Software stocks set new records despite earnings, pandemic

You might have missed it, but amidst the current political-M&A-pandemic-election-disinformation news cycle we find ourselves in this week, SaaS and cloud companies reached new public market records.

Yesterday, the Bessemer-Nasdaq cloud index closed at 2,035.54, a new record finish for the basket of software companies. And, today, the index broached the 2,040 mark before ceding some ground.

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What matters for our purposes is that with a good chunk of the Q2 earnings cycle behind us, software companies are not only holding onto their gains from earlier in the year, they are managing to add to them, albeit modestly. Of course, valuation expansion during earnings season could still lead to gently falling multiples; as companies grow, if their shares gain value at a slower pace, their price/sales ratio can lose ground.

Regardless, for our purposes it’s notable that recent public market gains are not dissipating. Tech valuation boosts have helped major American indices regain ground lost early in the year, and Q2 earnings were a possible threat to prior progress. So far earnings-related dents are thin on the ground.

So, what’s going on? Why are SaaS and cloud stocks doing so well? Leaning on notes from two VCs — Jamin Ball from Redpoint and Mary D’Onofrio from Bessemer — we can unspool recent valuation highs.

The public markets could slip tomorrow and give back a chunk of recent gains. But software stocks keep not doing that. No matter what we may think about present-day valuations compared to historical multiples, we have to take current prices seriously. So let’s do that.

A few good guesses explaining strong software valuations

Yesterday when SaaS and cloud stocks were busy setting new record highs, I reached out to Bessemer growth investor Mary D’Onofrio, who keeps tabs on the value of late-stage startups and their public comps. Luckily for you and I, she’s generous with her time, so she gave us a grip of reasons via Twitter, which we have unpacked and summarized for you below:

1. The Fed: D’Onofrio noted the Fed’s current pace of balance sheet expansion, saying that the American central bank’s capital injections are supporting equity prices. She also stated that the Fed keeping rates low helps make equities more attractive.
2. Strong earnings: The investor said in her mini-tweetstorm that companies in the Bessemer cloud index Q2 results have “shown outperformance relative to estimates,” highlighting Shopify’s epic report as an example of her point. We will return to this argument shortly.
3. “Visibility into ongoing growth”: In D’Onofrio’s perspective, the COVID-19 pandemic has “pulled up digital transformation initiatives,” the result of which is that the cloud software market is larger than before, allowing for “sustainable” growth rates of 30% or more. Obviously, if faster growth is possible, the present value of future cloud cash flows has gone up, making their equity more valuable.
4. Inherent strengths during a pandemic: Finally, D’Onofrio highlighted that SaaS and cloud companies tend to sport gross margins of 70% or better, while generating free cash flow of 5% of revenue or more. They are, to quote her, “just great businesses.”

Those are compelling arguments for why SaaS and cloud stocks are valuable; if they are a sufficient set of notes to indicate that SaaS and cloud companies were undervalued a few weeks ago we’ll leave to you.

But let’s unpack point two a little before we wrap and check our investment accounts to see our current YTD return. On the earnings point we can see what D’Onofrio is talking about in the following image that Redpoint’s Ball tweeted yesterday:

Summary of today's cloud earnings reports: pic.twitter.com/0b6K1B2I0y

— Jamin Ball (@jaminball) August 3, 2020

As you can see, not only all three of the cloud and SaaS companies that reported yesterday manage to best expectations, two of the three also managed to beat forward expectations. This dataset bleeds into D’Onofrio’s third point, of course; by forecasting above future growth expectations, RingCentral and Five9 are painting a picture of a more lucrative future.

Let’s wrap with the other end of the spectrum, the possible issues. Venture capitalist and content machine Jason Lemkin wrote something that has been rattling around my skull for a bit. Entitled “Atlassian and AWS Say: ‘Maybe Worry a Little Bit‘” the Lemkin piece noted that the recent strong earnings run had had some weaker points.

Here’s Lemkin:

These are crazy times. The economy has contracted at a record rate of -33%. Yet, the Cloud is on fire during Work-and-Do-Everything-Possible-from-Home. Shopify grew 100% at $3 billion in ARR. Zoom is growing at rates we’ve never seen before in SaaS and Cloud. And Morgan Stanley has predicted Cloud penetration will be pulled forward 5+ years or more.

And yet … the Cloud and the overall economy can’t be disconnected forever. IT budgets come from the cash generated from selling end products to people. And that economy has taken the steepest fall in history.

Lemkin went on to cite AWS growth slowing (Azure as well), slower-than-anticipated Atlassian guidance, and Box’s Aaron Levie, summarizing a chat with the enterprise cloud CEO as indicating that “CIOs are spending more on collaboration/work-from-home solutions” and security but that “everything else is very, very tight right now.”

That’s the flip of the bullish argument that has, thus far in 2020, been proving right again and again and again.

More as we have it.