Annual Letters

I’ve been reading Warren Buffett’s Annual Letters. You can access them back to 1977 at Berkshire Hathaway’s website, or you can buy a book with the full unedited collection going back to the start (1965).

They’re excellent. I’ve learned a lot, not just about investing but financial and economic history as well. It’s one thing to read about stagflation in the ’70s in an economics book and another to hear someone trying to generate returns in a business talk about it as it was happening.

I was curious who else writes thoughtful annual letters and learned from an excellent post by Ben Horowitz about CEOs that Jeff Bezos does. 

Horowitz referenced Bezos’s 1997 letter (the first one after its IPO) as an excellent example of how a CEO gives a company a strategy and a story. All of Bezos’s letters are well done and worth reading. You can find them here. 

I’m going to write more about what I learn from all of this reading, but for now I just wanted to note the power of writing these letters. They’re an excellent way to organize your thinking, both retrospectively, allowing you to share what happened and why, and prospectively, describing what you plan to do. 

In Buffett’s own words (from a lecture he gave at Notre Dame):

I proposed this to the stock exchange some years ago: that everybody be able to write out “I am buying 100 shares of Coca Cola Company, market value $32 billion, because…” and they wouldn’t take your order until you filled that thing out. 

I find this very useful when I write my annual report. I learn while I think when I write it out. Some of the things I think I think, I find don’t make any sense when I start trying to write them down and explain them to people. You ought to be able to explain why you’re taking the job you’re taking, why you’re making the investment you’re making, or whatever it may be. And if it can’t stand applying pencil to paper, you’d better think it through some more.

Bezos has clearly taken this idea of writing’s ability to help you think even further. At the beginning of every meeting of senior executives, the entire team sits in silence for thirty minutes reading a six page memo discussing various aspects of the issue at hand. 

From Fortune:

Amazon executives call these documents “narratives,” and even Bezos realizes that for the uninitiated—and fans of the PowerPoint presentation—the process is a bit odd. “For new employees, it’s a strange initial experience,” he tells Fortune. “They’re just not accustomed to sitting silently in a room and doing study hall with a bunch of executives.” Bezos says the act of communal reading guarantees the group’s undivided attention. Writing a memo is an even more important skill to master. “Full sentences are harder to write,” he says. “They have verbs. The paragraphs have topic sentences. There is no way to write a six-page, narratively structured memo and not have clear thinking.”

Mobile

The mythology of Amazon’s founding is that it all started in 1994 when Jeff Bezos read that the internet was growing 2,300 percent. It’s not clear what that metric was exactly. Some say it was annually, some say monthly, and I haven’t been able to figure out exactly what the metric was measuring, whether pages, page views, etc. Another story talked about user growth—from 16 million in 1995 to 31 million in 1996. 

It doesn’t matter really. It was a huge shift. He perceived it. And he acted on it. 

The equivalent, if not more significant shift today, is mobile. And by far the best articulation of those trends that I’ve seen is here (h/t to Fred Wilson):

2013 05 BEA - ’Mobile is eating the World’ from Benedict Evans

Slide 6 had the most impact on me. The world in 2017 will have about 7.5 billion people of which 3.2 billion will have smart phones (i.e., small internet-connected computers). And that’s from a base of about 1.2 billion in 2012. 

That compares to a PC base of about 1.5 billion, with sales collapsing.

Consider the following from Pew Internet for another perspective:

Recalling what Jeff Bezos saw of a doubling in internet users, the percentage point increases in the above are mind-boggling. In April 2012, 18 percent of Americans over the age of eighteen had a tablet. In May 2013, that had increased to 34 percent. The right hand column is misleading in giving point increases and not percentage increases. The percentage growth is tremendous, 80 percent and even 100 percent or higher in many cases.

The uniformity of adoption is amazing, too. 

Low income, minority, elderly, rural—those are the fastest growing percentages. Granted, they’re from smaller bases, but they’re converging to the average adoption.

Paul Graham wrote the most thoughtful post I’ve seen on the imprecise nature of describing these devices. He pointed out that if the iPad had come first, we wouldn’t think of the iPhone as something very different. We would think of it as a small iPad that you can hold to your ear to double as a phone. It’s just slightly more tailored to one specific app on the phone.

So smartphones and tablets are really the same thing—a new internet connected device with a touch capability that can run different types of applications that also has special characteristics like knowing where it is in the world, how it’s physically moving through space, and how it’s oriented. That’s all in addition to its ability to deliver all the pre-tablet consumer services that are more valuable with increased mobility: music, video, email, etc.

Oh, and they can be pretty cheap. Sure, Apple is extracting margin for the time being. But given the dynamics of supply chains, contract manufacturing, and scale, prices will drop dramatically. I already know of one entrepreneur that is building an incredible business leveraging the fact that he can buy Android phones built to last year’s specs in bulk for about $50 per unit.

Returning to my earlier post on prophecy, this is one of those shifts that may be prone to both of the failures Clarke identified: failure of nerves and failure of imagination.

On nerves, there’s no doubt the world is moving in this direction. We have to accept it and act accordingly (which means boldly).

On imagination, there’s more that we can’t imagine about what will be possible than we can imagine so entrepreneurs have to be willing to experiment and investors have to be willing to dig to the core of an idea or offering and be willing to suspend disbelief, relying on more fundamental signals—the quality of the entrepreneur and the product. The rest will emerge over time.

It’s an exciting time.

SaaS Valuations: Part 1

Long story short: The revenue multiples we typically use to describe SaaS company valuations obscure a lot of information, particularly growth. Replicating those multiples using simple discounted cash flow valuations shows that growth rates have a large impact on valuation. So let’s not react to multiples without giving equal, if not more, weight to the assumptions about growth rates and their persistence. IF you believe the high growth rates, you believe the multiple—that’s mechanical. 

Longer version:

The market isn’t crazy—at least not in the long-term. It tracks fundamentals (revenue, cash flows, capital invested, etc.).

Consider the following three perspectives:

• Since taking over Berkshire Hathaway in 1965, Warren Buffett has focused consistently on growing book value per share in the belief that the company’s market value per share will track accordingly. That belief has proven to be pretty true:

• In their popular book Valuation: Measuring and Managing the Value of Companies,  McKinsey & Company described an analysis they did in which they estimated the earnings multiple of the stock market at specific points in time over a forty year period based on a forward-looking cash flow model. They compared the predicted price-to-earnings (P/E) multiple to the actual P/E multiple, drawing the chart below. They concluded: “Over the long term, the stock market as a whole appears to follow the simple, fundamental economic laws described in Chapter 3: Value is driven by returns on capital, growth, and—via the cost of capital—interest rates.”
  

• A more recent study by McKinsey & Company tied different economic eras to stock returns. A nice (and deliberate) aspect of the descriptions is that they include eras long enough so that major drops in the stock market (e.g., the dot-com bubble and housing crash) are placed in proper context. Their conclusion was the same: 

Unlike the market for fine art or exotic cars, where value is determined by changing investor tastes and fads, the stock market is underpinned by companies that generate real profits and cash flows. Most of the time, its performance can be explained by those profits, cash flows, and the behavior of inflation and interest rates. Deviations from those linkages, as in the tech bubble in 1999–2000 or the panic in 2009, tend to be short-lived.

 

So for SaaS companies…?

I liked McKinsey’s approach of replicating the multiples with discounted cash flows. It squared the circle, so to say, for me by explicitly tying the shorthand language of multiples to the more meaningful underlying assumptions about fundamentals. 

I wondered: could you do the same for SaaS multiples? Could you describe a large part of the difference in multiples with simple assumptions?

Below are SaaS multiples for the most significant public SaaS companies:

These are all the SaaS companies from Pacific Crest’s weekly Software Company Valuations distribution as of May 3, 2013. (I’ve included the specific distribution here. See page 2 for the SaaS companies, and their detail.) 

The projected revenue growth rate from 2013 to 2014 is on the x axis, and the corresponding current enterprise value as a multiple of 2014 projected revenue is on the y axis. 

(Those outliers at the top are NetSuite, to the left, and Workday, to the right—I’ll dive into what’s going on there in a later post.)

There’s a pretty clear relationship:

The red point is RealPage (RP), which is projected in the Pacific Crest document to grow at 16 percent and is trading at 3.3x 2014 projected revenue. Specifically, it has an enterprise value of $1.5 billion and projected 2014 revenue of $454 million.

I valued RealPage using a simple discounted cash flow, with the following assumptions:

• Revenue decay rate of 10 percent (i.e., revenue growth of 30 percent this year, 27 percent next year)

• Unlevered free cash flow margins of 20 percent

• Forecast period of 10 years

• Share count increase of about 2 percent each year

• Discount rate of about 12 percent

• Perpetual growth rate at the end of the ten year period of 2.5 percent

The resulting valuation is pretty close (RP*):

If you take that discounted cash flow analysis and just change the growth rates to reflect assumed ‘13 to ‘14 revenue growth rates of 10 to 50 percent and keep everything else the same, you get the following points and trend line (orange):

In other words, if you’re reasonably confident a company will grow its revenue 50 percent in 2014 and that it will see no more than 10 percent decay in that growth rate for the next ten years while sustaining 20 percent unlevered free cash flow margins, you’d be willing to pay 7.5 times 2014 projected revenue for that company. 

And you’d only pay 2.8 times 2014 projected revenue for a similar company that would only grow revenue 20 percent in 2014. 

That’s mechanical. Those assumptions are certainly arguable, but that’s not the point. The point is that the multiples tell you nothing. They just incorporate deeper—more meaningful—assumptions that do tell you something. Those assumptions at least you can debate, test, and research. Those assumptions and their robustness drive the valuation. Not the multiples. The multiples are just a summary. 

In other words, a 7.5 times revenue valuation by itself doesn’t indicate a valuation that is expensive or cheap.

Now, let’s take those points and draw them again changing one assumption: revenue decay rate.

Let’s say, hypothetically, there were SaaS companies with very talented management, large revenue bases, high historic growth rates, great products, and proven development and sales capabilities attacking tremendously large markets with incumbents that were constrained by technology and legacy deployments from responding. And let’s say that for those reasons you believe those companies can sustain high growth rates for a long time horizon.

So let’s say instead of a 10 percent revenue decay rate you forecast a 5 percent revenue decay rate and keep the other assumptions above the same.

You get the red points and trend line:

Remove NetSuite and Workday, and you get this:

That’s a pretty good match. 

Conclusion

My goal with the above is to make clearer the language we should use to think about SaaS valuations. Revenue multiples obscure too many assumptions.

At the highest level, they obscure the impact growth has on valuations. If you’re an investor for the long-term, buying these companies for the future cash flows they give you in return for your investment, the higher valuations as a function of higher growth rates are completely justified. If you believe the growth rates and other assumptions, you believe the multiple—that’s mechanical.

At deeper levels—operating margins, capex, discount rates, perpetual growth rates—this gives you a framework to work with. We know roughly the assumptions the market is pricing into the valuation of these companies. We can then determine where we differ.

SaaS Valuations: Intro

I’ve had a few conversations recently that led me to dig deeper into SaaS company valuations. The conversations were along the lines of: 

• “Workday is trading at 15 times 2014 revenue—that’s crazy!”

• “Let’s hope SaaS company valuations hold up.”

• “I need to value [early stage SaaS company]—what are SaaS companies multiples looking like?”

These conversations bother me because embedded in them are a number of incorrect ideas.

In the first, it’s the idea that a 15 times revenue multiple is too high. It ignores the fact that Workday is forecast to grow revenue north of 50 percent in 2014—and that’s on 2013 projected revenue of $425 million. That’s tremendous growth by any standard, but on $425 million it’s incredible. So the number of 15 times revenue tells you nothing.

The second implies the valuations are unreasonable and that we are at the whim of the market in selling shares to the public. The reality is that, one, the valuations are reasonably supported by SaaS company fundamentals and that, two, the market overall is pretty good about aligning prices with fundamentals. At least, it is in the long-term. Not so much in the short-term. 

The third statement is, in part, a version of the first. Most private SaaS company are growing revenue at much faster rates than the public companies. Applying the same multiple ignores that fact.

It’s also flawed because the market for private SaaS companies is very different than that for public SaaS companies. Public SaaS companies have pretty definitively reached escape velocity. They are clear going concerns, whose near-term revenue growth is relatively known. Private SaaS companies are riskier affairs. I argue actually that they reach escape velocity earlier than people seem to think, justifying what many believe are unreasonable valuations. But given the risk at various stages of development, the right way to value them in my opinion is the probability-weighted forecast of an IPO at any given stage.

So I’m going to write three posts to address these and related points. Those posts are:

• Part 1: The stock market isn’t crazy. Stock market values in general track fundamentals, and SaaS company valuations do so as well. 

• Part 2: What are the chances? An approach I’ve been toying with builds on that idea. If the IPO values have a dependable logic to them, then the right approach to valuing earlier stage private SaaS companies is a valuation based on the probability that the company goes public. Having seen these valuations done, I know this is what investors in the private market do anyway. I’d just like to formalize this a bit. 

• Part 3: Embedded options in public SaaS companies. Finally, I’m going to explore a bit whether public SaaS valuations might be missing some key elements of SaaS companies: (1) low downside risk, given recurring revenues and high steady state cash flow margins and (2) dramatic upside potential given (i) their strong competitive positions in large markets and (ii) their R&D and sales/marketing capabilities that allow them to create or acquire complementary products with high growth potential. The low downside risk with upside potential is an option embedded in public SaaS companies that tends to be overlooked. 

Performance

I’m reading Creative Capital by Spencer Ante. It’s a biography of Georges Doriot, who in 1946 founded American Research and Development Corporation (ARD). It was one of the first venture capital firms, and it was the first to have an institutional base or to focus on technical ventures.

ARD’s biggest success was Digital Equipment Corporation in which it invested $70,000 in 1957. After the company’s IPO in 1968, ARD’s stake was worth $355 million.

But Doriot was a fascinating person in other ways. From 1946 to 1966, he was widely considered by many to be the most popular professor at Harvard Business School, not because his class was fun but because it was hard and taught students how to think. 

In a predecessor to the case method at HBS, he had students write two reports: a topic report and a company report.

The topic report asked students to write a report on “a subject of your own choosing which will be a contribution to the future of American business,” but there was a twist: they had to imagine the impact of the problem, product, or technology ten years in the future.

The company report made students learn the nuts and bolts of a business by actually working with local manufacturing companies. For half a year they’d study companies up close. 

Doriot on why he had them do that:

Up until that time when the students read that the price of copper went up, to them it was just statistical information which they might feed back to the teacher. In this case, I want them to say, “What does it mean?” And also very important, “What do I do about it?” I want them to learn to have pains in the stomach, you see what I mean?

This idea of really challenging people to help them grow is a theme throughout the book.

Georges Doriot was a thirteen-year-old boy in his home country of France when he placed second in his class. He was excited and raced home to show his parents the certificate he received. His mother, Camille, gave him a hug and baked him cookies. But when his father, Auguste, came home and saw the certificate, Ante describes a very different reaction:

In stark contrast to Camille, Auguste seemed unimpressed with his son’s award. He acknowledged the certificate with only a cursory glance, nodded perfunctorily, and then fixed his son with one of those chilling stares of appraisal. “And why not first?” asked Auguste.

The story goes on to describe how upset Georges was at this. He ran to his room bewildered and humiliated. 

Ante describes how Georges recounted the experience to a friend many years later:

His father…was not concerned that Georges had failed to achieve first place honors in his class at Ecole Communale. No, he was concerned that Georges was happy placing second. To Auguste, a famous automobile engineer who had raised his children to strive for excellence in everything they did, celebrating anything less than the best possible result smacked of contentment. And contentment, Auguste believed, is a state of mind that recognizes no need for improvement.

Georges apparently told that story often because many that knew him felt the experience played a large role in what he achieved later life. And the key point is worth repeating: 

Contentment is a state of mind that recognizes no need for improvement. 

This resonated with me for many reasons. My father was like this as well. It had a big impact on me, and I believe it’s the right approach. Yet, I’m seeing many indications that cultural norms are moving in the other direction. In both the parenting and professional realms, I see people giving less feedback, particularly negative feedback, and being less clear about what they expect. 

On parenting, I’ll make the perhaps controversial statement that I thought Battle Hymn of the Tiger Mother was a great book. It was well-written and entertaining. But more importantly, I respected Amy Chua’s approach. She expected the best from her children and pushed them to achieve it. She approached her interactions with her children assuming strength on their part, not weakness. She openly acknowledged throughout those years that the cultural norms around her were different. She actively and thoughtfully dismissed them, and she was happy to tell you why. (If you missed this controversy, read the WSJ article.)

In the professional world, I’m surprised how little I see people giving direct, timely, and thoughtful feedback, both good and bad. Early in Creative Capital, the book describes the career of Georges Doriot’s father, Camille. He was a brilliant automotive engineer at Peugeot, and he was actively mentored by Armand Peugeot on all aspects of the business, ultimately starting his own company.

Apprenticeship is the most natural way to learn, and yet it seems people are becoming loath to giving feedback. I just don’t hear it very often. I believe the right model has two interrelated pieces:

1. Frequent, even daily, feedback. These are immediate observations on what went well and what could have been better. For example: “You responded poorly to a question in that presentation. It sounded like you were ill-prepared, but I think if you had just paused a beat or two, you would have made a bigger impact.”

2. Periodic reviews. I think yearly reviews are too infrequent. In the quarterly reviews, you highlight common positive and negative themes (i.e., connect the dots from what should by then be a large amount of feedback) and review milestones and achievements (or the lack of them). The quarterly review could still be less involved than the more significant, but quarter reviews seem about the frequency to tie together trends, give higher level feedback, and evaluate (and potentially redirect) progress towards goals. 

In both of these worlds—parenting and professional—I believe these behaviors can have immense impact if there’s a genuine desire to see the person succeed. With parenting, I’d like to believe that’s obvious. You want to see your kids succeed. In professional settings, I see that vary much more. 

The other related element is expectations. People have to believe that mistakes are a necessary step to growth. Negative feedback shouldn’t be perceived as a knock. It isn’t personal. Every single person that has achieved something significant made missteps along the way. Those missteps are a necessary ingredient for growth. You need to at least learn from them on your own. But if someone else can help you do so with even more effectiveness, all the better. So if you can defuse the inherently defensive, painful nature of feedback, there’s tremendous opportunity for growth.