January 19, 2021
It’s not an understatement to say that COVID-19 and the ensuing global pandemic have forever rewritten history…
And while the virus has crushed many facets of our economy, it has also supercharged other sectors.
Just look at Zoom Video Communications (ZM)… Most of us had never heard of it before last year. Now it’s used in conversation almost as often as “Google.”
And how did Zoom’s stock fare in 2020? It surged more than 450%, bringing smart investors a hefty payday.
There are winners in every crisis… You just have to know where to find them.
Lucky for you, today we’ve got financial research investment writer Bryan Beach here to tell you all about another technology powering the current pandemic lifestyle.
This Isn’t Just Another ‘Hyper-Charged Market Fad’
We all thought Shantanu Narayen was crazy…
My clients… my former employer… industry pundits… competitors… Wall Street… Everybody.
Some analysts believed Narayen – software titan Adobe’s (ADBE) CEO – was making the most boneheaded blunder in Silicon Valley history. I am not ashamed to admit that I thought he had lost his mind.
It was May 6, 2013.
Adobe was the dominant name in publishing software, with $4 billion in revenue. Its products ranged from the ubiquitous Acrobat document creator and reader… to print and digital publishing tools like Photoshop, Illustrator, InDesign, and Dreamweaver… to computer-animation tools like Animate… and much more.
But its leaders prepared to make a radical change… They wanted to revolutionize what everyone on Wall Street seemed to believe was a highly successful business model.
Investors were aghast… They punished the stock in the days after the leaders’ big move.
But as you’ll see… Adobe was right, and everyone else was wrong.
What these Adobe executives knew back then is exactly what has powered the hottest sector in the stock market today…
For most of my years in the software business, Wall Street hated the idea of a subscription-based software model…
Firms and investors strongly preferred software companies that sold software under the “perpetual license” model. (That’s when customers buy the software and install it on their own servers or computers.)
But by May 2013, Narayen could sense that his customers were ready for a big change… And he surmised that investors would eventually jump on board.
So Adobe became the first major company to shift from a traditional revenue model to a completely subscription-based revenue and sales model.
And although Wall Street hated the change at first, it turned out to be one of the shrewdest market moves of the past 30 years.
Software as a Service
These days, the model Narayen helped pioneer is known as Software as a Service (“SaaS”)…
This technology is all the rage today. It’s powering life during the COVID-19 pandemic by enabling food delivery, working from your basement instead of the office, and even closing on a new home without visiting the realtor’s office.
And Wall Street eventually changed its mind about the subscription-based SaaS model… It has been the market’s hottest sector for at least two years. In 2020 alone, SaaS stocks were up 113%. That’s more than double the tech-focused Nasdaq Composite Index.
But today, we’re going to explore a new side of the story. In the past couple of years, SaaS has captivated Mr. Market as much as anything since the late 1990s…
Back then, “dot-com” was the buzzword. And of course, we all know how that situation turned out… The ensuing bust destroyed many investors’ life savings.
Because of that, many pundits in the mainstream financial media worry that we’re headed for a “Dot-Com Bust 2.0″… With the valuations of SaaS stocks soaring like many of their dot-com predecessors, these folks believe that disaster could be lurking around the corner.
So has the SaaS buzzword become a hyper-charged market fad similar to the dot-com era? Or is SaaS really a better business that rightfully deserves a premium valuation?
It may seem counterintuitive, but the answer to both of these questions is “yes.”
Narayen and a few other software visionaries realized something important about the “Adobe shift”…
The SaaS model temporarily hurts numbers since no upfront windfall exists… But over time, an affordable subscription model allows revenue and cash flows to consistently pile up.
Because a SaaS startup doesn’t take in the upfront payments, it isn’t profitable right away like a company with the same quality of software and similar customer demand that operates under the perpetual license model. It typically takes about six or seven years for a SaaS business to reach profitability.
Recommended Reading: Prepare for a ‘Cash Panic’
We’re at the very beginning of a mass financial panic – but not the kind most people expect. The words “mania,” “euphoria,” and “frenzy” are all over the press… while fund managers are STAMPEDING out of cash at record levels – and pumping billions of dollars into a specific corner of the markets. A dramatic financial event over 20 years in the making has finally begun. Here’s what it means for YOUR money.
However, after the sixth or seventh year, the SaaS cash flows continue to compound thanks to ever-increasing rates as customers from all the preceding years continue to renew.
On the flip side, traditional software firms don’t see this “rolling snowball” of profitability… They must keep fighting, quarter after quarter, to bring in new sales and customers.
It has taken about 10 years, but Mr. Market eventually caught on…
Over longer periods of time, the SaaS model generates significantly more cash than the traditional perpetual license model.
Investors began paying huge premiums for rapidly growing SaaS businesses…
In the seven years since Narayen’s big move, Adobe is up about 900%. And Salesforce (CRM) is up 7,700% since pioneering the SaaS business model back in 2004.
Not wanting to miss the next great stock rocket, investors have been bidding up shares of almost any SaaS-related business in recent years. That pushed many stocks to nosebleed valuations.
And naturally, these stretched valuations attracted some skeptics…
The Financial Times called SaaS valuations “insanity”… During a recent Bloomberg TV interview, a fund manager referred to one valuation as “ridiculous”… And a headline from online publisher TechCrunch perhaps best summed it up: “What the hell, SaaS valuations?”
As I mentioned at the outset of today’s essay, plenty of cynical market observers have drawn parallels this year between SaaS and the dot-com days.
In the late 1990s, scores of hopelessly unprofitable gimmick stocks popped up as everyone tried to make a quick buck from the dot-com euphoria. (Remember Webvan and Pets.com?)
These businesses didn’t earn any profits, though. So in terms of assigning value, popular earnings-based metrics – like price-to-earnings (P/E) – were off the table.
Instead, analysts turned to the price-to-sales (P/S) ratio, wherein analysts value a business based on how much revenue – as opposed to cash or earnings – that it generates. The P/S ratio became the official valuation metric of the dot-com mania.
Then… the dot-com bust happened. And some continue to associate the P/S ratio with an unwarranted tech euphoria.
As such, a “here we go again” exasperation exists among some market commentators when it comes to SaaS.
But it’s an apples-to-oranges comparison between the dot-com mania and current SaaS valuations…
The market was immediately smitten with the dot-com darlings of yesteryear. But it was anything but love at first sight with SaaS…
And unlike dot-com duds, well-run SaaS businesses with high renewal rates aren’t hopelessly unprofitable. On the contrary, dozens of success stories 2004 clearly prove the superiority of the SaaS model – from the standpoints of both revenue and cash flows.
The problem is, since even the best SaaS businesses take six or seven years to reach profitability, we can’t use earnings-based valuation metrics. While the market waits for earnings, the controversial P/S ratio is the only available mainstream valuation option.
And using that metric, the SaaS firms do trade at a premium to other software companies… But when you dive deeper into the SaaS renewal rates, it makes perfect sense…
The best SaaS companies’ renewal rates range between 95% and 98%. Mathematically, a 98% renewal rate means the average customer stays around for nearly 50 years.
Talk about “sticky revenue”! That means a dollar of revenue won in 2020 will – without any additional sales effort – revisit the company again in 2021, 2022, 2023, and so on.
So yes, a dollar of SaaS revenue really is much more valuable than a dollar of widget revenue… a dollar of retail revenue… or even a dollar of perpetual license revenue.
Of course, as with everything in life, this whole concept isn’t limitless…
Every car guy knows that Ferrari makes some of the world’s best sports cars. But that doesn’t mean you should pay triple the Ferrari’s sticker price… even if you can afford it.
I look at SaaS the same way…
When it comes to business models, selling in-demand SaaS software is indisputably superior to things like building factories and selling widgets. But price still matters… At some point, even the best SaaS companies are too expensive to buy.
But what if you want to get the best of both worlds? What if you could buy great SaaS businesses without paying today’s premium SaaS prices?
The reality is you can… You’ve just got to know where to look.
P.S. The pandemic pushed us into technology dependence… And as a result, we believe SaaS stocks are destined to soar. If you’re eager to claim a stake in this rapidly growing sector before prices skyrocket from here, Bryan’s latest research report is your guide. It covers the “hidden” SaaS stories with the biggest upside potential today… Click here to get the details.
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Managing Editor, American Consequences
With P.J. O’Rourke
January 19, 2021