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  • Writer's pictureTarpon US Equities

Software – June 12, 2020

Updated: Apr 13, 2021

I will jump through the commonsense introduction that software is eating the world,growing immensely, and transforming society. This is all obvious and investors overlooking software firms are likely out of sync with reality (unless they operate well in some rare, unaffected niche). Also, this is not news; rather, software companies have been around for decades, enabling investors who dedicate the time to study many companies and their stories, as well as the basic of computing and software development, to try to master the business dynamics of this sector.

Over the last ten months or so I have been dedicating most of my time to study software firms (mostly B2B ones ) – that has been helped and incentivized by Zeca, who helps me think through all I am writing here. When it works, software is a terrific business model, with durable cash flows derived from high switching costs and extremely high gross margins (80% plus). Getting to this sunny place though is hard. We hear about the success stories, but the graveyard if full of well funded startups and even companies who achieved certain scale just to become irrelevant as others leapfrogged them.

A software company usually begins by trying to do something an already established peer does, just with a newer code, more user - friendly experience, easier implementation process, and a cheaper price. With the industry’s great economics, there is a never - ending wave of startups coming up with such sort of new products. They begin with the simplest versions, targeting SMBs, try to build revenue so that further investments in R&D can lead to larger clients, which brings more revenue and so forth, until, at some point they start to invest big time in an internal salesforce to go after large enterprise clients, usually the ultimate desire for most software vendors, as these clients are very sticky and pay huge bills. I have seen companies lose their pace in all types of phases; it is not easy.

When Salesforce came up with its Cloud CRM, it followed exactly the playbook above. Its

innovation was on selling software through the cloud, without an expensive upfront license

fee, making adoption much easier as clients committed only to a monthly or annual subscription that can be cancelled anytime. Hence, we can say that Salesforce hugely accelerated growth in the industry; nonetheless it also made any incumbent’s position more vulnerable. Today, for instance, Salesforce is, in my view, an incumbent challenged by many

up - and - comers, such as Zendesk, HubSpot and Intercom. That doesn’t mean it is under imminent threat, to the contrary, it is still growing double digits and enjoying a very entrenched position with large enterprises, but the multiple it trades is already very different from that of the newer guys.

Oftentimes, however, the transition from “beautiful growth story” to “having your lunch being eaten by the other guy” is quite fast (years rather than decades), rendering the attacked company almost worthless as it succumbs before reaching a level like that of Salesforce. An example that comes to mind is DropBox, which saw its product be easily copied and had no moat to rely on. Another one is New Relic, which is not doing bad, but has seen its position of darling of its sub - sector taken away by newer firms, like Datadog. In other words, absent a clear moat, I do have trouble investing in a software

firm, even when it has lots of momentum.

One thing that amazes most people when you first show them the P&L of a software compa

ny is how much goes towards sales and marketing as opposed to R&D. I would say most such firms spend at least twice as much on selling than on developing. I do not believe one creates a great product or moat by throwing millions on salespeople. As Atlassian’s co- CEO says, “good software is bought, not sold”.

Looking at all of that, as capital allocators, we must ask: how do we pick the best software companies? The ones that are most likely to be much larger and generating huge free cash flows ten years from now?

Obviously, it all begins with a great product, about which we can learn through customer reviews, Gartner reports, customer retention and revenue growth. A strong management team, preferably founder - led also helps. But that is not enough for me. I want a good moat, and technology alone is, in most cases, not enough. As I studied the sector, I found the strongest moats in two sources, which usually come together: (1) a product that becomes standard across a use case, leading professionals all over the world to evangelize it – think about Microsoft Excel; and (2) a mass market distribution system that leads to economies of scale – hiring people to go beat on clients’ doors won’t build moats, but creating a brand to which customers flock just by share of mind, or by “taking my ass of the wall” kind of decisions does.

Fortunately, I have been able to identify a few software companies that fit the bill. In two of

them we are already shareholders, Intuit and WIX. GoDaddy, in parts of its business can also enter the fray. The same is true for Amazon, as AWS increasingly develops software to bundle with cloud infrastructure. I have written at length about the moats of thesecompanies, but in the context here it is worth highlighting their great products as well, with WIX being the clear leader in website building tools, now migrating to serve more demanding developer clients, with a low - code feature that may unlock a large market, and Intuit having done a very successful transition to the cloud, which now gives it a huge potential to explore customer data to not only constantly improve the core QuickBooks product, but also launch add ons and transform itself into a broader platform connecting clients to lending partners, for example. Below I list some other businesses that rank high in my wish list (no specific order). But before I do so, one final thought: given that most software firms already trade at high valuations to begin with, why bother trying to pay a little less for the ones less likely to succeed ten years from now? The game here lies much more on picking the right businesses than the cheapest ones.


Founded in 2002 by a pair of Australians who still manage and control most of the company,

Atlassian owns Jira and Confluence, two products that are often used together and enable teams to work more effectively. Jira has been adopted so widely amid software developers worldwide that it is an almost indispensable tool in the field. Developers use it to coordinate work and all they do is recorded within Jira, making it very sticky. At a price point of $7/user/mo, Jira is likely underpriced, although most users buy it alongside Confluence (for documentation), which comes for another seven bucks; anyway $14 is still a low price given the criticality of the product. Jira sells itself, making Atlassian a business that can still grow north of 30% annually, spend twice as much on R&D than in sales and generate free cash

flow margins above 20%.

Within Jira+Confluence there seems to be a good runway for growth and pricing as software development grows worldwide and more clients transition to the cloud (35% of revenues still on premise today, at a lower ARPU).

Currently, Jira likely has about 9M developers as users, compared to 25M developers worldwide. Moreover, total users are likely close to 15M already, with many being non

developers who increasingly must work together with developers to get things done in all sorts of businesses. Apart from that, a newer product, Jira Service Desk, is growing extremely fastby solving the same issues within the IT department – this is another huge market, largely un-penetrated (especially in mid-market companies where Atlassian thrives)

and with much higher priced competitors.

With revenues going to $ 2B and FCF nearing 500M, Atlassian is already worth 45B, but it has all the ingredients to be a 100B plus company down the road.


Another one from Australia, Xero can be easily defined as that country’s QuickBooks, but

natively created on the cloud, with an untapped potential for new features and cross sell.

The company has a highly effective go to market strategy through accountants that have learned to rely on it to serve their SMB customers and a strong brand. It has been able to replicate this success in the UK and is trying to crack the US market, which would be huge given that cloud accounting penetration there is still low despite QB’ success.


Twilio has created a set of APIs for developers to embed communication features into their

apps. The company was the pioneer in this field not many years ago, bringing software to the telco industry and creating a seamless way for developers to create apps that work globally. Twilio has become the standard amid developers. Like Atlassian it enters clients through word of mouth. The company invests tons of money in R&D, much more than any peer is led by a visionary founder and growing faster than 35%.


This one I have been admiring for a long time. It is the WIX for e-commerce, only better in terms of market dominance and TAM. Recent growth amid larger and larger clients and prices much below competitors’ give it a long runway. Tobi, the founder is perhaps the best amid his generation. He mastered two key points: low prices and great product to make his software the global dominant one, and the platform transformation of his company, in which thousands of app developers make his core product better and better, a great flywheel.


Probably the best software company ever, Microsoft has made a tremendously successful

pivot to the cloud over the last five years, making its core products even more widely adopted and better monetized. Excel, Word, Outlook, and Windows have moats from being standards, simple like that. Not even Google was able to jump through this moat. Moreover, MSFT has become one of the top two cloud infrastructure providers, a business with enormous scale advantages that by itself is already worth north of $500B. Given the relied-upon incumbent position MSFT has with companies of all sizes worldwide, MSFT has a one-of-a-kind go to market approach by bundling many services and owning so much

indispensable parts of the software stack a typical client needs that not only makes it a very tough competitor to beat, but also leads to high margins.


Just like Atlassian and Twilio in their fields, Adobe enjoys a standard moat position amid creators (photos, videos, marketing campaigns, etc) in an even bigger market, whose growth will only accelerate as our lives turn more digital. Designers learn Adobe while in college, which is amazing. Adobe also sells itself in this market, with a cloud-based offer for$53/month for all-you-can-eat that seems quite ok for an essential tool (the price is obviously cheaper per user for large clients). The company also owns PDF, which seems an under monetized asset, with huge potential as documents shift from paper to digital.

As if those two were not enough, Adobe is the top provider of Marketing software tools to large corporations worldwide, a business with not so great economics, but with a good deal of synergies with its core Creative Cloud segment. At ~13B in annual revenue, Adobe is still

growing almost 20% annually, with a 5B plus FCF and equity dilution below 1% for stock -

based compensation. The market cap of ~200B seems reasonable in that light. The company’s founders are on the board; and management has been remarkably successful and tends to allocate most FCF towards buybacks.


Just like designers learn to use Adobe’s Creative tools in college, engineers and architects all

over the world master AutoCAD before graduation. AutoCAD had historically been licensed for high upfront sums, leading most users to be “non-compliant”. Over the last years,though, Autodesk, the owner of AutoCAD, has successfully transitioned to a subscription model, making the product more accessible and slowly converting users to pay and benefit from the latest upgrades. This process still has a long runway, as the company claims to have at least twice as many non-compliant users as paying ones, which number about 5M. Continued improvements to the product, along with features for mobile devices should bring more and more people to subscribe.

Autodesk has also expanded within the construction industry with a suite of software products for everything from planning to execution. This industry’s digitalization seems to be on its early days, hinting at a good growth potential. Meanwhile, Autodesk’smanagement has been delivering on its financial goals, generating about 1.3B in free cash flow last fiscal year and aiming at 2.4B for FY ending on Jan/ 2023, which would render its 48B market cap sensible. This is the latest company added to our list and we still have some work to do though.


Amid a handful of SaaS providers to HR and payroll solutions I have been following, Paycom sets itself apart with a clearly superior combination of growth and margins (lower sales opex). In terms of moats this business is not in the same league as the prior ones, but the competitive environment is interesting with many mid- market companies that Paycom targets still using legacy solutions. In fact, legacy, decades old players in the field, such as ADP and Paychex, still grow mid-single digits and deliver margins close to 30%.

The company was founded in 1998 in Oklahoma, is still based there and led by the founder .


The smallest and “most niche” one here, AppFolio develops ERP software for managers of residential real estate assets. This industry also has incumbent players who mostly cater to the largest clients. Appfolio is coming for them from the bottom, growing revenues above 30% to surpass 300M shortly, with low sales costs. I see some moat in this company given that it is such a niche industry and that non-technical people working on it tend to learn and adopt one software solution. AppFolio’s newer, cloud native product seems to have a superior UX, enjoying great reviews and spreading through word of mouth. Nevertheless, there is one larger peer, also public traded, called RealPage, whose products are also cloud native, that is led by a wise founder who constantly uses his cash flows to make accretive tuck in acquisitions, including one recently to combat AppFolio. RealPage is also on our wish list.


A workspace messaging platform that aims to substitute e-mail and has initially grown through word of mouth in the Silicon Valley, Slack is already marching towards 850M in revenues and 9M paid users. The company boasts integrations with all software applications clients use, a great UX, scalability and security as its selling points. But this is the most open case regarding moats in our assessment today.

On one hand, Slack may be able to become a standard like Outlook has done, especially if clients adopt more and more its shared-channels feature to communicate amid themselves, not just within the same company. On the other hand, Slack does not seem to be an irreplac eable tool yet, nor is it an easy sell looking at the company’s sales cost; furthermore, Slack in threatening the reign of no one less than MSFT, which is coming after it strong with Teams

bundled within Office 365. Google is also said to be working on a competing tool.

A recent deal with Amazon, who will become a customer and work to integrate Slack for AWS developers worldwide, seems a great seal of approval, after all, Jeff Bezos wouldn’t bet his company’s communications and a lot of integration work on a company for which hecould see a meaningful chance of failure. It is an open question yet, Slack could be huge, just as it could go nowhere from here, as in the case of DropBox. Its 17B valuation, in a huge TAM, reflects this impasse.The founder is the face of the company, CEO and 7% owner.

To close, it is quite likely that at least one of these companies will pop-up in our portfolio

sometime this year, despite them all being “fully priced” and the high opportunity cost we have today. Remember though, from my previous text, “fully priced” companies, with low downside and positive scenarios that may be quite convex, though tough to imagine, is exactly what we are looking for.

Guilherme Partel

Tarpon U.S. Equities

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