This article was originally published on Forbes on Dec 29, 2022,09:41pm EST

CrowdStrike has one of the better fundamental profiles out of the cloud category. This is due to its 50%+ revenue growth rate, GAAP operating margin of (7%) and free cash flow margin of 31%. The company also has one of the best Rule of 40 numbers in the cloud category at 89%. The companies that have higher growth rates or higher Rule of 40 numbers tend to be IPOs, which are designed to be strong out the gate and then fade over time. Meanwhile, CrowdStrike has consistently offered best-of-breed performance for over three years.

Therefore, it’s important to look into what caused CrowdStrike’s weak price action following its earnings report particularly because the stock is widely recognized as one of the strongest cloud stocks on the market. CrowdStrike’s steep selloff of (27%) over the past 30 days isn’t fully satisfied by the $10 million miss on forward revenue and ARR in the last earnings report. Forward Q4 revenue was expected to be $634M and the company guided $619M to $628M for a miss of about $10 million, if we take a midpoint of $624 million (about 1.5% miss). ARR was $2.34 billion compared to analyst expectations of $2.35 billion, for a $10 million miss (less than 1% miss).

Although this likely contributed, I believe the analyst we quoted in our Pre-ER write-up for premium members may be providing a missing link. An analyst from Barclays was modeling for net new ARR of $224M to $230M-plus for this key metric compared to actual results of $198 million.

At the midpoint, this would be more of a miss of 14.6%.

Here is what was said in the Pre-ER write-up for our premium members:

“An analyst note from Barclays’ Saket Kalia is modeling ARR net addition of $224 million “but thinks upside could be $230M-plus given strong pipeline commentary.” At $230M, it would represent 5% sequential growth and 35% YoY growth. This would be down from 15% sequential growth in the previous quarter and 45% YoY.”

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The reason we flagged this prior to earnings is because the net new ARR at a high point of $230M would still mark a strong deceleration to 5% sequential growth down from 15% sequential growth last quarter. This means the company would have to meet the number the Barclays analyst modeled or we would be nearing flat to negative sequential growth on net new ARR. Therefore, we emphasized the importance of this number prior to the earnings report as it was truly a “line in the sand” moment for CrowdStrike’s earnings performance.

With the actual of $198 million reported, this dropped the net new ARR to negative sequential decline of (9%) down from $218 million last quarter. This marks a change compared to the comp of +13% sequential growth from Q2 2022 to Q3 2022.

In August/September time frame, during the Q2 reports, we also emphasized that the market is nervous that cloud will become the other shoe to drop by stating: “I also want to be a messenger and say that another reason we are seeing strong price activity [with cloud stocks] is that analysts are concerned that enterprise spend will be the next shoe to drop. This concern was expressed across quite a few cloud companies’ [Q2] earnings calls. The thinking is that enterprise spend will follow consumer spend, (eventually), yet is slower because budgets are cut more slowly and added back more slowly.”

Because enterprise and cloud budgets are slower to be cut than ad or marketing budgets, there is outsized pressure being placed on sequential growth. The market does not care about YoY because it’s assuming enterprise spending wasn’t affected yet this time last year. We cautioned in a previous analysis two weeks ago “Slowing Growth in Cloud Stocks: When Will We Hit a Bottom” to be careful of YoY guidance as QoQ growth in cloud saw a remarkable slowdown.

CrowdStrike Q3 Financials:

CrowdStrike beat both top line and bottom line for Q3. In fact, an area where CrowdStrike continues to stand out from its peers is the health of the bottom line and both Q3 actual and Q4 guide was no exception in this regard.

For example, the free cash flow margin of 30% is exceptional for the cloud category. The company reported revenue of $581 million for growth of 53% compared to revenue of $574 million expected for growth of 51%. This is a slight deceleration from 58% last quarter.

For Q4, the company guided for revenue of $619 million to $628 million compared to expectations of $634 million. At the midpoint of $623.5million, this is a $10.5 million miss. This represents growth of 44.7%.

Adjusted EPS for Q3 came in at $0.40 compared to $0.32 expected. Adjusted EPS guide for Q4 also beat at $0.42 to $0.45 compared to $0.34 EPS expected.

GAAP operating margin of (9.70%) compares to (9%) last quarter and (10.5%) in the year ago quarter. This resulted in GAAP operating loss of ($56.4) million which is a tad higher than the $48 million losses last quarter and the $40 million losses in the year ago quarter.

The adjusted operating margin was a beat in Q3 and Q4. This was a bright spot in the report with adjusted OM of 15.4% compared to 13% estimated. This compares to 16% Adj OM last quarter and Adj OM of 13% last year. This was essentially flat and it’s important it did not contract. The guide on adjusted operating income of $87.2M to $93.7M implies an adjusted operating margin of 14.5%.

CrowdStrike is very strong on cash flow and is one of the top-ranking cloud stocks in this regard. This quarter the company reported a free cash flow margin of 30% for FCF of $174 million. The company is guiding for a FCF margin of 28% to 30% next quarter. The operating cash flow was $242.9 million for a margin of 41.8%.

There is $2.47 billion in cash on the balance sheet. The company paid $140 million in stock-based compensation for a margin of 23.7%.

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Key Metrics:

To recap, CrowdStrike reported a quarter with 52% growth and forward growth in Q1 of 44.7%. The company leads popular cloud stocks on free cash flow with a 30% margin and has a healthy adjusted operating margin of 15%. Although stock based compensation weighs on GAAP operating margin, it still ranks high compared to peers with a GAAP operating margin of (9.7%) —- so why did the stock selloff after hours and is down (27%) over the last 30 days?

The answer is found in the key metrics.

RPO was up 44% year-over-year for $2.797 billion and was up 11.6% sequentially. However, management reminded analysts that ARR is the leading key metric for their business.

Ending ARR grew 54% year-over-year to $2.34 billion and grew 9.3% sequentially. Therefore, because ending ARR was strong, the net new ARR could be easily underestimated in terms of impact. The net new ARR at $198 million in fiscal Q3 compared to $218 million net new ARR in fiscal Q2 indicates a 9% sequential decline.

The market has the jitters right now so the sequential decline is important to pay attention to especially because management said to expect further weakness in the upcoming Q4 quarter. Here is what the CFO said:

“Even though we entered Q3 with a record pipeline, we are expecting the elongated sales cycles due to macro concerns to continue, and we are not expecting to see the typical Q4 budget flush given the increased scrutiny on budgets. While we do not provide net new ARR guidance given the current macro uncertainty, we believe it is prudent to assume that Q4 net new ARR will be below Q3 by up to 10%.”

This implies a net new ARR of $178.3 million for Q4 (10% lower than the current quarter at $198.1M) compared to net new ARR of $216 million in the year ago quarter. This is important because it’ll mark not only a sequential decline but a year-over-year decline in net new ARR. The market had already sold off for what I presume was a sequential decline in CrowdStrike’s leading key metric, and management then stated the decline would be steeper for Q4 on the call. Once the comment above was made, we were certainly not going to see a reversal in the stock price from the earnings call.

Customer count was strong at 44% growth. The mix of domestic versus international was slightly lower than usual for North America at 69% with EMEA being slightly higher at 15%. Deferred revenue grew 56.4% year-over-year and backlog grew 19%.

Additional Commentary:

CrowdStrike was transparent about the importance of ARR even in the face of net new ARR being lower than expected.

Here is what was said by the CFO:

“And then finally, just to comment on ARR. You pointed out that's how we run our business. ARR, though, is really an X-ray into the contracts themselves. And as we view that as the most important — or most transparent metric into the outlook for our business, that's the one where we're focused on. So, hopefully, that gives some more clarity on how we think about cRPO and ARR.

Later on, an analyst did zero-in on the (9%) decline.

“Andrew Nowinski

Great. Thank you for taking the question this afternoon. So total ARR of $2.3 billion, growing 54% is still absolutely amazing, I was – and it's at scale. But I was wondering, were you surprised that the net new logos that you added were down 9% this quarter?

Burt Podbere

Thanks, Andy. So when we think of the net new logos, it really corresponds to what we talked about in terms of what we saw in that SMB space. The SMB space is the one that drives the velocity of our net new logos. And as we talked about, we saw an 11% increase in our sales cycle in the SMB space. And that actually equated into $15 million in terms of deals in that space that could push out. And so when you think about 15 million in that space and what it means in terms of logos, where you can do the math, it's a pretty big number.

So that's how we think about net new logos corresponding to what we saw in net new ARR from the SMB space. So from that perspective, we weren't surprised at the end of the day when we saw that what happened with respect to the increased sales cycles and the amount of money that got pushed out in the SMB space.

“Push out” refers to a delayed sales cycle for an impact of $15 million. The CFO did reiterate the 10% further sequential decline in net new ARR between Q3 and Q4 when he said:

“When we do talk about net new ARR, I did talk about in the prepared remarks about how we think about up to 10% headwinds going into Q4 from Q3, and that's just to coincide with some of the headwind activity that we saw accelerated at the end of this quarter. So that's how we think about that.”

Conclusion:

The market is cooling off from previously popular cloud stocks. The reason is that QoQ likely hints at what is to come for enterprise budgets that are typically determined in January of the new year. There will certainly be some cloud stocks that are stronger than others, comparatively. Attempting to guess which ones these will be carries outsized risk if the QoQ trends we saw in Q4 continue into Q1.

The quarter from CrowdStrike sounded very familiar, in my opinion.

Here is a brief overview from our Microsoft’s post-earnings report:

“Microsoft is guiding down for next quarter with analyst expectations for the December quarter at $56.04 billion compared to management guidance on the call for revenue of $52.75 billion, at the midpoint. This represents 2% growth. […] That’s a 11% deceleration over the next few months. Some of this is coming from Azure as the company is expected Azure to decline 5% next quarter for its current growth rate. This will be 37% growth on a constant currency basis, down from 42% this quarter.”

While some investors believe this is a stock picker’s market – we disagree with this thinking. In May, we pivoted to hedging up to 100% of the I/O Fund portfolio as macro will eventually affect even the strongest companies. We are seeing that now with Tesla – a strong consumer company that is following its consumer peers into a material slowdown that is entirely macro based. Our macro coverage, such as Divergences Point Toward the Market Moving Higher, which called the October low, is published bi-monthly for our free readers and published daily for our premium readers along with real-time trade alerts. The hedging strategy has proven successful since we pivoted 8 months ago, primarily it has removed the pressure of the market’s intense selloff while allowing us to build key positions at valuations that are extremely low.

Ultimately, we started to move toward a neutral stance with cloud after Q2 reports after we saw initial signs of weakness and continued to trim/cut following some Q3 reports. We continue to hold one cloud name at a high allocation and we hold three more at medium sized allocations. We call this a neutral stance to where we are participating but not overweight. If we get additional signs that cloud is too weak to withstand macro pressure, we have a short candidate in mind. If we get signs that cloud will be resilient in 2023, we will buy into those with underlying strength.

Notably, the I/O Fund portfolio manager sees a relief rally of sorts coming in the early part of this year. That will be the time that we determine what to do with our remaining cloud positions — whether we sell into strength or buy into weakness.

Note: This analysis was originally published on November 30th 2022 and accompanies our previous free analysis: Slowing Growth on Cloud Stocks: When Will We Hit a Bottom.