Preparing for Earnings Season
What must companies do to keep our hard-earned investment dollars?
Every company has a story. That story is written by the news and information the company creates. Within this framework almost no info is as useful or relevant as the earnings report. The numbers in these reports are invaluable, mostly because the tale they tell is never biased. The challenge is having a plan in place to make sure they are interpreted properly.
Why does that matter? Because each of us has a thesis for owning a stock. If you’re actively managing a portfolio, earnings season is the ideal time to double check your work. Heading into a report, what information must you see in order to feel your thesis still holds? Personally, I try to determine what I’m looking for prior to viewing the actual results. This calms my mind and lets me review some crucial information without scrambling to crunch numbers, decipher conference call chitchat or react to after hours prices. I want to create a process for proactively evaluating this new information rather than emotionally reacting to it.
Most of my current companies reside in the Software-as-a-Service (SaaS) sector. The most successful seem to share some common traits:
Strong revenue growth (accelerating growth is even better but tough to find).
A large recurring or subscription revenue component.
A low capital structure which inherently leads to high gross margins.
Expenses, secondary margins and cash flows that are all moving in a positive direction. That means shrinking as a percentage of losses or growing as a percentage of profits.
Appropriate customer growth to support current business momentum.
High net expansion or retention rates.
Conference call comments that match the press release numbers each quarter. This is more subjective, but I like to leave the call with at least the same general sense of enthusiasm I felt coming in.
Those are the baseline attributes I’m searching for. Another important factor – in my personal calculus at least – is a history of beating and raising guidance. Being honest, for all intents and purposes this has become a requirement for most growth companies in today’s market. Like most investors I never take initial guides at face value. However, rather than ignore them I review the firm’s recent trend of guides versus actuals to estimate the next quarter’s numbers (I’ll cover more of the math in a separate post). My remaining assessment of the quarter flows from there. Here’s a sample of the this thought process heading into Smartsheet’s (SMAR) Q1 2020 report:
SMAR guides for $55M in revenues and 51.4% growth. They’ve beaten guidance the last three quarters by $2.9M (7.3%), $2.4M (5.4%) and $2.2M (4.4%). Given that trend, I think it’s reasonable to expect an upcoming beat of at least $2M (3.6%). That would put revenues around $57M and growth at 56.9%. Those are the headline numbers I’m hoping they can meet or clear.
Beyond the headlines, I’m looking for them to continue their momentum in large client growth and take advantage of a expansion rate that has accelerated to 134%. I’m also interested in their annual contract value (ACV). As their CEO stated last quarter:
“…one of the real blessings of the company is, even though we did see a 50% step up in ACV, the number is still tiny. I mean, we're taking $2,500 on average. So the opportunity for us to really reach the full potential with an account, we were talking orders of magnitude, not order of magnitude.”
Will any of those orders of magnitude find the top or bottom lines next week? We’ll see.
The very first thing I do when reviewing the report is hold myself accountable to my expected numbers. No excuses or rationalizations allowed! I treat anything too far below my expectations as a possible sell signal. I’ll check the secondary numbers to see if they still support my thesis. I listen to the call and/or read the transcript. After plugging everything in and examining the results, the last thing I do is eyeball current guidance to see if it’s high enough to keep playing the beat-and-raise game.
So, how did things turn out for SMAR that quarter? Here is my post-earnings recap:
I wrote last month I was looking for something around $57M in revenues with signs they are taking advantage of their room for growth…They came in at $56.2M (+55%) and held their 134% retention rate. Subscription growth accelerated slightly to 57% and subscriptions now account for 89.5% of total revenues. Gross margins are strong at 81%. High-end customer growth (>$5K, >$50K, >$100K) remains healthy and their average annual contract value grew 48%. Operating, net and FCF margins remain negative but continue to grind in the right direction. They also announced several developments this month, including designation as the only work execution platform listed in the FedRAMP marketplace for federal agencies and government contractors.
The flip side is SMAR also announced a secondary offering of 6.5M shares on June 10. That announcement led to a small dip, but the offering was priced strongly and the price action since suggests the market doesn’t seem to have a big issue with SMAR padding its coffers as it continues to grow. Putting it all together Smartsheet appears to be on the right track. They continue to execute and commented on their call that “every [sales] team outperformed their goals”. Despite coming in a tick below the revenue number I was looking for, their Q2 (51.0%) and FY (49.1%) guides make it fairly easy to see them continuing to challenge mid-50’s growth for the remainder of the year. All in all I viewed this as a solid but not spectacular quarter based on my expectations. I’m keeping my allocation as is for now.
Some other examples:
NTNX was an auto sell right off the Q2 2019 release. Nutanix was already a complicated company for me to follow (a lesson in itself). Not only did the numbers disappoint, but the CFO stated in the release “our third quarter guidance reflects the impact of inadequate marketing spending for pipeline generation and slower than expected sales hiring”. Frankly, that might have been the easiest sell decision I’ve ever made. I didn’t even need to plug in the numbers. No regrets and I didn’t look back.
I sold VCEL in early 2019 when total revenue and the expected contribution from its flagship product didn’t pass my smell test. Their call comments were much more guarded and even a little defensive compared to the prior quarter. In addition, the guides for the next quarter and full year were way too low to think they had any chance to post attractive numbers in the beat-and-raise game. That let me exit with a profit just before a significant decline in the stock.
In Q2 2019 this process kicked out $116-118M in expected revenues for OKTA. They came up just short at $115.5M. That got my Spidey senses tingling slightly and alerted me to dig deeper. After dumping in the secondary figures and listening to the call I decided the thesis still held. I kept my shares but shortened the leash. I still own the shares today.
Using the same process, I came up with $123-125M for OKTA’s Q3 2019. Actual revenue came in strong at $125.2M. All the supporting figures lined up, their call was confident and they posted a record 10.5% free cash flow margin in a quarter management had already said would have higher expenses. I wasn’t surprised to see a post-earnings pop and actually had more conviction in OKTA exiting this particular quarter than the one prior.
Obviously, no matter what I estimate it is impossible to know the exact numbers a company will report. I can also list numerous instances where the market emphatically disagreed with my interpretation of results. That’s OK though. Investing is hard, and being wrong is a feature of the system rather than a bug. Trying to nail an estimate or predict short term market moves is not the point. The point is having a sensible plan for regularly reevaluating the thesis that earned my hard-earned money in the first place. To that end focusing on process is much more important than fixating on results. While I know this process is far from perfect, I’m comfortable saying it has helped immensely in understanding what I own and more importantly why I own it. And I believe I’m a better investor as a result.
I hope this helps and am more than open to any alternative methods or suggestions for improvement. Thanks for reading and good luck out there.