“Optimism is the engine of capitalism.”
The markets have climbed a steep wall of worry in the face of the ongoing pandemic, social issues, and weak economic conditions including a weakening dollar, unemployment, retail bankruptcy approaching highs, and Congress on break until Labor day with no new stimulus approved (the lack of a deal leaves millions without a $600 per week federal unemployment benefit, there is no eviction moratorium, and the Paycheck Protection Program application window has shut). But the markets have embraced Daniel Kahneman’s axiom and are unabashedly optimistic. While SaaS valuations are down 8.3% from their all-time highs set earlier in August they’re still at the same level as late June (which already felt extended), up a whopping 102.4% from their mid-March trough, +31.2% above the pre-COVID high water mark (which in and of itself doesn’t feel too crazy), and +55.0% above 12/31/2020.
The optimist in us wants to believe that maybe it is really as simple as the prevailing narrative makes it out. Software is eating the world and we’re in a long term tech valuation bust - these companies are operating in markets that are so big, the businesses themselves are so defensible, efficient, and predictable that large and enduring cash flows over the long term are obviously a sure thing. As we’ve noted previously, we also can’t ignore how the interest rate environment expands multiples. But as investors support revenue multiples near their all-time highs we again beg folks not to forget about fundamentals, like how there are levels to revenue quality that should skew multiples - positively or negatively - from the mean. And that is our topic for this week. If it was simple, companies would sell a subscription for $120 / year and recognize it ratably - $10 / month - for the year. ARR would be $120 and MRR $10. But it is never that simple.
As we wrote in May, Alteryx’s use of ASC 606 was bound to negatively impact growth. We felt the business should be valued 40% or more less than where it was trading. Well, after Alteryx’s Q2 earnings release, the stock sold off and has settled 35% below its pre-earnings price. That the stock was setting up for this move wasn’t a mystery: the management team guided to 12.5% growth but the Street’s whisper number was still significantly greater than the company’s guide. But the guide was obvious given what 606 meant for growth if new business slowed at all. We should have been more articulate in our original post: not all software revenue is created equal. Alteryx never pretended to generate mostly SaaS revenue - it doesn’t (it’s mostly on-premise, which is why 606 accounting has this impact on the business). Yet it continues to be bucketed as a SaaS business because it sells software and has a little bit SaaS revenue.
Similar to our frustration with the lack of consistent retention disclosure we are concerned by the many different ways “SaaS companies” - which just selling software qualifies a company as (see Alteryx) - don’t consistently report or define revenue. Of the public SaaS companies we track, just 34% provided “ARR” in their last available annual report (we did not review interim quarterly reports), 47% disclose “subscription revenue”, and the remaining 20% report total revenue.
Of course, those that provide ARR don’t agree on how to report it (big surprise) and what companies like BigCommerce call ARR is really annual run rate including likely lower margin partner revenue and non-recurring services and integration revenue. Others that report subscription revenue, like Avalara, include in that number less predictable overage usage revenue as well as interest from funds held for customers. Before we move down to cost of goods sold (what is the margin on each revenue stream?), through to OpEx (what is burn productivity), and even the cash flow statement (how is the company booking, billing and collecting), everyone needs to spend significantly more time looking at revenue and specifically revenue quality. We’re all being told a story, and in the public markets it is a management team telling us that story. In everything they do their narrative pervades. Not all companies do it well, and sometimes it falls apart taking the stock price with it! We’re bullish on SaaS long term, but we feel too often folks are keen to assume every business is created equal when in fact each is unique and accounts for and positions their business in the way that serves them best. In what feels like the ninth inning of a triumphant bull market with SPACs galore, Robinhood traders and businesses buying Bitcoin instead of holding bonds or cash… it’s a great time to re-focus on fundamentals.
Financial Resources
SaaS Benchmarks
My colleague Kyle Poyar took an early look at the data from our 2020 SaaS Benchmarks Survey (take the survey here - more data = better survey - or view last year’s report here). How are SaaS startups doing as a result of the COVID-19 crisis? The TL;DR is "it depends." Most commonly, 35% of respondents noted a “moderate negative impact” (-10 to -24% impact vs. original budget). But "just” 25% noted an impact greater than -25% (vs. their original 2020 budget). The remaining 40% either noted a small negative impact (20% of respondents, a 0-9% negative impact vs. budget) or a positive impact (20%). We’re also encouraged by how proactive companies have been in changing strategies in response to COVID. The most popular responses our question “which defensive tactics have you adopted” have been: cutting discretionary spend (65%), shifting marketing messaging (60%), and adopting more flexible contract terms (55%).
Public SaaS earnings appear to show continued strong buying activity for software. While Gartner expects spending on software to experience setbacks throughout 2020 and into 2021 (-5.7% growth in spend in 2020) the crisis has also exposed areas of historical under investment from businesses, and a “return to growth” should be realized (the TAM pull forward many have discussed) to improve capabilities that were lacking during the crisis.
Our benchmarks report will be released in October, and we look forward to sharing more detail on how SaaS companies have performed then!
Capital Markets Resources
Markets + Economic Data
We enjoyed ARK’s mARKet update webinar for the month of August earlier this week. Highlights include (1) why ARK still believes we will experience a very steep V-shaped recovery (the fastest, and best outcome from economic recovery), and how (as we’ve written) the current interest rate environment supports current valuation levels. All but the SaaS index closed up from last week, with SaaS appearing to settle into a new level post-Q2 earnings (SaaS -0.84%, Dow +1.81%, NASDAQ +0.22%, S&P 500 +0.64%).
What Else We’re Reading
Participate in our 2020 SaaS Benchmarks survey! The public SaaS companies we track closed the week trading at 10.2x 2020E revenue at the median (-0.5x vs. 10.7x last week). Democratization vs territorialism in software. Notes on the Economics of Strategy. Investing Mistakes. Hayden Capital 2Q 2020 investor letter.