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How long until usage trends start to move the other way?

Have you ever seen one of those rope bridges strung across a river in a jungle or high across a canyon. Scary as heck, at least for this writer. Investing in high growth IT shares these days reminds me of that as much as anything else. It is possible to see the objective on the other side, but the bridge, often made of plant material and a few slats of wood and rope, sways and seems terribly unsteady. And the bridge seems to sway in every breeze, and one can see storm clouds all around. Perhaps not the most comfortable of metaphors but in some regards a realistic description of the environment.

The storm clouds of April 25th seemed a bit more ominous than some. Consumer confidence down, UPS (UPS) forecasting weak results as consumer behavior changes for the worse and First Republic (FRC) continuing to unravel and needs another rescue. Within the tech space, Tenable (TENB) indicated that some of its expected deals didn’t close at the end of the quarter due to uncertainties created by the turmoil in the banking sector created by the failure of Silicon Valley. And then came earnings reports from Google (GOOG) (GOOGL) and Microsoft (MSFT) that suggested that the reports of the demise of the IT space have been exaggerated.

This is an article about MongoDB (NASDAQ:MDB), and not an article about macro conditions. But I want to acknowledge again, if it necessary to do so, that investing in Mongo, as well as any other high growth IT name is unlikely to work until investors are willing to look across the chasm and consider the very substantial opportunities for Mongo that are outlined in the balance of this article.

It ought to be obvious after the last 18 months that high growth IT stocks simply won’t work as investments in a risk off environment. And it also ought to be evident that in an environment with macro headwinds, the percentage growth of IT companies is likely to compress. Further, the level of growth expected from software companies whose model is based on usage is sensitive to macro headwinds. At this point, none of this is new or unknown, and yet when macro data is seen as disappointing, investors sell high growth IT shares, even when the companies have already acknowledged the changed environment and altered their forecasts accordingly.

I think that this is a good time to consider the shares of MongoDB – not because I doubt that the macro environment is deteriorating; the signs of that are too pervasive and substantial to ignore – but because the shares and the company’s forecast reflects that deterioration. Mongo dominates a high growth space, i.e. that of the NoSQL database. It has technology advantages and its strategy of appealing to developers as the platform of choice has resonated. I am not trying to forecast when the Fed Board will finally acknowledge that their demand destruction has gone far enough. I think it is a matter of months, if not less, but I surely do not know. Obviously fixed income traders who are bidding down yields substantially at the moment feel they have a good insight on the Fed pivot.

I surely don’t know when sentiment toward high growth IT shares is going to finally pivot. Perhaps when the Fed actually articulates a victory over inflation, or when it actually pivots on rates. It is easy to see just how toxic current sentiment is – there have been numerous surveys of investor sentiment, including those of both institutional and retail components, that make that point – which is why valuations in the space have continued to compress even when results are better for companies such as Mongo and turn out to be better than feared. It can be difficult and lonely to recommend the shares of a company such as Mongo that will be battling macro headwinds. But to me, the logical time to enter a position is when everyone is already negative and is suggesting that earnings reports should be black bordered and positioned next to the obituary page.

Mongo shares may not seem cheap now, and on some measures they aren’t. But if one looks across the proverbial chasm and dares to cross that flimsy bridge, I think a case can be made as to why the shares are far cheaper than might be surmised by some commentators. The aphorism popularized by the sage of Omaha, Warren Buffett, about being greedy when others are fearful ought to be in play here. I will discuss the valuation at the end of this article, but while currently, based on the company’s recent guidance, the shares have an EV/S ratio of about 9.5X, and the company has a modest free cash flow margin, in a recovery scenario the components of that EV/S ratio will change substantially, and the company’s free cash flow margin will grow several times.

In the last several years many IT companies have developed business models based on consumption, rather than seats. It is, I believe, a win/win situation. The users actually pay for the value they receive, and are not stuck buying seats that are often under-utilized and which represent a fixed cost that hurts in times of economic stress. And most of the time, a usage paradigm is going to reward vendors with higher revenue in return for some variability and uncertainty. Over the course of years, the vendors will most likely wind up with more revenue, and conceptually, at least, new users are easier to sell, knowing that their software bills will be part of opex and not capex and will relate to the actual value they are receiving from an application.

But for at least the last 9 months the paradigm has been troublesome for the vendors, although perhaps comforting for the users. There is a great debate amongst software analysts and investors as to when “cloud optimization” will abate and usage growth will start to resume traditional patterns.

Much as I might wish for it, I certainly don’t have some crystal ball that provides me with specific insights on the subject. Recently the analyst team at Morgan Stanley released the findings generated from its AlphaWise IT survey. I didn’t think the findings were earth shaking; the survey indicated, about 75% of the respondents said that 2023 would be a year of cloud optimization/digestion which is consistent with what vendors have been reporting for some quarters at this point. The MS analyst team said they were surprised that this cohort of respondents said they would reaccelerate their cloud spending next year, and were planning on having an increasing percentage of applications reside in the public cloud post optimization.

IT spending optimization initiatives are a consistent theme for users. And once they happen, usage growth returns simply because usage is like data, there is inevitably more of it. As applications get deployed, and become part of the operating fabric of an enterprise, and as users find new insights to be had from applications, usage rises. It is not as though there is some well of new optimizations – they are based almost entirely on remediating workflows that have become inefficient, and that is not something that is done as a consistent process.

Before diving in to some of the relevant details around MDB’s current and future outlook, I think the following quote from the CEO on the latest conference call is worth parsing.

Our principal focus is acquiring — or said another way new applications, which is the biggest driver of our long-term growth. In our market, it’s important to understand that the unit of competition is the workload, getting both new and existing customers to deploy new workflows in our data platform is our overarching goal. Once the world has been onboarded its consumption growth is not something we can meaningfully influence. Some workloads will grow faster than others depending on the underlying business drivers for their specific application, the macro environment, seasonality and other factors.

While we cannot control the rate of growth of existing workloads, we do know workloads typically grow over time. So as long as we keep acquiring new workloads at a healthy rate, we are well-positioned for the long run.

In a broad sense, it is not possible for vendors to greatly influence consumption. Over time, the usage of most apps/workloads is going to grow. It is my opinion that long term investors should try not to focus too much on consumption which has a cyclical component that is beyond the control of Mongo and other vendors with usage based models. It can be easier to simply focus on reported revenue growth and look at statistics relating to the percentage change in the various metrics related to sales performance on a quarterly basis. But to some extent those metrics are backward rather than forward looking.

In my opinion, the aspect of the business on which to focus is the growth of new applications. Some of those will create major revenue streams, others will have less of an impact. With that as a backdrop, which companies make best sense as investments looking ahead to next year in an improving environment for IT spending growth? There are, to be sure, many IT companies these days with usage models which will benefit from a return to usage growth and will also benefit as applications migrate to the public cloud. And there are a number of IT vendors who have been able to acquire new customers and sell additional functionality to existing customers even though the revenue growth from that success is less now than it was 2-3 quarters ago. There isn’t lots of history about how consumption tracks either during a recession, or in a recovery. The last real recession in the economy was more than a decade ago, and none of these companies existed at that time in meaningful form. What is available is the data that was recorded during the initial stages of the Covid-19 lockdown, and then the recovery from that impact, as work from home paradigms were created. The companies themselves were surprised at the rapid increase in usage at that time.

At this point, I am looking for companies not so much from the point of view of their specific usage trends in these quarters of macro headwinds, but at companies that continue to acquire new workloads and are selling their user base on using their services for new applications. In my opinion, one of the best such companies is MongoDB and that is the subject of the rest of this article.

Aren’t MongoDB shares expensive?

Valuation is always a fraught question in looking at high growth IT companies. A year or so ago, critiques centering on profitability were easy to write when looking at Mongo. Initially profitability was not a concern of most investors, and Mongo certainly wasn’t reporting any. I first wrote about MongoDB on the pages of SA way back in 2018. It has come a long way since that time. Back then, it had a non-GAAP operating loss margin of about 33% and its free cash flow margin was negative 16%. When I next wrote about the company last April, the shares had already fallen by about 35%, but more was to come. At that point, the non-GAAP operating loss margin was about 6%, and the company’ 12 month operating cash flow margin had recently reached break even. The shares most recently made a low in mid-November, falling by another 60%+. Since that time the shares have seen a bit of a rally, albeit from a very compressed level, and are now up more than 50%, although far below the level they were when I last wrote about the company.

Is that compression enough? Valuation compression by itself is not a reason to buy stocks. Mongo is a fairly controversial stock on SA with a neutral rating, but brokerage analysts have a much more positive evaluation with most ratings at buy, although the average price target of $253 is just 10% above the current price. The company was profitable in the latest fiscal year, and generated a modest level of free cash flow, and it is projecting about 5% non-GAAP operating margins in the current year.

The company has projected revenues of $1.51 billion for the current fiscal year which is growth of 17%. The consensus analyst projection as depicted by 1st call for the following fiscal year, at least as published, is for revenue growth of 19%. I doubt that anyone owning the shares or contemplating making an investment in MongoDB believes that 19% number although it accounts for the modest price objective of many covering analysts. Revenue growth for Mongo, at least in the short-term, is significantly correlated with usage. Usage growth has been pressured for Mongo since the summer of 2022. Has usage growth reached its nadir?

The company during its latest conference call held in early March indicated that usage growth had actually returned to “normal” in February, after falling short of expectations in December and February. Normal, however is not at the rates of early 2022, but the rates the company had seen in last fiscal year’s Q2-3.

Obviously reported revenue growth in the 2^nd half of this year and in fiscal ’25 is going to depend on usage trends, and they are not really knowable in advance. My guess is that usage growth will start to return toward its long-term trend in 2024, although whether it can actually reach such a level and when is more or less imponderable. That said I will devote some space in this article as to why I think Mongo’s usage growth, and thus its revenue growth is probably underestimated by the consensus. In fact, my 3 year CAGR estimate for the company is in the mid-high 30% range, with a steady ramp in terms of non-GAAP margins and free cash flow generation.

If one looks at Mongo shares solely based on historical data, or even the company’s projection for this current year, the shares still look expensive-although the forecast, like many other forecasts by high growth IT companies, appears to be de-risked. The current EV/S was 9.5X on April 25, and relative to average valuations these days, that isn’t a particular bargain. (Mongo shares are highly volatile and I picked the point at which I had finished writing this article as the date on which to compute the EV/S ratio). And 6% free cash flow margin is not a standout either. If one, however, looks at the growth opportunities, and the improving margin, an opposite conclusion is reached, and that is the one I think is most likely.

Why is Mongo still growing rapidly?

First of all, it isn’t AI. Or at least not directly AI. The company’s conference call last month was one of the few held by an IT vendor that didn’t include a mention of growth headwinds from AI. I am a firm believer in the AI revolution. I have written about it on SA, with an article on MSFT somewhat recently. But the reality is that the proliferation of AI applications have been going on for years now. What is new, is the emergence of generative AI, and the attention this has garnered for the technology. AI itself has been inside many applications for some time now – Salesforce (CRM) has offered Einstein and IBM (IBM) has offered Watson for more than 5 years. All of the modern cyber security companies have used AI for years to identify anomalies and potential breaches. There is, perhaps, some thought that the popularization of AI will lead to more workloads for Mongo – but that is a weak correlation. Mongo is not, and is not likely to be an “AI stock” and much as AI is revolutionary at some level, this is not the stock for readers looking to invest in that technology.

But that said, there are a few answers to the question as to why MongoDB is likely to remain in hyper growth mode, once the current economic environment changes, and will be in that mode for years to come. At the most basic level, Mongo offers a non-SQL database, which has tremendous advantages compared to the relational database model that has been in use for about 50 years. Relational databases simply can’t provide the performance necessary to ensure end users have a reasonable experience. Mongo has been, is, and will continue to be a company focused on developers. Developers find relational data base technology difficult to work with. The technology doesn’t really cope with unstructured data and it was never meant for use with internet workloads that require massive scaling over a brief time period. And, the dominant vendor in the space, Oracle (ORCL), is well known for aggressive and intrusive sales practices and contract terms. The database space was ripe for disruption when Mongo emerged offering its non-SQL technology.

That said the relational database market is enormous. While Oracle no longer reports relational database revenue explicitly, the relational market alone is apparently worth $70 billion in annual revenues. The market for non-SQL databases is still smaller than the market for legacy technology but growing several times faster – the linked analysis suggests a CAGR of 30% for the next several years. And Mongo is the dominant company in that space with a market share of 45%. Oracle does, of course, have an offering, MySQL, which it acquired when it acquired Sun in 2010. It exists, but is not an effective competitor in the space for users outside the Sun/Oracle ecosystem.

As management has stated many times, the real measure of growth for Mongo is that of workload acquisition. Not all workloads will have similar usage. New workloads are being continuously envisaged and constructed. Mongo’s percentage revenue growth has obviously declined. A year ago, before macro headwinds impacted usage trends substantially, the company was growing revenues by 57%. At that time, it noted that a small part of its business was being impacted by macro headwinds that had trimmed 1 percentage point from the sequential growth of Atlas, these days its dominant product offering. Last quarter revenue growth was 36%. Its forecast for revenue growth this fiscal year is 17%. The 17% forecast reflects a continuation, but not a further deterioration of the usage trends the company has experienced the last couple of quarters. The company’s forecast for its fiscal Q1 reflects the heightened slowdown from consumption over the holiday period. It also reflects the fact that Q1 has 3 fewer days than Q4, and that will obviously impact consumption revenue. In addition, the full year 17% growth forecast reflects a significantly smaller contribution from growth of what is called Enterprise Advanced, the company’s initial product. EA has had several quarters of growth that has been above trend; the company is forecasting that EA comparisons will be constrained because of these elevated year earlier period. Because Enterprise Advanced has a subscription/seat based pricing model, the current accounting conventions call for a substantial component of upfront revenue recognition, so changes in EA deployments have more substantial revenue impacts in the short-term than the growth in the company’s Atlas, cloud product.

I think everyone interested in, or invested in Mongo shares is well aware of this reported growth deceleration. What may not be as well appreciated is that through this time, new customer acquisition has remained at strong levels, and has not deteriorated as might be expected if there were existential demand issues. Specifically, the company’s direct sales customers, who are those with the highest level of contract value, have been increasing at 500/quarter over the past year. The smaller customers, which are best represented by the growth of Atlas users have been rising by about 1700/quarter, just slightly below trends earlier in 2022.

New customers are being sold as part of a paradigm of workload acquisition. There has been no real slowdown in workload acquisition, but workload acquisition impacts revenue over time as applications get written, deployed and go into production. So, not all of the new workload acquisition activity is reflected in usage/revenue thus far in 2023.

Another major source of growth relates to migration of users from their legacy relational database model to Atlas. That is something that has been going on consistently for some time now, but it is more of a focus for MDB in an environment in which concerns abound that it will be more difficult to secure required approvals for projects to launch new workloads. Last year, Mongo introduced what it calls its Relational Migrator which includes an enhanced user interface and what is described as a data synch engine. The version of Migrator that customers can directly use is scheduled for availability later this year.

Last quarter the CEO indicated that a growth focus for MDB has been its search capability. Like most other IT vendors, one of the ingredients to sustained high growth is to offer users solutions in adjacencies. In the case of Mongo, one of the adjacencies of choice currently is search. There are, of course, other adjacencies one of which is called Time Series which is a specialized variant of the standard data base solution offered by the company. Time series supports additional use cases, as well.

It is hard as an analyst to know precisely what percentage growth expectations investors have for Mongo these days. Certainly far greater than what is in the published consensus. Mongo growth will probably exceed trends when the current climate of macro headwinds abates.

I am not about to hazard a guess as to exactly when that will be. Anecdotally, I have heard of some suggestions that the deceleration in usage growth has seemingly abated – not reversed, but abated. That said, most observers will be laser-focused on exactly what the cloud hyper-scalers have to say on the subject – although by now, it should be obvious that the exact correlation between hyper-scaler cloud usage and usage for Mongo’s Atlas is nothing like one for one.

What will Mongo’s revenue growth look like in a recovery scenario? Anything I say here has to be considered a guess. I don’t imagine that Mongo can return to 57% growth, either next year, or in the foreseeable future. On the other hand, I would be surprised if Mongo didn’t grow faster than the forecast of industry analysts for market growth of 30%. It is enjoying some success pushing into adjacencies that are not considered in market growth, and the company has been, and is likely to continue to take share in its market. I do think in recovery quarters its percentage revenue growth rate will scrape the 40% level. As long as the company continues its focus on acquiring workloads/use cases, it prospects to remain a hyper growth vendor remain strong.

When commentators write that Mongo shares are overvalued – and there are of course many such commentators – they overlook the likely growth upswing during a recovery and choose instead to focus on the current state of the IT space and its effect on Mongo’s growth. It is simply a backward, as opposed to a forward looking methodology in evaluating high growth shares, and not one that I choose to follow.

Competition

While Mongo may have been a pioneer in developing and popularizing a non-SQL database, there are of course many competitors. All of the hyperscalers are in the market and have been for years now. I have linked here to a 3^rd party analysis of competitors; I didn’t find anything in this analysis or others publicly available that was particularly useful in evaluating how product features were impacting competition.

I am not going to try to address all of the functional advantages offered by Mongo. For as long as I have followed the database market it has been characterized by an avalanche of claims with regards to features and functions, and that remains the case. In most cases, trying to evaluate all of the claims will not result in a better investment conclusion. I certainly do not purport to be some kind of expert on the technology of the database market; I know just enough to conclude that Mongo has a desirable set of offerings that allow it to win over the key developer community.

The reason Mongo has been increasing its market share is the same one that has been in evidence for years; developers prefer to use Mongo and they continue to be the major proponents of Mongo in its largest accounts. Over time, and in many cases, the influence of developers often leads to Mongo becoming a standard, but this is a lengthy and involved process. It would appear that despite macro headwinds this paradigm is still in evidence.

Mongo also competes with some very specialized point products such as companies who offer a database exclusively for a particular workload such as that of time series referenced above. In the current environment, there is some vendor consolidation occurring, and Mongo has been a beneficiary of that trend. The company maintains that something similar has been occurring with regards to the company’s search functionality, where developers use the Mongo platform to enable an application built on the company’s database and search functionality. It is not something that the company has quantified, and I am not altogether sure that it can be quantified, but it is another factor that leads me to conclude that Mongo will be able to grow at rates above the market in a less hostile macro environment.

Mongo has an offering in the space known as serverless data bases. This is just now becoming a mainstream technology, but will almost inevitably become a greater proportion of total database installations because of its advantages in terms of cost and architectural factors. Mongo is likely to enjoy competitive success here, and it is part of the company’s evolution to address the many corners of the database market.

It has been said by some that Mongo shares are primarily held by its community of developers. While that is probably apocryphal – 93% of Mongo shares are held by institutions and another 3.5% of the shares are held by insiders leaving very little to be held by individual investors. On the other hand, Mongo’s developers are an enthusiastic and vocal community and the company caters to them, and this paradigm has become a virtuous circle, and is likely to remain so, given management’s priorities.

Mongo’s Profitability Pivot – Is it fast enough?

What was sound corporate strategy a year ago simply will not satisfy investors in the current environment. Mongo is profitable… barely, and it is generating a bit of cash. The question relates to the planned cadence of profitability improvement. The company is forecasting a 100 bps improvement in non-GAAP operating margins this year. That rate of improvement is, no doubt, a sticking point for some investors, and is certainly less than the profitability improvements being forecast by most other high growth IT vendors.

Overall, while Mongo has been able to avoid layoffs, it is reducing its hiring and the overall growth of its opex. Part of the issue that is embedded in the conservative cadence of opex margin improvement that has been forecast were a couple of factors that helped results in the last fiscal year, and which are unlikely to recur this year. These are most notably the stronger growth in Enterprise Advanced, which has a front-loaded revenue recognition model, and the revenue recognized in Q4 from unused contractual commitments. In turn, this has led to the company forecasting high teens revenue growth, which constrains the cadence of operating margin improvement. Overall, Mongo is forecasting opex expense growth in the low-mid teens range which includes merit increases and some selective hiring.

Many IT vendors are facing the vexing question how to size their business during this time of macro headwinds, while ensuring their choices to not hobble growth in a recovery. I am not sure that there is a single right answer to that kind of Hobson’s choice. Writing about Mongo and its shares at the end of April, I imagine that most stakeholders and potential shareholders are aware of the company’s decisions, and this less than average increase in non-GAAP operating margins is already baked into the valuation.

Mongo uses stock based compensation. Last quarter, stock based compensation was 27% of revenues compared to 26% of revenues the prior year. I look at dilution as the actual cost of stock based comp as opposed to the results of using the Black Scholes formula. Dilution last quarter was 0.87%. I have used slightly more than 3.5% dilution for the current year in calculating valuation. Given the expected decrease in hiring rates this year, I expect that SBC expense ratios will decline, although it takes longer for that to feed through into weighted average shares.

Gross margins were 73% of revenue last quarter compared to 69% of revenues the prior year. Mongo’s non-GAAP gross margins have improved, but are still being constrained by the rapid growth of Atlas which has an entirely ratable revenue recognition model. Last quarter, as mentioned, gross margins were above trend, because of the recognition of previously unutilized contractual usage commitments.

Last quarter did see some opex ratio improvements, but this business model has a long way to go before it reaches levels that most would find reasonable. Sales and marketing costs were about 42% of revenue last quarter on a non-GAAP basis compared to 44% of revenue in the prior year period. Research and development expense was 19% of revenue last quarter, compared to 19.5% of revenue a year ago, and general and administrative expense was about 8.4% of revenue compared to 9% of revenue the prior year. Overall, non-GAAP opex was 70% of revenue in this latest quarter, significantly less than the 76% of revenue reported in the year earlier period. About half of the improvement in the ratios was apparently a result of the revenue recognition of the previously unbilled commitments.

The company’s free cash flow can be influenced by the level deferred revenue generated by its Enterprise Advanced non-cloud offering. Over time, as Atlas becomes even more the dominant revenue source, changes in deferred revenue will diminish as a driver of free cash flow. The increase in deferred revenues fell last quarter from the year earlier level which was something of a record for Enterprise Advanced bookings/renewals. Last quarter, free cash flow rose about 15% year on year; free cash flow growth was constrained because of a substantial rise in receivables. The company’s full year free cash flow margin was negative I expect free cash flow margins to be in the range of 5%-6% this year as it should track the improvement in non-GAAP operating margins and, in addition, is not likely to see a continued increase in receivables.

Wrapping Up – Mongo’s valuation and the case to own the shares

I started this article by saying it isn’t about macro trends. That said, it is worth noting that the usage issue, and cloud optimization has been somewhat resolved with Microsoft’s earnings release and guidance, and to a lesser extent by the release of Google’s numbers showing sustained growth of GCP revenues. I wrote earlier in the article about anecdotal data points that suggested that the most aggressive cloud optimization effects were beginning to abate – not reverse – but abate. And so it now seems to be confirmed by 2 of the 3 large public cloud vendors.

At this point, Mongo’s EV/S ratio of just greater than 9.4X (based on the closing price of 4/25) is above average for its growth cohort. But that is essentially a measure of macro headwinds, and a couple of factors unique to MDB’s revenue. If cloud optimization is now at a peak, then growth estimates for Mongo are far too low for its FY ’25 year. It is going to be one of the single most significant beneficiaries of a return to less painful conditions in the enterprise IT space as its usage model will drive substantial upside to what the current published consensus suggests. While the company’s current profitability forecast and free cash flow generation are certainly not at a level that investors find acceptable, trends in profitability and cash flow generation are highly correlated with the trajectory of revenue growth.

In the article I focused on why the company is winning, and why it ought to continue to grow more rapidly than its core market, that of NoSQL databases. I think understanding the company’s workload acquisition strategy is a key tenet in supporting my buy recommendation for the shares. While Mongo has competition, it has continued to increase its market share in its core market, and to grow even more rapidly by starting to sell solutions in adjacencies such as search. And I reiterated my belief that Mongo’s focus on the developer community was resonating in the market.

I have made the point several times that Mongo shares are unlikely to perform well consistently until investor sentiment pivots to a more risk-on mode. And I make no forecast as to when that pivot really happens; while I would like to believe that the results of Microsoft, and to an extent Google might ultimately impact investor sentiment, I suspect that there is still lots of fear, uncertainty and doubt to overcome.

Mongo should be on a short list for investors willing to look across the chasm and to invest in an IT recovery. It is not for the risk adverse, or for those focused on stock based compensation as reported. While investing in something seemingly as mundane as data base technology doesn’t have the pizzazz of investing in the generative AI space, there is likely some correlation between Mongo workloads, and applications built using generative AI. But not enough to make that a pillar of the investment case.

I am willing to look across the chasm, knowing that despite the quarterly reports of two hyper-scalers there are still macro headwinds. It is on that basis that I believe that Mongo will generate positive alpha over the next year, and that the current valuation provides investors with an attractive entry point.