Chit Chat Stocks - Procore (Ticker: PCOR) Not So Deep Dive

Episode Date: November 22, 2022

Procore Technologies (Ticker: PCOR) provides a cloud-based construction management platform and related software products. The company's products allow for collaboration between internal and external stakeholders during all stages of the construction process. At the end of the month, we will publish an Arch Capital episode that will cover the company: Autodesk. Listen closely as Brett and Ryan go through the history, financials, and future prospects of Procore. Enjoy the show! ****************************** Interested in becoming a member of 7investing? Subscribe with code “MONEY” and get $100 off your annual subscription for life: https://7investing.com/checkout/ ****************************** Subscribe to our Substack to receive free show notes and charts that go along with every episode: https://chitchatmoney.substack.com/ Want updates on future shows and projects? Follow us on Twitter: https://twitter.com/chitchatmoney Contact us: [e-mail] Timestamps Company Background | (3:01) Industry | (12:37) Management & Ownership | (14:48) Earnings | (19:49) Balance Sheet | (24:48) Valuation | (26:09) Our Analysis | (27:17) Disclosure: Chit Chat Money hosts and guests are not financial advisors, and nothing they say on this show is formal advice or a recommendation. Brett Schafer and Ryan Henderson are general partners and portfolio managers at Arch Capital. Arch Capital and its partners may hold securities discussed on this show. Learn more about your ad choices. Visit megaphone.fm/adchoices

Welcome to Chit Chat Money. On this show, hosts Ryan Henderson and Brett Schaefer interview industry experts and riff on the world of investing. As a quick reminder, Chit Chat Money is a CCM Media Group podcast. Ryan and Brett are also general partners at Arch Capital, and Arch Capital may have positions in the securities discussed in this podcast. Anything discussed on Chit Chat Money by Ryan or Brett or any other podcast guests is not formal advice or a recommendation. Now, please enjoy this episode. Welcome in. This is the Tuesday Not-So-Deep-Dive episode on Chit Chat Money. Today, we are discussing Procore in our fourth, third, third installment in the engineering software series

for the month of November. Previously, we covered Dassault Systems, which was the, or no, was it, is it fourth? I think it might be fourth. What was the one? Oh, yeah, Bentley we covered. Yeah, this is the fourth for the engineering software systems. We had Dassault, Bentley, ANSYS. ANSYS, yeah. Yep, simulation all around.

Procore is more construction, which we're going to talk about today. First up, though, housekeeping items. Remember, for each one of these episodes, we are putting a newsletter out for free that has the show notes and charts and metrics that we may reference throughout this episode. So sign up for that. The link will be in the show notes. It is free over at Substack. Second, I think that is it. So let's just go to the advertiser, 7investing. Use our code money to get $100 off your annual subscription for life. What is 7investing? I guess we should probably talk about that at least some

of the times because we kind of go into the details of what they do. 7investing is a research service for stocks that does seven recommendations each month, hence 7investing, where they have seven different advisors. Yes, they love the number seven that do one research report each month and they track how the recommendations are doing versus the market. They update you on all the recommendations. They want to be active in, okay, we recommended this a year ago, but is it a good buy now? We're going to keep updated with the company. We might say, okay, these ones we made a mistake on, but these other ones are actually doing extremely well. So we focus on these areas of the companies that we're recommending. They do love to have an active

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and on the fence of subscribing. But it is a great service and they provide a lot of value for individual investors. So use code MONEY to get $100 off your annual subscription. All right. I think that's it, Ryan, for the intro.

Let's talk Procore. Technically, Procore Technologies is the full name, but we're going to abbreviate it Procore for this show. So for those that have listened to the show before or are recurring listeners, you may have heard us talk about the business before. So unlike, I would say, Bentley Systems and Dassault and maybe even Ansys, this is a business that both Brett and I were pretty familiar with heading into it. So, however, we hadn't really kept up as much with the stock and the valuation and I think quite as much with the financials, but we had a good grasp on the business.

And if you want, we've interviewed the CEO in the past, I think twice on the show. So feel free to look those up, but let's get into it. So Procore is one of the leading providers of cloud-based construction management software. So their stated goal is in quotes here, connect everyone in construction on a global platform. And so to kind of try to lay the foundation, no pun intended here, and I've got a feeling I might have a couple of puns throughout the show, but to lay the foundation on any given project, like a construction project, there are typically a number of different stakeholders that have to work together.

So there's the general contractors. The general contractors will also hire out for specialty contractors. There's the owners, there's the architects, the engineers, and all of them are often working from disparate locations. So specialty contractors may come in for a little bit. They may have an office somewhere else where they do their work. People at the general contractor might be going to and from the job site and the office. And so having one uniform platform where everybody can access important project information, communicate, use the platform as a system of record is really, really helpful. And in a way, I guess this feels similar to, and you can maybe differ with me on this analogy, it feels a little bit like Dropbox for the construction industry. yeah or or google drive or with a combination of communication so slack as well yeah it's like those workplace management tools that people might use but tailored to the construction industry because they have very specific needs yeah they cover a number of important industries or important areas for their customers and so i'll try to go through each one so the first one

is pre-construction um in order to get work if you're a construction team you submit bid proposals to potential projects. That includes, I'm sure a lot of general contractors are like, have existing relationships with owners. So maybe the bids aren't as important in that process, but for specialty contractors to get work from general contractors, there'll usually be a project. You will submit a proposal. Your proposal will say basically what you can do for them and how much it'll cost. And then if they select you as their specialty contractor, then you go in and you join the project with them. So within the pre-construction product, Procore has that bid management software. So you can manage and create all your bids from one dashboard. It's really

seamless and easy. But the main product that most people use is what they call project execution. So this is where Procore started and it includes their core offering today, which is just kind of what we talked about in the lead up here, which is project management. So the project management product itself accounts for 51% of all of Procore's annual recurring revenue right now. And then within project management, it's probably a little bit what it sounds like. It's pretty holistic. So you can upload models, you can upload pictures or drawings if you're on the job site and you need to send something back to the office for someone to kind of tweak. You can take a picture of it because it's not always the same as it is in the models.

And then you can add data, you can add specifications. Basically, it serves as sort of that communication platform and system of record, as I mentioned. And then I think there's other stuff within project execution, but that's really the biggest product. And then the two other ones they have are workforce management and financial management. Workforce is pretty straightforward. And I think it's a pretty easy upsell. So it just helps customers measure field productivity and plan out their workers and their work time. So kind of a replacement for whiteboards or time cards, stuff like that. Financial management, this consists of, I looked through this product because I didn't know it that well, but basically you're editing and revising budgets

constantly throughout a project. And within the financials, this is really where you're doing it on Procore. I believe this is probably the most, this is typically, I'm guessing, replacing Excel for a lot of these customers. And it allows you to kind of do it in one place where a lot of other people on the team can have access to it as well. So it's not as, that's kind of one of the benefits there that Procore is unlimited users. I probably should have mentioned that. They charge on an ACV basis. So they charge their customers for annual construction volume. So instead of charging on a per seat basis, basically they're combining how many projects they're running on Procore and what the value of those projects are worth. And then they're giving them custom pricing based on that.

And then they can allow as many users to join the platform as they want. So you're not getting a user here or a user there that's not in sync with everyone else. So that part's kind of nice. The other thing I'll mention, 44% of ProCourse customers use four or more products. So this has been going up over time. There's an increase in attach rate, and I think they're continuing to build out and improve the additional products beyond just that project management solution. Anything else that I should talk about, you think, for the business?

I will have a chart in the newsletter that has the net retention rate, which kind of goes over the revenue growth from existing customers. And it's consistently been over 100%. So yes, very impressive land and expand model for them. Yeah. The other thing is just in terms of size, Procore has more than 14,000 customers. And keep in mind, these customers are often big. So big general contractors, there's definitely more users than just the customers.

And then as far as I can tell, they are the premier product or the market share leader for construction management software. seems like the most used app used app on the job sites um as for history procore was initially founded in 2002 by tui court of manch uh prior to procore tui had he'd worked in construction throughout kind of middle school high school college and then he always had a technology interest so uh he basically got taken under his wing by a family friend who who worked in technology and kind of taught him different elements of software and then there was also So some self-teaching going on there as well.

And he ended up starting his own company in Silicon Valley called Webcage in 1996. From what I understand, they basically just sold user interfaces to HR companies. And then that ended up being a decent success. They were still running it, but his wife and son, I believe, wanted to go back down to Montecito, didn't want to live in San Francisco. He was going to and from, and they've started to build out this new house. And while he was building out the new house, he realized how little communication and just continuity there was on a project, on a construction project. And he thought it was kind of the perfect tie between both his interests in technology and construction.

And he had software developers from WebCage draft up basically this little project management tool or software that allowed him to manage the property from a different location. And apparently it was a bit of a success. People that he knew in the area wanted to license it and use it. And I'm not sure how he ended up switching from WebCage to Procore, but he thought this is a business that could really work. However, it didn't get as much traction as most people would probably think. In 2002, there really weren't that many internet connected devices on the job site. And so it wasn't quite as useful.

And it really didn't start to pick up until about 2008 when there was that proliferation of internet connected devices and more and more people had iPhones and- Tablets. Tablets as well. And so that's when the value really started to show itself for Procore. Since then, I think throughout the 2010s,

it's been just steady growth. They seem to be a really good sales oriented business where they're selling it at big general contractors, expanding within the general contractors, upselling them to other products. And then they've acquired, they've not only built out a bunch of iterations to the platform, probably from customer feedback, but it made some acquisitions as well that have

helped with the platform. The other thing I'll mention, a lot of construction companies have their own softwares that they use. So think of all the potential partners here. A lot of construction companies probably use things like DocuSign. Procore has a pretty extensive partner marketplace or app marketplace that you can integrate your own softwares that you already use on there so it really kind of just serves as a dashboard for uh big construction management firms yeah all right i'll hit industry competition at their investor day which is actually quite recent so good timing on this it was in november they put out a lot of good numbers on their addressable market and the industry numbers uh that they go through and research and they know

about that better than most other people because of all the data they have uh which we'll link in the newsletter if anyone wants to check out that presentation uh if we look at the industry Industry construction spend globally was about $11 trillion in 2020, and that is expected to go to about $15 trillion in 2030. Now Procore's opportunity is not in the trillions, but I think they should be thought of as a low single-digit percentage of overall construction spend since, given their model, they would go off of the construction volume of projects. Now, right now, less than 2% of industry spend is spent on IT software and stuff like that.

And construction is one of the least digitized industries in the world. Only agriculture and hunting are behind it, I believe. So if we look at Procore and try to estimate kind of an opportunity for them and take that $15 trillion number, multiply it by 2%, that comes out to $300 billion. I think I'm doing that right. Yes. 300. It's a massive cap.

It's huge using that methodology. Now, if I put my common sense hat on, I think that might be high. I think it's high. But the opportunity is still large. If it's only $100 billion for construction software, I mean, it's quite large. If it's only $50 billion, I still think that's quite large. As we'll go into later, they're less than a billion dollars in revenue today. I believe competitors, there's like Ryan mentioned before, there's kind of a standard workplace management software and stuff with Microsoft, Oracle, Dropbox, Google Drive, I guess, even for the free version. However, the main competitor with PurePlay construction software is Autodesk, which we'll actually cover next week as that's a company we own. They have their Autodesk construction cloud, which launched a couple of years back, and they've copied a lot of what Procore offers, and they offer a lot of similar products. Um, but Procore was definitely the visionary in the space and a lot of these other companies are trying to catch up.

Now let's move to management, ownership, compensation, uh, Ryan, go ahead. I guess one thing on TAM, because you'll see a lot of, if you look through their 10K or even their S1, there's a lot of talk around the total addressable market. This is an industry where I think there's still a lot of low hanging fruit and they're often not competing with existing solutions they're not trying to replace existing software systems but just trying to convince a lot of the customers that it's worthwhile to try to use a construction man like a software for managing communication and documents so uh i guess that's that's to say that it doesn't look like it's going to be a winner-take-all market right and i'll

remind the listeners yanks i think this is important uh they are one of the least digitized industries in the world. Construction, I should say, is one of the least digitized industries in the world. Only agriculture and hunting are behind that. Now, let's go to management. The founder, CEO, and chairperson is Thuy Quartemont, just like Ryan mentioned. He's been running the ship for around 20 years, owns about 5% of the company, but does not, and this is important, have voting control. So it's standard stuff, no dual class, all that good stuff. If we look at the board, there are nine members of the board, and it's a big mix between other software executives and venture investors that were in Procore. TUI is the only Procore executive on the board.

I thought it was interesting, pretty standard in that regard. Board of Directors pay was about $3.2 million in 2021, or 0.6% of gross profit. Now, if we look at executive compensation, in their proxy statement, they only listed three executives for their named executive officers. However, if you look on their website, on their IR page, they have 15 executives and SVPs. So the actual pay there, it might be a bit different. But really the executive compensation for the people that are listed, it was $20.2 million in 2021 or 3.8% of 2021 gross profit. So not a bad number there. A lot of this was in stock options and RSUs.

but for some reason, when looking at the proxy, they were not listing out why people achieve stock awards. I cannot find it on this year's proxy statement. And they've only been public for a little while. So maybe that'll come next year. But again, the proxy was a bit barren versus some of the other stuff we've seen, which isn't a bad thing. But just if you're following the company, maybe look at next year and hopefully they have more detail. Now, the one thing I did see that their compensation practices are very standard. I don't know if this is necessarily a good thing, but it's not a bad thing. There are cash bonus pools each year that are based on dollar values of new subscriptions and operating income. So basically, if they hit some sort of

dollar value that they added in subscription revenue, or they hit some operating income target, they will get some cash bonuses, the executives and quote here, if they hit individual objectives set by the compensation committee. So there are not hard rules. Sometimes the executives can get bonuses on purely discretionary manners. Didn't find any big red or yellow flags with the proxy statement, which is a good thing. However, I get a little bit nervous with companies that have heavy venture capital influence. They have different compensation and hiring philosophies that may not align with public shareholders. If we look at their ownership table. Iconic Hue Strategic Partners has 32.3% of the stock, and Bessemer Venture Partners has 9.7%

of the stock. So heavy, heavy influence from the VC firms that are still there as of the proxy statement. And I looked up, and again, it's hard to get the update for some of these people because they don't all file 13Fs. But according to Whale Wisdom, the ownership aggregator, these two venture firms still own a large portion as of now. Let's see, other things are important to note. Yes, lastly, at the end of 2021, and this is important, there were 12.6 million potentially dilutive securities, which are stock options or RSUs, which is just under 10% of shares outstanding at the time. If we look at their shares outstanding from 2017 to 2021, It grew a 10.6% a year.

So make sure you're looking at revenue per share numbers. Make sure you're looking at cashflow per share, gross profit per share, because they like to finance this business by issuing stock to employees and other people. There may have been some pre-IPO grants. Oh yeah, for sure. Yeah, but it was consistent each year. And yes, the IPO, they raise stock, but that's how they finance it. So just look at that. It's not necessarily a bad thing because they've grown quite quickly. And if we look at revenue per share, it's grown at 32% over that same time period. So quite impressive, but don't look at revenue in, what am I trying to say? In a vacuum. All right. Earnings, Ryan, what do you got for us?

One other person that's on the board and owns a big chunk, and you have him here listed in the ownership table, is Kevin O'Connor. He, I believe, was the first investor in the company. I think in 2004, he wrote them basically a million-dollar check and has kind of been with the company ever since. Hey, wow. Yeah, I'm sure that has given him plenty of good returns since. I think, I believe Paul Leandros, the CFO, was in there really early at the same time. So all three of those, I think they were the initial executives between Tui, Paul, and Kevin. They're all still around. So it seems like they get a lot of value out of this job and plan on sticking with the company. So a little bit of a positive there. As far as earnings go, I'll touch on 2021 and then go into the most recent quarter. So just over half a billion dollars in revenue in 2021, that's growing at 30% year over year. And then 81% gross margins, almost a very standard software-like income statement, high gross margins.

Yeah, for SaaS too. And like I said, there seems to be a lot of customers that are available to sell to. And so they're spending a ton of money on sales and marketing. But a lot of that is stock-based compensation. So you'll see a pretty big discrepancy between their gap earnings and their operating cash flow. They were operating cash flow positive last year, but they've basically been around break-even on a cash flow basis. And I'll have a lot of charts that can show that in the newsletter to kind of visualize that from 2017 to now. Most recent quarter, $186 million in revenue, really just a strong quarter.

It was up 41% year over year. However, they made a pretty big acquisition of Levelset, which I'll talk about in a little bit. If you exclude that, still growing 34%, 80% gross margins again. And then they're spending, as I mentioned, all of their gross profit and then some on operating expenses and primarily that sales and marketing. So operating expenses breaks down as 50% sales and marketing, 32% research and development, and 18% general and administrative. And a fifth of the operating expenses are paid in stock-based comp. So they really are trying to incentivize a lot of their corporate employees with that stock. Revenue and per share, everyone.

with this one. Yeah. And then more than 14,000 customers, as I mentioned earlier, their customers are growing at 20, 21% year over year. And that actually excludes level set. So good organic growth there. And they're also, they have a 116% net revenue retention rate this quarter. So not only are they growing customers quite quickly, but they're cross-selling a lot of their solutions and getting more spend out of their existing customers. Other important numbers to mention that typically their contracts are one to three years. So remaining performance obligation can be a good indicator of what revenue is going to be moving forward. So they had $715 million in remaining performance obligations. That was up 44% every year. So it's

growing faster than revenue growth. You like to see that 70% of that is expected to be recognized in the next 12 months so uh revenue for the next 12 months looks like it's going to be pretty strong uh it's a fairly easy business to forecast on a revenue basis yep and at the investor day the cfo mentioned that the correlation uh between short-term rpo which is remaining performance obligations and revenue is extremely high so that can tell you that's the most important forward-looking indicator that they give out each quarter yeah the last metric i'll throw throw in here, 95% gross retention rate. Since they're increasing the spend from their existing customers that stay on, it's probably the more important figure, but 95% just means 95% of the

logos are staying year after year. Did that number surprise you at all? I don't think so because there's a lot of small contractors that go out of business and it's a low margin industry. Or maybe use it for a couple of projects kind of thing. That's right. They might not need it for every project. I don't think that's a huge issue. I think net retention is probably the most important one because those large contractors like Skanska or something like that, that's going to drive the majority of revenue. They actually give a great outline of specific customers. They probably use the best example, but of some European one that went from 100,000 ARR to 2 million over a few years. Now, not every customer is going to be like that, but they are very, very good at landing

and expanding with the large general contractors, even if maybe some of that gross retention is lower. All right. Balance sheet and liquidity, really straightforward, pretty easy. This job wasn't too tough for me. more than half a billion dollars in cash and marketable securities and no debt. They actually had more than a billion, I believe, when they first joined the public markets from their equity raise. Billion in cash, not debt, right?

Cash. Yeah, yeah. But they acquired Levelset for half a billion dollars and 425 million of it was in cash, 75 million was in stock. So they used a lot of it to make that acquisition. However, on basically breakeven cashflow. Looks like they have more than enough liquidity to be happy. Only other line item that was maybe worth noting is deferred revenue. This is recorded as a liability for them. We kind of just mentioned it,

but it's just cash they've collected from customers in advance of servicing the contract. And given that it's a software business, not very costly to service that. So it's- Yeah, it's like, I kind of think of it- It's a pseudo liability, really. think yeah i people might take a maybe they probably want to take offense to this but i

kind of think of it as a fake liability you want to see it grow yeah uh if it's growing that's a great thing that's uh that means they're they've got plenty of backlog um and a lot of their customers are paying up front so um really clean balance sheet not a whole lot to talk about there all right yeah i'll hit valuation pretty simple one here and since they're unprofitable it's not going to be the best one to value on. So market cap 6.9 billion and enterprise value, since the high net cash position is actually down to 6.38. So let's call it 6.4 billion. The only two metrics I have are EV to sales and EV to gross profit, just because they're not generating positive earnings and they're not generating positive cash flow. I think cash flow is fairly close to flat,

but again, that's not going to really help us out here. So EV to sales trailing 12 months is 9.6 and EV to gross profit is 12.1. That gross profit multiple, I think is the most important and it is still quite the premium versus the average stock on the market. I think the average would be around six to seven for a company out there. So again, they're probably around double

what a standard one is. And go ahead. That kind of, it has not gotten sold off as much as I would have thought given sort of the timing on their IPO. Yeah. Well, their revenue has just grown. They've been too good. They've been too good at growing revenue. All right. Let's move to anecdotal evidence. Ryan, what do you got for us? We do have some friends in the industry, so it's been all positive. Yeah. The college we went to has a decent construction management program. So we had a couple of friends, I think, that I have old friends. And at the investor day, they talked about how I think they're in like 95% of education

institutions. So that was a really, really positive note I saw. And they're 95% of construction management colleges. Yeah. I'll maybe throw that in my highlights too, even though I forgot to write it down. Yeah. I got a couple of friends that work for general contractors and I probably annoy them when I ask about it because I've asked about it maybe one too many times, but they all swear

by it. They say they love Procore. it saves them a ton of time and they end up spending a lot of time on the platform because it makes their life easier um and maybe that leads into something else that's worth noting because you can add unlimited users if you are a customer of pro core there is a little bit of a network effect here where if you add specialty contractors to your project or something like that they can kind of see the value of the platform without having to pay initially and then it's virality but yeah it's uh they described it as a network effect in the investor day i kept

thinking i wanted to yell at the computer screen it's vi it's virality not network effect but again that's an advantage what about you uh yeah same here uh any friends that i have in the construction industry say they like procore um i think that bodes well for not just procore but the construction software market in general because there's just a lot of people that are using highly inefficient pens and paper right now to go through stuff and the value add for say giving two percent of your project dollars for a huge increase in efficiency seems like just a great proposition you have a everyone wins um in the situation uh all right future growth opportunities they got a lot of things moving uh maybe we can debate of whether they're they have too many things but i don't

think it's it's not too many but again there's a lot to choose from here so ryan what'd you have Yeah, for me, it's Procore Pay. So on any construction project, there's obviously a lot of invoices going in and out for different stakeholders. So for things like materials or labor, you think about payroll as well. A lot of those documents are being uploaded to Procore's platform already. So being the facilitator of those payments seems like a logical next step. And they made that pretty clear. So during their investor day, they mentioned that they're planning to launch Procore Pay in 2023. This would obviously enhance their financial management solution, but I would think, and I don't know how they'll end up categorizing it.

It could also be applied to workforce management because you could potentially manage payroll within that also. um and then i think the level set acquisition should help here as well so as i mentioned last october pro court bought level set for 500 million dollars level set helps construction companies stay lean compliant and i might be lying lean l-i-e-n yeah i do not know how to pronounce that i i see it all the time you see it all the time documents yeah when i first read up on the acquisition i i did not know what it was so i kind of looked into it a little more and it seems like they provide a lot of value to companies in the construction process. So here's

what I wrote when the deal was first announced. The construction industry has a median of 90 days sales outstanding and 74 days payables outstanding. They mentioned that, which is the slowest of all industries surveyed across the globe. Given this complexity and delay in the payments process, a tool that's often used and relied upon by construction groups is known as a lion or lean, in particular, a mechanics lean. This tool ensures that the parties involved in a construction process or project get paid appropriately for their work by using the physical property as backing. So basically, yeah, the lien collateralizes the project, but on top of it, it's difficult to stay lien compliant. There's like a lot of filings that you have to do and

kind of legal work around it. So level set is where you manage all those liens and it gives you basically the step-by-step on how to stay compliant. So, and you can, from what I can tell, Levelset's growing pretty quickly and was growing quickly prior to the acquisition. And that should be a helpful component, I would imagine, with ProCorp Pay. I kind of laughed when they talked about ProCorp Pay

because a lot of software companies hype up that they're doing payments just because it's such an easy value add. However, there's big cashflow issues in construction, a lot of working capital stuff. So if they can improve that a little bit for their customers, that's going to be a huge value add as well. Yeah. They named a couple of growth avenues that they're going to try to explore in 2023. So we attached, if you're reading the newsletter at all, check out the relevant links. We attach the investor day slides. They talk about that.

Yep. All right. I'll hit mine. This is typically a cop-out answer for a lot of businesses. And Honestly, if you look at a company and they keep hyping this up, it's a bit of a yellow flag for me because anyone can really talk about it. But I think international expansion has a lot of problems for Procore, specifically because of their high net retention rate. So if you look at international revenue as a percentage of revenue, it went from 8.2% in 2017 to 14.6% in 2021. And I believe in constant currency, it's marching higher, but the FX headwinds have hit them a bit in 2022. Now, with how many markets they are pushing heavily into, again, go on to the investor day, they were only in a couple different markets heavily before the last year

or so. Then with a more loaded product suite than they had in 2017, even earlier, if we're looking at maybe the US market, I wouldn't be surprised if international revenue grew at 30%, 40% a year for many, many years. The growth there has been very, very impressive, and now it's becoming a meaningful part of this business. I'm pretty excited about that if I'm looking at Procore. And given that construction, yeah, there's slight differences in each market and there's language barriers and stuff like that. It's kind of the same blueprint, right? So it's pretty replicable. It's not like moving some sort of media thing from the United States to Brazil where the culture might be entirely different for construction.

I believe it's a lot of overlap. And something that I believe you mentioned to us in one of our interviews is that a lot of their existing customers are multinational companies. So they kind of have a logical foot in the door when it comes to a lot of these markets. So seems like the international growth could be a little more seamless for them than other software-based businesses. Highlights, lowlights, I'll go first here. So two that I forgot to write down, but the university lock-in is always kind of nice to see where if you're a construction management student, you want to get acclimated to this software because they're going to be using it in the real world. Additionally, if you're a firm and you're hiring new construction management students, you want to use Procore because it's the software they're used to using. If a software is listed on a job listing as a requirement, that usually indicates a strong moat.

Yeah. Other thing, I mentioned this earlier, I think there's a ton of low hanging fruit in terms of potential customers. I might be botching this quote, but I remember him. I remember Tui telling us 50% of customers we reach, they reach out to are still relying on pen and paper. So it's more selling, selling the value prop of software in their business than trying to replace competitors. And that makes sense. I think common sense, thinking about the industry, it totally makes sense. Let's see other highlights. I hate to use the word channel checks. Cause I think it's like, you're just like, yeah, channel checks is hyping up people. You message. Yeah. Every, all my quote unquote channel checks lead me to believe that Procore is valued by their customers and fairly sticky it just it seems to really make everyone's life easier in construction and a lot of the construction friends i've had said everyone they know is kind of switching to it it's becoming sort of the go-to software um last one i think

pro core pay is is could be pretty additive to the platform the payments thesis i think it works Yeah, but I feel like every company you think like, well, everyone talks about payments, but it really works for this business. It seems like it does, given the invoices that are going in and out for each business and the potential payroll synergies there. Low lights for me though. And even though Procore has customers that work internationally or have subsidiaries internationally, I imagine Autodesk has more international customers. So given that they're plowing a lot of resources into this construction cloud, I would think they might have a leg up in the international markets. Yeah, they probably have more sales reps in countries already, stuff like that. Yeah, that's potentially a low light. And then I put here the gross retention wasn't quite as high as I would have pictured. I would have thought it would be stickier, but I think this market's pretty early in the digitization. So maybe a lot of customers are kind of trying it out and not realizing, or they use it for a short time period.

I think that retention is more important, but yeah, the gross retention, something to track. If they stop reporting that, that would be a concern, right? Because they don't have to. Another low light, having spoken to TUI, I sometimes worry that it can cloud my judgment or put blinders on for me. That's not specific. It's not a problem with the business, but more a low light for me potentially investing. Yeah, that's always true, but that's something I personally got to deal with. All right, my highlights. Industry tailwinds, great.

I think you already talked about that, but I would not be surprised to see revenue growing quickly. And this is a really easy business that you can identify and think they can, quote unquote, ride the wave of the industry growth for many, many years, probably the next five to seven years. I would not be surprised to see them growing 20% a year. Second highlight, they're landing expanded net retention numbers are very strong and leads me to believe they have a great sales culture and are providing tremendous value to these customers. It's not one of those fake software programs that, I mean, not fake, but like software programs that are nice to have, it's a need to have. Third, I think the switching costs for these software programs while they've added these new products really enhances that.

So they talked about in the investor that it kind of, you know, it's like, oh, okay. Because that was a concern with me while, you know, when they released their S1 and they went public, I was a little bit concerned that they were a one trick pony, but they've really fixed that and are fixing that with all the new products that they're adding on here. I think that's really great for the switching toss. Low light's income statement is ugly. 74.1% of gross profit was spent on sales and marketing in 2021, and 57% of gross profit

was spent on R&D. On the latest conference call, management said this will change and that they're looking to, quote, grow more efficiently. But it's still a wait and see game. So again, it's a low light until they can prove that it's not a low light. Second, low light, competing with Autodesk while they're focusing on this is a bit of a concern. However, this market opportunity is so large, I think they're both going to do well. Third, revenue per employee was much lower than some of the other software companies we looked at.

It was only $178,000 in 2021. I think this could easily change five years from now. If we get net retention well above 100%, we move into international growth to continue growing quicker than overall revenue. but it gives me less confidence that they can hit 20% cashflow margins within a few years. Maybe they couldn't five, but that revenue per employee, I think is a big highlight because we looked at say, and I don't want to get this wrong. So maybe I'll confirm it while we're talking, while I'm talking about this, but some of the other engineering software companies that we've looked at have maybe 300,000 to 400,000 revenue per employee. And that allows them to get to that

30 40 margin where pro core has a lot of progress to make before they can achieve that yeah one of my thoughts here is that a huge chunk of their employee base is in sales and they're younger they're younger they're younger business so and a lot of those employees are likely compensated on a commission basis and so when you get a big like big years of customer additions i imagine a of that commission is recognized up front so you're going to have like increased expenses in years that you're growing quickly yeah but that's the same for ansys and they're at 373 000 374 000 excuse me revenue per employee again but they're not growing they're growing customer account much quicker that is that again that's true i think they will get there over time

but the path to the same sort of margins as uh an ansys or bentley or just so So they are going to have to get more efficient if they're going to hit that 40% margin. Don't think they need to. But again, I would not expect margins much more than 20% unless they get their revenue per employee higher. Yeah. All right. Yeah.

Go ahead. Next section. Bull case. I'm just going to go through some of the numbers to kind of just paint a picture on it. So let's say five years or in the next five years, they have twice the customers that they have today globally. That would be about a 15% annual growth rate. that's, I think, rosy. But like I said, there's a lot of customers that can adopt this solution

and the international expansion is in its early stages, in my opinion. So between that and the domestic markets still having some low-hanging fruit, I think there's a path to 15% customer growth a year. And then whether it's through product expansion, volume increases, or price raises. And by volume increases, I mean that just their customers are adding more projects with Procore. Customers increase their spending with the company by let's say 8% annually. So that's about half of the current net revenue retention rate. So I guess you could say that's conservative. It kind of depends how much value. Reasonable, reasonable, probably. It's going to low eventually it can't be 125 forever yeah when you look at a business like autodesk who might

have more pricing power i would say they do uh that's still running at 110 percent that revenue retention rate right they say well they don't give it out specifically but they do 100 to 110 i think it closed it's closer to 110 and again they're more mature but yeah you can't you can't be that you can't be getting revenue growth that's that high from your existing customers forever All right. Well, let's say 8% annual customer growth, customer annual spending per customer, and then double or 15% growth in customers each year. That's about $2.2 billion in annualized revenue. Now, in the investor day, they didn't really have a margin target, but I vaguely remember on their investor roadshow, which I could not find the link to, them targeting 20% operating margins long-term. So if we just throw that on there, like I said, this is the bull case here, that's $440 million a year in non-gap operating income. Now, like I said, bull case, so it's a lot of rosy assumptions.

throw 20 times on that um it's an 8.8 billion dollar price tag versus i think it's probably six six and a half billion dollar enterprise value today so it's richly valued those returns would not be that great no but they could grow they could exceed those estimates that i think they could grow revenue overall revenue a bit quicker but again those are high expectations yeah so i I think the business has to perform pretty well for this to be a good investment. Yeah, I think my bull case is similar. I'm just going to say from a more maybe holistic perspective that we are probably at the earlier stages of this multi-decade tailwind in construction software.

And I think it could be similar to the engineering software markets maybe 20 to 30 years ago, which would be very, very positive for the industry. And I think it could lead to durable double-digit revenue growth for 10 plus years or longer. It's dangerous to extend that time horizon, but I think you might have to, given this valuation today. And we talked about the margins, that's going to be an important thing here. But if they can grow revenue by 15% a year for 10 straight years, it would be hard for the stock not to work, I think.

and yes it's very hard to say oh 10 years from now they're going to grow a revenue of 15 a year i mean the world's very unpredictable but given the durability of the construction industry and given the tailwind of the construction software market i think procore lands into my 99th percentile of companies that i'm confident can like in their like how fast they can grow for the next decade yeah i'd agree with that all right bear case i think it's going to be margins and multiple huh yeah three three primary risks for me one is multiple compression second is dilution um right right didn't hit that yeah we we hardly touched on that and then the third one is potentially slower than expected attach rates on their new products so if a lot of the customers

are really just signing on to that project management solution. Now, trends are showing that attach rates are growing, but... Well, they're spending a lot of sales and marketing to do that. So we need, you know, how, what's the, right? I think, yeah. We need to see the leverage there over time. Exactly. So if those three things kind of occur, it feels like it's hard to justify the current

valuation. I like the business. I think it's a really good sales organization. I'm not that worried about the competitive landscape, but just a lot of things, they really have to perform well, attract a lot of customers, and add more value to those customers over time for the current price tag to be warranted. Yeah. And for my bear case, I'll throw some numbers in here. Like if you go through also those scenarios and you think they can get to $500 million in cashflow, which, you know, it's pretty good, but given their dilution and how fast share count is rising, that's probably a 15 times to 20 times multiple a few years from now. uh and if that happens like i mean you're going to take a lot of revenue to get there revenue growth to get there you're going to need to expect not only five like high revenue growth five years from now you're going to need to expect revenue growth to continue to stay high

five years from then so that's just the big bear case for me business is great but yeah all right more or less interested i think we both know the answer i think listeners know the answer here uh that valuation just holding us up yeah more interested love the business love the market great market i just can't i struggle to make it work at these prices yeah and i i'm going to say the exact same thing don't need to repeat it when we cover autodesk again slight competitor here also within the industry doing a lot of different things but they also overlap a little bit with the new product um if you look at the sales multiple and gross profit multiples autodesk is in a similar spot but they they have proven and are in a pretty good spot to hit 40 profit margins and that's just

a way you know huge difference between that and 20 so yeah it's just a different stage business for like it's not the typical stage of a business where i like to invest and i've seen a lot of i mean a lot of investors have gotten burnt over the last couple years investing well you need a discount yeah you need a discount i don't yeah exactly all right kind of it's it's a testament to the business model and potentially the durability of the growth that they still trade at this valuation given how much carnage there's been in software yeah and especially because they are not profitable software either um yeah so kudos to them they've executed phenomenally all right stock for next week is going to be ptc another core engineering one doesn't overlap with

pro-corporate overlaps, I believe, and what we'll get into it to so enhance us a bit more and maybe Bentley a little bit. And then as well as the month wraps up, we're going to be doing our Arch Capital episode on Autodesk to complete this series. It's going to be very exciting to cover those and get a holistic approach where we think if everyone listens to the episodes within this series, you'll have a great overview of the engineering and construction software market. All right, that's going to do it for this episode. Thank you all for listening. Remember, we are not financial advisors. And anything we say on the show is not formal advice or recommendation. We are general partners at Arch Capital and clients may hold securities discussed

in this podcast. Thank you all for listening. We'll see you next time.