The Network Effect Heard 'Round the World

Random Words from our sponsor, Public.com

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Jason’s Random Words

My guess is that if you read this newsletter and listen to our podcast, you probably have heard about what happened with CrowdStrike (CRWD) on Friday. And if you're one of the unlucky travelers or medical patients who suddenly had their travel, a medical procedure, or a court date delayed as a result, you may not be a very big fan of the company anymore. 

For those of you who don't know what happened, the short version is that a CrowdStrike software update basically crashed millions of Windows devices all over the world, grinding much of the digital and real-world economy to a halt. And while the company pushed out a fix quickly, the chain-reaction effects of millions of computers in business environments all crashing at once is likely to have repercussions that last for days, and in some cases, many weeks, for the businesses and their customers who were affected. 

CrowdStrike stock, as one would expect, took it on the chin, selling off more than 11% and erasing about $9 billion in value for its shareholders. 

Needless to say, in many of the corners of finance and investing social media that you'll find me, the general consensus was BUY BUY BUY! When you get the opportunity to buy shares of a wonderful business at a cheaper price, you should take advantage of it. 

In general, I agree with that! CrowdStrike is, by almost all the evidence, a very wonderful business. It has a dominant share of the cybersecurity category that in many ways it has created. It has been growing at an exceptionally high rate for years, both adding new customers, and expanding its relationships – business speak for how much money they spend – with existing users. Part of the draw is the network effect benefit of the cloud-based Falcon platform, that gives everyone the latest updates in seconds. That’s great, except when that update crashes a big chunk of the global economy on a Friday morning.

And I think that’s where a small case to be made for selling, and the biggest case to be made for, as Jeff put it, trade less, learn more. Let me explain. 

As a starting point, it does seem that CrowdStrike acted incredibly quickly to fix this. But! This wasn't a non-event. CrowdStrike's customers, in the aggregate, likely saw billions of dollars worth of commerce interrupted, and many of them will have added expense as a result. I'm not making the case that CrowdStrike has any liability (not a lawyer!) or that any or many of those customers will ask for something. Some surely will. 

But what I am making the case for is that at least some of those customers will revisit their cybersecurity software vendors, and there's a very good chance that SentinelOne's (S) salesforce made a lot of calls to CIOs and CTOs today. And at least a few of them agreed to a meeting. If a few big customers leave, and more and more tech executives tell their colleagues that they're making a change, we could see CrowdStrike's growth slow, or even reverse, much faster than you may expect. 

Don't get me wrong: I don't expect that's going to happen. But I think investors should take the time to consider the implications before just blindly buying shares assuming that it's a non-event and the stock is just going to rocket higher from here. 

CrowdStrike also isn't exactly cheap. After the big selloff, shares are down about 22% over the past few weeks, but still trade for about 22 times sales and over 60 times operating cash flow. That's significantly higher than it's been for much of the past 18 months, when its cash flows got large enough for the cash flow metric to be meaningful. And when its sales multiple was much higher, it was growing revenues at 50% per year, versus the 30% growth rates we've seen in recent quarters. 

The point is, even with the big selloff, the stock is expensive. For more context, you could have paid about the same price to buy shares back in late April, and very briefly, early June. This isn't exactly a once-in-a-decade buying opportunity. 

In a way, that's actually reassuring. There are some very smart people out there who know this industry very well and don't seem to be selling. That bodes well, and there's the case to be made that had the stock fallen 20% or more, some in-the-know investors were getting out before word that some big customers were leaving. So a bigger selloff would have maybe been a bigger red flag? I think maybe so.

So what's an investor to do? The same as we should do most of the time: probably nothing. Maybe buy some. Your financial goals and your plans for how you were going to allocate your capital probably shouldn't have been altered that much by Friday's event. For most of us, we should probably sit on our hands, let things play out a little more, and learn what the implications likely are before knee-jerk buying or selling on Friday's incident.

I made a video basically saying the same thing as these words if you want to watch it.

Jason