Your Grandmother + Snoop Dogg =

Boring software companies that will make you rich!

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There are THREE certainties in life:

  1. Taxes

  2. Death

  3. Successful companies PAYING software bills.

Ok, well with a creative accountant you can probably avoid number 1.

With the advancement of modern medicine or Elon Musk coming up with a way to download your consciousness into the cloud, you might be able to avoid number 2.

But you’ll never get around number 3.

“Software contracts are better than first-lien debt. You do not realize that a company will miss the interest payment on their first lien, until after they pay their software maintenance or subscription fee. We get paid our money first. Who has the better credit? He can’t run his business without our software.” - Robert Smith, CEO of Vista Equity Partners

In the current-day version of Maslow’s hierarchy of needs, WiFi now forms the base for individuals. But, for companies, it’s SOFTWARE!

Software makes everything easier.

Need to balance the books at your small business? Fire up Intuit’s Quickbooks.

Need to make that Facebook ad pop? Use Adobe’s Photoshop.

Need to keep your “Always Be Closing” salesperson organized? Salesforce’s got you.

COVID accelerated all aspects of digital transformation, as companies scrambled to ADAPT or DIE.

Lives shifted online almost over night and software powered the move.

Last week, I covered how you want your grandma’s companies in the safe portion of your portfolio.

Today we’re going to talk about companies that resemble your grandma becoming BFFs with Snoop Dogg. She just got a little swagger in her step!

You can tuck these names into your portfolio, set it and forget it as you make them part of the “80%” that I talked about last week in the 80/20 portfolio.

This week, let’s look at Sizzling’ Software in <5 mins:

  1. Why Now?  👉 Stocks pulling back from recent high

  2. Traits 👉 Recurring Revenue, High Margins, Free Cash Flow & Bullet Proof Balance Sheets

  3. The 4 Horsemen 👉 Microsoft, Adobe, ServiceNow, and Salesforce

  4. How Grit’s Playing it 👉 Which one am I buying?

1.   Why Now?  👉 Stocks pulling back from recent high

Buy Low, Sell High ; )

A timeless truth of investing.

The hyper growth cloud names in software have pulled back significantly.

Below shows an ETF of cloud companies down around 11.5% from the high.

A lot of this was due to the re-opening of the economy and interest rate pressure.

BUT the fundamentals of these companies remains strong, we are heading into earnings season and the world is only going to get MORE digital not less.

With a catalyst-rich set up, this looks like a time to…

BTFD = Buy The F****** Dip !

2. Characteristics 👉 Recurring Revenue, High Margins, Free Cash Flow & Bullet Proof Balance Sheets

Matured software companies share Warren Buffett-like characteristics but with a sprinkle of growth on top. So you get a strong STEAK with some SIZZLE!

Characteristics:

A) High Recurring Revenue

B) High Gross Margins

C) Strong Free Cash Flow

D) Bullet Proof Balance Sheets

Let’s break them down…

A) High Recurring Revenue

Software companies typically sell on a “per seat” basis. That is, the customer pays for a subscription service for $X/month(or year) for each license that is used.

This subscription service becomes so ingrained into the workflow of each person in the company. Making them work faster and smarter and dramatically increasing their ROI as employees. So naturally companies love it!

Unless a competitive software is 10x better or 10x cheaper — it won’t be ripped out or replaced. It’s extremely sticky!

This is what Warren Buffett calls a castle with an economic moat.

No one can enter the castle — not even if a beautiful princess throws her long, magical, golden hair out the window — because the cold, shark infested water surrounding it will kill you — just like Alcatraz prison.

B) High Gross Margins

Matured software companies have excellent control over their COGS (Cost of goods sold) due to the ease and scalability of production and distribution – all done over the cloud. Typically, they enjoy margins north of +75-80%. The largest cost on this line item is typically server costs (think Amazon’s AWS).

Just to put that margin in perspective Tesla’s is ~20% and Starbucks is ~14%.

Needless to say +75% is next-level sizzling HOT!

C) Strong Free Cash Flow

Software companies always begin in a hyper growth phase, investing a lot of money into product development (Research & Development/R&D) and user acquisition (Sales & Marketing/ S&M).

Successful companies need both, but typically the best ones start as product-focused, then move into a sales push.

Once “exit velocity” is achieved, revenue growth on an absolute basis FAR outpaces expense growth, which drops the high gross margin revenue right down to the bottom line, becoming FREE CASH FLOW generating.

And you know how I feel about free cash flow, it is the holy grail of investing.

No longer dependent on outside capital (ie. raising equity or taking on debt) to keep growing, a company becomes UNSTOPPABLE!

D) Bullet-Proof Balance Sheets

If you look at the cash balances of the big dogs, it’s some of the best in the league. If you count only the four stocks I am about to talk about, they have +$26B in cash sitting on the sidelines. If you leveraged that 20-to-1 you could buy JP Morgan, the biggest bank in the U.S.

Or you could have read my newsletter a few weeks back and converted the cash to Bitcoin, and have a lot more now…

They also carry little to no debt and only issue debt when its extremely cheap, making them some of the best capital allocators in the biz.

This leaves a massive war chest for acquisitions. They can opportunistically buy any up-and-comers that are synergistic to existing businesses lines, or to refuel growth.

Now that we have reviewed the FOUR characteristics Buffett loves, let’s check in with our Outrageous Chartered FinMEME Analyst Dr. Patel and see what he thinks of Software Stocks?

A DOCTOR’S DIAGNOSIS

This is all great Dr. Patel and Genevieve BUT how do I make money from these insights?

Let’s breakdown the 4 Horsemen of BIG Software!

4. The 4 Horsemen 👉 Microsoft, Adobe, ServiceNow, and Salesforce

Let me start with the stock I actually own: Microsoft.

A) Microsoft (Ticker: MSFT) AKA Your Work Husband/Wife ;)

Secret Sauce: The original gangsters of software and operating systems enjoyed a near monopoly in their early days of revolutionizing computing. Their early dominance with MS-DOS in the mid 1980s (and later Windows) revolutionized IT business models.

They literally sell the ‘guts and glory’ that make computers run.

They had a bit of a lull about 10 years ago where growth slowed and competitors entered, but Satya — only the 3rd person to hold the CEO job in Microsoft’s +45-year history — has since heavily shifted towards software subscription revenue and cloud, restoring the company to its former glory.

I would argue it is the most consistent and important growth story in the history of the stock market.

Hot Products You Might Recognize: WindowsOS, O365 (Excel, Powerpoint, Word, Outlook, OneNote), Explorer, Azure, LinkedIn, Skype, Teams, OneDrive, HoloLens, Minecraft, Xbox.

B) Adobe (Ticker:ADBE) AKA “I swear this is what I look like in real life!”

Secret Sauce: Adobe sells software that powers the creative industry. As much as photoshop seems like a magic trick at times, the real magic was the company’s transition from a license model to a Software-as-a-Service (SaaS) model. From ONE to MANY!

From 2010-2019, recurring revenue as a percentage of total revenue increased from less than 10% to +90%; leading to a much higher valuation. Over that same time period, Adobe’s trailing EV/S multiple has increased from 4.0x to 18.0x and its EV/EBITDA from 8.5x to 32.0x!!

This is the kind of multiple expansion move you want to get in front of!

Hot Products You Might Recognize: Adobe Creative Cloud (Photoshop, Lightroom, Spark, Premier Rush, Adobe XD, Illustrator, InDesign, Premiere Pro, Acrobat Pro), Marketo, Magento.

C) Salesforce (Ticker:CRM) AKA “Always Be Closing”

Secret Sauce: You don’t reach your customers, you don’t have a successful company. Enter Salesforce. Marc Benioff, Salesforce’s CEO, is a master class in how to build a software business. The list of CEOs that have worked under him and then went on to start their own companies is LONG, and the collective market cap of those companies is HUGE!

Salesforce is an incredible example of utilizing the ‘land and expand’ model of dominating a niche then moving into horizontal applications.

Hot Products You Might Recognize: Customer 360 (Sales, Service, Marketing, Commerce, Analytics, Integration, Learning, Employees, Industries, Platform, Einstein AI)

D) ServiceNow (Ticker:NOW) AKA Everyone’s Favourite IT Guy

Secret Sauce: ServiceNow’s purpose is to “make the world of work, work better for people” by optimizing workflow. They build applications that automate existing processes and create efficient, digitized workflows with a consumer grade user experience.

Picks and shovels type of stuff. They’re about as close as it gets to a Swiss Army Knife by providing all the types of tools that businesses need during digital transformation.

The stock is as consistent as Ketchup. They reliably grow revenue, generate 30% free cash flow which they reinvest into growth and M&A.

Hot Products You Might Recognize: IT Workflow, IT Service Management, IT Operations Management, Software Asset Management, Customer Service Management, HR Service Delivery, Governance, Risk & Compliance.

4. How Grit’s Playing it 👉 Which one am I buying?

As you can see in the chart below, I have a Bloomberg account (or borrowed one from a friend ; ).

As you can also see in the chart below, these software names have drastically outperformed the S&P over the past 5 years.

These 4 companies serve as a good “starter’s pack” for software investing. 

As I said above and in my previous newsletter, I own Microsoft. But given their recent pullback, it’s a good time to do a deep dive on the others to find another boring consistent performer.

After doing this dive, writing this newsletter and talking to a tech portfolio manager I highly respect I’ve decided to add ServiceNow as a new position in my Boring Portfolio. It’s got the smallest market cap of the four, they are dominating in their niche and growing their total addressable market at the same time. But MOST importantly the stock multiple is starting to expand nicely. So I think this one has the most Grandma x Snoop Dogg ‘FO SHIZZLE’ effect!

This week was all about the steak software companies but in coming weeks I want to explore higher growth, higher multiple “product killers” where you can find that next 20 bagger! Like in niche exciting areas like DevOps, Cloud, Security, and Ecomm.

Software companies are representations of the new economy but also new valuation frameworks. “Value investing” used to be buying companies at lower multiples and shorting companies at higher multiples based on earnings and book value.

But are these really as relevant any more? NO!

What we are seeing now is rapid investment into R&D which is creating a lot of INTANGIBLE ASSETS rather than HARD ASSETS. Because R&D is registered as an operating expense rather than depreciating an asset on the balance sheet, this skews the importance of certain line items on financial statements.

And that’s the money maker insight right there!

Boomers with pocket protectors are confused when they pull out their calculators. They don’t see the HUGE value being created. Because they are aren’t looking in the right place. Luckily WE are!

To build a moat, you no longer need hundreds of millions in CAPEX (unless you’re in semiconductors…). You need a strong product, with a stronger go to market strategy and software does this in a cost-effective high growth manner.

Like my favourite saying goes: “BUILD ONCE. SELL TWICE” - Jack Butcher

I see “value investing” as buying something for less than it’s worth, and this is alive and well in software right now!!

Until next time. Always Yours. Incessantly Chasing ROI,

-Genevieve Roch-Decter, CFA

P.S Bitcoin blows past $60k this weekend and Peter Thiel says it threatens the US dollar. This is why we can’t discount the possibility the FED is secretly stockpiling Bitcoin for themselves ; )


What else we Grittin’ On?

90% of the U.S EconomyRoars back to health with the ISM Non-Manufacturing — which represents the service economy — surges to record HIGH. The trend is our friend!

Baseball Cards. TOPPS going public via a SPAC. One of only a handful of profitable SPACS out there ; )

Vaccine. 1 in 5 Americans are fully vaccinated and 1/3 have received at least one dose of a Covid-19 vaccine. Biden is on a roll!

U.S Trading Volumes are drier than the Suez Canal….


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