Earlier this week, 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. 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 15X 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.”
