Cloudera: Land-And-Expand Story Affirmed At Investor Day

Summary

• Cloudera shares have recovered somewhat from their post-earnings crash on the back of optimistic commentary at the company's investor day.
• While Wall Street will take some time to adjust to Cloudera's new org structure, particularly possible sales disruption, the company is overall on solid footing.
• Key takeaways from Cloudera's presentation focus on its hugely successful land-and-expand model. Customer ARR continues to grow, with the typical G2K customer generating just under $0.5 million annually.
• The sales transition will also include a new VP to head sales to public sector clients, a huge new vertical opportunity for Cloudera.
• With the company's guidance hinging on conservative assumptions, shares remain cheap at just 3.5x forward revenues despite the recent relief rally.

It's probably not an understatement to say that the coming quarter will probably be the most critical time in Cloudera's (NYSE:CLDR) journey as a public company. Moving past the worst earnings quarter in the company's life to date (and particularly painful for loyal investors like me, who've lost nearly 50% of the value of the stock in the past two weeks), Cloudera stands to face a giant test: can this company continue to grow at its previously rapid clip, or will growing pains turn it into one of those stale, old software companies that no one likes to talk about? (think MicroStrategy (MSTR) or Pegasystems (PEGA), two "legacy" vendors way past their prime that have mostly fallen off investors' radar).

The past week has brought a lot of updates from the company, all coming from Cloudera's inaugural Investor & Financial Analyst Day on April 12. Investors have generally liked what the company had to say, with Cloudera shares recovering somewhat to $14 (up from a low in the mid-$12s, but still far off recent highs of $22):

CLDR Price data by YCharts

I've been following Cloudera closely over the past week - in part because I have my own stake tied up in the company, and in part because it's extremely fascinating how a growth stock like this can trade at such a cheap valuation (in my personal opinion - many other investors think Cloudera's execution risks are true justification for the lowball valuation). At Cloudera's current market cap of $1.96 billion and enterprise value of $1.50 billion (netting out the company's considerable net cash of $460.7 million), it's trading at just 3.4x EV/FY19 revenues - the cheapest multiple of any software company that's growing at least double digits. Even Hortonworks (HDP), Cloudera's rival in Hadoop that's been public since 2014 and never attracted a premium valuation, is trading above 4x revenues. And as I covered in a prior article, Cloudera is trading at less than half the valuation at which Intel (INTC) purchased a stake in the company, and it's not impossible for the semiconductor giant to consider a full buyout of Cloudera at these rock-bottom prices.

This article will focus on updates from Cloudera's investor day, along with key takeaways and slides that reinforce the bullish narrative. Being bullish on Cloudera at the moment is a very contrarian position, with the majority of Wall Street lowering their expectations - but it's in times like these that true contrarians can make the largest gains.

I'll make one other note: I had hoped for some more specific clarity around Cloudera's disappointing FY19 guidance ($435-$445 million in revenues, or +20% y/y), but management didn't shed any additional light on the supposedly conservative net expansion ratios they used in driving the guidance range. Nevertheless, I still find Cloudera's refreshed narrative to Wall Street encouraging, and have used the selloff to build my position and am holding fast to my shares for a $21 price target (5.5x EV/FY19 revenues).

Sales issues are the result of growing pains

I've digested and re-digested the commentary coming out of Cloudera's earnings call. In case you haven't been following the company that closely, Cloudera's CEO commented that the company missed bookings targets in Q4 due to sales execution issues, which sparked a lower guidance forecast and sent shares tumbling 45% in one day. Since long-term, multiyear bookings don't explicitly appear on the financial statements (only the billed portion will appear as deferred revenues), it's uncertain when the near-term bookings weakness will start impacting Cloudera's revenue growth, hence investors' apprehension.

No one wants to hear that the company saw "softness in expansion bookings," as the CEO commented in answer to a question during Q&A. The issue, according to management, is that the company chased too many prospects outside its target market and ended up a little empty-handed.

The resulting re-org, which Cloudera updated investors on in the investor day, is a direct response to these challenges. These are the updates to Cloudera's restructuring:

Source: Cloudera investor relations

Cloudera is focusing its sales org on functional product specialists within its three key areas: machine learning, data analytics, and cloud infrastructure. Each of these three areas is now headed by a general manager (shown in the org chart below), reporting to an SVP, who will eventually partner with a new global sales head (search still pending).

Breaking up go-to-market efforts by lines of specialty, in my opinion, will engender greater trust in customers than generalist account execs who target any and every customer with a checkbook. Cloudera is a well-recognized technology leader, a Gartner-designated category champion - and its sales efforts should revolve around its product expertise.

In addition, Cloudera will be bringing on a new VP to head up the company's public sector vertical, an area which it has left relatively untapped. In the wake of the highly public $10 billion Department of Defense contract that market observers are increasingly saying won't go to Amazon (AMZN), partly due to President Trump's criticisms of the e-commerce giant, software companies have all scrambled to get their federal certifications and ramp up their public sector efforts. While Cloudera's scale and scope doesn't quite match the DoD's request for an all-inclusive cloud infrastructure ecosystem, it highlights the growing desire of government bureaus to switch to cloud, positioning top vendors like Cloudera for additional opportunities.

Cloudera is suffering from growing pains - completely normal for Silicon Valley companies approaching a ~$500 million run rate at a >40% growth rate. The company is restructuring its go-to-market approach to match the needs of a more mature organization, and while near-term disruption is a possibility, it doesn't nullify Cloudera's technology strengths or long-term potential. In an update to its TAM, Cloudera cited a $73 billion market opportunity from an IDC study ($28 billion in analytics and machine learning; $45 billion in databases). Based on this estimate, Cloudera is less than 1% penetrated in its target market.

Land-and-expand economics are still viable

The other key to the Cloudera story: its land-and-expand business model, which means that the company will target new customers for early single-use deployments (averaging a mere $73k in first-year ARR, according to the company) with the hopes of expanding them to multi-million deployments over the coming years.

Given that Cloudera's CEO called out that expansion bookings (where an existing customer orders more seats or more products) makes up the lion's share of Cloudera's growth, with new customers contributing only a few percentage points of growth, the success of land-and-expand is more important and visible to Wall Street than ever.

Investors got some additional clarity around Cloudera's success with this model during its presentation. The chart below shows that a greater proportion of Cloudera's revenues came from its top-tier enterprise customers:

Deployments greater than $1 million made up 53% of FY18 revenues, up 5 points from last year. And small deployments of <$100k (the new customers) made up only 8%, 2 points fewer than last year. This is extremely important from a profitability standpoint - because sales expenses are greater than customer acquisition costs in the early stages, but essentially flatlines as a customer expands to greater than $500k in ARR, as shown below:

The company further reported that its average Global 2000 customer generated $479k in ARR in FY18, up 27% y/y from $377k in FY17 - right on the edge at which ARR takes off and greatly exceeds a flattened sales expense, as shown above. ARR is expected to continue growing through FY19 (though perhaps at a slower pace than before), and as it does, Cloudera's profitability will as well. Cloudera is still on the cusp of capitalizing on this land-and-expand business model - investors should be patient as it works to fine-tune its sales org to prepare the company to become a much larger player.

Profitability still a near-term goal

Investors were obviously also disappointed when Cloudera guided to becoming profitable on an operating cash flow basis in FY20 (the year ending January 2020), later than some were hoping. The company's near-term challenges on the expansion bookings side, as well as its sales reshuffling, are causing a small impact to Cloudera's near-term profit potential.

We've seen Cloudera's long-term operating model (its target margins when it reaches a steady state) before, but it's useful to review this target against its full-year FY18 results:

The one salient point to take away here: one of the greatest profitability levers for a software company is its gross margin. High gross margins are the key to Cloudera's ability to turn its large ARR clients into cash cows after they've surpassed a certain billings scale - and at 73% in FY18, Cloudera is only about ten points away from achieving its ultimate goal of 82-84% margins. Given the company has been improving gross margins at about 4 points per year, the company should be able to hit this target relatively soon.

Note that 82-84% gross margins is extremely high compared to the rest of the software industry. But at 73% today, Cloudera already matches or exceeds the gross margins of existing large-cap software companies like Salesforce (CRM) and Workday (WDAY), which are extremely FCF-profitable:

CRM Gross Profit Margin (Quarterly) data by YCharts

While these companies are still growing, they've essentially already come close to reaching their target states, with their revenues of $3 billion (Workday) and $10 billion (Salesforce). Cloudera is puny in comparison, yet it's able to pull off its 73% gross margin with a target of marching still higher.

The main takeaway here: don't worry about Cloudera hitting OCF profitability this year or next year. In the long run, its customer unit economics are extremely favorable due to its land-and-expand strategy, and if it can get its sales house in order and re-ignite the expansion bookings engine, it will get to profitability very quickly.

Final thoughts

Finally, a nod to the opposition, which has been extremely vocal of late: while I recognize that being a longtime bull on a company makes it difficult to see the bearish case, it would be remiss and short-sighted not to acknowledge that Cloudera faces some unique risks in the coming year.

For a company that drives the majority of its growth from expansion business, and with expansion bookings turning soft in Q4 (arguably the most important quarter for any software business, as IT buyers tend to be freewheeling spenders in November and December), there is risk to Cloudera breaking its long streak of earnings beats. The company was right to guide soft for FY19, and investors are right to be concerned that bookings trends can cause longer-term decay. Like many other investors and analysts, I've lowered the price target at which I'm willing to let go of the shares (but I'm still waiting for $21 or 50% upside from current levels).

Still, however, I contend that everything must be viewed from a value-oriented perspective - and at 3.5x forward revenues, Cloudera is a tremendously attractive value proposition from a risk-reward standpoint. This is a top-notch software product running into (hopefully) short-lived growing pains - but in the end, superior products win out the day. Stay long and profit from the recovery.

Analyst’s 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.