Are stable SaaS valuations driven by logic or hope?

Hello and welcome back to our regular morning look at private companies, public markets and the gray space in between.

The resilience of the American stock market in the face of near-record unemployment (there were nearly three million more unemployment claims reported this morning) has become a regular topic of conversation. The disconnect between what the American economy’s health appears to be (poor, falling) and the recent, rebounding performance of American equities has been covered broadly — CNBC, Fortune, the Washington Post, NYMag, the list is endless.

The answer concerning why the stock market is holding up in the face of a rapidly deteriorating economy isn’t singular. Reading around and listening, there are a number of reasons that have support from serious folks. If you hunt around even a little, you’ll run into arguments like, “well, where is everyone going to put their money when interest rates are low and the government is boosting the money supply?” or, “big tech companies are driving the major indices, and they’re holding up, so everything makes sense.”

Whichever line of thinking makes the most sense to you is fine. Most are subjective. The argument about technology companies holding up the sky, however, has some empirical truth to it. Tech companies are outperforming other cohorts, which in turn is bolstering the indices in which they reside.

How long the trend can persist is unclear. As Bloomberg’s Joe Weisenthal wrote this morning, the future of the economy can’t purely be what we consider tech because “every company that we’re talking about depends on non-tech companies to do business with.” Adding to that, others have noted that even tech giants have exposure to the slipping economy. In time, some technology companies may fall prey to the same economic gravity that is compressing so much else of the nation’s businesses.

The differing fortunes of stocks and the economy becomes even sharper if you zoom in to look at just public SaaS and cloud firms. This particular cohort of tech companies has seen an even more striking return to form than tech shares more broadly.

Late last week SaaS stocks set new record highs, meaning they appreciated off their lows so sharply that the market is valuing them more now than in the pre-COVID-19 era. This is a bit hard to parse, but the concepts of “where else to put money” and “tech is doing just fine” certainly apply. However, are those arguments enough to explain why SaaS and cloud companies are now being valued as if there were no economic issues at all?

By this point I am sure you are bored with my take on Software as a Service and stocks, so let’s hear from some other folks. After the Bessemer cloud index hit a new, record high last week I pinged a few folks, asking what they thought about the matter.

So, what follows are notes from Bessemer’s SaaS and data expert Mary D’Onofrio, Redpoint’s Astasia Myers — who has done some interesting research on public SaaS valuations, and Anshu Sharma, a former venture capitalist who is now the co-founder and CEO of Skyflow, and has told me for a long time that I am too worried about SaaS valuations.

The SaaS index has given back a bit of ground since its record highs, but the trend has held up well enough to make our question worth answering. So, why are SaaS valuations holding up? Here are some thoughts.

Software valuations

We’ll start with D’Onofrio. When I asked why SaaS stocks are reaching new valuations when the economy is slowing, here’s what the late-stage investor had to say:

I think that cloud software companies are safe havens for investment dollars because of their revenue predictability and balance sheet health, which underpin their valuations in the current environment.

She then broke down her answer, providing more detail. Here’s the Bessemer VC on why predictability matters (bolding: TechCrunch):

During a period of economic uncertainty, investors prioritize the predictability that cloud business models deliver. With recurring revenues of 90%+ and strong renewal and net retentions rates (often 80%+ and 120%+, respectively), cloud companies have predictable existing businesses, and reduction in demand will mainly affect only new business. Also, with annual and multi-year contracts commonplace, in a subscription cloud business weakening demand spreads over many quarters – contracts (many of which are paid upfront) accrue to the balance sheet as deferred revenue then hit the income statement ratably over time, making prior year billings a major determinant of current revenue and reducing the impact of current demand softness while providing investors tremendous visibility into future earnings and cash flow. This means that 2019’s bull market is still flowing through to [the Bessemer cloud index] revenue attainment.

You see predictability in the recent earnings results from cloud businesses – of the [the Bessemer cloud index] companies that have reported on the most recent quarter, the average beat to revenue has been +4%, and run rate revenue growth continues to exceed +35%. While many cloud companies have withdrawn guidance for 2020, Morgan Stanley data suggests that consensus 2020 revenue for these companies is down only -1%. The market anticipates that 30%+ growth will continue in cloud, also bolstered by digital transformation tailwinds from this disruption, and it has more visibility into that growth than it does in many other sectors, many of which do not have estimated timelines for recovery.

This argument stands up incredibly well if those contracts don’t break, churn doesn’t rise and cloud companies are effectively held up by long-term contracts that allow them to bounce over a multi-quarter downturn. I’m perhaps a little more pessimistic than D’Onofrio about contract durability, but we’ll be able to see this in the Q2 numbers we’ll get in a little under three months. (She has better insight into churn at the moment than I do, of course, given her visibility into present-day startup SaaS results.)

The second point of her argument concerns balance sheet health, or what normals might call “being super-rich.” Let’s read:

Cloud companies tend to have strong balance sheets, with positive net cash positions and low leverage, positioning them well to withstand and outlast a downturn and thereby making them appealing assets. The average [the Bessemer cloud index] company has over $275M of net cash and is also free cash flow positive (+6% FCF margin), helped along by a high average gross margin of 72%. That cash flow is also re-investable into the business to sustain operations and to grow.

Investors agree that today’s market is uncertain. Cloud asset demand and increased valuations are a reflection of today’s heightened imperative to invest in businesses that will predictably grow and perpetuate through that uncertainty.

It’s hard to argue with any of this; even if churn rises and growth slows, net-negative revenue growth from SaaS and cloud companies can be covered by extant cash positions. So the firms are safe, in the sense of staying ongoing concerns. But, cash can’t be the reason why SaaS and cloud companies are currently trading at historically high valuation multiples; that has to come from growth expectations, or at a minimum a view that the sector has better growth prospects than others.

Let’s now turn to Redpoint’s Myers, who provided TechCrunch with her own take on the question:

Investors are buying SaaS/cloud stocks for a few reasons: 1) other asset classes have been more affected by COVID so investors in part don’t have anywhere else to go, 2) many of these SaaS businesses don’t sell to SMB so are less affected by COVID and have rebounded faster, and 3) a lot of the high-growth SaaS names still have great fundamentals. Datadog recently reported a great quarter: $500M ARR growing ~90%.

The investor’s first point is something we’ve discussed, so we can leave it. We need to unpack her second and third points, however.

The argument regarding SaaS companies not having SMB exposure is useful; historically SMB-focused SaaS companies have endured elevated churn rates compared to SaaS averages and lower overall net revenue retention. While there are some SaaS companies that sell to SMBs that are seeing demand surge, it’s fair to presume that small business-focused software companies as a whole are not doing as well during the pandemic as enterprise-focused software companies. Enterprise-focused SaaS has historically better churn and net retention rates than SaaS averages, and, as larger companies have more cash than smaller companies, they are perhaps better customers in a downturn as well.

Myers’ argument, then, that some SaaS companies don’t sell to SMBs makes the case that a large portion of SaaS will be sheltered from the pandemic-driven downturn. This seems reasonable.

Finally, her third point is one arguing that recent results indicate that things are going well. This may be true, but I don’t think it’s proven. Not yet, in other words. Lots of companies have pulled guidance (as D’Onofrio noted and TechCrunch has covered), meaning that it’s hard to know what will be reported when Q2 and Q3 are completed and turned in. Datadog did have a great Q1. A number of SaaS companies did. However, I’d be a little hesitant to read those results as indicative of future performance. (Again, the investor has a better view into present-day results at SaaS startups than TechCrunch does, so please read our occasional credulity with your own.)

As always, I fret that I am being too negative.

Speaking of which, let’s bring in Anshu Sharma, a former Salesforce VP and venture partner with Storm Ventures. He’s since founded a company called Skyflow that is building privacy-focused APIs. API-based businesses are hot these days, as we’ve recently seen.

Sharma is also a cloud bull, which given his operating and investing background in SaaS makes him a great person to talk to about our topic. Before sending over an extensive set of notes, Sharma summarized his views as follows: “In exponential curves, linear blips are invisible.”

By this Sharma means that if you zoom out from a trend that is exploding, you won’t really notice small wiggles in the line where it may have had slowed down or sped up for a short period of time. He later expanded the point, saying in an email that “When you are dealing with secular, long-term exponential growth that spans decades, a year or two of setback simply does not matter.”

Here’s a bit more from Sharma that is worth reading, tailoring his general view into more specific SaaS examples:

If you are investing in SaaS or cloud because you actually think Zoom will eat up a large part of travel needs over next 20 years, Slack will eat up a large part of email, Okta will eat up passwords, and so on, then you are going to view every ’01 and ’08-like crash as a buying opportunity.

People with deep conviction in long-term shifts buy.

The “real economy” in some ways has no impact on digital when you are going from 0.1% to 10% (a 100x shift).

I wonder if public investors are thinking with that level of depth and long-term patience; given that tech folks sometimes complain that public market investors are too impatient, the idea that SaaS and cloud stocks are bouncing back because of long-term optimism makes me pause a little. Still, we are in the midst of software taking on more and more of the market, and SaaS now is the software market, so maybe your local mutual fund manager has learned something.

I’d say that a return to form for SaaS and cloud stocks seems rational, given the above. I’m not sure that new, record highs feel right given that growth should slow at these firms for a while. Let’s see what happens.