Deep Dive On Cloud Stock Valuations (Part 1)


With the market for technology stocks having just undergone one of its most rapid corrections in history – with the tech-dominant Nasdaq 100 Index falling almost 30% in just a few months – it’s time to take a close look at the valuations of companies producing leading cloud technology.

Cloud technology stocks have been the epicenter of a ten-year bull market backed by massive amounts of money, as the entire global technology infrastructure has shifted to the cloud model for delivering information technology (IT) services. This is not a subtle move — it’s the biggest technology transformation in history.

The gains and stock action have been uneven. Large blue-chip technology companies like Amazon, Microsoft, and Google have led the market with surging profits, rapid growth, and understandable valuations. They have gigantic amounts of cash on their balance sheets. Some traditional technology conglomerates, like HPE and IBM, have been almost completely left out due to their inability to take market share in cloud infrastructure and services. Many of them trade at value levels with price/earnings (P/E) ratios of less than 10. And elsewhere there was an explosive bubble of freshly minted Initial Public Offerings (IPOs) carrying valuations to nosebleed levels. Those stocks have been crushed.

So what’s next? Investors in cloud technology will have opportunities here, but it’s messy and they should probably focus on the most defensible valuations of companies with the most solid positions. Google and Microsoft are the first two companies to pop into my mind.

Let’s dive deep into the valuations and what may happen next.

Bear-Market Catalysts May Be Temporary

Investors will haggle over the definition of a bear market, but with the Nasdaq now down 28% year to date (as of this writing), it’s hard to argue this isn’t at least a short-term bear market — if not a crash. The standard definition of a bear market is down 20% or more.

What’s different about this one is the speed of the descent. Technology shares have been hit hard in just a few months by a historically fast rise in interest rates and inflation, which decrease the premium that investors are willing to pay for growth. This has compressed market multiples and caused many investors to pull back in fear of an economic slowdown. But people also forget how fast tech stocks went up — the Nasdaq Composite doubled in less than two years off the pandemic bottom in 2020. Easy come, easy go. Up 100%, down 30%, what’s the big deal? A few trillion dollars in stimulus and Fed money will do that.

The path forward comes down to whether you think the recent catalysts are permanent or temporary. Will inflation stay elevated for more than a year? How will the war in Ukraine play out? What will the impact of 3% yields have on the stock market? These catalysts for the correction came quickly, but they could also subside.

This is why I think the current action is merely a vicious, quick correction, not a secular bear market. In the cloud, there are too many long-term economic drivers. This is demonstrated by the perennial shortage of tech workers to fill job requisitions that outnumber workers by nearly 4-to-1 in some tech sectors. For example, the cybersecurity industry currently has more than 2 million unfilled openings. Another factor is the fundamental shift to digitalization by global organizations, a long-term trend likely to last 10 years or more.

Looking at the long-term, cloud infrastructure and services markets remain some of the fastest growing segments of the economy – and are likely to be so for a long time. Cybersecurity, cloud business services, FinTech, cloud networking, edge compute — all of these markets are going to experience continued strong demand, according to Futuriom research. The long-term growth rate of many cloud technology segments is above 20%. The current environment is an opportunity for investors believing in cloud in the long term.

Big Cap Tech a Place to Start

So where to start? It’s probably best to separate out private cloud technology companies into buckets. I look at the cloud tech world in three buckets:

1) Big-cap tech companies: Large, market-leading blue chips like Amazon (AMZN), Apple (AAPL), Google (GOOGL), and Microsoft (MSFT). These are must owns in any technology portfolio.

2) Deep value traditional tech companies. Large conglomerates such as IBM and HPE are trading at discounts to the markets and paying high dividends (5%+)

3) Young cloud tech growth companies. These include fast growers with high multiples, including IPOs from the last four years such as Cloudflare (NET), Datadog (DDOG), Mongo DB (MDB), Twilio (TWLO), and Zoom (ZM).

The recent IPO crop has been crushed the hardest, with some stocks having taken haircuts ranging from 50-80%. So let’s start with the more conservative buckets – big-cap growth and value tech.

The megacap leaders like Amazon, Google, and Microsoft are not only public cloud leaders but also among the most profitable companies in the world. They have the cheapest valuations in years based on their profits and cash flows. I have put Apple in this bucket, even though it’s mostly a consumer technology company. That’s because Apple operates one of the largest clouds in the world and is ramping up its cloud services businesses. You could also add VMware into this category, even though it is a bit of a ‘tweener – neither fast-growth nor deep value – but certainly an important leader in cloud technology.

Gavin Baker, Managing Partner and CIO at Atreides Management and a former fund manager at Fidelity, Tweeted on Wednesday that he’s “super bullish” on megacap tech, with growth at more than 10% and all-time lows in valuations based on an enterprise value/free cash flow (EV/FCF) multiple.

On the mid-cap front, which we will cover later, Baker pointed out that younger tech companies are trading at 40%-70% discounts to recent private equity buyouts. We’ll cover that in the next section.

Now onto the next bucket: Big Value Tech. Some of the slower-growing big-tech companies – companies like Cisco (CSCO), Dell (DELL), and HPE (HPE) — are even cheaper.

Here is a quick chart showing you some of the valuations of key big-tech companies. I’ve sorted them by the forward price/earnings (P/E) ratio (the forward ratio projects the valuation based on analysts’ consensus estimates for the next year).

On a forward P/E ratio, Amazon is clearly the most expensive – but that’s because Amazon has aggressively reinvested most of its earnings. Analysts project that with its leverage, earnings will grow significantly next year.

One of my favorite metrics is the PEG – the ratio of the P/E divided by the growth rate – which measures the valuations based on a company’s growth rate. In deep-value big tech – stocks such as HPE, Dell, and IBM – valuations are very cheap on a relative P/E and PEG basis. They also all pay dividends of at least 4%. But that’s because they don’t have the growth of the cloud leaders such as Amazon, Google, and Microsoft, which have always traded at a premium to the market because they are perceived as the best companies. Microsoft and Google seem very reasonable. I still don’t understand Cisco being priced like a growth stock that’s not really growing.

In the big-tech value bucket, investors in these companies will get paid on the basis of the companies’ capability to execute on new cloud initiatives and M&A. IBM, for example, is a bet on the growth of its Red Hat division, after it established a cleaner corporate structure spinning off unrelated assets. Oracle is building up its public cloud infrastructure in a bid to gain market share from the top three (Amazon, Google, Microsoft). Cisco needs to prove it can convert more revenue to its software and cloud services business, especially in cybersecurity. In search for new growth, I like the prospects of Dell, HPE, and VMware the best.

The market seems to be doubting the growth numbers, which is why they have been so heavily discounted lately. Of all these larger tech companies, Microsoft seems to have the best growth prospects and franchise, with a wide moat in cloud-based business applications and its Azure cloud growing at a 40% annual clip, right on the heels of Amazon Web Services (AWS).

The IPO Bubble Implosion

Technology is always the center of some interesting and spectacular bubbles, and in the last five years we’ve seen huge momentum investments in recent cloud tech IPOs. Some of these stocks have had some wild rides, which have unfortunately not ended well.

Most of the companies that have taken the hardest hits are IPOs from the 2017-2020 vintage. Let’s take a look at two poster children: Cloudflare (IPO 2019) and Datadog (IPO 2019) are both excellent technology companies considered leaders in software infrastructure for the cloud and the Internet. Built from the ground up as venture-backed companies in the last 15 years they have become essential tools. Of course, they were fast-growing and they got investors excited after IPOs. But the valuations got ran out of control, and like most high-multiple stocks, exacted a price in the pullback.

Cloudflare makes a secure content delivery network (CDN). Think of it as cloud service that helps organizations leverage a more secure and faster version of the Internet. It’s had spectacular revenue growth – growing from $130 million in annual revenue in 2017 to $650 million last year. Its market capitalization is $22 billion, still trading at 33 times (33X) sales. It’s still expensive, even after the stock fell 75% in six months. The lesson here is the high multiple stocks always have the furthest to fall in a disappointing environment. Long-term, this is still going to be a fantastic company and I could see it growing into its valuation.

Datadog makes data monitoring and analysis tools that are fundamental to cloud infrastructure. Similarly, Datadog’s stock has been chopped in half and it still trades at a 23X sales, with a market cap of $31.5 billion and annual revenues just over $1 billion.

Neither of these stocks has a cheap valuation, but they are two places I would start to look. I would put them in a portfolio but at a smaller weight as speculative plays on growth. One of the reasons these stocks may find a bottom soon is that they would be highly coveted acquisitions by larger companies.

To look at a broad basket of the cloud tech companies, I combed through a couple cloud indexes such as the First Trust Cloud Computing Index, and selected companies I recognized in a screener. When screened by forward P/E, this is what you get (where the fields are blank there are no earnings to calculate):

Looking at this list, there seem to be great opportunities in fantastic long-term cloud franchises such as Adobe (ADBE) and Intuit (INTU), which are still somewhat richly priced but not crazy. As a small business owner, I can tell you from my own Adobe and Intuit cloud bill, those revenues are not going away any time soon.

The one that jumps out at me the most on this list is Zoom Communications. Zoom has become the de facto standard for cloud communications (and it also makes up a significant portion of our cloud bill!). It has introduced new webinar products, which are best-of-class. While Zoom got overpriced during the pandemic, it added 400,000 new business customers since the pandemic started and is now trading at a pre-pandemic price with a forward P/E of 20! With a PEG of 1.5, that’s a pretty good price for an excellent technology company with premier market position. Dropbox (DBX) is also interesting, with a great leadership team and product suite with opportunities for new monetization. Its valuation is intriguing, with a forward P/E of only 11.

Conclusion: A Sensible Approach to a Technology Portfolio

The market is currently messy, and many of these stocks have been treated in a different manner. There is a wide range of valuation considerations between the deep-value tech companies, the megacap leaders, and the young growth companies.

To sum it up, I think the biggest opportunities are in the megacap leaders such as Google and Microsoft, but I think it’s a good time to build (or rebuild) a sensible portfolio that balances names across three of the cloud buckets we have outlined. Next week, I’ll update the major trends that I see in cloud and build a model portfolio of these names!

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