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IPO Bake Off – DocuSign versus Smartsheet

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We have two business SaaS players coming public tonight. While their businesses are very different we thought it would be fun to compare them using our typical framework for evaluating new companies.

If you don’t already know them DocuSign (DOCU) is an online system to allow documents to be signed by multiple parties to speed the normal paper-based approach. Smartsheet (SMAR) is an online spreadsheet-based collaboration and productivity tool used by teams for a broad variety of tasks from scheduling to project management.

Both of these deals are attractive on fundamentals and proposed valuation. Our IV on SMAR is $25 and our IV on DOCU is $44. Institutional demand for both deals has been strong enough for the price ranges to be increased. SMAR went from $10-12 to $12-14 and DOCU increased from $24-26 to $26-28.

[For reference: SMAR Roadshow Slides, DOCU Roadshow Slides, Transcripts will be posted shortly and updated with links here.]

Size and Maturity - DocuSign

DocuSign’s $519M in revenue last year is almost 5x the $111M in sales for Smartsheet. The customer ratio is similar with 370,000 for DOCU and 74,000 for SMAR.

Largely due to their larger scale, DocuSign has is now cash-flow positive versus Smartsheet which is consuming cash as they ramp up the business.

In short, DocuSign is in the “$500M to $1B” revenue expansion phase while Smartsheet is in the “$100M to $250M” phase.

Institutions prefer companies that have achieved great scale as they have a more tested, durable growth strategy which is less likely to be disrupted by competition.

Management - Smartsheet

Both companies have experienced management teams. However, we give the nod to SMAR because their team has a much longer history together and at Smartsheet.

SMAR co-founders and board member Brent Frei has worked with CEO Mark Mader since 1995 when they both worked at Onyx software which Frei co-founded and was as CEO from 1994 to 2004.

The rest of the Smartsheet team has been built out with experienced executives from Microsoft, Amazon Web Services, YuMe, NetSuite, and Box.

DocuSign has a strong team and board but they have worked together for a shorter period. For example, the CEO joined DOCU in 2017. The same is true with their CMO and CTO. Other members of the team have been with the company longer but as a team, they all may need some time to forge their working relationships.

Growth - Smartsheet

This one could go either way but we are giving the nod to SMAR because 1) their 60% annual growth rate is much higher than the 40% at DOCU and 2) SMAR has introduced a slew of new related product features and services that should sustain this higher growth rate over the next 2 to 3 years.

The argument for DOCU would be that since they are larger their rate of growth is bound to be smaller but their growth in absolute dollars is higher - $38M last quarter versus $11M for SMAR.

The diagram below illustrates the additional product features that SmartSheet has added to their core spreadsheet product. These open up incremental market opportunity in areas like project management, business intelligence, and administrative applications.

Market Opportunity - Smartsheet

Both companies have similar “current market opportunity” that they estimate at just above $20B. Of course, their efforts are not worth much because they equate roughly to “whatever every company became a customer” which is never the case.

SMAR is much more of a general purpose system that will suit a variety of applications. DOCU is a more focused solution around contracts and agreements. The long-term opportunity for DOCU depends on their ability to "become a platform for agreements" which as a growth aspiration is a bit vague and may be hard to execute.

There are lots of other established players in the "prepare" portion of what constitutes agreements. The "act" and "manage" spaces have been very fragmented so they could be fertile ground for DocuSign to expand into.

Smartsheet doesn't have much evangelizing to do - their core product and additional tools are general and easily used for a wide variety of tasks. It's a little like asking "how big is the market for spreadsheets?" It's essentially unbounded because so many new use cases are created every day for the existing product suite.

Competition - DocuSign

There are some other e-signature solutions out there but the market is dominated by DocuSign and Adobe (who acquired EchoSign in 2011). Adobe has integrated this with their PDF product suite. Anecdotally it seems that very few people are using Adobe as an e-signature platform. Adobe relies on their Creative Suite to drive the bulk of their revenue and profits and may not be as aggressive in promoting their potential as an "agreement platform."

DocuSign also has the advantage of being a "Switzerland" in working with other large software companies like Microsoft and Oracle since they don't view DOCU as a competitor.

Smartsheet may not have many direct competitors but they have scores of "substitute solutions" that are viable for many of the use cases they target. Microsoft Excel and Google Sheets are the most obvious. There are also platforms like Zoho (Private) that could be used as a viable solution for many Smartsheet applications.

Google Sheets is probably the biggest threat to Smartsheet. It's not so much that Google Sheets is a great product but rather the ecosystem of tools and online services that can be integrated with Sheets. General purpose automation solutions like Zapier (Private) can extend and integrate with hundreds of applications to create "code free" solutions for almost any use case.

Although they are somewhat developer-focused, Atlassian (TEAM) acquired Trello in 2017 for $425M. Trello brings 20 million users of their online management tool.

Smartsheet has done a good job of executing on the product and product management to make sure they capture a good share of the market but as a still-small player, they could be disrupted by either Google Sheets or a more open and online Microsoft Excel.

Valuation - DocuSign

We’re going with DOCU here because the 8x price/sales ratio compares to 12x for SMAR. Our IV estimates below show a bit more upside for SMAR but we think there is less short-term risk in DOCU relative to the proposed valuation.

Related Companies

Workiva (WK), Veronis (VRNS), Atlassian (TEAM), ServiceNow (NOW), Zendesk (ZEN), Google (GOOG), Adobe (ADBE), Microsoft (MSFT), Slack (Private) and Zapier (Private).

Pivotal Software – A pretty platform for big, ugly applications.

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Pivotal Software ($PVTL) went public on Friday at $15/share. The offering didn’t get a resounding vote from the markets. Unlike other recent enterprise software deals, this one ended quietly at $15.75.

We think PVTL is likely to do well from these levels. Partly because investors focused on “slowing growth” in revenues. That misses the most valuable aspect of the growth story - services revenues are actually declining YoY while software subscription revenue growth remains robust.

The table below illustrates the underlying dynamics. Note not only the growth in SaaS revenue but also the overall increase in gross margin. With 90% margins on the SaaS business, this is the one we want to grow.

 

Our IV estimate (below) suggests the shares may see $34 in the next year.

Industry Context and Background

When we say “big and ugly” we mean that in a good way. Enterprise IT is a very complex beast. Enterprises have legacy applications, individual and global architectures, multiple databases and transactional systems and need a high level of security, monitoring, and compliance.

Being productive in such an environment is an ever-present challenge. Over the years there have been waves of technology in this space. In the very early days, we had “Computer-Aided Software Engineering” or CASE which spawned an array of tools and techniques that saw some adoption.

In the 1990’s this shifted to “model-based development” led by companies like Rational Software which ultimately was acquired by IBM. During the same period, large companies started to shift away from mainframes thanks to distributed software infrastructure from companies like BEA Systems which was acquired by Oracle.

For the past decade, most new trends in development have been toward lighter frameworks, speed and “agile” development methods. At the same time, the infrastructure has shifted yet again to the cloud led by providers like Amazon (AWS) and now Microsoft (Azure).

A whole crop of “cool” infrastructure technology providers have come public including Twilio (TWLO), MuleSoft (MULE), MongoDB (MDB), Nutanix (NTNX), ServiceNow (NOW), Zendesk (ZEN), Okta (OKTA), Atlassian (TEAM), Coupa (COUP), Tableau (DATA), ZScaler (ZS) and New Relic (NEWR) to name a few! These stocks have mostly done VERY well.

Today enterprises are looking for ways to exploit the advantages of these new development technologies to increase productivity and be able to leverage the cloud for their own business needs.

At a very high-level PVTL provides 1) a development framework and approach, 2) a set of development tools and 3) a deployment platform that works on top of mainstream services like AWS and Azure.

If you want a more complete “feel” for the PVTL platform you can learn more by just skimming the portal to the documentation: https://docs.pivotal.io/

Stock Conclusion

As long as Pivotal continues to grow their subscription revenue the investment case is strong. It's recurring and much higher margin than the services business which is more appropriately performed by large partners like Anderson Consulting, PWC, or IBM.

Investors worry about what Dell may do with the rest of the shares they own. This "overhang" may be part of the reason for the lack of post-IPO performance. The Dell stake also might make it harder for a natural acquirer like IBM or Oracle to make a move on PVTL.

At these levels, PVTL offers attractive risk/reward - especially versus some of the other infrastructure software names that have moved up sharply and trade much closer or even above our IV estimates.

Zuora Strives for Sex in Billing Software

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Enterprise subscription management software is pretty boring. But the world is shifting from purchase to subscription. Every company now wants “continuous customer relationships” and consumers love subscriptions. In many ways, the subscription economy isn’t new. Even cars were often leased versus bought but they were still treated as an asset. Companies like Zipcar took it to a new level of all service.

Sellers like subscriptions because it gives them more predictable revenue and consumers like to avoid making large purchases and prefer smaller, predictable and cancellable subscriptions.

Some of the key drivers for this trend in business stem from four main drivers (according to Forrester):

  1. Everyone wants stickier customer relationships. That demands a move away from "one and done" transactions and to models that keep the customer more locked in and coming back for more. For example "family plans" have caught on with service providers because it makes it much, much harder to change since it requires everyone in the family to change which is a major hassle.
  2. Products are now connected. Thanks to the IoT trend everything is full of sensors and "smart" which require ongoing monitoring and updates. This opens up lots of business model innovation for companies which demands new types of billing to go along with them.
  3. The cloud enables subscription and usage-based revenue models. In most developed (and many semi-developed) areas the cloud is ubiquitous and the general expectation for any cloud-based offering is that it will be sold on a subscription basis.
  4. Data-driven customer care and business insights. If a customer walks away with a one-time purchase your opportunity to collect data and learn how to build a relationship is nil. But if they are linked by a recurring subscription they can be monitored based on usage, engagement, and sentiment. The data can be used to provide better service, product innovations or improvements in interfaces and packaging.

Large enterprise software companies have already gone down this road - Salesforce (CRM), Workday (WDAY) and Adobe (ADBE) are all leading corporate examples. Almost everything in the cloud uses a subscription-based model.

Zuora (ZUO) is an enterprise-scale solution for companies wanting to offer a subscription-based business model. Their revenues have grown substantially in the last two years ahead of their IPO. Their loss from operations has remained high however at ($35-45M) per year for the last three fiscal years (their FYE is January.)

(As usual we have the ZUO IPO slide deck available but also did a full transcript of the ZUO IPO roadshow if you really want detail.)

In total ZUO generated $133M in operating losses to build a $168M revenue business. This is due in part to the general SaaS model but it's a bit worse for ZUO because their system is a truly "enterprise" which makes it harder to implement than other offerings. That's also why the company has a fairly high portion of revenue from professional services.

One odd thing about the ZUO P&L is that sales and marketing expense growth isn't really the major culprit in the steady losses - major increases in both R&D (good) and G&A (not so good) have contributed a good deal to the growth in expenses and blunted any potential margin expansion from the increased scale of the company.

Below is the ZUO revenue growth model. The first 2 are typical "land and expand" for a SaaS company but the volume-based growth is an extra kicker for them. Note that some customers reject this pricing model if they can because they view the volume charges as a "tax" on their growth. But it's a common-enough model in business to be accepted most of the time.

Two key metrics are customers over $100K/year and dollar-based retention. Zuora gets paid via subscriptions and also with a share of “processed transaction volume” which gives them some “skin in the game” in helping their customers grow.

Gross margin is 77% and will move into the mid-80’s as professional services becomes a smaller portion of total revenue. (Professional services are run as a break-even business.)

Operating losses have improved from 49% of sales in FY16 to 21% of sales in FY18. Management declined to provide a long-term target model for the company, leaving investors to infer one from comparable companies. Some "comps" we think are appropriate for ZUO include Coupa Software (COUP) and Apptio (APTI) on the enterprise application side and Twilio (TWLO), Cloudera (CLDR) and MuleSoft (MULE) on the infrastructure side.

The ZUO IPO has priced fairly aggressively at $14, the original range was $9-11. I opened for trading at $20 which is not very attractive relative to our $24 IV.

Competition

This is an area we may do some more work on post the IPO and as the company gets closer to having stock coverage. Zuora makes it seem like they have little or no direct competition in their space. This is at least partially true. However, Forrester had SAP positioned much higher than we expected when they evaluated the vendors in this space in 2015. It's true this is a bit dated so we will be going back in to see if ZUO has extended their lead or whether other vendors may be catching up.

The Spotify

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The Spotify Deal

Call it what you will (IPO, DPO, simple listing) but Spotify (NYSE: SPOT) will begin trading in the public markets on April 3rd. The shares have a trading and price history that the company includes in their prospectus - they place a high emphasis on “transparency” in their corporate culture.

Spotify is a company we’ll be following since they are at the heart of how technology is changing in the music and entertainment business. They are also the gorilla in this segment amidst very large technology companies - they have 157M monthly active users, $5B in revenue, $1.8B in cash and are cash flow positive.

There is no “price” on this deal. In order to get one, we used the transaction history summary from June 2017 through February 2018 with a weighting by volume (VWAP). Using 9 months of data the VWAP is $95.39. However, the average price for the first three months of 2018 was $109.58. If we average these two we come to a $102 price level that we’ll use as the “offer price” for our IV model. (Note that the transaction history doesn’t include volume at specific prices so this is the best anyone can do with the information provided.)

At $102 and 177M shares outstanding that puts the market capitalization at $18B. Our IV below suggests the shares should trade at $170. But there are some big caveats around this number. Nobody knows what the long-term operating model will look like. Every 1% difference in the long-term margin drives about 25 points on the stock.

Some banks have initiated coverage of SPOT in advance of the listing. Both RBC and MKM came put with “Buy” ratings and price targets of $220 and $200 respectively.

Distilling the SPOT Investment Case

There’s a plethora of filings, presentations, and commentary out there on Spotify. Plus investors have seen at least a somewhat similar deal when Pandora (P) came public in 2011. They came out at $16 and one research firm, BTIG, boldly predicted they would trade down to $5.50 and they hit that nail on the head. That same analyst, Richard Greenfield, wrote in March of last year "The intersection of 50 million subscribers, consumer love, great underlying technology supported by an engineering culture and a daily use app on mobile, makes Spotify one of the most compelling acquisition targets in media today.”

Here are the aspects upon which our investment view of SPOT rests:

  1. The company has a great management team and corporate culture. Sometimes you are willing to “bet on a team” even when the industry is challenging. This team has considerable resources as well with their public stock value and $1.8B in cash. Investors can be “bribed by excellent results” by a strong team that keeps delivering. The situation reminds me a bit of GrubHub (GRUB) which most “experts” dissed at the IPO and is now up 4-fold.
  2. Their current Life Time Value to Subscriber Acquisition Cost (LTV/SAC) ratio is 2.7x which is good. As long as that ratio remains the company will continue to be in “grow customer numbers” mode.
  3. The biggest single negative for SPOT is that they have high variable costs. This means they can’t just “make it up in volume.” Contrast their structure with Dropbox (DBX) which has relatively high fixed costs but very little variable cost. In two years Dropbox gross margins more than doubled from 32% to 66%. Spotify can’t do this. More customers and more usage will keep driving costs up.
  4. Efforts to reduce churn tend to aggravate the gross margin problem. For example, the “family plan” is a great way to lock people in lowers the price paid per user per month and some typical family members, particularly teenagers, may have worse-than-average unit economics.
  5. The “two way marketplace” is interesting and helps to differentiate Spotify and give them a more noble mission. There have certainly been some notable success on the artist side and long-term this *could be disruptive* to the industry but it’s too soon to know. (see below)
  6. Curated playlists are the solution for a big part of the industry and that part of the Spotify business is growing rapidly. It also gives them tremendous power to “break” new artists by introducing them to their curated playlist/brands when they fit.
  7. Spotify is building a strategic asset for *somebody,* even of we don’t know who it is. Their customer base, revenue size and growth, and positive cash flow enhance their attractiveness as a core asset in consumer entertainment. It’s hard to picture one of the large technology players buying SPOT but other more consumer-focused companies like Disney (DIS) seem more likely.

Content Creation, Labels and the Potential “Netflix Effect”

Spotify has built the best consumer software music platform but they are working hard to also build an effective platform for the artists who create and deliver content. So far Spotify has built a combination of data, tools and curated entertainment properties that can catapult new artists into success.

Spotify offers a growing number of features that help artists create new content, connect with and engage more with their fans.

These included “artist pages” which could be used more effectively if consumers prefer an alternative to “sharing on facebook” when it comes to music. They also have software tools to help create content and data on fans in terms who they are and where they live. The latter makes selecting locations and venues for tours much more informed. Spotify even has some ticketing capability to allow artists to sell directly to “super fans” before the general public.

Spotify has also delivered some remarkable innovation around the smartphone. They give artists the ability to “take over” the screen when their song is playing. This creates some great effects and opens up opportunities for artists to do more than simply release a song and/or a video.

The growth of curated playlists has been strong and we expect it will continue. There’s just too much new music out there for consumers to manage it. The playlists have been a huge success and have now even morphed into “brands” or in some ways “labels” of their own.

That brings us to the whole comparison with Netflix (NFLX). It’s true that Netflix also has variable costs associated with serving content. They also have hugely ramped up their spending on new and exclusive content for their subscribers.

In the US Netflix has 46% gross margins on $6.2M of annual revenue. Their gross margin on their $5.1B of revenue is only 19% although it’s been climbing rapidly in the past two years. Overall operating margins at Netflix are 7%. Investors have decided to grant Netflix an “Amazon-like” status which comes with a 100+ P/E multiple and 10x sales.

Spotify still has a way to go before they can achieve this level of investor confidence. The stock is likely to trade on the momentum seen in new subscriber growth, reduced churn, and overall business metrics. If SPOT continues to outpace Apple and everyone else in music the shares probably will not be held up to traditional valuation metrics.

Valuation

We’ve built an intrinsic value model for Spotify which suggest a $170 stock price. Spotify faces huge competitors although it's hard to pinpoint just how important "music" is to Apple, Google and Amazon.

For example, when the iPod was meaningful for Apple it was critical to have iTunes and “own” the music consumer. They have continued to suggest music is important but it seems to be more because “it’s cool” and perhaps because Tim Cook doesn’t have much strategic vision and simply continues to push forward on the strategy that Steve Jobs forged years ago. Music is now a relatively small part of what Apple is about.

Our IV suggests there is fundamental upside based on the level the shares are likely to debut at on the NYSE tomorrow. Please note that the model is *hugely conditioned* on the long-term operating model. The 7% level is where we are starting out but *every 1% difference on the operating margin line creates a 25 point swing in the IV price.* 

 

Sizing up the Dropbox.

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The Dropbox (DBX) IPO is well-trod ground at this point. The deal is expected to price on 3/22 and open for trading Friday, 3/23. The company raised the range to $18-20 so we are using the $19 mid-point in our analysis.

To add to the general pomp and circumstance, Salesforce (CRM), stepped up to buy $100M of the deal at the IPO price. Here are some of the key points that appeal to investors:

  1. Revenue growth of 31% to $1.1B and gross margins have doubled from 32% in 2015 to 66% in 2017.
  2. Although not profitable DBX generated $300M in cash flow last year which is up more than 2x from the year before.
  3. Dropbox has a “sticky” mostly recurring revenue base which has some built-in growth from converting “freemium” clients to paid plans.

Putting the basics together in our first cut analysis suggests a $27 potential IV for the shares post IPO. After what we saw with Zscaler (ZS) last week maybe DBX shares will get there.

Challenges

Yet there are some reasons to be uncertain of their future success. They have done a great job of using a “bottom-up” strategy to capture the consumer and SMB market for a cloud-based file system that handles backup, synchronization, and sharing of files.

But going forward the growth of Dropbox will depend on being able to make some big changes:

  1. Shift technology platform from files to teams.
  2. Move the business model from consumer to enterprise.
  3. Move development focus from objects to workflow.

None of these are trivial and they are likely to impact the financial model as well. For example, much has been made of their low relative cost of sales. That will change as the company goes after larger customers.

As they move into teams and workflow their position relative to their partners and competitors will change along with it. Sure Salesforce (CRM) is a partner and is making an investment on the IPO. That’s good news.

But other companies like Slack, Microsoft, Google and Atlassian (TEAM) that view Dropbox as a partner today might not see things the same way if Dropbox strategy is based on launching products that compete directly with these companies.

As a small business, we love Dropbox. We use it to manage all our files internally (although we use Amazon AWS for our client-facing content.) Paper even seems like a great new lightweight collaboration tool.

But now Dropbox is entering the big leagues where things will be tougher - growth will come at higher costs, partners could turn on them and investors may become worried about the growth strategy, competition and the material dilution coming as “excluded shares” come into the market over the longer term.

Looking at Valuation Scenarios

We’ve played around with our IV model and looked at a few scenarios.

No matter how you look at the deal looks good at the IPO price. The question is how to handle the aftermarket. Again look at ZS, you could have chased it at $33 on the first day of trading. But ZS has an IV of $30 it seems better to wait.

Here’s the basic IV, there's definitely upside based on this model. But below we show the same model including the “excluded shares.”

There’s always been a big debate in the investment world on how to handle “stock-based compensation.” Nobody smart things it should be ignored or excluded. It doesn’t typically demand special attention but in the case of DBX the numbers are fairly large.

If you account for all the incremental shares the IV shrinks from $27.25 to $19.47.

Cloud Security with the Zscaler IPO

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In case you haven’t noticed we’ve seen an acceleration of enterprise cloud adoption. Stocks like Nutanix (NTNX), Twilio (TWLO), MongoDB (MDB) and Okta (OKTA) have all taken off in the past few weeks on the back of improving fundamentals.

The shift is captured in a quote overheard during an industry conversation - “large companies are now moving their core IT to the cloud.” For the last decade there has been plenty of cloud “adoption” but it’s been part of a “hybrid” strategy. Now it’s full-on.

Corporate networks have not evolved fast enough to keep up with cloud adoption. Anyone who has had to use a “corporate VPN” to access their applications outside the office knows how creaky these approaches have become.

Zscaler (ZS) preaches a new approach to network security which is to stop thinking about data center as “castles” and security as “moats” designed to protect assets. They refer to the resulting network topology as “hub and spoke” which is inherently not very cloud-like.

To be fair Zscaler has kind of “snuck up” on this vision as a result of their individual product strategy. One product, ZIA, provides secure access to external applications and another, ZPA, provides secure access to internal applications.

You can review the whole ZS IPO slide deck and our transcript of the ZS IPO roadshow presentation for the full story.

By bringing these two products together Zscaler is able to offer an end-to-end security solution that can bypass some of the intermediary components since - reducing cost and complexity while enhancing scalability and performance.

It’s not perfect but they are the leading vendor in this space with a widening lead according to Gartner Group.

Symantec (SYMC) is also positioned in the leaders quadrant thanks to their $4.65B acquisition of Blue Coat in 2016. Given that Zscaler is taking share they will have room to grow their valuation form the proposed $1.3B. (Our IV is below.)

Parallels with Akamai (AKAM)

Another way to think about Zscaler is to consider how Akamai (AKAM) pioneered content delivery on the internet. Back in the day every time a user accessed a website the contents were served from the host to the browser. But the more people that accessed the site, the slower it got.

Akamai took the simple idea of using a local “cache” of the data, putting servers everywhere and wrapped it with network math to be able to serve massive amounts of content in a highly-distributed manner.

The result was that the more heavily accessed a site is, the faster the content can be served which fixes the scalability problem - at least when it comes to static images, graphics, files and streams.

Thus the “Content Delivery Network” or CDN was born. It’s a core feature of our infrastructure today and now multiple vendors including Amazon (AMZN) offer their own versions. Akamai is still a big player but the CDN became more commoditized it reduced their TAM and they have never been able to really succeed in developing a large adjacent business.

Zscaler has done something similar by deploying in over 100 data centers around the world. (Much of that aligned with new growth of cloud applications like Microsoft Office 365.) One way to think about this is imagine a "mini-stack" of security software deployed everywhere in the cloud.

Does anyone get hurt?

The Zscaler approach begs the question "will traditional network security vendors get hurt?" Companies like Palo Alto Networks (PANW), Fortinet (FTNT), CheckPoint (CHKP), FireEye (FEYE) or F5 (FFIV) certainly know about the shift to the cloud. The security appliance market is $17B so there's plenty of spend there.

For example FEYE has already been moving to a software-based security solution. They still sell appliances for customers that want/need that kind of solution but it's not like these companies are going to be blindsided by Zscaler approach.

Security technology has been so strong for so long that it's been a growing pie for nearly all the players. At some point there could be some pressure on security budgets and if there is indeed "a better way" to secure cloud applications without as much heavy investment in the network then we could see some fallout.

One more interesting loser might be Symantec/Blue Coat (SYMC). They are still a leader in secure web gateways but they are already losing share to ZS. Without a strong position in network or even endpoint security, Symantec might have more risk than the other security vendors.

 

Investment Conclusion

Zscaler is still a small company at $150M in sales with low penetration of the enterprise market. They haven't "broken though" to be considered with the "big boys" like NTNX. However we expect the company to continued to grow on the strength of their individual offerings and trade up towards their IV of $30.

As ZS grows up we may see a “Battle Royale” between the big network security companies and cloud-centric vendors like Zscaler. For that reason owners of PANW, FTNT, CSCO and CHKP should keep a close eye on ZS (and maybe a small position just in case!)

There's more work to do on Zscaler once it's public and we see how they do over the next couple of quarters. Their product positioning and go-to-market strategy are promising.

 

Roku Ready – Updated

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

  1. "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.
  2. 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.
  3. 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

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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

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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.

visualcapitalist.com

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

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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.

Man on a Mission

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.

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