Whether the NBER or the president choose to acknowledge the reality, a recession is either here or shortly impending. It is not, perhaps, a typical recession, but then there is really no such thing as a typical, i.e. inventory based recession any more. This recession has not featured massive unemployment at this point, and some parts of the economy remain in growth mode, albeit at a more subdued cadence than before.
In recent weeks the market staged a significant rally that has lifted the valuation of high-growth IT stocks along with many other risk asset classes. That rally came to an end recently with a consensus view that apparently opines that the recovery in the valuation of risk assets has come too far, too fast. In the wake of the "Jackson Hole speech" in which the Fed Chairman outlined a scenario of rising rates, and a commitment to keep raising rates even in the wake of distressing economic indicators, one of the hopes on which the late rally had been based has seemingly been vitiated. While the late rally was certainly substantial, it left IT stocks significantly below historic valuations. A recent analysis published by Morgan Stanley (MS) showed that software stocks were trading at 30% below their average EV level of the past 5 years. The analysis also shows that the average free cash flow multiple is down by 45% from its peak.
A recent poll conducted by Bloomberg, which included but professional and retail investors said that 84% of the respondents believed it would take two years or longer for the Fed to achieve price stability as defined as 2% reported CPI. The respondents further believed that in the interim, consumers will cut spending, and unemployment will rise. On Friday, August 19, German producer price inflation was reported at 37%. While much of the German inflation is related to the cost of energy, it served to remind some, if a reminder was needed, that the path to lower inflation is neither straightforward or a matter of one or two benign inflation reports.
Currently, investors are being faced with concerns about a worsening global drought which is driving up some prices in some locations. I don’t do weather forecasts, so I have no idea as to when or how these different droughts will end; from what I have read, places like Las Vegas and Phoenix and even Dallas have gone from drought to flooding in a number of days.
I am reasonably sure that I have no second sight with regards to how long it will take for the inflationary spiral to unwind. Some of it will be unwinding by itself, as supply chain issues ease; that process is already visible according to some companies that I follow in the tech space. In addition, many commodity prices have fallen rather steeply. Eventually, the impact of those falls in commodity and transportation prices will work into inflation numbers. The growth in the cost of shelter has been elevated. That should be coming to an end; housing sales are falling, which should result in a halt to the significant escalation in the cost of shelter as recorded by the CPI. Even the rental market seems to have cooled in many localities as vacancy rates have risen.
On the other hand, inflationary pressures have become embedded in much of the economy. Even a company like PayPal has (PYPL) raised its service fees. And the cost of restaurant meals continues to climb. Employment numbers are not supportive of any near term decline in either the growth of wages, or the concomitant cost pressures on employers. While productivity growth is not as bad as presented in recent statistics, it certainly is not a factor offsetting the rise in employment costs.
Commentary by the Fed chairman, Jay Powell, in his eagerly awaited speech at the Jackson Hole summit was judged to be “hawkish” with no emphasis on slowing the level of rate hikes. On the other hand, realistically, the latest PCE inflation report, out at the same time was quite benign, and certainly will be an input into Fed decision making regardless of its short-term impact on markets and bond yields.
With the earnings report of Salesforce (CRM) of August 24, it is hard to doubt that macro headwinds are impacting demand growth in the enterprise software space. Most software companies are experiencing demand headwinds. Those that aren’t are standouts. I might have thought investors have already discounted the impact of macro headwinds on enterprise IT demand, but the initial reaction to the Salesforce guide down, as well as Splunk’s commentary about its cloud transition and ARR growth, suggests that, at least at the margin, some “surprises” are really surprises. Perhaps the concern isn’t so much about the specifics of the current headwinds, but fears that these headwinds being currently acknowledged are just a “first shoe.”
I would be surprised if Fed rate hikes didn’t end sometime in 2023, and I would be surprised as well if IT demand didn’t adjust to a lower level of economic activity. The level of economic activity can constrain the ability of some enterprises to afford IT solutions, but in these days of digital transformation, and very high ROI’s for software, I expect that IT budget cuts will be far less draconian than in past cycles. But that, of course, is speculation, and nothing I can prove, anymore than the dire prognosticators, of whom there are many who can “prove” their forecasts. The question of whether software expenditures are really discretionary, and whether enterprises will need to reprioritize what they invest in will really only be known in retrospect. In compiling this list, one guide rail was to find enterprise software companies whose solutions really are far less discretionary than average.
One size does not fit all when it comes to investing. There are investors whose focus is almost exclusively drawn to historical valuation metrics. I am not trying to address that particular cohort of investors in this article. Other investors, and more than a few brokerages have taken the tack of recommending “defensive” stocks as their picks for a recession resistant portfolio. That will appeal to some - but not to this writer. Other investors want to avoid investing in companies whose earnings reports no longer show the level of growth seen over the last several years. And some investors are fixated on recent inflation reports and how high inflation will lead to elevated bond yields, and in turn lead to additional valuation compression. More than a few commentators and readers are concerned about the expense of stock based compensation. For better or worse, the preponderance of investors do not share that view. I actually track valuation vs. stock based compensation expense for all companies I follow. There is, essentially no discernible correlation between low relative SBC expense and valuation, nor has there been in the several years for which I have maintained records. Some investors are using screens based on percentage declines from peaks to date. That was not a specific animating metric in the recommendations I am making here although I have, of course, considered relative valuation.
A few subscribers, and one commentator on one of my most recent articles have asked for my suggestions for a portfolio for the current and impending environment. My principle guide rails in putting this list together were not to find particularly defensive companies, or to focus on slow growing, low valued companies, but to find companies whose valuation has imploded significantly, but whose outlook has not been significantly impacted by macro headwinds. And of course I look at companies who are delivering market share gains, and are expected to continue to do so. Basically, the only way companies will not be impacted by macro headwinds is if they are able to gain market share to make up for those headwinds. My contention is that everyone is well aware that a recession is creating substantial headwinds for most areas of IT demand, and that will continue. I don’t suggest I know how long those headwinds, or a recession might last; I am not sure there are any analysts with that kind of insight since so much will depend on future policy changes and macro factors that are essentially unknowable.
While I am anything but a traditional value investor, I have followed the advice of one of the canniest stock pickers of the last two generations, Warren Buffett, still going strong, apparently, at 92.
“Be Fearful When Others Are Greedy and Greedy When Others Are Fearful”
Conforming to the conventional wisdom in looking to put together a suggested portfolio of IT vendors to weather through a recession is simply highly unlikely to achieve a differentiated return. Many institutional investors and hedge funds have already positioned their portfolios with a concentration on IT vendors with slower growth and lower valuations. And that strategy has been appropriate thus far. The Morgan Stanley article mentioned above shows that the lesser valued IT names are far closer in terms of valuation to their 4 year trailing EV/S ratio than the other companies in the IT space. But these slow growth companies are going to see growth slow even further or turn negative in a recession, while the relative performance of their high growth brethren is likely to be far more differentiated.
Investors, or so it seems to this writer, are terrified of a slowdown in the growth of IT vendors which is why a company such as Palo Alto (PANW), can see strong share price performance simply for achieving the headline results it had previously forecast (Just to be clear as to the reason for the company's share price appreciation, Palo Alto is a vendor which forecasts billings and continues to use that metric as a performance yardstick. It had forecast billings growth of 26% for the quarter recently reported but then reported billings growth of 44%, a growth acceleration from the 40% growth in billings reported for Q3. Perhaps of equal significance, the company’s backlog (RPO balance), which I use in calculating bookings rather than billings, rose by 19% sequentially, and by 40% year on year.) Equally telling is the reaction of Workday (WDAY) shares to that company’s reaffirmation of guidance.
Investors are also terrified that the Fed will continue to raise rates for several more quarters. What is new about that are the sentiments of Fed speakers that rather than stopping at a neutral rate of interest, the Fed wants to tighten rates to some level that is seen to be restrictive.
I am not the writer to provide some kind of insightful commentary about economic macros. Many other contributors on SA, and brokerage strategists and economists provide plenty of that kind of commentary. I might simply observe that while a recession is impending or is here, at least in some sectors of the economy, and while there will be more rate increases, the fears that are seemingly animating investors at this point, seem a bit over-wrought and perhaps inherently contradictory. Demand destruction will ultimately lead to the unwinding of inflationary expectations, and the Fed is not likely to wish to embrace policies that will lead to a deep recession with elevated levels of unemployment.
So, I am arguing here for a bit of greed in looking at a portfolio for these troubled times, with more risk than some might think prudent. And that is a key in the construction of this set or recommendations which are in no way the low risk strategy for dealing with a troubled economy.
In creating a list of 5 names, inevitably some good choices get left out. And as I have written often, none of these picks is going to work unless the environment is one in which market participants are looking for growth and are willing to accept some risk in exchange for growth. I have chosen 2 companies whose offerings are in the analytics space, one company in what is called the observability space, one company in enterprise storage and one company in the cyber-security space. All of the companies are generating free cash flow; most of them have significant free cash flow margins.
There are other names and spaces that I wanted to include - but with a self-imposed constraint of 5 recommendations it just wasn’t possible to include all the companies that I believe to be investment-worthy despite the macro headwinds. I haven’t included any fintech choices, or any ecommerce choices not because of any lack of opportunity, but simply because I wanted to provide a concise, curated list and those sectors generate an excessive amount of unresolvable controversy as investments at this point. And I just couldn’t jam in another sector like adtech, even though there are some excellent investment opportunities in that area as well.
I apologize in advance for the length of this article. It deals with 5 companies, and that has led to its length. I also want to make clear that none of these recommendations are trading calls. I don't purport to know the specifics of what CrowdStrike or Pure will report this week. And I can comfortably suggest that these 5 recommendations aren't going to perform in a risk-off environment.
The two companies I have highlighted in this space are somewhat unique in the enterprise software world. They both enjoyed accelerating growth last quarter. Nobody without some kind of unique crystal ball can say with certainty that these companies will continue to grow when most IT vendors are seeing noticeable slowdowns in their growth. Salesforce is the largest pure SaaS software vendor with a broad platform that incorporates multiple clouds and multiple verticals. It reduced its revenue guidance for the last half of the year by about 4%, excluding the incremental impacts of currency. Alteryx and Snowflake increased guidance. Apparently, in this turbulent environment, where conditions are changing rapidly, business managers are willing to prioritize applications that allow them to reconfigure their own plans based on evolving market conditions. I think the sales trends these vendors reported speak eloquently to the value of analytics to business managers; apparently that value has grown in spite of macro headwinds. I think companies that can achieve accelerating growth in times of stress such as this are worth premium valuations.
Why does Alteryx make this list? Recent results coupled with an encouraging outlook, and leadership in a space which is being prioritized by users as important in the turbulent environment. The shares are modestly valued, especially as profitability, an ingredient heretofore lacking on a consistent basis, is starting to show sustained improvement.
A few weeks ago Alteryx reported the results of its latest quarter. The results were a beat, the guidance was a raise, and most conspicuously, the company said that its sales cycles were shortening. That commentary is a major outlier in the IT industry these days, where almost everyone else outside of cyber security vendors has indicated that their deals were seeing increased scrutiny and were taking longer to close. Of course Alteryx shares appreciated significantly at that time; they rose by 29% in the week after the earnings were announced, but recently they have retraced some of their appreciation. That said, the shares, while about flat year-to-date, are down substantially from the all-time high they set in 2020.
The Alteryx revenue model can be somewhat difficult to understand; even though all of its product revenues are subscription based, it recognizes a portion of the total value of a signed contract upfront. The proportion recognized upfront can vary, and the duration of a contract also has an impact on the revenue recognized in a given period. Thus, the 50% growth the company reported last quarter, and its revenue forecast for this current quarter which equates to revenue growth of about 56% are not actually indicative of the sales performance of the company. A more consistent performance metric is the growth of ARR which has risen for several quarters at this point, and which has reached to the mid 30% level on a constant currency basis.
What is of even more significance in evaluating Alteryx at this point, is that the results of the last few quarters have come despite the absence of any significant benefit from the company’s pivot to offering cloud solutions. Some of the benefits from cloud offerings will show up in 2023; more in 2024. Cloud bookings, of course, will result in a small immediate revenue impact but will augment the growth of ARR.
Much of the improvement in Alteryx performance has come from a significant pivot to enterprise sales. Sales process and sales strategy are more important than realized for enterprise software companies, and that has certainly been the case for this one. While hindsight is 20/20, it is apparent that Alteryx needed to refocus its selling motion, and in turn recruit enterprise salespeople in order to best present its technology to users.
Over the years there has been a fair amount of confusion/controversy about just what are the company’s competitive advantages/differentiators. Although the specifics have changed over time, the theme has remained. Alteryx offers what it calls “citizen users” a platform that enables data integration/cleansing coupled with advanced analytics. The platform has always been low code/no code in order to make it useable by individuals without an extensive IT background. In the last several quarters, the company has extended its product footprint to include the ability to use AI technology to improve the accuracy of its analytics offerings. The company acquired Trifacta earlier this year in order to better integrate its capabilities with Snowflake and the other public cloud providers, Amazon (AMZN), Google Cloud (GOOG) (GOOGL) and Microsoft (MSFT). It also acquired Hyper Anna which is part of its initiative to allow its users to add AI capabilities to their analytic projects.
Many analysts and investors are dubious about the company's ability to continue to achieve growth if macro headwinds persist. I don’t have second sight, and obviously in a prolonged and substantial economic downdraft, just about all IT investments outside of cyber-security are likely to be pressured as companies try to mitigate costs. The company no longer has a substantial weighting of smaller users who were responsible for so much churn during the period in which the pandemic impacted demand. And the company has been able to make market share gains of significance, mainly because it has both cost and functional advantages compared to SAS Institute, its most direct competitor. The value of analytics and AI in dealing with substantial uncertainties is, I imagine, obvious. This is a way of optimizing supply chain constraints, making better forecasts for demand and helping a process to optimize inventory. Overall, I believe, analytics is going to be a priority investment for almost all classes of uses, and Alteryx has had and continues to have a leadership position in enabling a broad swathe of users to automate their tasks.
For the period since its IPO in 2020 until recently Snowflake shares have been valued at astronomic levels and there was little controversy about its business prospects. The shares have fallen by more than 60% since they made a high back in November, 2021 and of course there is now controversy regarding its business prospects. Some of that uncertainty was relieved based on the results of this latest quarter.
The basic reason Snowflake is on this list is not specially the quarter it just reported, impressive as it was. But essentially, Snowflake’s position in terms of being the leading cloud data base on the market was reaffirmed. And of greater significance, at least for this list, is the priority that users have given to deploying and for using Snowflake apps. It turns out that use of Snowflake is far less correlated with the macro environment than had been feared by many. Basically, the consumption of Snowflake turns out to be far less discretionary than had been feared or postulated by many analysts and commentators.
For those unfamiliar with the company, it is basically a database for the cloud that offers advantages of performance, and ease of use for complex analytical applications. Simply put, Snowflake is used to provide predictive insights and prescriptive solutions. The core offering of the company is called the Cloud Data Platform. Snowflake is the standard for cloud data warehouses in terms of performance and functionality. Snowflake competes with the major public cloud vendors, Amazon ('AWS'), Microsoft and Google but it has significantly better performance, and it is able to unite data from different clouds and it automates maintenance processes. Snowflake describes the data sharing relationships of its users deploying its technology as stable edges. A significant component of the growth in Snowflake usage relates to these stable edges; 21% of customers now have at least one compared to 15% a year earlier. I wrote about Snowflake’s functionality fairly recently; it hasn’t changed substantially since the time the article was published. Overall, the company has enjoyed very high user satisfaction, and in turn this has translated into very high net retention levels which were again over 170% in the quarter just reported.
Snowflake does not have a SaaS based business model. Its pricing is not seat based but is rather based on the amount of data stored and how much compute time is used. It turns out that in this turbulent environment, usage based pricing is very attractive to customers who want to try out Snowflake but who are not willing to make massive commitments. Last quarter, the company called out that the growth in usage had been less in some verticals on the part of some customers. This brought the shares down after the quarter was announced in May. Prior to the release of earnings this time, some analysts had written about resellers missing targets, or uncovering other negative demand signals. That turned out not to be the case. Usage growth was strong, although it did vary by vertical. Clearly users are prioritizing usage of Snowflake as opposed to some other kinds of applications.
Over the past several months, there has been a substantial issue in inventories, supply chain malfunctions procurement problems and how these have all been factors in constraining the operational performance of many different enterprises. I have speculated in some articles that part of these problems are really data problems with users not effectively deploying solutions that can optimize supply chains and improve inventory management. I think that this realization is part of what has been driving consumption of Snowflake and leading to its continued acquisition of large new users. The company added 12 of the Fortune 2000 as users last quarter. These new users typically ramp their usage over the course of 9-12 months, providing some visibility on the course of the company’s revenue. In fact, some of the upside last quarter was the result of newer users ramping their usage at rates greater than had been heretofore projected.
Obviously Snowflake has competition. Although Snowflake runs on the 3 cloud hyperscalers, all of those businesses have their own data bases designed to compete in the data warehouse market. Of course IBM (IBM), Oracle (ORCL) and SAP (SAP) also have cloud data warehouse offerings. The fact is, however, that when it comes to performance, and to the ability to access data from different clouds, as well as the automated management capabilities, Snowflake is considered by 3rd party reviewers to have multiple advantages.
In terms of functionality, a private company, Databricks, probably is the most significant competitor in the space. There are considerable differences between the technology and the user interface offered by the two companies. Databricks has tended to be favored more by developers and to be less used in production applications.
One of Snowflake’s key development priorities is to enhance the components of its offering that appeal to developers. Much of the company’s development effort is going to be focused on that component of the business opportunity, and the company’s recent acquisition of Streamlit is a major addition to the company’s development offering.
Snowflake’s profitability is improving. No, it is not GAAP profitable. And yes, its SBC expense is significant and above average. It continues to hire at elevated levels and its stock is volatile. These are factors leading to elevated SBC. Its share dilution, which is what I track in my valuation models is noticeable, but not really elevated.
Despite the modest level of non-GAAP operating margin, Snowflake is, however, generating a decent free cash flow margin - it raised that projection to a 17% margin for the current fiscal year, and non-GAAP operating margins are rising, and will likely continue to do so because of the very favorable unit economics of the model.
Currently, after adjusting my model for the quarterly results just reported and for the company’s projections, I have estimated SNOW’s EV/S ratio to be around 19.5X. Of course that is elevated, and above average even if Snowflake’s 3 year CAGR remains above 60%. The company’s sequential revenue guidance of about 8% is quite prudent, and obviously, after the revenue over attainment last quarter, needs to be taken as a floor as much as a projection. There is really no way companies can successfully and consistently forecast usage. Overall, revenues last quarter were a beat of 7% but that compares to a beat of just 2% the prior quarter. The company has enough large new users whose ramps are starting to achieve accelerated growth but it seems reasonable to be conservative in this very nervous environment. The company is forecasting growth for the full year of just shy of 70%, and I chose to use that growth rate in forecasting 4Q forward revenues. In this last quarter, the combination of Snowflake’s growth and its free cash flow generation yields a Rule of 40 metric of 100. Adding profitability and growth together yields a valuation that is actually a bit less than average. Using a weighted average cost of capital from Finbox of 7.8%, the discounted present value of Snowflake shares is more than 60% greater than the current share price.
The analyst at JPMorgan described Snowflake as being in elite territory. I just simply think that in building a portfolio to ride out a recession, buying the best in a space, which Snowflake is, is really the most prudent strategy.
I think that any IT growth portfolio has to include cyber-security representation. It is clearly the least sensitive component in the IT space to trends in economic activity. Cyber-criminals are increasing the threat surface almost daily. The consequences of breaches and hacks for companies can be existential. Compliance alone is driving demand. The cyber security space is almost certainly going to be showing elevated growth, not just this year, or next year but over the next decade or more. I typically suggest to investment advisory clients to keep at least a 20% weighting in the space; sometimes more than that.
There are many investment choices in the cyber-security space. Perhaps if Palo Alto hadn’t just reported results with shares jumping 12%, I might have chosen it for this list. Zscaler (ZS), which is reporting after Labor Day, might also have been a choice, although its value remains elevated, even on a relative basis. There are other potentials in the space as well; at some level, Cloudflare (NET) is a company in this space, although it offers users much more than just cyber-security. Many investors consider it to be a content delivery network, although I would suggest that its most significant competitor is actually ZS. Rapid7 (RPD), which provided disappointing guidance when it reported results due to macro issues in Europe is another possible choice. Even Checkpoint (CHKP) has shown some signs of life lately. While Jamf (JAMF) is not a cyber-security company, about 20% of its current bookings are coming from its set of security offerings that are optimized for Apple’s (AAPL) Mac. Even companies in the Devops space are incorporating security capabilities in their stack.
But at the end of the day, I chose CrowdStrike, the leader in cloud-based end-point cyber-security. The company reported its results on 8/30. My recommendation has nothing to do with any expectation regarding the quarter. I expect that the company will beat on revenues and earnings. While the results of Palo Alto suggest that macro headwinds aren’t a factor in cyber security, and carefully considered, the results of Fortinet (FTNT) were not indicative of demand headwinds, I never really have insight on how a specific company might guide in a specific quarter. In addition, about a month ago, rumors circulated that CrowdStrike would be buying an Israeli cyber-security company for as much as $2 billion. It is certainly possible that such a deal could be announced as part of an earnings release which could have short-term impacts on reported margins, that might, in turn, cause short-term share price perturbations.
I have been a CrowdStrike share holder for years. I sold some once because the position got too large as a proportion of my portfolio. I should have put modern portfolio theory on the shelf, but other than that I have never sold any shares. Overall, given the environment, CRWD shares have performed strongly. They are almost unchanged since the start of the year, and are down by 32% since their high. In this environment for high growth IT names, that represents outstanding performance. While some look backward at historical valuation metrics, the combination of growth and a substantial free cash flow margin - currently estimated to be in the low - mid thirty per cent range-makes the valuation attractive. With a Rule of 40 metric in the high 90’s and consistent performance over many quarters, it isn’t surprising that the shares have an elevated EV/S. They should!
I believe that CrowdStrike is on its way to achieve dominance in the end-point security space. End-point security is not the fastest growing market in cyber-security with a CAGR forecast to be just 8.3% over the next 6 years. CrowdStrike has been gobbling market share at a prodigious rate for years now, and end-point security is a large market. And CrowdStrike has become a multi-product company with a TAM substantially greater than that for just end-point security. One of the major growth drivers for this company has been the growth of its customers deploying multiple modules of its product. At this point, nearly 20% of customers have 7 or more modules, while more than 70% of the company’s users have more than 4. This factor in turn, has resulted in a DBE ratio consistently greater than 120% and with a gross retention rate of 98%+, one of the highest such rates to be seen in the enterprise software space. This is one of the reasons why CRWD has been able to achieve such a strong level of profitability. One relatively new module is that of identity protection which is used in the fight against ransomware. Ransomware is a huge problem and sadly its growth is not slackening because of any recession. While no one really thinks of CrowdStrike as a competitor in identity management, the CEO called out the early success of this module during the latest conference call.
The company has been and is likely to remain exceptionally profitable... not on a GAAP basis, but in terms of free cash flow which ought to be an objective standard. As I mentioned earlier in this article I don’t propose to debate the issue of SBC here - it is unlikely that I will persuade anyone of my point of view, and I have considered the other side of the debate for more than a decade. I account for SBC by trending outstanding shares which avoids the many inconsistencies that can plague Black-Scholes based calculations as to the period value of such compensation.
Over the course of time, CrowdStrike’s percentage growth rate has gradually compressed. On a revenue basis it was 61% last quarter, and it will be less than 60% this quarter. The company’s net new ARR growth has been greater than 60% the last couple of quarters, basically at record levels. The compression is not a function of demand, but rather a function of the scale of the company. The company’s revenues have crossed the $2 billion run rate. At that scale the percentage growth that the company had achieved is past years becomes almost impossible to manage efficiently.
Recently, an author on SA opined that CrowdStrike had a minimal competitive moat, and should best be compared to VMWare’s (VMW) Carbon Black offering. This Reddit thread linked here speaks to the competition, but the reality is that these days CrowdStrike is a comprehensive platform offering and Carbon Black is not.
SentinelOne (S) is often suggested as a competitor of CrowdStrike. I have linked here to a comparison from a 3rd party consultant. The results speak for themselves. SentinelOne needs to spend money it simply doesn’t have to compete with the higher levels of CrowdStrike. Obviously SentinelOne’s growth is impressive-on the other hand, its cash burn is also impressive, at 63% of revenue. SentinelOne has plenty of cash and it isn’t going away, but it really lacks the resources to effectively battle with CrowdStrike in the largest enterprises. SentinelOne is going to report its results the day after CRWD; it will likely continue to see year over year growth in triple digits, but it needs to resolve profitability issues before I can seriously consider it as an investment.
(After completing my draft CrowdStrike reported the results of its fiscal Q2). The results were indeed another beat. So far as it goes, the beat in terms of revenue upside was quite consistent with prior periods at just less than 4%. The company did have record quarters in terms of new users, and for the total growth of net new ARR which was 45% year on year to a new record. The company wound up generating more cash and stronger non-GAAP profitability than it had forecast, and those metrics were noticeably stronger in terms of their upside than in the past. The company raised guidance, although the increase in guidance was pretty muted, as has been usual for this company. I would call out again, as did management, the company's success with its identity module. Whether hyperbole or not is always hard to say, but the CEO talked about identity management eventually becoming as large a revenue driver as end-point security for CrowdStrike.
Of course there was discussion about macro headwinds. That said, after reporting a quarter like this, it can be difficult to be totally fixated on what macro headwinds do exist with regards to cyber-security. When asked why this company has been quite so successful despite the headwinds the basic answer is the same as Palo Alto provided earlier on its conference call. In this environment, there is a tendency toward vendor consolidation, and that is a factor in the results the company is achieving. Like the other recommendations on this list, a key component of the CrowdStrike investment thesis is that of continued market share gains.
I am estimating that the company will achieve about 53.5% revenue growth for the next 4 quarters. With that estimate, the EV/S falls to less than 14X. Free cash flow grew at an extraordinary level this past quarter, rising 84% year on year. It is unlikely that this is a sustainable growth cadence but given typical seasonality, I am now estimating that the full year free cash flow margin will reach 36%. Once again, the rule of 40 metric is closer to 90. Because the company's free cash flow margin is so high, CRWD shares are less highly valued than average for the company's growth cohort.
The company did not wind up announcing any acquisitions this quarter. At this point, gross cash on the balance sheet is above $2.3 billion, and the company is either going to make an acquisition or will need to consider capital allocation to reward shareholders.
The shares are down by a bit more than 6% as I write this on the morning of Wednesday, August 31st. Presumably there has been an element of "buy the rumor, sell the news" in today's trading activity - I view it as an opportunity to add to positions. About the worst thing I can think of to say about CrowdStrike is that its beer is not likely to get much colder, although there is no reason to believe that it can't remain at frosty levels for some time to come.
I think many investors under estimate the need for observability solutions. The IT space is larded with jargon terms, and some of the industry participants seem delighted to keep things arcane for the rest of us. Observability and applications performance management are often conflated and for the purposes of this discussion, I won’t try to differentiate between the two sets of functionality.
The concept of observability has been around for a long time. One of the leaders in the space, Dynatrace (DT), was founded in 2005. At one time the space was kind of an odd ball; many developers didn’t feel the need to test their creations in stressed environments. New Relic (NEWR) was an early entry in terms of offering a modern observability solution. Splunk (SPLK) was one of the pioneers in providing an analysis of logs and traces. After a bit of a rough patch while it migrated its users to the cloud it is back on track, although its most recent earnings report was not considered adequate by some. Of course the space was completely disrupted by the advent of Datadog (DDOG), a cloud first observability solution that has come from nowhere to become the industry leader in a few years. The problem with DDOG as an investment, at least for some, is its valuation. I personally maintain a position in the shares and have done so for years; its valuation is not for everyone. Fortunately for investors there are alternatives in the space with more modest EV/S ratios, along with more modest growth rates. Dynatrace ranks high in terms of a combination of technology and market awareness. Its most recent report sounded a somewhat cautious note with commentary about elongating sales cycles. Another, smaller competitor in the space, Sumo (SUMO), reported reasonable growth last week but also chose to be somewhat cautious in its guidance acknowledging the macro headwinds as a possible element in the company’s growth dynamic. Sumo, with an EV/S of just greater than 2X, will appeal to some investors because of that metric, although the company has not yet generated free cash flow.
My recommendation in observability is somewhat unorthodox. While there are numerous choices that can be made to participate in the space, I believe that the optimum choice is Elastic (ESTC). Elastic made this list because in common with the other companies, it hasn’t experienced any impact from the macro economy on its business. Indeed, when the company reported its results last week, it reported that it was growing orders at a rate greater than 40% rate which represented a reacceleration this past quarter despite macro headwinds. Besides not seeing a slowdown in its orders. It also indicated that the field had driven a significant increase in Elastic Cloud pipeline creation over Q4 and that it was achieving an uptick in new logos last quarter compared to earlier periods. Needless to say, there was some incredulity about these results from the analysts on the conference call, but the CFO even went so far as to say that business in June, July and through the first weeks of August was at or ahead of the company’s plan.
Elastic shares have fallen along with almost all other high growth IT companies. At this point, the shares are down by 30% so far this year, and are down by 55% since their high point in November 2021. They have recovered by 38% since their low point in mid-May.
I believe that Elastic’s approach in which users can use the technology for search, observability and security is a factor in its success in being able to avoid macro headwinds. During recessions in the past there has been a tendency to see some amount of vendor consolidation. Because Elastic can provide users with several functions from a single platform it may be enjoying some measure of success from that trend. A further element of the company’s success is its association with GitLab (GTLB). GitLab is considered by many to be the leading SecDevOps platform and it uses Elastic to run its SaaS search functionality and to manage its data logging infrastructure.
Elastic can be a more difficult company to understand because it uses its search technology to enable a variety of use cases including observability. Elastic entered the market for observability a few years ago using the technology of its high-performance search engine as a tool to monitor logs and traces. Elastic’s technology is quite different than that used by other observability competitors. It is based on Elasticsearch an outgrowth of the Apache Lucerne open source project . Elasticsearch is thought to be the most popular enterprise search engine. One of the founders of Elastic, the company, was Shay Banon who created the precursor to Elasticsearch, the engine. These days, Mr. Bannon is the CTO of Elastic after having been the company’s CEO for a few years.
Currently about 40% of Elastic’s revenues are derived from observability/APM. Another 20% of its revenues are coming from its suite of cyber-security offerings, and the balance of the company’s business comes from applications that have been built on the company’s hyper-fast search engine. While the observability product analyze logs and traces which is the traditional way of evaluating the performance of applications and the resiliency of a network it does so differently than the more traditional technologies. The result, as these linked threads suggest, is a product that scales to an extreme level, and has lower cost of ownership characteristics when compared to competitors.
The company has been transitioning its offerings to the cloud for the past couple of years. It has forecast that the cloud will exceed 50% of revenues a little less than 2 years from now. Cloud revenues have been growing significantly faster than the rest of the business, and have been adding about 200 bps to their share of revenue each quarter for some time now.
The shift to the cloud has caused a modest headwind to gross margins which were 74% last quarter compared to 77.5% in the year earlier period. That said, the major factor in the gross margin decline last quarter was the fall in services gross margins which can be variable without any pattern. Non-GAAP subscription gross margins remained consistent year on year. Overall, the company’s non-GAAP operating loss margin was 1.9% last quarter compared to a profit of 3.7% in the year earlier period. Overall, non-GAAP operating loss margins significantly exceeded the guide and resulted in the company beating its prior non-GAAP EPS forecast considerably.
The company’s forward guidance for revenues was unchanged despite an increase in FX headwinds. Overall, adjusted for those headwinds, the company actually raised its constant currency growth expectations by about 200-300bps, one of the few enterprise software companies to have done so. The company reduced the size of its expected non-GAAP EPS loss from a prior expectation of $.31, to about $.25, reflecting the beat in its fiscal Q1. The company’s guidance philosophy basically calls for modest quarterly beats; some analysts have yet to have incorporated that messaging in their thinking.
In the immediate aftermath of the company’s earnings release, shares fell a bit more than 5% apparently due to some displeasure with the rate of growth the company reported for cloud revenues, or perhaps the size of the beat which was about 1.5% in terms of revenue. Ultimately, the other elements of the earnings release, including the raise of constant currency revenue guidance, and the indication of strong order strength caused the shares to stabilize, and considering what Friday was like for enterprise software companies in terms of market performance, the shares basically recovered their relative loss. Some investors were listening to the strongly positive narrative the company presented.
Will Elastic be able to continue to steer a path that avoids macro headwinds? Elastic has a pricing model that is consumption based, similar in part to that of Snowflake. The evidence thus far is that users are continuing to expand their usage of Elastic’s solutions once installed; the company’s DBE ratio has been stable at 130% for several quarters. New customer acquisition has also continued at consistent levels. It appears that for most customers the need to observe and to search data is mission-critical and this factor is enabling usage growth to remain consistent despite macro headwinds.
These days, the valuation of Elastic shares has become reasonably compressed; I have estimated the forward EV/S ratio, based primarily on the company’s projections, to be less than 6X. Adding in the company’s free cash flow margin, valuations are just a bit below average. Of course, this company’s growth is not expected to compress during the forthcoming quarters which will stand out to an extent from the results of other companies in the IT space. This is another recession resistant company with a strong competitive position in a variety of attractive spaces.
The fall of 2007 was a fraught period for the American economy and for the enterprise software industry. That autumn marked unmistakable signs of the start of the great financial crisis. It also marked the start of an exceptionally difficult period for vendors in the enterprise storage space. It may be hard to believe, but there were those who speculated that NetApp (NTAP) would go under. The results of EMC, the leading storage vendor at that time were also quite dismal. Overall, revenues crashed. 15 years later there are those who believe that the enterprise storage space will crash again.
Many analysts, recollecting the hyper-cyclical demand pattern for enterprise storage back then are concerned about a potential for a reprise. Interestingly, NTAP reported results last week; the company beat prior expectation, reaffirmed guidance and talked about no current pullback in terms of demand. On the other hand Dell (DELL) called out weakness in demand it sees in its Infrastructure business which includes storage although the specifics of its forecast were that its ISG revenues would continue to grow.
While of course spending on infrastructure and storage is based on cyclical factors, the cyclical factors these days are just not the same as they were 15 years ago. In the time preceding the GFC, enterprise storage demand had been driven by exceptional growth in demand by the financial vertical. That demand growth was partly a function of the real estate bubble. Mortgage documents have to be retained, and back then with no cloud, large FI’s had to buy storage to retain those mortgage documents at an exceptionally elevated rate. With the advent of the GFC, FI’s were under existential threat as the viability of the US financial system wavered. So, demand from FI’s essentially evaporated, and many other segments of the economy that depended on credit-think autos as an example-also declined precipitously and stopped buying infrastructure. If the government has to bail out an enterprise, then investing in infrastructure ceases to be an option.
At this point in the cycle, that kind of dire scenario is not playing out. Demand growth for Dell storage is slowing; part of that is the environment and part of that is market share loss. That said, Dell’s 6% storage revenue growth in the quarter it just reported was actually a bright spot in what was overall a disappointing quarterly report. But it seems highly likely, that when Pure reports this week, it will once again be reporting share gains, with Dell being a significant donor.
Pure makes this list because it continues to see robust demand with no signs of cancelled or downsized projects. In addition, its free cash flow margin has been rising consistently, and its many product introductions have provided the company with lots of visibility. Pure has reported a couple of quarters with growth far above trends, partially because it had storage availability and its competitors were suffering supply chain woes.
Will Pure be able to continue to escape the headwinds of cyclical factors? Storage is a key building block for applications that are built on artificial intelligence and machine learning. The more data, the more accurate any kind of AI based prescriptive solution is going to be. And storage is a key component of zero trust security solutions. Of course a deteriorating economy will bring demand headwinds that ultimately will impact Pure. But I believe that the impact on Pure will be less than the other vendors in the space.
Pure shares have fared better than some of the other vendors on this list or compared to most other IT vendors. This means they are only down by a bit less than 10% YTD, although they are down by 19% since the high they reached in April of this year. In fact, Pure shares are barely above where they sold for 4 years ago, during which time the company has doubled its sales, created a backlog of $1 billion, and now gets about 35% of its revenue from subscriptions. Free cash flow has also grown by several times over the intervening years.
Pure is going to report its results this week. It is very unlikely that it will grow anywhere close to the 50% it reported for its first fiscal quarter. Some of that growth was a result of customers who were unable to secure products from Dell, Net App and others. Some customers, in an effort to get ahead of supply chain issues wound up pulling orders ahead. Many of these customers bought rather than opted for a subscription model. The company’s non-GAAP operating margin of 13.8% last quarter was, in part, a function of the soaring revenues the company attained.
Pure has sold some of its arrays to hyper-scalers, and 9 months ago it sold a very significant order to Meta (META). The company has not forecast a reprise of that order, or sales to other hyper-scalers. They are in essence lagniappe when they happen and they can’t be forecast. Of course, given the size of such orders, they have noticeably lower gross margin content. Pure’s product portfolio is uniquely positioned to capture hyper-scaler demand, but if a large order from such a customer were to happen it wouldn’t really change the overall valuation calculus that much because it wouldn’t necessarily be repeatable.
The company’s forecast for the remainder of the fiscal year suggests more muted performance, with growth percentages decreasing throughout the year as the company starts to lap the unprecedented quarters of upside that were, in part, based on its ability to deliver product when its competitors were severely supply constrained. The company does anticipate that it will be able to continue to grow margins. My guess is that the company will exceed its current expectations for both revenues, EPS and free cash flow, but I believe that it will not raise guidance any further. That said, I believe that the current revenue growth consensus for FY’24 of 14% is far too constrained.
While of course Pure sells hardware, its hardware is not quite the commodity that some believe is inevitable in the space. For example, Pure has been able to develop arrays that have remarkably efficient characteristics with regards to form factor, electricity consumption and heat dissipation, all of which figure significantly when calculating total cost of ownership as well as promoting sustainability, a key component in corporate priorities these days.
In June, the company released newest incarnation of FlashBlade, an array optimized for unstructured data. It usually takes a few quarters before new technology such as FlashBlade is deployed at scale, but the market opportunity to poach share from Dell which has lagged in updating the technology it acquired many years ago for unstructured data is quite substantial. The company also offers a DirectFlash array based on QLC technology. Without boring readers, QLC is a big deal when it comes to storage price/performance, and Pure has adopted it faster than its storage rivals. It is cheap enough that it can begin to replaced spinning discs since its TCO profile is so attractive, that the cost of replacing old hardware can be justified because of advantages in all of the other elements that make up cost comparisons.
In comparison with other storage vendors, Pure is currently deployed in only 54% of the Fortune 500. That is both an achievement and an opportunity. Pure’s market share has reached a bit greater than 15% in all-flash arrays, which compares to 14% in the year earlier quarter. Overall, Pure shipped 60% more capacity in the latest quarter, while the overall storage market declined by 6% in terms of shipments - that overall market decline includes spinning discs.
Because Pure is valued as a hardware company, which it is, of course, despite gross margins that have been at or greater than 70% for some time now, its EV/S has been compressed for years and that remains the case. Its current EV/S ratio is around 2.7X, and the combination of an estimated 3 year CAGR of 25% + a free cash flow margin of 17% yields of Rule of 40 metric greater than 40, and a valuation that is more than 35% below average.
It is perilous to recommend just about anything before earnings, but Pure shares are certainly not discounting any kind of fantastic quarter, or strong guidance. Looking out over the next year, I think the enterprise storage space will be able to see modest growth, with all-flash continuing to displace spinning disc. And within all-flash, I see Pure’s share gains remaining a constant, yielding decent margins in the midst of a recession, and an even better outlook when cyclical recovery comes.
The last 9 months or so have seen most growth portfolios crumble, and that includes the portfolio of this writer. While some high growth IT stocks have not had their share price cut in half, more than a few are sporting even greater percentage losses. I have tried to put together a list of 5 recommendations that I believe are well suited for the recession that is either here, or which lies just ahead. Unlike some other lists of recession resistant stocks, my recommendations are not based on companies with the lowest valuations, or which don’t use SBC. I have considered free cash flow generation as a significant, but not a governing component of my evaluation.
What I have considered of primary importance in compiling this list were companies who hadn’t already started to see some level of demand headwinds from the macro economy. I considered companies whose visibility was improving and who were not suffering elongated sales cycles.
I don’t really think any companies are going to be beneficiaries of a recession. Even the analytics companies that made this list, Snowflake and Alteryx, and going to have some contracts downsized or delayed; the difference for them is that the priority for analytics is rising enough to offset those headwinds.
Another factor in my evaluation was market share gains. All of the companies on this list are enjoying market share gains. As the growth in software demand wanes, share gainers are going to be able to keep growing while companies whose market shares are declining are going to experience very visible problems.
And, as best as I could, I tried to pick the right sectors. In an environment in which there is a rising tide and IT budgets are flush, choosing the right sector is not of existential importance. Budgets will exist for all software categories. In a constrained budget environment, the choice of the right sector becomes more important.
Regardless of the amount of care I have tried to take in finding the right names to ride out this recession, two things are true. One is that high growth names are just not going to appreciate in a risk-off environment, basically regardless of their fundamentals. The other comment is this is not an all-inclusive list. I could easily have included names such as Trade Desk (TTD) or Shift 4 (FOUR), Global-E (GLBE) or ZoomInfo (ZI) on my list. But then it would have gotten unwieldy. Of course, there are some readers who doubtless think this article is unwieldy.
I am not going to offer any prognostications with regards to Fed actions, or how long it might take for the economy to reach a bottom. Despite some of what I have read published by SA and elsewhere, I was both shocked and saddened by the Jackson Hole speech. To essentially suggest that incoming data won’t inform Fed decision making if not unprecedented, is certainly unusual. And the Fed has a dual mandate…one of which is to maximize employment consistent with price stability. I personally think that prioritizing one over the other is a serious error.
And I have to wonder to what extent the Fed can act independently of interest rate decisions from the EU, and just how the EU will wind up dealing with its energy cost calamity. The energy cost spike is the equivalent of a massive dose of fiscal restraint, i.e. the equivalent of a massive tax increase, that has typically been included in rate setting decisions.
If a recession is deep and prolonged, as was the last recession engineered by the Fed in the early 1980’s it will impact these 5 companies, along with just about everyone else. But I believe that these 5 companies will still show differentiated performance in that scenario. I fervently hope that the recession that impends is not deep or prolonged and that the individuals making monetary decisions do so with a different construct in mind than that which was seemingly articulated by Jay Powell. But regardless, I feel that trying to find share gainers, trying to find highly profitable companies with excellent business models in the most prioritized spaces is worth the effort in these perilous times.
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Disclosure: I/we have a beneficial long position in the shares of SNOW, CRWD either through stock ownership, options, or other derivatives. 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.