There’s a saying in markets that they don’t ring a bell at the top. You won’t know when a so-called bubble pops, because signs of mania can compile. Each subsequent one seems like too much, but the market keeps going, until it doesn’t. Whatever the theme, whether it’s today’s AI investing, yesterday’s SaaS investing, or cannabis, or crypto, or whatever else, you can trace these stories.

Last week, some would argue we got a bell ring. But I heard more interesting notes in the signs of new depths, and the end of an era. I don’t know that bottom is in for the smaller software as a service companies that were so exciting leading up to and during the pandemic. It’s clear, however, that we’re in a grittier, grimmer environment.

Market Tops and Bottoms

The bell ring at the top is the precipitous rise and Friday sell-off of Super Micro Computer. The company sells server and computing services, and is caught up in the AI computing hype. It had a very strong 2023, more than tripling, and then more than tripled again in the first 6 weeks of the year, before dropping 20% on Friday. This is just meme stock stuff. Super Micro Computer benefits from AI, and is growing rapidly, but when it’s the 1^st or 2^nd most traded stock in the market as a $44B company, there’s just silliness. SMCI is trading at 61x trailing GAAP earnings, and 28x 2025 non GAAP earnings. That’s high for that sort of company.

A previous round of silliness came during the pandemic, when everyone piled into stocks like Zoom and Docusign and Twilio, companies that were transforming our world to digital forms, built on excellent specific services, and proving the promise of software as a service, or SaaS. The most dangerous type of market silliness is one based on reality. SaaS investing was based on a reality. Everyone needed to get on Zoom in 2020, and its business soared as a result. The problem was Zoom started off expensive, and its stock soared many times more than its business.

These stocks have fallen into hard times. Twilio shares trade 43% below its January 1, 2020 level. Docusign is 34% lower, and Zoom is 10% lower. That’s even as all of their revenues have at least tripled over that period. The issues are obvious: the valuation at the start was too high, and the potential growth now is too questionable.

Gloomier Notes

We’ve already mentioned valuation in the ‘bell ring at the top part’. There were three recent SaaS events that typified the gloomy tuba at the bottom, though, that I wanted to go into.

Docusign’s failed sale

Start with Docusign, which is arguably the healthiest of these companies financially. It trades at 13.6x trailing free cash flow*¹, is expected to finish off the last year with 9% revenue growth, and then put up 5.8% and 7.6% growth the next two years. Docusign’s service – e-signatures – is an accepted must in our world, embedded into processes for home sales, bank account openings, and legal contracts.

The company put itself up for sale recently, and according to all reports, the price was going to be around $60/share. This would be higher than Docusign had traded for most of the last year, and also 20% below where it started 2020. It might have both been the best bet for Docusign shareholders, and a huge disappointment. In any case, the deal fell apart, and Docusign announced new job cuts in the wake of that news.

Twilio’s (S)egment problems

Twilio is less financially healthy. It is still negative EBITDA, even adding back an impairment charge. It trades for 29.2x free cash flow, and that’s before share-based compensation. The messaging service is growing revenue faster, but its gross profits are on an entirely different level, 49.2% for last year. (Docusign is at 79.2% for the first 9 months of 2023, for comparison).

Which makes Twilio’s big news striking. After replacing the founder/CEO Jeff Lawson in January, the company announced it was reviewing its Segment unit, which suggests Twilio might sell the unit. Twilio bought it for $3.2B at the time, though since it did it in all stock, that purchase should only amount to $640M now. Twilio took an impairment of $285M on Segment, which shows how much the company values it for now.

That is striking, because Segment was meant to be the higher value service Twilio was taking onto its messaging service. While they haven’t filed a 10-K to give a more precise gross profit, Segment’s gross profits are likely around 80%, which should be more attractive than Twilio’s core business. Except, that Segment, a marketing customer data platform, grew only 7% for the year, and only 4% in Q4.

Dropbox’s Drop

I want to bring in one more company before tying together themes and talking about Zoom. That company is one I still own, Dropbox. Dropbox is a file storage service, and was one of the first SaaS 2.0 companies to come to prominence and then to public markets. By the time the pandemic emerged, it was already old news. It is the only one of the names I’ve mentioned, SMCI aside, to trade above its 2020 price. (Its fellow boring storage company, Box, has also grown since 2020).

The news in Dropbox’s earnings isn’t good either, though. The company reported its Q4 earnings last week and sold off 23% as a result. Why? For one, Dropbox only expects to grow its revenue by at most 2%. Even if the company beats its expectations, that is very slow growth. Analysts had expected more than 3% growth, still slim but at least something. More troublingly, Dropbox’s paying users and annual recurring revenue figures dropped in Q4. Those are important indicators of revenue growth, and scared people.

Three Woes of SaaS

What ties these together, besides being in a similar field? I see three things we can pull out quickly, which will help us understand Zoom, which I continue to think of as the paragon of this category.

Share-based compensation can’t be ignored

If you look at estimates for Twilio’s EPS over the next three years, you will see very positive numbers. Twilio only trades at 22x 2024 earnings. It’s even better when you factor out all of Twilio’s cash on the balance sheet. Not so bad, right? And yet, Twilio had negative EBITDA last year. EBITDA is one of the more flattering lights to look at a company’s profitability. What gives?

Share-based compensation. While these companies are generating actual cash, that cash is inflated by the company paying employees in shares, and a lot. Docusign’s free cash flow for the last 12 months is $751M; its share based compensation is about $600M. Zoom’s free cash flow is $1.3B, but its share-based compensation is also $1.3B. Dropbox has $633M free cash flow and $338M in SBC.

I’m not puritan about this to the point of ‘tut tut, these companies are stealing your money as shareholders.’ It’s a cost of doing business. It’s just not a cost that can be ignored, especially at basement prices where companies have to issue more shares to keep employees paid the same. Sustainable economics have to include this factor.

Self-fulfilling slowdowns

Tech companies have been in a job recession since at least early 2023, if not going back to the bear market of 2022. That impinges on these companies in several ways; their stock is not as attractive tender either for acquisitions or to pay employees, for example.

Specifically, if companies from the giants like Alphabet and Meta on down are laying people off, that’s fewer Zoom users. Fewer Docusign seats. Fewer Dropbox group subscriptions. And less advertising or marketing will hit Twilio one way or the other.

There’s also the underlying mindset. A company going through years of efficiency will look at everything. Do we really need a top tier Docusign subscription? An external marketing data platform? Another file sharing service? This focus on making do with less tests how essential these products are, stressing the companies’ revenue. Which leads into…

Bumping into each other and the giants

The knock on Dropbox has always been, “who pays for that with Google Drive, Microsoft 360, and Apple Cloud all available?” Dropbox has been able to trundle along, but it’s certainly acted as a restriction on the company’s prospects. Docusign has the same knock vis a vis Adobe sign.

And Zoom epitomizes the scarier version of this – that the big guys will focus on your market. Even though Microsoft Teams and Google Meet are vastly inferior to Zoom, they are either free or included with other products, and good enough to save money. In the context of the efficiency drive I mentioned above, it becomes easy to consolidate and just go with the old staples.

This problem gets even deeper, though. Not every company wants to rely on the same 3-4 vendors, so there are opportunities. With all these public software companies competing for those opportunities, though, it gets tough. Zoom is expanding into contact center sales, which is a relatively clear-cut category, but also building out Zoom chat applications and the like. That crowds on Slack’s turf (Slack is now part of Salesforce.com). Monday.com is butting up against Atlassian. Dropbox has an e-signature service in its subscription. And Twilio tried to climb up towards Salesforce.com with its Segment purchase (and SendGrid was an expansion before that).

My podcast co-host, Akram’s Razor, wrote an opus in 2019, Once Upon a Time in Tech². It’s very long, and very good, and I want to be careful about paraphrasing it wrongly. But one of my biggest memories of its conclusions is that a lot of software companies are selling ‘point products’, solutions to an individual problem. As their businesses grow, and their valuations demand more growth, they have to expand to other fields. Otherwise, as Steve Jobs famously told Dropbox’s CEO, Drew Houston, their business is not a product, it’s a feature.

As these companies try to expand, they compete with each other more and more. This, almost by default, makes it harder and harder for companies to grow. Some of them will, and many will stagnate. What happens from there? Buyouts that would feel embarrassing three years ago; job cuts and cost savings; and mergers to try to compete against the megaliths. The pandemic came in and postponed this reckoning, but four years on from the lockdowns, here we are.

The state of point product SaaS investing. Photo by Sophia Müller on Unsplash

A last Zoom lens on SaaS investing and thematic investing

This is all on my mind because of it just happening, and because of Dropbox. I had sold some shares earlier this year, and decided I’d like to hear earnings before making the call to sell everything. This was, evidently, a mistake, even as I think the sell-off is somewhat overdone. But Bank of America was fair – the bull thesis is gone, and only new ‘AI-powered’ tools lurk as saviors.

I’ve been eying Zoom as a potential Dropbox replacement in my portfolio. Its management is highly esteemed. Cash makes up 1/3 of its market cap. Its product is great, and its expansion to contact centers and enterprise phone is one of the more logical options available.

And yet, the company is already in its barely growing mode – 3.2% growth for the first three quarters of its fiscal year. It has that huge share-based compensation, which was in part due to the big drop in the share price. And if Zoom decides it wants to be the buyer of smaller peers, that would only heap more risk on the pile.

Thematic investing has been popular in recent years, with Cathy Wood and Ark Investing as the most notable practitioners. The idea is to pick a trend, like SaaS or AI, and invest in the leading players, valuation be ignored. There’s something to this – fish in the right ponds and you’ll catch the big ones.

Part of that, though, is recognizing when the theme has changed. And it seems SaaS’s day in the sun is past us. Which may make the only move not to play.

And with Nvidia reporting earnings this week, we will get our latest update on where the AI excitement theme is.

Interested in more from Middle Coast Investing? Or in talking to us? Get in touch.

Disclosure: Middle Coast Investing clients and portfolios have long positions in AAPL and DBX. We may sell DBX shares in the coming days. Positions may change at any time without notice. Nothing in this post is investment advice.

1. This is much worse when you back out share based compensation – 68.3x. As will be discussed later ↩︎
2. Originally posted on Seeking Alpha, if you want to see the 2019 timestamp – ↩︎