's no counterbalance in the free cash-flow figure. (A humble suggestion from Alphaville is that buybacks should be split out in the cash flow statement to reflect their purpose, but that's another matter.)
However, the practice also poses an existential risk to a company in the advent of a bear market. Workers, worried about a falling stock, may not be so willing to accept pieces of paper in lieu of hard cash -- exacerbating cash-flow issues during a downturn.
Yet software engineers still seem happy accepting funny money, and the cloud kings are willing to oblige. Indeed, in the past financial year, 32 of the group grew the dollar value of their stock compensation faster than revenues.
Within the cloud software space there are clearly excellent businesses. Adobe, for instance, in 2018 posted free cash flow margins of 41.7 per cent, while increasing revenues 23.7 per cent. Similarly Dell subsidiary VMware, worth just under of $77bn, last year had ebitda margins of 30.9 per cent, and grew its free cash flow 15.9 per cent.
So when the model really works. It really works. The question is, with valuations gazing out to an ever-receding horizon, will it work out for investors?
Related Links:
Wayfair is nuts, when's the crash? — FT Alphaville
Tilray is nuts. When's the crash? — FT Alphaville
This is nuts, when does Netflix crash? — FT Alphaville
What is a “Domo”? — FT Alphaville
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