Tech stocks are in a slump
It’s no secret that the US stock market is undergoing an upheaval. Especially so in the tech sector. As of this writing, Nasdaq has underperformed the S&P 500. The tech index is down 27%, while S&P 500 is down 18%.
If you look at the constituents of Nasdaq, 92 companies (out of a total of 102) have generated negative returns, and so far, the worst performer is Netflix (down 69% this year).
Overall, the tech sectors have taken a beating. Why is that so? There are two possible reasons.
- Reason 1: A reassessment of their growth rates?
- Reason 2: Interest rates hikes by the Fed
Reason 1: Are investors reassessing growth rates of tech companies?
Despite the overall macro uncertainties in the past 12 months, tech companies have been growing rapidly. The median revenue growth rate for the last twelve months (LTM) of Nasdaq companies is 22.3% CAGR. Out of 102 companies in Nasdaq, 99 had positive revenue growth in the past twelve months (Figure 3).
But despite the historical revenue growth, these stocks are getting hammered by investors. Why is that? Is it because their estimated future sales are being reset due to weary investors?
It seems like it. In Figure 4 below, we plot the rate of change of revenue growth between LTM vs. expected revenue in the upcoming fiscal year. For the most part, they are negative. The expectation is that the revenue growth for most companies will slow down.
Why the change in investor expectations?
Is it because we are in a recession?
Technically, we are not in a recession yet. For us to be in a recession, we have to have two sequential quarters of negative GDP growth. In Q1 2022, real GDP went down -1.4%. According to the Federal Reserve of San Francisco, the odds of a US recession in the next six months is less than 20%. However, if GDP contracts in Q2 2022, the US will officially be in a recession.
If we are to enter a recession, consumers and businesses alike will reduce their spending. But not all spending cuts are created equal: if a recession hits and you want to cut spending, you will likely stop your Netflix subscription or cancel your Airbnb trip, but it is unlikely that you will stop paying your taxes with Intuit (maker of software and accounting tools) or stop buying your medications at Walgreens (pharmacy chain). In other words, the recession will not impact the underlying businesses equally. Companies that sell discretionary products and services will likely be hit the hardest.
But again, we are not in a recession. Despite elevated inflation, consumer and business spending remains strong.
Expectations of a recession alone does not seem to paint the whole picture. Could there be another explanation?
Is it because the changes that COVID introduced turned out to not be permanent?
Possibly so. Upon the global lockdown in early 2020, consumer behaviors were significantly altered: Adoption of work from home was accelerated. Sales of computers spiked. Consumers shifted their spending habits, spending more on goods, since they could not spend on travel and services. Consumption of anything that entertained people at home increased (mobile games, social media, Netflix, Peloton, Spotify). Ecommerce adoption went through the roof.
Through all these changes, adoption of the above accelerated (see the hump in Figure 5). But what happens as we return to normalcy? At the peak of the pandemic, you can imagine three possible futures:
- (1) Up, up ,and away! The acceleration of adoption will continue into the future.
- (2) A step function. These services pull forward demand, but after we return to normalcy, the growth rate will continue to the old rate.
- (3) Return to normalcy. After enjoying a boom, these services will experience a decline, before returning to the long term growth trends.
In the early days of the pandemic, everyone thought that (1) was the most likely scenario – that the changes would be permanent. McKinsey called it the quickening (â€œ10 years growth in 3 months!â€). This was the consensus. As a result, investors were willing to pay for these companies at any price, and we saw the outcome in the appreciation of their share prices.
But investors were not the only ones in this camp. The companies producing the goods and services too believe that the new future would be further acceleration of adoption (1). Peloton was clearly in this camp. After the surge of demand in 2020, they produced so many bikes and treadmills in 2021, they had to temporarily stop production in early 2022 because they experienced a â€œsignificant reductionâ€ of demand globally. Turns out scenario (3) above is reality ðŸ¤”.
What about E-commerce? We see a similar behavior there as well (Figure 6 below).
E-commerce penetration rate in the US accelerated in Q2 and Q3 of 2020, but has been declining and/or flat in 2021 and Q1 2022. Again, scenario (3) is playing out. This is why companies such as Shopify have declined more than 73% this year. They are struggling with the burden of unrealistic expectations.
You also see a similar trend with Netflix (see Figure 7 below).
Now that we are returning to normalcy, what we are learning is that early assumptions about continuous skyrocketing growth were not correct. What is likely to happen is scenario (3). This means that in the short term, some companies will lose sales or experience a decrease in growth, but in the long term, the good businesses will likely continue to be strong. The problem, of course, is the volatility until we stabilize into the long term.
Reason 2: Interest rate hikes by the Fed
Not all tech companies are created equal. There is a subset of tech companies that generate subscription based recurring revenue (SaaS companies). Since they generate their sales from recurring revenue streams, they typically enjoy more stability in the sales growth and higher multiples. So far in 2022, these SaaS stocks have been taking even more of a beating than even the overall tech sector.
We looked at 85 SaaS stocks – in 2022, 83 experienced a decline. Some of the hottest IPOs from the last couple of years, Confluent (CFLT, down 75.2%) and Asana (ASAN, down 71.25%), along with COVID darlings have performed the worst. The median performance is -43.4%, almost 2x worse than that of Nasdaq companies (Figure 8).
These SaaS companies typically operate in the red. They spend a lot of money in order to grow rapidly to acquire a future cash flow. Future cash flow gets discounted to the present, and that discount rate is a function of the interest rate. So in a way, the share price of SaaS companies have high duration (highly sensitive to the prevailing interest rate). If the interest rate goes up, then investors’ willingness to invest in these companies go down (as they have better alternatives), and as such, the share prices of SaaS companies tend to tumble.
As of May 2022, the Fed has increased rates to a range of 0.75% to 1%. They may further increase this by year’s end. The market has already priced in future increases, even before they happen, with pricing based on rates rising to 2.75% to 3%.
The change in interest rates has caused a broad re-rating of valuations across all companies, but more acutely in the tech sector. In Figure 9, you can see that Forward P/E has declined to levels similar to late 2019. A portion of the decrease in the share prices is because we wind the clock back by three years, in terms of valuations.
Some have made comparisons between the current downturn vs. the 1999 Tech Bubble. But as you can also see above, it’s not even close. In the tech bubble, Forward P/E peaked as high as 50x, and many of the bubble companies had no real revenue nor business model.
Ok, so far, we have discussed stock prices and valuations. But, at Vested, we often write about businesses, not share price. If a business is in decline, typically the share price goes down. But, just because the share price goes down, does not mean the business has become bad. Take Cloudflare for example. Despite the share price being down more than 57% this year, the business appears to be strong:
- It’s a global cloud SaaS platform that provides mission critical network services (content delivery, cybersecurity, etc). This means that its customers are very unlikely to turn off its services in the event of a recession (they only turn Cloudflare services off if they shut down).
- In the past 4 years, its revenue has grown an average 51% CAGR.
- It has a strong net dollar retention of 127% (this means, even if it does not acquire any new customers, its existing customers will increase spend with the company at this rate)
- It has 78% gross margins.
- It has more than $1.7 billion of cash on hand.
- The downside is that it has not been able to achieve consistent positive operating cash flow. In the past six quarters, it fluctuated between -17% (in Q1 2022, which translates to -$35.5 million) to 21% (in Q4 2021, which translates to $40.6 million). These numbers are much lower than cash on hand, however. This means that the company can continue to fund operations through tough times if need be with the existing balance sheet.
While it is difficult to predict how long the storm will last, it is useful to look back at recent history to guide us through these choppy waters. Since SaaS as a business model is relatively new (a little over a decade or so), we turn to the great recession of 2008, where we were at the brink of the collapse of the modern financial infrastructure (the US GDP contracted 4.3%, one in ten people were unemployed, and at its peak, more than 11% of mortgages went into delinquencyâ€¦ yes – it was as bad as it soundsâ€¦).
How did SaaS perform through the last Great Financial Crisis (GFC)?
To answer this question, let’s look at select SaaS companies that went through the GFC, in particular: Salesforce, NetSuite, and Concur. We picked these three companies because:
- They went through the GFC and survived (note:this analysis inherently has survivorship bias since we only look at the survivors, not the other SaaS companies that died during the crisis and are lost in the anals of history)
- They are SaaS companies
- They all sell mission critical services to other businesses
Ok, let’s look at how these three fared through the GFC. We’ll do so in three charts.
As you would expect, upon the recession, the stock prices of the three (and therefore market cap) fell. All three experienced between 84% to 90% decline. NetSuite had the unfortunate timing of going public in December 2007, right before the market collapsed. It took almost 3 years for its market cap to recover (Figure 10 above).
The decline in market cap is partly because of a significant decline in valuation. All three saw massive compression of their valuations (see Figure 11 above). NetSuite Ipo’d at almost 25x price-to-sale ratio (P/S). It took almost 6 years before the company reached the same valuation heights. This is why it’s generally not a good idea to invest in IPOs. Both Concur and Salesforce saw their valuation slashed by more than half throughout the crisis.
But, as drastic as the fluctuations of their market cap and valuations, their businesses didn’t see the same level of volatilities.
In Figure 12 above, we show the percentage quarterly revenue change (year-over-year) through the same period. Yes – revenue growth did slow down through the crisis, but they never went negative (negative revenue growth means revenue declined), with the exception of one quarter for NetSuite. In fact, all three companies were able to maintain the same level of growth rate from the beginning of 2009 to 2015 (with a consistent growth rate ranging from 20% to 40%).
When you look at the three charts together, you’ll notice that the businesses were all growing at a stable rate, and it was only after that the share price (and therefore market capitalization) went up.
While it is difficult to predict the future, the old adage of investing in good businesses remains to be true. Good businesses tend to survive crises, while the bad ones disappear. As an investor, it’s much harder to predict the market’s actions, but much easier to analyze businesses.
At these volatile times, we often go back to one of Warren’s famous quotes (from his 1986 investor letter – that’s more than 35 years ago!):
â€œOur goal is more modest: we simply attempt to be fearful when others are greedy and to be greedy only when others are fearful be fearfulâ€ — Warren BuffettÂ
True to his words, Berkshire’s recent disclosures seem to suggest faster capital deployment in recent months (it shrank its cash holdings by about $40 billion to $106 billion). It has bought large stakes in HP, Occidental, Chevron, and bought back its own shares.
- Both NetSuite and Concur are no longer public companies. They were acquired by Oracle and SAP, respectively.
- There’s no perfect way to predict a recession. It is also impossible to predict the length of one.
- When there’s a market downturn, dollar cost averaging might be useful.