Enterprise Software: Earnings Season and Metrics to Look Out For
Crossing the Chasm – Many Unknowns Before Becoming the next Salesforce or Microsoft
As earnings season starts to pick up momentum in the coming weeks, much of the attention – as far as growth names are concerned – is on software companies. Names like Twilio ($TWLO), Cloudflare ($NET), Asana ($ASAN) traded at multiple times their current share prices just a few months ago. Will they make a comeback within the next few years, and which ones will become next-generation Big Tech companies?
My Foray into Technology
I am not a developer or computer science graduate – my background is in finance, accounting, banking, and real estate. My initial investments were all related to properties and REITs. Perhaps I had earlier feared technology because it seemed so complex, and the dot-com bust had forged a memory on my mind that companies in that sector faced high displacement risks. Webvan, Palm, and Alta Vista are all cautionary tales from that era.
Getting ripped and replaced in the software space is par for the course: Workday ($WDAY) is trying to supersede PeopleSoft; Crowdstrike ($CRWD) is taking the place of legacy endpoint security providers like Symantec while trying to keep out newer entrants like SentinelOne ($S); Datadog ($DDOG) is muscling into all pillars of observability previously dominated by Splunk ($SPLK) and New Relic ($NEWR).
But will these new names themselves be displaced one day? Up-and-coming vendors are already converging into each other’s territory. For example, Cloudflare ($NET) is seeking to creep into Zscaler’s ($ZS) space in network security, even as the latter is busy trying to dislodge traditional firewall players like Palo Alto Networks ($PANW). Rapid product development – especially when innovation is a primary competitive moat to stay ahead – ensures that better and faster solutions will always appear on the horizon.
Looking for the next enterprise software giants is an exciting intellectual pursuit, but it can also be full of left-field surprises. Who knew that Amazon ($AMZN), which started as an online bookseller, could one day develop Amazon Web Services to become an existential threat to traditional enterprise data storage names like Oracle ($ORCL), IBM ($IBM), and EMC ($DELL)?
My earlier technology investments were conservative, and focused on the largest names like Microsoft ($MSFT), Salesforce ($CRM) and Amazon. These are all staple stocks in many portfolios, since their platform offerings have become so entrenched, the risks of getting displaced are much lower. I also hold (smaller) positions in lesser-known names like Zscaler and Twilio. Learning about these companies has not been easy, and I try to be hyper vigilant for any signs of weaknesses. Like any eager beaver, I attend conferences, talk to experts, and read as much as I can to learn.
Some days I wish I had just put all my money into real estate (or Microsoft) to call it a day, especially in this bear market. But with digitalization disrupting every industry – including the ever-stable world of properties – I believe pivoting into technology is essential, whether via direct holdings or index funds. I cannot afford to stick my head in the sand, staying invested only in older economy companies. I must tolerate some additional volatility from having exposures to the world of enterprise software companies, many of which are arming corporations old and new with mission-critical tools to survive digitalization.
Potential Metrics to Watch
My lack of in-depth technical knowledge may actually give me a more dispassionate view of the enterprise software space. I am not welded to any singular name because of personal usage history or dislike for a certain practice. I am watching key metrics for signs of continuing dominance or lagging competitiveness. Two primary forward indicators I look out for – and commonly reported by software companies – are:
Remaining Performance Obligations (“RPO”)
This tracks the cumulative contract values of all deals signed to date. Revenues are yet to be recognized since implementation has not taken place. A software vendor that is gaining momentum, in general, secures more deals with longer duration and larger values. Examples include Alphabet ($GOOG, for Google Cloud Platform), Datadog, Crowdstrike, and Zscaler. Beware of seasonality though when looking at sequential movements – busiest sales motion tends to happen towards year-end, so RPO numbers jump the most in the December or January quarter. RPO can also be subject to noise, if subscription contracts happen to be shorter in duration, like Elastic ($ESTC) as it transitions its business model from on-premise licenses, towards to a more usage-based, monthly cloud plan.
$100,000+ Customer Cohort
Crossing the chasm entails getting to wider adoption, and there is no better product validation than when larger customers start adopting a solution at scale. Signing up for a trial does not count, neither does adoption at project-level. It needs to be large enough to be a convincing proof point and hitting that $100,000 annualized revenue mark is a useful indicator. Bonus point: when an enterprise software vendor starts reporting how much these $100,000+ customers account for total annualized revenues. Cloudflare first made that disclosure in March 2022, when its large customer cohort exceeded 50% of total business.
Diversification versus Concentration
Because I know I am limited in my knowledge compared to software gurus – Software Stack Investing is great by the way – I diversify across consumer, real estate, and technology names, mixing Big Tech with emerging names. There are plenty of investors who choose to hold less than ten stocks in their portfolio, and I admire their convictions. I tend to get a little wrapped up in my own theses at the expense of healthy skepticism; past mistakes have included Alteryx and Tufin. And I will continue to make mistakes so I establish wider diversification as a guardrail.
Having an exposure to Nasdaq 100 may be a great way to gain exposure to technology as well, and allow the annual index rebalancing to get rid of laggards. Have a read of my previous post on Coffee Can investing.
Some Closing Thoughts on the April-June (or May-July) Quarter
This coming earnings quarter may be fraught with noise. US dollar strength will no doubt cause reported numbers to look weaker, especially for companies with higher proportions of international revenues. A more cautious economy, combined with political uncertainty, will also impact RPO and $100,000+ customer count, since deal cycles (be it new customers or upselling to existing ones) would have likely taken pauses during the quarter. Tough comps from H1 2021, which benefited from pent-up demand from 2020, will further obfuscate year-on-year numbers this year. Greater clarity should come as we transition through 2022.
May the force be with enterprise software companies trying to get through this difficult year.
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