Weekly Update: Handling the Headwinds in SaaS & Keeping an Eye on AI
Highlights from the week of 11/28
The WCLD cloud index climbed 4%, closing the post-holiday week at $26.16.
Fortunately, the primary factor weighing down SaaS valuations has moderated over the past month. The risk of runaway inflation driving more aggressive Fed interest rate hikes in the near-term has abated. In his speech on Thursday, Chairman Powell gave reason for the bulls to cheer:
The time for moderating the pace of rate increases may come as soon as the December meeting.
Meanwhile, 10-Year Treasury yields, which were at 4.2% a month ago, have come down to 3.49%. Money is a little cheaper today than a month ago, so your friendly growth company is worth a little more. Circle of Life of Asset Prices!
Unfortunately, there is a secondary risk for SaaS valuations that has intensified - the risk of cautious customer behavior due to fears of recession.1 This was the culprit in the market pummeling Crowdstrike (CRWD) for providing a weak outlook in their earnings announcement early this past week:
The “falling off a cliff” move on the left in the chart was in reaction to their earnings announcement on Tuesday. The softening of inflation concerns later in the week likely helped the stock recover somewhat. The other factor that likely helped the stock recover was management’s surgically precise explanation of their performance. Crowdstrike’s clear communications about their business is a great example for any company concerned about how to discuss their performance with investors in a tough macro environment.
Crowdstrike is a well-known leader in cybersecurity. Less well-known, they are a leader in management transparency about their business. They were one of the first public SaaS companies to report their annual recurring revenue, ie their ARR. Just a few years ago, most SaaS companies only reported their accrual-based revenue and left analysts guessing at the much more important ARR figure. Now, after Crowdstrike’s lead, most have followed suit and report this metric.
Crowdstrike remain one of the few public software companies to report their gross revenue retention, which is remarkably high. From their recent earnings call, they reported:
Our best-in-class gross retention rates remained at record levels above 98%.
This means that for every $1 of revenue they get from a customer this year, they will only lose $.02 - and that doesn’t include their substantial volume of up-sells! They have a net revenue retention of 123%.
While net revenue retention tends to get more attention from investors, gross revenue retention is arguably more important. When gross revenue retention is at that level, a SaaS company only has to have a so-so product development capability to generate efficient growth. For Crowdstrike, which has a strong product development capability, it’s easy to predict they will continue to have highly efficient growth (although this is not a recommendation to buy their stock - I have no idea if the valuation today is a good one!)
In their earnings announcement, they also gave an impressively precise explanation of weakness in their non-enterprise accounts:
In our smaller, more transactional non-enterprise accounts, we saw customers increasingly delay purchasing decisions with average days to close lengthening by approximately 11% and net new ARR contribution decreasing $15 million from Q2.
I have never seen a public SaaS company offer details on “days to close” ie their sales cycle for new logos. I read this as a strong signal that management has best-in-class understanding of their business. Crowdstrike is also one of the few SaaS companies to volunteer metrics on their sales efficiency:
In Q3, our magic number was 1.2, reflecting the continued efficiency of our go-to-market engine. We believe a magic number in excess of 1.0 indicates very favorable go-to-market efficiency and supports our current investment plan.
The Crowdstrike management team is arguably the runaway leader among public SaaS companies in disclosing metrics that create high fidelity resolution into their business. For SaaS companies unsure on how to communicate about their business in the face of macro headwinds, this is the way.
Podcast Recommendation of the Week:
I’m a fan of the All-In Podcast. It hasn’t (yet) had an episode this week.
In lieu of a podcast recommendation, here’s a transcript of a fake podcast created by All-In’s David Friedberg using OpenAI’s just-released ChatGPT:
Please click through to see what the world’s best chat bot is capable of producing. I don’t think it’s a harbinger of an imminent AI-induced apocalypse, but it’s a stunning breakthrough. AI’s importance in the tech economy seems poised to boom.
Reading Recommendation of the Week:
Semil Shah of Haystack has been one of the most successful of the “solo GP” seed stage funds started in the pre-Pandemic era. He penned a blog post that’s a great distillation of the high pessimism of the moment. The post covers the challenge of the many “difficult conversations” that VCs are having with founders. He writes:
For an early-stage founder, it can feel like the walls are closing in. And, they are.
Sadly, for many founders who raised at bubble-era valuations last year and who ramped up expenses in advance of profitable revenue, I think he’s right.