Adam - thanks for the comment. I like your description of "modest growth, immodest buybacks", it very much fits a pattern that has worked for us.
I fully agree that there is almost certainly gold among the rubble of SaaS businesses that have sold off significantly over the past 18 months. We've been looking and there are certainly some excellent businesses that are now selling at attractive prices based on the underlying unit economics. Generally it seems those are the exceptions in terms of stocks that have been crushed, but as Constellation Software has long demonstrated, vertical b2b software businesses are excellent businesses with enduring competitive positions in many cases. You outlined the unit economics well of a high quality enterprise software business.
Thanks for the refresher! You really can't go wrong with this approach and the investment universe is large enough that you can exclude businesses that are unprofitable or lack consistent profitability, cryptocurrencies and other non-cash generative assets, etc. and still be left with a sufficient number of potential investments. The issue with buying cheap low quality companies is if you overpay you almost always lose money whereas overpaying for very high quality business can mean you earn poor returns, but in my opinion the risk of permanent loss of capital is much lower.
Part of the strategy you described reminds me of a "design pattern" I like to refer to as "modest growth and immodest buybacks" which is essentially buying a company that trades at a double digit FCF yield and is allocating the majority of free cash flow to share repurchases and is growing modestly at a rate of 5% to 7%. When it all comes together it's a beautiful combination since you get the tailwind of multiple expansion combined with double digit increases (some might say immodest increases) in per-share FCF even though top-line revenue growth is rather modest.
That being said with the recent correction in tech, I have been exploring making investments in technology companies that haven't reached GAAP profitability, but I believe can reach GAAP profitability in the next five years. It definitely didn't make sense to invest in these companies the last few years when they were trading at such high revenue multiples, but I think some are a bit more compelling now.
In particular, I'm very interested in horizontal B2B SaaS companies that sell mission critical software that provides compelling value to the customer and are very difficult to move away from once implemented. Generally I'm also looking for these companies to be industry leaders in their particular segment, e.g. category creators/category leaders (e.g. when you say CRM to most people they think Salesforce not Microsoft Dynamics), etc. I'm still wary of B2C technology companies selling discretionary products like Bumble regardless of valuation and still avoid those.
The reason behind my interest in this area has been driven by the fact that these companies have very good unit and customer acquisition economics. This combined with high gross margins, net negative working capital, and operating leverage inherent to their business model should mean that these businesses should ultimately produce a predictable stream of earnings with very high margins and a strong net-income to FCF conversion rate given the limited need for additional capital reinvestment and working capital is a source of cash for growth investments in a growing net negative working capital business.
For example, a company with a customer acquisition cost of the first 18 months of revenue with 20% FCF margins and a 99% retention rate would pay 150 dollars for 100 dollars of revenue which converts into 20 dollars of FCF valued at 10x FCF would be 200 dollars of market value. This is a 33% return on reinvested capital and it can be done on a pre-tax basis since those acquisition expenses are done opex like sales and marketing spending, etc. This also entirely discounts the impact of a >100% NRR and the ability to drive increases in revenue per-customer by cross-selling additional modules, etc.
I'm also fairly confident some of these businesses are within my circle of competence since I work in the technology sector and I've got a fairly decent understanding of the enterprise IT landscape and the value some of these solutions provide relative to the alternatives, etc.
Anyway I'm going to shut up now since this comment is getting way too long. The TDLR on this point is I do think there could be some interesting value in some of these technology companies that haven't reach GAAP profitability and have a clear path towards GAAP profitability over the next five years, but there is also a sufficient number of businesses that excluding these types of businesses from your investment universe isn't the end of the world either.
I think like you said it all depends on your circle of competence and where you believe you have an edge in your understanding relative to other investors, etc. Or in the absence of an edge, just the ability to remain rational while others are behaving irrationally :)
Adam - thanks for the comment. I like your description of "modest growth, immodest buybacks", it very much fits a pattern that has worked for us.
I fully agree that there is almost certainly gold among the rubble of SaaS businesses that have sold off significantly over the past 18 months. We've been looking and there are certainly some excellent businesses that are now selling at attractive prices based on the underlying unit economics. Generally it seems those are the exceptions in terms of stocks that have been crushed, but as Constellation Software has long demonstrated, vertical b2b software businesses are excellent businesses with enduring competitive positions in many cases. You outlined the unit economics well of a high quality enterprise software business.
Thanks again for reading!
Fantastic read. Thank you!
Dan, a basic q, pls - how did you work the value re-rating is 6%, in the example you give. what is the math behind that, pls
Thanks for the refresher! You really can't go wrong with this approach and the investment universe is large enough that you can exclude businesses that are unprofitable or lack consistent profitability, cryptocurrencies and other non-cash generative assets, etc. and still be left with a sufficient number of potential investments. The issue with buying cheap low quality companies is if you overpay you almost always lose money whereas overpaying for very high quality business can mean you earn poor returns, but in my opinion the risk of permanent loss of capital is much lower.
Part of the strategy you described reminds me of a "design pattern" I like to refer to as "modest growth and immodest buybacks" which is essentially buying a company that trades at a double digit FCF yield and is allocating the majority of free cash flow to share repurchases and is growing modestly at a rate of 5% to 7%. When it all comes together it's a beautiful combination since you get the tailwind of multiple expansion combined with double digit increases (some might say immodest increases) in per-share FCF even though top-line revenue growth is rather modest.
That being said with the recent correction in tech, I have been exploring making investments in technology companies that haven't reached GAAP profitability, but I believe can reach GAAP profitability in the next five years. It definitely didn't make sense to invest in these companies the last few years when they were trading at such high revenue multiples, but I think some are a bit more compelling now.
In particular, I'm very interested in horizontal B2B SaaS companies that sell mission critical software that provides compelling value to the customer and are very difficult to move away from once implemented. Generally I'm also looking for these companies to be industry leaders in their particular segment, e.g. category creators/category leaders (e.g. when you say CRM to most people they think Salesforce not Microsoft Dynamics), etc. I'm still wary of B2C technology companies selling discretionary products like Bumble regardless of valuation and still avoid those.
The reason behind my interest in this area has been driven by the fact that these companies have very good unit and customer acquisition economics. This combined with high gross margins, net negative working capital, and operating leverage inherent to their business model should mean that these businesses should ultimately produce a predictable stream of earnings with very high margins and a strong net-income to FCF conversion rate given the limited need for additional capital reinvestment and working capital is a source of cash for growth investments in a growing net negative working capital business.
For example, a company with a customer acquisition cost of the first 18 months of revenue with 20% FCF margins and a 99% retention rate would pay 150 dollars for 100 dollars of revenue which converts into 20 dollars of FCF valued at 10x FCF would be 200 dollars of market value. This is a 33% return on reinvested capital and it can be done on a pre-tax basis since those acquisition expenses are done opex like sales and marketing spending, etc. This also entirely discounts the impact of a >100% NRR and the ability to drive increases in revenue per-customer by cross-selling additional modules, etc.
I'm also fairly confident some of these businesses are within my circle of competence since I work in the technology sector and I've got a fairly decent understanding of the enterprise IT landscape and the value some of these solutions provide relative to the alternatives, etc.
Anyway I'm going to shut up now since this comment is getting way too long. The TDLR on this point is I do think there could be some interesting value in some of these technology companies that haven't reach GAAP profitability and have a clear path towards GAAP profitability over the next five years, but there is also a sufficient number of businesses that excluding these types of businesses from your investment universe isn't the end of the world either.
I think like you said it all depends on your circle of competence and where you believe you have an edge in your understanding relative to other investors, etc. Or in the absence of an edge, just the ability to remain rational while others are behaving irrationally :)