Technology

Roku Ready – Updated

10/03/2017 by Candyman

We sent out the ROKU notes below on September 27th but are providing a few UPDATES here:

"Splitting the difference" turned out to be about right - it suggested $20/share and that's where ROKU settled the first day of trading. Since then it's moved up a bit more to $23. There are some reasons to be cautious.
An author we follow on Seeking Alpha wrote an intriguing post about "The Postage Scale Problem" which probes whether some of the success of Roku has come from the ability to illegally stream content via "private channels." Roku had to shut this down and replace it with their own "Roku Channel" which hasn't gone over so well. It's not clear how this will impact their business but it's an underappreciated facet of the story.
Finally, Ben Thompson at Stratechery revisits the Roku backstory (it was once part of Netflix and Reed Hastings decided to spin it off rather than launch it.) Ben notes that in many ways "a bet on Roku is a bet against Netflix." His content is subscription only but highly recommended.

My own reflection of Roku is that their story is really one about better digital advertising. Despite the early success and total domination of Google for search advertising - general digital advertising remains is a shambles of missed opportunity. For some reason serving relevant and effective digital ads is much harder than anyone imagined.

Original Note:

Roku has chosen an exciting time for their IPO - not in terms of the market which remains good but because they are at a crossroads in their business. If you have been to a Best Buy or bought a new TV lately you have probably heard of Roku. Their "box" allows your TV to access content on the internet or "Over The Top" AKA "OTT." OTT content can be accessed without going through a traditional cable TV set-top box or dare I say it, an antenna.

Roku is not alone - they are surrounded by Apple TV, Amazon (Fire TV) and Google (Chromecast). Much to their credit though Roku is the leader in terms of users and has executed well against the big guys. Roku counts 15M active users. The figures below include less active users but Roku has a slight lead. We've got a few issues with these numbers but we will revisit that later.

It's clear that OTT is a thing now. Music has gone that way as well thanks to Pandora (P), Spotify and Apple (AAPL). Video programming has taken a bit longer (the content payload is much bigger) but it's definitely here. Much of "TV" has become "non-linear" which is a way of saying we watch what we want, when we want to. It's less about "appointment TV" and more about choice and flexibility.

Unfortunately OTT also brings complexity and at times, so-so performance. The business model is also still evolving. Netflix (NFLX) started it and the content providers followed with their own subscriptions - I have a bunch including HBO, the NFL, and Tennis Channel. (Sadly when you add all these up it starts to look like that "high" monthly cable bill all over again.)

Most of the OTT growth so far has been in subscriptions. The new kid on the block is "free" content that has advertising. At first glance, this seems a little insane - part of what makes OTT worth it is the lack of advertising. But you can only pay for so many subscriptions before the cost and accounting gets to be too much. So when you feel like watch The Late Show with Stephen Colbert and don't want to subscribe to an "All Access Pass" you can watch it with commercials.

This new OTT advertising-based model is what Roku is about now. Before that Roku was focused on the player which makes up the bulk of their revenues. The current strategy is to focus on the "platform" part of the business which is digital advertising. In 2015 the $320M in revenue was split 84% player/16% platform. In the most recent six months their $200M of revenue has shifted to 58% player/42% platform. Player revenue is declining and platform revenue is growing at close to 100%. This pattern will continue for the next year, dampening total revenue growth but eventually leading to a higher multiple revenue stream.

There is some writing on the wall here for the other "TV" box makers. The Roku "box" has merged into the TV. In many models the Roku technology is already integrated into the set, there is no separate box and it's "free" from a consumer perspective. If Apple, Google, and Amazon want to play in the TV space they may have to give their box away or come up with more reasons for a consumer to want their device. Because Roku is independent they offer the broadest access to different content types - no "Apple TV won't show Amazon Video" and vice versa nonsense to contend with.

Roku is offering 16-18M shares at $12-14 to form a ~$220M IPO. There will be 95M shares outstanding for a market cap of $1.2B which is about 3x current revenue. Although there are no "direct" comparable stocks we'd note that TIVO trades at 3.5x and NFLX is at close to 9x. ROKU looks more like TIVO than they do NFLX though so the multiple should be closer to 3x than 9x.

If we "split the difference" that would put ROKU stock at $20/share.

This isn't our last word on ROKU. A cleaned up and expanded version of this will appear as a post. We also have a transcript of the ROKU IPO roadshow and of course the ROKU IPO slide deck.

Veritone – AI research going public

05/11/2017 by Candyman

If you're interested in AI then Veritone (NASDAQ: VERI $14-16) is an IPO you'll want to at least have a look at. It's a small deal led by three smaller banks - Wunderlich, Craig-Hallum and Northland. The larger firms wouldn't touch this - it's still more like a research project than a company. [UPDATE: Under pressure from institutions the deal size has been increased to 2.85M shares and is expected to price at the high end of the range tonight. Aftermarket is harder to call based on what the syndicate is seeing now.]

Veritone is playing into what has been a red-hot trend of using "AI" as a label for almost anything in software. Whatever a company was doing before they are now doing it with "AI" and not just advanced programming. At least 50% of what is going on in these companies wouldn't pass for AI in most circles. But Veritone is aiming at harder problems that leverage much of the work going in in areas including image recognition, speech understanding, sentiment analysis, etc.

For the public markets, Veritone will be one of the first and few "pure plays" on AI technology - especially for small cap investors for whom companies like Google (GOOG) and Facebook (FB) are not fits. There are other companies that have an "AI angle" like RocketFuel (FUEL) and Criteo (CRTO) but these are still online advertising companies.

Before we get to specifics part of the reason to pay attention is that Kevin Kelly, one of those guys who really gets it right when it comes to technology, emphasized in his recent TED talk that for AI to be really productive it would require a variety of reasoning types, each with very different capabilities. That's what Veritone is aiming to do - connect and orchestrate a number of distinct reasoning engines so that they can perform notably complex and varied tasks.

An example from the Veritone IPO roadshow slides illustrates what they are trying to do. In the scene below (includes both video and audio) there is an event happening with the driver of a race car, let's say it's about a crash. Being able to "understand" the event requires analyzing the video and picking out things like logos and identifying objects, processing the audio yields the words being said by the driver and sentiment analysis helps define whether the emotions are fear or triumph. By knitting together multiple engines the analysis can be completed effectively and according to Veritone management, for low cost - especially when compared to a human.

Veritone is aiming high and is striving to be "an operating system (OS) for AI" and deliver a platform that transforms AI processing into "actionable intelligence" for enterprise customers. Today however what Veritone is delivering is a solution that handles mostly audio and video processing for the media industry (advertising). It's a very long road from here to a general purpose platform.

In other words, this is an advertising technology company that has just launched an "AI Platform" business not unlike what RocketFuel and others are trying to do.

Getting valuation right for a company like this is hard. It's too young to be able to build a credible long-term IV model. We'll let the numbers speak for themselves:

At the upper end of the range ($16) the deal size will be $46M and the market cap will be $228M.

Revenues of $8.9M for 2016 were down from $14M in 2015. The company nearly doubled G&A spending from $8M to $15M during the same period.

It's fair to ask "what are investors actually buying here?" A case can be made that Veritone is at least a play on the growth of AI-focused business applications. Management works hard to paint a picture of themselves as being the right team to pull this off but a close reading of their actual backgrounds and job history in the Veritone prospectus suggests otherwise.

In conclusion, we'd suggest investors avoid this deal and instead consider a more substantial company like Cloudera (CLDR) which already leverages data to provide enterprises with AI-based insights into their business.

Cloudera Wants to be the King of Modern Enterprise Data

04/23/2017 by Candyman

Data Evolves

Exponential growth in data creates new demands for which traditional data management techniques like relational databases are not satisfactory. The pervasive nature of the internet and the so-called IoT has ensured that the exponential growth of data remains unchecked.

The point of processing this type of data is to be able to react - make decisions, automate tasks, refine actions and content. This is very different than the traditional methods of store, warehouse, process transactions and then update the "system of record." Bank accounts still work that way, but real-time streams of location data from a fleet of a million vehicles do not.

Companies like Google and Amazon have had to deal with this problem early and built their own data infrastructure to do so. Much of it incorporates and gives back to the community in the form of open source software. The first big building block put into open source was Hadoop, which became the standard and is very widely used. A host of additional Hadoop-based open source projects have built on and extended the capabilities of Hadoop into a real data platform.

The problem is that building, maintaining and using this software is hard, very hard. Because it's new there is also a shortage of skilled engineers and "data scientists" that can make it work and get real value out of the tools. The situation is similar to what we had with the Linux OS 20 years ago. Back then, Red Hat (NYSE: RHT) seized the opportunity to take Linux and make it business friendly and enterprise ready. Today Red Hat generates $2.5B in revenues and has a respectable market cap of $16B.

Those of you who have followed the software IPO market closely might be saying "wait a minute, wasn't this the positioning of Hortonworks (NASDAQ: HDP)?" which came public in late 2014? With Goldman as the lead bank, no less? You'd be right - this was precisely the positioning of HDP. From the HDP IPO Roadshow Slides - "Our mission is to establish Hadoop as the foundational technology of the modern enterprise."

Hortonworks didn't really succeed and their current share price is about 1/2 of what it was post-IPO. There are two main reasons - 1) they focused more on open source technology and architecture than enterprise needs and 2) Cloudera.

Cloudera was smart and lucky at the same time. We'll get to the smart part next, but the lucky part was a $740M investment from Intel in 2014 which gave Cloudera unmatchable resources to make the heavy investments required to satisfy large enterprise customers. Their level of financing allows them to hire and spend aggressively to satisfy customers and drive increased contract sizes.

Much has been made of the huge ($4.1B) valuation of that Intel-led round, but that's all misguided noise. Intel didn't make the investment for a financial return so the valuation isn't relevant. The "real" private valuation of Cloudera pre-IPO should be considered to be $1.8B, which was the valuation of the last financial round just before the Intel investment.

Cloudera as an Enterprise Data Platform

Large enterprises approach technology in unique and challenging ways. Their scale is much greater and they have an array of "must haves" that include fine-grained management, real-time support, reliability, recoverability, security, etc. Each one of these often requires substantial investments and together they are too daunting for most companies to address. That's why the exit strategy of so many "enterprise" software companies is to sell to a big player like Oracle, Microsoft, SAP or IBM rather than IPO.

Cloudera started with the "boring parts" like handling data collection and batch processing. These are the basic building blocks for the enterprise and serve as the foundation for what Cloudera delivered next, which was the ability to process unstructured data and enable real-time and interactive stream-based data processing. From this deeper base, Cloudera was there to bring their customers down the path to enable advanced analytics and machine learning.

In order to qualify as a real "platform" an infrastructure technology has to do more than work inside a single type of use case. Unstructured data, stream processing, and machine learning may be where all the sizzle is, but basics like data storage, management, and back-office processing must work too. Large enterprises are especially keen on platform technologies that bridge across multiple areas rather than having to adopt a new one for each. That's the key difference between what Cloudera has done versus other more niche-oriented "platform" companies like Hortonworks, MapR and Pivotal Software.

One big and illustrative product introduction from Cloudera was Impala. The lingua franca of the database world is SQL. Impala has many technical advantages over other approaches for analytics, but by using SQL it allows it to integrate with the existing array of tools and technologies already in use. For example, the mainstream business intelligence tools can incorporate analytics from Impala because it supports SQL.

Cloudera can be thought of as a software layer that sits on top of dozens of advanced data processing tools and makes them look like more traditional tools with extra services for managing security and performance.

Competition

We already mentioned Hortonworks (NASDAQ: HDP) which is a competitor, especially in situations where a very open source version of Hadoop is wanted but without all the enterprise bells and whistles. An all open-source solution is unlikely to ever address the specific needs of the large enterprise user. This is due to the highly variable environments there and the specific features needed. They don't translate well into general purpose open source projects.

MapR has built their own commercial and enterprise-flavored version of Hadoop infrastructure. MapR has a reputation for extreme performance but requires that customers use their own MapR filesystem and related toolsets. It's a good solution for many environments focused on performance but not as enterprise-friendly and versatile as Cloudera, especially when it comes to traditional data processing environments. In some cases, projects that are exclusively Hadoop-focused that demand very high performance might opt for MapR.

IBM is in the space with a whole stack of products that address development, deployment, business intelligence and traditional data management. However, the IBM product suite does not work so well with tools from other companies, which makes it problematic as a platform choice since many of the best-related data management products don't come from IBM.

The big traditional guys, Oracle, SAS and Teradata, are forces to reckon with. They own the installed base and have extended their traditional data tools with higher performance and more flexible offerings. They do tend to be much more expensive and this difference becomes profound when data volumes get very large. Design issues can make scaling up to large volumes on Oracle nearly impossible.

For example, a few years ago AMD migrated over 200 TB of data from Oracle to Cloudera due to outages and long recovery times. In addition to overcoming limits imposed by Oracle software, the performance of their systems was vastly improved in terms of response times.

Oracle is kind of a "frenemy" since they also want their products, like the Oracle Big Data Appliance, to work well in a Cloudera environment. For example, Oracle is a partner with a quote from the SVP of Oracle Server Technologies: "As the leader in Apache Hadoop-based data platforms, Cloudera has the enterprise quality and expertise that make them the right choice to work with on Oracle Big Data Appliance."

Given the size and scale of companies like Oracle, IBM, SAS and Teradata, Cloudera goes after three categories of use cases that are the most difficult for those vendors to compete for - customer insight applications, creating newly connected products and related services (like IoT) and next-generation risk management systems. Once installed, the Cloudera team will be in a better position to compete for additional projects, even ones that can be done with traditional data infrastructure.

Business Fundamentals and Valuation

The good news is that Cloudera is producing very strong growth, and if they can attain the margins in their long-term target model the company will provide great returns for investors. However today, like most SaaS companies, they are spending $2 for every $1 of revenue. Of course, it's recurring revenue and fairly "sticky" but one has to acknowledge it because any slowdown in the growth rate at this level of spending can be alarming. The market also can become suddenly impatient with this whole class of stocks as we witnessed during the first two months of 2016. That turned out to be a great buying opportunity (by March they were in full recovery) but it was painful.

We like to look closely at the dynamics of sales and marketing (S&M) spend and revenue growth. In the case of CLDR, the level of revenue generation to sales and marketing spend has been consistent at 1.2-1.4x during the past four quarters. Growth in S&M spend has been very lumpy so quarterly measures are not very helpful. On average though, revenue growth to S&M growth is 2x which is very good. Although the revenue growth rate has declined in the past few quarters, the efficiency of that growth has improved.

We do note that expense areas other than just S&M have been lumpy on a quarterly basis. For example, last quarter G&A expenses were up more than usual, even acknowledging the typical "IPO bump." As a private company these step changes are fine, but once in the public markets Cloudera might find these abrupt shifts unwelcome. The first few reports and conference calls with management will be closely watched.

Turning to Intrinsic Valuation (IV), the shares look inexpensive at the high end of the range $14. If one believes Cloudera will achieve their target model in the next five years then the IV comes in at $55-60/share. This is unlikely though, so we also ran a model (included here) that uses a 15% operating margin. That is still a stretch, but investors appreciate the recurring nature and profitability of the revenue stream. Using the more conservative IV we still get to a $35 price objective.

As usual, we have captured the Cloudera IPO Roadshow slides (as best we could since it's more video than slide presentation). We found the full Cloudera IPO roadshow transcript to be more helpful.

Yext is Next

04/11/2017 by Candyman

Just last week we posted that Software Infrastructure is Hot Again (and OKTA priced above the range at $17 and has moved up to $23). Less than a week later we have a story out of the Information about how now technology companies are scrambling to find experienced CFO talent to lead them to an IPO. That's a major change in thinking.

This week (Wednesday) we get the Yext IPO (NYSE: YEXT). Yext is a bit of an odd duck in the space. Despite some initial concerns it looks like demand for the deal is strong. The banks are Morgan Stanley, JPM, RBC, PacCrest and Piper - not a bad cover. We'll deal with the Google elephant in the room below. The roadshow is such that the slides are not super-helpful although we have them available. You might be better off reading the Yext IPO roadshow transcript instead of trying to follow the sparse slides.

Some investors were spooked by the surrealistic beginning of the roadshow (which is a video in the Facebook style) during which the CEO (Howard Lerman) is seen preaching to a group of rapt employees in some conference room high up in the sky. Mr. Lerman is suited up in an all black ensemble and stares into the camera with blazing blue eyes of conviction. What ensues is a discussion of where to go for lunch and how "curly fries are the best kind of fries."

Despite the misgivings Yext is definitely onto something. Conventional internet "search" is giving way to different ways of looking for things, especially mobile applications and maps. Consumers also expect much more information at their fingertips, not just a website. Now "results" include detailed business information including hours of operation, reviews, complete menus of food or services, amenities, credit cards accepted, photographs, etc. Questions like "does this hotel allow pets?" or "do they have gluten free menu options?" are often answered right in the listing.

Map-based searching has a much higher conversion rate for businesses which provides huge ROI when they get it right. Surprisingly, much of this information is sourced by web crawlers and crowd sourcing. Something as simple as a change in hours of operation can result in conflicting information online and confusion with customers.

Yext helps businesses manage their online presence. Sounds simple until you realize there are dozens of places that basic information is stored online. Google is primary for many but others - especially Facebook, Snapchat, Instagram, Yelp, the Apple App store and scores of other niche and local sources.

What Yext has built is a "system of record" for businesses to maintain their information online that syncs with hundreds of different services automatically. Yext has managed to get all the major online service providers to accept their information into their systems via an API.

The Yext website is a bit cheesy since it aims to convert small businesses to the Yext network automatically. However they have signed up a number of very large customers like Marriott and Arby's who rely on Yext for their online information. For example one of their enterprise customers expanded from less than $100K in billings to over $750K per year as they expanded their number of locations and took advantage of higher level Yext services. The ability of Yext to win a greater share of the enterprise market will be a key to their long-term positioning.

Small business is $15-17M per year and is expected to stay flat while medium and large businesses are growing at ~50% YoY. Yext is also investing in vertical industries like automobiles and government services where they are in a better position to consolidate their lead and get the larger customers.

Yext has rolled out a developer-facing service but it's too soon to know how that will play out. Their hope is that new applications of the Yelp "knowledge engine" will emerge and some may provide M&A opportunities for Yext as they grow.

Our IV shown below suggests YEXT shares have upside from the IPO, even if they price above the range. This is a $15-20 stock.

The big risk of course is Google and to a lesser extent Apple. While Yext doesn't have any customer concentration issues they have a big platform concentration. When it comes to mobile there is only Apple and Google in terms of the operating system. Companies like Facebook and Snapchat are well placed in mobile but these are not really the platforms for search and discovery that consumers turn to first.

Google has stumbled along with offerings like "places" but they haven't worked very well. But Google knows that maps and mobile are the key to their future. The much higher ROI isn't lost of them. One challenge for Google is that they rely on the advertising model. It's easy to see why this works so well in Search but not so easy when you consider Maps.

Google Maps wins because of quality and functionality with consumers. Google is working hard to integrate local information and lots of content into Maps. For example they have managed to get their own restaurant review numbers up. They still lack the depth and quality of Yelp but it's often "good enough."

It's hard to see how business-supplied data isn't better quality than crawled and crowd-sourced information in many cases and excluding Yext data seems like a bad idea. Google would have a hard time approaching Yext customers with a paid-for "system of record" offering that works across multiple services (not just Google.)

Yext has lots of work to do in order to cement their position and Google could certainly make their life more difficult with changes to their algorithms and content methods. Yelp has kept their pricing fairly low making it a "no brainer" for many businesses who need to maintain and manage their internet presence.

Everbridge IPO looks like a safe bet

09/15/2016 by Candyman

The Story, the Reality & The Valuation

The Story - Everbridge (EVBG) provides software to enable organizations to rapidly respond more effectively to emergency situations, like natural disasters, terrorist attacks and school shootings to name some examples. (See the EVBG IPO Slide Deck for more.)

The software enables effective mass communication and alerting to the right people in minutes. Everbridge fills the gap that exists between when a disaster strikes and the 15 minutes it takes a typical "first responder" to arrive at the scene.

It's a growing niche market and Everbridge has already secured the leading position in the market (in 8 of 10 largest cities, 8 of 10 largest investment banks, 4 of 4 largest CPA firms, 24 out of 25 busiest airports, etc.) These are also very "sticky" customers - once this software is in it is hard to move away from. Their market share gives them an edge in selling where CYA and FUD are potent weapons. (Cover Your Ass and Fear Uncertainty and Doubt for those of you unfamiliar.)

This fact supports the economics of customer acquisition at EVBG. They spend almost a $1 to acquire a $1 of revenue but then only .07 to retain that $1 of recurring revenue (they had a 116% revenue renewal rate in the last year.)

Large corporate customers spend several hundred thousand dollars per year and state government contracts get into the millions. The current revenue mix is 50% corporate, 34% government and 16% hospitals.

Everbridge is really a specialized communication platform for emergencies and critical events. Not only are the functions they offer tailored to the application, but the company has also invested much in having redundant systems across the entire technology chain including datacenter, communication networks, operation centers, and access points.

From their roots as a mass communication and alerting company they are investing in new products to extend their reach and increase the number of applications they can sell into their client base. Most of the thrust is into more predictive and analytical applications that are related to “smart sensors” and the so-called “Internet of Things” or IoT space.

Positioning the company as an IoT play is a bit desperate and feels more like investment banking “spin” then reality. However, IoT is real and as it spreads it does give them a bigger market opportunity since those devices will provide alerts that generate the need for core Everbridge functions.

The Reality

There are quite a few selling stockholders in this deal. Given the strength of the story it’s a little surprising to see how many would like to sell shares right away at the IPO price rather than wait six months for what would presumably be considerably higher prices. From a financial planning perspective it makes sense, the CEO for example would be selling only about 10% of his holdings and that’s only if the green shoe is exercised. Diversification is your friend. Still it’s somewhat rare to see a company with these seemingly stellar growth prospects with insiders selling in the IPO.

Revenue growth as decelerated. Growth was running at about 40% in 2014 and 2015. So far in 2016 it’s 30%. It’s especially surprising since beginning in 2015, Everbridge dramatically increased their spending on sales and marketing. This increase is still going on in 2016, yet sales growth remains slower than prior periods. The company is mum about this in their public roadshow so we are left to wonder.

One reason could be a focus on new accounts. During the roadshow the CEO did mention that the company “signed up 150 new accounts last quarter” which sounds like too many for what is typically a fairly large sale. That suggests that many of these accounts were in the five figure range and may be a way to seed more growth in later quarters. If true, it would be a very smart strategy because it “builds in” an acceleration of growth post-IPO. This team doesn’t seem that smart. And if they were why sell any in the IPO? We’ll know in 6 to 12 months which it is!

The Deal & Valuation

It's a solid group of underwriters but not the "A-team" of Goldman and/or Morgan Stanley. The leads are Credit Suisse and BofA with the selling group being fairly good on the research side with Stifel, Canaccord, Pacific Crest, William Blair and Raymond James.

It's a $90M deal at the $12 mid-point of the range. 7.5M shares are being offered and post-IPO total outstanding will be 28M for a market capitalization of $336M.

They should do between $75M and $80M in revenue in 2016 which gives them a current P/S ratio of 4.3x, which is not bad for a SaaS company.

This stock could trade in a very wide range. In this IPO market we have seen how with some stocks valuation feels like it is "all in the eye of the beholder" rather than traditional consensus methods. Look at how names like Twilio (TWLO) have performed.

In terms of EVBG, they would like to have investors compare them to a ServiceNow (NOW) which trades at 11x sales. This has become a fairly common level of a successful SaaS company. That would put the shares at $30. We've done a base case IV which straight lines the top line growth and gets them to the middle of their target financial model figures. That suggests a valuation of just over $24/share.

We suspect that in the recent quarter EVBG may have sandbagged some revenues and is prepared to announce strong results for the September and December quarters, but it's hard to know. It also stands at odds with insiders selling here. As a grow-by-acquisition company there's some messiness to the underlying business versus the carefully painted picture of the powerpoint presentation. But the company does have a solid niche that they should be able to execute in.

Twillo looks to join Apigee in the API software space

06/22/2016 by Candyman

There are lots of eyes on the Twilio TWLO IPO this week. It’s scheduled to price tonight. So far the IPO market in 2016 has been dominated by healthcare deals. Normally we tend to have a more balanced mix with more technology deals like Twilio. As a private company Twilio received quite a bit of VC interest at high valuations. So some of the interest in the IPO is based on the “valuation gap” between the private market valuations in technology versus the public markets. (We’d also add that BOX was an example of the gap, it’s what has helped to keep companies private longer where capital raising has been easier.) Mattermark published a deeper look at this in the context of Twilio.

As we go to press the capital markets are saying that the TWLO deal is “well oversubscribed and worthy of a trade.” These words have to be taken with a grain of salt since the markets can change on a dime but it suggests it will come tonight. The proposed price range is $12 to $14 on 10 million shares plus a 1.5 million shoe.

Twilio is a software company that provides developers with simple cloud-based interfaces to embed communications into their applications. (Still with me?) From a technical standpoint it is tedious, time-consuming and dull but it’s a critical part of how modern applications like Uber and AirBnB work. When you book and Uber and communicate with the driver via messages and calls it’s done using the Twilio platform.

We like the space and view Twilio as an important name to own in technology. To that end we’ve beefed up the TWLO IPO roadshow deck to include many more slides from the video-intensive roadshow presentation. We also put together a full IPO Candy TWLO roadshow transcript.

We’ve actually had a very similar company come public little more than a year ago - Apigee (APIC - $12.96) came public in April 2015 at a price of $17/share. There was strong demand for the deal but as can be seen in the chart investor interest took time to develop post-IPO. The shares were a real bargain and have found some sponsorship with investors now. Note the RS has gone from almost nothing to a very respectable 71.

APIC Chart June 2015

Apigee is a more general purpose technology which serves developers in any application, not just for communication. As the first company to come public in the space Apigee management had to do much of the heavy lifting in terms of educating investors and communicating with the markets about their value proposition. As a “money losing SaaS” company they took an extra hit early in 2016 when the whole sector got pummeled.

From a positioning point of view Twilio is going for the “platform” designation and comparing itself to other industry leaders in related segments. It’s interesting to note that Stripe is still private. We’d expect them to be watching TWLO with great interest.

Twilio Positioning

TWLO Valuation

To cut to the chase the deal is expected to price in the $12-14 range. At $13 that’s a market capitalization of $1.3B on sales of $167M in 2015. That may look rich but the company is growing fast and I’d estimate revenues in 2016 to come in around $300M which puts the valuation at a reasonable 4.3x.

As a reference point Apigee at the current price has a market cap of about $400M on revenues of about $100M but they are not growing as fast at about 35-40% versus the 80% growth at TWLO. We’d point out that many of the same major trends Twilio presents are driving Apigee as well. The trend toward more custom application development (versus packaged applications) and the need to integrate with myriad in-house and external cloud-based services are now imperatives in the software world. The key building block in this type of architecture is the API.

New Relic (NEWR) is a valid comparable and sports a market cap of $1.5B on expected 2016 revenue of $250M. NEWR is trading at 6x forward sales and is growing at 55-60%.

All these companies are losing money but have the desirable combination of high gross margins on recurring revenues. In the case of TWLO that gross margin is on the low side at 55%. However the model is fairly efficient in terms of CAC. The long term model for TWLO is 60-65% GM and eventually 20% operating margins.

Main Investment Points

Twilio is building a strategically valuable software infrastructure business. In much the same style as how Amazon built AWS. Our own twist on the story as presented would highlight the following key points:

1. The company is effectively embedded in most modern enterprise applications. While they are replaceable doing so would be inconvenient and consume precious development resources. So as long as Twilio continues to execute they have almost no risk of displacement once they are in.

2. Their usage-based business model means it’s easy for developers to adopt (low friction) but then revenue to Twilio scales as those applications are deployed and grow over time. So each new customer continues to grow. The reported expansion rate on customer contracts has been high at 150%.

3. The global communications network they have built gives them an asset that would take time for competition to replicate. It’s similar to what Akamai (AKAM - $54.70) did in the content delivery space. FWIW AKAM enjoys a $9.7B market cap today which is about 4.4x current sales.

4. Management appears to be very serious about the long term and has built a company with a distinctive culture and value system. They also want to exercise control over the company for a long time as evidenced by their dual class share structure (class B is a supervoting stock.)

5. The platform positioning makes add-on acquisitions (like Authy) attractive and rapidly integrated. If done with strong price discipline these acquisitions can be very accretive and further improve positioning.

6. Twilio is at the center of a high-stakes game that companies including Oracle, IBM, Microsoft, Google and Amazon can’t afford to lose in. That is likely to translate into an acquisition of Twilio at some point. Many speculated that it would occur before the IPO.

Biggest Risks

As with any IPO there is a litany of risk factors enumerated in the TWLO prospectus but we’d isolate it to a few:

1. Although efficient the company loses money - about $30M per year. This is often overlooked in “risk on” markets but as we experienced earlier this year it’s a real downer in “risk off” times.

2. Competition is serious. Amazon comes to mind first given their dominance with AWS and services they already have like messaging. Amazon tends to disrupt with pricing so if they do get deeper into the communication end of the market it could cause pain for Twilio and slow their growth. Other larger players with a major footprint in development and/or cloud communications include Microsoft and Google. At the lower end of the spectrum communication software companies like BroadSoft (BSFT - $43, $1.3B Cap) could get more granular and develop some special capabilities “closer to the metal” but so far we’ve not seen it.

3. Having a new “currency” as a public company might spur management to step up the pace of acquisitions. As we noted at the opening of this note the valuation of many private companies are at high levels, that makes acquisitions very expensive unless they are done with discipline. Any kind of “land grab” mentality will cost shareholders.

Conclusion

We like the company and the space. I expect we’ll put some in the portfolio tomorrow. Once the stock settles will complete our intrinsic valuation model to guide our position sizes over time. Summer can be a quiet time in the market and we may see opportunities for better prices later. We will be watching TWLO closely after pricing and into street coverage when the quiet period ends.

Seems like a safe initial buy around the IPO price. As a limit we might suggest the NEWR valuation of 6x 2016 revenues which for TWLO would translate to $21-22/share.

Mimecast Salad

11/16/2015 by Candyman

Mimecast (Nasdaq: MIME) is a SaaS/Cloud company focused on enterprise email security and archiving. The story is a little mixed up though. The company focuses on email but is positioned (at least by Gartner Group) as an information archiving company. There are also some misleading statements regarding market opportunity to take into consideration as well. The vast majority (96%) of customers buy their email security add-on for Microsoft Exchange, Microsoft Office365 and Google Apps. Beyond that a good portion (2/3rds) add an "email continuity" service which keeps enterprise email running even when there are problems with the underlying email system (Exchange, Office365 or Google Apps). Email security would probably be the best part of the "story" to go with but Mimecast is into backup and archiving as well. While this gives them some cross and up-sale opportunities with customers it broadens their exposure to focused competition and advances from the email platform providers Microsoft and Google. Looking at the vital stats Mimecast is doing well with $116M in FY15 (March) revenues growing just over 30%. Adjusted EBITDA margin is 15% and the company has a realistic target of 20-22%. Revenues are all SaaS/recurring so visibility is good and the quarterly growth has been very consistent. At the $11 mid-point the market capitalization of MIME will be $600M or 4.5x sales which is reasonable for a company with their growth and profit margins. See the Mimecast IPO roadshow slides for more information. The "market opportunity" slide is a little misleading given the product set. As shown in the graph they include the entire backup and recovery market in the graph and it makes up the largest part of it. But Mimecast isn't a backup and archiving company in the broad sense which would include other IT assets, operational data, etc. In making some adjustments to reflect a more realistic market sizing we'd accept "secure email gateway" and "data loss prevention" and then take 10% of "E-discovery" and 10% of "back up and recovery software" to come up with a 2014 market size of $3B. Applying the same math to the 2017 forecast would get us to $3.5B. The bad news is that $3.5B is a big haircut from the suggested $11.6B but given our 2020 revenue forecast for MIME of $400M it doesn't cut into the medium or even longer-term growth story. They do appear to be gaining share, especially from providers of older technology solutions. Competition is our biggest worry for Mimecast. There is already one strong public player already in ProofPoint (Nasdaq: PFPT). ProofPoint has revenues of over $250M, a market capitalization approaching $3B (about 14x sales) and has a broader solution of products. I doubt that Mimecast will be able to win deals against ProofPoint if they find themselves head-to-head. If ProofPoint caps the top end of the market the bottom may be pressured upwards by continued investments from Microsoft and Google in improving their enterprise capabilities. Security and management are certainly strategic to them and they are unlikely to want to leave it alone. Investors may see this as the ultimate end-game for Mimecast - get acquired by Microsoft. That might happen but as with all M&A related bets, it's hard to get visibility on. Another "dark horse" to potentially acquire Mimecast would be BlackBerry (BBRY). They have a stated goal to become more of an enterprise software company around messaging and Mimecast would definitely help them get there. Turning to valuation the offering at $11 is fairly attractive given the valuation afforded to companies like ProofPoint which came public in April of 2012 at a price of $13 and stands at $75/share today. MIME is better than PFPT in terms of size at the time of the IPO and profitability and many investors will appreciate that. Our IV estimate is about $18 for this year and $23 for next. Buying stock anywhere below $15 seems like a fairly safe bet.

Measuring Square

11/13/2015 by Candyman

Square (NYSE: SQ) is coming public as a $1B revenue company with quite a few moving parts.
There's the negative margin Starbucks business which is going away, plus the "ratchet" provision whereby prior investors will have their number of shares adjusted based on the IPO price to preserve their prospective returns. We suspect it will take at least a quarter or two for analysts and investors to get a better understanding of how the long-term model will develop for Square. It helps to have a starting point so we're publishing our initial IV model which suggests a current price of just over $17/share. Interest in the PayPay (Nasdaq: PYPL) spin-off has been high and we expect Square will generate similar levels of activity.
Suffice it to say that the jury remains out on which players will be long-term winners in the payments game. In addition to Square itself, their strategy has implications for direct lending (Lending Club LC and OnDeck ONDK among others), marketing (Constant Contact CTCT, HubSpot HUBS, GroupOn GRPN) and possibly larger firms like** Intuit INTU**. The press has been guarded if not outright negative on Square for the last few years as speculation about their momentum and ultimate fate swirled around. Now that we have a concrete IPO we can sort through the facts as they stand. Here are the main points as we see them: Going beyond "just payments" and into data analysis, marketing and financial services seems like a good strategy for the SMB market that Square targets. Generally speaking small companies lack the resources and interest in decoding Google Places, AdWords and services like Constant Contact or Mailchimp. They are forced to invest in compliant POS services to run their business so additional benefits like financial services and marketing make sense. The cash advance business is another nice addition to services. PayPal has been pushing this too so it's not unique. Compared to the rates that OnDeck charges for short-term money this might not be good news for them. This business should grow nicely and ultimately cuts into the territory that American Express occupies with small business owners. Like PayPal it's easy to get going with Square. Since we don't have a physical POS IPO Candy and IPO IQ use Stripe which suits our online needs best. However at the beginning we did use gateways like Authorize.net and there were many forms to fill out, approvals to get and ongoing costs. No SMB should have to deal with that. PayPal has been smart in making acquisitions like BrainTree. That gives them much newer technology to compete with Square. Starbucks was a big early customer for Square. Unfortunately one with negative gross margins! The relationship is ending and will ramp down to zero in 2016. The revenue loss is negative but is more than made up for by improved gross margins. We're on the fence with respect to Jack Dorsey and the management team at Square. The next few quarters will be a real test for the team. Their aim to continue to be truly innovative in their experience, add more services and deliver "everything a company needs to grow" and improve margins will all be carefully evaluated. The two big questions about the long term model are 1) how high can transaction gross margins be and 2) how large can the software and data business be. Our initial estimates are in the model but they will be refined. In terms of execution it's not known how Square will approach acquisitions. Companies like HubSpot (HUBS) or Constant Contact (CTCT) seem to make a good deal of sense and there are many others. If they are aggressive and good at integration this could be the only viable path to get big enough, fast enough. Our preliminary IV Model:

Xtera Communications XCOM IPO

11/05/2015 by Candyman

Xtera (NASDAQ: XCOM) provides long-range high-capacity optical networking systems. Company claims that they are unique because they simultaneously offer very high speed *and* long distance solutions. In the past most customers wanted one or the other - now everyone wants both.

XCOM is growing rapidly but is still fairly small. They should do about $60M in revenues this year - on which they will lose about $5M. The company is offering 5.5M shares at a $10 mid-point. Once public the market cap would be just under $200M or about 3x sales.

Investing in the latest optical network product cycle has been difficult since the last one ended in tears back in the late 1990's. The problem is the lack of pricing power and consistent margin expansion. The industry is capital-intensive and very competitive. Even if we give Xtera the edge in capabilities right now, companies like Alcatel-Lucent, Ciena and Infinera ZTE are right at their heels. So Xtera can win but often must deal with aggressive pricing actions and give up margin to close a deal. FWIW trading multiples for some of these are 4x for INFN, 1.5x for CIEN and 1x for ALU.

In defense of the margin pressure the company claims that over the life of a contract they can make up some additional margin and ultimately see mid-50's gross margin once a customer fully deploys. If the company can defend their position and capture a significant share of additional cards for their own platform, profit margins can be good.

It's somewhat puzzling that the long-term model shows a gross margin target of 43-44% which seems low based on the commentary above. In presenting the target model the CFO stated that because they have 3x the number of channel cards per chassis their gross margins will be better than competition and lower operating expenses will allow more of it to flow to the bottom line.

The scale required in this business suggests that the most likely long-term exit for Xtera will be an acquisition by one of the larger industry players. Handicapping the most likely companies to buy Xtera is a little tricky since they are both a hardware and a services/solution provider. They will take on a turn-key proposal for a terrestrial or under-sea network. Most companies are either independent integration firms *or* hardware suppliers. Xtera does both. We have seen some evidence of this as a trend. For example Digi International (NASDAQ: DGII) has shifted to this strategy with some notable success.

See the full deck of XCOM IPO slides for more information.

Adesto is more than meets the eye

10/19/2015 by Candyman

Adesto (NASDAQ: IOTS) doesn't look like much on the surface - flat revenues, consistent losses in a heavily commoditized business - computer memory. So it's not surprising that they just reduced their proposed price to $7/share with their tier-2 underwriting team of Needham, Oppy and Roth. It'll be a very small capitalization company at the new price - just over $100M.

But some further work is justified because underneath flat revenue growth there has been very rapid growth from new products with a steep drop in revenue from legacy products. At this point the revenue is almost all the new stuff. That means revenue growth will accelerate dramatically over the next few quarters. The ramp in design wins from 32 in 2013 to 65 in 2014 to what will be between 100 and 150 in 2015 makes the acceleration in revenue growth a given.

There also is a fundamental need for faster, much lower power electronics for embedded, wearable and mobile devices. Adesto has a technology advantage that allows them to serve this growing niche better than any of the larger competition. (see technology discussion below)

Unfortunately Adesto didn't make their roadshow presentation public which is a bad decision and amplifies the limited reach a small tier-2 group of underwriters provides. So building a decent IV model for them isn't easy due to the timing between design wins and revenue, price and volume trends and not even knowing what the target model is.

The memory business is a generally known quantity though so based on comparable companies and results we were able to put together a fairly solid model. The main parts we will have to watch for is how rapidly they can grow the top line, can gross margins get back to 45% and how much will they need to invest in R&D and S&M to support the growth.

Our IV suggests a near-term objective of $9 which would expand dramatically in 2017 if the company executes well enough for long-term numbers to be believable.

We published a research note on Adesto as a private company back in January of 2013. It's worthwhile background and context for where the company is today. Here is a major excerpt:

Adesto Technologies which is a next-generation memory company that has now moved from the development stages to commercialization and expansion. We expect the company to capture a significant portion of the non-volatile memory outside of the commodity data storage market and enjoy profitable royalty licensing from a number of other markets.

Adesto has spent the last five years developing a non-volatile memory (NVM) that delivers an order of magnitude improvement in speed with lower power consumption. It's a simple technology in concept: a solid electrolyte between two conductors can be "turned off or on" with a charge that creates or removes a conductive channel in the material. The invention is "obvious" but hard to execute. There’s an industry consensus that this is the most promising new emerging memory technology for mainstream applications. From the start Adesto has focused on commercialization by attracting strategic funding and licensing agreements, securing intellectual property, sticking to a profitable business model. This is the combination that can drive high consistent returns on invested capital. Presently the company is shifting from the development to the commercialization stage after investing $55M in capital from a mix of strategic partners and top-tier VC firms. The strategic investors and technology licensees have helped to develop the manufacturing process and have strong interests in end market adoption. Adesto acquired substantial revenues and relationships with nearly every major OEM from their purchase of the Serial FLASH business from Atmel. Having this product line and distribution channel provides a solid business foundation and accelerates the process of bringing the new technology into the marketplace.

The management team is made up of industry veterans with experience that spans many leading companies including AMD, Silicon Storage Technology, National Semiconductor, Broadcom, Transmeta, Cirrus Logic, Fairchild, AMCC, and Tower Semiconductor. Over the next 12 to 18 months we expect the company to sign additional licensing deals, and begin to experience a ramp in their revenue growth while margins expand at the same time.

Technology, memory and storage has a long way to go in order to deliver the performance, capability and efficiency we're going to need in our computational systems. Complicating the challenge is the shift to mobile and wireless. This means that power consumption is as important as speed unless and until the "battery problem" is solved in some profound way. Memory close to the processor in mobile devices is a critical component for which disruptive advances in the speed/density/power envelope can create significant market opportunities for semiconductor companies. This helps to explain the dizzying array of R&D pro-jects aimed at producing the "ultimate memory." There is a great chasm between the breathless descriptions of memory technology “breakthroughs” in R&D labs and devices that can be shipped by the millions and embedded in consumer products. It’s fun to talk about molecular memories and storing bits as spinning electrons but when the discussion turns to manufacturability, data retention, cost, stability and endurance, excitement evaporates quickly. The technology Adesto has been working on is called Conductive Bridging RAM (CBRAM) and has been gaining adherents around the industry (a few very large semiconductor firms have licensed the technology already from Adesto.) Adesto has tackled the key obstacle to mainstream CBRAM adoption, which is manufacturability.

The advantages from CBRAM come from simplicity and the relatively low impetus needed to create and destroy connections or “bits” of information. The lower impetus means greater durability and lower power requirements. Simple design improves density and per-formance. Adesto has worked through advanced manufacturing partnerships to develop the expertise needed for effective scale manufacturing. For example, Altis Semiconductor is an investor and manufacturer that is based in Europe and has key manufacturing platform expertise gained from a history involving both IBM and Infineon.

Market Opportunity Memory in general is a very large existing market on the order of $70B/year in sales. Ini-tially, however, Adesto will be offering discrete products in the lower density but “sticker socket” used for code rather than data storage. This part of the market is relatively small but still in excess of $5B/year. The licensing model of the Adesto business plan gives them access to the much larger (but highly capital intensive and competitive) data storage market. As far as we’re concerned this is the only way to go after the memory market and achieve high returns. Any market that is highly competitive, commodity-like and capital intensive is not good for equity investors. Going after the attractive low density segment and licensing the rest is the right approach. Adesto investors should look at the market in terms of the margin opportunity. By making their own devices in the lower-density code storage market and licensing in data storage the company can capture a meaningful total share of the available gross and operating margins in the total memory business over time. The next few years of execution will dictate the ultimate revenue opportunity and operating margins that can be achieved in the longer term.

Competition & Industry Dynamics No major innovation in the memory market is going to slip by unnoticed. Most of the large firms in the market and some that are not have ongoing R&D initiatives that are closely related to the Adesto CBRAM technology. Right now Adesto is recognized as the leader and has a substantial IP base upon which to build. However, we expect other memory-makers to offer at least something competitive.

In terms of semiconductor industry dynamics we’ve seen this many times before. Some examples include Invensense INVN (motion processing chips), Nvidia NVDA (graphics processing), and OmniVision OVTI (image sensors). All of these companies have competed against much larger, broader semiconductor firms and maintained their advantages to build meaningful independent public companies. We expect the Adesto timeline to show additional licensing agreements, next generation products and a strong revenue and profit ramp.

Probably the biggest risk to the story is that the major makers of memory have their own competitive products which are generally inferior to what Adesto has for special applications but they may become "good enough" to cap the TAM for Adesto and limit their ability to reach a scale where they can generate attractive margins.

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