Microsoft's Current Trading Multiples Should be Illegal
Microsoft's Current Trading Multiples Should be Illegal
It's Time to Talk About Software Again
Hi Everyone 👋,
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It was a big week!
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What do you look for when you start your investment process?
Do you like companies with:
Sticky, recurring revenue
High EBITDA margins
Strong free cash flow conversion
Large and expanding market sizes
Bulletproof balance sheets
I know I know… sounds too good to be true. And even if it was, it would probably be expensive to buy these…
WRONG!
We’re undergoing a seismic shift all across growth technology right now, as high-quality software companies are getting thrown in with speculative SPACs, overpriced IPOs, and one-trick ponies.
Are we at the bottom yet after this massive sell-off? Probably not yet, but there is going to be an opportunity over the coming months that will be one of those once-in-a-decade types of trades.
RIGHT NOW, Microsoft is trading at a lower P/E multiple than Costco. Let that sink in for a while. Sure it’s fun to roam the isles and see how many free samples you can stock up on at Costco before going to try to squeeze into a pair of Kirkland jeans…but common.
Oh… and MSFT just put in a bid to buy Activision for $70B last week…
This week, in <5 minutes, we’ll cover the risk/reward opportunity right now in the software space:
Macro Environment Recap 👉 Rates, Contractionary Monetary Policy, Inflation
Digital Transformation 👉 Everything Shifting Online
Software Characteristics 👉 Key Attributes and Metrics
Multiples 👉 Dissecting Components of the Contraction
How GRIT’s Playing it 👉 Where to Start, When to Pounce
Let’s get started!
1. Macro Environment Recap 👉 Contractionary Monetary Policy, Inflation
The Fed has expanded its balance sheet at a rapid rate, beginning with the 2008 financial crisis and extending into the Corona crisis recovery. Right when they began the first phase of QT in 2017, it only lasted 2 years, until 2019 when the virus hit and more money needed to be injected back in the system.
Additionally, just M2 has increased an unprecedented +42% over the last 2 years.
If we look at the US 10yr in the post 1980s, it seems we never get back to a high water mark after expansionary and contractionary cycles:
When there is so much money in the system, it needs somewhere to go. less and less money gets directed to fixed income assets because there is no yield to be found. Instead, there is a better risk/reward profile in equities, so more capital overall gets directed there.
Last week, we covered in-depth how contractionary monetary policy leading to rising rates negatively impacts technology stocks. Since some of these companies focus on achieving growth at an early stage, they burn cash upfront in exchange for revenue growth. The narrative expands to say that these assets are disproportionately punished by a rising rate environment because of the long tail duration of these assets.
However, I think this narrative is being openly violated within the megacap and large cap software space. If we look at a company like Adobe, they drop about 47% of their revenue straight down to free cash flow. What this essentially does is shorten the duration of this asset, which should theoretically insulate it from rising interest rates.
What we are instead seeing is everything grouped together as software is getting thrown down the drain with the more speculative names like Virgin Galactic, that has no revenue and launches people into space, but might have revenue, but who knows…
During such a rapid sell-off within technology names, its important to sharpen your pencils back on fundamentals and focus on the underlying businesses so that you are ready to pounce on opportunities when the tide changes.
Under the Radar
TRACK RECORD OF EXCELLENCE. Greenbriar Capital is a leading developer of entry-level housing, renewable energy, green technology, and sustainable investment projects. Since 2013, the team has built and financed +$180B of renewable energy projects, including 50,000 MW of solar! Their current projects, including a housing development in California and a solar farm in Alberta, are even more exciting*!
SAFETY FIRST. BIGG Digital is on a mission to bring security & accountability to cryptocurrency with its trusted data-analysis and risk-scoring capabilities for blockchain/Bitcoin and other cryptocurrencies. How does it do this? Netcoins is the safest & fastest way to trade crypto, and Blockchain Intelligence Group is setting the standard in crypto forensics*!
LEADING FOOD INNOVATION. MeliBio, a CULT Food Science portfolio company, just received the JUST Food Magazine Excellence Award in the Innovation category! Previously, it was featured in TIME’s 2021 edition of “Top 100 Inventions of The Year”. And they’re not done yet: the bee-free honey-producing trailblazer is expanding production and hiring top scientists to develop delicious new flavors*!
TRANSFORMING HEALTHCARE. CloudMD’s has built a full, healthcare ecosystem that addresses all points to an individual’s care, and they’re targeting employer healthcare. The connected platform already has over 560,000 individuals onboarded, and has some major Corporations like Sun Life using it to manage the health and wellness of their employees. CloudMD is revolutionizing the delivery of healthcare and most recently acquired MindBeacon, a leading iCBT mental health provider. Their platform delivers proven, improved health outcomes including: 70% symptom improvement in depression and 98% satisfaction rate*!
INCUBATING TECH GIANTS. Sears, then Amazon. Blockbuster, then Netflix. BlackBerry, then Apple. It’s the circle of life (read: capitalism). That circle now spins tighter than ever which means the next big tech giants are already being built, and the best-in-class are doing it at Victory Square, where investors get ground floor access and have given away 3 dividends with plans to give away more*!
WORLD’S LARGEST PLANT-BASED ONLINE MARKETPLACE: During the pandemic, online grocery sales grew 54.0% in 2020 to reach $95.82 billion. Vejii is a digital powerhouse that’s built for rapid scale! Their infrastructure of data, tech, marketing, and logistics is giving ethically-aligned buyers access to the world’s largest selection of plant-based and sustainable-living products online*!
*This is sponsored advertising content.
2. Digital Transformation 👉 Everything Shifting Online
We all know that nearly everything shifted online as we stacked up back-to-back zoom meetings and heard “can you hear me?” way too often. Communications software rightfully took off and was a very direct beneficiary of the pandemic.
At first, capital crowded around the idea of what is going to benefit the most right now, over the shorter term. Obvious winners were ones like tele-health and communications software, but there was also a fundamental shift in “how we work.”
Back in the 80s and 90s companies bought more “tech” through IBM servers and mainframes in order to build out their capabilities. In a multi-decade cycle, we shifted to the PC where it not only created a lot of IT and infrastructure jobs, it also fundamentally changed how the individual American worker actually “worked”, ushering in a technical skill era.
Now, everything is cloud-native meaning built first and foremost in an environment that is not on-premise. What this does is further expand an entire army of infrastructure-focused workers, but now you don’t have to work on one instance of one document and send it back it forth, where version control becomes a nightmare.
Through interoperability multiple people can work on a project in an asynchronous or synchronous manner, depending on the requirement. Software has also saved management teams millions and millions of dollars. If you start to think in your head, “Yeah but we’re already there, this is old news.” You’re wrong. The amount of paper processed invoices across all major businesses today is alarming.
Software has moved up the chain of command within organizations as well. The implementation and maintenance of this software is no longer just decided upon by the IT department of a company, the decision is now a C-suite decision. Especially in a tight labour market, software replaces headcount that is getting more and more expensive.
The one takeaway I have to give over all this macro noise that is going on right now is this….
Software is in a secular pattern, not a cyclical one.
Sure the stocks can have cyclical behaviours due to the underlying macro conditions. But this is a flow of capital analysis situation, not a fundamental one. The fundamentals couldn’t be stronger and I believe we will see this over the coming earnings period.
But first, let’s check in with our Outrageous Chartered FinMEME Analyst Dr. Patel!
3. Software Characteristics 👉 Key Attributes and Metrics
When you look at the fundamental characteristics of Software companies, they have the following characteristics.
1. Recurring Revenue - Most software companies have subscription revenue that recurs on an annual basis. They charge per seat per year. A key metric to look for within this is Net Revenue Retention (NRR). NRR is equal to the revenue generated from a particular cohort of customers in year 2 divided by the revenue from the same Cohort in year 1. This accounts for the ability to upsell and cross sell as well as revenue churn from existing customers. As an example, the best in the biz is snowflake with a NRR of 173% in their most recent quarter.
2. Scalability - The Software playbook is to build something once and sell it an infinite amount of times. This is fuelled by a deployment that is digital and instantaneous. Once certain back end “connectors (APIs)” the ability to scale within the organization is magnified while providing a moat through an implementation phase.
3. High Gross Margin. Since the marginal cost to deploy one more unit of software is near zero, the gross margin of this recurring revenue is very high. Typically, the #1 COGS item is hosting costs. But if you think about hosting costs - every single enterprise and consumer facing software has to pay this. The COGS for these companies are the revenue opportunities for cloud and server hosting businesses like AWS, GCP, and Azure. Focus specifically on tools within this space, and you get companies like MongoDB, Snowflake, and DataDog.
4. Bullet Proof Balance Sheets. Since megacap software prints so much free cash flow, you are commonly hard pressed to find any debt on the balance sheet of these companies. Quite the contrary you find very strong cash positions which afford companies to pursue M&A activities and to buy back shares - both extremely accretive to shareholders. On the back of the recent Activision acquisition, lets take Microsoft as an example:
5. Ability to Leverage Operating Margin. This is the key to the puzzle. A lot of folks down in SV will talk about a couple terms. The first concept is that the product initially has to solve a critical pain point for its customers, and do so persistently (product market fit). The second concept is that after the product is built and sales are really starting to accelerate, the increase in revenue line far outstrips the cost of selling the product (exit velocity). Combining the two is a potent combination to converting a business from burning cash to printing it.
Take in combination these five attributes of software, and it’s no wonder why software has been “eating the world” and also beating the market. But as we’ve discussed, even stocks with solid fundamentals can get rocked by the other component baked into a stocks price… sentiment (multiples).
4. Multiples 👉 Dissecting Components of the Contraction
If you haven’t yet subscribed to Jamin Ball’s newsletter Clouded Judgment, you should do that now. Since the high growth asset selloff is dominating the headlines of nearly every financial news outlet, his analysis is spot on, and now more relevant than ever.
Ball goes through each individual basket within the tech space, and groups SaaS companies by growth buckets. I found this chart particularly compelling:
Look at the rapid contraction in the high growth median (blue line) between Jan 21, the bull trap bounce, then right back close to that 20x level. From the looks of this chart, it looks like we still have compression to go in the high growth, more expensive names, but we are pretty close to 2018/2019 levels in the mid growth names.
Wrapping Up…
I believe that the opportunity in growth equities will occur in two phases: 1) Investing in free-cash-flow generative names that pull cash flows forward, shortening their duration. i.e. Microsoft now trades at a lower P/E multiple than Retail Chain Costco. 2) Once the rebound takes hold, invest in high growth companies that dominate their niche and are positioned in industries with rapid market expansion.
All my channel checks are pointing to a solid earnings period, and no one is cutting back on software spending as everything moved digital over the course of covid – this has not changed. At the end of the day, every company that does not consider itself a technology company has to either buy a product from one, become one, or get left behind. The strategy here should be to own high free cash flow generation and high growth.
Subscribe to the paid version of this newsletter in order to see the stocks that I’m buying and selling in order to capitalize on this opportunity.
There will be a once-in-a-decade entry point over the coming months
Stocks go up, stocks go down, thats how they work. Stick to the overall secular trends and cost average down when market corrections get overdone.
Until next time. Always Yours. Incessantly Chasing ROI,
-Genevieve Roch-Decter, CFA
P.S The long-term chart on bitcoin looks great. Higher highs, higher lows. Those who know, know…
What else we Grittin’ On?
THE STOCK ACT. A bill to ban Congress members from trading stocks is gaining momentum. Devastating news for Nancy Pelosi.
COMP UP, PROFITS DOWN. Goldman Sachs shelled out an additional $4.4B in compensation in 2021, sending it to its only quarterly profit decline of the year. Goldman compensation expenses increased 33% last year!
NOT SO DUMB ANYMORE. Professional fund managers are paying close attention to "dumb money" which has made life hell for some short-sellers. Nobody wants to be on the wrong side of WallStreetBets again.
LIQUID GOLD. Oil prices hit a 7-year high this week amid low spare capacity of OPEC and allies. Some analysts are forecasting crude could trade at more than $100/barrel this year.
RETAILERS CRASH THE METAVERSE. Walmart is among the latest retailers to announce plans to venture into the metaverse in search of young shoppers. They're even creating their own cryptocurrency.
Sources:
https://www.federalreserve.gov/monetarypolicy/bst_recenttrends.htm
Clouded Judgement 1.14.22
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