So following the market sell-off, we spoke with a number of traders and stock analysts at several banks to garner perspectives on what catalyzed the selloff and the future outlook for the public software market specifically. Below, we’ve provided a collection of notable insights from conversations over the last week (not necessarily our opinions).
What sparked the selloff?
The sentiment among the individuals we spoke with suggested that the sell-off was part profit taking, part technical, and broadly all catalyzed by what is (probably) an overreaction to macro factors many of us are already aware of: trade / tariff worries, rising rates, changing bond yields, uncertainty around the Fed’s intentions, November elections, and an uncertain global growth outlook.
When the market overreacts to macro factors, high-beta stocks (beta represents how volatile, or risky, an individual stock is vs. the market as a whole) such as the public SaaS companies (and tech broadly) are hit hardest as investors flee towards the safety of lower risk assets. The reality is we’re still in a pretty good spot, relative to a year ago in many tech stocks, despite the sell-off. There has been strong year-over-year growth and investors who exited in the sell-off had already made great paper returns and sought liquidity for their positions as uncertainty loomed. Overall, our conversations reinforced a sentiment that the correction was healthy – some of the more popular names were overbought by investors who didn’t want to miss out.
Taken together, the message these discussions delivered was clear: we should expect volatility to continue as the Fed raises the low interest rates which catalyzed economic growth. For the global markets as a whole though, it sounds like a period of high volatility is more likely than a sustained downward movement.
If there’s a downturn, what happens to software?
As enterprise software investors, we wanted to understand what risk a sustained downward movement poses to public software companies if global markets do take a turn for the worst.
To help frame their opinions, the individuals we spoke with reinforced that we can’t underestimate the theme of digital transformation within the enterprise. This transformation is a real thing and businesses need software to remain relevant. Gartner estimates that IT spend on enterprise software will grow more than 8 percent in 2019. Recently, Salesforce CEO Marc Benioff noted that the “economy is ripping.” This is the strongest buying market for software he’s ever seen and incredible demand from customers to rebuild their systems continues.
Enterprise software is mission critical and will continue to be in a recession.
So what does this mean for valuations? More likely than not, we’ll see a bifurcation in SaaS stocks, as opposed to a total sustained sell-off. The highest quality stocks – supported by the themes above – will remain favorable and perform well, while less proven, higher cash-burn names with negative trends and inability to prove out their growth model will take the brunt of a ‘risk-off’ mentality from the market. Regardless, software continues to eat the world, and executives all the way down to line-of-business managers are bought in on the business value software delivers.
Could the bull run continue?
Despite obvious volatility investor appetite on roadshows is, by all accounts, as strong as ever. At OpenView, we wrote earlier this year about the return of software IPOs in the first half of 2018. Since then, SurveyMonkey, Anaplan, SolarWinds, and Elastic have all priced and Qualtrics is planning an IPO in the coming weeks.
It isn’t just IPOs that are generating interest—public equity investors as well as strategic and private equity (PE) buyers are still putting money to work. We learned that investors are still buying into some of the highest valued stocks that have delivered “permission to believe” in growth and upside. These businesses have continued to post compelling results by extending their growth model with innovation into new markets and new products. Large strategic buyers are under threat from disruptive entrants as well as competition from PE mega-funds and 2019 could see continued acceleration of high-multiple M&A. The evidence for this is there. Shortly after the sell-off, SendGrid was bought for 11.2x their forward (2019!) revenue estimate.
The folks we spoke to all hinted that they don’t sense anything more sinister happening. Software stocks are still a popular asset for investors and absent an appealing alternative they’ll continue to experience strong demand.
What drives software valuations?
Private valuations leverage public comparables as a means to triangulate value, but how can we be sure that all of the money going into the public markets is based on data-driven insights and not riding hype? The analysts we spoke with confirmed their recommendations leverage robust analysis considering growth, gross margin, and key SaaS metrics.
1. Rule of 40. The concept of balancing growth and burn – not the hard line at 40 percent – is what matters. Public stock analysts favor businesses that offer sustainable, durable growth bolstered by strong fundamentals over the long term.
2. Gross Margin. Margin profile is key to the success of public companies long term. The “right” range depends on software and customer type but without the ability to scalably and repeatedly deliver a product future cash flows are uncertain.
3. Retention. The right retention metric (gross or net retention) depends on the business, market size and customer type, but we heard that the market has responded well recently to companies who’ve demonstrated strong ability to drive accelerated expansion of cohort average ACV (including Smartsheet, one of the businesses in our PLG Index). That said, net retention isn’t the end all be all, and must be balanced by strong net new revenue growth.
4. Unit Economics. At scale, most public companies are generating comparable efficiency metrics, but the historical and long term trend is key. If a business can generate compelling trends, public stock analysts will view them more favorably.
Despite the growing unease around the markets, we’re encouraged by the attitudes we’ve seen towards software. The market sell-off in early October was driven by broader uncertainty, but there are strong themes to support continued growth of the software sector and the valuations in the market right now are comprehensive and data-driven, not falsely inflated.