8/7 OpenView Capital Markets Roundup
Whispers on Wall Street
Were we right, or were we right? From our May 22nd roundup…
The SaaS treadmill is moving at warp speed (the expectations for future growth so extreme) that under current conditions it seems inevitable that it will be impossible to keep accelerating (delivering strong performance). It won’t even be an earnings miss, but rather a beat that isn’t quite big enough that causes price to fall.
SaaS stocks were a sea of red on Friday after week 2 of Q2 earnings (index finished down 5% ). As we predicted in May (above), a surprising amount selling driving down prices was in names that “beat” their guidance. Since when is a beat a bad thing?
Well, it would probably help to explain the quarterly reporting cycle for public companies at a high level. Once public, a company reports earnings on a quarterly basis (within some SEC-required number of days after their quarter end). They publish documents and hold a call to provide a summary of performance (laced with non-GAAP metrics to support their narrative) including revenue, costs, expenses, customer adds, etc. They also (usually) provide forward guidance for the next quarter and the year (i.e. “we expect $100M of revenue in the third quarter”). Analysts then ask a few (occasionally softball) questions, nod and grunt their understanding, then update their models with… mostly exactly what the company said it would do… which is averaged into what we call “consensus estimates”. Then companies try to beat what consensus says next quarter. Except it isn’t this simple. There is a third number - the whisper number.
“Expectations weren’t met,” “multiples were stretched already,” “this is a healthy pullback” - these rationalizations for the decline this week are all correct. But key to interpreting why good performance resulted in a pullback is the whisper number. This number is the one that the big hedge funds moving prices are modeling and buying based on. NTM consensus revenue guidance may say a company is trading at 30x revenue, but a fund(s) might be modeling something more "reasonable” like 27x their number (the whisper). Take Datadog - in Q1 Datadog beat their revenue guidance by $13M but this quarter “only” beat by $3M - that’s a nearly 70% decline in outperformance, or a 70% expectations miss (a miss of the whisper). Datadog would have needed a beat of approximately $14M this quarter to outperform guidance (attain the same percentage beat of their guidance) as in Q1, and even more than $14M to accelerate the expectations of investors (trade up). For Datadog and other companies that beat and traded down, it was because investors updated their models with a lower number. As revenue came in lighter than their original model, stock price needed to come down for them to pay the same multiple as before. Datadog and other names are great businesses with long runway for growth and excess shareholder returns, investors just had all too high of expectations in the microcosm of this quarter.
As this S&P article found, “[Only] 16.75% of the index's member companies that issued quarterly EPS guidance in 2018 went on to report results within their guided range…The vast majority of the time, companies beat their guidance, and especially in high-growth sectors like tech and software, doing so has become synonymous with success. Companies' habit of setting beatable targets is widely known and expected...But critics of the practice say it has enshrined a custom that ultimately only misleads investors.” So, we must ask the question: why is it acceptable that the analysts covering companies, the investors purchasing stocks, and companies themselves all know they’ll outperform? Why is no one pushing companies to be more forthcoming - what is the point of guidance at all? It seems horribly inefficient that some in the market know a company is sandbagging. If you’re an investor who doesn’t get management access or have a network like a big fund and believe stocks just go up, you can’t really compete on a level playing field.
Folks can and should still be "long SaaS stocks” but when we wrote months back that the risk reward profile didn’t make sense anymore, it was the expectations for future performance that didn’t make sense. No company could continue to beat guidance by multiple millions each and every quarter. This downward adjustment in prices to levels which were the new “all-time highs” as recently as July 1st of this year is indeed healthy but even at these prices, things are still “hot” and multiples are stretched above historical averages. That said, with low interest rates and the Fed fracking (see below) that are likely to persist for multiple more years driving people and institutions into equities as an off-set to not being able to find yield almost anywhere else, we shouldn’t expect complete regression to historical means anytime soon.
Financial Resources
BUILD Podcast
Blake released yet another hit! This week, Blake spoke with President of Atlassian, Jay Simons. Among several other topics, they discussed Atlassian’s secret to creating compounding customer value. The podcast launch is timely, as our post last week questioning the lack of M&A was inspired by Atlassian’s recent acquisition of Mindville (and a few months earlier, Halp). We hypothesize that businesses like Atlassian with a product led growth model can execute, integrate, and deliver excess shareholders returns through M&A much more effectively than traditional sales-led businesses. A reader last week shared that data has shown that 80% of software companies that successfully scale from $100 to 500M in revenue and stayed independent did it through M&A... and 100% post-$500M require M&A as their core source of incremental growth. The beauty of the product led model is that in so precisely identifying an end user pain, and solving said pain in a way that allows a company to extract value from the solution - you can easily identify progressively new pain points to fix and extract value from. You don’t need to figure out revenue / cost synergies, retrain a sales team, integrate a product into yours, figure out product messaging and marketing - that foundation and muscle exists because of the bottoms up approach to building the business with product in mind. Just buy the company, plug it into your PLG engine, and customers will do the rest! Atlassian has made M&A incredibly easy (down to publishing their term sheet publicly - like it or leave it!) and as a PLG-posterchild, they’ve put on a masterclass in scaling inorganically. As Hiten Shah noted in How Atlassian Built a $10B Growth Engine: “their biggest—and most unusual—lever for growth has been to consistently acquire other products throughout the company’s history and integrate them into the existing product suite.”
Capital Markets Resources
Market Update
We covered most of the important equity market updates above, but we enjoyed this quote from a newsletter we receive, analogizing oil fracking to the what the Fed is doing, Fed fracking is “The process of injecting money at high pressure into Treasuries, Corporates, ETF’s, Municipals High Yield etc. so as to force yields down for all risk assets and extract lower interest rates for the government.” The Fed continues to help buoy asset prices with liquidity injections and interest rate policy and the markets, despite economic uncertainty (more below) remain… okay. The biggest loser in software this week was Alteryx, which as we expected posted results mostly in line with their guidance, but far below expectations (given how quickly GAAP revenue growth slows under ASC 606) and the company ended the week worth 30% less. All but the SaaS index had strong intra-week performance and closed up from last week (SaaS -4.76%, Dow +3.80%, NASDAQ +2.14%, S&P 500 +2.45%).
Economic Data
Jobs data, new government stimulus, progress on the virus: the trio of things that matter in the economy right now, and what’s driving a bit of an economic “holding pattern”. As Austan Goolsbee noted, “…rule #1 of virus economics: slowing the virus is the way to fix the economy.” How it was ever believed we could have the latter without the former is a mystery, but here we are. There was little progress this week on government stimulus, and while jobs data in July was better than expected, the virus is still here and we’ll be trapped in a stimulus, recovery mirage, stimulus cycle until we can tame the pandemic.
What Else We’re Reading
Participate in our 2020 SaaS Benchmarks survey! The public SaaS companies we track closed the week trading at 10.7x 2020E revenue (-1.6x vs. 12.3x last week given the aforementioned post-earnings decline). The Trouble with Earnings and Price/Earnings Multiples. The Most Dangerous Equation. Public to Private Equity in the US: A Long Term Look plus some interesting summary analysis in this Twitter thread.