WisdomTree: The attractiveness of cloud

May 18, 2020

By Chris Gannatti, Head of Research, Europe, WisdomTree

While “crises” and “market disruptions” may not be as infrequent as we’d like to believe, they have rarely had as significant an impact on day-to-day life as we have seen with the Covid-19 pandemic.

If people think back to when “software” meant going to a store and possessing a box with a disc inside, they might remember wondering, if the disc would work as expected and how long it would be until the disc was outdated. Cloud computing solves these issues, as it updates to the latest version and solutions to problems can be downloaded. While these benefits were there before Covid-19, with so many people living on the internet and working from home, the realisation of these benefits has been greatly magnified.

Some cloud companies have been doing particularly well in 2020:

• Zoom: With returns of more than 145% year-to-date, Zoom has become a facet of everyday work and social life for many people. “Zoom hangouts” are a real thing in the video communications market.
• Everbridge: With returns of more than 100% year-to-date, Everbridge, which provides communication/notification services during extreme events, has made very strong strides in the generation of new clients.

Considering the strong performance of some cloud companies this year, it’s worth asking how do we determine what a strong company in this space looks like, bearing in mind that these companies should be looked at slightly differently to companies in other sectors. The hallmarks of a strong company within the cloud space could be broken down into “5 C’s”, which would stand for:

• Committed Annual Recurring Revenue (CARR): It is always important to monitor how well companies are doing for regular revenue. Growing CARR more strongly = stronger cloud company.
• Cash Flow: The conversion of revenues into cash is important as cloud companies consider future investment opportunities. Some will measure the efficiency to indicate this, which is revenue growth + free cash flow margin.
• Customer Acquisition Cost (CAC) Payback Period: This is the length of time it takes for a new customer to generate enough value to pay back the sales and marketing costs it took to find them. It is tough for a cloud company to fund growth if CAC payback is greater than 36-months.
• Customer Lifetime Value (CLTV): This is the net present value of the expected recurring profit streams from a given customer, minus the costs of acquisition. As a rule of thumb, cloud companies should aim for CLTV/CAC in the range of 3.0x or higher.
• Churn: Another term for the renewal rates of customers. If a cloud company is able to get lots of renewals and upgrades to services, this can be a big positive.

Limitless potential?

In our view, the software and business model advantages of cloud companies have historically led to better margins, growth, free cash flow and efficiency characteristics as compared to non-cloud software companies.

There are currently thousands of private cloud companies and 86 of them are considered “unicorns”—companies valued at more than $1 billion. Seeing this active ecosystem is one way to think of the future potential for cloud, in that a lot of the disruptive, exciting ideas come from these new firms. By 2030, it is possible that cloud will power more than 80% of enterprise software.

With the potential being shown by cloud companies, it’s obvious to see the sectors appeal to investors. Cloud computing may be an avenue for more specific exposure to technology firms with a different set of growth prospects over the next decade.

While the NASDAQ 100 Index has exposure to cloud companies there is a difference between a diversified approach to the technology sector—where some companies touch the cloud and others do not—and an approach where every company focuses on cloud as their main business strategy. We find that many investors have a specific thesis on cloud and they want a specific strategy that can execute on it.