Cloud stocks have been among the biggest winners on the market in recent years.
By allowing for scalability, ease of use, and better functionality, cloud computing companies have seen tremendous growth as businesses continue to move their IT needs onto the cloud.
As a result, software-as-a-service (SaaS) stocks have surged in recent years and cloud infrastructure providers like Amazon.com and Microsoft have also seen a significant tailwind.
The chart below shows the massive returns that some SaaS stocks -- including Shopify (SHOP +0.16%), Alteryx (AYX +0.00%), and The Trade Desk (TTD +0.52%) -- have delivered in the last few years.
All three of these stocks have trounced the market and delivered incredible returns. For beginning investors, however, cloud stocks aren't the most user-friendly. Often, these companies compete in niche corners of the IT world and offer services tailored to IT managers, meaning uninitiated investors may struggle with some of the language and terms these companies use to describe their business and performance. To get a sense of the strength of a given cloud stock, investors can start by examining three key industry metrics.
1. Dollar-based net retention
Most cloud businesses -- and we're talking about the SaaS sector here -- operate on a subscription model. That means these companies have two ways of growing revenue. They can either add new customers or get their current customers to spend more on their platform, generally by upgrading or expanding their service. It's generally more cost-efficient to grow sales by getting current customers to spend more rather than finding new customers, so it's important for cloud companies to grow sales to their customer base. That shows those customers are pleased with the service and are expanding their use of the product. Cloud companies have dubbed this growth model "land and expand," meaning they acquire new customers and then grow their business with those customers over time.
Image source: Getty Images.
To measure growth from existing customers, SaaS companies use a metric called dollar-based net retention, also called net dollar retention or dollar-based net expansion. This number, expressed as a percentage, shows how much of a company's existing customer base is spending from one year to the next. For example, Okta (OKTA +1.53%), a SaaS company that specializes in identity and security, reported 117% dollar-based net retention in its most recent report, meaning sales to its previously existing customer base grew 17% over last year's sales.
Slack (WORK +0.00%), the popular workplace-messaging platform, posted 134% dollar-based net retention in its most recent quarter, showing it grew revenue 34% from its existing customer base. Using those two numbers alone, you can see that Slack is doing a better job of growing revenue from its current subscriber base. Not surprisingly, its overall revenue growth of 60% was also better than Okta's at 45% in their respective quarters. SaaS investors will want to make sure that any net dollar retention rate is above 100%, meaning that the company is growing existing customer relationships, preferably with a solid margin of safety.
2. Gross margin
Gross margin is important for almost any business. Generally, it means the percentage of revenue remaining after direct product or service costs are subtracted, also known as cost of goods sold or cost of revenue. In cloud computing, these costs tend to include computing costs like networking and infrastructure to keep the software running and personnel costs like customer service. Since operating costs further down the income statement tend to be more fixed or harder to control, a high and increasing gross margin is one of the best signs of profit potential, especially in cloud stocks, as the company should become more profitable as it scales and matures.
Okta saw its adjusted gross margin increase from 75.8% to 77.8% in its most recent quarter, a bullish sign, which also allows it to spend much of its revenue on research and development and sales and marketing, as well as general and administrative costs like corporate employee salaries.
By comparison, Twilio (TWLO +4.50%), a cloud company focused on enabling communications like the text messages that Uber sends you when your ride is ready, saw its gross margin rise from 55% to 58% in its third quarter. While that increase is a positive sign, the lower margin shows that Twilio's core business model is not as profitable as Okta's.
3. Customer acquisition costs
Cloud companies tend to be fast-growing, but unprofitable. That's because almost all of them spend significant percentages of their revenue on sales and marketing expenses. These companies aim to capture the potential opportunity in the market and build out customer relationships first, then focus on delivering profits from those customers later.
Therefore, it's worth looking at customer acquisition costs (CAC), which show how efficiently cloud companies are able to get new customers and grow their business. Generally, CAC is measured by dividing sales and marketing spending by the number of new customers added in a given period. It's not a perfect measurement, as some marketing spending goes to existing customers, and some customers are more valuable than others, but it's a good approximation for marketing efficiency.
Okta, for example, spent roughly $87.2 million on marketing in its most recent quarter and added 400 customers, giving it a CAC of about $218,000. If the lifetime value of those customers is worth more than the $218,000 the company is spending to acquire them, then it's using its marketing budget wisely.
Calculating customer lifetime value isn't always so straightforward and requires the investor to make some assumptions, but investors can also get a sense of customer acquisition costs by looking at how they've changed over time. With Okta, we can see that its CAC was just $126,500 in the third quarter of 2018, showing that customer acquisition is getting more expensive. Nonetheless, Okta's revenue growth has remained strong, while marketing expenses have remained close 60% of revenue from year to year.
Still, investors may want to keep an eye on CAC going forward as eventually sales and marketing spending should come down as a percentage of revenue, helping to drive overall profitability.
Of course, there are more metrics than these that cloud investors should consider when evaluating a stock, including overall revenue growth, subscription revenue growth, and free cash flow, but the three above can give investors a good start for understanding the potential of an individual cloud stock. For more, check out this primer on SaaS stocks.
