• Marketplaces are great businesses. Dominant marketplaces are extremely profitable. Zameen is a dominant real estate marketplace in Pakistan with significant pricing power.

• Pakistan is the world’s 5th most populous country, with a fast-growing economy, and significant demand for housing. Pakistan’s real estate market has decades of growth ahead, from trends such as urbanization, a 10-12m housing shortage, and a reduction in household size.

• Zameen has significant room for growth as it continues to penetrate Pakistan’s mostly analog real estate market. Zameen will also benefit from the long-term structural growth in Pakistan’s housing market.

• FDV owns 30% of Zameen and several EM marketplaces. FDV is free cash flow positive and the current market valuation significantly undervalues its assets.

Marketplaces

Marketplaces are where buyers and sellers meet and they generally facilitate a lot of economic activity. Marketplaces can vary from a simple physical location to shopping malls, or stock exchanges. Marketplaces that can capture some of the economic value they are facilitating can become very profitable businesses.

When you think of a typical business, they have to source supply (i.e., retailers need inventory, banks need capital, software companies need software) and then find the customers who demand that supply (i.e., distribution, sales, advertising). The amount of power a business has over its suppliers and customers goes a long way in determining its profitability. Dominant marketplaces do not have to haggle for supply or demand, but they become the de facto destination for supply and demand. This is why established online marketplaces are extremely profitable businesses with a lot of pricing power.

To illustrate this dynamic, let’s look at Airbnb which is the world’s leading marketplace for unique holiday rentals. They dominate both the demand and supply side in this market as their platform has reached verb status among consumers and they have over 6m unique listings on their platform. At Airbnb’s inception, they had to spend a lot of money on Sales and Marketing to acquire both users (demand) and hosts (supply). This can be costly and capital intensive, which is why as of 2019 Airbnb had generated cumulative losses of $1.4b since its inception. However, in 2022 alone Airbnb generated $3.4b in free cash flow, which was more than their total cumulative pre-COVID losses. The chart below shows the extreme profits that a marketplace can generate once it becomes dominant, with ABNB generating a 5x return (gross profits) on S&M in 2022.

I’ve included a list of leading online marketplaces below. As you can see, the group has more revenue growth (pricing power), higher margins, and higher returns (profitability) than most other businesses. The group has a median Rule of 40 of 47 and a Return on Capital of 20%. This compares the average company in the S&P 500 with a Rule of 40 of 14 and a 9% Return on Capital. Some of the most dominant and profitable marketplaces tend to be in travel, property, and auto markets. Travel marketplaces have been highly profitable given the global scalability of the vertical, while property/auto classifieds are regional and very hard to unseat once they become dominant.

Introducing Zameen – a dominant marketplace

Zameen is Pakistan’s leading online property marketplace. Zameen has a monopoly position in Pakistan and is set to continue to benefit from long-term structural trends such as the growth of Pakistan’s economy and housing market, urbanization, and internet penetration. Before touching on Zameen’s business model and market position, I'd like to dive into some of the features of Pakistan’s economy, the housing market, and some of the issues facing the country.

Pakistan’s Economy & Property Market

Pakistan’s Economy

Pakistan is the world’s fifth most populous country, with a fast-growing population and economy. Pakistan’s population is expected to grow by 20% over the next 10 years, which should underpin its economic growth.

In addition to strong levels of population growth, Pakistanis have also benefitted from a growing economy with real GDP per capita accelerating to 2.5% per year over the last decade, which compares to 1.9% over the previous decade.

This increased prosperity is due to the growth and sophistication of Pakistan’s textile industry and the growth in their services exports (i.e., IT services). For instance, 20 years ago non-retail quality cotton was Pakistan’s largest goods export, whereas today value-added products like suits, knitwear, and house linens are Pakistan’s largest exports.

While there are some near-term risks to the Pakistan economy, over the long-run population growth is generally the key factor that drives economic growth. Pakistan should also be a beneficiary of the trend to diversify supply chains (away from China). Furthermore, as China’s manufacturing base continues to age, Pakistan should stand to benefit given its established expertise in textiles.

Pakistan’s Property Market

Pakistan’s property market presents an attractive long-term investment opportunity. Pakistan has a fast-growing population and is in the early stages of urbanization (~60% rural population). There are 35-38m households in Pakistan (~6-7 people per household) and there are typically 250-300k homes built each year (0.8% housing stock growth), significantly under-indexing the 2% population growth. As a result of these trends, Pakistan has a growing housing shortage of 10-12m homes.

Due to long-term structural trends such as urbanization, population growth, and the shift away from multi-generational households, Pakistan’s real estate market should continue to experience decades of growth. The bulk of Pakistan’s housing demand is in the new build segment (primary market), and they are generally multi-residential apartments. This development trend is similar to the trends seen in places like China.

One key feature of Pakistan’s property market is that it is not as reliant on mortgage financing, with household debt only 3% of GDP. Therefore households are not as interest rate sensitive, unlike developed markets with highly indebted households. Most new home developments in Pakistan operate on an instalment plan, where buyers pay down in instalments, with the building process tracking the instalments. This process can take years.

The lack of access to capital can help explain the severe housing shortage in Pakistan. As the Pakistan economy continues to develop, and if their citizens can begin accessing capital to fund their homes, this could light a fire under Pakistan’s housing market and would present a generational growth opportunity (i.e., like 2000s China).

Risks - A lot is going wrong at the moment

The key issue with Zameen is that there are multiple economic and political risks within Pakistan. While Zameen’s business is structurally sound, these broader economic factors make Zameen a high-risk investment.

Pakistan might go bankrupt

Pakistan’s government is at risk of default, which has placed significant pressure on its currency and reserves, pushing up inflation. While I am no political / credit expert - and Pakistan defaulting is a risk for Zameen - I believe this is not a long-term structural issue. Many countries have gone bankrupt and lived to tell the story. For instance, Germany has been bankrupt 8 times, while half of the countries in Europe have been bankrupt at least once. More recently, countries like Iceland (2008), Argentina (2001), and Mexico (1982) experienced bankruptcy. These countries were able to restructure their debt, and their economies have grown post-bankruptcy.

Interest payments on government debt make up 50% of Pakistan’s total expenditures and are greater than their total deficit. This makes me believe that there is a path forward if they were able to restructure their debt.

The one ace that Pakistan has up its sleeve is that it’s a nuclear power. One advantage of being a nuclear power is that those countries, particularly smaller economies, can get easier access to capital. World powers and neighboring countries get zero benefits from witnessing a nuclear country collapse and nuclear codes fall into the hands of potentially unstable individuals. As a result, struggling countries that possess a nuclear arsenal tend to get easier access to foreign capital and grants. We have seen this repeatedly with regard to North Korea. China continues to be North Korea’s largest financial sponsor and aid provider, as China has no interest in seeing the regime collapse, experiencing turmoil at their border, and potentially having to deal with an even more unstable leader. Similarly for Pakistan, despite experiencing significant fiscal imbalances, Pakistan has continued to receive backing from its largest lenders, (China & Saudi Arabia), while the IMF recently extended further capital to Pakistan.

Political Turmoil

The other risk within Pakistan at the moment is political turmoil. Former President, Imran Khan, was recently arrested and there have been violent clashes between his supporters and the state. While political turmoil is not uncommon in the region (1999 non-violent coup), the clashes have since subsided.

Property Market

Due to the above risks and high levels of inflation, the property market has been under pressure. While higher interest rates are not directly impacting demand (i.e., low mortgage penetration), the backdrop has significantly impacted property market sentiment. While Pakistan’s property prices are still rising, activity is slowing. Zameen saw their 1Q23 revenue fall 21% due to lower levels of activity.

Why Zameen - what’s the opportunity?

I might have laid out a compelling case to avoid investing in Zameen and Pakistan! While I recognize that the near-term backdrop isn’t great, many factors make Zameen an attractive investment.

Zameen is a dominant digital marketplace with high levels of pricing power. Zameen has significant room for growth as Pakistan’s real estate market continues to digitize (only 21% internet penetration), and as Pakistan’s housing market continues to grow. Due to these strong structural tailwinds, Zameen has grown at a 64% CAGR over the last 5 years and is profitable and free cash flow positive. Due to its market position and internet economics, Zameen should be in a good position to weather the near-term headwinds (1Q23 revenue -21%, Costs -20%).

Zameen’s Dominance

Zameen has a stronger market position than most of the other dominant property marketplaces. When assessing online property classifieds, the most important factor that determines dominance is its audience. While marketplaces need to balance supply and demand, as advertising businesses, their online audience (i.e., users, engagement, brand strength) is the most important factor that determines their competitive advantage and pricing power. Advertising dollars always follow the eyeballs.

As shown in the chart below, Zameen is extremely dominant, with a 30x traffic lead to its nearest competitor Lamudi (FYI - even though Graana has more traffic than Lamudi, my research indicates Lamudi is the true no.2 as Graana’s traffic is very low quality/inflated). Google Trends also indicates the massive branding advantage Zameen has over its competitors.

For comparison, realestate.com.au (one of the world’s most valuable property portals) has a 3.3x traffic lead over its nearest competitor. UK’s Rightmove has a 2.9x traffic advantage over Zoopla, while the US’ Zillow has a 2.3x lead over Realtor.com. This further shows the extent of Zameen’s dominance within its market.

While looking at traffic metrics are important, it is also important to assess the quality of traffic. Zameen’s traffic quality also mirrors that of the leading marketplaces (i.e., higher engagement = higher quality traffic). While Zameen is already profitable, its dominant market position and engagement should enable them to be a very profitable business at scale.

Pricing Power - How does Zameen make money?

Zameen makes money by advertising properties on behalf of property developers, owners, and leasing agents. As previously highlighted, the bulk of Pakistan’s housing demand is in the new build segment. Zameen makes the bulk of its money (85%) by facilitating sales of new developments and apartments. Zameen also dominates the resale market, however given the lifecycle of Pakistan’s property market, this remains a small part of their business. This dynamic is uniform across most emerging/growing markets.

Zameen has established a really powerful transaction monetization model early in its lifecycle. Many property marketplaces are trying/tried to transition into a transaction model.

Marketplaces that can facilitate direct transactions can demand a much higher fee (i.e., bringing a direct sale is more valuable than bringing a lead). To put this into perspective, Australia’s realestate.com.au charges A$1,500-3,000 for their highest value property ad, while Zameen made A$8,300 (1.2m rupees) per transaction in CY22, which equates to 5% of the average home price in Pakistan. It is important to note that Zameen are just facilitating these transactions, they are not home flippers.

Zameen has two products for the primary market:

• General Advertising Package: Zameen acts as a general advertising channel, advertising the project across its platform and then passing off the leads to the developer.

• Transaction Package: This is a 360-degree package where Zameen will become the outsourced sales agent for the developer, conducting everything from advertising to property tours and closing sales. Zameen uses a mix of in-house and outsourced personnel to complete these processes. Zameen usually has exclusivity for these projects, and can also outsource a portion of their volume to 3rd-party brokers who would keep a portion of the commission. Zameen charges 10-15% of the final sale price.

Zameen’s market position and success rates are what allow it to charge a premium vs traditional marketing companies and brokers, who would try to charge 5-7% of a property’s value but regularly fail to sell the project on time.

Why invest when the business is going backward?

While Zameen’s revenue will go backward in 2023, I believe investors should look through the current cyclical weakness for several reasons:

1. The current weakness within Pakistan’s housing market is cyclical and will not structurally change Zameen’s market position and pricing power.

2. Housing demand in Pakistan is not going away: the current risks are not systemic. Given the lack of mortgages in Pakistan, higher inflation and mortgage rates won’t cause systemic shocks to their market. Conversely, permanent 8-10% mortgage rates in places like AU/UK would cause systemic risks to housing.

3. The Pakistan housing market and Zameen’s best days are ahead of it, not behind it. Zameen is still in the early stages of growth and Pakistan’s housing market still has long-term structural demand. Whereas I can make the case that REA Group and Rightmove’s best days are behind it (i.e., fully penetrated, house prices are fully-loaded with debt, slowing population growth).

4. Zameen is free cash flow positive and is at a scale where it should be able to weather the storm. We saw this in Q1 when Zameen reduced their costs by 20% to offset revenue declines of 21%.

5. Pakistan’s housing weakness started in Nov-22, Zameen is 5 months away from lapping these softer comps.

6. The market has priced in a significant portion of the risk (see valuation below).

Zameen - what’s the opportunity?

Zameen’s strong revenue growth has been driven by their growth facilitating the sales of new developments.

I estimate that Zameen has increased its share of Pakistan’s new home sales from 0.2% in 2016 to 3.3% in 2022, up 17x. Given this low level of penetration and Zameen’s market position, Zameen has a long runway of growth.

Scenario #1 - Terminal 30% penetration

In 2022 Zameen facilitated 3.3% of the new homes sold in Pakistan. If we assume Zameen eventually gets to a 30% market share of new home builds, Zameen would generate A$541m in revenue. On this basis, I estimate that Zameen would be worth over A$3.7b.

Scenario #2 - Steady ramp

This scenario assumes Zameen slowly ramps up its penetration over the next decade and achieves a 10% penetration of new home sales. On this basis, Zameen would be worth A$3.1b, equating to A$819m today (ignoring the cash generated between CY23-32). Due to the current headwinds, I model CY23 revenue to decline 37%.

How to invest in Zameen?

While Zameen is a private company, there is an ASX-listed company called Frontier Digital Ventures (FDV AU) that owns 30% of Zameen. FDV owns several emerging market marketplaces, predominantly focused on Real Estate and Automotive verticals. FDV’s current portfolio consists of 15 marketplaces that operate in 20 countries, across LATAM, MENA, and Asia. FDV has complete ownership of most of its key assets, while they own 30% of its crown jewel, Zameen.

FDV was founded by CEO Shaun Di Gregorio, who owns ~9% of the company. Shaun is an experienced internet executive and previously worked at REA Group, leading their international / emerging markets strategies.

Valuation - Potential for a lot of upside

FDV’s current enterprise value is A$154m, and below I back solve for Zameen’s implied valuation. If I assume 2x revenue (i.e., 20% normalized margin / 10x earnings) for FDV’s larger/profitable businesses and 1x revenue for the rest, the implied valuation of Zameen is A$200m (FDV’s 30% share $59.7m) or 2.4x sales or 13x EBITDA. This valuation compares to Zameen’s most recent funding round where it was valued at US$400m (A$526m at 2020 FX rates) in Dec-20, equating to 13x revenue.

Using the two scenarios from above, I believe there is significant upside. Under Scenario 1, assuming Zameen hits its 30% penetration rate, the FDV share price could increase 7x from current levels (+620% upside). Under Scenario 2, the current valuation of the FDV share price should be $0.82, indicating +110% upside. While there are near-term risks, I think the current valuation of FDV factors in the majority of those risks and ascribes very little value to Zameen’s long-term growth potential, while also undervaluing FDV’s LATAM assets. If FDV continues to trade at current levels, I think it presents an attractive acquisition target for an internet-focused financial investor, or even Zameen’s majority shareholder (Dubizzle Group).

Other Considerations

Dubizzle Group (formerly EMPG Group) is Zameen’s largest shareholder. Dubizzle recently raised US$200m, led by Affinity, and is in the process of preparing to IPO their business. Alongside Zameen, Dubizzle owns four other EM marketplaces. The IPO of Dubizzle should present some sort of catalyst for FDV. In my view, Zameen is Dubizzle’s most attractive asset, and it makes sense for them to try and consolidate ownership before the IPO. Furthermore, Dubizzle is branding itself as the largest classifieds player in emerging markets, so in my view it would also make sense for Dubizzle to acquire FDV completely prior to IPO, as they would consolidate Zameen while also getting access to a large group of emerging market assets, giving them greater scale, a global presence, and more relevance as a listed business. They would also be completing this acquisition at a time when valuations are significantly depressed.

FDV’s Other Assets - while I have ascribed 2x sales for FDV’s 3 other large businesses, I believe it significantly undervalues them. For instance, InfoCasas (LATAM property) generates $20m in revenue and is currently growing double digits with a 4% EBITDA margin. Encuentra24 (Colombia property) is growing at double digits while maintaining an 11% EBITDA margin. It is unlikely that these businesses are worth only 2x CY22 revenue (i.e., 7-10x normalized earnings). Furthermore, the FDV Group (ex-Zameen) is also Free Cash Flow positive, which leaves the business in a great position.

Views are my own. This is not financial advice.

Subscribe now

The 2023 NBA Playoffs have been fantastic. I've always enjoyed listening to interviews and post-game press conferences with NBA players and coaches. It's fascinating to hear them discuss their game plans, the challenges they face, and the adjustments they need to make.

While watching this year's playoffs, I started thinking about how much investors can learn from the NBA and apply it to the game of investing. Here are some intriguing aspects that caught my attention.

Games of Outliers

The NBA is a game full of outliers

The NBA is a team sport, typically consisting of 15 players on each team's roster. Despite this, there are typically only one or two players - aka outliers - that make the most significant contributions to winning.

NBA players already stand out as outliers, representing the top ~0.0001% of the global talent pool, along with most professional athletes. However, even within this highly talented group, there are notable outliers in terms of their contribution.

Throughout NBA history there have been a total of 4,797 active NBA players. Over this period, these players have collectively scored 13.4 million points. However, a significant portion of the scoring has been achieved by only a handful of players. For instance, the Top 100 Players (based on scoring) represent just ~2% of the NBA's overall population, yet they have accounted for over 16% of the total points scored in NBA history.

The Median Player within the Top 100 has scored just under 20,000 points throughout their career. This compares to the median NBA player, whose career points total is just 661. The Median Top 100 player’s scoring contribution was 30x greater than the median NBA player.

There’s a similar outlier dynamic when you look at Most Valuable Player (MVP) awards. The MVP is a yearly award that’s (typically) given to the most impactful player on one of the leading teams. There have been 68 MVP awards in the NBA’s history, but just 5 players have won over 35% of all MVP awards.

There are also plenty of outliers at the team level. In the NBA there are 30 teams, and each year one team wins the championship. Over the last 30 years just 4 teams have won 63% of the championships.

Investing is also full of outliers

The outlier dynamic is way more pronounced in investing. Warren Buffett - one of the investing GOATs - recently stated that in his 58-year investing career, only 12 decisions or investments had driven the bulk of his returns. Over Berkshire’s 58 year history they had probably made close to 300 individual investments, which implies a 4% hit rate. It is amazing that 96% of the investments made by one of the world’s greatest investors turned out to be duds. This shows the impact that outliers have on investment returns.

“At this point, a report card from me is appropriate: In 58 years of Berkshire management, most of my capital-allocation decisions have been no better than so-so. In some cases, also, bad moves by me have been rescued by very large doses of luck . . . Our satisfactory results have been the product of about a dozen truly good decisions – that would be about one every five years” Warren Buffett - 2022 Shareholder Letter

There is also empirical data which affirms this outlier dynamic. An expansive study by Hendrik Bessembinder looked at the performance of 25,300 US public companies over the period of 1926-2016. The study found that the Top 90 performing companies (0.36% of companies) accounted for over half of the wealth created, and the top 4.3% of companies (1,092) were responsible for all of the wealth creation.

A separate study by Vanguard showed that between 1987-2017, the average return of a stock in the Russell 3000 Index was 387%. However, the median stock only returned 7% over that 30-year period, losing value when accounting for inflation. Over that period, 47% of all stocks in the Index had been unprofitable investments, while only 7% of stocks had cumulative returns in excess of 1000%.

The studies show that Warren Buffett’s experience is not an anomaly. Only a select few of outliers – or compounders – drive the bulk of investment returns.

The thing that all those outlier investments have in common is growth. In the short term, market noise and sentiment are key drivers of a stock’s performance (i.e., multiple expansion & contraction). However, over the long run, growth is the most important factor that creates value. Companies that can sustainably compound their earnings / free cash flow over the long run will increase in value.

That’s why my personal approach to investing revolves around finding businesses with meaningful long-term growth potential. Companies capable of sustaining such growth are more likely to be outliers and generate outlier-like returns.

Losses are Part of the Game

This section might read like a motivational pep-talk for investors, but it's important to recognize that investing, much like sports, can be an emotional endeavour.

Here are some great clips of all-time great NBA players discussing how they have dealt with losses and adversity.

The greatest players in the league constantly dealt with adversity. Early in Michael Jordan’s career he kept losing in the playoffs and there was constant chatter that he might never win a championship. LeBron James was constantly berated for failing to win an NBA championship with many media outlets claiming that he wasn’t clutch (i.e., perform when it matters the most).

Investing can also be full of adversity. There will be investments that fail, there will be misjudgements, and there will be bear markets. As highlighted in the previous section, with only 4% of stocks in the US' history responsible for creating the majority of value, a significant proportion of individual investments are bound to be losers. Losses are a feature of investing, not a bug. Managing emotions, taking the L, and dealing with adversity are key traits for investors. Furthermore, these losses hold some intrinsic value as they provide abundant opportunities to learn from mistakes and grow.

Staying Ready - Always Learning

While the NBA is a star driven league (aka outliers), the non-stars play an important role in a team’s success. There are many role players on a team that do not get playing time. However, these role players must constantly train, improve their game and stay ready as they never know when their number might be called.

Jeremy Lin was an undrafted young NBA player that was struggling to find a roster spot and was bounced from team to team. Jeremy Lin had to sleep on his friends couch while fighting for a roster spot on the New York Knicks. Due to an unforeseen injury on the Knicks roster, an opportunity opened for Jeremy Lin. He ended up going on an incredible scoring tear with the Knicks and this period became known as Linsanity.

Despite not having a permanent roster spot, Jeremy Lin had to constantly train and hone his craft as he never knew when he would get an opportunity. When his number was called, he was ready and went on to have a successful NBA career.

Investing is very similar to being an NBA role player. Just like a role player, constantly learning (training) is essential. Investors are always assessing new businesses, industries, and emerging technologies as the investment landscape is always evolving. Being able to adapt and learn is critical for investors to continually make well informed judgements and take advantage of opportunities that present themselves.

There are many styles to win - Play to your strengths

There are many different playing styles in the NBA. I previously highlighted how just four teams - Lakers, Spurs, Warriors and Bulls - had won 63% of the championships over the last 30 years. Those teams had very different playing styles, but they always played to their strengths:

• The Lakers have been star driven, relying on strong performances from legends like Kobe, Shaq, and LeBron to win championships.

• Spurs have a somewhat boring, but highly effective and mechanical style to basketball.

• The Warriors have won with a fast-paced, perimeter orientated game.

• The Bulls had Air Jordan.

The same goes for investing. Despite what I said earlier about compounders creating all of the value, there are many of ways to win in investing. There are investors that try and find those compounders; there are contrarian investors that never buy compounders and hunt for struggling companies; there are investors that only look at charts; and there are investors that only focus on macro.

There have been many investors that have generated significant returns under each of their respective strategies and areas of expertise. In my view, investors should play to their strengths.

Share

Subscribe now

However, despite the recent thrust of AI into the spotlight, many companies have been using AI within their products for several years. One of those companies is CrowdStrike, which has a long history of utilizing AI to protect its customers against cyber threats.

CrowdStrike: AI, Cloud, and the Crowd

CrowdStrike (CRWD) is a market leading cybersecurity company that has modernized the industry. CrowdStrike was one of the pioneers in leveraging the power of the cloud and AI to deliver a next-generation cybersecurity suite.

A key differentiator of CRWD has been its ability to leverage insights from billions of daily cybersecurity events, learning from these events in real-time, and use AI to provide advanced endpoint protection across all its clients.

CrowdStrike does this by crowdsourcing billions of daily cybersecurity events (i.e., attacks, patterns, adversary tactics) across all its customers’ endpoints via a lightweight agent. It uploads this data into its centralized Threat Graph database, uses AI to conduct machine learning and pattern recognition, and utilizes those learnings to automatically detect and prevent threats in real-time.

CrowdStrike has combined the benefits of various cutting-edge technologies, such as the cloud for scalability and AI/ML for learning and speed, to deliver a next-generation product. This market-leading approach has driven CRWD's strong growth, with its annualized recurring revenue (ARR) growing at a 78% compound annual growth rate (CAGR) over the last five years.

Prior to expanding further on CRWD’s position and financial profile, I would like to provide an overview of the cybersecurity landscape and why it will remain a significant area of investment for all businesses.

Big Picture: Cybersecurity is non-negotiable

1) Cyberattacks can lead to business failures

Cybersecurity is a critical piece of infrastructure for all businesses in the digital world. Cyberattacks and breaches can create going-concern risks as it can result in an inability to conduct business or a disclosure of their IP, which can have serious financial, regulatory and reputational ramifications. Here are some recent examples:

• In 2022, global logistics company Expeditors International lost $40m in sales and incurred $20m in remediation costs after ransomware prevented it from conducting full operations for 3 weeks.

• Optus - Australia’s second largest telecom - recently set aside $140m of remediation charges after their customers’ information was breached. The damage to Optus’ goodwill and brand is hard to quantify.

Smaller companies are particularly vulnerable since they face the same risks as enterprises but lack the IT resources of enterprises. The SEC previously stated that 60% of SMBs go out of business within 6-months of a cyberattack.

2) Digital transformation has increased the attack surface

The perimeters of businesses (aka attack surface) have grown significantly as they moved to the cloud, adopted various SaaS products, adopted more connected devices, and became more distributed (WFH). This means there are more endpoints or potential vulnerabilities for bad actors to exploit and enter an organisations network. According to the FBI, the total losses from cybercrime complaints had increased 4x over the last 4 years.

3) Private Sector needs to defend itself against Foreign Governments

According to Microsoft, over 85% of enterprise focused attacks by nation states were targeted at non-government sectors. Cyberwarfare is one of the only domains of war where a foreign nation can directly attack businesses, and those businesses are largely left to defend themselves. Given the rise in state-sponsored cyberattacks, businesses need to invest in next-gen cyber solutions to protect themselves against military-grade, nation state adversaries.

4) Physical infrastructure is not immune from cyberattacks

It isn’t just the digital domain that is at risk: physical infrastructure such as pipelines and utilities are at risk from cyberattacks. These assets are now at play for bad actors as many of the operational technologies that ran these assets became digitised (i.e., connect to the internet/ethernet). Nation states are particularly focused on attacking critical infrastructure.

Therefore, due to the significant business risk that companies face and the enhanced capabilities of bad actors, cybersecurity is regularly highlighted as one of the leading areas of investments by CIOs. This will continue to be a tailwind for cybersecurity providers.

What is CrowdStrike?

CrowdStrike is the market leading cybersecurity software provider in the endpoint protection market. An endpoint is any device that connects to a network, such as laptops, mobiles, cloud servers and IoT devices. The endpoint is probably the most important digital real estate for businesses as this is where all their data is created. This is why 90% of all cyberattacks start at the endpoint and 70% of all successful breaches occur at the endpoint, as compromising an endpoint would likely enable bad actors to gain access to a network. This is why endpoint security is one of the most important lines of defence.

In addition to being a leader in endpoint protection, CRWD has expanded into other cyber verticals, and now offers a platform of solutions.

Product: Why CrowdStrike wins?

Market leading product

CrowdStrike has a market leading product in the endpoint protection space as highlighted by Forrester and Gartner reports. CrowdStrike’s product leadership is due to their superior efficacy rates in threat detection and prevention; ease of adoption; lower total cost of ownership; lightweight endpoint agent; and ease of implementation.

User ratings on review sites such as Gartner and G2 (G2: CRWD 4.7/5 vs MSFT 4.4/5) also highlight CRWD as a leading endpoint product. Further evidence of CRWD’s leading product has been their ability to take market share and grow the overall market.

Next-gen approach to cybersecurity

CrowdStrike disrupted the endpoint cybersecurity market by leveraging AI and the cloud. A traditional endpoint product is locally hosted and uses signature-based malware detection models. A signature-based model just means that they have a list of signatures / patterns of known malware and use that list to prevent known malware. This has obvious limitations, mainly that they won’t be able to prevent non-malware attacks (which are the majority of modern attacks) or prevent zero-day threats (i.e., unknown/new).

CrowdStrike changed this approach by using a lightweight agent at the endpoint (doesn’t burden CPU/memory) and cloud-based AI to prevent non-malware and zero-day threats using behavioural analytics and machine learning. CrowdStrike also leverages crowdsourced data across all its endpoints in order to identify new attack patterns, using these learnings across its product suites in real-time.

Network Effects - Data has gravity

AI based models are only as good as the quality and quantity of the data that is fed into them. CrowdStrike’s scale is a significant advantage as their market leading share of endpoints enable them to ingest billions of daily security events into their cloud platform. The more data that is fed into the platform, the more intelligent it becomes, which creates attractive network effects and increases the value of CRWD’s solution.

Product-led company: Platform approach

The cybersecurity industry has always been highly fragmented. While CRWD maintained a strong lead in the critical endpoint security market, they are taking the platform approach with regards to their product investments and have expanded into other verticals such as cloud security, identity protection and observability.

CrowdStrike’s new products are fully integrated into their platform and run on their single agent, which has allowed their customers to try/buy new products in real-time, as opposed to having to go through lengthy implementation cycles or deploy multiple agents. CrowdStrike is in a great position to consolidate parts of the security market.

Financials: Why CrowdStrike is an attractive investment

Large and growing addressable market

CrowdStrike’s end-market growth is driven by the organic growth in the cybersecurity industry, as well as CRWD’s product expansions into new verticals. CrowdStrike’s current addressable market is $71b, indicating significant room for growth (~4% penetration).

Rule of 40

Rule of 40 (Revenue Growth + Free Cash Flow Margin) is one of my favourite SaaS metrics as it balances growth and efficiency. CrowdStrike delivered a Rule of 85 in FY23, and I expect them to operate on a Rule of 70 in FY24.

Product-led growth = Land and Expand

I previously highlighted CRWD’s product leadership driving their module expansion. This product leadership has provided financial benefits as 62% of CRWD’s customers use 5 or more of CRWD’s modules, which is up from 2% in 2018.

This dynamic powers CRWD’s land-and-expand motion, which is evident by their 125% net retention rate (i.e., existing customer increase spend by 25%, net of churn). In addition to strong land-and-expand dynamics, CrowdStrike also has low churn rates (2% in FY23) which is further evidence of their product leadership.

Strong Go-To-Market with world class unit economics

It is critical for market leading software companies to have an effective go-to-market strategy, whether it be a viral DTC model (Slack or Atlassian) or a powerful channel motion (Microsoft). CrowdStrike has continued to invest in its channel program, and the channel now drives the bulk of its revenue.

CrowdStrike’s strong channel program enables them to have world-class unit economics, as shown below (lower the number, the better). Furthermore, given their low churn, CRWD’s LTV / CAC has averaged 38x over the last 3 years.

Valuation - 80% return in three years

• I expect CRWD to generate +$6b in ARR by FY27 (~2026) with a 35% FCF margin. Given CRWD is already generating a 30% FCF margin at this point in its lifecycle (i.e., still in landgrab mode), it could comfortably generate a 40% FCF margin on a normalized basis.

• Based on that framework, I believe CRWD’s equity should increase by at least 80% over the next three years, delivering a 22% IRR. It is also worth noting that CRWD should have $6.5b of net cash in 3 years, which would equate to ~20% of the current market cap. If CRWD can generate anything close to my / consensus’ revenue forecasts I believe the businesses value should be significantly higher and they will be in a prime position to conduct accretive buybacks and acquisitions.

The peer set below has a 2.3% median FCF yield with 19% revenue growth. This gives some comfort in the target 4.0% FCF yield used above given CRWD has one of the strongest financial profiles out of its peers, with top-quartile growth, free cash flow and efficiency.

Other considerations and risks

Forecasts too bullish

The key risk for the investment case is that my ARR forecasts could be too high. The main driver of CRWD’s revenue is net revenue retention, which I have falling from 125% in FY23 to 117%/118% in FY26/FY27. To test a downside scenario, I modelled NRR to fall by 5 points each year across FY23-FY27. Assuming a 5% FCF yield, I still get a positive return (S&P 500 averaged a 4.3% FCF yield over the last 5 years). Furthermore, in a lower growth scenario I expect CRWD’s dilution would be lower than I have modelled (2.3% pa).

Dilution

While CRWD is FCF positive, it is unprofitable largely due to share-based payments which accounted for 23% of sales in FY23. I am not advocating to ignore stock-based compensation, however I think investors need to evaluate SBC on a case-by-case basis (i.e., dilution relative to growth, unit economics, company/industry lifecycle, LT guidance). CrowdStrike have already provided guidance for SBC to fall to the mid-teens (as % of revenue) over the next two years, or 2-3% annual dilution over the next few years.

Competition - Microsoft Risks

The big risk for CRWD is Microsoft as they are their largest competitor and are also doing well in the cybersecurity market. Industry feedback and customer reviews continue to point to CRWD as the overall best solution, but MSFT Defender is no slouch. CRWD will need to continue to invest in product and the channel to remain competitive. One advantage that CRWD has is the channel. Microsoft’s products have low margins for channel partners and some of their recent channel changes make it even more difficult for channel partners to make money. In my view this only further incentivises MSPs/SIs to bundle in non-MSFT products like CRWD in order to improve their margins and diversify vendor risk.

Enterprise IT spend is under pressure

Recent results from the hyperscale cloud vendors as well as other SaaS companies indicate continued pressure on IT budgets due to macroeconomic weakness. CrowdStrike have called this out as well, which should weigh on their growth.

These views are my own and is not intended to be financial advice.

Subscribe now

Share

Over the last few years, we've witnessed several massive technological advancements and Hype Cycles. Currently, AI is all the rage and I believe the hype around it is justified. AI products have the potential to transform our lives in significant ways, and it will be particularly disruptive for businesses.

However, this post isn’t about AI. In this post I will examine some of the significant technological advancements that we have seen over the last decade and share some thoughts on what lessons can be drawn from those technologies and Hype Cycles. These lessons can provide insights for investors on how to approach the AI revolution and future emerging technologies.

Mobile Internet (3G & 4G)

One of the most significant technological advancements over the last decade has been the mobile internet. The third (3G) and fourth (4G) generation of mobile networks gave utility to the mobile supercomputers that we now couldn’t live without.

The rise of the mobile internet spurred the growth of numerous industries, including social media, digital advertising, streaming, and the mobile economy at large.

If an investor in the early 2000s possessed amazing foresight and recognized the potential of 3G/4G networks, where should they have placed their capital? An obvious bet would have been the telecom sector, as they owned and operated these highly valuable networks. This bet would have been logical.

In hindsight, it would have been one of the worst ways to play this thematic. While telecommunication companies built the networks that underpinned the mobile economy, they all failed to capture the economic activity that their networks enabled.

The above chart is pretty remarkable, particularly when you consider that telecom companies had first-hand insights into the structural trends taking place in society. They would have seen the explosion of mobile web traffic across their networks and would have seen which specific products were thriving (such as social media and streaming). Given these insights, one might assume that telecom companies would have been well-positioned to invest in (or create) Over-The-Top (OTT) and mobile internet products.

However, despite being at the forefront of the technological change happening within society, and somewhat responsible for it, telecoms failed to capitalise on it. As a result, the telecom industry has barely grown since the rise of the mobile internet. The businesses that captured the value from the explosion in the mobile economy were those that created new products and services that leveraged the mobile internet.

Cloud computing

Along with the mobile internet, cloud computing has been the other significant technological advancement over the last decade. Cloud computing has become the backbone of countless consumer and business products, ranging from video streaming to enterprise software. It is the infrastructure that has enabled the hypergrowth of companies like Airbnb and Uber, as they were able to achieve global distribution quickly and efficiently using the cloud.

Amazon Web Services (AWS) pioneered cloud computing in 2006. In a span of 10 years, AWS’ revenue has increased by >27x and now sits at $84b run rate.

Jeff Bezos received a lot of flak when he first launched AWS. Many investors would have preferred Amazon remain an e-commerce business. However, as we stand today, AWS is what has allowed Amazon to become one of world’s most valuable businesses, and it is the infrastructure that underpins most of the digital economy.

While AWS was established in 2006, it took close to a decade for the business to reach meaningful scale. Over that period there were plenty of customer testimonials, industry reports and feedback that investors could have assessed in order to determine AWS’ future success. Here are some instances of early customer testimonials and feedback on AWS:

• Netflix became an AWS customer in 2009. Below is a testimonial from 2012 where they talked about the instant scalability and cost efficiencies that AWS provided.

• Nasdaq adopted the cloud in 2008 to provide traders access to real-time market data. The cloud was a no brainer as it provided improved performance, quicker deployment and lower costs

• Newsweek adopted the cloud in 2009 and reduced monthly operating costs by 75% while also retaining scalability during peak traffic events

• Yelp migrated to AWS in 2014 to save costs and get new systems running in days, as opposed to months

• Pinterest (2014) touted the benefits of AWS’ scale and speed, and the benefits of being able to focus on their product as opposed to underlying infrastructure

• In 2014 Ticketmaster used AWS to reduce an applications costs by 80%

• Amazon was AWS’ first customer and a great case study for AWS. They struggled to scale due to many of their internal teams building their own infrastructure for their applications, leading to duplication and higher costs. Amazon’s engineers eventually looked for ways to decouple their applications from their infrastructure, allowing for greater scalability, cost savings, and accelerated product development. This led to the creation of AWS.

While it took a while for cloud computing to become mainstream and investors were initially sceptical; the point I am trying to draw out is that there were plenty of publicly available studies, data points and customer testimonials which investors could have leveraged to understand the cloud. Gaining insight from the users of new technologies is crucial, and it is the most effective way to understand the value it offers.

Web3 / Blockchain / NFT

We all witnessed the explosion and subsequent collapse in the crypto / web3 industry over the last two years. The hype around crypto was extraordinary, with significant amounts of capital being deployed by both retail and institutional investors.

However, early on in the crypto boom, it became evident that there weren't many use cases for the technology. A few interesting perspectives that really stuck with me were those of the CEOs of ICE and Nasdaq. ICE was an early investor in Coinbase, while Nasdaq sells its exchange software to most of the crypto exchanges.

“When we look at the blockchain you can see it's version 1.0, the database is rudimentary compared to what we're doing. . . . It doesn't solve a lot of the major problems that we have . . . if you look at globally the interest in it and the investment going in . . . it's somewhat consumer-oriented” - Jeffrey Sprecher, ICE CEO

“We want to be on the forefront of making sure [our] technology is as modern as possible, bringing it into the cloud and allowing it to scale . . . But what I think is somewhat ironic is that the blockchain is meant to be a decentralized kind of trustless environment where buyers and sellers can actually find each other organically but every single crypto has been launched on a centralized exchange” - Adena Friedman, Nasdaq CEO

Both ICE and Nasdaq, two of the world’s largest exchanges, stated that their businesses had little use for the technology underlying Blockchain / crypto. The CEO of ICE basically said the only use case of crypto was to allow consumers to speculate on crypto. Investing in technologies without a clear use case is rarely successful.

What are some of the takeaways?

1) Speak to Customers and Users

This is the most important step when analysing any technology or product. Gaining insight from users of a particular technology allows you to determine the value it creates. Investors who took the time to speak with businesses that were early adopters of cloud computing would have had a better understanding of its growth potential. As previously highlighted, it was evident that cloud customers were reaping the benefits of increased efficiency (lower costs) and rapid deployment (higher revenue). Lower costs and higher revenue creates value in any business environment.

2) Avoid Hyped Technologies looking for a Use Case

Investors should be cautious when assessing emerging technologies that don’t have a use case. Investors should focus on the end-product and determine whether it provides any value. During a Hype Cycle there will inevitably be slick technologies that are overhyped but lack real world applications, just as we saw during the web3/crypto boom.

3) It’s not always the most obvious play: New Technologies might require New Products

The telecom companies spent billions building 3G & 4G networks, but they failed to participate in the incremental value created by those networks. This is because they did not create new products and services that would have leveraged the mobile internet. There is no guarantee that those companies closest to the technological advancements will benefit from said advancements.

4) It’s okay to be late

During a Hype Cycle, investors can feel pressured to deploy capital in any idea linked to that theme. However, it’s important to remember that it’s okay to be late. For instance, Amazon launched AWS in 2006 but they only began disclosing its revenue in 2015. An investor could have taken a decade to understand and gain comfort on the benefits provided by cloud computing and still made a 6x return by investing in Amazon in 2015 (or 6x in Microsoft the no.2 cloud player).

5) Look for Products, not Features

When evaluating new technologies that might have a single application, investors should ensure the single product can be monetized in a meaningful way and won’t end up as a feature within an established incumbent. (i.e., a slick calendar app is a feature, iOS/Android provides this feature for free).

6) Bet on innovative business leaders

Amazon was a leading online retailer but their innovation with regards to computing and infrastructure is what gave us AWS. Management quality is critical when evaluating investments, and backing management teams that are innovative, bold, and willing to pivot is a great strategy for investors looking to play a new technological theme.

7) Don’t be afraid to make mistakes: there are no Clean Sheets in investing!

Mistakes are a feature of investing, not a bug. We should take comfort that even the world’s greatest investors and businesspeople have made plenty of investment mistakes. Therefore, learning from mistakes, whether it be our own or others', is an important practice for all investors.

A critical error is to let previous investment mistakes scare us from betting on future technologies. Even if you do everything right - speak to all the customers, run the best financial models, understand the industry - there will be investments that fail. This shouldn’t discourage you: be bold, dust yourself off, and keep moving forward!

Subscribe now

Leave a comment

Yes . . . a blog post about Stock-Based Compensation (SBC). You might be wondering why I would willingly write about such a seemingly dry topic. While normally it’s a non-issue, it has been an increased area of focus over the last few years. There has been egregious amounts of stock-based compensation within the tech industry and some high-profile investors like Warren Buffet, Jim Chanos and Daniel Loeb have been calling out the excessive use of SBC and “adjusted earnings”.

On the other side of the debate, many technology companies continue to exclude the cost of SBC from earnings and there was a particularly entertaining clip of Keith Rabois (Opendoor co-founder), where he came out swinging in defence of ignoring SBC, calling it fake - a fugazi. (The SBC bit starts from 1:40 below).

Who is right? Is SBC real, or is it a fugazi? Dilution is real, so SBC has to be real. Case closed . . . right?

I believe the discussion is nuanced because in some instances the accounting cost of SBC can significantly overstate the real cost of SBC. However, I agree that SBC usage in the technology space has been excessive and the recent focus on efficiency will force companies to clean up their acts.

Before diving in, let’s just cover some basics.

What Is Stock-Based Compensation?

Stock-Based Compensation is when a company pays its employees in stock and/or options. The key premise underlying SBC is that it creates alignment between employees and shareholders as employees now have skin in the game and have more incentive to get the share price up, which is ultimately what shareholders want.

Stock-Based Compensation sounds like a good thing – what’s the issue?

Creating more alignment between stakeholders is a good thing . . . but too much of a good thing can be bad. The key issue is that there has been too much SBC in the technology sector. The other issue is that some management teams have seemingly been ignoring the cost of SBC over the last few years, presenting their financials in a way that excludes the cost of SBC.

To illustrate the point, check out the financials of Salesforce and Atlassian. In FY23 Salesforce made over $31b in revenue and only $1b in net operating income - a tiny 3% margin. Atlassian generated over $2b in revenue in FY22 while losing over $100m. However, after adding back SBC and other adjustments, Salesforce and Atlassian claimed to have generated profits of $7.1b and $600m.

The cynics view this as gaming the system as management have found a way to dish out as much of their expenses below the line via generous SBC packages, while seemingly hitting their “earnings” targets. As the market accepted adjusted profits as a benchmark, this created an incentive for management to shift as much of their cost base into SBC – which is exactly what has been happening. To be fair, this also happens in many non-tech industries with EBITDA being the main culprit.

But . . . is all of that SBC cost real? Not All SBC is created equal. There are two main types of SBC – Stock Options and Stock Grants.

Options: the best SBC

Options are great tools that create alignment between shareholders and management. Most option plans are issued with a strike price equal to the current market price. As a shareholder, if an option is issued with an exercise equal to the current market price, is there really that much dilution? Let’s use a hypothetical example below.

In this scenario, the stock is worth $1 and employees are granted 5 options with a $1 strike. While the share count or EPS has been diluted, the enterprise value of the company is unchanged. As a shareholder I have already factored the impact of the options within diluted market cap (plus some restricted cash). However, within the accounting statement, these options would represent a significant cost as the option is valued using the Black-Scholes model, which is influenced by factors such as duration or the volatility of the underlying security. Using Black-Scholes these call options would be worth $0.41 each or $2.05 in total. So, within the P&L this company would be recording a $2.05 expense equal to 41% of their total profits.

As an investor in the above business, did that option grant really cost me that much? Did it really result in a 41% reduction in the free cash flow of my business? From my perspective it didn’t – especially considering I have already modelled for the dilution.

In a case like this, I believe the accounting cost of SBC is mostly a fugazi. While I agree that the options issued above have value, I just do not think it represents a significant cost to me as an equity holder – especially not to the extent that the accounting P&L would imply.

Stock grants: this is not a fugazi

Stock grants are when employees are given shares that vest based on tenure and are generally not linked to a KPI. It is a stretch to treat this as a “non-real” expense. Ignoring this cost while continuing to give away stock is the equivalent of Modern Monetary Theory for companies.

Salesforce is regularly called out as one of the bad actors when it comes to SBC, especially given their size and maturity. Management are also prolific sellers of the stock.

Across FY22 and FY23 Salesforce granted 38m in shares to its employees, which accounted for $4.4b and $3.8b in value and 17%/12% of Salesforce’s revenue. Unlike options, the stock price does not have to go up for employees to receive these grants and employees do not have to contribute any capital to the business. Salesforce (and many others) continue to exclude the cost of these issuances from their earnings, which just acts as a hidden tax on shareholders (just like inflation or money printing).

Final Thoughts

Options > Grants

• Shareholder friendly option plans are a great way to create alignment between management and shareholders.

• The accounting cost of options can significantly overstate the real world cost of the options issued, and I contend that the accounting cost can be a fugazi. On the flip side, the accounting cost of options creates a nice cash tax shield.

• Stock grants are a straight up costs and I struggle to see how we can exclude this from operating income.

• As always, investors need to assess investments and SBC plans on a case-by-case basis.

FCF > Earnings: Focus on Free Cash Flow per Share

I understand why the cynics are sceptical when they see a huge cost item in the P&L that management try to ignore. However, as the most conservative of investors will tell you, ultimately the focus has to be on cash.

Irrespective of how management teams decide to allocate capital (i.e., opex vs capex vs dilution), the ultimate metric that underpins a business’s value is Free Cash Flow per Share.

“Why not focus first and foremost, as many do, on earnings, earnings per share or earnings growth? The simple answer is that earnings don’t directly translate into cash flows, and shares are worth only the present value of their future cash flows, not the present value of their future earnings. Future earnings are a component—but not the only important component—of future cash flow per share.” Jeff Bezos - Amazon’s 2004 shareholder letter

As the charts show, despite plenty of dilution across the stocks below, they have increased Free Cash Flow per Share - which has generally created value. (Note: Share Prices & FCF are as of financial period end)

Tech Dilution has been excessive but should come down

• I agree with the overarching view that SBC/dilution within tech has been excessive. This is mainly due to the fat that has built up within the tech sector over the last few years.

• Investors have always assumed SBC falls as companies mature, however this hasn’t been the case as even mature tech dilution has doubled over the last few years. Does Salesforce - with its $200b market cap - really need to dilute their share-base by ~5% every year to achieve their business objectives? Probably not.

• Given the recent focus on efficiency, I expect SBC issuance to tighten up.

“You [investors] think that Spotify is a great product with a great experience. But some may also think that we’re a bad business or at least a business with bad margins for the foreseeable future.”

While there have been many zombie companies that raised capital over the last few years with questionable economics, Spotify is not one of them. In this post I’ll lay out Spotify’s pricing power and why profitability should increase meaningfully, which I believe should result in a much higher valuation.

1) Pricing Power - Long tail of price increases to come

In my previous post, I highlighted that the existence and growth of Spotify as clear evidence of pricing power, as Spotify’s product is one of the key reasons why society began paying for music again. Furthermore, in 2020/21 we also saw some more recent and tangible evidence of Spotify’s pricing power as they launched wide scale price increases (up to 20%) across over 30 markets, including key regions like the UK and the US. Despite this, churn continued to decrease over the period and Spotify continued to grow subscribers.

Spotify’s Family Plan (6 users, 1 subscription) has been the largest contributor to growth over the last few years and is also responsible for reducing churn given its lower price point and increased stickiness (i.e., painful to cut a plan when 5 of your friends/family are using it). In my view Spotify’s Family Plan is significantly underpriced, with users getting monthly access to the world’s music and podcast libraries for less than the cost of a cup of coffee. The Family Plan is also >70% cheaper than the Individual Plan across most of Spotify’s markets.

Spotify’s Family plan has been a great product to drive adoption and increase stickiness while they have been in land grab mode. However, given the value they provide users and the current pricing of the product, I believe there’s significant opportunity for price increases in this plan, especially across developed markets. In my view Spotify can increase Family Plan pricing by at least 2-3x over the longer term, while still remaining cheaper than the Individual Plan.

We have already begun seeing higher prices flowing through the industry. Apple Music increased their US Individual and Family prices by 10% and 13% in October 2022, while Amazon Music recently increased their prices by 11-20%. This leaves Spotify in a great position to also increase prices going forward.

2) Low margin but still has internet-like economics

A key issue investors have with Spotify is its low gross margins. While Spotify is an internet business, it sells access to media which will always represent a significant portion of the cost of goods sold - resulting in lower gross margins. Low-gross margins are generally looked upon unfavourably by tech investors. However, in Spotify’s case, the low-margins are mostly optics. Would the fundamentals of the business change if Spotify reported a Net Revenue figure instead? (i.e., Revenue less Royalties). Despite the low margins, the business still has internet-like economics as it is highly scalable and relatively capital-lite. A great way to visualise this is to look at Spotify’s cumulative financials over the last few years.

Despite generating losses of €3.3b since 2015, Spotify has generated €1.3b in Free Cash Flow due to the capital-lite nature of the business.

Conversely Netflix - who enjoys much higher gross margins than Spotify (Netflix 40% vs Spotify 26%) - has burnt a cumulative $7b in cash over the same period despite generating profits due to the capital intensity of the business.

These charts above highlight the platform-like scalability of Spotify’s business model, despite being a media business. As I highlighted in the previous post, Spotify differentiates on all things non-content while the SVOD players solely compete via content differentiation. Constantly having to create hero content in a high-churn industry is capital intensive and carries more risk, as much of their financial performance (i.e., sub adds) is driven by the success of said content.

Content differentiation in the music streaming landscape is not a viable strategy due to the fragmented nature of music supply (from an artist perspective), which inherently lends itself favourably to an aggregator like Spotify. We saw this playout in 2017 when several artists began promoting Tidal, a competing streaming product.

Case Study: Got 99 Problems but Tidal ain’t one

In 2017 Jay-Z removed his music catalogue from Spotify in an attempt to nudge listeners onto Tidal. Tidal was owned by Jay-Z and several other artists including Rihanna, Beyoncé, Jack White, Kanye West, Usher, and Madonna. Over the years several of the artist/owners began launching albums and songs exclusively on Tidal in an effort to increase its user base. Despite this, Tidal failed to gain traction and Jay-Z eventually returned his full catalogue back on Spotify in 2019.

While some of Spotify’s users would have been disappointed that Jay-Z’s content was no longer on the platform, the abundance of substitute products (i.e., rap songs from other artists) and Spotify’s leading user experience kept users on Spotify. Content exclusivity failed to create a competitive advantage due to the fragmented nature of music consumption.

Fragmentation in music consumption continues to increase. In 2021 the top 50 US artists accounted for 12% of total Spotify streams, whereas during the CD era the top 50 artists accounted for 25% of CD sales. We are also seeing increased geographic diversity of our listening habits with countries like Puerto Rico, South Korea and Colombia becoming major exporters of music. The increased diversity of society’s listening habits will only strengthen Spotify’s market position over the long run.

3) Profitability is going to increase . . . a lot

Spotify has never reported an operating profit. While part of this was due to lack of scale in its early days, I believe this is mostly due to reinvestment in growth initiatives and market conditions that didn’t demand profitability from management teams. Spotify’s aggressive hiring has resulted in a significant degradation of their per employee efficiency metrics. Spotify’s gross profit per employee peaked in 2019 at €391k (US$430k) per employee. Since 2019 Spotify has increased its total headcount by 130% while revenue only increased by 73%, which has brought gross profit per employee down to €288k.

This is clearly unsustainable and management have made it clear to the market they intend to improve the businesses efficiency from 2023 onwards (i.e., recently reduced headcount by 6%). At Spotify’s current scale (c.€3b in gross profit), they are clearly more than capable of covering their core operating costs and generating profits, given ~49% of employees sit within R&D and R&D accounting for 47% of gross profits.

With a renewed focus on efficiency I think Spotify could comfortably generate more than €500k gross profit per employee, which will leave it in decent company relative to some peers/tech leaders below.

Another area where Spotify should deliver some efficiencies is within sales and marketing. Spotify’s subscriber acquisition costs have exploded over the last two years with sales and marketing spend per gross subscriber add up 44% since 2019. This is primarily due to increased investment in above-the-line marketing spend and non-music endeavours like advertising sales staff, podcasting, and sponsorships.

Given the renewed focus on efficiency, I believe we could see Spotify’s headline S&M per gross add return to pre-COVID levels of €11 per gross subscriber, which alone would drive ~400bps of margin improvement.

Final Thoughts

Spotify is the market leading audio platform that is driving adoption of audio streaming around the world. As of December 2022, 8% of the world’s population was a monthly active user of Spotify (ex-China, Russia). Spotify’s subscription adoption within its developed markets has increased 3-4x since 2016 with 15% of North Americans and 13% of Europeans paying for a monthly subscription. Over the long run, I expect 20-25% adoption of Spotify’s subscription service in its developed markets.

Spotify continues to remain free cash flow positive, with limited share-based compensation dilution. They are in prime position to continue to self-fund their growth ambitions and dominate the audio streaming market. While they are yet to generate a profit, the business is more than capable of delivering profits at their current scale, especially when considering they are overinvesting in R&D and Sales & Marketing (47% & 54% of 2022 gross profit).

Assuming the above terminal margin framework - which I believe is achievable - I see a realistic likelihood that the business will increase in value by more than 2x over the next three years, assuming a 15x multiple. This valuation is not ridiculous when considering Netflix and Tencent Music at 23x and 14x.

There are a few risks I’d highlight with regards to the business case.

1. Macro - The advertising market is very weak and is expected to further deteriorate in 2023. I currently assume Spotify’s ads business falls 3% in 2023 (i.e., Impressions +20%, CPMs -23%), but this could prove too bullish in a tough macro environment which presents risks to my earnings and revenue forecasts.

2. Competition - Spotify needs to reinvest in product to maintain its competitive advantage and differentiation. I do not believe anyone will ‘out-Spotify’ Spotify, however there can always be new music distribution models which can present risks to Spotify. As we stand today, the current SaaS model of audio consumption seems well entrenched for the foreseeable future.

3. Operating expenses - While I have laid out a framework for Spotify to comfortably generate an operating profit, they have yet to generate profits and there is a risk that I have overestimated the scalability of the model or the efficiencies available within S&M and R&D.

Share

The internet was terrible for the music industry. The internet made pirating, and the sharing of pirated music, extremely easy. In the 90s many of us would have pirated music by burning CDs. It was quite common, but there was still a lot of friction in this process as you had to burn a CD one at a time and most CDs could only be written over once. As the speed of the internet increased in the early 2000s, peer-to-peer (P2P) file sharing platforms like Napster, LimeWire, and The Pirate Bay exploded in popularity. This really put the squeeze on the music industry as it became much easier for consumers to freely access almost all the world’s music. The improvement in music playing devices like MP3 players, iPods and mobile phones also made it easier for consumers to enjoy their pirated content.

Technology made pirating frictionless and gave it scale. It was great outcome for consumers but it was a rough time for the music industry as industry revenues fell by 41% from 1999 to 2014. Piracy was killing the music industry.

While it is hard to find concrete data on music piracy, research reports indicate that LimeWire was installed on 36% of computers globally, with the bulk of traffic on the platform being used to share copyrighted material. Piracy was also quite prevalent amongst wealthier countries and young/technologically savvy cohorts. Countries like Sweden, Australia and Finland were notorious consumers of pirated content.

Spotify - The Music Industry’s Growth Engine

However, in 2015 the recorded music industry began growing for the first time this millennium. This is largely due to the growth in Spotify and the adoption of streaming. By 2021 the recorded music revenue industry reached $15b in the US, which surpassed its 1999 peak of $14.6b.

Spotify delivered a product that was so good that consumers began paying for music again. Reports indicate that global music piracy declined by 65% from 2017 to 2021, while piracy has been all but eliminated in regions like Norway. This is quite extraordinary - especially when you consider that piracy had only gotten easier over the years (i.e., smartphones were more powerful, the internet became faster, cheap VPNs, pirated music streaming sites etc).

Thanks to technological improvements and Spotify achieving product-market fit, consumers began willingly paying for a product that they were previously getting for free. This is a clear example of a business with product-led growth and pricing power. While it seemed like the internet was going to kill the music industry, the internet eventually enabled Spotify - a business that would slay the pirates and help drive the music industry to record heights.

The Spotify Machine

Spotify is the world’s leading music streaming and audio platform with close to 500m monthly active users and a presence in over 180 countries. Spotify has a leading market position with a 38% share of global subscribers (ex-China) and has the highest retention of all streaming competitors.

Despite many investors perceiving the music streaming industry to be commoditized, Spotify has been able to grow paying subscribers at significantly higher rates than competitors, while also expanding gross margins, reducing churn, and increasing prices. Spotify’s performance runs counter to the notion that its product is commoditized. If Spotify’s product was truly commoditized, they wouldn’t be winning a disproportionate share of the industry while also increasing margins/user retention.

While the music catalogues across streaming services may be identical (aka commoditized), the streaming product and the user experience is not identical.

Why does Spotify win?

1. Industry leading User Experience

A superior user experience is a competitive advantage. While some investors might not think of user experience as a significant moat, two of the greatest businesses of our generation - Apple and Amazon - provide great case studies on the power of User Experience.

Apple’s key competitive advantage has been its focus and investment into user experience. Even Steve Jobs said as much himself:

“One of the things I’ve always found is that you’ve got to start with the customer experience and work backwards for the technology. You can’t start with the technology and try to figure out where you’re going to try to sell it . . . and as we have tried to come up with a strategy and a vision for Apple, it started with ‘What incredible benefits can we give to the customer? Where can we take the customer?’ Not starting with ‘Let’s sit down with the engineers and figure out what awesome technology we have and then how are we going to market that?’ And I think that’s the right path to take.” – Steve Jobs, WWDC 1997

User Experience was one of Steve Jobs’ top priorities and a critical factor that helped Apple become the world’s most valuable company.

Jeff Bezos has said on multiple occasions that Amazon’s competitive advantage is their obsessive customer focus. He explained his business philosophy in a 1999 interview when the interviewer was giving him a hard time because Amazon was not a “pure internet play”. It’s a great interview so I’ve included it below.

“If there’s one thing Amazon.com is about, it’s obsessive attention to the customer experience . . . It doesn’t matter to me whether we’re a pure internet play, what matters to me is ‘do we provide the best customer service?’ Internet, shminternet . . . . They [investors] should be investing in a company that obsesses over customer experience. In the long term there’s never any misalignment between customer interest and shareholder interests.” - Jeff Bezos, 1999 interview

Tying this in with Spotify, they have also adopted this philosophy of focusing on user experience as a key business strategy.

“We believe our superior user experience is what has enabled Spotify to become the largest global music streaming subscription service. Investing in the user experience has and will continue to generate significant benefits for our platform . . . . The vast majority of the content we offer to users is licensed to Spotify on a non-exclusive basis. We believe that personalization, not exclusivity, is key to our continued success.” – Spotify’s F-1 (Prospectus)

Spotify has continuously invested in maintaining a superior user experience (interesting UX case studies 1 & 2) since its inception, which has allowed it to outcompete its well-funded competitors and incumbents. In an industry where businesses are all selling the same product or service (i.e., be it mobile phones like Apple, books/retail like Amazon, or music catalogues like Spotify), user experience becomes critical to drive differentiation and competitive advantage.

A tangible example Spotify executing and benefiting from this philosophy has been their investments into the single user interface. When Spotify launched podcasts it would have been much easier for Spotify to launch a separate podcast app from a development perspective. However, Spotify invested in imbedding podcasting functionalities into their core app to create a seamless user experience.

“When we entered podcasts, we were strongly advised to follow the status quo and, instead of creating an integrated app, create a standalone podcast app, because that would be easier for us….. But we asked ourselves, why should the user have to adapt to the format by switching software? Shouldn't the software adapt to the user?” - Gustav Söderström, Chief Research & Development Officer – Spotify 2022 Investor Day

This is what allowed Spotify to go from 0 to 100 in the podcast market. As soon as Spotify began investing in podcasts the category already had distribution to Spotify’s then ~200m users, as opposed to having zero users and trying to scale that organically. This obviously has material financial benefits as Spotify has gone from a distant third in podcasts to becoming the market leader in a span of 3 years.

Spotify followed Steve Jobs and Jeff Bezos’ philosophy of starting with the customer experience, then building the technology/product (aka internet, shminternet). This sole focus on user experience is what has allowed Spotify to dominate the audio market and drive differentiation in a seemingly commoditized market.

(Note: I get that it is a bit ironic that I am referencing Jobs and Bezos’ philosophy on UX, with regards to why Spotify is beating peers like Apple Music and Amazon Music!)

2 - Unique discovery engine and personalization = Engagement

A key area where Spotify’s product stands out in user reviews is their strong music discovery engine and great personalized playlists. Spotify currently drives 22 billion artist discoveries every month, of which 1/3 of those new discoveries are made through Spotify’s personalized playlists. This discovery engine is a key driver of engagement (i.e., use of the product), which is a major KPI for any media business. Spotify’s unique discovery engine and personalization is what allows it to have market leading engagement, even within the Apple ecosystem. Apple’s own data below shows Spotify having a significant engagement advantage across all competitors amongst iOS users. Higher engagement means more value for users, which ultimately results in more benefits for Spotify (i.e., be it lower churn, more ad impressions, pricing power).

3 - Superior tech stack helping Spotify becoming the audio Superapp

Spotify adopted a microservices architecture early in its lifecycle, which has allowed it to develop new products and deploy improvements much quicker and more effectively. A microservices architecture is when components of an application are broken out and deployed individually, as opposed to a traditional monolithic architecture where one code base runs all the components of an application.

It is easier for a company to start off with a monolithic architecture as it is simpler to manage and is more cost effective. However, at scale, shipping changes and launching new features within a large monolithic architecture becomes very problematic as this would require updating and testing the entire application. This results in a slower development cadence and can prevent scalability. It also eventually leads to tech debt which can be very detrimental to growth.

While Spotify’s investments into its microservices architecture was more cumbersome and costly early on, it has paid dividends as it is what enables Spotify to quickly launch new verticals within the same application, giving it major distribution advantages (i.e., as opposed to Apple and YouTube which still run multiple apps across audio streaming).

4 - Unrivalled audio distribution creating Network Effects

Spotify’s market leading position as an audio platform enables it to create valuable (indirect) network effects. In Spotify’s infancy its network effects were not that strong. While the platform did possess some network effects (i.e., more users = more value for artists), the network lacked density given its single product focus.

As Spotify evolved into an audio platform they have been able to create strong network effects. I’ve tried to illustrate Spotify’s current network in the diagram below. It is a lot messier than the previous graphic – which is a good thing. The denser (or uglier) the chart, the stronger the network effects. As Spotify’s network strengthens it delivers more value to users and partners, making them less likely to leave (and more likely to pay) – which ultimately increases the value of the Spotify.

A tangible example of this is Spotify’s podcast launch, which increased user engagement (i.e., lower churn, more ad impressions) and resulted in a 76% increase in the lifetime value of each ad-supported user. As Spotify further launches additional verticals like audiobooks and reels, engagement will continue to increase which will further densify Spotify’s network and increase its value.

Summary

Spotify’s superior user experience and growing network effects has enabled it to drive differentiation and have a competitive advantage in a seemingly commoditized market.

Spotify recently reaccelerated its user growth (which is difficult at this scale) and is in a great position to more than double its user base to 1b in ~5 years. Although revenue growth will slow in 2023, they are shedding their bull market fat and their recent user growth acceleration bodes well for future revenue growth.

While Spotify is still loss making, it has been free cash flow positive since 2016 and will comfortably self-fund its growth with minimal dilution to shareholders. If you assume a normalized operating margin of 12.5% (management long-term guidance of 20%), Spotify is currently on ~11x normalized operating income. In my view, it will be a much more valuable business over time.

This was part one of my posts on Spotify. In my next post I’ll dive into Spotify’s financial profile and share some more detailed analysis.

This strong period of growth and ensuing collapse in the sector is reminiscent of the Australian mining boom, which can serve as a helpful case study for investors. I’ll share some observations from the Australian mining boom and some of the lessons that can be learnt from the period.

The Australian mining boom (2004-2014)

Iron ore was a boring commodity after the 1970s mining boom. It wasn’t keeping up with inflation and its price remained consistently below US$20/t. This all changed in 2004 when demand from China and other emerging economies drove up the price of commodities like iron ore and coal. Over a period of 8 years the iron ore price increased 13x off its pre-boom levels. It was an extraordinary time to be in the iron ore business - everyone was making money - all you had to do was shovel dirt onto a ship and you would get $180-200 per tonne.

The boom in commodity prices resulted in a flood of capital to the mining sector as companies rushed to increase production in order to meet this newfound demand. Plenty of marginal/moonshot projects became economic and secured funding. According to the Reserve Bank of Australia (RBA), investment spending by the mining sector increased from 2% of GDP to 8% of GDP during the boom. There was also an increased demand for labour, leading to a tight labour market. The RBA estimates that the boom lowered Australia’s unemployment rate by 1.25 percentage points, significantly softening the impact of the GFC on Australia’s economy.

The mining boom was an incredible period for Australia and mining companies. A key feature of the mining boom was the significant expansion in the cost bases of companies. During the boom times, cost bases expanded across the board as companies competed for talent and spent aggressively on growth initiatives. Efficiency took a back seat.

Fortescue Metals Group presents a good case study on “bull market costs” and how organizations can get fat during the good times. It also presents a good framework on the amount of cost savings that can be extracted once management are incentivized to identify efficiencies, which results in a permanent increase in profitability.

Fortescue Metals Group (FMG) – the new force in iron ore

Fortescue was a fast growing iron ore miner that quickly became the fourth-largest producer of iron ore. They also had a pretty inflated cost base, with their cost per tonne one of the highest out of the major iron ore producers.

While the market was hot and commodity prices remained elevated, Fortescue’s inflated cost base (and large debt balance) was not a major concern. Over this period, Fortescue’s share price increased 3.6x off its 2009 levels.

However, as soon as the iron ore price started to fall in 2014, Fortescue came under huge pressure and its share price declined by more than 70%. Some were even speculating whether the business would go into administration. It was during this period when Fortescue’s management rolled up their sleeves and went to work on their cost base. As a result, Fortescue were able to reduce their cash costs from US$48/t to US$13/t.

The collapse in the iron ore price caused Fortescue to forensically look at their cost base – something they never had to do before. The fact that a fixed unit cost, process intensive business was able to identify permanent unit cost savings of ~70% is incredible, and it’s a great reminder of how easy it is for organizations to get fat during the good times.

It’s worth noting that it wasn’t just the high-growth, marginal producers like Fortescue that got fat during the boom periods. Even the well-oiled major producers were forced to realize tremendous cost savings. Over the same period, Rio Tinto and BHP reduced their unit costs by 43% and 55%. This is further evidence that there were a lot of cyclical “bull market costs” floating around in the sector.

The mining boom’s parallels with the tech sector

Many of the dynamics that we saw during the mining boom are similar to what we’ve seen in the tech sector over the last few years.

1. Growth was the key driver of value

   1. During the mining boom the whole industry was focused on growth.

      "For about a decade, if you were in this industry, what was important was spending your investment quickly so you could get your production out as quickly as possible," Former BHP Chairman Jacques Nasser

      This has also been the case in the technology sector. Anyone following the sector would be aware that growth has been the key measure to judge a technology company’s performance, with less focus on efficiency or unit economics. (Note: I still believe organic growth is one of the most important qualities of any business, however this has to come with attractive unit economics).

2. Capital flooded the sector

   1. Technology valuations got pretty ridiculous in 2021, as the chart below shows. Several large hypergrowth SaaS companies were trading on EV / Sales multiples in excess of 70x whilst also burning cash. In private markets, deals and funding exploded from late 2020 and into 2021.

      

      

3. Moonshot projects securing significant funding

   “It is another common feature of bull markets that as a mania progresses, the quality of stocks that attract speculation declines - a rising tide floats all ships, even the most unseaworthy” – Chancellor, Edward. Devil Take the Hindmost.

   1. During the mining boom, super marginal projects with high costs and in remote/risky regions attracted funding. This has also been the case in the technology sector. Meta’s $10b binge on the metaverse is a perfect example of this dynamic. While I have an Oculus Quest and like the product, its use case is super niche and mass market adoption of this technology is still questionable. For the world’s largest social media platform to bet 30-40% of its free cash flow on such an adjacent and moonshot endeavor is pretty extraordinary, and probably would not have happened in a non-boom environment.

4. Significant expansion in cost bases

   1. These charts below summarize the story. Over the last few years the world’s largest software and internet companies had increased headcount at record levels. If we focus on Alphabet and Meta: during COVID they both entered a period which could be described as almost perfect operating environments. The whole world was indoors and went online; most of the developed world received free money from governments; and every business needed to spend on Search (Google) and Social (Facebook & Instagram) to reach those online customers. Did Alphabet and Meta really need to increase headcount at record levels in order to capture those COVID-boom advertising dollars? It is obvious that they didn’t. During the boom times companies just get fat. It is easy to get complacent when things are going so well, and if you have high incremental gross margins!

      

   2. Anecdotally, there’s plenty of evidence of excess in the start-up, small-tech and “web3” space as well. Coinbase was paying $1m for engineers while their Chief Product Officer also secured a +$600m payday after less than 2 years of joining!

The downturn will drive technology companies to discover efficiencies

Just like the Australian mining companies during the boom, many tech businesses have gotten fat over the last few years. Fundamentally, when you think of software it’s still one of the best business models with zero/minimal incremental cost to serve, super scalable products and recurring revenue. They should be extremely profitable. However, because most technology businesses have been focused on growth and reinvesting free cash flow in pursuit of more growth, the super high margin nature of technology business models has not always been evident.

The fall in commodity prices after the mining boom forced mining companies to discover significant efficiencies within their businesses. Similarly, this current downturn in technology valuations will force technology companies to identify efficiencies within their businesses, which should lead to a significant improvement in profitability across the technology sector.

So, what are the key takeaways?

Drawing on some of the learnings from the Australian mining boom, there are a few lessons that can provide some insights into how the next few years will play out.

Lesson #1 – Organizations get fat during the good times

Do not underestimate the amount of fat that gets built up within organizations during the boom times. Fortescue was a perfect example of this dynamic and the market was clearly ignorant to the quantum of “bull market costs” that were floating around in the business. In the technology sector, we’ve also seen an extraordinary period of growth in businesses cost bases. There has been a lot of bull market spend – remember those viral “day in the life” TikToks from tech employees (below)? You can be certain that there ain’t going to be many eucalyptus towels handed out in 2023!

We are entering a period where technology businesses will “shed their bull market fat” or “do more with less”. Unit economics across the space will improve and companies will operate more efficiently – showing the true high margin nature of technology business models.

Lesson #2 - The market mechanism works

The market forces companies to change. At the end of the mining boom it was the collapse in commodity markets that forced management to change their capital allocation policies and optimize cost bases. The market had created an environment that incentivized management teams to identify structural efficiencies within their businesses.

In the tech sector, the collapse in valuations and rising cost of capital will force management to operate more efficiently. The market is the mechanism that rewards outcomes (i.e., be it outcomes related to growth, profitability and/or product) and those outcomes inform the incentives set for management. In an environment where the market permanently places a low value on revenue growth, management incentives will inevitably change to incorporate what the market wants.

“Show me the incentive, I’ll show you the outcome”- Charlie Munger

And as I previously mentioned, a recurring revenue business model (i.e., don’t have to acquire or dig for your revenue everyday) with +80-90% gross margins are the best models from which to extract efficiencies.

As shown in the chart above, the market mechanism has already forced a lot of unfortunate, but necessary layoffs within the sector. Even the extremely profitable businesses with no requirement for external capital are taking cues from the market (i.e., Meta cutting staff, Alphabet shutting moonshot projects like Stadia). (Note: I am not celebrating layoffs, they are painful for everyone involved).

Lesson #3 - The recoveries can be violent

After the mining bust Fortescue was forced to structurally lower its cost base, which left it in a much stronger position to take advantage of any future increases in iron ore prices. In 2016 iron ore (surprisingly) entered another boom cycle, which - combined with Fortescue’s structural improvement in unit costs - led to Fortescue’s equity eventually increasing ~15x off its post-boom lows.

Like Fortescue, I think the technology sector’s recovery out of this downturn could be violent. I believe a permanent improvement in profitability across the technology sector plus the continued structural growth in the adoption of technology products will drive strong free cash flow generation across the sector, which will lead to higher share prices / valuations.

Furthermore, as we enter into a macroeconomic slowdown, growth will inevitably slow across the board (i.e., for all companies, not just technology companies). However, the product-led technology businesses that still have attractive structural elements to their adoption will continue to grow. Only now, these companies will be operating with a significantly improved cost base, which should allow more of this incremental revenue growth to drop through to free cash flow. In my view, a business with structural growth combined with high incremental profitability presents an attractive proposition for any investor, especially in an environment where growth is scarce.

Final Thoughts

I think we are currently in a pretty exciting period for technology investors. We have the opportunity to invest in generational growth stories at pretty attractive valuations. While many of these businesses might not show much profitability today, I think the key question investors need ask is: are these businesses structurally unprofitable or just fat?

In the same way that Fortescue - the beaten down, fat, marginal iron ore producer - delivered significant returns once it rationalized its cost base, technology companies that fix their costs bases and still maintain structural adoption dynamics will deliver significant returns to investors.

While the macroeconomic picture will get shaky, the structural trends that have been underpinning the growth of technology are still underway (i.e., companies are still digitizing workflows, adoption of the cloud is still increasing, cybersecurity is still a huge area of growth). An economic slowdown doesn’t stop or reverse the structural adoption of technology - it may slow the adoption, but the end state does not change. In my view, this current market has created a great opportunity to invest in market leading technology companies that still have a long runway for growth.

Leave a comment

Share

Subscribe now

What is Dropsuite?

Dropsuite is a global cybersecurity SaaS business that operates within the cloud backup and recovery market, which is an industry that has been growing at 24% annually and is expected to reach US$22b by 2025. Dropsuite mainly sells data backup and archiving solutions for productivity applications such as Microsoft 365 (M365), Google Workspace and email. Dropsuite’s products are targeted at the SMB segment, and they sell their product entirely through channel partners such as managed service providers (MSPs) and IT distributors.

Why Dropsuite?

What makes Dropsuite such an attractive investment is its strong financial profile. Dropsuite is one of the fastest growing SaaS businesses globally, having grown annualized recurring revenue (ARR) organically at a 75% CAGR over the last 3 years. In addition to being a hypergrowth business, Dropsuite is also profitable with a 5% net operating margin in 1H22 (inclusive of SBC) and expectations for margin expansion going forward.

Prior to expanding on Dropsuite’s attractive business qualities, I’d like to address one of the key questions I usually get about the business: why are backups needed in the cloud?

Why do you need backups in the cloud?

It is a common misconception that SaaS solutions do not require backups. While most SaaS applications have disaster recovery measures in place from a platform delivery perspective, they do not guarantee the recovery of their customer’s data. Microsoft’s Service Agreement Clause 6b notes the following:

‘…online services suffer occasional disruptions and outages and Microsoft is not liable for any disruption or loss you may suffer as a result. In the event of an outage, you may not be able to retrieve Your Content or Data that you’ve stored. We recommend that you regularly backup Your Content and Data that you store on the Services or store using Third-Party Apps and Services.’

The major cloud vendors operate under the “shared responsibility model”, which is a framework that helps separate the vendor’s responsibilities from the user. As shown in the exhibit below, customers are still responsible for their own data, even in fully managed SaaS environments. A helpful analogy of the shared responsibility model is the relationship between a landlord (SaaS or cloud vendor) and a tenant (user). The landlord is responsible for providing and maintaining the home and associated infrastructure, while the tenant is responsible for their own personal content within the home. In the same way that a landlord is not responsible if a tenant were to damage or misplace a personal item within their property, cloud providers are not responsible for the customer’s personal information and data within the cloud. Therefore, this is a critical reason why third-party cloud/SaaS backups are needed and recommend by the major cloud/SaaS providers.

Because of this misconception around SaaS applications and backups, data loss within the cloud is a common occurrence. In a 2019 survey by Veeam (exhibit below), 80% of respondents indicated that they experienced data loss while in the cloud. The businesses that do not backup their SaaS applications put themselves at risk of data loss, which can have financial, reputational and/or regulatory ramifications.

In addition to providing protection against data loss, backups are critical for defending organizations against cybersecurity threats such as ransomware. Ransomware is a form of malware that takes control of an organizations critical files or systems, encrypts them and renders them useless. The bad actors then demand payment from the victim organization, forcing them to pay a ransom to decrypt their data to prevent further business disruption. Ransomware has seen tremendous growth over the last few years, with Verizon indicating that ransomware was used in 25% of all breaches in 2021 (see exhibit below). Zscaler cited an 80% year-on-year increase in ransomware attacks as of Mar-22, while Palo Alto state the average ransom payment from their clients increased by 78% to US$541K in 2021. A critical way for organizations to protect themselves against ransomware is to have ongoing cloud-based backup solutions to access uninfected versions of their data so that they can continue to operate undisrupted.

Therefore, in summary, there are three key reasons why you need backups in the cloud:

1. Because the cloud says so;

2. To protect yourself against data loss, which is a common occurrence within the cloud; and

3. To provide protection against ransomware and other cyberthreats.

Now that we have covered the basics of why SaaS backups are critical, I’d like to discuss some of the qualities that makes Dropsuite such an attractive investment.

Quality 1: Hypergrowth

Dropsuite has been able to grow at such a high rate due to the multiple structural trends that are driving overall growth in their end-markets. These include:

• Large and growing addressable market

  • Dropsuite is primarily used to backup M365 environments. M365 is the world’s leading SaaS solution, with Microsoft having close to ~370 million commercial M365 seats as of Sep-22. Despite this large install base, Microsoft are still growing their commercial seats at 14% per annum. This large and growing M365 install base is Dropsuite’s addressable market, and the fact that this large end-market is still growing at 14% presents a nice baseline for Dropsuite’s growth. As of Sep-22 I estimate that Dropsuite has c.0.23% penetration of the total M365 commercial install base, which is up 3.4x in three years.

• Low levels of SaaS backup adoption - mostly whitespace

  • In addition to a large and growing addressable market, the majority of M365 seats do not have 3rd party backups. This is primarily due to the misconception that SaaS products have backups. A recent IDC survey indicated 6 out of 10 M365 users did not backup their email and collaboration environments (i.e., 40% penetration of backup). I believe that IDC’s survey was skewed to enterprise users. In my view, adoption of M365/email backup solutions in the SMB space is even lower than the number IDC stated above. Over the past year I have spoken with numerous SaaS backup vendors, software distributors and MSPs that have indicated that the adoption of SaaS backup within their SMB client base is closer to 15-20%, which indicates significant runway for backup to grow.

• Proliferation of cyberattacks and ransomware

  • A recent survey by ConnectWise indicated that 76% of surveyed SMBs had suffered at least one cyberattack, up from 55% in 2020. Cybersecurity is a data problem, and a critical step for organizations to protect themselves against cyberattacks is to have access to secure, uninfected versions of their data to ensure business continuity.

• Growth in the MSP industry

  • Dropsuite sells their product through MSPs. The MSP industry continues to experience strong growth as businesses increasingly outsource their IT operations to specialists. Independent reports suggest the MSP industry grows at 3-4x the overall IT market as they continue to take share of total IT spend. This acts as an additional baseline for Dropsuite’s growth.

• Increased adoption of cloud-based SaaS applications

  • While M365 seats continue to grow, the strong growth in the hundreds of other non-M365 SaaS apps (i.e., CRM, accounting software, Zoom/Slack) means that businesses are storing an increasing amount of critical data and IP within these cloud environments. This creates a need for organizations to ensure their IP residing within these environments is protected and retained, which will drive further adoption of 3rd party backup solutions.

• Increased data related compliance and regulation

  • Increased complexity with regards to data sovereignty requirements and legislation around data retention and archiving drives adoption of sophisticated backup solutions (like Dropsuite’s) that are fully GDPR compliant and make it easier for account administrators to manage data retention policies.

Quality 2: World-class unit economics and channel program

One of Dropsuite’s key competitive strengths is its world-class channel program that it has fostered over the years. Dropsuite sells its products entirely through its +3,000 channel partners. It is no easy feat to establish a strong channel program, as it takes significant amount of time and investment to build relationships with distributors and partners (i.e., it can take 18 months for new software vendors to get onboarded with a distributor), whilst it also requires extensive product development to ensure product-market-fit both at the end user and the partner level. Dropsuite’s strong channel program and product-market-fit is what powers its world-class go-to-market efficiency.

While many high growth SaaS businesses regularly spend 40-50% of revenue on sales and marketing, my analysis indicates that Dropsuite spent 16% of its revenue on sales and marketing in 2021 and 21% in 2020 (i.e., 25% of employee expenses plus advertising costs, despite sales and marketing staff accounting for less than 15% of total headcount). This efficiency is best measured by CAC payback, which measures how long it takes for a company to earn back the costs spent on acquiring new business. The lower the number, the more efficient the company. In 2021, Dropsuite had a CAC payback of 7.6 months, and I expect their 2022 payback to fall to 6.9 months. The chart below benchmarks Dropsuite against several leading Australian and global SaaS businesses, as well as a select group of leading cybersecurity/infrastructure SaaS businesses. Out of the group below, Dropsuite is second only to WiseTech, which itself boasts some of the strongest unit economics of any software business globally. (Note: For simplicity, CAC payback below is calculated as total GAAP/IFRS sales and marketing spend divided by net new GAAP/IFRS gross profit, converted into months).

With such attractive returns on sales and marketing spend, I’m excited for Dropsuite’s future growth prospects as they continue to invest in the channel and expand into new regions.

Quality 3: Market leading product

My discussions with several Dropsuite users, partners and competitors indicate that Dropsuite has a market leading M365 backup solution within the SMB space. Dropsuite was preferred for several reasons:

• Industry leading cloud email backup and archiving features (i.e., highest number of daily backups, highest data capacities)

• Superior UI for both users and partners

• Seamless integrations and ease of implementation

• Superior discovery and search capabilities

• Strong compliance features due to archiving capability

• Very easy to use and simple

• A cloud native backup solution

• Strong customer support at both the account management and technical support level

• Simple à la carte pricing

Dropsuite has also been ranked as the market leading email backup solution by SoftwareReviews for three consecutive years, beating out well-funded, enterprise-grade competitors such as Veeam, Mimecast, Commvault (Metallic) and OpenText (CloudAlly).

Quality 4: Strong financial profile

Dropsuite’s product strengths and structural tailwinds results in an attractive financial profile. A key metric that neatly demonstrates Dropsuite’s financial strength is the Rule of 40. The Rule of 40 is a popular SaaS metric which adds a company’s revenue growth to its free cash flow margin, with 40% being a key benchmark. It is a metric that shows the delicate balance between reinvestment and growth. For instance, if a SaaS business has 0% revenue growth, it should be generating at least 40% free cash flow margins in order to achieve the Rule of 40. As shown in the comps sheet below, the average Rule of 40 for the leading infrastructure software and cybersecurity companies is 40. In 2022, Dropsuite will operate on a Rule of 81 (2021: Rule of 68), with 77% revenue growth and a 4% underlying free cash flow margin.

In addition to the Rule of 81 and strong unit economics, I’d like to highlight a few other financial features of the business and present a financial model below:

• Capital-lite business: As Dropsuite highlighted in their recent investor day, they are a very capital-lite business. Dropsuite has raised a total of $35m in capital since inception but have only spent $12.7m of this capital ($22.3m in cash as of Sep-22). Dropsuite now has a $102m enterprise value with only $12.7m of external capital deployed to-date.

• Low churn: Dropsuite’s annual revenue churn has remained consistently below 3%. Churn of sub-3% is considered excellent for an enterprise SaaS business, so it is quite impressive considering Dropsuite services the SMB sector.

• Net Revenue Retention (NRR): Dropsuite could not achieve this type of hypergrowth without a solid NRR (revenue generated from existing partners). At their AGM, they indicated that their partner NRR was >125%, which is close to world-class.

• Gross Margins: Given Dropsuite must store extensive amounts of data, its gross margins are lower than typical SaaS businesses, with 66% gross margins as of Sep-22. As Dropsuite continues to scale, we see a pathway for them to reach margins in the mid-70s, similar to backup/infrastructure peers such as Datto, Box Inc and Dropbox. Dropsuite can achieve this from further scale benefits and adopting multi-cloud and/or hybrid cloud architectures.

My forecasts assume a moderate slowdown in ARR growth (CY15-21 +77% CAGR; CY22-25 +40% CAGR) due to a meaningful slowdown in the rate of Dropsuite’s net-new user adds (chart below). I also forecast little success from Dropsuite’s new products, despite the indications from management that they would launch 1-2 new products per year. There’s further upside if Dropsuite can continue to scale their net-new-adds growth at historical levels, conduct value accretive M&A, and launch new products.

Valuation - potential 3-4x within the next few years

With such a strong financial profile (plus 18% of its market cap in cash) and attractive structural tailwinds, I think the business is significantly undervalued on its current valuation of 3.9x ARR or 0.1x growth-adjusted ARR. Looking out two years to CY25, I forecast Dropsuite will generate +$70m of ARR. If you assume a 25% normalized FCF margin and a 4-5% FCF yield, I believe the business will be worth 3-4x its value today (Note: comps average FCF yield of 3.2% with 23% growth). The 3-4x scenarios imply EV/ARR multiples of 5.0x-6.3x for a profitable business growing +30%, which I believe isn’t excessive given recent M&A transactions (i.e., Datto acquired for 9.3x trailing revenue, with only 18% growth).

Potential catalyst: accretive acquisition on the horizon

In Aug-21 Dropsuite raised A$20m of equity for the purpose of conducting acquisitions. Since then, technology valuations have declined materially and Dropsuite have still not completed an acquisition. While most investors are generally wary of acquisitions and synergies (rightfully so), I believe software acquisitions can be highly value accretive. A key reason why a potential acquisition by Dropsuite could be value creative is because Dropsuite already has global distribution with +3,000 partners that will allow it to accelerate the growth of the acquired products.

I think Dropsuite has an opportunity to acquire an adjacent security related solution and scale it across their existing channel base. I have spoken with several of Dropsuite's leading distribution partners that have spoken highly of Dropsuite and have indicated that they would be highly receptive to future product launches by Dropsuite.

Management

Dropsuite is led by a solid and well tenured management team. CEO Charif El-Ansari (ex-Google) has been managing the business since 2013, while COO Ridley Ruth (ex-Cloudflare) has been with the business since 2014. Dropsuite have also recently announced some key hires, with CTO Manoj Kalyanaraman (ex-BitTitan, Intuit) joining in Mar-22 and Eric Roach (ex-Nextiva, Microsoft) joining as SVP of Global Channel in Nov-22.

I am particularly impressed with Charif and how he has been able to build a global business, with a world-class channel program whilst also remaining disciplined with regards to capital allocation. As you’re all probably aware, capital efficiency has not been a term commonly used within the tech sector over the last few years! I am also impressed with management’s ability to manage crisis’ and continue to position the business for growth. In 2018 Dropsuite’s business primarily revolved around providing website backups. At the beginning of 2019, Dropsuite’s largest partner (a domain hosting business) announced it would be launching its in-house backup product, which resulted in 31% of Dropsuite’s revenue being lost in a span of 9 months. Despite this, management were able to accelerate their pivot into the fast-growing and more stable email backup and archiving market and still managed to finish 2019 with ARR growth of 13%.

Risks

As with any investment, there are always risks both known and unknown that may materialize. Some of the risks to Dropsuite's business include:

• Microsoft Ecosystem Risks: There is a risk that Microsoft could launch their own SaaS backup service. While I view this as unlikely, it presents some headline risk to Dropsuite. However, even if Microsoft were to launch their own product, I still believe Dropsuite will continue to thrive. The main reason is that in Dropsuite’s end-market, MSPs are the gatekeeper. The MSPs are the ones that decide which products to present to a client and clients generally accept the product mix that MSPs present given they pay MSPs for their technological expertise. So, I don’t think a native Microsoft backup solution will result in the demise of 3rd party backup products. There is already precedent for this scenario, for instance, Microsoft have a native Azure Backup solution, but my discussions with distributors indicate that they mostly sell 3rd party cloud backup solutions because MSPs want to diversify vendor exposure. Also, the channel is incentivized by margins and Microsoft’s product margins are well known to be low. Therefore, MSPs will continue to bundle 3rd party solutions into their product offerings in order to generate better margins.

• Point solution: Dropsuite is mostly a point solution, which can present a high deal of risk given they lack revenue diversity from a product perspective. This can present risks as larger vendors aim to consolidate products as part of their go-to-market. Some larger vendors already do this today, but Dropsuite has been able to continue grow thanks to their seamless integrations into MSPs practice management solutions such as ConnectWise and Autotask, which allows MSPs to choose best-of-breed solutions rather than experience vendor lock-in. Dropsuite’s plans for further product launches and acquisitions will allow them to diversify their product mix.

• Competition: Dropsuite operates in a competitive market. Dropsuite have been able to grow share within this market due to their product-led growth and strong investments in the channel. Despite this, Dropsuite will need to continue investing in their product and the channel in order to maintain their market position.

• Damage to partner relationships: It is critical that Dropsuite maintains strong relationships with their distributors and MSPs. In my discussions with distributors, it is extremely rare that a software distributor kicks a vendor off their pricelist, so I do not think a distributor ceasing to sell Dropsuite is a likely scenario. However, Dropsuite will still need to continually invest in the channel to ensure they meet the channels needs from a product and capability perspective.

• Macroeconomic headwinds: A slowing macro environment typically results in growth headwinds like extended sales cycles and higher churn. Depending on how bad the macro picture gets in 2023, this will present some growth risks to Dropsuite. However, the MSP industry tends to be less macroeconomically sensitive than other parts of the economy given IT spending is basically infrastructure for most businesses today. During the GFC many MSPs thrived (source & source).

I hope you found this post insightful. This is my first post and I intend to publish articles on investing, markets, and tech periodically. I’m always eager to have a chat so please comment, or reach out if you have any thoughts/questions, or even if you just wanted to chat on investing & markets more broadly!

This is not financial advice. The opinions expressed are my own.

Leave a comment

Subscribe now