“Because you have to wonder: how do the machines know what Tasty Wheat tasted like? Maybe they got it wrong. Maybe what I think Tasty Wheat tasted like actually tasted like oatmeal, or tuna fish. That makes you wonder about a lot of things. You take chicken, for example: maybe they couldn't figure out what to make chicken taste like, which is why chicken tastes like everything.”
-The Matrix (1999)
Innovation often comes in the form of new technology that makes our lives easier thanks to more or faster functionality, or both. One of the earliest software systems was created in 1960 by IBM and American Airlines. It was a reservations system called Sabre.
Before Sabre, a client would call the airline, tell an agent their date of travel and destination, at which point the agent would hang up and go to a big board in the agent’s locality trying to find a seat traveling out of the local hub. The agent would next call the arrival hub and ask one of their agents to try to continue the ticket, and so on, until the origination point had been connected to the destination point and a ticket was issued.
But if one of the interconnecting hub agents failed to find a leg of the journey, the original agent would have to go back to the big board and start all over again (AA employed reservations agents who worked in that system until not that long ago!). Sabre, a software-based global distribution system (GDS) with all its attendant quirks and difficulties, was a breath of fresh air for airline ticket agents and a welcome innovation by comparison to the older system.
Today, Sabre is still the underlying system for AA, with new software and systems written on top of that core. But as anyone who has called AA in 2022 to change a ticket can share, Sabre no longer vibes as cutting-edge innovation.
Back to the Technology Grind…
We spent some time this summer on database stocks. A database is the logic structure your app uses to store the 1’s and 0’s of data generated. The database organizes and keeps data to make it available for later use. Oracle (NYSE: ORCL, $211B cap) is the biggest and most successful database company in the world. Its core product organizes data into columns and rows, not unlike Microsoft XLS on steroids. A more recent industry hero such as MongoDB (NASD: MDB, $26B cap), by contrast, uses an architecture that is much more like Microsoft Word (these oversimplifications are not entirely unfair).
If your reaction is like mine, you have just sat back in your seat wondering; is that it? Is that all it takes to ‘innovate’ and make billions in enterprise software? Copy the architecture of some older system and make modifications!?! (Except, in this case, Oracle predates XLS.) Like shooting fish in a barrel, maybe.
And if you didn’t know, Salesforce’s famous and giant Sales Cloud (NYSE: CRM, $190B cap) is basically a hanging spreadsheet in the cloud. Smartsheet (NYSE: SMAR, $5B cap) is similar, only built for more generic usage with more ability to customize. If everything is based on the concept of a spreadsheet, how did the creators of the spreadsheet know what to make?
The whole state of large cap enterprise software doesn’t exactly ring in as splitting the atom. ServiceNow is a system for ticketing. Enter needs on one side, produce digital ticket on the other, and track progress. It is sold as Digital Transformation but it can only be considered that for boomers like me as the software is used mainly as a wrapper around normal work (BTW the cool kids have moved on to DevOps.) If this makes you think you should have started a software company any time between 2001 and 2012, you might be right.
YOUR MOTHER SAYS YOU HAVE TO DIGITALLY TRANSFORM BEFORE YOU CAN GO OUT WITH YOUR FRIENDS
Starting about a decade ago, op-eds appeared in famous news outlets warning regular companies that the speed and agility of the emerging digital natives such as Amazon and Facebook and Google or Uber, meant that digital natives would disrupt regular businesses. Like Pac-Man eating Ghosts.
A decade of gradually rising investment in digital transformation ensued (due to the readiness of Moore’s Law, not due to the exhortations of opinionistas like me) and the sector benefited with revenue acceleration and rising valuations. Soon, a sector that was mostly buried in the back office and part offshored to cheaper locations after the last bubble, one that shied from limelight and cloaked itself in abstruse acronyms and dusty jokes, became sexy. Young entrepreneurs made big bucks. VCs flooded the playing field. Hedge Funds climbed over the public to private wall and got in on the action, inflating valuations. Everyone was having fun.
By 2021 I caught myself out loud wondering, why do so many people care about the architecture of automation? It was a topping signal. People cared because it was sexy, and there was money to be made.
Fast forward one year and the software world is like a boxer after a bad round. Growth rates have slowed but are still elevated compared to the last decade. Companies started discussing pockets of weakness on 2Q earnings calls. Multiples have fallen more than in half. As an analyst watching this happen, it does seem as if companies are walking softly hoping not to wake the Bear or be swallowed in their canoe by a lurking great white. No company will be immune.
Most have accepted that growth will slow. The hard reset on valuations has forced them to accept that reality. But companies will also stop waiting for problems and pivot from defense to offense. Acquisitions and larger refinancings, perhaps even dilutive equity raises are going to appear.
One of the stubborn realities of the software world today is that the global 6K companies dominate revenue and billings for most of the industry. Even companies built to support ‘the little guy’ such as Cloudflare (NYSE: NET, $26B cap) are now more than 60% driven by $100K+ customers on a quarterly basis. And, to match this reality, SaaS companies spend anywhere from 30-70% of revenue to create a go-to-market to land this large market TAM and expand within it. At an industry level, much of the go-to-market efforts are duplicative. Sure, great customer success teams champion specific software solutions. And topnotch marketing teams create just the right roadmap to attract and retain large customers. But that still leaves a lot of repeat marketing and selling programs.
The software industry has not acquired for efficiency in a long time. I am dubious on the impact of such acquisitions to growth rates. But done right, efficiency-oriented acquisitions could be good for cash generation.
Beyond that, you still must believe that vendor innovation will drive customer investment. But…does it have to be another iteration of the spreadsheet? Maybe it’s time to move beyond the narrow constraints of two-dimensional enterprise technology and into a future driven by real innovation.
Immediate-term Risk Range™ Signal with @Hedgeye TREND signal in brackets:
UST 10yr Yield 2.66-2.94% (bearish)
UST 2yr Yield 3.01-3.37% (bullish)
High Yield (HYG) 76.23-79.15 (bearish)
SPX 4013-4311 (bearish)
NASDAQ 11,890-13,169 (bearish)
RUT 1 (bearish)
Tech (XLK) 137-152 (bearish)
Utilities (XLU) 72.25-77.60 (bullish)
VIX 19.03-23.99 (bullish)
USD 104.79-107.41 (bullish)
Have a great day out there,
Ami Joseph
Managing Director, Technology Sector Head
