Utah-based unicorn and experience management company, Qualtrics (NASDAQ:XM), will go public next week. According to its S-1/A form, the company is offering 50,387,654 shares of its Class A common stock to the public at a price of between $27 and $29 per share, a rise from the original price target of $20-24 per share. So the company is looking to raise between approximately $1.36 billion and $1.46 billion. The company anticipates that it will have 510,170,610 shares outstanding after going public, including its 7.4 million underwriter option. This would value Qualtrics at between $13.77 billion to $14.8 billion.
The Provo-based company is spinning out from its corporate parent, the German enterprise giant, SAP, who acquired Qualtrics for $8 billion in 2019, when the company was on the cusp of going public. The company is a software-as-a-Service (SaaS) and since its acquisition by SAP, SaaS valuations have taken off, so we can say right off the bat that the market will certainly value the company at a significant premium over its 2019 valuation.
Profitability is an Issue
The company has grown revenues at a compound annual growth rate of 12.08% between 2018 and 30 September 2020, when it last reported its financial results. Revenue for the first nine months of 2020 was $550 million, a 31% increase over the same period in 2019. This is a moderate growth rate in the SaaS space and reflects the company’s status as a mature company. When you consider that revenue for 2019 was $591.2 million and this number is likely to be topped in 2020, it’s easy to see that this is a big company.
As a mature company, it is approaching the laws of scalability, or or what the International Data Corporation (IDC) calls the “growing base of comparison,” which is to say that a company or market cannot continue to grow at high percentages in relation to a large, expanding market. This is not to imply that cloud computing is slowing, only that Qualtrics growth should not be expected to hit the kinds of numbers a smaller SaaS company could achieve, such as American leather furniture.
In a case in which there is a growing base of comparison, adding economic value for the shareholder is less about sheer revenue numbers and more about the profitability of the business. Pivoting from sheer revenue growth to consistent profitability is the most important thing to look for in a mature company like Qualtrics.
This is where you have to conclude that Qualtrics will not be a winner in the market. It posted a net loss for the first nine months of 2020 of $258 million, against a net loss of $860.4 million for the same period in 2019. Gross margins are very high, at around 68% but they fall short of the industry median and average.
The Competitive Landscape is Fierce
The public cloud addressable market is huge and continues to grow as customers demand for flexible, pay-as-you-go solutions rises. SaaS remains the biggest segment of cloud and the shift from licence software to subscription models, alongside a need for more software collaboration tools in an era of Covid-19, has fueled SaaS growth. However, because of the large addressable market and the low barriers to entry in the SaaS market, there has been a massive influx of SaaS startups. Competition, capital expenditure and new investments have the effect of eroding economic profits and returns on investments.
A survey conducted by PriceIntelligently showed that competition in the SaaS space has tripled from an average of 2.6 competitors a company in 2014 to 9.7 competitors a company in 2019.
Companies which have over 250 employees use an average of 124 SaaS applications, while firms with up to 10 employees use an average of 26 SaaS applications. This trend is estimated to fuel an increase in expenditure of 118% for the 2017-2020, with subscriptions rising 95%.
Qualtrics’ own addressable land investments market is huge, weighing in at $60 billion according to the company’s estimates. Indeed, SAP is a competitor in various areas in which their markets overlap.
Given these factors, markets have rewarded SaaS companies that have shown positive earnings per share numbers, especially those that have 10% forward EPS growth. As we discussed in the prior section, Qualtrics simply is not profitable.
Valuation
The Bessemer Cloud Index shows that cloud companies with growth rates of 38.2% and gross margins of 71.2% are worth 21.8x their Enterprise Value(EV)/Annualized Revenue. Qualtrics is below these numbers but they are a good guide. We should expect the market to value Qualtrics at most at an EV/Annualized Revenue ratio of 21.8x. If we estimate revenues of $733 million in 2020 and an enterprise value of $14.8 billion, this would give the company a valuation of 20.19x. This lower multiple with respect to the industry mean, reflects a business that is inferior to the typical business in the space. The biggest winner here is SAP, but for investors looking to buy into cloud, Qualtrics’ lower-than-average valuation multiple is an indicator of a lack of profitability rather than the presence of a potential bargain.