How To Pick Cloud Software Stocks

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Includes: AMZN, CRM, MATR, PRO, SAP
by: Mark Gomes

Summary

Many investors missed the boat on cloud software winners like Salesforce.com and Netsuite. They are not to blame for "getting it wrong." This article will explain why.

The cloud software business model is not widely understood by retail investors. In contrast, institutional investors rightly focus on the long-term business value of a large and loyal customer base.

The true profitability of a recurring customer base often gets masked by investments in attracting more customers. This article expounds on this concept and how to profit from it.

This article is written for anyone who wishes to profitably invest in cloud software stocks but haven't spent their careers in the software industry. I will discuss a key characteristic of these seemingly high-risk companies. If successful, my explanation will help you understand why these companies only appear overvalued.

I will do this by providing a case study on Concur Technologies, a cloud software that rose from obscurity and heavy losses to being acquired by one of the world's largest software companies.

Let's jump right in...

Company: Concur Technologies
Founded: in 1993 by CEO Steven Singh

Background: Concur was founded a year before I became a software stock analyst for International Data Corporation. Concur offered expense management software. They automated expense reports so you could submit them electronically instead of filling out paper forms. Very boring stuff.

After a period of rapid revenue growth (and an even more rapid expansion of net losses), the company flat-lined at just under $40M in revenue.

$40M sounds pretty good, right? But here's the catch - until 2001, net losses exceeded revenue every year.

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To do that, you have to spend more than $2 for every $1 you bring in. This will come as no surprise, but many thought this was crazy. Some even felt that CEO Steven Singh should be replaced.

Would you buy stock in this company?

If you truly understand how software companies work, you wouldn't dismiss the idea.

Software companies gain value as they build ever-bigger bases of customers. These customers buy more software (or maintenance on their existing software) year after year.

That "recurring" revenue doesn't require the same sales/marketing effort as it took to attract the initial business. As a result, recurring software revenue is very profitable.

This is what makes cloud software companies so valuable. If you missed out on Salesforce.com (NYSE:CRM) years ago, this is likely one of the reasons why.

Understanding this concept may help you catch the next one.

At a certain point, the customer base starts generating enough profit to offset the company's investments in sales/marketing (which are geared toward acquiring more new customers). At that point, each dollar of new revenue can drive upwards of $0.50 to the bottom line.

In other words, the company can become wildly profitable.

These are called "incremental margins" (the profit on each additional dollar of revenue a company brings in). Incremental margins are more important than actual margins because they provide insight into the company's potential for future profits. All you need is a spreadsheet to model it out.

This is what drives a company's stock value, not what it has done in the past.

The reason this works for software is simple. Once built, software costs almost nothing to replicate. Once you've covered the initial cost to develop it, most of the incoming revenue is pure profit.

As an investor, if you buy the stock just before things take off, you get a bonus. There are many reasons for this:

1. Often, impatient investors have given up on the stock. Its price doesn't reflect its opportunity. In short, the risk/reward is attractive.

2. Investors who buy the stock just before profitability (but after substantial losses have been generated) are often getting a free asset known as "Net Operating Loss Carryforwards" (a.k.a. NOLs).

NOLs are tax assets. Basically, if you take a $100 loss in one year, the government won't tax you for $100 of profit in a future year.

This encourages companies to take risks to build a big business. This is what Amazon (AMZN), Salesforce.com and countless other companies have done. Often, investors mistakenly believe that these companies are overvalued low-margin businesses. In reality, the exact opposite is being built (an undervalued, high-margin business).

Here's the trick - even though NOLs are tax assets, companies write them off of the balance sheet because there's no guarantee that they will ever be able to use them. Thus, they become hidden assets.

So, if/when the company turns profitable, the income flows to the net income line without being taxed. FYI, even though NOLs usually get written off (hidden), management still discloses their "value" in 10-K filings with the SEC.

Getting back to our case study, let's see what happened to Concur in 2002-2006, even with crazy Steven Singh still at the helm...

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Incredible, right? This crummy company and its crazy CEO suddenly stopped pulling in $30M in revenue and started pulling in $30M of net income. The stock sold for as little as $0.3125 during the March quarter of 2001, giving it a market cap of just $8 million. Now, net income was $34 million and EPS was approaching $1 per share.

At this moment, you might be thinking, "Wow, now I understand why stocks like CRM and AMZN really weren't overvalued 10 years ago."

But here's where the story gets really crazy.

Instead of letting his company remain profitable, Mr. Singh decided to increase sales and marketing expenses even more to attract even more customers. Have a look:

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OK, so revenue went through the roof, but so what? Losses increased every year from 2012 until 2014 (when net losses topped $100 million, more than 3x the revenue they were generating at the beginning of this story).

Surely they went bankrupt, right?

Wrong. After 21 years of losses, CNQR was acquired by SAP (NYSE:SAP) (one of the world's smartest and most-pragmatic software companies) for $129 per share.

That represented an enterprise value of over $8 billion. Concur had risen from $8 million to $8 billion. Incidentally, the buyout price was equivalent to 12x Concur's annual sales. This was considered "rich" by many. I was among those folks, but must admit that SAP knows more about the fair value of a software enterprise than I.

Since then, many small software companies have followed Mr. Singh's lead. In fact, to speed up the process, they now bypass the period of profitability that Concur demonstrated in 2003-2006. Indeed, empirical studies from investment banks like (Roth Capital Partners) have shown that this maximizes long-term risk/reward for investors.

To be clear, it doesn't increase the odds of success. To the contrary, this strategy is riskier. However, while the risks increase moderately, the potential rewards increase exponentially.

Now, here's the best part - despite undertaking a strategy that improves the risk/reward, many of these stocks trade down to lower valuations.

For example, Pros Holdings (NYSE:PRO) embarked on a cloud strategy a couple of years ago. The transition killed its stock (it traded for less than 2x sales earlier this year). However, the strategy has started to take hold and the shares have doubled since February.

Another example is Mattersight (NASDAQ:MATR), which I have been covering here on Seeking Alpha. MATR is a little earlier in its process than PRO. Not surprisingly, it has also been bid down to less than 2x sales.

This doesn't guarantee that PRO and/or MATR will flourish. Indeed, historical perspective suggests that one will succeed and one will fail. However, I've discussed both of these companies with industry experts. The consensus is that their products are uniquely differentiated and that their market opportunities are sizable relative to their current penetration rate.

Investors just need to understand that not every story turns out like Concur. There are risks. However, those risks are one of the reasons why companies with the potential to be acquired for 12x revenue can trade for under 2x revenue. The other reason (investor misconception) is what makes these companies so profitable to invest in.

If you've learned anything from this article, you now know that most retail investors don't understand how software companies work (because most people are not business managers at cloud software companies). Since so few people understand how they work, the potential rewards far outweigh the risks that get baked into the stock prices.

Properly vetted (through industry experts), a basket of these companies only needs one big winner to make up for nine losers. This is how early-stage VC firms make money.

Before understanding the strategy that Steven Singh undertook, you might have believed that the company was imprudently run and headed for bankruptcy. However, institutional software analysts know better (it's their job).

That being said, retail investors who grasp this concept have the greatest advantage, because institutions generally won't (or can't) invest in a company until its market cap tops $150 million (the approximate threshold for inclusion in the Russell 2000) and shows some earnings consistency.

As a result, many of these stocks get no love from anyone except those who understand the strategy and that things don't happen overnight and are willing to take the chance that maybe the CEO isn't so crazy after all.

Disclosure: I am/we are long PRO, MATR.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.

Additional disclosure: The information in this article is for informational and illustrative purposes only and should not be regarded as investment advice or as a recommendation regarding any particular security or course of action. The opinions expressed in Pipeline Data, LLC publications are the opinions of Mr. Gomes as of the date of publication, and are subject to change without notice and may not be updated. All investments carry the risk of loss and the investment strategies discussed by Mr. Gomes entail a high level of risk. Any person considering an investment should perform their own research and consult with an investment professional. Additional important disclosures can be found in the Important Disclosures section at PipelineDataLLC.com.