The increasing prevalence of cloud-based work solutions for file storage, web meetings, organization, email marketing, web design and more predates COVID-19. However, the global shift to remote work necessitated by the pandemic has introduced new questions around the physical vs. digital workplace and the viability of fully-remote collaboration. According to a Gallup poll from May 2020, 70% of American workers were working from home due to coronavirus concerns and 50% of this group said they preferred the remote environment and were more productive on a daily basis.
The future of the office model remains unclear, but recent trends certainly portend growth for cloud-based software companies like DropBox and GoDaddy. This week, we sat down with Chase Chandler, the Founder/PM of Canterbury Tollgate to discuss his GDDY and DBX positions and his perspective on the remote work landscape at large. Chandler has been a member of SumZero's Cap Intro community since early March 2020 and published several theses on his software and cybersecurity investments.
Canterbury Tollgate espouses a "philosopher-investor" mentality in an attempt to resist the cognitive biases that breed dislocations and applies an iterative investment checklist to determine: 1) sustainable growth, 2) quality management, and 3) valuation.
Avery Pagan, SumZero: Chase, thanks for making the time to speak with us. We usually like to frame these conversations with a brief background on your investing career and currently managed strategies. Can you provide some color on your professional experience and Canterbury Tollgate’s approach to investing?
Chase Chandler, Canterbury Tollgate: I started in capital markets in 2007. I presume I don’t have to explain what that was like to SumZero patrons. I didn’t have much responsibility, but I experienced firsthand the despair and the problematic aftermath. In 2012, after about five years working as an advisor, I struck out on my own with all the wisdom a 26-year old could have. Mistakes were inevitable. We were very good at wealth management and strategy, not so much at operating a business. We grew rapidly without knowing how to build a world-class infrastructure to support it. Through the 2010s, my capital allocation skills improved but much of my time was still spent dealing with the day-to-day aspects of running a business. In 2017 we merged with a Chicago-based investment and financial advisory shop focused on UHNW clients, where I worked as co-CIO for one year. I launched Canterbury Tollgate in late-2018 with the goal of being a lean and effective investment manager.
Beginning my career in the Great Financial Crisis probably caused me to be overly cautious on the investing front early on. I wasn’t afraid to make mistakes, sometimes out of ignorance. Some blunders turn out to be the best teacher. I did what many aspiring value investors do in buying cheap-looking companies. I learned the hard way that sometimes what looks expensive isn’t and what looks cheap is in fact worthless.
We are philosopher-investors. We spend a lot of time on the fundamentals—working to figure out how things work and what drives outcomes. This leads to a deeper sense for discrepancies between widely accepted narratives and reality. Or, not infrequently, simply realizing that lots of conventional wisdom is true most of the time. For instance, markets are often efficient and price movements are almost always random in the short-term. This does not imply randomness equals efficiency. We can simultaneously believe a security is undervalued and short-term price changes will be random. But it would not hold to say we believe the security is both undervalued and priced correctly.
I spend a good amount of time reading and trying to understand varying views. There will always be opportunity for those who do this because, for whatever reason, most people associate “being smart” with having answers and certainty. My general rule is - if I can’t compellingly argue both sides of an issue, I don’t understand that issue. People also tend to slide into what those around them are doing and thinking, which is a well-known phenomenon. However, while this is understood intellectually, I think people underestimate its pervasiveness. Peter Thiel has two sayings useful to what we do: (1) If 75% of people believe something, it’s probably true. If 99% of people believe something there’s something wrong. (2) We need to steelman, not strawman, opposing arguments if we want to learn. Building strawmen only serves to keep us away from the truth. Kathryn Schultz’s book “Being Wrong” also centers on this. Anyone who wants to face reality should have a strong desire to find as many insightful and intelligent opposing views and ways of thinking.
AP: Great, that’s helpful context. Based on your research published on SumZero, it looks like you’ve been focusing on the B2B software and cybersecurity space for some time now. What draws you to the sector?
CC: I didn’t start out as a tech investor, nor with the goal of investing in software firms. I simply learned over time how value is created. That has a lot to do with the ability to grow and generate free cash flow. Software turned out to be a business I can understand.
It seems there’s still a lingering focus among many value investors on EPS and EBITDA. I suppose this stems from the notion that book value growth is paramount. BV growth is still important, and more relevant in some industries than others, but there a lot of judgement that goes into GAAP accounting (e.g. revenue recognition, amortization periods, goodwill, and impairments). What really matters is durability of cash flows, particularly in businesses with lower fixed assets needs. Hence, a company like Amazon can be overlooked for many years because so many are focused on earnings over cash generation.
Management is, I would say, the only thing that matters more than cash flow. How do they treat employees and customers? Are their interests aligned with shareholders? What drives the compensation system? Who makes investment decisions and how? Bad management in a decent business is like a 16-year old in a Ferrari. Every day without a wreck makes the impending doom that much worse. My job is to find the durable businesses with great management teams and buy at a good price. The most durable businesses are those who can consistently reinvest at high returns on capital. Certain recurring revenue software and cloud businesses have these characteristics. Then it is a matter of avoiding firms that (a) look promising but are overpriced and/or (b) appear fairly priced but have unsustainable returns.
AP: Do you view COVID-19 as a net-positive for some of your primary holdings such Dropbox and GoDaddy, given the immediate need for digital workplace solutions? Do you envision a permanent shift to remote office arrangements?
CC: Recent conditions have certainly benefited both Dropbox and GoDaddy, which is something investors have woken up to in the past month or two. They both came into this year with (what I would submit were) very attractive valuations. They are even more undervalued in this environment.
I don’t know how sticky the shift to remote work will be. My sense is, and what I think we should be asking is, have the efficiencies of cloud-based collaboration, web meetings, and the like been established? I think the answer is yes. For Dropbox, engagement is up dramatically since launching “New Dropbox” and has picked up steam in recent months. Anyone that hasn’t tried it should. It makes life much easier.
AP: Let’s dig into GoDaddy first. In your report on SumZero, you cite new leadership and GDDY’s symbiotic alignment with major tech companies like Microsoft as key catalysts. Can you elaborate on the combined effect of these factors?
CC: GoDaddy acts as a vendor for Office 365, which makes their platform a turnkey solution for essential online business services (i.e. domain, website, email). Their domain and hosting customers are incredibly sticky, and these are add-on services they had never really penetrated. The power is not in having Office 365, email archiving, website building services as standalone offerings. The power is in the combination and the value provided to the end user.
As they’ve rolled out these add-ons—no/low-code web design, email marketing services, and Office 365—they appear to be shortening contract periods getting customers in the door. Deferred revenue has been declining as a percent of total revenue, but retention is still very high. I believe they will continue providing that value to customers profitably, and as customers become more ingrained, pricing power improves. I’m not sure how many market participants understand the hassle for SMBs to switch websites, email service providers, or organization/collaboration systems. Inertia is a powerful force once companies get on a certain platform.
AP: How has Aman Bhutani already started revitalizing GoDaddy’s image and what can we expect from his tenure as CEO?
CC: First, as I stated in the SumZero report, this guy did not have a straight-forward path to CEO of a major U.S. company. Management likely being the most important factor, when you have a company with a non-founder CEO and/or low insider ownership, in my mind, there’s a higher bar to show aligned interests and management’s ability. Bhutani has had to be a world-class operator to get where he is. (This is the “butcher test” from Nassim Taleb.) Within a year of starting his team has rebranded and has gotten the word out that they are a best-in-class platform for entrepreneurs and business owners and operators.
I must say before I go further, I have a pre-determined checklist of violations that make me re-think or exit an investment. GoDaddy violated one of those items in the most recent quarter by changing the measuring stick — they didn’t disclose total users and ARPU for the first time. This is the first strike and they seem to be clicking on all cylinders, so I’m giving them leeway for now. From what I can tell, their users grew slightly but ARPU expanded quite a bit. I hope management realizes very quickly that long-term investors will trust them far more if they “tell it like it is.” Give us reality. Playing games is not a good sign, especially when theirs is a perfectly understandable reason as to why customer count might have recently taken a hit.
AP: It sounds like the business model is evolving in some critical ways toward longer-tail customer engagements like web design and email connectivity. How has your hypothesis already started to play out in GDDY’s reported fundamentals?
CC: The company has ramped up it’s “business applications” segment, which is more of a SaaS model than their traditional business of selling domain names and then having customers renew. This is a business where we were a customer first, having switched over to their email system from another provider. It’s the most intuitive system I’ve seen.
This is a natural extension of what GoDaddy was already doing. You’ve already got the customer coming to your site at least once a year to renew a domain, a large portion of which have more than one. Why not add value by keeping their email and potentially website backend in one place? Business applications are already proving to be an incrementally higher margin business because GoDaddy already has the infrastructure in place to handle exactly this type of business. Revenue growth was stable at +11.5% year-over-year in Q1 even with COVID-19 and we’re seeing traffic pick up significantly since about early April.
AP: Does GoDaddy face competition from other “web design in a box” platforms like SquareSpace and WordPress? Where does GoDaddy beat them out?
CC: GoDaddy is a supporting platform for WordPress users, not necessarily a direct competitor. The more established players in no/low code web design are Wix and Shopify. Both are going after fundamentally different markets—Wix: design-oriented businesses like photographers and artists; Shopify: e-commerce. There are some valid questions about Shopify’s model and how many users are sustainable, but so far the market has given them the benefit of the doubt. GoDaddy, on the other hand, has an established customer base who needs a professional web presence, but not all the bells and whistles Wix and Shopify provide. GoDaddy is also more affordable at $20/mo for their premium service which includes more pragmatic add-ons than the others (e.g. 25,000 emails per month). And this is coming from someone who previously owned and has been a Wix customer since 2012. That’s not a contradiction, it’s inertia.
AP: What makes investors undervalue companies like GoDaddy and Dropbox?
CC: I’d quote William Hazlitt, “Though familiarity may not breed contempt, it takes off the edge of admiration.” There’s a tendency in boom times for the novel to become more popular. Various narratives become linchpins, often having to do with large addressable markets. So today we see newer SaaS firms with negative cash flow priced at 20-30x EV/sales. Meanwhile Dropbox and GoDaddy are trading at ~4.6x EV/sales. I understand negative non-cash earnings, but negative free cash flow means they are reliant on capital markets to finance that growth. Just because Netflix might have pulled it off doesn’t mean all the others will.
Let’s say Wix, a profitable company trading at 12.1x FY2020 sales of $1b, grows revenues at 20% p.a. for the next three years. That’s puts them at $1.7b in FY2023. Now assume GoDaddy, trading at 4.6x FY20 sales of $3.24b, grows at 10% p.a. to FY23 sales of $4.3b. If we say they’ll each have similar growth beyond 2023 but there will still be a multiple discrepancy of 7.5x for Wix and 4.5x for GoDaddy, what’s the outcome? Wix goes from an EV of $11.6 billion today to $13.6 billion in 2023, a 17.2% increase. GoDaddy, from $14.8 billion to $19.4 billion, or a 31% increase.
Similarly, take Hubspot and Dropbox. The former trading at 11x sales, assume they grow by 20% p.a. to $1.39b in 2023. Say Dropbox grows at 12% p.a. to $2.66b. If we assume a 2023 EV/sales multiple of 7.5x for Hubspot and 4.5x for Dropbox, EV rises by 17.2% and 38.6% respectively. This thought experiment turns out to be far more egregious for firms trading at 30-40x sales.
AP: What do most analysts underestimate about Dropbox’s staying power?
CC: Analysts have been fairly bullish on Dropbox. Before COVID-19, most market participants were not. I think they were underestimating (1) the value of Dropbox’s core professional users, (2) the future value of the free users, and (3) the fact that DBX is a founder-led company.
Re: point one, the company has a core group of professional, technologically savvy users who run their workflows through Dropbox—for collaboration, storage, content sharing and public previewing, to name a few. For all of these use cases, there really isn’t anyone out there (other than potentially Box in a very specific use case) who has come anywhere close to the user friendly, practical applications with full content control and consistent syncing. These are customers in multiple industries who, barring some major change, will never let it go. That was part of what initially attracted me to them as an investment. These people would pay much more and think Dropbox is a steal. It is a minority, if I had to guess I’d say less than 1/5th of paid users. So the company needs to grow that segment. On point two, there is great value in currently free users. Dropbox just needs to figure out how to best convert them. And finally, on the third point, Drew Houston is a talented leader and is improving as a public company CEO. Sure, there are still some areas where he and management need to improve. They need to talk to shareholders more. They need to figure out how to get the word out in addition to building a great product. But on the whole, there just aren’t a lot of founder-led companies with this type of profitable model.
AP: How is Dropbox similarly aligning itself with major tech/communication companies like Google and Slack?
CC: Drew Houston’s vision is for Dropbox to be the OS of the cloud. That means just about everything one would need would run through Dropbox. Aside from email, that framework is already up and running. To name a few: Salesforce, Google, Zoom, Slack, Autodesk, DocuSign and HelloSign, Facebook’s new “workplace” application, Ring Central. They all have existing integrations, many of which can be launched or managed from Dropbox’s desktop application. Specifically Zoom, Slack, and HelloSign are ostensibly getting higher user engagement.
AP:Many small and medium enterprises (SMEs) are setting up digital marketplaces, data rooms, and shared drives for the first time in this new environment. How are GDDY and DBX managing through the crisis and making their offering accessible to those with little to no digital integration?
CC: Given the ease of Dropbox’s system, I’d bet many basic paid users have been added recently. Anecdotally, I’d say many start-ups are more digitally savvy and are Dropbox users. From what the company has said on analyst conferences, they are very focused on transitioning mid-size and larger enterprises to the platform, which seems to be going well.
AP: What other names does Canterbury Tollgate hold and where are you seeing opportunity in the markets these days?
CC: Our ten largest holdings at the end of May were Amazon, Facebook, Dropbox, GoDaddy, AbbVie, CyberArk, Verizon, Etsy, CVS, and Comcast. We’re seeing opportunity in some smaller, lesser followed names. In many cases, the “baby’s been thrown out with the bath water.” I can’t comment too much at this point, but I think there is opportunity in the small and micro-cap space.