Portfolio Manager Brian Demain discusses the emerging trend of Software as a Service (SaaS) solutions and the importance of uncovering smart, sustainable growth as the industry evolves.

Key Takeaways

• Software as a Service (SaaS) is a powerful trend that has made software easier to distribute, use and scale, creating growth opportunities.
• The virtues of the SaaS business model lead us to believe that these businesses can grow faster than the broad market and the economy for many years.
• The space has grown rapidly in the short term and has begun to evolve. We believe now is the time to focus on smart, sustainable growth and long-term value creation.

The SaaS Opportunity

Software as a Service (SaaS) – the delivery of software via the cloud, paid for on a subscription basis – is rapidly displacing the traditional model of buying and installing software on individual computers. SaaS companies and their customers have found this method makes software easier to distribute, use, improve and scale, thus creating opportunity by growing the total addressable market for software.

We believe the transition to SaaS is a long-term theme, and we expect these businesses to grow faster than the market and the economy for many years. Indeed, as growth technology stocks have led the market higher in recent years, SaaS companies have virtually all appreciated. In light of this growth, we think it is prudent to look more closely at the industry and offer a counterbalance to the ebullience for these names.

Virtues of the SaaS Model

The SaaS business model clearly has many virtues, including recurring revenue streams, lower barriers to customer adoption and more rapid product iterations. Recurring revenue is a benefit for both the company as it plans for investment and for investors evaluating the company’s cash flows. Lower barriers to customer adoption, including much lower upfront and maintenance costs, help to speed sales and market share gains. Additionally, more rapid product iterations allow firms to focus on improving their software to remain competitive and to bring updates to consumers quickly and seamlessly, improving customer satisfaction.

Focus on Smart Growth as SaaS Evolves

Thus far, companies that have been able to execute on this disruptive business model have been rewarded by the market. Many remain in the early high-growth stages of their development and are valued accordingly. As the industry progresses, however, we believe the market will increasingly distinguish between these companies. Therefore, we think it will be important to focus on companies that exhibit the potential for sustainable growth and high return on invested capital versus fast-growing momentum companies with less-visible long-term profit models. In other words, we advocate a focus on smart growth, not just fast growth.

An analysis of the dynamics within SaaS reveals how different companies are currently positioned. For one, different companies face different unit economics, or the cost to gain a customer measured against the value or profit generated from acquiring that customer. For instance, some companies must hire an extensive sales force to grow; others can grow organically by viral adoption within their customer bases, reducing customer acquisition costs.

While SaaS companies must often spend significantly to acquire customers and gain valuable market share, investors should evaluate those costs against the returns they generate over the long term. During this high-growth phase of their lifecycles, SaaS companies are often evaluated on top-line revenues rather than bottom-line earnings. To merit their valuations in the long run, however, revenue growth must eventually translate into tangible earnings. At current levels, given very different unit economics among SaaS business models, we believe that, in some cases, investors are pricing unsustainable prospective margins into valuations.

More Considerations for SaaS: Competition and Compensation

As the SaaS space evolves, companies are beginning to face changing competitive dynamics. So far, many of the SaaS winners have profited from wide-open competitive runways. As firms have grown, some of these runways are beginning to converge, creating heightened competitive pressures. In the face of these pressures, some firms will experience slower growth and increased uncertainty. On the other hand, firms that have sustainable competitive advantages, or moats, around their businesses should be able to withstand competition and maintain growth over the long term.

SaaS companies are among the most liberal users in the market of stock-based compensation. This mode of compensation has its benefits, creating a way to pay employees without using scarce cash resources. It also aligns the interests of employees, as co-owners, with those of other shareholders. However, equity compensation, if not properly accounted for, can artificially inflate valuations and cash flows. As companies mature, growth slows and the focus on bottom-line earnings increases, firms with significant noncash compensation may see their values decrease.

As the SaaS industry develops and valuations climb, there are clearly many factors to consider. We believe that SaaS is a powerful trend with long-term staying power. However, all assets have a price. Ultimately, when it comes to SaaS, we believe that investors should consider higher-quality businesses with good unit economics and strong competitive positions at the right prices.