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over the past month and a half we've seen what happens when the most alluring group in the wall street fashion show suddenly goes out of style I'm talking about the high-flying cloud-based software stocks that have just been slaughtered in recent weeks some of these names have been hit harder than others z scalar was well over 100 percent for the year that's highs not some 21 percent for the year the cloud cakes Adobe Salesforce ServiceNow Splunk Twilio VMware and workday they're down on average 18 percent from the highs of those only Adobe and Salesforce have said less than 10 percent now I love many of these software service companies you know that but this is why I tell you that you have to take some profits some schnitzel I call it in your biggest winners while you still have them momentum stocks can go from heroes to zeroes practically overnight especially as they all tend to trade together many are banded together by silly ETS that should never have been crafted as I told you before I think there are two things going on here first many of these clouds suck simply got way too expensive that's why I kept telling you to let them pull back before you pull the trigger second this market got hit with a powerful rotation as money managers started feeling more bullish about the economy they sold the cloud stocks and they swapped in two more single names they can deliver gigantic or any speeds when commerce is strong the cloud can deliver great numbers even during a slowdown hit but if there's not gonna be a slowdown that makes their stocks less attractive in the eyes of Wall Street hence the hideous multi-week breakdown many of which stops you've comment on in Twitter I know you're depressed by it but here maybe we can pretend some light on which brings me the big question now that this group has been bludgeoned half to death what are we supposed to do alright you gotta remember with a few exceptions the fundamentals really haven't changed at all our favorite cloud companies are still pretty up excellent numbers the markets are starting to judge these numbers through a much more punishing prism which means we need to be more selective so tonight we're helping you figure out which cloud stocks to double down on to wheat this and which ones well maybe you got a cut loose sum up we know this whole group has gotten a lot cheaper over the past eight weeks but we need a way to distinguish between the high-quality names that have been dragged down by the rotation and the lower quality names that never should have been up in the first place when you make these kinds of decisions you to be ruthlessly logical not emotional I always try to check the emotions to the door we're in triage mode right now and that means we need to be as objective as possible that's why we've put together a simple screener for the software-as-a-service Docs we're gonna run our whole cloud universe through through these two filters one is fundamentals and one is for evaluation anything that passes both filters well then you got my blessing to buy down here after the big sell-off basically we're doing a quick and dirty analysis of the cloud stocks to separate the wheat from the chaff and this is done by real portfolio managers every single day I want to teach you how to do it at home it's a quick and dirty rule of thumb that Wall Street's been using to assess the enterprise software stocks for ages you know what it's called and I've only heard it once among our guests it's called the rule of 40 and it's quite simple if you're running a software as a service company the rule of 40 you're just a rule of 40 says it's your revenue growth plus your profit margin should be greater than 40 percent if it's below 40 here in trouble again weren't you guys motor we want a simple rule it tells us which of these cloud stocks need to be able tainted from our portfolios I like this rule of 40 because it recognizes that there are two ways to win the healthiest cloud Sox read they're growing very rapidly and losing money where the growth is slowing but they've got increasingly stronger knees if a company has a 30% revenue growth at a 20 percent profit margin it passes the test if it's got 70% revenue growth and then negative 20% profit margin that also passes however if you're only growing in a 50 percent clip and you got a negative 15 percent margin well wait a second that's 35% combined it falls below our rule of 40 threshold like I said it's a quick it's a quick and dirty way to look at this but this is how venture capital firms and hedge funds and companies themselves like to assess the trade-off between growth and profitability that we talk about every night here now let's put it into practice revenue growth is straightforward remember that's just the sales line but there are a lot of ways you can measure margins some more generous than others because we want to keep it simple we're using the adjusted earnings before interest taxes depreciation and amortization or Ebay top margin so who passes a new all seven cloud Kings past mostly with flying colors Twilio you know what how much should be like Twilio twelve that was the highest scores the company has been to grow at a 72 percent clip this year further bolstered by a 10 percent EBIT da so this is our winner okay really terrific adobe comes in second with only a twenty four percent growth weight because it's much more profitable with a forty four percent EBIT dom margin reports this week I think it could be very very good and it's Thursday just you know now after the cloud Kings the quality really starts to drop off our cloud princes Atlassian Koopa software HubSpot New Relic ouch they don't fare as well neither New Relic nor octave makes the cut even before New Relic cubes disappointing forecast this morning they're slowing growth was a problem octa on the other hand is growing in to 41 percent clip but it's negative 9 percent EBIT on margin drags it down so it doesn't deserve the praise at least on this method hey how about the rest of the cloud stocks we've talked about PACOM Viva systems Alteryx we had them on last week green central Zendesk we've had them on 5 9 with a Z scale or MongoDB smartsheet and plan but we have on appium less than half them to make the cut using this year's analyst estimates PACOM Viva Alteryx ringcentral and send s pass 5 9 and C scalar would pass on last year's numbers but they fall a little short on this year's estimates call out a path to everything else or cutting hey what about the cloud IPOs from the past of 2019 we got zoom video CrowdStrike dynaTrace slack technologies pager Duty freesias truth in software and cloud fair we looked at 32 stocks for this analysis and zoom vide has the best score zoom which helps explain why it's been such a great perform with them on last week right even though it's pulled back of late crowd surpasses dynaTrace failed last year but it passes on this year's 4th yes thanks to accelerating revenue growth or our everything else must go which brings us to the second squeak valuation we want to keep this simple so I'm I'm failing anything that trades in more than 10 times sales unless we can come up with a very good excuse 10 times sales by the way very expensive as it is look at the cloud Kings Adobe and ServiceNow are both over the line of 10.4 and 11 times next year's earnings next year sales and wait I'll tell you I don't know if you saw it but we saw some big moves of all these stocks but ServiceNow had the biggest but you know what mm-hmm not cheap I'm going to give Adobe a pass because it's so profitable it sells for less than 30 times sensors earnings estimates and that's fine by me I like ServiceNow but there are no extenuating circumstances this year trades it's 61:10 observing it's not gonna make it totally was a borderline case trading right at 10 times earnings but giving us five this rule 40 square I say we let it stay in this group as for the cloud princes of the remaining names both Atlassian and cuca software both trade it well or more than fifteen times sales that leaves HubSpot is the only prince pisses both tests HubSpot Wow okay how about the cloud commoners only five nine RingCentral and Zendesk trade at less than ten times actually your sales so we've got to be careful with the rest of them finally you've got remaining the IPOs CrowdStrike zoom video and dynaTrace but CrowdStrike consumers still ultra expensive trading at more than 20 times that's your sales I don't feel comfortable wrecking that recommending that to you at this environment bottom line when you try to be objective about the cloud Sox the ones that you want to keep our Adobe Salesforce Splunk Twilio VMware workday HubSpot 5 9r a central Zendesk and dynaTrace everything else what can I say you need to be a lot more cautious perhaps more subjective and that's not the best way to invest hey gotcha whist stable C
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