7/31 OpenView Capital Markets Roundup
M(oat)&A
The lack of (significant) strategic M&A this year should puzzle software investors. The 41 deals announced by public SaaS companies YTD represent just a $5.6B annual run rate transaction value vs. $27B+ in 2019. And average deal values are just 1/3 of 2019 (per Pitchbook data). So much focus + public attention has been on SPACs, IPOs, and Direct Listings and not nearly enough on the lack of M&A. M&A pricing tends to be mostly efficient and we have to imagine that every VC would be lining up for an all stock deal to get Zoom on their Portfolio page (“we ‘invested’!”). What would have cost Zoom 100 shares in March would only cost them ~42 today. With the cost of capital at all-time lows (which, remember, is helping multiples to all-time highs) it has never been cheaper for SaaS companies to acquire, so the $1.1B of cash on Zoom’s balance sheet or even a debt raise would be that much cheaper than equity (if Slack can get investors to fork over nearly $1B at a nearly free 0.5% interest rate… imagine what Zoom might get - negative rates?).
But our confusion over the lack of M&A goes deeper than “capital is cheap”.
We’ve written ad nauseum that SaaS companies are investing in large market opportunities at rates of return so far in excess of their cost of capital that we see no end in sight for growth and value creation (stock price appreciation). Now that said, almost overnight the market has leaned into the 20-year DCF as the standard for calculating (rationalizing, justifying) SaaS valuations. Because long duration assets can invest heavily today for large cash flows tomorrow, we need to model cash flows over 20 years, which we discount back to present at a near zero rate plus some terminal value of perpetuity growth. So the reason we want more M&A, and the question that we’re trying to answer, is: do enterprise SaaS companies have a path to 20 years of sustained value creation?
In “Measuring the Moat”, Michael Mauboussin writes that sustainable value creation (the magnitude between the spread between a company’s return on invested capital and the cost of capital and how long it can maintain a positive spread) is a “moat”. And on the question of “do enterprise SaaS companies have a path to 20 years of value creation” a question was posed, “what is Zoom’s moat”. From Mauboussin’s piece we take that SaaS “moats” typically result from consumer advantages, specifically high switching costs (sometimes network effects). Once implemented software is so mission critical, switching requires employee retraining, incumbent solutions are highly configured / customized, migration is expensive / time consuming, and searching for an alternative is costly. But for some of the highest valued PLG companies (like Zoom), the ease of adoption and use we love about PLG (the “consumerization” of enterprise IT) also means switching costs are non-existent. We do believe that Zoom has a mini-moat today - a clear path for sustained value creation over the next 5 years - and it is the virality inherent in the product (despite many noting virality isn’t a moat). But when valuation is justified by 20 years of cash flow, investors should demand a clearer moat for the next 15 years. M&A today would do this!
Zoom is on phones and laptops, it’s the new word for video chat (we don’t call this FaceTiming anymore!), and it is in the office “Zoom rooms” but this isn’t enough. Zoom needs to own every part of how we interact with peers from meeting creation, scheduling, reminders, notes, and much more. Perhaps the best use of capital for Zoom and others today spent investing in their core products and customers (although Zoom is cash flow positive, and probably not investing enough), but we don’t have a crystal ball and in the current environment (with the cost of capital so low) and in order to feel absolutely sure that Zoom or any company will grow into their 20-year DCF - ensure sustainable value creation for the long term - we need to see significantly more M&A!
Financial Resources
BUILD Podcast
Low-code / no-code, is it all just hype or is there substance to this software movement? On the most recent episode of the OV BUILD podcast our in-house PLG expert Blake Bartlett sat down with Howie Liu, the Co-Founder and CEO of Airtable to discuss.
Capital Markets Updates
Public Market Update
The markets keep going up. This was the first of several weeks of earnings releases for public SaaS companies. We’ll save any summary statistics on how many companies either beat or miss and raise or lower until we have the full set of Q2 numbers printed (and our banker relationships wrangle all the data), but the early trends were promising as all companies traded upwards after beating Street estimates (accelerating expectations). It is worth noting that even before this recent period of volatility it was widely recognized that most companies sandbag their guidance. As the data come in we’ll be careful to examine the magnitude of the “beat” (that is usually priced in by the buy side funds) and if “beat” performance remains consistent or if beat vs. consensus margin spreads are tightening on a company level. Key indices finished the week with mixed performance (SaaS +1.08%, Dow -0.16%, NASDAQ +4.03%, S&P 500 +1.73%).
Economic Data
Q2 GDP was not as bad as predicted, but it was bad. Unemployment is still increasing as jobless claims rose for the second straight week, and Congress can’t agree on how to extend the economy’s economic lifeline, which is running out. The $600 in benefits individuals were receiving ended yesterday with no concrete plan for extension. Also this week the 10 year treasury yield plunged to its lowest level in 234 years:
“The U.S. has been through depressions, deflations, wars, restrictive gold standard regimes, market crashes and many other major events and never before have we seen yields so low back to when the Founding Fathers formed the country.”
And finally, Fitch affirmed the U.S. credit rating at AAA but lowered the outlook to 'negative' from 'stable'. Low yields (risk off sentiment), a deteriorating economy, high unemployment, an increasingly levered government (with a worsening credit rating), and a stock market at all time highs. Something still doesn’t feel quite right to us.
What Else We’re Reading
Participate in our 2020 SaaS Benchmarks survey! The public SaaS companies we track finished this week trading at 12.3x 2020E revenue vs. 11.6x last week. Software Equity Group’s 2Q20 SaaS Public Market Update. Are we due for a SaaSacre? 3 SaaS Risks To Watch For In 2020.