7/10 OpenView Capital Markets Roundup
The limit does not exist
Welcome to all of our new subscribers! After a week off for the 4th of July holiday, we’re back with the same mandate - rounding up the top financial resources and capital markets news from the week so you don’t have to. Archive everything else and check your inbox every Saturday AM for the latest from your friends at OpenView!
In our last roundup we covered the incredible leeway public companies have when it comes to defining “retention”. There was significant follow up on social and we particularly enjoyed discussion around prior statements from Shopify’s CEO:
My ambition is that Shopify is going to be one of those very few companies that is public but is trusted to the degree that it can act as, similar autonomy to what private companies can do, highly trusted private companies. That was my goal.”
And while we will still have a bone to pick with companies like Alteryx (we won’t dive into just how flawed CAC payback calculations that use GAAP subscription revenue and sales & marketing expense are because of ASC 606), positioning a company’s opportunity effectively through whatever (legal) means necessary - telling an awesome story - is an especially important competitive advantage. As was pointed out on Twitter, a strong narrative lowers the cost of capital whilst still enabling equity to appreciate - it enables investment, talent retention, robust culture, and more. Twitter (the company) saw this in action earlier this week, as a job posting for an engineer to work on a subscription product drove a narrative that added billions in value! It has been noted that much weight has been given to “the narrative” lately given how dislocated fundamentals are from prices in the market. So again we ask, is there any quantitative explanation for prices?
We’ve written before that SaaS companies invest at rates that are so high above the cost of their capital (ROIIC > cost of capital) chasing large market opportunities that there is infinite runway for value creation. The “large market opportunity” point got a lot of attention this week and the cost of capital (vis a vis ROIIC) didn’t get nearly enough. The analyst in us finds the former rationalization generally correct but just a bit too simplistic. And it is especially questionable as we consider new forecasts on spend from Morgan Stanley and Gartner. We can’t help but ask - is spend really increasing or being pulled forward? Spend won’t go away (expense for existing projects will continue), but if the current recession is prolonged growth expense creating new software spend will slow, and Morgan Stanley’s CIO survey and Gartner’s research confirms this. Let’s turn our attention to the cost of capital – narrative isn’t all that lowers this.
In “The Math of Value and Growth”, Michael Mauboussin writes about the commodity Price / Earnings multiple. What should you be willing to pay for $1 of earnings into perpetuity assuming no value creation? The answer is $1 / cost of capital - so multiples rise as the cost of capital falls. And multiples go to infinity if we take the limit of a / b as b approaches zero. The limit for SaaS multiples is infinity. Mauboussin also discusses the concept of duration, noting that “stocks of companies that have opportunities to make value-creating investments in the short run in order to generate higher cash flows in the long run have longer durations... Long-duration assets are more sensitive to changes in interest rates than are short-duration assets. Keep this in mind: companies that can invest a lot today at high returns on capital will not only grow faster than the average company, their stocks will have valuations that are more sensitive to changes in the discount rate.”
Sound like SaaS, right? Tons of opportunity to make value creating investments today for higher cash flows tomorrow. Explanations like TAM expansion are great but the trend of digital transformation has been here and widely acknowledged for years. The real development impacting prices today is the now lower cost of capital. Eventual SaaS free cash flow is more attractive than ever because it costs less than ever to invest at the same high rates of return. Now these rates of return are potentially trending higher as well given TAM expansion / pull forward - a dollar of investment yields more revenue in a larger market with more willing buyers - but that is less certain and quantifiable in this new recessionary environment.
Everything is valued on cash flow eventually, and when that cash flow costs and is discounted less, multiples go up.
Capital is really cheap today. Mortgage rates are low, governments are selling cheap debt – the cost of capital is as low as it has ever been. So we pose this question to all companies and investors: where would you invest differently than you are now (through your P&L, balance sheet, or personal account) with this knowledge? What investments might you double down on? How can you start positioning your narrative today for a capital raise in 3, 6, or 12 months? We’re in an entirely new interest rate environment, the Fed has been clear that this isn’t changing anytime soon, so we must start getting used to this new normal for SaaS multiples and lean into what the “why” behind it (the lower cost of capital) means.
OpenView BUILD Podcast
On this week’s BUILD Podcast, OpenView partner Blake Bartlett spoke with Wes Bush, founder of the Product-Led Institute, author of “Product Led Growth: How to Build a Product That Sells Itself” and fellow PLG enthusiast. Blake and Wes unpack a ton of useful information in this episode including when and how your sales team can make the biggest impact, how to get started with product led growth, the importance of customer empathy and much more! You can listen to the episode here.
Capital Markets Resources
The markets continue to shrug off all the negative news the world throws at them - all major indices finished the week up (SaaS -1.82%, Dow +0.96%, NASDAQ +4.78%, S&P 500 +1.76%) with the NASDAQ closing Friday at another all-time high. The NASDAQ is now up nearly 25% this year (led by tech names like Apple, Microsoft, Alphabet, and SaaS companies). While we’ve noted above that the new interest rate environment and duration justifies expansion of SaaS multiples we have serious concerns about the upcoming Q2 SaaS earnings season. Many companies pulled their full year guidance, had solid prints in April and May, and have run up double (and triple) digit percentages since then. But those earnings didn’t factor more than 1 month of COVID impact, and SaaS companies tend to sandbag estimates to maintain a beat and raise cadence anyway. With three full months of COVID / recession impact factored into the numbers we expect some to see some companies hit speed bumps in their price appreciation. While all major indices have traded up from their March 23rd lows (NASDAQ +54.65%, S&P +42.35, Dow +40.25%) we take some comfort in the fact that only the former has set new all-time highs - both the S&P and Dow are still -5.94% and -11.15% below their February 19th high water marks, more closely tracking the reality of the pandemic and economic recovery (reopening) that we’ve seen to date.
There has been tons of positive economic data over the last two weeks like jobs (topped estimates, although not without debate over data quality), manufacturing (the ISM Manufacturing Index saw its biggest monthly increase - 9.5 points - in 40 years), and consumer sentiment (increased 12.2 points in June). Since we are after all officially in recession it is encouraging to see improving data. But as the pandemic persists, time will tell how long this “recovery” in certain key economic indicators goes on. A refresh on the “key economic indicators” to focus on is here, for those interested.
What Else We’re Reading
The public SaaS stocks we track closed the week trading at 12.3x 2020E revenue (versus 12.7x and 12.1x as of 7/3 and 6/26 respectively). What Does An EV / EBITDA Multiple Mean. Visualization of COVID impact on sales & marketing data from HubSpot. What do investors bidding up tech shares know that the rest of us don’t?