Over the last few years, the software as a service (SaaS) industry has emerged as a leading segment within the tech sector and the cloud computing space. This is unsurprising given the large number of SaaS companies growing revenue at well over 30% a year.
SaaS stocks are an exciting, and potentially lucrative, area of the market to follow and invest in. This post is all about the SaaS industry, with examples of promising SaaS stocks, and how to analyse and invest in them.
- What are SaaS stocks?
- Advantages of the SaaS business model
- Types of SaaS companies
- Investing in SaaS stocks
- Metrics for evaluating and comparing SaaS stocks
- Examples of promising SaaS stocks
What are SaaS stocks?
Until recently, the most common way to obtain and use software, was to buy a licence. The actual software was then downloaded online, or from a disk, and installed on a user’s computer. In most cases a licence was valid indefinity. However, unless a user purchased each new version, their software would soon become outdated.
The SaaS business model introduces two major changes to the way software is sold and used. First, the software is located “in the cloud” on remote servers, rather than on the user’s computer. Secondly, users pay a monthly or annual subscription fee, rather than buying the software outright.
Advantages of the SaaS business model
This new business model has transformed the software industry in a number of ways that are better for software providers and users alike. The result is that the number of viable businesses in the industry has grown, companies are growing at faster rates and software has become more accessible to more people.
Advantages for software providers
- Monthly subscriptions make software affordable to a larger market. Consider a software product that may have originally cost $250 to buy and would on average need to be replaced after 3 years. A lot of potential customers may not have $250 to spend – but if it were available for $25 a month they might be able to afford it. The company now earns $300 a year, with a larger market of users who can afford it. But even if they charge just $10 a month, they will earn $360 rather than $250 every three years. In this case the potential market size is even bigger.
- The subscription model reduces the chance that a customer will replace the software with a competitor’s product when it becomes obsolete.
- Subscription sales are recognised as recurring revenue which means future cash flow is more certain. This gives investors more confidence and makes planning easier for company management.
- The SaaS model can be combined with a “freemium model” or free trial periods to allow potential customers to try the product before buying it.
- The SaaS model gives more startups a viable go to market strategy. They can start with a limited set of features and small market. As features are added, the potential market grows.
- The SaaS business model is easy to scale and operating costs typically grow at a substantially slower rate than revenues. This allows SaaS companies to achieve a very high margin soon after they become profitable.
- A subscription model offers opportunities to cross-sell additional products and offer a tiered pricing system.
Advantages for users
- Users can access the software from multiple devices, including smartphones and tablets. They can also access their subscription from a device at work or at home.
- Users do not have to reconfigure their own settings when they install a new version of the software.
- Users do not have to wait for a new version to be released for new features. Upgrades can be added as soon as they are ready. This increases user value and makes marketing the product easier.
- The combination of cloud delivery and subscription pricing that software as a service offers, makes it easier for companies to scale their technology needs. They can simply add or cancel subscriptions from month to month, and don’t need to worry about hardware requirements.
- In some cases, subscribers only pay for the features, products or service levels they need.
Types of SaaS companies
The range of SaaS companies is growing rapidly. However, most SaaS stocks fit into the following categories:
- Productivity solutions: A large number of B2B SaaS companies provide solutions to help companies manage business processes, projects, and aid team collaboration.
- Data management: Collecting, managing, and analysing data is becoming increasingly important for companies. Unsurprisingly a large number of cloud solutions are available in this segment. Many of them are also making big data, machine learning and artificial intelligence applications available to companies via the cloud.
- Cybersecurity: As the risk of cyber-attacks grows, this is an increasingly important segment. The big advantage of cloud security solutions is that they can be updated with new code in real time.
- CRM: Several SaaS providers, including one of the largest, Salesforce, provide customer relationship management solutions to clients.
- ERP: The “enterprise resource management” software market is currently undergoing a second digital transformation as solutions are being migrated to the cloud. The companies that dominate the industry like SAP, Oracle, and Microsoft all offer cloud and legacy solutions.
- Communication Platforms: Several companies operate video conferencing, audio and text communication platforms. These platforms are used by businesses and consumers.
Besides these distinct categories, there are lots of companies that operate in smaller niches, and across several categories. Others are vertically integrated and focus on providing several solutions to a specific industry like the logistics or creative industries.
Investing in SaaS stocks
SaaS companies combine the high margins of the software industry with the numerous benefits of cloud computing. This means they can scale quickly across very large markets. The result is that numerous SaaS stocks are also potential multibagger stocks.
In the long term, the valuation of a SaaS company depends on the market size, the market share that each company controls, and each company’s profit margin. However, many of these markets are still growing, which means you must deal with uncertainty – and therefore volatility. In the medium term, you will need to pay attention to revenue growth, margins and how the company is performing relative to competitors.
Like many growing companies, SaaS companies often prioritise growth rather than profitability in the early years. But this means margins should improve as growth begins to slow. Like other cloud stocks, the rule of 40 can be used to filter stocks. Simply add the annual revenue growth rate to the net profit margin and discard stocks with a result below 40.
Metrics for evaluating and comparing SaaS stocks
The fact that SaaS companies can become very large means they often trade on very high valuations, despite the fact that many are not even profitable. This means there is always the risk of a steep correction if it becomes apparent that they are indeed overvalued. You can reduce the risk of being caught off guard by paying attention to the following metrics, some of which are specific to software stocks. These metrics can be difficult to calculate – however companies sometimes publish them, and other investors often mention them on forums.
- Price to sales ratio: This is the most appropriate ratio for comparing valuations – although it means little on its own.
- Cost of acquiring new customers: CAC is calculated by dividing the marketing and sales expenses by the number of new users. If this number is rising the company is struggling to make new sales. Even though revenue might be growing, growth may be unsustainable.
- Customer Lifetime Value: If you can find or calculate the CLV (not always possible) you can calculate the return on marketing spend, and whether or not the company is spending too much on marketing.
- Churn: The churn rate will show you whether the company is keeping customers, or just signing up new customers only to lose them later. You can calculate this by comparing the number of new users to the total number of users over several periods.
- Dollar Based Net Expansion Rate: The DBNER shows you whether or not the company is managing to sell new products or subscriptions to existing customers. This is a good sign as it proves that customers see value in the product. DBNER can be calculated by dividing the revenue from existing customers by the revenue from the same customers in the previous periods.
Examples of promising SaaS stocks
Most of the listed SaaS companies are based in the US. Europe does have a large number of SaaS companies, but they are smaller or are not yet listed. There may however be some interesting listings in the future. There are also very few investable SaaS companies in Asia. While China’s tech giants, like Tencent and Alibaba do own some SaaS platforms, they account for a small slice of total revenue.
The world’s largest software companies and other tech giants – namely Microsoft, Google, Apple, and Amazon all provide at least one product that could be described as a SaaS service. However, since we have covered all these companies elsewhere, we will only include examples of pure play SaaS stocks here.
- Adobe Inc (ADBE)
- Zoom Video Communications (ZM)
- Salesforce.com (CRM)
- Atlassian Plc (TEAM)
- Slack Technologies (WORK)
- Cloudflare Inc (NET)
- Shopify Inc (SHOP)
- Alteryx Inc (AYX)
Adobe Inc (ADBE)
Adobe is probably the best example of a company that has made a successful transition from the traditional software model to cloud computing. In 2011 the company announced that it would move its suite of creative products, including Photoshop, Illustrator, and InDesign, to a cloud-based subscription model. The cloud solution was launched in 2013, and by 2015 both revenue and net income were growing at the fastest rate in two decades. This increased growth rate has continued for the last five years.
Adobe’s creative suite now gives users access to 20 software products for $50 a month, while subscriptions for individual products cost $10 to $20 a month. Since this model was introduced, revenue from the creative products has grown from less than $3 billion to over $9 billion and now accounts for almost 70% of the company’s sales.
Adobe has grown revenue at 22% a year for the last five years, with an 87% gross margin and a 32% operating margin! The market value of $217 billion puts it on a price to sales multiple of 17. This is quite a modest valuation relative to other SaaS stocks, though it is a more mature business.
Zoom Video Communications (ZM)
Zoom is a company that has become a household name in 2020 as it has become an essential tool for remote working during the COVID-19 pandemic. Zoom, which provides an easy to use video communication platform, held its IPO in May 2019 and was already a market favourite before the pandemic began.
Over the course of 2020 the stock’s price has risen from $100 to as high as $600 as revenues have grown at 147% quarter-on-quarter. Its current price of $430 puts it on a price to sales ratio of 93x, with a market value of $125 billion. Zoom may well grow a lot more in the future, but it may be a risky prospect at the current valuation.
Salesforce is another favourite amongst SaaS stocks. The company has revolutionised customer relationship management with a range of data driven tools. Salesforce software helps companies manage and analyse customer data from a single dashboard. The edge it gives clients has made it an essential tool for large organizations. Salesforce is currently the most valuable SaaS company in the world with a market value of $240 billion. Revenue has grown at 26% annually for the past five years to $19 billion, and with a net profit margin of 12%.
Atlassian Plc (TEAM)
Atlassian which is based in Sydney, Australia, owns 13 different subscription-based software products. The products are used for project management, collaboration, code management and security. The most well-known of these are JIRA and Trello. Atlassian earned $1.7 billion over the last 12 months, with revenue growth averaging 38% over the last five years. The company is not operationally profitable but has gross margins of 83%. Atlassian trades at 28 times sales which is around the average for SaaS stocks growing at this rate.
Slack Technologies (WORK)
Slack is a popular communication platform which markets itself as a replacement for email. The platform is built around an instant messaging tool, and allows teams to collaborate, share content and code, with a searchable paper trail of all communications. The platform also integrates with several other SaaS products like Trello, Asana, Salesforce and Zendesk.
Slack has a cult like following amongst developers and project teams and boasted over 12 million users at the end of 2019. However, it is now facing competition from Microsoft’s Teams platform. Slack is still a relatively small company with annual revenue of $768 million. However, revenue has been growing at close to 50% year-one-year and the gross margin is 86%, which makes the $15 billion valuation look reasonable compared to other SaaS stocks.
Cloudflare Inc (NET)
Cloudflare is a cloud platform that provides cyber security, content delivery and other services. The company helps companies safely distribute content to over 27 million websites. It also protects digital platforms and connected devices from DDOS attacks.
Cloudflare’s solutions are in demand and the company has grown revenue at over 50% for the last two years. The company which is now worth $19 billion is trading on a relatively high price-to-sales ratio of 19. The current valuation means the risk of a reversal is high, but that may create an opportunity later.
Shopify Inc (SHOP)
Shopify is another market favourite. The company provides a plug-and-play solution to e-commerce stores. For anyone wanting to sell products online, Shopify provides a website and all the infrastructure related to shopping carts, payments, inventory management and shipping.
Shopify has become the undisputed market leader in this space and experienced very rapid growth over the last five years. In fact, in just five years the stock price has risen from $35 to as high as $1100. The current price of $980 is 47 times annual sales which is probably stretched, and a correction would offer a better opportunity.
Alteryx Inc (AYX)
To remain competitive, companies must optimise the way they collect, store, and use their data. Alteryx is a cloud-based data analytics platform that can be used by people with little or no coding knowledge. With a market cap of just $7.6 billion, Alteryx is smaller than most companies in this list.
However, the company is rapidly gaining traction across a wide range of industries. It already has 6000 corporate clients, up 30% in the last year. The company also has a large arsenal of products to cross sell to existing customers. Despite its size, Alteryx is already profitable at the operating level, and is growing revenue at 60% a year. The stock trades at 15 times 12- month revenue
Conclusion – SaaS stocks for the digital transformation
SaaS companies are an important part of the digital economy which still offers plenty of growth potential. These stocks have a lot going for them and are an important component of portfolios targeting growth. The biggest risk is the valuations, and the fact that there may not be room for every company out there. For this reason, risk needs to be managed carefully, and initial positions should be small.