Complements of Byrne Hobart at the Diff, who thinks and writes well on many things, but Tech in particular as that is a world in which we recognize we are not the key player at the table.
My current favorite profitability metric for tech companies is free cash flow minus stock-based comp. It’s a simplistic way to adjust for 1) the possibility that tech worker compensation will remain high, but be more weighted to cash than stock, and 2) the fact that stock-based comp is a cost, and for many tech companies it’s a big one. For Datadog, this margin was -2% in 2018 and 2019, 5% in 2020, and 11% in 2021. Meanwhile, revenue growth has been chugging right along, at 83% last quarter (a quarter when free cash flow less stock-based comp was 19.6% of revenue, a new high-water mark). Consensus estimates call for a deceleration in sales growth to 57% in 2022 and 37% in 2023, and current margin trends would put their free cash flow excluding stock-based comp at around 20% of that total, or $440m or so. Which is still a nosebleed valuation; Datadog has dropped from its peak price, but only by about half, which is actually a fairly good performance for a high-growth company, but it’s trading at a $30bn enterprise value. At its peak in 2020, Datadog was going for 74x sales, and the current 26x is just about their Covid low of 24x.
Our reference here is several-fold. The first regards one of the world’s oldest arguments in regard to stock compensation: if it is not a cost, what is it? At CSC we simply plead intellectual fatigue and deduct 50% of stock comp costs from our math in valuation and fundamental analysis.
The second regards the nature of man and high growth companies. It is our direct experience that aside from a narrow group of early and true Kool-aid manufacturers, most employees are attracted to the excitement of a new enterprise, the ability to feel you are doing “meaningful” work, and the possibility of becoming stupidly wealth. So what happens when the distance between the current stock price and where your options were struck becomes a distance that even Elon Musk finds too far to contemplate? Do people just stop caring at all and focus on moving to a new company where they can be marked to market? Does management have to swap to cash compensation to retain the workforce and ergo the current math of profitability and valuation becomes highly suspect under the harsh glare of cash costs? (Enter new “adjusted” metric – cash costs without cash we deem not as cash as the other cash.) Which in and of itself leans on valuation which continues this negative flywheel of stock price and retention?
This theme supports our contention that we are not remotely done with the drubbing of “silly” in financial markets. The lookback at “what in God’s name were they thinking” in regard to the tech bubble, the out-and-out fraud in crypto masquerading as an institutional asset class, and the upcoming credit/PE debacle will be fascinating reading for those who have not lived through it.
We don’t pretend to live in a neighborhood that will not be affected by collateral damage. But in most cases, our risk will be “quotational” rather than permanent loss of capital.
And ready for it – we are hereby asking for money. There is/will be gargantuan opportunities to make money in smaller, perfectly decent public trade companies. You will not make the bottom. Lean in.
-jb
