What Investors Get Wrong
Lessons from a short-seller report on a company that subsequently became one of the greatest cloud companies in the world
During November 2012, a firm called Kerrisdale Capital released a short-seller report on a company that has subsequently become the third largest cloud company in the world with a stock price increase of 2,118% since the report was released
“Shorting” a stock means betting against a company that the stock price will fall. The person short selling the stock borrows shares and then sells those shares. They then closes their short position by buying shares (the opposite of what you normally do). If the stock price goes up then the short position loses money and if it goes down then you make money. The loss potential on a short position is theoretically unlimited since the stock price can go up forever.
The attacked company in this short-seller report was ServiceNow…
Given ServiceNow’s absurd $4.7 billion market capitalization, when compared to its projected 2012 revenue of $239m, we think NOW’s share price is poised to collapse. — Kerrisdale Capital
What the Short-Seller Got Wrong
Underestimating Market Size
A company’s total addressable market (TAM) represents the maximize annual revenue opportunity for a company’s product. TAM is represents the revenue ceiling because it doesn’t consider what a company realistically can obtain because of competition, geography, price, etc. The serviceable obtainable market (“SOM”) is usually a much smaller portion of TAM and represents what a company can realistically obtain.
Investors frequently pass on investment opportunities because of a perceived TAM issue. Below is one of the key reasons Kerrisdale shorted ServiceNow:
The overall ITSM [IT Service Management] market size is only $1.5 billion, less than one-third of NOW’s $4.7 billion market capitalization. Furthermore, Gartner's research predicts that only 50% of IT organizations will move to SaaS by 2015, implying that the total market opportunity for NOW's ITSM business is less than $1 billion. — Kerrisdale Capital
ServiceNow introduced the SaaS business model to ITSM and gained significant market share, but Kerrisdale couldn’t understand how ServiceNow’s valuation could be so much larger then the current ITSM TAM. Kerrisdale severely underestimated how mainstream SaaS would become (most people did) and how the ITSM market would continue to grow.
Some of the biggest, most iconic companies today were able to exceed all expectations because they were early to a major trend and they rode the wave.
The market doesn't have to be big yet, nor do you necessarily have to be in it yet. Indeed, it's often better to start in a small market that will either turn into a big one or from which you can move into a big one. —Paul Graham
Investors frequently pass on investment opportunities (or short a stock…) because they underestimate the TAM potential and the power of dominating a niche. ServiceNow was early and rode an enourmous wave.
There is power in the niches, which can lead to great riches.
ServiceNow Leadership Team
A failing of this short report was properly considering ServiceNow’s management team. Frank Slootman became CEO of ServiceNow about one year before ServiceNow’s IPO. While slightly lesser known back in 2012, Frank already had a great track record and now in hindsight is clearly one of best tech CEOs ever.
A company’s product can propel them into dominance of a niche, but the right leadership has the power to unlock an almost infinite amount of TAM.
Today ServiceNow has 37 products listed on their website. While ITSM is still their flagship product they certainly have gone beyond that and greatly expanded their TAM.
If companies are *really* great at something and they have a great management team, then a limited TAM will now slow them down.
Investors are implicitly saying they don’t trust management when they say that they don’t think the market is big enough. They don’t believe management can unlock additional TAM through adjacent opportunities or other additional opportunities.
In ServiceNow’s case, they were able to both 1) ride an enormous wave of ITSM via SaaS and 2) have the right management to unlock much more TAM.
Power of Revenue Growth Endurance
Underestimating both ServiceNow’s TAM and management team caused Kerrisdale to greatly underestimate ServiceNow’s revenue potential. At the time of the short seller report ServiceNow was doing $240M in revenue per year. Today it is nearly at $9B in annual revenue…
In the below table I show annual revenue, growth rate, and growth endurance.
Growth Endurance = current year growth rate / last year growth rate
The compounding affect of high growth endurance is extremely powerful.
Look what happens to ServiceNow’s revenue since 2012 if its growth endurance was lower (like most other companies).
Under the 70% growth endurance assumption ServiceNow would “only” have $1.4B in revenue today. At 80% it would be at nearly $4B in annual revenue which is still less than half of the $9B ServiceNow actually has today.
Over the past decade ServiceNow has scaled with an average growth endurance os 86%! There are not many companies in the world that have or will ever be able to grow with that level of sustained growth endurance. Growing at 23% at $9B in revenue is incredible.
A key to ServiceNow’s strong growth endurance has been its phenomenal gross retention rate (GRR) of 98%+ over the past many years.
ServiceNow Today
ServiceNow has had better stock performance than any other cloud company that has been public since 2012 — its stock price has gained 2,118% since November 2012. Over this same period of time the technology ETF QQQ gained 538%, which is better than 3 of the 8 below companies.
The short-seller report stated that ServiceNow’s $4.7B market capitalization was “absurd”…
Today ServiceNow is at an “absurd” $141B market cap! The 3rd highest among cloud companies. Their annual revenue is approaching $9B, nearly 2x the market cap that Kerrisdale thought was absurd.
ServiceNow generates some of the highest FCF margins at 28% on an LTM basis.
There are only two companies on an LTM basis that have a higher growth rate on this list (CrowdStrike and Palo Alto Networks). What’s interesting is both of these higher growth companies have an expected growth endurance of 75% next year while ServiceNow remains best-in-class at 95%.
The short-seller report said the following about ServiceNow:
Even if it beats guidance in Q4, sequential quarter-over-quarter growth will likely decline below 10% in 2013 and probably below 5% by 2014, which implies annual revenue growth of 20% to 30%.
Well….10 years later they were finally correct about the revenue growth range.
Takeaways
Small markets can turn into big ones. There is often power in dominating a specific niche that can then be expanded.
Great teams will continuously unlock TAM beyond what people think the current possibilities are.
Betting against a good company with strong leadership because it appears overvalued is often not a great idea. The stock may fall short-term but they will figure out a way to keep growing beyond what you expect.
The compounding affect of high-growth endurance is incredible.
Reading & Other Stuff
Why Warren Buffett would never short a stock — and you shouldn't either
This discussion reminds me of one of my favorite headlines predicting the downfall of Amazon…Jeff Bezos did OK though.
Really loved the concept of Growth Endurance here.
Good history lesson! Also a good review of the key factors that have driven NOW's performance, it's been one of my better performers.