This Isn't a 'Dot-Com Bust 2.0'... But Price Still Matters

A front-row seat for Adobe's $4 billion gamble... This new software model is all the rage today... Exploring a new side to this story... From widely mocked to pioneering genius... An apples-to-oranges comparison... This isn't a 'Dot-Com Bust 2.0' – but price still matters... Three ways to make up to 3,000% in the long run...

We all thought Shantanu Narayen was crazy...

My clients... my former employer... industry pundits... competitors... Wall Street...

Everybody.

Some analysts believed Narayen was making the most boneheaded blunder in Silicon Valley history. I (Bryan Beach) am not ashamed to admit that I thought he had lost his mind.

It was May 6, 2013.

Narayen, software titan Adobe's (ADBE) CEO, and the other top executives were making a $4 billion gamble... The move could sink not just the company's share price, which had more than doubled since the 2009 financial crisis, but also its entire business.

Think back just seven years... Adobe was the dominant name in publishing software, with $4 billion in revenue in 2013. 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 in today's Digest... 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. And I had a front-row seat to the whole thing...

You see, before joining Stansberry Research in 2012, I spent nearly a decade focused on the software industry...

First, I served as a "Big Four" auditor and later as the controller for a publicly traded software company. I even ran a small accounting consulting practice that focused on software clients.

Wall Street hated the idea of a subscription-based software model for most of my years in the software business... 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.)

As one of my main jobs during my time in the industry, I made sure my employer and clients correctly structured their contracts as perpetual licenses... thereby avoiding the subscription-based revenue model altogether. We had to give Wall Street analysts – and the stock market – what they wanted to see... which would maximize our valuations.

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 Narayen and 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.

These days, the model Narayen helped pioneer is known as Software as a Service ('SaaS')...

Regular Digest readers know that SaaS is all the rage. We've discussed the merits of this type of software time and time again... and detailed how SaaS technology is 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 – during a global pandemic – SaaS stocks are up 64%. 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."

But before we explain why, you must understand the power of 'capital efficiency'...

We've used this term at Stansberry Research for at least a decade. Capital efficiency refers to a company's ability to grow without the need for significant investment from owners.

Software companies – SaaS or otherwise – are some of the most capital-efficient businesses you'll find. They can grow rapidly without adding new buildings, equipment, or factories.

That's because the cost to produce each sale is very low. Software is nothing more than computer code... It costs roughly the same amount to make one copy or 1 million copies.

And SaaS companies take capital efficiency to another level...

As I said earlier, companies traditionally sold software under the perpetual license model.

For individual customers like us, this old way of doing things isn't particularly challenging or expensive... We would simply buy the latest version of Microsoft Office at the store, stick the CD into our home computers, and follow the steps on the screen to install the software.

But for businesses, things are much more complicated... Deploying software for hundreds of employees often involves buying costly servers to run it. And in many cases, companies also need to pay consultants just to install the software.

Customers pay big money for these upfront investments. And as I explained above, for years, Wall Street loved those lumpy upfront fees. But the costs don't end there... Customers also must pay maintenance fees that cover the costs of troubleshooting the software if it doesn't work properly – things like customer support calls and bug fixes.

Again, though, that was the old way... The SaaS model changed all that. With SaaS, customers aren't really buying software at all. Instead, they're renting it. Here's how it works...

The software company typically "hosts" its product in the cloud on servers that it owns, and customers access it via the Internet. Any bug fixes or upgrades occur automatically and seamlessly, with few disruptions. For this "service," customers pay a low monthly fee.

This is a classic win-win situation...

Customers no longer need to endure the six- to 18-month installation period. And they don't need to deal with enormous upfront payments, maintenance headaches, or bulky servers. For many companies, it's easy to stomach smaller, steady fees as long as the business operates. It's much harder to pay one, big lump sum... and then also all the other fees.

And although the software makers lose the huge upfront payments, subscription fees pile up for years and years... So the long-term profitability dwarfs the old perpetual license model.

The 'Adobe shift' provides an excellent illustration...

When Narayen announced his plan in 2013, Mr. Market widely mocked him.

As we said earlier, Mr. Market loved the old way in the software industry – the perpetual license model. It was unclear at the time if the new way (SaaS) would be successful or not.

And as regular Digest readers know, the markets hate uncertainty... So in a span of about three weeks after Narayen's announcement, Adobe's shares fell roughly 10%. And as I explained to my subscribers in the February 2020 issue of Stansberry Venture Value...

Industry pundits and competitors scoffed [following the announcement in 2013]. Thousands of Adobe customers signed a petition demanding that Narayen backtrack on his decision. But he held firm...

Eight months later, when the accountants closed the books on 2013, Adobe's numbers looked horrific. Revenues were down 10%. Net income plummeted 62%. Worst of all, cash flows – our favorite measure of a business's health – fell 22%.

All this carnage... right in the middle of a raging economic recovery.

The thing is, Narayen and a few other software visionaries realized something important...

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.

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 enormous premiums for rapidly growing SaaS businesses...

In the seven years since Narayen's big move, Adobe is up about 1,000%. And Salesforce (CRM) is up 9,000% 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 Digest, plenty of cynical market observers have drawn parallels this year between SaaS and the dot-com days.

And in one particular way, the comparison makes sense...

You see, like they did in the late 1990s, a lot of tech bulls use the price-to-sales (P/S) ratio to value SaaS businesses. And this causes nightmare flashbacks for many investors...

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) and enterprise value to earnings before interest, taxes, depreciation, and amortization (EV/EBITDA) – were off the table.

Because of that, the P/S ratio became the official valuation metric of the dot-com mania.

Then... the dot-com bust happened. Two decades later, some folks still recall this hard lesson... They continue to associate 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. "The more things change, the more they stay the same," one financial blogger lamented in April 2019, also referring to the P/S ratio as "a blast from the past."

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 as we showed you above, 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 since the start in 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...

As of July, the universe of SaaS firms was valued at 19 times sales versus just 6 times sales for software companies operating under the perpetual license model. That's a hefty premium. 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...

The P/S ratio of 19 is just the average for the entire SaaS space today. You can find plenty of extreme cases right now – like Zoom Video Communications (ZM), for example.

Investors have flocked to the video-chat maker's stock in our current work-from-home world. As a result, Zoom's P/S ratio has ballooned to roughly 80 in recent weeks.

At some point, it really does get ridiculous...

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.

In other words, the SaaS skeptics aren't completely off base.

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?

That's exactly what I've tried to do in Venture Value since shortly after we launched the newsletter in 2017. The secret is looking for "hidden" SaaS dynamos. And over the past three and a half years, I've found a few high-quality businesses that fit the bill...

For example, in October 2019, we discovered an American SaaS business trading in London.

At the time, investors on both sides of the Atlantic Ocean were ignoring the stock for geographic reasons. (U.S. investors didn't want to buy shares of a London-listed company, and London investors didn't want to buy shares of an American company.)

Now, despite pandemic-related headwinds, this stock is up 317% in 11 months. A brand-new U.S. listing helped its returns, but most of those gains came from the strong SaaS growth trajectory of this business. And we're optimistic for more upside moving forward.

You can also find some hidden SaaS stocks trading north of the border... Since Canada isn't known as a traditional tech hot spot, these tiny companies can fly under the radar.

I've also identified ways to profit from companies that are transitioning to "pure" SaaS models... These stocks are often overlooked by investors casually looking for the next SaaS darling. Buying these "SaaS transitions" early can be a great way to lock in a nice SaaS business for a non-SaaS price. But to do that, you've got to know where to look...

In Venture Value, we do all of that work for our subscribers. And it has paid off... Overall, our seven SaaS recommendations since 2017 are up an average of 89% annualized through yesterday's close.

Despite those impressive early gains, you still haven't missed the boat...

As I've shown in today's Digest, the stickiness of this sector is incredible. The best SaaS companies will continue collecting money from their customers for generations to come.

But like with most stocks, the key is not paying an excessive premium to buy shares.

On that note, I just put together a brand-new special report that details three incredible opportunities to make up to 3,000% in the SaaS market over the long term. All three of these opportunities are still largely "hidden" today... They aren't yet trading for the crazy valuation multiples that have been drawing the ire of critics.

So if you're ready to take the next step, I encourage you to watch this important message from our publisher Brett Aitken right here. As you'll see, you can get instant access to my new report – and all my research in Venture Value – at more than 65% off the regular price.

New 52-week highs (as of 9/9/20): Barrick Gold (GOLD) and Gravity (GRVY).

In today's mailbag, thoughts about cryptocurrencies based on Wednesday's Digest about a "rich man" investing idea for a new era. Do you have a comment or question? As always, e-mail it to us at feedback@stansberryresearch.com.

"I am a senior citizen (& an Alliance member for years). Before Stansberry started talking about crypto currencies, I tried to open an account [elsewhere]. My poor eyesight and the long strings of #s were more than what I could cope with at the time (or today for that matter).

"How about starting [an exchange-traded fund ("ETF")] of crypto currencies for Stansberry members who don't feel capable of investing in them on their own? Then Stansberry can deal with all the # accounts for buying individual cryptos!

"I would be the first to invest, if you created this product." – Stansberry Alliance member Barbara C.

Corey McLaughlin comment: I love the idea of creating an ETF, if for no other reason than we would get to pick our own stock ticker. Unfortunately, the first two that come to mind for a cryptocurrency ETF – COIN and CRYP – appear to be taken by other companies.

Maybe someone else has some suggestions...

Seriously, though, if you struggled before to buy cryptos and don't feel capable of it, you're not alone. The good news is... the whole process has become a lot simpler over the last few years. And more important, as we said yesterday, you won't find anyone better to guide you through the crypto world than our colleague and Crypto Capital editor Eric Wade.

Among other step-by-step instructions and coin recommendations, Eric's Crypto Capital service includes a special report exclusively for subscribers titled, "How to Buy Your First Bitcoin."

It's a great place for beginners to start. And since you're a loyal Alliance Partner, you already have access to this research at no additional charge.

Even better, I just looked at this report again... There are only 10 numbers in the whole document, almost all of them single digits! Thanks again for your continued support. Best of luck if you decide to try it out.

Good investing,

Bryan Beach
Roswell, Georgia
September 10, 2020