Please refer to our disclaimers, which can be found in the footnote of this page and here.

Contents

• Contents
• Performance
• Reflecting on the First 5 Years
• Salesforce
• Business Overview
• Business Quality
• Why do we own it?
• Key Risks
• Valuation
• Business Update

Performance

Performance for 2023 was +64.5% net (vs. the MSCI ACWI at +22.2%). Since inception, the portfolio has compounded at +18.8% gross / +16.0% net (vs. the MSCI ACWI at +11.7%), representing +7.0% gross (+4.2% net) annualised outperformance. Top contributors for 2023 include Salesforce, Alphabet, Meta Platforms, and Microsoft. The biggest detractor was Alibaba. During the 4th quarter October weakness, we increased our investments in Alphabet, Meta Platforms, and Okta. We also added Visa back into the portfolio based on relative valuation attractiveness. Later in the quarter, we reduced our investments in Meta Platforms, Microsoft, Block, and Snowflake for valuation reasons.

Returns Summary

Portfolio Statistics

Reflecting on the First 5 Years

This letter marks the 5-year anniversary of the strategy (although we have only managed external capital since September 2023). What an interesting 5 years to be investing — a global pandemic, a tech bubble, and the end of zero interest rates. We are proud of the performance generated throughout this challenging period on both an absolute and relative basis (see above). The 5-year mark is a good time to self-reflect, to read back through our decision log, and consider what we have done well and, more importantly, where we can improve.

The best decision we made throughout this time was to own great companies. Macro events are hard to predict and the impact on asset prices even harder. We try to own quality companies with a high degree of business resilience that can navigate through these unpredictable events. With some exceptions, we’ve done a good job here.

We are also happy with our valuation discipline. We were selling down our higher-growth companies in the 2021 tech-bubble. In some cases (e.g. Salesforce, Snowflake, MongoDB, and others), we were able to re-invest again after the bubble burst. In other cases (e.g. Block), we finished our underwriting but then waited several months for valuation to improve. We in no way predicted the bursting of the bubble, only that the long-term range of expected returns no longer compensated us for the risks we were assuming. With the benefit of hindsight, we should have sold much more in 2021. In the same vein, in late 2023 we made significant cuts to our positions in Microsoft, Meta Platforms, Block, and Snowflake, and we fully exited our MongoDB position earlier in the year (for the second time). These stocks may continue to rally but the forward expected returns justified the move. Our cash position built up over the year, reduced as we deployed into the October 2023 sell-off, and subsequently built up again, ending the year at circa 13%. We do not make top-down calls – our cash position is simply an outcome of the bottoms-up opportunities.

Finally, for the most part, we have made good sizing decisions. Position sizing is a function of quality (i.e. true business risk), valuation, and conviction. Our sizing has helped us capture gains in stocks where our conviction held steady and to avoid additional losses where we had underwriting mistakes and/or lower conviction, especially in our higher-growth names. That said, there are two notable disappointments in our sizing decisions. First, we mark ourselves down for not being more aggressive in Meta Platforms in late 2022. We had conviction and deployed more capital in mid-2022 (after selling some in late 2021), but our combination of quality, valuation, and conviction in late-2022 warranted a much larger position. Second, we increased the size of Twilio in 2022 and in hindsight, we had too great a size in a name where the business quality and our conviction had deteriorated.

On areas of improvement, in 2022 we re-deployed into some of our higher-growth companies as valuations retreated. We were too early in this decision. Inflation proved more persistent than our initial transitory view. While we do not make top-down macro calls, the long-term cost of capital and exit multiples for our companies needed adjustment to reflect the new long-term interest rate reality. This would have led to different valuation views. We now face the same decision going forward but in reverse. After realising our error, we increased our cost of capital and reduced certain exit multiples. This move already considered a future reduction in rates since we are underwriting the next 5-10 years, not the next 12 months. As such, we are comfortable with our current assumptions and make no attempt to time a potential rally if/when the Fed eases.

On stock-selection, our hit rate has been very solid overall. However, we have been wrong in Alibaba and Twilio. In Alibaba’s case, we underestimated Pinduoduo and were too sceptical of its ability to sustain its advertising and promotion spending. The impact has been market share-loss and margin reduction in Alibaba’s core business. In Twilio’s case, we overestimated the newer growth areas that had the potential to improve the overall business quality (Flex and Segment), while at the same time, the competitive lead in their core business (i.e. communications) narrowed more than expected. In addition, we underappreciated the execution risks in Twilio’s acquisition of Segment (acquisition risk has also been an issue in Block and Okta). Why then do we still own Alibaba and Twilio? The key reason is valuation relative to alternative homes for capital. Certainly, at some level of quality-deterioration we need to cut our losses and move on no matter the valuation. We wrestle the most with Twilio here. In contrast, despite the market share losses, we still view Alibaba as a high-quality company and, while our valuation has been revised down significantly, the share price has retreated much more.

While we do not judge our decisions on returns in the shorter-term, we are happy that our 5-year returns significantly exceeded our objective and the cost of capital for our companies. In fact, the portfolio has likely over-earned what we should expect given the high-quality nature of the businesses we own relative to the market.

Salesforce

We ended 2023 with Salesforce as our largest position. We first bought stock in June 2020 and at year-end, it represented 18% of the portfolio. As of 31 Dec 2023, the IRR for our investment over the 3.5-year holding period thus far is +29% and the annualised TSR over the same period is 13%. Key position changes throughout this time are shown in the chart below. Key moments of additions/disposals include trimming in Feb 2021, cutting meaningfully in Oct/Nov 2021, adding at various times in 2022, and trimming in Dec 2023. We do not try to generate returns by trading in and out of positions. Rather, these sizing changes are simply driven by the relative risk-rewards across the portfolio. We also do not claim success just yet – this will depend on what happens going forward.

Kalakau Avenue’s Salesforce Investment Journey

We first started learning about Salesforce in our competitor diligence for our Microsoft investment. We saw a lot of what we liked about Microsoft — sticky products, exposure to secular growth propelled by the public cloud transition / digitisation of business, and robust global enterprise sales and distribution with strong consulting and system-integrator networks. At the same time, we could see the business was becoming more and more Microsoft-like. That is, it was transitioning from a customer relationship management (“CRM”) provider to a business productivity provider. This was highlighted at the time by the Tableau acquisition and later by the Slack acquisition. With this, the business quality was also improving.

Business Overview

Founded in 1999 by Marc Benioff [1], Salesforce began as an on-demand sales force automation / CRM subscription software provider. Today, the business spans various business productivity applications though it remains centred on the customer relationship. The core products serve sales force automation, customer service, marketing automation, ecommerce platform management, business intelligence analytics (Tableau), application integration (MuleSoft), and employee communication/collaboration (Slack). Salesforce also offers industry-specific solutions (think out-of-the-box customisations for specific industries) and its Data Cloud. Data Cloud has had various incarnations, but the aim is to offer a real-time customer data platform that is integrated across the product suite with machine learning functionality (Einstein). Although it remains to be seen, Salesforce also hopes to offer a competitive Generative AI product given its advantaged data position.

Salesforce Revenue Mix

Business Quality

Why do we own it?

Strong enterprise-grade value proposition

Salesforce is a category leader in most of its products standalone, but its core value proposition is its ability to offer a one-stop-shop solution across various areas of customer management with global enterprise-grade reliability and support. We see this as a “superior” value proposition because no other company can offer this in its entirety. CRM systems are highly strategic decisions for customers and they act as a system of record. The reassurance of partnering with a company with a strong reputation that is itself a robust business is important. Customers also value the access to the Salesforce app exchange as well as the broader support ecosystem, including a labour pool that is trained on the platform. Some of what makes Salesforce appealing to enterprises also represents what customers see as a key detractor. That is, it can be seen as too complex, clunky, and expensive.

Very high switching costs

The high switching costs of CRM systems comes up time and again in our software channel checks. The reason for this is two-fold. First, it acts as both a system of record and a system of engagement. This means the systems are extensively integrated with a customer’s other applications. Second, it is intrinsically linked to business and people processes. Switching means both training and behavioural process changes, which is hard to do. Salesforce does not take this for granted and continually reinvests into the value proposition.

Global enterprise sales relationships and go-to-market ecosystem

Having a great product isn’t enough in software. Great go-to-market execution is a must. The global enterprise relationships of companies like Microsoft and Salesforce are valuable and represent intangible advantages that are hard to replicate. Having a strong network of consultants, system integrators, and independent software vendors that help sell, distribute, and transition customers is equally important. These networks are hard to build – it is one thing to get on a consulting partners recommended list, and another to have consultants pushing your product to their clients. Salesforce’s strong go-to-market mechanisms also afford it an M&A / cross sell advantage as acquired companies are integrated into the sales motion.

Structural growth tailwind in public cloud transition, digitisation of business, and data

Salesforce is exposed to solid growth markets with long duration runways. An ongoing debate since we first invested is whether Salesforce can sustain mid-teens organic revenue growth. While the end-markets are attractive, Salesforce’s core products and markets have been maturing and Salesforce already has high market share (especially Sales Cloud). We are conservative in our growth assumptions and assume a deceleration to high single-digit growth in our base case. However, we still see a long duration of growth at this level and see this profile as attractive for the valuation. Salesforce’s broader markets have compounded in the mid-teens and are expected to continue this trend (see below for the company’s likely inflated view of their end markets). If Salesforce can just maintain market share it should be able to sustain these levels (based on our view of its value proposition, we think it can). Supporting this, broad Chief Information Officer surveys consistently rank cloud-based CRM applications as a top strategic priority and Salesforce usually features strongly. A critical element is to continue expanding with existing customers by selling additional cloud services — it is both a revenue and a churn-reduction opportunity. Salesforce has been executing well on this.

Salesforce is also making progress in its industry cloud solutions. These are essentially an industry-customised version of the platform to make it more “out-of-the-box”. These come with a higher selling price and churn is lower. Essentially, the solutions provide additional value to the customer because they no longer need to worry about maintaining/supporting their own customisations. Salesforce also provides bespoke staff for these solutions. Some of the drawbacks found in our channel checks include overpromising of capability (sadly not new for Salesforce) and that customers may first lose some of their custom functionality before regaining it in the product roadmap. Representing 12% of ARR in FY23, we think the industry solutions can help support the duration of growth, even if progress is slow, because it delivers real value to the customer.

Finally, Salesforce’s Data Cloud and Generative AI offerings may create upside to growth. We do not assume this in the base case because of Salesforce’s underwhelming execution in data and machine learning to date. We are still optimistic here given Salesforce does have a key advantage given its offerings represent critical data required to train any AI models.

Attractive economics

Despite a low current operating margin, Salesforce has a healthy FCF margin at 20%+ because of its billing / working capital cycle, which means its growth is self-funding. As and when growth slows, the operating margin and FCF margin will expand as sales and marketing (“S&M”) spend falls. We look at the unit economics of the business to get a picture of what the margin might look like in the lower-growth state. Salesforce hasn’t got the best cost-to-book (“CTB”) incremental revenue, given enterprise-CRM is an intensive sales process. In addition, it does not enjoy the more automated sales processes we see in businesses like Twilio or Snowflake where users can sign up and start using products on their own. CTB has also worsened over time given a greater skew towards enterprise, international, multi-cloud, and industry clouds. However, where these reduce churn (which is the case in multi-cloud and industry clouds, the overall unit economics improve).

The sales process has also become somewhat bloated over time (discussed below). However, even with no future improvement in CTB, the reduction in S&M combined with some scale efficiencies in the cost-to-serve (COGS, R&D, G&A), GAAP operating margins and FCF margins should be >30% in this lower growth state. To note, the company gives some information on the zero-growth margin potential (see below chart), but we think their numbers are inflated because they exclude stock-based comp and because they do not account for the S&M expense of simply renewing existing revenue.

Like various other tech companies, Salesforce has announced various staff cuts and has instigated a focus on improving overall cost efficiency. Also like other tech companies, the biggest cuts are hitting S&M expenditure. S&M is often the quickest and easiest area to reduce costs. However, it is not necessarily healthy for long-term value. In Salesforce’s case, we think it is. Our channel checks highlighted how bloated the sales process had become. We even heard examples of sales meetings with 20 Salesforce reps on the call for only 2 customer reps. In addition, our understanding is that commission pools, while shared, had a lot of duplication to retain these people. The company is also focused on building its reseller network, improving automation in customer renewals, and a self-service model at the lower-end.

Former employees have expressed concerns that they have cut too much in areas such as product specialists and solutions engineering. Our checks also highlighted a potential future opportunity to restructure the R&D division with a view that there are too many senior staff that are not actually productive (i.e. redundant management layers with people not actually designing and coding software). We are comforted that key areas, like AI, are still getting the level of investment warranted.

In 2022, Salesforce had an activist presence emerge in the shareholder base and on the board. ValueAct is the most influential of these activists and their CIO has taken a board seat. We know the team at ValueAct very well. They are great investors and have a very long-term approach when it comes to activism. Having observed them in other investments, we think their presence is positive and that they will help drive accountability and discipline on costs / efficiency without driving cuts that could hurt long-term value. Overall, this presence increases the potential for efficiency improvements. While positive to long-term value, we see it more of an acceleration since we were already assuming various improvements.

Strong & aligned management

Salesforce has a solid execution track record, and we like the alignment of a founder-run business. Marc still owns ~2.3% of the company (worth about $5.7b), which means he is very aligned to long-term performance. He is still young at 59 but succession is a consideration. The company has had two co-CEOs in the past, but both ended up leaving. We note that Marc has been selling shares – his stake has fallen from 2.9% 6 months ago with continuous small sales and a $130m sale in late December.

As mentioned above, Salesforce has an M&A advantage given its established sales & distribution network. However, there has been mixed performance in larger acquisitions. While there are various examples of success, two large acquisitions in Slack and Tableau have been disappointing. We think Slack made strategic sense given Salesforce’s Microsoft-esque transition and because it doesn’t make sense for Slack to be a standalone business. However, the price paid versus growth realised has not been great. In Tableau’s case, the significant reseller distribution was not well integrated and supported by Salesforce, which has led to disappointing growth versus the price paid.

Strong business resilience

Salesforce has a high level of recurring subscription revenue and 1.3x contracted revenue versus FY25 expected revenue. In addition, there is limited debt with high cash interest coverage and long maturities.

Key Risks

Growth slowing more than expected. The biggest risk to our investment is that we are wrong on the future growth profile. This could play out through a combination of market saturation combined with competition. The areas of competition that concern us most are the lower and mid-market. Salesforce is a complex enterprise-grade product and is more expensive than other solutions. While its functionality is greater than companies like HubSpot and Microsoft Dynamics, the price of these products make them attractive options for smaller businesses. The risk is that Salesforce becomes more and more enterprise-heavy and loses ground in the valuable mid-market (lower contract values but many more potential customers). In the meantime, the HubSpot and Dynamics products are constantly improving. We also observe pureplay competitors branching into other verticals. For example, Zendesk, which competes with Service Cloud, is branching into sales.

M&A Risk. As growth slows, companies like Salesforce come under greater pressure to make acquisitions in higher-growth areas with the risk of overpaying or poor execution. We have seen this in Slack and Tableau (discussed above). We gain some additional comfort here from the presence of ValueAct on the board, who we think can help instil M&A discipline.

AI Execution. Generative AI has the potential to create a step-change in functionality in customer data and engagement applications. Salesforce has an advantaged position given the breadth of data in its systems, but it will need strong execution. This is something we continue to monitor, and the risk goes both ways. That is, it could create upside as well as downside relative to our base case.

Valuation

Our valuation summary is shown below. We outlined our valuation approach in our founding letter. We typically model businesses towards a steady state (usually over 5 years but sometimes longer) and focus on the free cash flow generation of the business. As of 5 Jan 2024, our IRRs going forward in our downside, base, and upside case are -1%, +14%, and +24% respectively [2]. We compare this range to our cost of capital for a business of this quality and assign a valuation score of 1 out of 3. With the strong stock price appreciation, the forward returns have compressed but are still attractive versus competing alternatives.

In our base case, we assume that growth decelerates to high single-digits, which still represents a 5-year CAGR in the low double-digits. Our rationale for this is discussed above. Our downside case assumes a more rapid deceleration. The upside case assumes the low double-digit rate continues, supported by various initiatives including AI.

Our base case has significant margin expansion. This is primarily due to reduced S&M spend to align with the new norm of high single digit-growth. The downside case also assumes a further deterioration in customer acquisition costs, while the upside case represents higher S&M spend to support higher growth. Other areas of margin expansion come from economies of scale, efficiency improvements (discussed above), and a roll-off of acquisition-related intangibles amortisation given our projections assume no new acquisitions. The business has already made substantial progress on the margin in FY2024 relative to the FY2023 numbers shown below.

Combined our base case has FCF per share compounding at ~20%. We assume an exit Forward-FCF yield of 5% in our base case (versus 3.5% today), which reflects the quality, growth, and margin profile of the business at exit. This multiple compression creates a 8% annual headwind to returns.

Business Update

We welcome two new clients to Kalakau Avenue and are enormously grateful for this privilege.

We look forward to the next 5 years and beyond.

Matthew Brown

Founder & Chief Investment Officer

Footnotes

[1] Also Parker Harris, Dave Moellenhoff, and Frank Dominguez

[2] Refer to our disclaimers, we make no guarantees of future performance, and our projections should not be relied upon