Investing In The Software/Cloud Computing Space Now, Part 2

Tactics: A guide to taking advantage of extraordinary valuations in the software/cloud space

It would be difficult to ignore the massive valuation implosion of most software equities over the past 3 months. In Part 1, I outlined my thoughts regarding valuation and why I thought this decline provides a good time to invest in the high-growth IT space. In Part 2 below, I outline some of the themes I consider in looking at specific companies and their shares. The fact is that the shares of almost all Information Technology (IT) companies have seen their share prices plummet, but particularly those companies whose enterprise value/sales (EV/S) had been higher than average; investors have suddenly chosen to disregard fundamentals and specific positive announcements from the companies. The past 3 months have been one of the worst times to be an investor in high growth shares – and yet as bad as this decline has been for IT investors, the valuation implosion has presented one of the more significant opportunities to buy both the highest growth names and some fallen angels at what I believe will prove in time to be bargain valuations.

In the previous part of this article, I explained what has been happening during this great rerating of share prices and valuations, why it happens, and how it might end. I proposed a conservative strategy to buy the ETFs that in whole or part reflect the sector for those readers who had not the willingness to deal with the volatility inherent in this space; I suggested the most appropriate ETFs would be the (CLOU) and the (IGV).

But I imagine the majority of readers/subscribers are interested in investing in individual stocks. For those investors with a long-term outlook and the sangfroid to deal with the current negative sentiment, I will suggest some tactics to utilize in considering the construction of a buy list at this point. I think readers/subscribers would be much better off with a portfolio of these opportunities rather than attempt to cherry-pick two or three and try to call their bottom.

Before starting on some specific recommendations, I want to suggest a couple of thoughts about methodology and valuation. There are two basic ways that analysts use to set price targets for shares. One of those is to use comparables. I have never been comfortable with that methodology. Finding a comparable always risks looking at the wrong comparable. This often happens when a covering analyst who specializes in a particular business segment attempts to use that segment as a comparable for a company that really doesn’t fit.

The better approach is to use what is called a discounted present value (DPV) analysis, which discounts the sum of future free cash flows back to the present using some kind of assumed discount rate, most often the weighted average cost of capital. This approach, however, requires analysts to present a multi-year estimate of free cash flow, and that is often a highly fraught undertaking. Many analysts do not have confidence in their estimates and use comparables because it is much easier and requires fewer assumptions. However, I use DPV, and it is why I present a Compound Annual Growth Rate (CAGR) and an estimated free cash flow margin for all of the recommendations I publish. What follows is not a comprehensive guide; for example, I do not address the FAANG names or other large-cap investment choices. That said and because of the rather indiscriminate nature of this decline, I believe that when a reversal sets in, it will tend to lift what had been all the highly valued IT names rather equally. Eventually, discernment will set in.

Try not to overthink stories

Perhaps the most important concept to consider at this point is not to overthink stories. Many readers will be tempted to imagine a story has changed because the value of its shares has imploded, something that challenges this writer on occasion. Many subscribers write to me to question if stories are intact, after such shocking declines. I get it.

Other readers see discussion boards that evaluate the investment merits of individual companies. Often these boards provide valuable insights, but sometimes they can focus on a single metric to the exclusion of attempting to provide a holistic picture that includes positives and negatives in assessing the outlook for a company. For the most part, the operational outlook for even the most devalued companies hasn’t changed for the negative. Indeed, I would argue that the current outlook, regardless of the share price, has tended to improve for most IT companies which saw peak share prices in early November.

Most analysts at large brokerages are obliged to reduce price targets in response to share price changes. In other words, rather than being changed in anticipation of company fundamentals, price targets are set to reflect the current level of share prices and the current level of market valuation. In this environment, looking at a reduced price target may suggest issues with the fundamental prospects for a company, but the reality is quite different. Some of the most vivid examples of shares prices imploding without a changed outlook have been in FinTech.

The fact is that regardless of the share price, the technology of evaluating loans and providing end-customers with digital experiences is one of the more seminal events in the financial services industry in several decades. Financial institutions can either enthusiastically adopt the new paradigms in evaluating credit and in providing their customers with a complete package of digital experiences or they will cease to be relevant and lose market share.

Upstart (NASDAQ:UPST) is perhaps the “poster child” for overthinking a story. In the course of less than one year, Upstart shares have emerged from the wilderness to become an investment darling last summer and then have seen more than 75% share price implosion. Upstart’s share price implosion really began after it reported Q3 results on November 9th, 2021 although there had been two analyst downgrades before that point. For the record, the company’s revenues reached $228 million that quarter, which was 2.6X above the revenues it reported in Q4-2020 and sequential growth of 17.5%. At the time, this level of sequential growth, which actually is an annual rate of 90%, was said to be disappointing and the beat of 8% above the company’s prior forecast was said to be inadequate.

As it happens, the company’s EBITDA for Q3 was almost double the level it had forecast when it gave guidance. In the quarter, the company originated 363k loans, compared to 123k in Q4-2020 and 287k in Q2. And its adjusted net income margin rose to 25%. But the issue was that there were numbers and estimates on some investment boards considerably greater than those the company achieved, and momentum investors felt jilted because the percentage beat was smaller than in the past and the raise in guidance was below the increases in that metric the previous two quarters.

Upstart now forecasts that full-year revenues will be about $775 million, with adjusted EBITDA margins for the year now forecast to be around 25%. The company’s free cash flow margin last quarter was 18%, and its free cash flow margin for the first 9 months of the year was 34%. At this point, consensus numbers are that the company will achieve revenues in 2022 of $1.2 billion.

Just from a financial perspective, it is obvious that Upstart shares have seen an enormous valuation compression. While $1.2 billion is growth of 48%, the estimate will probably turn out to be low simply given how these out-year consensus forecasts are constructed, and the track record of Upstart in terms of exceeding forecasts since it has been a public company.

The current investment issue which apparently has precipitated the last down leg in the shares had to do with delinquency rates. It is probably worth parsing this issue a little more thoroughly. Upstart’s platform uses AI technology to underwrite loans. To restate the obvious, AI is just a piece of software that allows users to plug in parameters to achieve certain pre-determined levels of risks and returns. It can be used to minimize defaults, it can be used to maximize yields, or more likely to maximize risk-adjusted yields. It is almost certainly going to improve on the results of FICO scores in terms of its predictive capabilities, and when used repetitively, or “trained” as it is called, it will become increasingly accurate. Absent some exogenous event, i.e. some kind of colored swan, it will simply allow users of the technology to map their requirements more closely onto a body of loan applications. But to repeat, it will not eliminate default/delinquencies unless it is tasked with solving for that, to the exclusion of yields.

There is a service called KBRA which evaluates many kinds of asset-backed securities, including the pass-throughs that Upstart offers. Readers can link to the report. Little more than a month ago, the analyst at Wedbush, David Chiavenni initiated his coverage of Upstart with a hold rating and a $160 price target. At the time, he called out what he described as a spike in delinquencies that were indicated in the KBRA report and said that until this spike was seen as transitory he could not recommend the shares. Recently, the analyst lowered his price target to $110.

This was really not because of any new information, but because comparables that the analyst uses in valuing the shares had declined sharply in their valuation. But he once again cited the KBRA report about delinquencies as an issue in valuing the shares. I believe there to be some significant issues with hanging a recommendation on the KBRA report that a careful reading will make apparent. Firstly, the latest delinquency rate ticked down a little, and so far as it goes, the delinquency rates have bounced around and are certainly not at a peak although they are higher than in the past.

But having seen that, it turns out that the current asset pass through pool minimizes exposure to the lowest rated loans, i.e. those classed C and D credits, and, as a result, the net yields provided to investors have been lower than the prior (2020) asset security sale. Overall, net of delinquencies and servicing fees, investors, are still receiving a net 16.75% return, according to KBR. The total delinquency rate for the current trust is essentially the same as the delinquency rates for the prior 2 trusts.

But even more telling, at least to me, is that one of the banks that is a sale sponsor, FinWise, recently dropped all FICO requirements from its evaluation of loans analyzed by Upstart’s technology. Further, FinWise does not receive any fees, whatsoever, unless the loans it sells to investors perform at some predetermined level.

It seems highly unlikely, at least to me, that FinWise would eliminate the use of FICO scores from its evaluation of loans that the Upstart technology has analyzed, unless its experience with those loans has been at least as expected. Yes, Upstart’s delinquency ratios have seen fluctuation, but the concept that the risk of its technology is causing spiking delinquencies seems rather overblown, to say the least. So what are Upstart shares worth?

One of my issues with the Wedbush methodology, and its $110 price target is that the analyst has chosen a price target based on looking at the company as a neo bank. Whatever else Upstart is, it is not a neo-bank or anything like a neo bank. Upstart is basically a software company with a consumption-based model. But the most appropriate methodology to value Upstart, or any other stock would be to use some kind of a discounted present value model.

Of course, such models require multiple assumptions, and that is why I choose to rarely publish the results of such an analysis. In the case of Upstart, and using a $1.4 billion revenue estimate for 2022, with growth of 52% in 2023, 40% in 2024, 33% for 2025, and 25%/year for the next 3 years, 20% for 2 years and a terminal growth rate of 5%, coupled with a 25% free cash flow margin throughout the period, and a weighted average cost of capital of 8.5%, the result shows a current DPV more than 2.5X above the current price of the shares. Readers, of course, may substitute different assumptions, and will then get different results. But I actually believe my estimates are quite conservative, especially that for the company’s projected free cash flow margin.

It is extremely difficult to accurately forecast anything, let alone the revenues and free cash flow margin of a company through 2030. The estimates I am using imply that at the end of the forecast period, the company will have more than $10 billion of revenues and will be generating $2.5+ billion in free cash flow consistently. Given that Upstart’s enterprise value currently is less than $8 billion, it should be obvious why its DPV is so far greater than its current share price.

Shares of Affirm (NASDAQ:AFRM) have been tracking a similar share price pattern to those of Upstart, and wound up the week of January 21st, down almost 17% and down by 68% since the shares reached their high point on November 4th. It may be difficult to accept, but the reality is that nothing has changed in the outlook for the company’s operational performance since November 4th. I confess that at that time, I thought the valuation was a bit frothy, but now…68% has taken valuations from frothy to compressed.

Unlike Upstart, Affirm does fund the credit it advances from its own balance sheet. In turn, it sells tranches of loans to investors. These notes are called securitization trusts, and the company raises capital for the credit it extends to its customers with what it calls funding debt. In an effort to assuage investor concerns, Affirm has actually prepared an analysis of its securitization offerings that was released late last week. The net of the December securitization data shows positive credit trends with delinquency rates plateauing and the non-interest-bearing credits showing very favorable trends. That along with an upgrade from the Stephens & Co. analyst has not impacted the fall of the shares.

For those unfamiliar with the company. Affirm is the leader in what is known as the buy now/pay later (BN/PL) space. Simply put, BN/PL offers consumers the option to pay for their purchases over time. Most typically, purchases are paid for in 4 equal installments, but Affirm’s version of BN/PL offers a multitude of flavors and offerings.

Affirm’s technology utilizes AI, in the same manner that it is utilized by Upstart in order to evaluate the credit of buyers. BN/PL has been a solution whose acceptance has been rapidly rising, not just for those with marginal credit, or credit history, but for most younger consumers, as an alternative to the use of high-interest credit cards as a payment alternative for any significant purchase.

Younger consumers are well aware of the sky-high interest rates that some credit card debt carries, and the numerous fees and inconveniences associated with that form of borrowing. BN/PL is just viewed by many of these younger consumers, regardless of their credit situation, as a better way to consummate a transaction. There are loads of alternatives in the space, and many observers/investors think there is little differentiation in terms of what is offered by the companies in the space.

In my view, this is quite inaccurate as none of these alternatives is anywhere near as technologically enabled with real differentiators when compared to Affirm.. A few months back, Block, Inc. (NYSE:SQ) bought an Australian company in the space, Afterpay. PayPal also offers a BN/PL service. Both Mastercard (MA) and Visa (V) are in the process of entering the space.

So what makes Affirm special? Its technology. Part of that is the use of AI, but part of it is also the flexibility of Affirm’s platform. Almost all Affirm alternatives allow end-users to split the payment for a purchase into 4 installments which are paid over 2 months. For many consumers and some merchants that offering is sufficient. But Affirm goes far further in expanding payment options for consumers and merchants. Merchants can select numerous options to offer credit with the Affirm platform. They can choose different lengths of repayment terms, they can offer promotional interest rates, or even “0%” rates. They can basically provide rules that the Affirm engine uses to make unique offers to different buyers for different products. It is a very flexible solution, and as a result, the company has a number of unique and strong partnerships.

The company actually launched its most flexible credit offering that it calls Adaptive Checkout at the end of September, and it is a significant differentiator and provides Affirm with a significant competitive moat. My process requires that I at least try to do a deep dive in what makes my own recommendations unique and while that isn’t influencing share prices and valuations these days, at some point, in the not distant future, investors will return to looking at the specific merits of individual companies more than macro trends.

What has happened in this meltdown is that investors have ceased paying much attention to the news and progress of individual companies, and have focused their attention pretty much exclusively on interest rates, and most recently the risk of a recession. I think Adaptive Checkout is a big deal, but it seems to me that investors, in their desire to move to what they perceive to be de-risked investments, have ceased to have interest in the specifics of the outlook for Affirm along with many other companies.

Affirm has a partnership with Shopify (SHOP), and Shopify began offering Shop Pay this past summer. In addition, Affirm has partnerships with Walmart (WMT), Target (TGT), American Airlines (NASDAQ:AAL), Apple/Canada (AAPL), and Peloton (PTON), amongst well-known sellers. Even Hammacher & Schlemmer, a large catalog merchant with a flagship store in NYC, offers Affirm as a payment option. Recent partnerships include that with Michael’s as well as agreement with Verifone (VERI), which offers e-commerce and card-present payment solutions.

At one time, Peloton was a substantial customer. Its share of Affirm’s business has steadily declined and was below 8% last quarter. Affirm’s forecast has included steadily diminishing contributions from Peloton and regardless of the actual situation with that company, its influence on Affirm’s current results and guidance is not going to be substantial, I believe.

Of course, the news that drove the shares to their peak valuation was the announcement of an exclusive partnership with Amazon (AMZN) for BN/PL solutions. This is an exclusive partnership that goes through January 2025, and as part of the agreement, Amazon got warrants to purchase up to 7 million Affirm shares for $.01 as well as a warrant for an additional 15 million shares at a strike price of $100. Just precisely what the revenue potential of that agreement might be is difficult to know.

Affirm’s revenues over the next 12 months are estimated to be about $1.6 billion. That amount excludes any estimate for the contribution of the Amazon partnership whose results won’t be forecast by the company until fiscal Q3, or the quarter ending in June 2022. Based on my revenue estimate, Affirm’s EV/S has contracted to less than 10X. I have used a 3-year CAGR of 52% in looking at valuation, but that is likely to be exceeded. In any event, the shares are valued at far below average for the company’s growth cohort.

Does this mean that Affirm will suffer from a higher interest rate environment? There are some analysts who have made that call in whole or part, and perhaps it would be something to be debated if the valuation of Affirm hadn’t imploded. Affirm is likely to pay more to raise money through its securitization trust sales. It is equally…