DDOG - 5 Stages Of Profitability And Where The Current Opportunities Are

Summary

• We look at the 5 stages companies can be in when it comes to profitability.
• They range from 1 to 5, from losing money and needing extra capital to returning money to shareholders.
• While the first category is sold off for good reasons now, there are opportunities for long-term investors in categories 2 to 4.
• Moving from one stage to another often goes hand-in-hand with stock price moves.

Introduction

This article is about a subject that is quite important in these uncertain times in the stock market. It's about different stages of profitability for companies.

I will divide companies into five different classes according to how they're making money and that can help you think about the stocks in your portfolio. Here we go.

Stage 1: losing money, needing outside capital

The first class is for companies that don't make money and will need more money in the foreseeable future. That money can be raised through either a stock offering or debt issuing.

Right now, these companies are punished the hardest. Just think about so many of the former SPACs, for example, which were very unprofitable. Most still are very unprofitable today.

It's very normal these companies are punished so hard by the market because the cost of capital has gone up a lot. They have to pay much more interest on their debt. And as their stocks have gone down so much, issuing new shares is also not appreciated by the market. It's just much more difficult to raise money right now. It also reinforces itself: a company that issues more shares now is beaten down by the stock market immediately. These companies are in a very tough place and often in a downward spiral.

In this environment, I would absolutely avoid these types of companies.

An obvious example is Nikola. The stock lost 97% of its value from the top and with good reason. In the last 12 months, it lost $721.6 million if you look at net income.

Looking at free cash flow, we see a loss of $463.6 million

If you look at the cash and the current assets, you know that Nikola will have to raise money at very unfavorable terms.

Another example? AppHarvest ( APPH ). $242.9 million in negative free cash flow in the last 12 months and just $36 million left on the balance sheet.

Stage 2: Losing Money, but not needing additional capital

The second category is the category in which companies still lose money but will not have to raise capital. This category is filled with companies that have money left for several years. I would say three years or more. They have the time to focus more on profitability in the meantime, but at the same time, there should already be improvements.

For example, a company that is clearly in this category is Twilio ( TWLO ). Twilio loses money each quarter, but it has such a big cash position that it could go on for years and years losing money at the same rate. Let's look at the numbers.

As you can see, Twilio lost $319 million in free cash flow over the last year. If you subtract all the outstanding debt from the cash, equivalents and short-term investments, you can see that Twilio still has $3 billion left. At the current rate of burning money, it could go on for almost 10 years like this.

It's important to note that Twilio's management said it will be profitable on a non-GAAP basis next year, though. This clearly shows that you shouldn't expect Twilio to raise money.

This category is generally not really appreciated by the market right now and that's an understatement. It's often black-and-white thinking: profitable or not, without the details that make all the difference. If you listen to management and what they say, you should look at how reliable management has delivered in the past. That doesn't mean the last quarter, but as many years as possible. If management says the company will focus on profitability and be profitable the next year or the year after, your first reaction should be to look at the financials. If these show that the company could continue for many more years, this is a stage 2 company when it comes to profitability.

Stage 3: Self-funding

The third phase is self-funding and as the name suggests, it means a company that can fund its own operations and growth. Examples of this are CrowdStrike ( CRWD ) and Datadog ( DDOG ). They still grow their revenue at a fast rate, but they do it in a sustainable way. They generate satisfactory cash flows.

To me, free cash flow is the most important metric because the GAAP numbers don't say that much about money that can be used for growth. And that's the most important thing for those companies. If you look at these businesses, you see that on a GAAP basis, they are not or barely profitable. That often has to do with stock-based compensations, which are non-cash expenses.

The third category, just like the second one, is punished hard by the market right now. I totally understand the market's skepticism for the first category, I can even understand it to a certain extent in the second category, because you still have to believe management that they will turn profitable before they need to raise money. But for a company that makes money, like in this third category, I don't really think it's long-term thinking.

I think these companies can actually benefit from a recession. That may sound strange because their results will be influenced by a recession as well, but their competitors, which are not always financially strong will have worse results as well, and they could even go out of business. Even if they don't, they will have to cut back on marketing spending. That allows the financially strong businesses which are in the self-funding phase to grab more market share. I have no worries about companies in the third stage. They will prosper over the long term.

Stage 4: Profitable but not returning to shareholders yet

The fourth stage is for companies that make money, also on a GAAP basis, but they don't really return money to shareholders yet under the form of buybacks or dividends. The reason is that the companies still keep investing in growth and in the meantime, their balance sheet looks better and better.

There are different types of companies there in this category, some still grow a lot organically, but have to invest in R&D and marketing to keep up that growth. Others grow by making several small or sometimes bigger acquisitions.

Salesforce ( CRM ) has been in that category for a very long time, although it moved to the fifth category recently, by starting sizeable buyback programs. But before that, it made many acquisitions, often quite big ones. Think of Slack, for example.

You can also think of something like ServiceNow ( NOW ), which also sometimes makes smaller acquisitions.

The Trade Desk ( TTD ) doesn't acquire companies, but it developed UID 2.0 in-house and then gave it away to a non-profit. That must have been pretty expensive, but the company definitely benefits from the new standard that it set. The company has been profitable since 2013, although on a GAAP basis, profitability is still low as it keeps investing for growth.

Stage 5: profitable and returning cash to shareholders

The companies in this category are more mature. They are profitable and return capital to their shareholders. That can be in the form of a dividend or that can be in the form of share buybacks or a combination of both, of course. Often, they see no better use for their money to get internal returns that are as big as giving money to their shareholders.

Some investors are only interested in these types of companies, but that's just a preference. Personally, I prefer companies that grow faster than companies that have a dividend, which is taxed twice, once at the company level and once at the shareholder's level. But each situation is different and so is every investor. Your portfolio should reflect your personality.

A Stage Move Often Means A Stock Price Move

You'll see that when companies move from one stage to the next, there is often a change in their stock price as well, positive or negative. Those moves are sometimes short-lived but can also last for a few years.

If you are a Sea Limited ( SE ) shareholder, you will remember the big move up after the last earnings results. That's the market realizing Sea is not in the first stage, but in the second. The stock has not really fallen back to the level it was before.

That doesn't mean it can't happen. If the total market falls, Sea's stock will not be protected. The next earnings will also be important. Does Sea convince the market even more it's not in that first category? Then the stock price will probably rise again. If there's even a shred of doubt about that again, the stock will be punished.

When Cloudflare ( NET ), a company in stage 2, showed profitability in its Q2 quarter, the stock shot up.

Of course, there are often other factors at play: the whole market, risk appetite, guidance etc. But this is one of the elements that play a role too.

You also see it the other way around, if you move from the fourth stage to the fifth. Very often the stock is punished by the market. Think of Apple ( AAPL ), for example. Apple started buying back shares in 2012 and installed a dividend program. Growth investors moved away from Apple. It often takes a few years before other types of investors start to get interested. Think of quality investors or even value investors. Warren Buffett was a buyer in that middle period during which Apple had to transition from the fourth to the fifth stage.

Looking back, Apple traded at a PE of 12 and sometimes even lower. This is from the announcement of the dividend and the buybacks until Warren Buffett bought his first Apple shares in Q1 of 2016.

As you can see, it underperformed the indexes quite a bit over those 4 years.

And this is Apple's PE ratio since then. As you can see, the PE ratio is almost always more than double that of the previous period, both at the top and bottom of the range.

This is typical behavior for stocks moving from phase 4 to phase 5. And it can really test your patience.

As I wrote, Salesforce has repurchased significant chunks of stock now and it will continue to return capital to shareholders. But don't expect this to boost the stock price anytime soon. It will take time before it gets appreciated more. That's why I don't add to my Salesforce position too quickly. Just nibbling every now and then, one or two shares at a time. I'm still bullish for Salesforce over the long term and I think it's a great company, but I have seen this picture before. It still could go down more before other types of investors start to get interested.

Conclusion

I hope you found this article helpful in thinking about your own investments. Companies can be in different stages when it comes to profitability. If they are in the first stage, they are very dependent on interest rates and it will be much more difficult to get access to capital now. That makes them very speculative now. The market recognized this very early and sold them off months before interest rates started rising.

Companies in stage 2 are still losing money, but their balance sheet is so solid that they won't need extra capital for years to come. Many of these are also focussing more on profitability now. But the market still treats them as if they are in stage 1. If there would be a deep and very long recession, these companies could still have trouble, but with a mild or moderate one, they should be able to survive and thrive.

For stage 3, companies earning enough money to fund their growth and other initiatives, the market is also not that forgiving in the current context, but I think this is temporary and these companies are now often great buys for the long term.

Even stage 4 companies, which are profitable already, but don't return money to investors yet because they first want to keep growing, are now treated as if they are money-losing companies. This market is all about 'show me the money and show it to me now.' Again, for long-term investors, there are opportunities in the stocks of companies at this stage.

The only stocks that are not totally sold off right now are stocks in stage 5, which return money to shareholders already. These feel much safer now, but if you are a long-term investor, I think buying stocks from category 2 to 4 will probably yield better results over the long term.

In the meantime, keep growing!

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