The technology sector has been hit particularly hard this year, with many of the growth drivers of the last five years falling in the pivot to value. Cloud computing has been heavily impacted by the macro-environment. While the macro does matter, many of the companies within the industry have operations that are generating increasing amounts of free cash flow.
It’s worth a more in-depth look, believes Christopher Gannatti, CFA and global head of research at WisdomTree, in a recent blog post.
“If most cloud computing companies are trading based more on macroeconomic factors, opportunities can be created because the companies where positive things are happening are being pulled down along with everything else,” wrote Gannatti
Zoom is one such example. It’s a company that soared during the work-from-home lifestyle necessitated by the onset of the pandemic in 2020, but since then it is targeting and obtaining a different client base of customers. These newer customers generate $100,000 or more annually in recurring revenue and it’s a customer subset that is currently growing 46% year over year.
In a challenging environment every dollar matters and finding companies that are operating more efficiently, particularly software-as-a-service companies that historically have 50% of their revenue eaten up in sales and marketing, can make a huge difference in free cash flow. Zoom is one such company. While they have recently bumped up their sales and marketing spending by 5%, this portion still only cuts into 25% of total revenue, half of the industry norm. That is the reason that Zoom generates around $2 billion in adjusted free cash flow annually, according to Gannetti.
“In the current environment, if these stocks start trading less on macroeconomic factors and more on fundamentals, we believe that the capability to transition from revenues to free cash flows to earnings will be prized, and Zoom is doing this,” Gannetti explained.
Sprout Social is a company that amplifies brands, companies, and people on social media and has operating costs that are also less than the average for SaaS companies. Sprout spends 39% on sales and marketing and is creating 9% free cash flow on just $240 million in annual recurring revenue. Most SaaS companies don’t generate this level of free cash flow until they bring in annual recurring revenue of $500 million or $1 billion.
Sprout has also historically grown at an accelerated rate and is worth keeping an eye on looking ahead. At $100 million Sprout had 30% growth, at $180 million, 34% growth, and at $240 million, 41% growth.
Box is a company that enables efficient data storage and file sharing and had a 1% operating margin in 2020 and its most recent operating margin reported was 20%. The sales and marketing portion is down to just 28% of annual recurring revenue with a free cash flow that is around 20% of revenue.
“The present environment makes us think that there could be an even greater value on businesses saving costs and finding efficiencies. To the extent that cloud subscription services can actually help businesses continue operating and save costs, we think this is a very interesting space for consideration,” Gannatti wrote.
WCLD Invests in SaaS Companies Operating Efficiently
The WisdomTree Cloud Computing Fund (WCLD) provides investors pure-play exposure to companies that provide cloud-based software. While growth and technology stocks have suffered in the first half of 2022, it means that funds such as WCLD are currently undervalued, providing a good entry point to the space for investors.
WCLD tracks the BVP Nasdaq Emerging Cloud Index, an equally weighted index comprised of companies that derive the majority of their revenue from software provided via the cloud. That could mean remote delivery or a cloud-based business model that is subscription-, transaction-, or volume-based.
WCLD offers multi-cap exposure to emerging companies within cloud software and services. Holdings include Sprout Social Inc (SPT) at 2.15%, Box Inc (BOX) at 1.80%, and Zoom (ZM) at 1.65%.
WCLD has an expense ratio of 0.45%.
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