Long-Term Investing Ideas in a Volatile Market
Simon recently spoke with a $35 billion global asset manager about how they're navigating the market volatility. The key takeaways are to think long term, tune out the noise...
In episode #2 of their new podcast series, Anirban and Simon dig deeper into the enterprise software industry.
February 6, 2024 – By Simon Erickson
Enterprise software is one of the investing world’s most intriguing industries. Mega-platforms like Meta Platforms (Nasdaq: META), SaaS-forces like Salesforce (Nasdaq: CRM), and micro-computer software providers like Microsoft (Nasdaq: MSFT) have been some of the best-performing stocks of the past two decades.
But things move fast in this innovative field.
Enterprises have been laying off employees and have begun to embrace generative AI. A focus on efficiency has them consolidating vendors, especially in fields like cybersecurity.
Will those same stocks continue to outperform? Will the mega-cap software companies of the Magnificent 7 still remain at the top of the market? Or will a new wave of smaller, nimble competitors displace them?
In the second episode of 7investing advisors Anirban Mahanti and Simon Erickson’s latest podcast series, the two discuss the enterprise software industry from an investor’s perspective.
In the first section, Anirban and Simon define enterprise software and describe difference between seat-based and usage-based pricing. Some companies like Zoom Video Communications (Nasdaq: ZM) who charge based on the seat could be more vulnerable to layoffs at their customers, while usage-based companies like Splunk (now acquired by Cisco) use a more efficient model.
The two then describe the “land-and-expand” business model. Companies typically try to get a foot in the door with developers first, then expand by adding more seats/usage or additional products as they organically grow over time. Anirban describes how this worked well for MongoDB‘s (Nasdaq: MDB) general-purpose databases, which won over developers in the enterprise away from Oracle.
Anirban and Simon then dug into the macroeconomic trends that are impacting enterprise software. The software industry as a whole is much more focused on cost savings and operational efficiency, forcing several companies like Twilio to reduce headcount and to restructure their managerial ranks. They also discuss the impact of generative AI — such as ChatGPT or Microsoft CoPilot — in serving the IT needs of larger companies for coding or software development.
The two then set their sights on acquisitions and software valuations. There have been several massive acquisitions in the space in recent years, for example:
There’s also been a rise in private equity deals recently as well. One company — Thoma Bravo — has been especially active during the past three years:
This brings us to the question of whether the big are getting bigger. There are now “super apps” like ServiceNow, Cloudflare, and others that offer dozens of products all within a single company’s umbrella.
In the final section, Anirban and Simon discuss why the largest enterprise software companies still have plenty of room left to grow, while smaller companies like Paycom Software and Confluent might be worth a place on your investing radar.
In their next episode, they’ll dig deeper into the impact that artificial intelligence has had on software — and which companies are best-poised to be AI’s winners…and the losers.
To subscribe for free to our 7investing podcast and have our episodes directly delivered to your Inbox, please join our free email list.
Publicly-traded companies mentioned in this podcast include Cisco, Cloudflare, Confluent, IBM, Microsoft, Paycom Software, Salesforce, ServiceNow, ZoomInfo, and Zoom Video Communications. 7investing’s advisors and/or its guests may have positions in the companies that are mentioned.
This episode is partially sponsored by Public.com, the all-in-one investing platform. Public has now launched Options trading, and they’re doing something no other brokerage has ever done before. Public is sharing 50% of their options trading revenue directly with you… the customer.
For each options transaction, Public Investing shares 50% of their order flow revenue as a rebate to help reduce your trading costs. This rebate will be displayed as a negative number in the “Additional Fees” column of your Trade Confirmation Statement and will be immediately reflected in the total dollars paid or received for the transaction. Order flow rebates are only issued for options trades and not for transactions involving other assets, including equities. For more information, refer to the Fee Schedule.
A disclaimer that options are not suitable for all investors and carry significant risk. Certain complex options strategies carry additional risk. Options can be risky and are not suitable for all investors. See the Characteristics and Risks of Standardized Options to learn more. All investing involves the risk of loss, including loss of principal. Brokerage services for US-listed, registered securities, options and bonds in a self-directed account are offered by Open to the Public Investing, Inc., member FINRA & SIPC. See public.com/#disclosures-main for more information.
Anirban Mahanti, Simon Erickson
Simon Erickson 00:06
Okay, hello, everyone, and welcome to our 7investing podcast, where it’s our mission to empower you to invest in your future. You can learn more about our long term investing approach and see all of our stock recommendations and get started for just $1 at 7investing.com/subscribe. My name is Simon Erickson, and I’m joined by my colleague, 7investing lead advisor Anirban Mahanti. We’re going to be talking about in this podcast, enterprise software. We have different industries that we look at when making stock recommendations. And software is one that Anirban and I have looked at quite a bit and made several recommendations in. But it’s not an industry that sits still, it’s actually probably one of the most innovative and fast moving industries that’s out there. And so we’re going to take a little bit of a nuanced approach of some of the things that are happening in enterprise software today. Anirban, anything you’d like to do to kick us off, before we jump into the weeds of enterprise software?
Anirban Mahanti 00:58
Well, maybe we can start by defining what we mean by enterprise software, right. And typically, in the word enterprise, refers to large customers with large number or rather clients with large number of employees. And so your customer that’s going to buy many seats, or large business. But typically, if you think about most of the companies out there today, doing enterprise software, they just don’t serve only the large customers, right? So the granddaddy of enterprise software is, you could say Salesforce is one of them. But Salesforce does serve small businesses with 50 employees or so. It was a medium businesses, maybe with those know, few 100 employees or so right. And of course, some are big, very large businesses as large as Alphabet or Apple. I don’t know whether they’re customers or not, but I’m guessing they’re at that size of customers. So I think enterprise as if a business is a software as a service type of business has a bend towards the large customers classify them as enterprise. And you’d see the way easiest way to see this is most large enterprise software companies, even small ones would disclose the annual contract value for large customers and different people define it in in different ways. But I think the most common standard is to assume $100,000 of annual contract value for the customer or more classifies as large. And you’d be interested in seeing what fraction of those customers account for the total of the revenue. So I’ll kick it out there and pass it off to you to talk about some of the other stuff.
Simon Erickson 02:49
Yeah. I’m glad you mentioned Salesforce. And it might depend on what decade you’re in, as to who you would consider the quintessential enterprise software company. If you go back long enough, you can remember Oracle would send out teams of salespeople, you’ve got the company card, and the budget to go out and close these massive deals for custom software you might build for somebody. Then you’ve got Microsoft, another “small company” that most of us have probably heard about. They’re building these platforms like Office 365, and getting it into everybody in the organization’s hands. Same thing with Salesforce. You’re selling an enterprise level. But it’s interesting, though, Anirban, because cloud computing has kind of brought a new model, a new format. For software, we’re calling software as a service, where it’s entirely hosted in the cloud. It’s got very, very low costs. You can actually convince organizations — and not even convince or have to sell to them anymore. A lot of times organizations are finding software over the internet, and then bringing it back into their group, and then scaling it up. And so maybe that’s a great segue into the next topic in this conversation, is the seat based pricing versus usage based pricing. Because seat based, you mentioned that earlier in this conversation, too, that’s kind of like it doesn’t matter how much you’re using the software, you just pay a certain amount every month or every year predefined. We’re recording this on Zoom. Right now we have an enterprise license with Zoom that says each member has to pay this much money per month. Doesn’t matter if we use it only 10 minutes or every single day, we’re still gonna be paying the same amount. But we’ve also seen kind of a lot of companies like Splunk, which just got acquired by Cisco, being one of the early ones that said, you know, we can actually do indexing. Splunk did indexing, but it was something that you could actually track the usage. And it didn’t matter if you had 1000 People you had 10 people using the same amount of capacity of the enterprise software. It’s been interesting to see this usage based software as a service model come into prominence here.
Anirban Mahanti 04:43
That’s right. And I think I think this goes hand in hand in hand with also the photo sales motion that these companies had rights. And in the good old day, you mentioned Oracle right. You know, you’d sign these contracts big contracts with and this would be actually like in a lot of this will be CapEx for You’d be installing machines in a data center either on prem or private data center, then installing the software, fixing everything up and then getting it all running. The move to SAS basically said, Well, you can change the so the capex, the sort of optics, because you can now decide what’s going to run in the cloud, I’m going to spend a little bit every year for some number of years, what the companies did not change during that process was they still wanted this thing, this idea that, you know, I want to get a contract of a certain amount. And then you can use what’s known as like, basically committed contracts, right? You commit contracts for, say, three years, I want to spend this much over three years with you, that’s sort of a hangover of those good old style, software days, right that kind over to this enterprise SaaS style software. And then sort of we have seen over time that, you know, even companies that as you said, usage, right, so that’s a new model, where you said, instead of saying, how many seats I’ve got, I want to just track usage. And that works really well. If you, for example, your database company, you know, you you’ve been built an underlying database, what you really want to charge people for, and that’s how I think the underlying company is getting its cost base of dry, like, it’s also hosting it somewhere, there are a number of reads and writes happening, really, you should be charging based on that. So if your application is really successful, or important, you’d get more money from, you know, and you’d also spend more money, right, and you’re scaling with that. But even those companies still kept with this model of, you know, we want to get certain number of contracts signed and have a commitment, right. But it becomes really hard to spend the commitment and have a cadence for that commitment. If you are a usage based model, it works. You know, what a seed based model, you can almost guess, guess what the kid says, you know, got five seats, or 100 seats or 5000 seats, your seats are going to probably expand at a certain rate, because you know, your company is growing at a certain grade. And therefore, you can predict quite easily, it’s hard to actually predict what your contract values are going to be over time. If your usage metrics, if you have a wildly successful application, your usage should scale and your spend with skill. Right? So that’s another nuance to think about.
Simon Erickson 07:10
Yeah, absolutely. Let’s talk a little bit about what’s going on in the economy right now, the macro and how this is impacting sales software. Like I said, land and expand model, right, you try to get a foot in the door with the customer. And then hopefully, they’re going to add more seats to what you’re offering to them. Maybe you’re offering a tangential software that’s similar, but it’s kind of a different than what they’re already buying, it’s kind of the idea is the same of a lot of new software companies land once and then expand the usage over time. So your margins can improve, you have to spend as much on sales. But we’ve seen some challenging trends here recently, right? Like for one, tech industry as a whole has been laying off a lot of people, hundreds of 1000s of people over the last two years. And you know, this has been less IT people to use the products that you might want to be selling to. And then also generative AI, you know, a lot of the coding that used to be done by people that had to go and manually do this is now you know, you can ask GPT or you know, whoever else that is generative AI, how do I code this so that it’s going to work correctly? Anirban, I would really like to hear your perspective on this. I know you have a PhD in computer science, you’re kind of like the innovator that’s right at the forefront of what’s going on in AI. How is this changing the whole industry out there?
Anirban Mahanti 08:17
Yeah, so I think you hit you know, so the layoffs are happening. And so the way I sort of read the layoffs is, so if you read the commentary from some of the largest companies, for example, like what alphabet is saying, it’s been positioned largely as a cost engineering effort, or, you know, reengineer, the cost base. And I think it makes sense, because a couple of things here, as he talked about the macro, you know, we we were in sort of a zero interest rate, a very low interest rate environment for a very long time. And then we sort of went to a very high interest rate environment, and we probably going to set up somewhere between that zero and high interest rate environment. And I think that the zero interest rate environment basically meant you can go for costs, you can go for growth at any cost, and people were just hiring left, right and center. And large companies became even very bloated, they had a lot of layers of middle management come into play. So what this cost engineering base is, it’s not about getting rid of getting rid of people who are actually doing the engineering actually, those people are still getting hired. It’s just getting rid of a lot of middle management. And what happens is, if you have got to middle management is a senior people. Well, you know, they probably don’t want to go back to doing 100% full time coding. So you know, basically getting rid of those people, and they may be finding other places to work or setting up their own companies and things like that. And, and then I guess the other thing to realize here is, you know, I personally think that what’s happening with Gen AI is, generally is is finding its footing in enterprise like people are using it right so Salesforce has products used based on GenAI. ServiceNow has products based on GenAI You know, you have co pilots that are based on Gen AI, I think these are productivity tools are adding productivity for existing employees. I personally don’t think that any of these layoffs are actually connected to Gen AI. Most of the layoffs are about reengineering the cost base to create operating leverage in companies like, you know, how does a company like Salesforce, for example, go from zero operating leverage to having a huge amount of operating leverage is because they’re not growing that cost basis, they’re actually reengineering the cost base. That’s what alphabet is working on as well. And you can sort of see that in, in the stock based comp, right? Like, I mean, alphabet, for example, is doing a lot of buybacks. But a third of those buybacks are basically going exactly third, that’s crazy. They turn to that buyback is actually just offsetting as we see. Right. But as you compare that with a company like say, Apple, it’s only 1/10 of the SBC of that buyback is going towards SBC. Right.
Simon Erickson 11:51
Yeah, I would agree with all of the above. And everybody, you know, if you go back just a couple of years 2021 Nobody was even looking at margins, you know, and 00 interest rate environment, like you said, it’s like, how fast is a top line growing? And you’re getting positive cash flow? The rest? Is this fine? No, no one’s no one’s caring about the gap numbers. Everyone just say anybody’s the adjusted, you know, numbers, you can pay as much stock as you want to. And I think that we have seen kind of a retrenchment in the whole industry. You mentioned Google, but certainly other companies, too. I’ve kind of cut back on that upper management level. Another example is Twilio, Twilio enterprise software, we get outside enterprise software, just look at software, I mean, snap, Snapchat has a lot of its kind of growth projects. Even Mehta, who’s not paying a dividend had really good results, but they have really become much more conscious about the bottom line, rather than just the top line growth. And I think that is a function of the sales cycle. I think it is a function of the macro environment that we’re in.
Anirban Mahanti 12:43
Yeah, you could do to, you know, one of the interesting things here with enterprise software is, you know, like, a lot of the users for enterprise software is also the kick. And as the cut back on the number of people that they’ve got, it does affect the seed sales, right? So there’s, there’s like this, there is this cycle. And that’s true as you enter, I guess, this feeling of being cost conscious, as it percolates through the entire industry. I mean, there is that cycle, but you know, everything is going to grow a little bit slower pace, because people just are not going to be adding as many people as they were adding in the past. And that does impact seed based models more than I think usage based models. Because if you’ve got a really great product for which the usage is just you notice example database, if you’re switching from, say, Oracle databases to or building your applications into a MongoDB, then if your application is really important, while MongoDB would see its share of usage decline. Yeah.
Simon Erickson 13:38
And everybody have one final question on this one before we move on to the next the next segment, but you know, is there a certain level of scale, that once a company gets to, maybe it’s not as vulnerable to a longer sales cycle, right, like, even though we are number of seats or number of employees that it has read, sales, Salesforce, Microsoft, you know, both of them have done layoffs in the last couple of years. But they’ve also got stock prices that have done incredibly, incredibly well, maybe because they’ve got a stronger foundation and cash on the books to ride out the cycle like this. Why does it seem like the big keep doing better and getting bigger and having trilling dollar market caps? And then we got a lot of a lot of other ones that really are struggling right now.
Anirban Mahanti 14:16
Yeah, so that’s a great point. I know, like you come back to something that you you talk about a lot, right? is like, you know, it’s one thing to be at $100 million run rate, it’s another thing to be at a half a billion dollar run. It’s another thing to be a billion dollar run rate. And it’s a completely different ballgame to be at a $10 billion dump run rate. And from there to be at 2050. It’s each like each doubling is it’s just incredibly hard, right? You know, 500 million to a billion is one game, but a billion to 2 billion is another game and 2 billion to four and so on. So I think that scale and ultimately, there’s a lot of scaling these things, right? incremental cost for that software is basically zero, right? So if you’re, you know, and once you’ve got the customer, really your Salesforce can go and get new customers As the existing customer is just going to continue using it. So I think that and then you generate plenty of cash on the book, which allows you to, you know, spend, you know, on sales and marketing, and then just word of mouth, you become the industry standard. So think scale matters, with reference to companies like Salesforce, Salesforce, super interesting, because if you look at what has happened to this company in last 667 quarters, they’ve just basically this company has just spent all this cash and buying companies and it’s just turned, it’s just got to the discipline where this discipline has made tremendous cash flows, right? Like it generated 9 billion, I think it’s trailing free cash flow number, that’s just insane. And the reason the stock prices are doing well is that when when the market sees, oh, you’re generating so much free cash flow, and your stock comes stock with comps are actually not impacting that much to the dilution, when you add the buybacks, these stocks actually might, some of them might be cheap. But the valuation is, you know, it’s the market is just rewarding. The fact that oh, okay, you know, if you continue on this path, even if you grow the scene, or 10%, and keep buying back your stock, it’s just, it’s just that formula that over the long term should just do well, right. And the markets are still pretty big for some of these companies. So yeah, so I think that’s the thing that getting to scale is very hard. And a lot of these companies that have been operating with operating losses, but still seeing leverages, as you said, okay, in the past is no longer okay to just to keep growing and diminished your operating leverage, what you really want is to keep growing and expand operating leverage, and the operating leverage needs to be positive, right? So you need to get a scale, I think billion dollars, in my mind is a really good cutoff point, like, you know, if you get $2 billion, and can still say grow at 20%. That’s really like, I mean, that means that you’re getting some good traction, that’s just my mental model. You know, you can always give or take a bit.
Simon Erickson 16:54
Well, once you get to scale, you also certainly start attracting some suitors, which is why we’re gonna talk in this next section about acquisitions and valuations on here. But I’ve got some of the largest acquisitions numbers right in front of me here of what’s been going on in recent years. Go back in time, five years 2018, Microsoft, six years, almost 2424. So okay, six years ago, yes, Microsoft buys get GitHub for $7.5 billion, right when they get to open source. One year later, IBM follows suit also wants to get into the open source arena, acquires Red Hat for $34 billion, the year after that 2020, Salesforce and acquires slack for $28 billion. And then just a couple of years later, we saw last year, in 2023, Cisco acquired Splunk for $28 billion dollars. And these are huge numbers. Why are companies spending so much money on these mega acquisitions rather than trying to build these platforms themselves?
Anirban Mahanti 17:50
Well, okay, so for some of these, like, some of these sufferers, services and applications, they have significant scale, right? So it’s the it’s this land and expand thing, right? If you have multiple products, and your more things to sell your more ways. So you an example might be Salesforce acquires slack. And, you know, Slack has some customers who example might not have, say, MailChimp, but they might be actually worthy customers to be buying MailChimp or Sales Cloud or service cloud and things like that. Or it’s the reverse way, right? You know, they might be having customers who have got Sales Cloud and service cloud, but don’t have slack, but probably could use Slack. Something is that it? I mean, if this on this list, you know, it’s just laughing along. It just seems like GitHub was probably the best buy of the lottery saw these look very expensive. And like, for example, if Salesforce waited, you know, for the peak to the bubble to burst, maybe slack would have been acquired for like 5 billion? Who knows? You know? Yeah, some of these look really expensive. But like, I have, I don’t think many of these are going to get written down, written down from it, you know, from an accounting perspective, because they’d still be making pretty good sales, and they’d still be growing pretty quickly. Right? Which then, you know, you consider that, you know, the valuation was, okay, that was not great, you know, except for maybe GitHub, and GitHub is a smart acquisition from Microsoft, because has other value add, right? Because the GitHub brings you a code database, which you can then use for something like a co pilot to help you code better, right? And, you know, so there is other benefits. There are other benefits to having these things. It’s, you know, like, for example, data benefits, right? The same sort of thing goes for Salesforce, like Slack gives you immense amount of data on which you can build AI applications, right, brings in another feed of data. So you know, I don’t know much about this Red Hat IBM acquisition that I can’t really make a good case for what for some of the other ones is there’s not just an expansion of clients or customers it’s there’s data advantages, network effects and data network effects. For example, come into play.
Simon Erickson 20:02
Yeah, it’s interesting, because there’s a lot of brunt of jokes that goes on around software acquisitions, right? Like we talked about this a little bit the last podcast we filmed of HP spin. And you know, what was it $11 billion on autonomy writes down 10 billion of it within the next year, it just seems like there’s a bigger sucker, kind of at play in this industry of like, who gets too excited about the next sexy, shiny object that they pay too much for, and then they have to write down. But counteracting that, though, you’ve got some companies that do it really, really well. Right to avoid saying Salesforce 10, too many more times in this podcast, I mean, you’ve got Constellation Software, they go out there, they serial acquirer, they’ve done very, very well for their shareholders with this with the same formula. You’ve got others like Roper technology, that’s kind of you know, you keep building in this base, a very, very hard high return on invested capital companies that kind of build from the ground up. And I would say that, you know, if you’ve got the formula, right, and you’ve been methodical, it’s almost a cultural thing of, you know, are you good at this, or you couldn’t make any acquisitions and bringing into this larger platform, which you hope still fulfills that same land and expand, right, you want to bring somebody in? That is that is that you’d be interested in selling your existing customer base to it’s not something you’re already doing. But you also don’t want to overpay for it, too? I guess maybe as somebody who sizes up these companies and all other things, consider are you excited about, you know, Salesforce going out there and spending $28 billion for for Slack? And are you excited about Cisco going out there and spending $28 billion for Splunk? Is this awesome? When you make these big acquisitions? Or would you rather see them kind of try to build this from the ground up?
Anirban Mahanti 21:37
I know, so I’m not excited at all about these large acquisitions. They don’t, you know, they don’t make me get nice fluffy feelings and things like that. Actually, you know, I’m much rather than build this ground up, right. I’m a big fan of talking acquisition city, a company that we’ve not talked about, for example, ServiceNow they don’t make huge acquisitions. Right, then they, you know, buy tech Dubai talent, right. So most of the growth effectively is organic. I’m much bigger fan, Apple, you know, I’m a much bigger fan of buying small things. And then building based on that, then you can just create an immense amount of value that way. The Salesforce I would say has been a good acquire this this one though, this is a head scratcher. But slack one they’ve done, you know, like mule soft was a great acquisition. Tableau was a great acquisition. But this this one slack, especially about their pay just looks like a head scratcher. But no, I’m a big fan of kind of that at all. I think it’s much better to acquire small things, right, much lower chances of going along.
Simon Erickson 22:44
And let’s chat about that as well, too. Because if you’re not a company that just got $30 billion lying around in your balance sheet, there was another another exit strategy for a lot of these companies, which is private equity. And private equity, of course, certainly is is much more scrutinizing about valuations and how much they’re going to pay because of the model that they have. But we have seen some companies that do this quite consistently, right? One example is Thoma Bravo. spelled like Thomas. It looks like it’s Thomas. Minus the S. Yes. But Thoma Bravo is, is kind of one of those quintessential private equity companies likes to go out there and make software acquisitions, some large, some small, just to kind of take a look at some of them that they’ve made October 2021. They buy Medallia for $6.4 billion, this enterprise software company, bought Anaplan for $10 billion in 2022. Then bought Coupa Software for 6 billion in December 2022 as well. So okay, if you’re, maybe let’s talk about valuation now Anirban. Because it seemed like you know, a lot of those companies I mentioned earlier, the big the big, big acquisitions were taking place 2020 2021, zero interest rate environment, money is printable, fine, go out and do a $30 billion acquisition. But maybe when interest rates went up, and it got a little bit harder to sell out there. It seems like some of these software companies that had founders at the helm that were doing very well, we’re growing like gangbusters, they slow down a little bit. And then the temptation is there to take the money and sell it to private equity. What do you think about this? Is this something that’s always on the table? What’s your thoughts about valuations and buyouts with private equity firms?
Anirban Mahanti 24:14
Yeah, so let me take the buyout stuff first, because I think it’s super interesting stuff you mentioned. And I think there’s, there’s an interesting angle there, which is the regulatory angle. I think like more buyouts are not going to be possible via private equity route, then by say, a large tech company acquiring the right, I think, especially because if you need regulatory clearance out of Europe, then they have sort of, you know, the European regulatory landscape, basically has made certain companies you know, persona non grata. And what is funny about that is and I think Microsoft is no longer person or non grata, so they can get away with an Activision Blizzard type of acquisition, but an Amazon cardigan by an iRobot All right, which I think is pretty funny. So I think those bigger companies, some of them, Apple, Google, Amazon, I think and Meta, these guys are not going to be restricted to buying small ones, Microsoft might still, for some time, get away with buying some big ones. But which basically means the field for certain sized companies are only going to be now open for either sort of lower down. So the sales forces and Oracle’s and IBM, so the word or to do private equity, which means for some large companies, the multiples that you might see for acquisitions might actually not be that large, because they’re less fewer competitors. In my mind. That’s what people are paying lower multiples. That’s kind of obvious that the multiples have sort of started expanding a little bit because people are thinking interest rates, as we talked about, you know, a week or two back interest rates are on a path to going down, although much rate cut Powell has said is unlikely to happen. Maybe it’s gonna be me. And there’s only going to be maybe they’re thinking about three rate cuts this year, maybe get four but you’re not gonna get six. That and I’m specifically looking at the US Fed rate cuts. So I think valuations are coming back up, but they’re no longer they’re nowhere near the peak for the pandemic. So that’s the other thing to keep in mind. And some companies which have seen growth slowdown, Twilio is a great example, where sort of post pandemic growth has slowed down valuation has sort of contracted SBCs leading into returns. Those companies have seen valuations compress like, you know, so Twilio, Okta a great example, where the growth has slowed down and the valuations are totally compressed. So getting but no suitors have arrived yet, for those companies. So I think I think we might see a few things happen, we might see that some companies that are not getting acquired, they will be looking to cut more workforce and probably jettison non core stuff to raise cash and become more lean and focused. I think that’s the other thing that we’re likely to see happen. But yeah, I would think that private equity interest would be pretty high right now.
Simon Erickson 27:11
Yeah, I’d agree. One other context I’d like to add to that, too, is that if you’re looking, if you’re a private equity investor, you’re looking at different things. And a lot of individual investors are for the software companies. Right, right. A couple of years ago, everyone was just talking about price to sales, we were totally fine with paying 45 times sales for Zoom video communications. I remember this, I remember the market just being so excited about the growth rate of that company. Of course, that didn’t work out so well. But if you are a private equity investor, or even an investor, you know, in this market that we’re in right now, you’re much more interested in things like EBIT/EBITDA: enterprise value divided by EBIT, maybe EV to gross profit, it’s not just the top line sales gross anymore, it’s actually kind of like, how actually profitable is this business? And I know that’s something you’ve looked at a lot in Nirvana, you know, the stuff that you put up a seven investing, it’s not just price to sales, and we just write it off. Like, it’s okay, you’re actually being much more methodical and scrutinizing how profitable these businesses actually are.
Anirban Mahanti 28:04
Like, I mean, one thing, you know, it’s good to own up to, is it’s very difficult, you know, like, when things you know, when the interest rate environment is zero, it’s very easy to justify 40 tax multiple for things because you’d like to just extend things out, and it’s the you know, and that, and zero interest rate environment is not necessarily just, you know, lower discount rate and things like that, it also because the money is so free. Money is coming into these companies, and these companies are actually growing faster at that point, right. So it’s like, it’s a, it’s a double sugar hit. Right, you get that high growth rate, and you basically discount less. And so, you know, it’s like, I mean, you know, I’ve held through Twilio being at 60 times the sales, and I justified somehow, in my own mind, that, Oh, it’s okay. And, you know, this company still at this rate growing at 40%, or 50%, at that time, which is, which is, you know, again, but we’re sort of at the opposite end of the spectrum right now. But, I mean, we are, at least I personally look at, you know, I prefer looking at a DCF, my reverse DCF style model, as we’ve talked about before, which gives you a much better insight into sort of how the free cash flows are going and what sort of is being embedded into the price. And does it make sense or not? You know, we look at other things, we look at how big the market is, and how the company is going around tackling that market. Right. And, you know, different companies have different opportunities there. Yeah, so try to be more methodological, but you know, it’s not, you know, unfortunately, not infallible. And, you know, I said, I’ve held through, you know, Twilio being five 1% gain in my own personal portfolio to be a loss, right, and these things happen, and it’s just part and parcel of being an investor.
Simon Erickson 29:52
Unfortunately, it’s always good to be humble, but Anirban you’ve also made some excellent picks in the software space. We’re going to talk about some of those in just a minute. We’re gonna talk about the Super apps. And if the big get bigger, and I’d like to touch base on that reverse DCF in just a moment. Right before we get to that though, we do have a sponsor read for our podcast today. Hello 7investing listeners, you might know public.com. It is the all in one investing platform, now they’ve launched options trading. And with it, they’re doing something that no other brokerage has done before publicly sharing 50% of their options trading revenue directly with you, the customer. So whenever you trade options on public, you get something back. And of course, there’s no commission or per contract fees either. By sharing 50% of their options revenue, you’ll know exactly how much you make from your options trades, because public is literally giving you half of it. In other words, there’s more transparency to options with no fees, and you get something back on every single trade. So going to public.com and activate options trading by March 31. To lock in your lifetime rebate. One more disclosure, this was paid for by public investing, and you must activate your options account by March 31. For the revenue share to apply. Options are not suitable for all investors and they carry significant risks full of disclosures are in our podcast descriptions. And this is for us members only. Anirban, before we jump in a little bit more, I wanted to double click on something you said which was inverse DCF or reverse DCF. Maybe everyone’s not familiar with what a discounted cash flow is, or what an inverse discounted cash flow model is. Just find out a little bit about why you do that.
Anirban Mahanti 31:33
So like it just kind of follows the standard traditional way of looking at invest like valuations, right, so a company is basically worth the discounted sum of the free cash flows you think it will make in the future. Right. And the future, by definition is unpredictable. But we can, you know, we can look at what’s happened in the past. And you can sort of think how the margins are going to move. And we can make a prediction about how the future is going to unfold. And we can come up with some ideas about what the free cash flow is now. And once you know what the free cash flow is, you can discount it by a discount rate, which would typically take into account like the risk of investing in the in investing in the public market. So it’s not risk free, you’d consider the base, US Fed interest rate, you might consider the cost of capital in this mix, you know, you might have different ways of doing it. But you know, we discounted back. So, and people typically would model explicitly maybe five or 10 years and then have a nominal growth rate attached for year 11 onwards, right. So it assumes something like you know that from 11 onwards, the company is going to be basically forever growing at say 3% is free cash flow, basically some sort of GDP level growth rate, right, or level more than that, or inflation plus, let’s call it, the inflation target is 2%. You know, you could assume 3% is a pretty good number to think for the growth rate. So that’s what a typical model will do. Now, one of the things, this is a great way of doing it, and a great way of September, you recently shared a model for a company called Wolf, that where you actually built it out. And now people don’t understand this, I want to point this out is you want somebody looking at it from the outside might get caught up with all the details that are there and, and the precision that is there. But the whole point of doing this model for somebody like Simon would be to understand the various levers that the company has, and you know what you, if you change this, what happens if the company changes that what happens, it’s a way to understand the business, right? And the valuation numbers should get, I think a byproduct of that, but it gives you, you know, it’s a DCF done in detail gives you an understanding of the mechanics of the company. And it’s a great way to actually understand the business. So I think I want to point that out. And then you know, don’t get caught up on the details, because my favorite quote for this is all models are wrong. So someone’s model is wrong, because it’s the model. But what it’s going to tell you is you learn something about that business, you’re really interested in that business, and you’ll get a lot of handles and you’ll understand what are the handles of the business. And then you can Track business progress against those handles over time. And so that’s the model I do that sometimes, but it’s incredibly time consuming exercise, right? And it’s really useful if you want to understand the business for the first time. That’s a really useful exercise to do or the business is really early stage and you want to sort of understand how it might shape up over time what are the you know, in a bull cases and the bear cases for it? I think it’s really incredibly useful. I remember somebody’s share a discount of free cash flow and going on a tangent for a company called afterpay which is which was the first inventors of buy now pay later and I looked at it and said whoa, this looks crazy. But you know what? The given write about it because it and play out according to their bookcase. And this, you know, the company got acquired by block or square for some gazillion dollars, which, at that time, you know, the way they did it, it was probably a sub $1 billion company for a while for like 20 or 30 billion or something like that. So, you know, it was a huge multibagger. So that gives you that idea of what can happen. But upside, the downside. Now, my own preferred model is to do so the opposite of that, which is reverse DCF, where, and this really works for companies, which have some free cash flow right now. So I start with the free cash flow now. And then I explicitly try to find out what is the implied growth rate for the next decade, that’s my model of doing the inversion, you could do it in different ways. But this is the simplest way of doing it. And then just basically assume a terminal growth rate going forward after year 10, year 11 onwards. So 3% terminal growth rate for the free cash flow, start with the years zero, free cash flow, and then basically assume a discount rate that I think is appropriate, and then basically just solve for the growth rate that the market is expecting for the free cash flow. Right. And then they basically look at that, you know, which gives me the current share price. The current, it says, basically says the current share price is fair, if, after year 10, the business is growing at a terminal rate. And this is the discount rate. This is the implied growth rate for free cash flow. And then I just basically look at that. And that gives me a lot of ideas, because it tells me whether I think for example, at a very high level, I could make the judgment as to whether or not I think the company can best do better than that, or would not be able to deliver that. It’s an example. Right. The other thing that you can do is for big, big Frick, free cash flow generators, such as Salesforce and say, Apple, what often people get caught up is, you know, you think of the top line and it’s all Apple is only growing at 2% or 3%. Right? But you’re ignoring what’s happening in the bottom line. And what’s happening below that top line number. So you can see that, you know, margins are expanding, and free cash flow is still growing. And then if you even had a modest growth through the free cash flow, you realize, oh, but this company can go from like 100 and $10 billion of free cash flow allow to maybe 220 230 billion free cash flow with a very modest growth assumptions over 10 years. But then you just add up all the free cash flow number and you say, Well, what is free cash flow is after the business has invested everything it needs for its business, right? What is it going to do with all that nobody’s gonna buy back stock. So if you, you know, if it’s gonna have generates a trillion plus dollars of free cash flow, it would buy back potentially a third or 25% of the company, while you can account for that too, in the stock price. And so a lot of us will lose, those are the insights and or you can make even insights such as my year 10, free cash flow needs to be this much for it for the current valuation to be justified. Do I think that margin is ever possible? Or if I zoom, very healthy margins? What does the what does the revenue look like? And sometimes you look at that for software companies? Oh, there’s no way I think this company can get to that revenue. It’s just, you know, or you could say, oh, that’s a revenue very few companies have actually achieved, right, so $10 billion of software revenue, for example, just to give it put a number. It’s very hard. Not many companies have actually gotten to $10 billion, you know, their hand counted. Number of companies that have got $10 billion plus of software revenue, right. So if your model requires you, your company to be actually delivering more than $10 billion of revenue, even in a decade, from now account for inflation, everything, your company better be very special. That’s a special club.
Simon Erickson 38:49
It’s fancy, I really liked it. I think that one, it keeps you out of trouble, right? It keeps you out of just paying a price to sales, you’re not doing enough diligent research, actually looking at, you know, the cash flows of the business, not just the top line growth might steer you away from some of the landmines out there. And then also, like you said, all models are wrong, but you can also be directionally correct. And just see something that’s out of sync with the market, the market is not, don’t take it, accept it, that the market is always right, the market is inefficient. A lot of things, if you find something that’s out of sync based on what you expect the performance to be is a great, great tool to use. Moving on. And a reminder, before we get into this, that all of the companies we are talking about here are not necessarily recommendations of ours, or we might have positions in them personally. But if you do want to see all of our actual recommendations, the official recs that is the stock picks of 7investing, please sign up at 7investing.com/subscribe and then check out our entire scorecard 7investing.com/recommendations. To get started for just one single dollar and see all of them including all of the Anirban software picks. But that said disclaimer out of the way to about let’s talk about a couple of companies. You mentioned so much about free cash flow. I know that a lot of companies you like or those ones that have already gotten to scale, right billion dollar run rate or more, or whatever it might be already throwing out free cash flow. And we’re kind of calling these super apps now, right? It’s the companies that have gotten big enough, they’ve maybe made acquisitions of other companies, or they’re international. But we’re kind of it got these, these platforms that have just gotten big. And they’re so embedded with the customers that they have. One that you’ve mentioned a lot of times, so they actually let’s do a two that you mentioned a lot of times as ServiceNow. And then CloudFlare, what is so appealing about these companies, I know that you talk about them all the time on seven investing, but what draws you to these companies are already so large?
Anirban Mahanti 40:35
Yeah, so, so CloudFlare, not that large compared to ServiceNow. ServiceNow is probably like $150 billion company. Cloudflare is probably like a $20 billion company, or $25 billion company, something like that. So, but ServiceNow is very interesting, because ServiceNow, as you said, it’s basically like a super app based, they enable different workflows to talk to each other, right. So you might need, you know, you might have, say, tickers for service being generated, you know, you could use a different different types of software to, you know, manage, let’s say it helpdesk requests, right, but you could then take those requests and automate, you know, what the responses are going to be, or how it set talks to other parts of other software, right, you integrate that, and that’s sort of what ServiceNow does, really, it enables different applications to talk to each other automates things for you across each other, then that suddenly becomes what is like, essentially, is super app, because it’s the ground where basically all these digital apps that, you know, applications that the enterprises use, meet, then doing a lot of work with Gen AI. So they actually have got these what they call the Pro Plus, you know, units or services or SK use, they don’t they like to call it, but plus, I just call them products. did, you know they’re off to a great start. And they’re all based on a company that they acquired a small company called element AI. So they acquired the team things the Canadian company that they acquired, and it’s unheard of embedded that into solutions. And those are off to a great start, they’ve never seen such good uptake to new software release. So that’s pretty promising. On CloudFlare, it’s interesting how you you’ve actually bundled them together conference is interesting as well, because it’s like, it’s a super app, but for networking really, like it’s a networking company, right. So it’s live started from, you know, hosting, or basically doing caching for content, right, then they make, you know, they do reverse DNS, and then they basically provide performance for your services or your websites that you host. But that was sort of the original the company, but from the so they built it, one of the things that they did is they went and built this network of applications and hardware that are very close to us is at at basically what’s called a point of presence across the globe. So you know, at points of presence across the globe, they’ve got their computers, and they’ve got their hardware and their software running, and then they can deploy code on it, it sort of allows them to deliver services to customers at good latencies and do it cheaply. Right, so you know, you get get some of the benefit of both worlds. So So then sort of migrated from, you know, sort of expanded from there to, you know, say, in addition to providing networking type services, so they can provide you like a private network, they can provide you, you know, that’s a carry across different networks that can provide you, you know, all sorts of different things. In addition to that, they can provide your Private Internet Access, they can do you know, what, like, basically, you know, zero trust services and things like that. So let’s sort of expanded from there to serve security, right. So usually we use for firewalls and stuff, but they can do more than that now. So those are some of the expansion. And sort of the basis for that the fundamental basis for that company is interesting. So the way I started looking at it, is networking has always been a hodgepodge of devices and software. And they’ve sort of moved it more to networking as a service. So I think that’s the higher level pitches there. The networking as a service company. And networking could mean anything from sort of network services, performance of, you know, service, performance of your websites and your applications to network security. So that’s sort of expanded there. It’s a pretty pricey stock though. And lot of good news is priced but again, this is one of those things that can grow if they can sort of execute on the vision because network as a service vision, means you could provide this potential to larger companies and then there’s a sort of migrated from there to being an edge computing service. Uh, you know, so doing instead of being centralized cloud computing can move things to the edge that’s been sort of, you know, a dream in the academic world for a long time. Right? So the edge computing, you know, you do most of your computing at the edge, and then you host it, you know, then you pass it on, it reduces latency. Now, I think the big thing to remember there is there’s there’s a strong debate now, do you really need edge computing? Because the actual edge computer is your iPhone or your Android smartphone? Right? Because you’ve got pretty strong processing power on device. Right? So why do you need edge computing? So those are there’s a lot of debate there. But maybe for some applications, that latency factor still comes into play, and is important. So I think it’s a very interesting company, and very interesting CEO to watch. Colorful CEO has a lot of opinions. To say I like that company. Yeah.
Simon Erickson 45:54
Okay, well as we close this out here, but I think one more topic I want to talk about is, you know, we mentioned kind of kind of the the size of these companies is all over the map. And it kind of depends on how big the addressable market is, and then how big these companies really could get several of them that we’ve mentioned on this show already today. We mentioned Microsoft earlier, that’s a $3 trillion company. Right. We also mentioned Salesforce several times $275 billion company, we just mentioned ServiceNow $160 billion company. And then as you mentioned, Clapper is smaller, but still a leader in its smaller, maybe niche market, that it’s in $30 billion company. But we’ve also talked about other companies to pay comm software’s. And another one we’ve talked about before about a $10 billion company, Zoom info, that’s another we put on people’s radar here recently $10 billion company. How do you think about the addressable market size and how large a company can get? And maybe if I can take that one step further. So this question of, it seems like we see these these companies gaining momentum gaining traction, you’ve got to go get her, you know, CEO, visionary founder or whatever it is. And then it could just scale. And like you said, it’s much, much harder to sell at $100 billion, or $100 million, and there’s a $1 million, and then a billion dollars, and then $10 billion, and every step of the way, kind of requires you to look at different things. But it’s also harder to compete against larger companies, too, right? If you’re a cybersecurity company, now, you’re up against Microsoft, who wants to do cybersecurity, it might be hard for you to maintain your competitive advantage, whatever niche you have. How do you think about this Anirban? Are we going hunting for just the really largest of the largest companies because of the safest? Or do you go out there after those five $10 billion market cap companies? Who might have a little bit more risk? Because they’re up against some of the bigger fish in the same same pod?
Anirban Mahanti 47:42
Like I would say, like, I think there’s no either or here? Because, like, I mean, you could win both ways. Right? Like, I mean, some of the biggest winners in the market have been these large companies, right, you know, the $500 billion companies becoming $3 trillion companies. That’s a six bagger, which, presumably lower risk, right? So I think there’s no either or I think, like, the way I think about this is, if you’ve got a big company, and you provide services that people love, and applications that people love, or, you know, you’re just a must have, it’s very difficult to displace that company. Right. And I think a business that tries to displace these type of companies usually does not succeed. They you know, that’s just my view, like, you know, like, you take an example of, like, if, if you’re going to do wearables, and you want to compete with Apple, it’s not going to work out, it’s gonna be very hard. It’s gonna be difficult. You might sue Apple, you might complain about it, you might go to various regulatory bodies, do whatever you want. Or if you for example, your your streaming service, like an audio streaming service, and you want to compete with Apple, Google, Microsoft, or Apple, Google Amazon, how’s that gonna work out? Because the stuff that you want to sell is a commodity. Right? You’re selling Taylor Swift’s music, either you have to be exclusive and definitely have to pay a boatload to Taylor Swift, or you’re gonna have the same deal as everybody else. And they can subsidize it. And you can basically if you’ve got a bad business model, that bad business model on opportunity of surviving inside a really, really strong company, because customers still want it and they’re only willing to pay a small delta for it. Right? Peloton is another example. Right? I mean, it’s just some business models are just very hard. So I think that’s the main lens to it is that and that’s probably for example, we talked about you mentioned zoom, many times my issue with Zoom is be just that, like, we use Zoom. But I mean, you you know, if, if you’re an enterprise and you know, Microsoft is selling your teams and it’s coming for free, along with everything else. That’s hard to fight against free and it might just be good enough. Right? And, you know, if someday, FaceTime becomes available, and I’ll be using FaceTime and maybe many companies will want to use FaceTime and FaceTime was interoperable that’d be again, competitive pressure, right? So I just sort of think of that. So that is very important. That doesn’t mean though, that you can’t have step change. Right. So one of the things that can happen in technology is a step change, for example, it’s very hard to compete against Oracle with traditional relational databases. But it is possible to compete against Oracle, if your database does something different, and does it better than Oracle. And therefore, you can slowly take either market share and stuff that Oracle is not good at. And then over time hope to get some Oracle share. And then all you need is really to get a little bit of that share, right, for a small company to be big, and then as you become bigger than your ambitions might become bigger. So that’s step change, or is something that you watch for, you know, document databases is a great example. Right? So MongoDB is the company I’m talking about, which is, which is interesting here, because it is trying to do something that is not the primary focus of other businesses and haven’t been and then bits of MongoDB got an upscale where they have become the default standard. Right? Now, the company that, you know, sort of I like to talk about, but since execution has been sort of, you know. And this company called confluent, where they’re trying to be sort of the Message Passing Interface for different applications that people use, right. And the vision there is that if you have different applications that you’re using, and you want to know what is happening in your enterprise, then you need this capability, where the citizen, the middle servant, takes certain information for granted, but gives you and gives you the intelligence of what is happening now, across the stack. Right. And this is a very difficult technical challenge to solve, which these guys at Confluent solve. And that you know, and, again, so let’s say you have some technical capability that is difficult to replicate, right? That solves something that can be really valuable to businesses. And that’s another opportunity that, you know, it’s not that this sort of thing does not exist, but at sort of this scale that they’re doing it, nothing off the shelf existed. Right. So when they built it inside LinkedIn, because when they were, you know, Jay Krebs was an engineer and his colleagues who founded this company, they look for stuff off the shelf and couldn’t find it. So they went and built it, and then sort of it became the default. Now, there’s origin story and stuff, like, you know, the default is the open source up to the day built, it’s used by, you know, 70% of fortune 500. That’s or fortune 100. That’s, that’s a sign that has got wide usage. Now, the question is, can you sell your software as a service that you’re offering for the free version? You know, so you’re offering this commercial version of it? Can you have the go to market to actually show the return on investment? That’s where this company is. But I think those are sort of things that can happen in software. Yeah, so same story with Salesforce and others is very difficult to replace, you know, you can’t replace them. But you know, coming up with a better just a better service cloud would not cut it just like a better streaming service would not like audio streaming service would not cut it, you need to do something, you know, something fundamentally different, just a little bit better would not correct, is that sort of my view, but then the term comes into play for for companies like, you know, the central nervous cloud, you can see that the term is can be pretty wide, depends on if you can realize it or not. Then another area that I like playing in is small software, companies that operate in such, you know, fragmented markets, let’s say you mentioned Paycom Software, this operates in sort of, you know, human capital management. And it’s a highly fragmented place, the payroll companies come into this highly fragmented, a lot of the old software exists. And then if you have, if you offer something new and offer something that’s good, you can overtime, convert, a lot of people who are using traditional solutions, when a situation is you might find a lot of companies actually use solutions that are built in house that are very difficult to upkeep and then they’re not keeping up with their growth, right? That’s an easy sell, because everybody needs payroll, right? But then what happens is, as you become big enough, then you need to really innovate because now you’re gonna compete with those companies that are going to be providing payroll to big companies. That is sort of where Paycom is right now, is that that juncture where their path to success in the future depends on making that transaction.
Simon Erickson 54:33
Lots of good stuff to chew on. They’re one of the most innovative industries of all enterprise software. Anirban, always a pleasure to hear your insights and your views about this. Thanks for being on the podcast today.
Anirban Mahanti 54:44
Thanks for having me.
Simon Erickson 54:45
The doc, Anirban Mahanti, a PhD in computer science. We hope that you’ve enjoyed this edition of our 7investing podcast. We enjoy doing this. We want to share a little bit of you know our own research process and what goes into how we select companies and stocks that we’re reading. Depending on our seven investing site once more 7nvesting.com/subscribe If you would like to get started for just $1 today. We think that you’ll enjoy seeing what’s behind the curtain. And not only our research process but in each of our recommendations. My name is Simon Erickson. We are here to empower you to invest in your future. We are 7nvesting!
Simon recently spoke with a $35 billion global asset manager about how they're navigating the market volatility. The key takeaways are to think long term, tune out the noise...
Anirban and Matthew were joined by Alex Morris, creator of the TSOH Investment Research Service, to look at seven former market darlings that have taken severe dives from...
On episode 5 of No Limit, Krzysztof won’t let politics stand in the way of a good discussion - among many other topics!