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Investing In The Picks And Shovels Of The Cloud And 5G Digital Economy

Summary

Massive transformation of the Digital space and the entire business commerce model is being disrupted.

Traditional metrics like P/S and PEG have to be tweaked and instead you need to.

Identify best of breed component providers, the cloud providers, the service and monitoring pr.

How to identify the winners with sky high valuations though some investments could sour so pick.

As I look around what’s happening today is a massive transformation of the Digital space and the entire business commerce being disrupted. In the old days we had monolithic software providers wiring the internet 2.0 with a complete stack for instance an Oracle or MS or IBM. Today the play has changed to best of breed where there are the various component providers, the cloud providers, the service and monitoring providers and the software app providers and its leading to disintermediation on a massive scale and leading to better digital experiences and efficiencies. Of course there are still industries like an insurance or a bank where the next set of products are yet to surface but that may be what a Square may eventually do . I am not sure who will be the winners eventually but I can definitely pick up a few players who may be in the reckoning and place my bets on them.

What is different with this breed is that they have to spend a significant amount of capex upfront but the revenue comes over a few years as they install and service the client. So traditional metrics like P/S and PEG have to be tweaked and instead you need to look at Sales growth, SM costs/Revenue and ARR (retention rate from existing clients). Let’s try to understand what is happening in each of these layers and look at mission critical providers that have a strong recurring revenue model (this may not be SAAS but something like an utility which you cannot stop and throw away). For instance bit coin may be an outcome even short lived but the underlying technology that is Block chain may have a strong long lasting impact and service industries that will survive for a long time (10- 40 years is what I my say)

Cloud Component providers – At the top of the list here are companies like ANET, NVDA, PSTG, UBNT, MDB etc. and a host of others who are providing the tools for the cloud to be created and ready for consumption . These underlying components help lay out the Digital cloud and help the service providers operate the cloud. What I would look at here is volumes and scale though a company like NVDA or ANET probably have a moat (which increases the CAP (the competitive advantage period) and ability to keep prices from dropping) . When volumes or margins start dropping one needs to quickly change investments decisions at a macro level.

The Cloud providers - use the above component to create the cloud as an e.g. AWS it’s a dated story and we already know who the winners though it does not mean they will stay at the top forever. You will have new upstarts trying to disrupt the incumbents but we are yet to see that happen.

Service and Tools - If you look at a company like NTNX , NEWR, OKTA, SPLK, they are providing a lot of add on tools to make the cloud experience better and cost effective both for consumers and companies providing those services. Again volumes and margins matter in this space.

Software App providers like PEGA, VEEV, WDAY, ADOBE, SHOP, SQ etc. are the final list that provides the apps that help consumers get and corporates provide , the last mile service or information needed to automate or deliver the services.

How to invest in cloud based businesses.

Since most of these companies are less than 5 years old, many still don’t have earnings and it is difficult to use the traditional metrics like PE . Valuations are mostly really high but we need to focus on a few key things and look at measures that are fundamentally different. I look at these questions -

How mission critical are the product or services offered?

Are they a leader or disrupting the space?

What is the TAM and SAM for the product or services offered? Are they increasing YOY?

What is the revenue growth and are they increasing revenue YOY ?

What is the moat or switching costs? Is there stickiness and companies cannot throw them during a downturn without disruption

How long will Markets/clients exist e.g. utility or small businesses like dental, lawyers, apartments will always need these services?

What is their plan and path to profitability? Are they sticking with the plan .

Are its customers are happy . What is their NPS and ARR

When I look at these stocks I look at sales growth over a period of time as that is the most critical factor and determines whether I should invest Look at the winners in the last decade like AMZN , APPL, ISRG, NFLX, EBAY, CRM and you know revenue growth determines stock price . Profitability is important to know when it will happen but If a stock at 15 X sales grows 50% per year for 3 years , this stock will trade for 3 times sales if price is at the same point 3 years later. Imagine if the company can grow 25% on average for 10 years and what will be the price . It’s obviously very difficult to predict growth accurately beyond a short time horizon but what one can do is 

Look at sales growth guidance over the next 2 -3 years

A large TAM and SAM that will grow significantly

A product that is loved and businesses keep buying more OR more number of businesses are buying (ARR and client growth)

Light asset with High gross margins

Recurring revenue

Operating margins expansion which shows path to profitability and pricing power

If you want to look even more closer see the CAC (client acquisition cost) and the number of years customer will have to stick for the company to make the money back from sales or better still find the TLV (total Lifetime value) and if you get a X times the CAC you are good (x being based on factors like industry, deal size , margins etc)

It’s a big change for the traditional value investor but if you can learn to change your outlook and not focus on valuation and price but instead on the foreseeable 3 -5 years and how realistically the company can make it and the probability of it succeeding . It is hard for us to sell the APPL , ORCL , SWKS and MKL and pick up NEWR and PVTL or MDB. The point to note is if these new age picks grow for 3 -5 years and double each year one would still make more money if they fail to spot the imminent crash of high value stocks because Wall street is so attuned to QoQ numbers . Lets take an example if one of these stocks crashes 40% (OLED recently did but it’s a blip and I added more) and one sells the stock you would still get a good return. Assume $100 becomes 600 USD in year 4 if the P/S is about constant and price crashes to 360 giving you a 35% return .

The basic premises is once a company has spent the costs on infrastructure and building the product or services, and the sales cost to acquire a customer , it's just a matter of expanding the client numbers to start seeing the effect of scale. And if the above comes with little to no debt and high inside ownership jump on that bandwagon without anchoring yourself to the price which will eventually fetch you a good returns .

Disclosure: I am/we are long on some of these stocks.