SaaS, one who has never sinned, and tech valuations

Mate, instead of doing business of EUR28.2bn (mid point) in 2020, as we had guided in April, we now believe we will be able to do only EUR27.5bn (again, mid point), down just 2.3%. We cool, right?

Sorry sir, you take our relationship for granted. This is simply not done.

But wait, that’s not all. We have a ‘cloud computing’ division. We shall ramp it up to EUR22.0bn by 2025 from just EUR1.9bn in 3QC20. You happy now?

Oh, that’s even worse. Obviously, there simply cannot be that much business to go by. You sell licenses now, which brings immediate $$$ (ok, EUR in this case). You start selling your software as a service (SaaS), you cannibalise your own business.

Oh, come on, be reasonable.

Sorry. In my eyes, the value of your business drops by EUR33bn TODAY; down 21% in one day.

What? That’s ridiculous. Hold on, I am buying. Almost EUR250m worth (note 1)

Well, that’s not gonna cut it, now. Over the next five days, we shall value you a further 7.5%, down another EUR6.5bn.

If they could speak, in my mind, this is how the dialogue between Mr. Market and SAP must have transpired in the week of October 23, 2020. SAP is a German multinational software company, known especially for its ERP. It is Europe’s largest software company by revenue and third-largest publicly traded software company in the world.

One who hasn’t sinned multiple times: Now, this is a true-blue market darling we are talking about. Over the past eighteen years, the stock is up over 13x. In early 2000s, managing enterprise resources was done through messy proprietary systems host to each country, region and/or local flavours. Today, we cannot fully fathom the enormity of the task to consolidate those statements at the end of each accounting period, let alone make all the data available for the purpose of managerial analysis. The thought of one integrated system that functions across the entire organisation was entirely utopian back then.

And, that is what SAP accomplished; and the markets loved it for that. So, what changed? Nassim Taleb summarises it in his book Antifragile – that for nature to be antifragile, organisms need to die. A system that sacrifices fragile units makes itself stronger to shocks. The fragility of every start-up is necessary for the economy to be antifragile. For e.g., individual restaurants are fragile–they compete and some shut down. But that is what makes the entire business of ‘eating out’ robust–it has survived the test of time.

Technology business is similar. History is littered with businesses that we thought were worth a lot at the time. Take Blockbuster (worth USD8bn in 1994), Palm Inc., (USD50bn in 2003), Alta Vista, Pebble, Vertu, Jawbone and many more that went bankrupt. Not to forget iconic companies like Blackberry (USD80bn in 2008) or Nokia that got sold at cents to a dollar on peak valuations.

Taleb says that this is where learning from mistakes of others benefits the rest of us, and, sadly, not them. Had the Titanic not had that famous accident, as fatal as it was, we would have kept building larger and larger ocean liners with inferior material and the next disaster would have been even more tragic.

So, whereas technology has kept changing over the past two decades, businesses and corporations that have survived are the ones which have learned to adapt. Take IBM for example; it was into consumer hardware, servers, services and even software, and despite giving up multiple lines of businesses over the past decade, it continues to remain diversified. Similar is the case of HP and Xerox (if one includes all the demergers). Or as Taleb puts it, “my characterization of a loser is someone who, after making a mistake, doesn’t introspect, doesn’t exploit it, feels embarrassed rather than enriched with new information, and tries to explain why he made the mistake rather than moving on.” For Taleb, “he who has never sinned is less reliable than he who has only sinned once. And some who has made plenty of errors (though never the same error more than once) is more reliable than someone who has never made any.”

Tech investing: The entire SAP episode brings the discord in tech investing to the fore. Tech investing is hard because: (a) technology changes at a reasonable clip; and (b) the narrative around technology in and of itself is changing as well. Over the past two decades, Apple Inc., has traded at 10x forward earnings multiples thrice and at 40x forward earnings multiples as well.

The narrative at higher multiples argues for technology to become all pervasive and it assumes that a company can deliver strong growth for an extended period. And the strong cash flow it generates will be ploughed back into R&D and/or returned via buybacks and dividends. At low multiples, the narrative changes to unpredictability of the technology and ability of companies to survive the technology shift.

To us, SAP willing to reinvent itself based on changing market conditions is a sign of maturity. The management putting its own money where its mouth is (instead of investing shareholders’ money for buyback) reflects skin in the game (a concept we deeply believe in). It’s quite possible that SAP’s latest gambit falls short of target, but in our view, history will be kinder to SAP than Mr. Market.

1: SAP executives and officials increase in stakes: Christian Klein, CEO – EUR204k, Luka Mucic, CFO – EUR75k, Juergen Mueller, CTO – EUR24k, Hasso Plattner, Chairman – EUR248,535k, Raif Zeiger, Board member – EUR 25k, Lars Lamade, Board member – EUR 20k

Information in this letter is not intended to be, nor should it be construed as investment, tax or legal advice, or an offer to sell, or a solicitation of any offer to make investments with Buoyant Capital. Prospective investors should rely solely on Disclosure Document filed with SEBI. Any description involving investment examples, statistical analysis or investment strategies are provided for illustration purposes only – and will not apply in all situations and may be changed at the discretion of principal officer. Certain information has been provided and/or based on third-party sources and although believed to be reliable, has not been independently verified; the investment managers make no express warranty as to its completeness or accuracy, nor can it accept responsibility for errors appearing herein.