Conclusions before substance:
Sort of like getting dessert without eating your peas or broccoli or… With the earnings season about half way done, it is becoming apparent that there is a significant divide in performance between "Old Tech" and "New Tech." There isn't either space or investment merit in exploring the thesis thoroughly so I am going to stick to the software space. I will pick just a couple of names that might illustrate the point. On the "old" team, I am going to select SAP (NYSE:SAP) and Oracle (NYSE:ORCL), two bastions of the software industry for the last 25 years. On the "new" team, my selections not too surprisingly are going to be Salesforce (NYSE:CRM) and Workday (NYSE:WDAY), the upstart challengers in the applications space. There is also a transition team in which I will include PTC (NASDAQ:PTC) and Autodesk (NASDAQ:ADSK). Not all companies fit neatly into a pigeonhole of old, new, or transition. Names like Box (NYSE:BOX) and Rubicon (NYSE:RUBI) are a bit harder to define although they are obviously on the new side of the equation. The outsourcing companies also are not easily defined as old or new.
Why write about this now? I think that almost everyone in the software business is trying to claim that they are part of the cloud revolution. If there is a company that doesn't use "cloud" in their press releases and earnings statement, I haven't seen it. But not all clouds are created equal and not all companies really offer cloud. There is much discussion of the merits of "private" cloud, "public" cloud and "hybrid" models. I am not going to try to settle that fight here. Needless to say, most legacy software vendors push hybrid models but in time more and more workloads are going to the public cloud. Another key consideration is the impact that the cloud migration is having and will have to the old companies. Migrations are often hard, painful and protracted and they do not always work as advertised.
When anyone thinks about buying or maintaining a tech portfolio for the purpose of share price appreciation as opposed to income and "stability," I think the first determining factor has to be how well target investments might fit into this new paradigm. Companies may screen well, companies may be generating lots of cash flow, companies may have years of steadily raising dividends. But there is a hurricane out there, or a tsunami better said, I think, and companies that do not adjust fast enough are in danger of being swept away when the tide rolls out.
One thing that needs to be understood by investors is that these days, tech is a zero-sum game. Gartner says that IT spending is rising at the "awesome" rate of -0.5% in constant currency. That's worldwide, of course. That is better than the fall of 6% registered last year, but a decrease is still a decrease. Overall, going all the way out to 2020, Gartner is forecasting no more than 2.8% annual growth in a single year. What that means is that if some companies are achieving double-digit growth, there have to be companies that are shrinking. The software business as a whole is a large business to be sure, at $1.5 trillion out of a total IT spending pie of just greater than $3.5 trillion. But it too has shrunk and is shrinking. Many investors look at dividends or free cash flow growth in attempting to value companies. But I think in an industry where the technology changes quite as rapidly as enterprise software, trying to invest in companies that are shrinking can be deadly to one's portfolio because the things that undergird valuation can be gone in a year or two and the investor is stuck owning a company suffering from declining revenues and most likely declining margins as well, given the high level of fixed costs in this business.
There is much excellent work on this site and in other publications regarding portfolio construction and suggesting that there isn't a single style of investing that is right for all seasons. There will be times when the old sector does better than the new sector, but such times are generally periods of economic contraction when tech should be avoided like the plague. But for now, with the economy in a moderate growth phase, I believe that new and particularly transition enterprise software vendors have the opportunity to far outpace old and to do so with a wide margin. I like PTC and ADSK. I love CRM and WDAY as companies although their valuation is scary to some and I am very cautious and dubious regarding the prospects for SAP and for ORCL.
Explain briefly what kind of creative destruction is going in the software space these days!
I think that most investors have heard about the cloud to such an extent that their ears are falling off. But it really is a once in a generation phenomenon. I think the key thing to understand is that any investment strategy in tech that doesn't pay attention to the cloud is doomed to failure. One of the things that I have been asked is why everyone is in such a hurry to move to the cloud. There really is one overarching factor and it is cost. The cloud is substantially less expensive for users. I think many investors are simply unaware of how much legacy applications actually cost. And I think that even more investors simply are unaware of how much the cloud is likely to save users.
If you are an Oracle or SAP customer with a full-fledged enterprise installation, your notional maintenance bill is 20%/year of the price of the software. But maintenance fees rise yearly and in some cases do so at rapid rates. But no one is going to simply rely on just vendor provided software maintenance. Many companies actually have contracted different elements of software maintenance to Indian outsourcing firms since inevitably, users have customized their installations over the year with code that was written by erstwhile employees and which is very difficult to maintain. But even more than that, companies with on-premise software typically maintain their own large staffs of IT professionals to do "projects" that involve tweaking or adding to purchased software. And then there are the costs of operating data centers. Those costs simply rise inexorably and involve customers in real estate operations and staffing that has nothing to do with generating revenue. SA editor, Robyn Conti recently wrote an article regarding the growth of Data Center REITs. The fact is that every user wants to get out of the business of operating data centers - it is a bad way for users to spend money especially when the alternative is to outsource much of the pain to other vendors.
I don't want to discuss accounting issues for SaaS companies as I doubt if I will ever persuade anyone. But I do want to talk about growth. If you ever want to understand why Salesforce is growing so fast and why the growth, at least last quarter, accelerated, the answer is pretty simple. CRM solutions just cost lest than anything on-prem and they afford users the chance to get rid of software maintenance, they afford users the opportunity to get out of the data center business and the real estate business and allow users to budget accurately and specifically what their IT operations are going to cost. And if they need extra capacity for some special reason, it is so much simpler to go to a SaaS vendor and rent a few more seats than trying to figure out if you need more database capacity, if your network is in shape to handle the peak load and if there are going to be installation or maintenance issues.
Last quarter, PTC reported that its bookings went from 14% in the cloud (subscription) to 54% in the cloud. It is not often that you see a swing of such magnitude but even within the past several months user attitudes regarding on-prem and cloud have gone substantial alteration. A few weeks ago I wrote a series of articles regarding the prospects for the 2 largest providers of public cloud services and one high profile challenger. One of the interesting things that came out of my research was the rapidity of the switch to public cloud for relatively mundane workloads. The consultants, themselves, were blown away by just how fast it is happening now.
Private clouds and hybrid clouds are going to be around for years. SAP and Oracle sell applications built on hybrid clouds with some level of success. But it really is not the best of investment strategies to attempt to navigate around the impact of a tsunami. Far better to ride the wave rather than get swamped.
Everyone is transitioning to the cloud. How do you pick winners and losers in that game?
There is a French expression, l'audace, l'audace, toujour le audace that I think sums it up. For those not familiar with the expression, it simply means be brave and well… audacious. By that I simply mean that it is impossible to make these kinds of transitions while trying to hold on-premise business. The most successful transition from on-prem to cloud thus far has been that of Adobe (NASDAQ:ADBE). There are many reasons for its success, of course, and it may be that the price point that Adobe charged for the cloud of less than $50/month opened up a consumer market that no one really knew existed for creative suite, but in the long run, I think the decision to stop selling its former on-prem solutions, was instrumental in putting the transition behind the company. I think that the current transition of Autodesk which has just stopped selling its enterprise on-prem edition of AutoCAD and which will stop selling its desktop edition of AutoCAD at the end of June is likely to have a salutary impact on the company's overall business strength.
I think that investors pick winners more by focusing on the nature of competition in the market. The new companies - by which in this article I mean WDAY and CRM - are taking huge amounts of market share from existing vendors. I don't propose to try to contrast every feature and function. It is time-consuming and not worth it. In order to make an investment decision you simply need to know that CRM and WDAY have purpose-built their offerings for the cloud and those offerings utilize a cloud architecture to offer users what most consider a superior experience when compared to the experience offered by legacy vendors. The legacy vendors are offering solutions that were essentially cobbled together and compromised in order to continue to support existing code bases. You pick winners in the space, I think, simply by identifying vendors with purpose-built cloud solutions that are competing with less than clean solutions offered by the legacy vendors. Eventually, the major vendors are going to have to scrap what they are offering and start over - both in the CRM space and in the HCM space because until that time they are basically competing with one hand tied behind their back.
Many readers and some observers think that now that Oracle and SAP are concentrated on the cloud they will inevitably retain their position of primacy. The problem with that thinking is simply that not all clouds are created equal and that is certainly the case with cloud applications. There is modern cloud architecture and then there is everything else. I won't bore readers with the specifics of that but suffice to say that because of where they have come from and their need to satisfy legacy constituencies, what Oracle and SAP are selling is really a quite degraded cloud experience than what is offered by either Workday or CRM in their respective market segments. That is not meant to be a universal statement covering every cloud offering of Oracle and SAP. They have products in the cloud and some of those do reasonably well in surveys. But until one or both of those companies chooses to cut the cord and develop purpose-built cloud solutions, the competitive playing field is going to be tilted in favor of WDAY and CRM. Those vendors are going to continue to win more than their fair share of competitive engagements and as they grow and mature they are going to get into more competitive engagements. That doesn't mean that Oracle and SAP will not migrate some or even most of their clients to their version of cloud. What it means is that over time, WDAY and CRM will continue to poach the market share of legacy vendors both in their traditional areas and in their new areas.
CRM is already close to a dominant vendor in sales force automation solutions. But the company is taking significant market share from Oracle and SAP in its newer product offerings such as analytics, marketing and service offering where it sells its whole product suite to users who are just now starting to sign up for mega deals. The same is even more the case for WDAY. WDAY has been a "thought leader" in the HCM space since the turn of this decade. Users who want all the benefits that they can get from the cloud and aren't tied to legacy products because of specific legacy installed environments are going to choose WDAY which explains its success as a company to a greater or lesser extent.
WDAY has now emerged as a serious contender in the market for financial apps. As I pointed out when I wrote about WDAY some weeks past, financial apps are a market that is several times larger than the HCM space. And it has the further characteristic that it is not growing at all. If WDAY is successful it will mean that Oracle and SAP are losing share that they can ill afford to lose. There are nascent signs that WDAY is going to be successful particularly in terms of "go-lives" and in terms of customers buying their entire suite of offerings including payroll (really a part of the traditional ERP stack), HCM and now financials. Essentially every dollar of revenue that HCM gets selling financial applications is coming directly out of base that used to go to SAP or Oracle and never even consider competitors.
A few years ago when IT spending was at least showing mid-single digit growth investors wouldn't have to face the dilemma that now confronts them. If CRM and WDAY continue on their current course of success, most of their growth will have to come from SAP and Oracle. There just isn't any other place from which those companies can grow. If CRM and WDAY are successful, then in a market that is no longer growing, it is hard to see how Oracle and SAP can achieve significant growth. Chief Justice John Roberts wrote in an opinion back in 2007 that "The way to stop discrimination on the basis of race is to stop discriminating on the basis of race." What is true on that subject is just as true on this subject. Investors who want to invest in the IT space these days and to ride the largest trend of this generation are well advised to... well invest in those companies whose future is completely based on maximizing their growth in the cloud and who do not have legacy boat anchors, disparate code bases, and a whole host of competing constituencies to please.
The problem for me is that I simply can't bring myself to pay the valuations of either CRM or of Workday. And I just hate the fact that all of their profitability is non-GAAP and they continue to use stock-based compensation to a significant degree. Isn't there another way to invest in IT that doesn't involve these nosebleed valuations but still gets the benefits of the cloud revolution?
Well, actually there is. I am well aware that CRM has an EV/S of over 6 and that it has a free cash flow yield of just a bit over 3% for this current year and that is after excluding the expense of purchasing the company's new office building in downtown SF. And I realize that WDAY has an EV/S of 8.6X based on analyst consensus estimates for the current year and it has a free cash flow yield of about 1.35%. So yes, both of these companies, regardless of their virtues have sky-high valuations and high valuations are risky. These companies will not get a pass for mediocre performance the way Oracle and IBM might - if their billings performance or guidance slips, the shares will see a material valuation reset of at least 25% or more. They are surely not for everyone.
But it is possible to find companies that have chosen to embrace the cloud that are in segments of the IT market where they do not have to compete with new upstart pure cloud providers. I have written in the past few months on both ADSK and PTC. Both of these companies are in the midst of transition to a cloud model. In the case of ADSK, that transition is just starting in terms of revenue and bookings coming from the cloud but it will obviously accelerate substantially since sales of on-premise software are coming to an end in phases between now and the middle of the year. Autodesk does not report subscription revenue on a separate line which makes it a bit difficult to quantify the revenue impact that the cloud is having. About the best that one can do is to say that total subscriptions for the company are 2.58 million and out of that total new model subscriptions which are cloud are currently 427k. The other metric we have is that ARR in total was $1.38 billion, while cloud ARR was $255 million, up 68% year on year. So, the transition to cloud is somewhere in the 15% range and it is going to take another 5-7 years to complete. And when the company comes out the other side, it is supposed to be generating $6/share in free cash flow in fiscal 2020 (ends 1/31/2020 and $11 in free cash flow by 2023 when the transition is completed.
As noted by the CEO during the latest conference call, new model subs are rising somewhat faster than had previously been modeled. Put another way, the switch to cloud is happening a bit faster than ADSK had thought last September. It is possible that the transition will take somewhat less time than had previously been forecast.
There are two really big differences between ADSK and the legacy competitors in other spaces such as Oracle and SAP. Autodesk actually has an offering called Fusion360 which is completely new and purpose-developed for the cloud. In fact, not too surprisingly, Fusion 360 is already ADSK's largest seller and has an overall market share of close to 15%. There is another competitor with a cloud only product called Onshape which is still private and has a 5% share in the space. That is an entirely different set of dynamics than the competition between CRM and WDAY on the one hand and Oracle and SAP on the other hand. ADSK was first to the cloud, it has the largest share in the cloud and it is a thought leader in the cloud. According to industry consultants, who are all I can go by, Fusion 360 is "the clear winner in creating native, cloud-based design applications."
ADSK embraced the cloud early, it is now putting an end to sales of its on-prem products and it is a market share leader in the cloud. The issue for investors is that there is still most of a transition to get through and the first couple of years of the transition are going to produce disagreeable headline numbers. And so, ADSK has a valuation of EV/S of 5X with a P/E that will not be meaningful for several years. It's free cash flow yield, excluding a one-time income tax payment, is about $650 million, resulting in a free cash flow yield of 5%.
PTC Corp announced its results for its fiscal Q3 that ended 3/31 about a week ago. There were a couple of pleasant surprises in the company's 2nd fiscal quarter that ended 3/31. Overall bookings grew above the forecast and despite weak macro conditions in key markets the company grew cloud ACV by 324%. PTC still offers users several different ways to acquire products. The company has yet to eliminate on-prem offerings and has offered an on-prem subscription offering for several years now. It has also embarked on an ambitious program to move its current installed base of maintenance paying customers to the cloud, particularly by offering an incentive plan to the channel.
PTC operates across a multiplicity of segments. It does have a desktop CAD solution called Creo that competes against ADSK. It has significant revenues from it calls Services Life Cycle management and it has an entirely different business unit called the Technology Platform Group which is rapidly growing but still a minor revenue competitor. The same basic comments apply to PTC as I made about ADSK. There are no new cloud-only competitors in its spaces with the one exception mentioned above. All of the spaces in which this company operates are competitive and fragmented. PTC is really new in the cloud business. Its mainline cloud offerings in CAD and in PLM only were generally available in March of 2015. The fact that the cloud represented 54% of total bookings for the quarter is a remarkable testament, not to PTC's execution per se, but to the strength of the factors leading to cloud adoption. Cloud adoption in PTC's market spaces had been held back because of security concerns and concerns about latency in workgroup environments. Within the space of a single year, seemingly those concerns are either gone or materially abated.
PTC shares have rarely been highly valued because so much of what it sells is related to product design which is not amongst the sexiest of market spaces to serve. Selling things to the automotive and aircraft business segments is simply not all that exciting. PTC has an enterprise value of $4.7 billion and anticipated fiscal year revenues (ends 9/30) of $1.16 billion. So that is an EV/S of 4X. It has a P/E on this year's consensus of 23X, which is somewhat misleading as the switch to cloud revenues is costing at least $0.50 in EPS and perhaps more.
Cash flow forecasting is a bit tricky for this company because of the switch to cloud. GAAP net income is likely to be minimal. Last year, the deferred revenue line contributed $67 million to cash flow. Free cash flow in fiscal Q2 was $97 million which compares to free cash flow for all of last year of just $149 million. I would be quite surprised to see cash flow this year grow from last year's levels. The increase in deferred revenues in both this past quarter and the full year hasn't started to show much growth. I think free cash flow is likely to track reasonably close to last year's attainment resulting a free cash flow yield of just over 3%.
Some Closing Thoughts!
The cloud is a once in a generation phenomenon in the information technology space. It is basically the same as a tsunami that is ripping apart long conceived measure of value and profitability and is creating a new bunch of winners and losers. There are a bunch of "pure" cloud companies that have sprung up in recent years to take advantage of the trend to cloud. And of course, there are a bunch of legacy companies fighting to remain dominant in their particular areas. Investors need to adjust their investment thinking to ensure their portfolios are congruent with the cloud trend. What has worked heretofore, will not work well in a new environment such as is being created.
Legacy competitors such as Oracle and SAP that have strong pure cloud competitors and they also have large maintenance streams coming from their installed base which will ultimately be displaced by the cloud. These companies are and will be the most impacted by their attempts to transition to cloud. The hybrid model that they are offering may be popular enough at the moment, but most users want to secure the full benefits of the cloud and that almost invariably means choosing new specialist cloud vendors. And many users find cloud solutions of from legacy vendors have been cobbled together from bits and pieces of a variety of on-prem code bases.
The pure cloud vendors have what many consider to be nosebleed valuations and many investors are concerned about the current inability of these companies to show some decent measure of GAAP profitability. There is an argument that can be made that it is the accounting that isn't reflecting economic reality, but even using free cash flow yield is not going to change the conclusion that these companies have high valuations.
The alternative to investing in pure cloud companies is to invest in companies with transition plans to cloud who are not having to compete, for the most part, with specialist cloud vendors. I have provided a brief outline regarding 2 such companies (PTC and ADSK) that have embarked on the journey and are showing early signs of success. There are, of course, many other companies that could be considered but to keep this article within some bounds of length I just focused on those two.
But regardless of whether you like one of my 4 picks or some other cloud company, just remember that the cloud is raining on some and that the cloud is in the process of becoming the standard software architecture for almost all use case. Eventually, even banking and insurance will around. Investors need to adjust their thinking to ensure that they focus on cloud companies or risk losing alpha!
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.