Cloud companies’ valuations peaked in November 2021 on extreme enthusiasm for their recurring revenue business models and unbridled confidence in their growth prospects.
Emergency rate cuts and other monetary stimulus unleashed during the pandemic threw fuel on the fire. The supercharging of growth rates as companies invested heavily in cloud services to facilitate the move to remote work and selling online, led to a double valuation boost.
For some unprofitable companies, share prices reached over 100 times their sales. To justify those valuations, revenue growth at these companies would have had to comfortably exceed what Amazon produced over the past 20 years.
The probability of delivering even a tiny fraction of that kind of growth were minute, yet the market was predicting many cloud companies would do just that.
Three catalysts have contributed to this bubble’s deflation. Firstly, inflation has remained above expectations, with an expected series of interest-rate hikes in the US and UK. That matters because higher rates make expected returns far out into the future less valuable today.
The second blow came in recent quarterly earnings updates, with many investors lowering their projections after realising that growth enjoyed during the pandemic by the likes of Zoom, DocuSign and Netflix was a one-off that in many cases pulled forward future demand.
Finally, high valuations had attracted a wave of capital into cloud start-ups. Companies vied to win market share by outspending each other on marketing and product development. With higher rates, and less money sloshing around, investors became less tolerant of companies burning capital.
As in the dotcom era of 2000, rate hikes are partly responsible for bursting this bubble. However, key differences now make us believe cloud companies will not experience a similar ‘lost decade’.
In aggregate, the tech industry was losing cash in 1999, whereas today cash generation and profitability are stronger. The tech-heavy Nasdaq trades at 24x estimated earnings a fraction of the 175x estimated earnings at the height of the 2000 dotcom bubble.
Then, it was not obvious who the winners would be, now the leaders are more predictable.
Demand for cloud infrastructure remains solid
So, how will cloud demand normalise after the explosive growth in 2020 and 2021, and what is the right price to pay for investing in the cloud? Our analysis suggests that share prices for the cloud infrastructure players may now reflect undue pessimism.
Comments from CEOs suggest cloud infrastructure demand remains firm. Analysts’ estimates for AWS sales, for example, show growth this year is expected to be 32%. Has this demand been pulled forward such that growth estimates in 2023 need to be revised down? The market has repeatedly been caught out by the growth in Amazon’s AWS exceeding expectations, so not necessarily.
Microsoft’s latest earnings release reported a step up in cloud usage, observing that labour shortages, cost pressures and competition is forcing companies to increase investment in digital transformation, which remains in its early stages.
We see a more nuanced picture in software services, where growth for some vendors has slowed post-pandemic and analyst expectations may still be too high. Those that are more tapped into enterprise applications appear to be maintaining momentum. We think the brunt of the slowdown has been felt by companies that benefited from stay-at-home orders, namely ecommerce businesses, video conferencing and online payments.
Correction will separate the wheat from the chaff
Valuations for some cloud software companies have corrected back to 2019 levels, though they’re still lofty compared to the overall market.
Investors who avoided participating in the cloud sector on valuation concerns should welcome a correction. In the dotcom implosion of 2002, the tech-heavy Nasdaq index corrected over 70% from its previous peak. Although it hasn’t come close to this kind of decline today, similar corrections have been seen in individual cloud companies such as Zoom, Shopify and DocuSign, which had all experienced declines of between 70% and 80% off their previous peaks at the time of writing.
A big correction will firstly make valuations cheaper; secondly, capital will exit the sector resulting in fewer start-ups. Coupled with a rising rate environment, investors will become less tolerant of losses. Hence, the post-crash period will likely lead to a greater focus on profitability, and less competition as weaker players exit or consolidate.
We continue to avoid unprofitable cloud software companies. However, even some unprofitable companies, such as Cloudflare in cloud networking and Unity Software in game engines, are sustaining colossal rates of sales growth and carving out dominant positions in their industries.
Rathbones’ top picks
And profitable cloud software companies have also seen their valuations knocked back. We think these companies are unlikely to be knocked off their perches, and can continue to generate predictably solid growth.
Zoom’s shares, for example, had fallen close to 80% since peaking at $559 in October 2020, though unusually for a young software as a service (Saas) business, it’s highly profitable and its sales are forecast to grow.
Some more established cloud software providers that are now more moderately valued by the market, such as Autodesk and Intuit, have controlling shares of their respective fields and should be able to sustain strong earnings growth over the long term.
The future is in the cloud
The past few months have shown that cloud companies are as vulnerable to boom and bust as those from previous tech cycles. The pendulum may now swing too far the other way, raising the possibility of finding some outstanding opportunities.
With valuations of cloud computing companies in general back to within 10% of where they were before the pandemic, we believe these are attractive levels for finding long-term investment opportunities.
Our conviction that the future is in the cloud remains unshaken. Still, investors must tread carefully, and we favour companies that are clear winners in their categories, with easy to articulate competitive advantages and plenty of growth runway ahead. Some, even now, whisper it, are starting to look cheap for the first time in years.
Ben Derber is an equity analyst at Rathbones Investment Management