Sometimes, you find the perfect secular grower.
It presents the combination of many factors, such as:
- Strong and accelerating revenue growth.
- Improving profitability and cash-flow.
- Huge popularity.
- High consumer retention.
- Outstanding culture and leadership.
- A product or service that is disrupting an industry/technology.
The perfect secular grower is usually poised to grow at a fast pace for the foreseeable future. And it usually has a valuation that may appear extremely expensive compared to its peers.
When a company is firing on all cylinders, and the main thing that concerns analysts is its valuation, I tend to pay attention.
The thing is, I'm a long-term investor. Remember, Wall Street and the vast majority of analysts on Seeking Alpha or elsewhere have a very short-term mindset. A quarter, maybe two, is their time horizon. They see a company as un-investable or an outright short idea because it is "20% overvalued," or because "the stock has run too much."
If anything, when I see a majority of opinions on Seeking Alpha calling a company "fantastic but clearly overvalued," the long-term thinker in me sees it as a perfect investment opportunity.
My biggest winners have often in common the fact that they were considered overvalued when I first bought them. And they were still considered overvalued when I bought more of them years later. Yet, they move on to become multibaggers in a matter of months. When you truly focus on the businesses with the highest quality, you have to pay up for them. In turn, they are the ones that may turn into true disruptors that will transform their industry - and your portfolio returns.
This brings me to MongoDB (MDB).
Software is eating the world, and data is its main course.
MongoDB is disrupting the database industry by providing a more flexible and open-source way for developers to harness information to create business-specific applications. There is a humongous opportunity ahead for MDB if it can lead the way in cloud-based database-as-a-service platforms.
The company is benefiting from three fundamental trends:
- Growing market: The world's data is expanding and changing. Every company is becoming a software company, with an endless string of digital information. More software means more data, means more databases.
- New customer needs: Developers have now enormous power and influence today in terms of how technology decisions are made. And MongoDB is the most popular NoSQL database in the world for developers.
- Platform shift: Software is moving from on-premise to the cloud. MongoBD is designed for the cloud. Amazon (AMZN), Google (GOOG) (GOOGL) and Microsoft (MSFT) have conveyed to MongoDB management that it is one of the most popular technologies on their cloud platforms.
MongoDB already is a three-bagger in the App Economy Portfolio. But all recent developments, combined with its outstanding culture, suggest that the company is on a path that could make today's valuation look very cheap in retrospect.
But if you don't have a long-term horizon and are not willing to cope with strong volatility in the share price should a market draw-down occur, you would be wise staying entirely away from MongoDB. If you invest defensively with a secular grower (e.g. using stop loss or trying to get in and out based on your "gut"), you will likely miss most of the gains at stake and perform below the market.
MDB is the kind of stock you buy and hold, but also the kind of winner you want to add to on weakness. I have explained in several posts why holding onto and adding to my winners is a fundamental part of my portfolio strategy. With shares down 15% from their recent all-time-high as of this writing, I'm adding more to my existing position this week.
Let's review the details.
Why secular tailwinds matter
This article covers the sixth company discussed in the Secular Growers Series.
This series started in March with articles about Huya (HUYA) and the rise of e-sports, Baozun (BZUN) and the rise of e-commerce in China, Match Group (MTCH) and Momo (MOMO) and the rise of online dating across the world, and finally HubSpot (HUBS) and the rise of inbound marketing.
I will continue providing details on what I consider the best framework to identify, research and invest in the best secular trends the world has to offer.
Going back to the definition of secular straight from Investopedia:
- Secular refers to market activities over the long term or a stock that isn't influenced by short-term factors.
- A secular trend, stock or market is one that's likely to continue moving in the same direction for the foreseeable future.
- Secular stocks include technology firms such as Netflix (NFLX) and e-commerce leaders such as Amazon.
Secular growth involves usually a constant growth of revenue and earnings above 10% over several years. The implication usually is that the trend is likely to stay the course over years to come because of the fundamental societal disruption it embodies over the long term.
Here are a few examples of secular trends of the 21st Century:
- Digital payments overtaking cash.
- E-commerce overtaking brick and mortar.
- Streaming services overtaking cable.
- Mobile ads overtaking desktop.
When possible, we want to capture a secular trend that also offers a potential exponential growth, the kind of growth associated with S curves.
You would typically see an exponential growth when technology is entering a sector and driving down costs, which then stimulates unit growth.
Of course, finding a business that's embracing a secular trend isn't sufficient. For example, the rise of online food delivery is a secular trend, but that doesn't make any food delivery service a good investment (I'm looking at you, Blue Apron (APRN)).
Many secular trends are not worth exploiting to begin with, particularly the ones that don't have strong unit economics or a clear path to profitability.
NoSQL database challenging the status quo
While the world's data is changing, with more granularity and complexity than ever before, so does the need for efficient and flexible databases.
Eliot Horowitz, co-founder and CTO of MongoDB, explained:
A relational database is fundamentally Microsoft Excel on steroids. Both are made of rows and columns organized into tables or sheets.
Since its first release in 2009, MongoDB has offered a new approach to database design, freeing developers from the constraints of legacy SQL databases. Faster, more flexible and easier to scale.
There's a wide range of use cases across many industries, as illustrated by MongoDB's portfolio of customers and the types of applications they use the service for.
For example, through my experience in the video game industry, I discovered that gaming studios use MongoDB to store user data and game state - both complex and ever-changing databases that require flexibility and speed.
Eliot Horowitz continues:
MongoDB takes an entirely different approach. Data is stored in the documents and just like physical medical records, one patient's document can have 3 phone numbers, two addresses and, 20 prescriptions and can live right next to another patient document that only has one phone number one address and no prescriptions.
As MongoDB has gained popularity with developers, a growing addressable market has taken shape. Management revealed during its Q1 FY20 earnings call:
IDC recently updated its forecast and expects the worldwide database software market to grow from $64 billion in 2019 to approximately $98 billion in 2023. We believe that much of this incremental $34 billion will come from modern applications and new workloads, which we are well positioned to capitalize on.
The company follows a land-and-expand strategy. Its software is free to download, letting developers learn, use, and build on the platform with a limited amount of storage. MongoDB then sells more storage and services as its relationship with customers matures. This is a successful strategy as illustrated by its dollar-based retention rate above 120%, meaning that MongoDB makes more money out of the same cohort of customers over time.
MongoDB Atlas is the company's cloud-based database-as-a-service offering.
Atlas represented 35% of revenue in the most recent quarter. It's the fastest growing segment of the company, growing 340% yoy. With such high growth, developers are clearly showing their preference for a product designed for the cloud.
The company had 14,200 customers at the end of April 2019, 60% of whom were in the United States.
From database to platform ecosystem
At its recent developer conference, management revealed a series of new products and features that fit in with the vision for MongoDB that Eliot Horowitz shared with ZDNet late last year. He said about the company's future:
It’s about going from just being a database to being more like a platform, and, whatever you need to do with it, it just works. So, in transactional use cases and analytics use cases, it’s really a sort of one-stop-shop for most of your data needs. It’s back to that core concept that data should be easy to work with so that you can develop those applications, be they web application, a mobile application or an analytics application it should really, just work.
Dev Ittycheria, CEO and president of MongoDB, also explained:
Our new offerings radically expand the ways developers can use MongoDB to better work with data. We strive to help developers be more productive and remove infrastructure headaches — with additional features along with adjunct capabilities like full-text search and data lake. IDC predicts that by 2025 global data will reach 175 Zettabytes and 49% of it will reside in the public cloud. It’s our mission to give developers better ways to work with data wherever it resides, including in public and private clouds.
Among the recent developments, MongoDB gained strong partnerships and features that are likely to power Atlas forward:
- A partnership with Google Cloud Platform with a deeper integration of Atlas with core GCP services such as identity and access management, logging and monitoring.
- Improved features for mobile integration following its acquisition of mobile database specialist Realm.
- New security features shifting away access from the local server.
- Ease of use with Amazon Web Services (AWS).
MongoDB is making the right moves to maintain its edge as a leader in NoSQL database - reinforcing its popularity with the community of developers. The virtuous cycle could go on for quite some time.
An outstanding culture and visionary leadership
Management and culture are primordial pieces in a company's bullish case. And MongoDB checks that box in a beautiful way.
Headquartered in downtown Palo Alto in California, MongoDB is at the epicenter of Silicon Valley, both digitally and physically.
With the vast majority of MDB's employees praising their company on Glassdoor, one can only imagine the high quality of the talent pool currently working at the company.
Dev Ittycheria is highly praised by his own employees with an approval rating of 94%. If you want to get a feel for his personality, you can find below an interview he gave a few days ago on CNBC.
The most recent quarter reported by the company was Q1 FY20 (quarter ending April 30, 2019).
Let's see the key metrics of Q1 FY20:
- Outstanding and accelerating revenue growth +78% yoy (vs. +71% yoy in Q4 FY19) showing popularity of the services.
- High gross margin at 68%, showing strength of the business (although down from 73% in Q1 FY19 due to the increased portion of the business coming from MongoDB Atlas, a service with slightly lower margin).
- Maintained R&D % at 35% of revenue (vs. 37% in Q1 FY19) in order to reinforce its ecosystem with new best-in-class features, maintaining popularity and relevance.
- Dropping sales and marketing costs % at 52% of revenue (vs. 66% in Q1 FY19) showing improved efficiency.
- Dropping G&A % at 17% (vs 22% in Q1 FY19) as the company matures, showing scalability.
- Finally, cash flow from operations has turned positive for the first time (+$3M). This shows the business's sustainability.
The company has reached $89.4 million revenue in Q1 FY20 and is expecting $375 to $381 million for the full-year FY20. This has resulted in economies of scale, but let's not lose sight of the fact that GAAP operating losses remain very high at -34% (although improving from -53% in Q1 FY19).
For fast-growing SaaS companies with most of their businesses powered by recurring subscription revenue, very high gross margins and heavy reinvestment in R&D, the long-term upside potential is astonishing.
That's why they often end up looking grossly overvalued if you are using traditional valuation metrics such PE or PEG ratios.
I recently published an article about how to invest in the right SaaS using graphs. After reviewing the efficiency score (sales growth + operating margin) of a wide range of SaaS companies, my focus has been on comparing them on an EV to Sales basis. Source: Data from Yahoo Finance. Sales Growth from most recent quarter. Operating margin from last 12 months. Graph from App Economy Insights. Bubble size based on market capitalization as of 7/10/2019. Find more details about this chart and the methodology behind it here.
I was able to identify a correlation between efficiency score and valuation. Performance, after all, must come at a premium.
As a result, I was able to automatically generate a trend line indicating the mid-range of SaaS valuations for any given efficiency score.
As a result, MongoDB appears most similar to companies like Atlassian (TEAM), Coupa Software (COUP), Elastic (ESTC), Alteryx (AYX) or Twilio (TWLO) on an efficiency basis. These six companies have trailing EV to Sales multiples ranging from 21 to 30 according to Ycharts.
MongoDB is right in the middle, with an EV of ~27 times trailing sales.
It's fascinating to realize that over the past year, most of these companies have maintained an EV over 12 times sales, even during the broad market sell-off in late 2018.
Does it make MongoDB cheap? Certainly not. But it makes it somewhat appropriately priced if you believe in the SaaS model eventually generating some of the biggest winners of the 21st century in our digital economy.
Back in 2011, Fred Wilson was suggesting that a SaaS revenue multiple should roughly be 5x this year's revenue and 4x next year's revenue. Eight years later, the median SaaS revenue multiples are hovering around 10x this year's revenue, about twice as much, around 20x or more for the fastest growers - and MongoDB is no exception.
Of course, not all SaaS are equal and MongoDB could be considered a best-in-class business and naturally be valued at a premium. With a top line growth at 78%, any valuation based on revenue multiple today could really turn out to be relatively small a few years from now.
Again, the bull case around MongoDB is not based on its valuation today, but what it could be a few years from now.
Make no mistake, if cracks show in its outstanding growth story, it wouldn't be surprising to see the shares slashed in half. It's a high-risk, high-reward proposition.
Since its 2017 IPO, MDB shares rarely fell very far from their recent high. As of this writing, the shares are 15% from their all-time-high.
The risks to keep in mind
First, MongoDB's generous valuation could prove to be problematic if its top-line growth slows down more than anticipated by the market in the coming quarters. It also could face a much larger draw-down than the indexes should a broad market sell-off occur and you should expect volatility.
Second, the company is investing in its future aggressively. R&D expenses are ramping up just as fast as the top line, and significant improvement in operating margins should not be expected anytime soon. There's $220 million of convertible senior notes on the balance sheet, which could generate future dilution should the company's cash flow generation weaken.
Third, the rising popularity of MongoDB with developers hasn't gone unnoticed. Intense competition from large players like Amazon was expected, as illustrated by its recent initiative with DocumentDB (virtually a MongoDB clone). More challenges could come from the open source nature of the product with companies building services on top of MDB's product. MongoDB will need to keep on innovating by building top-notch features on its platform.
Before this week, my MondoDB position was already a three bagger.
Holding onto and adding to your winners is a powerful strategy that is very simple, yet incredibly difficult to put in practice due to biases such as prospect theory, loss aversion, or anchoring.
MongoDB is far from being a sure bet. An open source strategy comes with its fair share of risks and uncertainties. But its trajectory is that of a true secular grower that could disrupt the database world for the next decade and beyond.
Even at its current stretched valuation, matching the historical revenue multiple of the best-of-breed SaaS, I believe buying shares today will be handsomely rewarded for those who have years to let the story play out.
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The rise of the App Economy is disrupting many industries: retail, entertainment, financials, media, social platforms, healthcare, enterprise software and more.
While keeping in mind some of the best recommendations from experienced gurus of Wall Street such as Warren Buffett, Peter Lynch, Burton Malkiel or Philip Fisher, I am trying to beat the S&P 500 index by a significant margin.
Here are some of the trends reflected in the portfolio:
Disclosure: I am/we are long MDB, AMZN, NFLX, MTCH, HUYA, HUBS, MOMO, BZUN, GOOG. 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.