Transforming the Enterprise
Despite the short-term pressure on stocks, we believe that the long-term wealth creation opportunity tied to select enterprise software businesses remains strong, buoyed by a massive and immutable move toward cloud computing.
Many investors, rattled by rising interest rates, higher inflation, and deepening signs of recession, have punished the stocks of enterprise software companies, pushing valuations to levels not seen since 2017. Despite this short-term pressure on stocks, we believe that the long-term wealth creation opportunity tied to select businesses within the enterprise software space remains strong, buoyed by a massive and immutable move toward cloud computing. In our view, many of our portfolio companies have the products, business models, and fundamentals that will allow them not only to survive but also to thrive as they create the services and systems that are transforming not just the enterprise, but also governments, the economy, and society at large.
Price-to-sales multiples, the most commonly used valuation metric in the technology sector, have fallen across the software sector to an average of six times sales from an average of 16 times in late 2021.1 These multiples were last this low in late 2017 when rates were also rising.
The decline in valuations has been even more severe for the stocks of the fastest-growing software businesses, especially those that remain unprofitable, as they have been hyper-focused on investing in future growth. However, we believe many of these companies, which have opted to forgo profits in the short term to enhance their competitive advantage and build bigger businesses in the long term, may emerge as leaders of this transformation effort, grow exponentially and ultimately have the potential to create wealth for their shareholders.
An Unstoppable Force
A lot has changed in the past decade since Marc Andreesen first penned his famous Wall Street Journal essay entitled “Why Software is Eating the World.” But his core thesis still holds true. At some level every company is becoming a software company. Those that aren’t innovating as part of this trend are at risk of falling behind their peers. This dynamic tends to play out across industries as software-driven features increasingly become the key battleground for competitive differentiation.
Indeed, we have seen consumers gravitate toward the disrupters that are designing and refining the products and services that best meet their needs and constantly changing preferences. Legacy retail banks, like J.P. Morgan, are spending billions to improve the digital experience for their customers. Similarly, John Deere is investing heavily in artificial intelligence and machine learning to develop its next generation of products. Even the U.S. government is prioritizing software investments to better serve employees and citizens.2
Cloud computing has emerged as the ideal environment to build a modern technology stack that allows enterprises to nimbly address the ever-changing needs of their customers. As a result, we have seen migration to cloud infrastructure, which has become one of the most significant secular trends of the past decade.
As shown in the following chart, enterprises are currently estimated to allocate about 15 percent of their information technology (IT) budgets to cloud-based technologies.3 By the end of the decade, we expect the cloud’s share to rise to about 45 percent as companies across all sectors of the economy race to invest in the cloud software that will enable them to unleash the power of their data, better serve customers, and operate more efficiently via increased resource utilization, greater workforce productivity, and new competitive advantages.4
The mission-critical nature of cloud computing is one of the driving reasons why chief information officers consistently list cloud migration and digital transformation as two of their top priorities when surveyed.5 It is also why we expect that IT budgets focused on digital transformation will be relatively resilient even in more difficult macroeconomic conditions. These are strategic decisions for most companies, meaning they are not investments most can afford to delay.
Most of the current cohort of cloud software businesses we track did not exist as public companies during the last U.S. recession from 2008 to 2009; but a few did, and they illustrate how these companies can do well despite a more difficult macroeconomic environment. One of these companies is now among the largest software-as-a-service (SaaS) customer relationship management vendors with more than $26 billion in sales for fiscal year 2022. The company was much smaller during the Great Financial Crisis with slightly more than $1 billion in sales for fiscal year 2009. Its revenue came primarily from small- and medium-sized businesses, and it concentrated on a single product: sales force automation. Because its customer base was sensitive to macroeconomic conditions, the company experienced elevated customer turnover and a slowdown in new business activity through 2008 and 2009. Revenue growth decelerated from 53 percent in the quarter ended April 30, 2008, to 21 percent in the quarter ended October 30, 2009, before accelerating to 31 percent the following October. While growth slowed on a year-over-year basis, revenue never declined sequentially and quickly re-accelerated as the macroeconomic environment improved. We believe the company’s ability to maintain strong levels of revenue growth despite significant turnover in its customer base helps illustrate the business value it continued to deliver.
Not every software business has or will experience this same result, but we think this is a useful illustration for the often mission-critical nature of software. In contrast to this business during the last recession, many of the software vendors we invest in today have a larger enterprise focus, are multi-product platforms, and are benefiting from even stronger secular trends toward cloud computing, SaaS deployment models, and digital transformation. Cloud software has proven to be a deflationary force often enabling millions of dollars in costs savings by replacing legacy technologies, or even worse, manual processes.6 This makes it easier for IT leaders to justify these investments in the short term even in more difficult business environments, while they work to prove their value over the longer term.
Finding the Needles in the Haystack
Given the scale of this trend, many companies are competing to be at the leading edge of this transformation. As we attempt to find businesses that fit with our criteria in this crowded field, we look for companies operating in attractive sub-segments of the market with strong technological competitive advantages and high rates of adoption. Some of these sub-trends include enterprise automation efforts; new approaches to cybersecurity; the rise of DevOps, which combines software development and IT operations; the proliferation of vertical operating systems; the modernization of employee and customer interactions; and the transformation of data and analytics efforts.
After initially screening for companies that fit within the attractive categories we have identified, we apply a general framework that builds on our six criteria for assessing the relative quality of software companies to determine whether we believe the business merits an investment. This framework leverages our collective years of investment experience in the sector, which has helped us gain pattern recognition skills to identify key traits that we believe give a software business a competitive advantage over the long term. Some of the areas we look at are opportunity size, competitive landscape, quality and scale of the ecosystem, ability to upsell the core product, and probability and materiality of a “second act.” We believe this overlay is critical to analyzing the sustainability of growth as well as to understanding the unit economics and corresponding long-term margin structure.
Snowflake, a cloud-based data analytics company, stands at the vanguard of the larger trends toward digital transformation and cloud computing while fitting squarely in the data/analytics subcategory we have identified. The company has become a favorite of business analysts and data scientists alike for its technologically differentiated approach to analyzing data in the cloud, which has revolutionized how business analytics is conducted.
This global cloud-native data platform raised the scale that analytics can operate on from terabytes to petabytes—a thousandfold increase—and reduced task execution times from days to minutes, meaning that businesses no longer need to wait overnight for key insights, like changing customer behavior.7 The company made it easy to get started on the platform and has seen rapid adoption over the past several years. JetBlue, for instance, leveraged Snowflake’s Data Cloud as a one-stop shop to build a better customer experience and promote competitive fares. Additionally, using Snowflake’s data sharing capabilities, JetBlue has been able to pool data with air traffic control and weather centers to create real-time fuel-prediction models for its fleet that have enabled it to generate meaningful improvements in cost efficiencies.8 Snowflake is one of several cloud data warehouse providers, but it has differentiated itself with easy-to-adopt technology that allows companies to scale their analytics capabilities up and down as necessary. The company has amassed more than 6,800 customers, including 510 of the 2022 Forbes Global 2000 (G2K) as of July 31, 2022, who use the platform to power numerous aspects of their businesses.9
Datadog, like Snowflake, is working to derive greater value from data through a unique platform that in Datadog’s words helps customers “turn chaos into insights.”10 The company’s core product offering allows businesses to monitor their essential infrastructure and application assets so that they are able to quickly identify and remediate issues when they arise.
Monitoring has become exponentially more difficult given the rise in the number of assets and applications that has accompanied the shift to cloud-native architectures.11 Applications have become a key differentiator for businesses, and they cannot risk losing customers because of a slow-loading checkout page or having employees unable to work because of critical systems failures.
Datadog allows companies of all sizes across numerous industries to ensure that issues like these don’t impact their business results. For instance, the London Stock Exchange Group (LSEG) has been able to use Datadog to monitor its website performance and make real-time adjustments to deal with changes in traffic volume.
In the past, a market-moving announcement might have caused the system to crash, but now with the insights provided by Datadog’s platforms, the LSEG can scale its website capacity in line with usage, creating a more seamless experience for its customers.12
Cloudflare is enabling the modernization of enterprise networking and security with the shift to the cloud. Cloudflare’s global network puts it in a credible position to offer a corporate “network as a service” to enterprise customers, securing and efficiently routing their traffic around the world. This network asset was built to accelerate and secure websites, but it can be extended to the management of enterprise traffic, constituting a powerful next act which positions Cloudflare to capture enterprise spending on networking equipment, elements of network security, and even elements of telecommunication spending. The company should also benefit from developers writing applications that run on its edge computing platform, Workers, where latency or data residency requirements preclude running workloads in a more centralized cloud environment. Cloudflare is also helping customers operate more efficiently and solve difficult problems.
It’s Not Always About the Profits
One of the benefits of being a concentrated investor with a long time horizon is our ability to dig deeply into businesses whose products and services are potentially misunderstood or underappreciated by the larger market and, as a result, get dumped with the broader market during selloffs. While investors have become increasingly skeptical of unprofitable businesses, we believe that if we only invested in companies with earnings, we could miss out on high-growth software and technology stocks that have the potential to add significant value to our portfolios over the next decade.
We believe it is better to be there than be getting there, meaning that we want to invest in businesses at the early stages of their growth and hold them for the long term. For instance, we expect Snowflake’s free cash flow (FCF) margins to be at 17 percent this year as the company closes its fiscal 2023. That’s up from -75 percent in its 2020 fiscal year.
But Snowflake remains unprofitable. As a result, its valuations have come under intense investor scrutiny. Despite having surpassed earnings projections for the past several quarters, its market capitalization, at $50 billion as of October 13, 2022, has fallen about 60 percent since November 17, 2021.13
Snowflake, like many other early-stage tech companies, including Datadog and Cloudflare, must make the choice to pursue profits or growth in the near term. Frank Slootman, Snowflake’s chief executive, explained his planned path to profitability in his book Rise of the Data Cloud: “You focus on growth first and foremost, then efficiency, cash flow and unit economics.” For many select technology companies, whose high gross margin profiles and strong underlying unit economics are suggestive of a highly efficient business, we believe profitability is a matter of when, not if.
The Path to Profitability
Despite the strong long-term potential for enterprise software to be transformative, the stocks in this sector remain under pressure. The average price of the 162 publicly traded software businesses that we track has fallen 57 percent from highs in late 2021.14 And, as referenced above, the declines have been even more extreme for companies that have yet to book profits on a generally accepted accounting principles (GAAP) basis because they have chosen to invest in sales and marketing and research and development efforts to drive a higher growth profile.
As long-term investors, we prefer to look at FCF margins over profits as defined by GAAP in this space. We believe there is a direct link between FCF and a company’s theoretical stock price. We also believe that FCF better reflects the actual economic value created by a software business (e.g., it captures benefits, such as strong working capital, that are not represented in GAAP numbers and better reflects in-period new business bookings versus revenue, which is recognized ratably on a lag over time).
On an FCF basis, the average margin of the software holdings in Select Growth and Global Growth is forecast to be 17 percent in 2022. Many companies included in that average, such as Atlassian, ServiceNow, and Datadog, are expected to generate margins that are well in excess of 20 percent, while others, such as Cloudflare and Okta, are expected to come in below five percent FCF margins for the year with these companies operating around breakeven.15
Ultimately, we believe all these businesses will reach 25 percent or greater FCF margins over time, including those that will have below five percent margins this year. As these companies scale FCF margins, we expect their GAAP profitability to improve as well.
Another important consideration in modern software businesses is their use of subscription business models that typically have very high renewal rates. That means that once a customer signs up, they often stick around for a long time and can be upsold at a much lower cost on additional products. This trend, which companies measure by looking at their dollar-based net retention rate, makes it easier to justify a high upfront cost of acquiring an incremental customer. Ideally, the unit economics of acquiring customers tend to look better after each year especially if they are regularly adding new products and services.
The Upside to the Downside
For instance, Okta, which provides cloud-based identity and access management software that allows enterprises to secure digital interactions, is currently operating with a FCF margin that is less than five percent. At its most recent investor day, it showed how its unit economics improved over time for new customers first added in 2018. In year one, its contribution margins (revenue less cost of sales and sales/marketing expenses) on this group of customers were -56 percent as the significant upfront expense to acquire a customer over what’s often a six-month-plus sales cycle was mismatched with revenue recognition. Contribution margins increased dramatically after the first year, reaching 54 percent in year two, 65 percent in year three, and 72 percent in year four.
This happens because the sales and marketing expenses required to acquire customers are front loaded, and in line with the company’s ability to upsell those customers on additional services at a much lower cost than that of originally acquiring them. We constructed the illustration below to show how lucrative this could be. We used Okta’s 2018 customer contribution margins over time, assuming they’re reflective of enterprise software broadly, and we assumed a net retention rate of 120 percent, meaning that a customer increases its spending 20 percent per year after being acquired. This rate is slightly below what Okta reports.
We compare scenarios in which Okta acquires $100 of new revenue in scenario one and $150 of revenue in scenario two. With the disclosed contribution margins, it costs an additional -$28 in contribution profit to acquire the higher amounts of revenue in one year under the second scenario. With this model, initially Okta’s profits look worse with the larger/faster-growing top line in scenario two.
However, as we roll forward these scenarios with Okta’s net retention rate and contribution margins, this short-term pain clearly drives significantly higher long-term profits. In this case, the cumulative profits in scenario two are $385 more than in scenario one, nearly 14 times the incremental $28 in selling expense from the first year. This simple example shows why many software businesses feel comfortable operating at breakeven, or even losing money, for extended periods of time given the strength of the underlying customer-level unit economics. Furthermore, these companies are often going after large markets where a winner-takes-most market structure tends to disproportionately reward the market share leader.
Creating the Future Takes Time
At Sands Capital, we seek out the visionaries. Creating the future takes time. Imagining cutting-edge technologies and creating new markets is not a highly lucrative phase for any business. However, for businesses capable of getting this right, large flywheels can be created, unlocking the ultimate profits that investors want to see and that we believe will help us generate wealth for our clients.
As we head into the final quarter of 2022, many investors remain unnerved by the macroeconomic backdrop and the volatility created by geopolitical tensions. Indeed, exogenous factors and sentiment can have an outsized and often unpredictable influence on stock price movements. At Sands Capital, we prefer to look past these phases of market panic and focus on the long term. We are business owners, not stock traders, and invest as such, evaluating a businesses’ potential long-term growth trajectory. Nothing that we have seen over the past year or the past quarter has changed our view of secular trends, like the shift to cloud computing, that will ultimately help define the companies of the future.
Across portfolios, these companies represent what we believe are among the select businesses that will sustain above-average growth by harnessing innovation and benefiting from secular change. These are the businesses that we expect to weather periods of economic decline, geopolitical tension, and global pandemic, as they work to create the future.
1 FactSet, Visible Alpha, and Sands Capital as of October 6, 2022.
2 J.P. Morgan Investor Day, John Deere: Planting the Digital Seeds of Change, and U.S. Department of State, “Digital Government Strategy”.
3 Gartner, Piper Sandler, FactSet, and Sands Capital.
4 Morgan Stanley 2Q22 CIO Survey.
5 Morgan Stanley 2Q22 CIO Survey.
6 FactSet and Sands Capital, Forrester Total Economic Impact Reports for ServiceNow, Datadog, and Atlassian.
7 Slootman, Frank, Rise of the Data Cloud, p. 3.
10 Datadog S-1 Filing.
11 Datadog 2021 Investor Day.
14 FactSet and Sands Capital.
15 Sands Capital.
The specific securities identified and described do not represent all the securities purchased, sold, or recommended for advisory clients. There is no assurance that any securities discussed will remain in the portfolio or that securities sold have not been repurchased. You should not assume that any investment is or will be profitable. A full list of public portfolio holdings, including their purchase dates, is available here.
Unless otherwise noted, the companies identified represent a subset of current holdings in Sands Capital portfolios and were selected on an objective basis to illustrate examples of the range of companies involved in creating cloud-based software solutions for enterprises. They were selected to reflect holdings with varied business models. This article is part of a larger series on digitalization and features businesses and related companies that were selected to illustrate current underlying macroeconomic and sectoral trends. The series uses rotation whereby businesses featured are selected to highlight different trends across sectors and geographies.
As of September 30, 2022, Atlassian was held in Select Growth, Global Growth, Technology Innovators, and International Leaders. Cloudflare was held in Select Growth, Global Growth, Global Leaders, and Technology Innovators. Datadog was held in Select Growth and Technology Innovators. ServiceNow is held in Select Growth, Global Leaders, Technology Innovators, and Select Leaders. Shopify is held in Select Growth, Global Growth, Global Leaders, and Technology Innovators, International Growth, International Leaders, and Select Leaders. Snowflake is held in Select Growth, Global Growth, and Technology Innovators.
JPMorgan Chase, John Deere, JetBlue, and London Stock Exchange Group are not held in any Sands Capital portfolios and were referenced for illustrative purposes only.
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