The Appeal of Enterprise SaaS
Growing addressable market, attractive financial and strategic traits
Digital transformation has been a secular trend for over two decades, providing significant tailwinds for innovative technology companies.
Enterprise software-as-a-service (SaaS) companies, in particular, have benefited greatly. Today, many of these companies fetch high premiums.
The chart below shows a scatterplot of revenue growth and multiples.
While many of these companies are growing annual revenue at high rates of 20%, 30%, 40%+, they seem to be quite steeply valued, trading at 30x, 40x, even 50x+ their revenue.
For related commentary on valuation, see SaaS Valuations Post COVID-19 and Intrinsic and Relative Valuation.
While this article won’t dive into the details of the valuation, it is clear that the market finds many of these companies attractive.
Why is that? What is it about these companies that the market finds attractive?
Growing Addressable Market
Although the trend has been in play for over two decades, the digital transformation market is still in early stages.
The digital transformation market, which generally includes cloud computing, big data and analytics, mobile, social media, cybersecurity, and artificial intelligence, is expected to grow at roughly a 20% CAGR for the next five years.
The current market size of roughly $340 billion will likely surpass $1 trillion in the next five to ten years.
See the appendix for a synopsis of the underlying studies.
If the market is growing at 20% CAGR, that implies that the average constituent will be growing at 20% CAGR, an attractive growth baseline.
Attractive Traits
Aside from the compelling macro environment, there are numerous qualities that make SaaS companies particularly attractive.
Efficient
The software-as-a-service model is inherently an asset-light business model. There is often no need for any significant assets. There’s no need to own real estate, no need for any factory, no need for heavy machinery, no need to own a flight of vehicles, no need to build out new stores, etc. For additional details on asset-light models, see When “Asset Light” Is Right.
Relatedly, an asset-light business model is capital efficient. It allows for greater free cash flow conversion. There is little need for capital expenses or tieing up cash in working capital. Sometimes, free cash flow conversion is greater than the company’s earnings, demonstrating a strong pricing power and ability to charge upfront. For additional details on deferred revenue, see Fundamentals: Revenue and Sales.
Software companies generally exhibit high gross margins. The top echelon sport gross margins of above 80%. They are able to contain their costs of goods sold (COGS), inclusive of any compute needs and customer support, to a minimum.
Research and development efforts are tax-efficient. Because research & development is counted as an expense instead of capitalized, these companies benefit from deferring tax payments into the future. If R&D efforts were to be capitalized as an asset, they would be amortized over a long period, resulting in a smaller expense up front. GAAP accounting does not allow for capitalization due to the uncertainty of value. Having R&D as an expense lowers profit today, while creating off-balance-sheet assets from which the company benefits for many years.
Predictable
The software-as-a-service model is, by design, forecastable. Subscriptions are usually monthly or annual, resulting in predictable revenue.
Many enterprise offerings are particularly sticky. Once an enterprise customer adopts a solution, they are likely to remain customers for a while. Given the stability, SaaS companies are able to accurately understand, control, and model churn and retention rates.
Many enterprise SaaS companies build up their pipeline and take commitments beyond the next 12 months. These remaining performance obligations, or RPO, provide a level of certainty on the company’s growth.
Strategic
Enterprise SaaS companies serve the B2B (business-to-business) market. Companies, as opposed to consumers, are more willing to spend money to increase efficiency.
Software is inherently scalable - there are low marginal costs for serving additional customers. The software is already built. The solution can serve 1 customer or 1 million customers alike. Bringing on a new customer is negligible from the servicing perspective. Sales and marketing efforts go a long way, looking to get more benefit from the work that has already been done.
Software companies have a well-established land and expand playbook. Many SaaS companies find and acquire customers with an initial product or offering. The SaaS model pricing is usually determined by value, such that revenue grows alongside their customer (i.e. pricing per seat or usage will scale as the customer scales). At the same time, SaaS companies look to identify and develop new products or offerings to sell to those same customers. As a result, sales grow across multiple dimensions. This change in per customer spend is tracked as net dollar retention.
Each and every software company offers a unique and differentiated offering. The way in which software is developed, such as the foundational data model, has a significant impact on its flexibility and future capabilities. Even if a company sets out to explicitly copy a solution, early decisions will lead to different outcomes for better or for worse. Every system is different. They are complex, difficult to replicate, and proprietary.
Enterprise SaaS company solutions become deeply embedded into operations and are therefore hard to dislodge. Many provide critical operations, be it customer management, cybersecurity, employee or customer identity and access control, or human resourcing needs. Not only are they critical, but they are often built upon. Many SaaS companies offer APIs by which customers build upon. This adds value to the customer, allowing custom solutions to further streamline operations. As a byproduct, this intricate coupling of operations increases switching costs dramatically.
Closing
The software-as-a-service model, pioneered by Salesforce, has been revolutionary for the industry.
It brings many benefits. The subscription model spreads out capital expenditures over long periods. With a focus on retention, it aligns service providers incentives on offering high quality service.
Enterprise software-as-a-service companies have run with this model. There are plenty of successful companies that match many of the traits mentioned above, including Salesforce, CrowdStrike, Cloudflare, Datadog, Veeva, Okta, Paycom, Workday, and many more.
Participating in an industry forecasted to grow at a 20% CAGR, these companies still have plenty of room for growth ahead.
Appendix - Synopsis of Digital Transformation Studies
The digital transformation market is difficult to measure precisely. By looking at a variety of studies, investors can shape their own understanding.
Grand View Research
Digital Transformation Market Size & Trends Report, 2021-2028
“The global digital transformation market size was valued at USD 336.14 billion in 2020 and is expected to grow at a compound annual growth rate (CAGR) of 23.6% from 2021 to 2028.”
All the Research
Digital Transformation Market Forecast to 2027
“The Global Digital Transformation Market was valued at US$ 340.0 bn in 2020 is expected to reach US$ 1409.4 bn by 2027, with a growing CAGR of 22.7% during the forecast period (2020-2027).”
IMARC
Digital Transformation Market Share, Size, Growth, Opportunity and Forecast 2021-2026
“Looking forward, IMARC Group expects the market to grow at a CAGR of around 20% during 2021-2026.”
Markets and Markets
“The global digital transformation market size is expected to grow from USD 469.8 billion in 2020 to USD 1009.8 billion by 2025, at a Compound Annual Growth Rate (CAGR) of 16.5% during the forecast period.”
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Torre Financial is an independent investment advisory firm focused on emerging and established compounders.
Federico Torre
Torre Financial
federico@torrefinancial.com
https://torrefinancial.com
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