Podcast on Cloud Stocks: Consumption Model Vs. Subscription Model
December 02, 2022
Lead Tech Analyst
In October, I/O Fund CEO and Lead Tech Analyst Beth Kindig joined Jeremy Owens, Tech Editor, and San Francisco Bureau Chief of MarketWatch, on Barron’s Live. They discussed cloud valuations including those that are trading at 2X above Covid lows, what metrics matter when evaluating cloud companies, and what to watch for in upcoming earnings season --- including a few comments on ad-tech.
Metrics and Valuations
As discussed in the podcast, the FOMC decisions have forced tech investors to look for cloud stocks that are expanding their margins and also have positive free cash flow. If you look at the best-of-breed companies that command the top 10 in valuations, the majority of them are free cash flow positive.
We had discussed with our premium research members back in May in a special report Compartmentalizing Cloud Stocks that “It’s true that cloud is deflationary but it’s also true that cloud can have profitability issues […] cloud is quite resilient in terms of growth, due to being deflationary, but those weak bottom lines may be questioned over time. Cash came easy over the past decade, and as cloud investors, we need to reframe our thinking on what constitutes an attractive cloud stock.”
Free cash flow is emerging as an important metric because cash gets rerated in a rising rate environment. As stated, not only were many cloud companies were not public during the previous rising rate environment of 2017 to late 2018 – but in addition to this, the previous rising rate environment was quite tame and we are currently in a more aggressive rising rate environment.
Along with free cash flow, GAAP operating margins are being closely examined. This has resulted in companies with high stock-based compensations being penalized during earnings.
The takeaway is that a best-of-breed company with a 10X or higher valuation must remain FCF positive or it will immediately lose its category high valuation. Revenue growth alone is not determining the top spots in this category any longer. This may seem obvious at first thought but we have found it’s better to close a stock at a higher valuation if it has contracting margins.
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The difference between Subscription and Consumption Models
Consumptions models occur in the Big Data and Analytics trend where data storage, processing, and analytic solutions are based on usage rather than on a recurring subscription fee. This trend is becoming popular because with consumption-based pricing model, revenue is uncapped. The consumption billing model does not have a ceiling on revenue, so if customer consumption rises, so does sales. There is what is meant by uncapped revenue potential.
We covered Snowflake’s Consumption Model in January of 2022 when we said in our free newsletter: “While Snowflake uses a “land -and-expand” sales strategy, it also uses a consumption billing model. For instance, Snowflake bills customers based on the amount of data they store and transfer and what resources they use. Accruing revenue based on consumption rather than a ratable subscription model decreases the predictability of quarterly revenue, but it leaves revenue uncapped. This provides revenue upside, because if consumption soars, then so will revenue.”
Some of the drawbacks, however, include the revenue growth being less predictable than subscription revenue. There also isn’t a floor on revenue because if consumption declines, then so will sales. Contracts help protect against this but are often only 1/3 of next 2.5 years of revenue.
The drawbacks were also discussed in the Snowflake’s Consumption Model article in January of 2022, “Another risk is the company’s consumption billing model, which is inherently unpredictable. This can make growth lumpy and some quarters may disappoint the Street. Investors should expect increased volatility in growth from Snowflake in the near term as new customers ramp consumption. However, management does expect revenue growth to smooth and become more predictable in the aggregate as customer consumption scales and matures on the platform.”
The lack of predictability is seen in Snowflake’s earnings history with Q1 earnings reporting revenue growth of 85% YoY to $422.4 million (beat estimates by 2.3%). However, the GAAP EPS missed by $0.02. The management had a hard time convincing the analysts in the earnings call that the company’s revenue was not discretionary and the consumption was lower due to shifting economic circumstances that impacted certain customers, particularly consumer facing cloud companies.
The company’s CFO, Mike Scarpelli, said in the earnings call, “Consumption patterns may fluctuate from quarter-to-quarter. This variability does not detract from our long-term opportunity. Customer’s overall demand for Snowflake remains unchanged. This is supported by the contractual commitments they are making with us and their longer-term plans for adopting the data cloud across their organization.”
Our update on Q3 cloud earnings will come next week following the last round of cloud earnings reports. We still have MongoDB, Zscaler and SentinelOne to report, among others. However, we are still seeing variability with Snowflake’s growth rate as the company reported 67% growth in Q3 and guided for 50% product revenue growth in Q4. Due to beingn consumption based, this variability will be to the upside when economic conditions improve.
In the podcast, we also discussed how net retention rates are often higher for consumption models as spending ramps over time and is uncapped. It’s easier to re-accelerate here for that reason and it’s not the best apples-to-apples comparison for subscription NRR. The net retention rates for subscription-based companies are in the range of 130-140 range while Snowflake has remained in the 170 range. The recent Q3 net retention rate is 165.
Another metric often heavily relied on to predict slowing or accelerating revenue is the remaining performance obligation (RPO). When customers sign onto the platform, they purchase consumption at specified prices, which gets recorded as remaining performance obligations (RPO). These contracts are for about 2.5 years. Although these key metrics are important, as mentioned earlier, what the market will reward or penalize most in a rising rate environment are operating margins and free cash flow.
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In the interview, Jeremy Owens reminds me that I was the first person to warn him about how the Apple’s IDFA changes that would negatively impact Facebook’s revenue many years ago. It was a bold call at the time because I called the top for Facebook when it was a stock market darling in 2018. Despite the odds, it turned out to be accurate.
We discuss how ad-tech stocks are trading at historically low valuations with many 50% lower than where they have traded during times of economic uncertainty. The share prices of these ad-tech companies can grow over 100%. When the market senses a bottom is in --- which I believe was either Q2 or will be Q3 --- buyers will step back in to support higher valuations.
We discuss why CTV ads is the most investable trend in media right now.
Note: as we’ve gotten more earnings reports, it appears the bottom is more likely to occur in 2023. We will be monitoring this and update you as we go along.
What to look in the upcoming Q3 earnings season
The podcast was recorded prior to Q3 earnings, and next week, we will reflect back on the takeaways following cloud earnings. Sign up for our free newsletter here.
Microsoft’s results are to be closely watched since the company is a bellwether for Cloud. Its suite of Cloud products drives down costs and it’s the most insulated cloud company. It benefits from cloud migrations and also the need for organizations to reduce costs.
Analysts in the earnings call are concerned that the enterprise sector is the next shoe to drop following consumers. The consumer cycle is very short, whereas for Enterprises, it depends on the renewal cycle and there is a period of negotiation. In addition to constrained enterprise budgets, many startups are not able to raise funding and are going out of business, which can weigh on cloud, as collectively startups are a sizable customer for cloud companies.
The cybersecurity sector has reported exceptional fundamentals given the economic headwinds. Many companies have been reporting high growth rates and are cash flow positive. This sector also has no exposure to discretionary spending, which will help the category sustain long-term.
For cybersecurity, we have earnings reports next week and the recap will be included in our free newsletter.
Bargain Cloud Stocks
Cloud valuations are trading very low and our analysis next week dives into forward fiscal year estimates and why 2023 is likely to provide returns for growth investors who find quality cloud stocks right now.
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