Market & Earnings Review - February 18, 2023
Brief market commentary, portfolio company earnings results, and closer look into Cloudflare (NET)
Market
The S&P 500 has held its ground above the 200-day moving average. After a rapid climb, the market has started to show some resistance.
Coincidentally, rates have reversed their retreat and climbed higher in February. Strong reports in both the job market and consumer spending seem to have strengthened the Fed’s case of higher rates for longer.
Following the rise in yields, the US Dollar has bounced off of its lows. After retreating over 11% since October, the dollar has gained 2.6% in February alone. A weaker USD benefits US companies with international exposure, as foreign exchange rates become a tailwind and allow for stronger purchasing power.
Q4 2022 Earnings
Sentiment was gloomy coming into earnings season. While results have been better than feared, the weakness against historical trends is apparent. From Factset:
82% of the companies in the S&P 500 have reported actual results for Q4 2022 to date.
Of these companies, 68% have reported actual EPS above estimates (below 5-year average of 77% and below the 10-year average of 73%)
Companies are reporting earnings that are 1.3% above estimates (below the 5-year average of 8.6% and below the 10-year average of 6.4%.)
If 1.3% is the actual surprise percentage for the quarter, it will mark the second-lowest surprise percentage reported by the index since 2008.
When looking at the results by industry, Technology, Healthcare, and Consumer Staples are the top 3 performers against expectations while Communication, Utilities, and Energy are trailing.
Over the last two weeks, 9 portfolio companies reported earnings: Paycom, PayPal, SP Global, Cloudflare, Agree Realty, Upstart, Airbnb, The Trade Desk, and Datadog.
Results from portfolio companies from Q4 generally beat consensus estimates, with PayPal and The Trade Desk reporting inline results.
Guidance for the next quarter is an important indicator, especially given the macroeconomic uncertainty and concerns of an impending recession. For the most part, sales projections seem to be holding up with the exception of Upstart.
Detailed results:
Some commentary:
Paycom, provider of critical payroll services to small and medium businesses, is demonstrating strong resilience with beats across the board and continued revenue growth.
Airbnb has similarly shown operating beats all the way through to their bottom line, and interestingly continues to surprise with strong revenue growth. Travel has been strong, but is considered discretionary spend and indicative of consumer posturing. A unique perspective of Airbnb is that hosts have a more flexible pricing structure (i.e. their costs are fixed, and guest income is extra) than hotels, so they are willing to lower the price and adjust to the market.
PayPal continues to focus on the core offering, checkout. As macro conditions tighten, competitors are likely to whittle out. PayPal CEO Dan Schulman announced he plans to retire at the end of the year.
Upstart was able to beat in Q4, surpassing revenue and earnings expectations. It appears most of that has been achieved through their willingness to assume loans on their balance sheet. They are working on permanent capital partners, and mentioned they are close. For Q1, they will no longer be taking on loans on their balance sheet, hence the significant drop in revenue. The company continues to invest in R&D, improving their model and automating the underwriting process. Once the macro clouds pass, Upstart will spring back with significant efficiency and profitability.
Reactions from the market do seem to indicate moods have shifted versus prior years. In the past, companies had to exceed guidance by a particular bar to be celebrated. These days, companies reporting inline results are seeing very positive price action. Even some surprising to the downside, whether Q4 or Q1 outlook, have seen heavy buying and upwards price momentum.
Cloudflare (NET)
Cloudflare’s mission is to help build a better internet. Founded with the idea of eliminating email spam, Cloudflare has grown into critical infrastructure behind many popular websites and is now expanding to be the critical infrastructure for corporate networks.
Cloudflare’s flagship product has been their cloud delivery network, or CDN. This is a layer that sits on top of a website’s server to help serve content to users faster. Websites, or web apps, generally serve their content from a web server. That web server is usually located in one place, say a data center in Virginia. Users in California will experience latency as data travels across the country on every request. With Cloudflare, a copy of the content is stored closer to the users so that they can retrieve it much faster.
This foundation has allowed them to build out security solutions. Because every request hits Cloudflare first, Cloudflare is able to inspect the traffic and filter out bad traffic, such as attackers attempting to overwhelm and take down the site.
Today, Cloudflare has expanded further, bringing this same foundation into network security. As more and more enterprises shift to the cloud, it is more important than ever to have a flexible, yet secure, corporate network. Virtual Private Networks (VPNs) have been used in the past to bridge on premise solutions and cloud solutions. Given the geographical dispersion, new tools, and new attack vectors, the industry is now shifting towards a Zero Trust model where users are verified every time access is requested. Cloudflare has been able to leverage their core infrastructure of distributed data centers and easy configuration to provide these services.
Cloudflare has long been touted for their ability to grow revenue steadily at 50%. Since 2019, Cloudflare has maintained revenue growth in the 48-52% range. Although they haven’t been quite able to maintain it in Q4, Cloudflare has been much more resilient than other SaaS companies and has started showing strong operating leverage.
Below is a summary of the financials:
Q4 revenue growth was held steady q/q at 8%. Guidance shows a deceleration to 6% q/q, but is inline with consensus. Y/y growth is expected to slow down to 44% from the 48-52% range.
Gross margins have come down from their peak of 78%, but seem to be holding at/above the long-term guidance level of 75%
Adjusted TTM EBITDA margins climbed to 11% vs. 1% from a year ago
TTM FCF margins are also showing improvement over the last year reaching -2% from -12%. More promising is the company’s ability to deliver on their plan – the most recent quarter’s 38m in FCF is nearly a 14% margin. That is a promising signal, showing opportunity for continued operating leverage.
Balance sheet is strong, with 1.65 billion in cash and equivalents, and 214 million in net cash. Considering they can maintain FCF positive, they should have no need to raise. Even looking back, their spend was about 40-80m/year, which means even at the old pace of burn, they would have 2-3 years of runway.
Share dilution, primarily from stock based compensation, has been decelerating significantly.
The market has reacted positively. The stock price nearly doubled from the low of $37.5 to $72.4 under heavy volume this year. Heavy volume is often an indication of institutional buyers, usually a strong foundation that can help lift up the stock price. Some of those gains have been given back this week.
Regarding valuation, Cloudflare seems to be defying the current state of the union.
These multiples are quite foreign to the current market, and more reminiscent of 2021. Cloudflare has significant potential with a large, critical market and has proven their ability to execute. Cloudflare is seen as a next-gen competitor to a wide array of popular solutions including Amazon’s AWS and Zscaler’s Zero Trust.
That being said, investors should be wary of the risks. Things must continue to run nearly perfectly to maintain the current valuation. If anything turns, there could be a significant repricing event.
Cloudflare will certainly be maintained as a portfolio company. I have, however, been slowly right sizing the position given the high valuation and uncertain macroeconomic outlook.
Closing
Investors are constantly presented with choices. These choices are inherent in the change that inevitably occurs and shaped by an investor’s belief about the future. Will rates continue to rise from here, putting pressure on equities and squashing the current rally? Will inflation come down, allow easing of rates, and super charge the existing rally? Will Cloudflare continue to execute seamlessly?
Decisions are constantly being made, even if not explicitly. Taking no action, and rather being patient, is often touted as a strength of many long-term focused investors. Even with high growth companies, many investors look back at the 50, 60, 70, 80%+ drops that Amazon, Netflix, and many other successful companies faced. Looking back, those were merely bumps in the road.
On the flip side, investors should be conscious and wary of risk. Investing is both an art and science, one wherein decisions must be made based on probabilities.
--
Torre Financial is an independent investment advisory firm focused on emerging and established compounders.
Federico Torre
Torre Financial
federico@torrefinancial.com
https://torrefinancial.com
Disclaimer: This post and the information presented are intended for informational purposes only. The views expressed herein are the author’s alone and do not constitute an offer to sell, or a recommendation to purchase, or a solicitation of an offer to buy, any security, nor a recommendation for any investment product or service. While certain information contained herein has been obtained from sources believed to be reliable, neither the author nor any of his employers or their affiliates have independently verified this information, and its accuracy and completeness cannot be guaranteed. Accordingly, no representation or warranty, express or implied, is made as to, and no reliance should be placed on, the fairness, accuracy, timeliness or completeness of this information. The author and all employers and their affiliated persons assume no liability for this information and no obligation to update the information or analysis contained herein in the future.