Not All SaaS Companies Are Valued Equally

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Includes: ADBE, ADSK, NOW, PFPT
by: Amit Ghate
Summary

Commenters on previous articles raised important questions regarding free cash flow analysis.

I attempt to answer these questions with both qualitative and quantitative arguments.

The takeaway is that companies like ADBE perform very differently than companies like NOW, PFPT and ADSK. In other words, not all SaaS companies are alike.

One of the two best things about writing for Seeking Alpha is the level of engagement of commenters, in particular their ability to thoughtfully and insightfully critique an investment thesis. (For the record, the other major benefit of writing for SA is the clarity that presenting one's rationale for any given position brings, i.e., it forces one to rigorously consider counter-arguments - aka the other side of the trade - in a way that often doesn't happen without making the idea public.)

Over the past year, I have written about my short positions in three SaaS companies: ServiceNow (NYSE:NOW), Autodesk (NASDAQ:ADSK) and Proofpoint (NASDAQ:PFPT), with the latter being the featured company in my most recent article. In comments left on that article - but which could equally apply to my thesis regarding all three companies - two astute critics question my focus on the income statement at the expense of considering the cash flow statement. Their criticism is central to the "other side of the trade", so I thought my answer deserved a full article, rather than just a cursory response in the comment section. Whether or not my arguments succeed I leave to the reader.

The Objection

Here's part of the first comment (but you should read the full text and back-and-forth at the link):

Your arguments on cash flow lead me to a bullish, not bearish conclusion.

This company's free cash flow margins and growth are impressive. Your fixation on income statement profitability seems misguided (and appears to be why this has been a bad short-sell investment). Whenever income statement and free cash differ (in this case due to revenue recognition pervasive in the SAAS space), free cash flow is ultimately what an investor is paying for (and therefore ultimately determines valuation).

And here's a second commenter's helpful observations and citations:

These give an outline of SaaS dynamics - trying to evaluate conventionally is like trying to evaluate a early stage cellular 'phone company with standard metrics - in both cases churn is a key metric. Too much churn and you don't have the revenue going forward to make up for the customer acquisition costs. In both cases very difficult to time as shorts as confirmation of failure is along way out.

http://bit.ly/2ttxYQO

double dip graph in this is key to understanding http://bit.ly/2svtPOT

http://bit.ly/2ttu7D7

- if all is going well it can step on the gas top increase customer numbers but in doing so will create an accounting loss.

The links provided are quite comprehensive, and include many metrics and ways to think about SaaS businesses. As they apply to the central criticism of my analysis, the two basic points are that while cash costs and expenses are outlaid in order to acquire customers, those customers only pay on a subscription basis which creates a mismatch/delay between the timing of cash spent and cash received. Long term, however, the essential point is that if the lifetime value of a customer exceeds the costs of acquiring that customer, then the business will be successful. Moreover, these businesses are said to be "sticky", hence the key is to get as much market share as early as possible (the so-called "land grab") and then reap unending rewards down the road. I have several disputes with this story, but before presenting them, let me reproduce one key section from the link above to flesh out these ideas (with my emphasis):

Take a look at the cumulative cash flow for a single customer under a SaaS model - the company doesn't even break even on that customer until after a year:

Company A, which is spending $6,000 to acquire the customer and billing them at a rate of $500 per month, doesn't break even on the customer until month 13.

And as the company starts to acquire more customers, the cash flow becomes even more negative. However, the faster the company acquires customers, the larger it grows its installed base and the better the curve looks when it becomes cash flow positive:

.

The key takeaway here is that in a young SaaS business, growth exacerbates cash flow - the faster it grows, the more up-front sales expense it incurs without the corresponding incoming cash from customer subscriptions fees. […]

So why would any rational person ever invest in a SaaS company?

Because once a SaaS company has generated enough cash from its installed customer base to cover the cost of acquiring new customers, those customers stay for a long time.

These businesses are inherently sticky because the customer has essentially outsourced running its software to the vendor, making them very predictable to model and more likely to yield high cash flows. Ultimately, we see the reverse of what we saw in the startup phase of the company: all the costs of acquiring that customer were incurred up front and long ago, and now the company gets to harvest nearly all the incoming cash flow from its customers as profits.

[…]

This is why many SaaS companies today invest aggressively in sales and marketing when adoption is high, even though it puts pressure on current profitability. That early growth is key: In winner-take-all technology markets, it's a land grab.

My Response

  1. In a certain way, the criticism gives all SaaS companies a pass, the idea being that at some point in the distant future the company will get huge free cash flows from its "captive" customers. I, on the other hand, think that you have to evaluate each company separately and be a bit skeptical of the idea that there's a free cash flow Garden of Eden somewhere way down the road. In one of my ADSK articles, I mentioned the fact that Adobe (NASDAQ:ADBE) is often held out as the model for ADSK's conversion to a subscription service, yet the financials of the two companies could not be more different. I provide another such comparison below, and just to put an emphasis on the point, while I'm short NOW, PFPT and ADSK; I'd never be short ADBE at today's valuations.
  2. The idea that these are "winner-take-all" markets with incredibly "sticky" customer sounds nice and can be used as an easy justification to spend just about any amount of money in customer acquisition, but the truth is that all of these companies are continuously competing for customers, and hence there is a substantial ongoing cost of customer retention. Moreover, the products are always under development (as opposed to say Coca-Cola (NYSE:KO) whose product has been essentially set for decades). The perpetual costs to retain customers and to improve their products at industry speeds is one key reason why I try to gage a "core profitability" metric. ADBE exhibits core profitability, my three shorts don't.
  3. The graphics in the excerpt above are merely examples, but they do raise the question, how many months or years can one expect to go before a company achieves consistent, rapidly accelerating free cash flows? The charts below (courtesy of the impressive features in YCharts) show the historical free cash flows minus stock based compensation (which I believe is really a financing cash flow, not a credit to operating cash flows) for the four companies discussed so far. First is ADBE which I submit is not a short candidate, next are NOW, PFPT (which have always been SaaS companies) and ADSK (which transitioned to SaaS a few years back). Even after years of operation, the free cash flow metric is either negative or chronically weak. There is no sign of the rapid trajectory upward shown in the figures from the SaaS valuation articles.
  4. To put a final valuation metric on this free cash flow, I conclude with a table summarizing the ratio of each company's market cap to current free cash flow - SBC figure.

Fundamental Chart Chart

Fundamental Chart data by YCharts

Fundamental Chart Chart

Fundamental Chart data by YCharts

Fundamental Chart Chart

Fundamental Chart data by YCharts

Fundamental Chart Chart

Fundamental Chart data by YCharts

Conclusion

Not all SaaS companies are created or valued equally. A company like ADBE is not a short candidate, but companies like NOW, PFPT and ADSK are, and as a result, I am short all three of them.

Disclosure: I am/we are short NOW, PFPT, ADSK. 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.

Additional disclosure: I actively trade around core positions.