Why Wall Street Loves the Hottest Sector in the Market
Editor's note: Marc Benioff's meeting with the "Hugging Saint" changed the course of history...
A few years after the visit in 1996, Benioff founded Salesforce (CRM). His company pioneered Software-as-a-Service ("SaaS") and revolutionized the software industry... Thanks to Salesforce's success, dozens of SaaS companies popped up in the following years.
Analysts Bryan Beach and Mike DiBiase have nearly 25 years of combined experience working in the software industry. And in today's Masters Series – the second part of the November issue of Stansberry's Investment Advisory – they explain why this burgeoning industry is valued so much higher than the traditional software sector...
Why Wall Street Loves the Hottest Sector in the Market
Software companies are some of the best businesses you'll find...
These companies make great investments. That's because they're among the most capital-efficient companies in the world.
Like all capital-efficient businesses, software makers can grow rapidly without needing to invest larger and larger sums into capital expenditures – like new buildings and equipment – that drain valuable cash and lower returns on investment.
Software companies also make great investments because their cost of producing each sale is very low. It's easy to understand why...
Software is nothing more than computer code. The "cost" of producing another copy of a software program is next to nothing. It's virtually the same cost to produce 1 million copies as it is to produce one copy.
You can see this in software companies' gross margins – the profit after subtracting all direct costs of generating sales. The average gross margins of all software companies in the S&P 500 last year was 81%. That's almost double the 45% average for all other industries.
This is important...
Producing high gross margins means more is left over to go to the bottom line. It translates into high profits. And because software companies' capital needs are low, most generate a lot of cash.
No matter what's done with the cash, it benefits shareholders. That's why in virtually any period you look at, software companies produce market-beating returns.
For example, if in 2004 you invested in the Russell 3000 index – an index of essentially all the publicly traded U.S. stocks – you would have earned an average annual return of 9% a year on your investment. A $10,000 investment would have more than tripled to $37,000.
That's pretty good.
The best-performing major sector of the index over that time was Information Technology ("IT"). It returned nearly 14% a year. And if you invested only in the software companies – a smaller part of the IT sector – your return would have been much higher... at 19% a year over that time. A $10,000 investment at this higher rate would have grown more than 13-fold to $135,000.
That's a phenomenal return.
But most people don't know you could have done much, much better investing only in a small subset of software companies... pure SaaS companies. Like Salesforce, these companies only offer their software over the Internet.
Around 400 software companies are publicly traded in North America. But only around 70 pure SaaS companies have gone public since Marc Benioff launched Salesforce in 2004. (A tip of the hat to venture capital investor Alex Clayton for the complete list).
If you invested in nothing but these pure SaaS companies when they went public, your annual returns would have crushed the return of not only the overall market, but all other software companies.
SaaS companies returned an astounding 56% per year on average over that time. That's nearly three times higher than the overall software sector... four times higher than the IT sector... and six times higher than the overall market. No other sector we know produced results like that.
We know what you're thinking, "I would never be able to buy companies at the IPO price." Even if you bought the stocks 30 days after the IPO – when the stock prices were 50% higher on average than their IPO prices – you still would have crushed the market. Your average annualized return would have been 46%.
We wanted to know what's driving these incredible results, and more important, if they're sustainable moving forward. So now, let us explain why pure SaaS companies are the hottest sector in the market...
Take a look at the following graphic. It shows the cash a customer would fork over by buying the same software under both the perpetual license and SaaS models.
The number of coins represents how much a software vendor would charge and the cash it would collect over a 10-year period.
The gold coins are most important. They represent recurring revenue. These fees are more valuable because they represent an annuity. The software company collects them year after year, as long as it keeps its customers happy. (In reality, these fees generally increase by a few percentage points each year to keep up with inflation.)
Instead of paying a massive, upfront license fee, SaaS customers simply pay as they use the software. All they pay is a recurring SaaS fee that can be settled monthly, quarterly, or annually.
Notice that SaaS fees are usually around two times larger than maintenance fees in the perpetual model. They're larger because they cover software, hardware, and maintenance fees all rolled into one.
Under the SaaS model, all the fees are recurring. Under the perpetual model, only the smaller maintenance fees are recurring. So SaaS companies have much higher recurring revenues and cash flows. Wall Street loves recurring revenue, and it places a much higher value on it.
The key to the SaaS model is the "stickiness" of the sales. By stickiness, we mean how many customers continue to renew their contracts. The best SaaS companies have extremely sticky recurring revenue. Most have renewal rates much higher than 90%.
But Wall Street has three more reasons to like the SaaS model besides recurring revenue. Let's start with that question mark at Year 6 of the graphic above...
1. It represents a major decision point. Software companies must continually improve their products or they'll get replaced by competitors. In general, they release major new versions every four or five years.
The problem for perpetual software vendors is that upgrades are disruptive and expensive for their customers. New software has to be installed and data migrated to the new system for an additional cost.
It's a headache for customers, and this creates a new decision point... It's almost like buying new software. Customers use a major upgrade to evaluate other software companies.
For SaaS customers, the upgrade process is much different. Upgrades happen automatically and seamlessly, so customers are always using the latest version. There is no downtime or additional expense for the customer. The software vendor only needs to update its software one time... and every customer immediately gets access to the latest version. Most important, it doesn't create new decision points.
2. As the chart clearly shows, perpetual-license revenues are lumpier than SaaS revenues, and they can cause earnings and sales to be volatile.
Notice that a perpetual software company collects more cash up front than a SaaS company because of the fat, up-front license fees. But that comes with a cost...
All the license revenue is recognized when the software is delivered. One or two big deals can make or break a quarter. SaaS revenues are much smoother and more predictable because revenue is spread out over the contract period. And Wall Street doesn't like sales and earnings surprises.
3. Last, the sales cycle is longer for perpetual-license companies. Perpetual license requires a huge initial outlay of cash, and the client is buying the software rather than renting it.
So the purchase is almost always accounted for as a capital expenditure. SaaS purchases aren't... They come from operational budgets rather than capital budgets. Large capital expenditures are typically more difficult to get approved, and the deals take longer to close.
And because customers don't need to pay any huge up-front costs, many more companies can afford SaaS software. That's what Benioff envisioned with his goal of "democratizing" software.
Given all these benefits, it shouldn't surprise you that SaaS companies command higher valuations than traditional software companies... around two to three times higher, on average.
The best method to value SaaS companies is based on sales. Valuing them using earnings or cash flows is often pointless because most young pure SaaS companies are growing fast but aren't yet profitable. They're investing all their profits – and more – in growth.
We compared the enterprise values (the current market value of their stock plus all debt minus cash) of software companies and pure SaaS companies today with their sales...
Pure SaaS companies have enterprise values around 6 times to 18 times sales, with an average of around 13 times sales. Perpetual software companies are typically valued at around 3 to 6 times sales, with an average of around 5 times sales.
It's clear Wall Street puts a much higher value on SaaS software companies than traditional perpetual software companies.
Here's an important point to know... This is nothing new. These are the valuation averages and ranges that SaaS and perpetual software companies have averaged since 2004.
In other words, both SaaS and perpetual license companies are trading today around their average valuations. While the average valuations vary from year to year, SaaS companies always command valuations 2 to 3 times higher.
Clearly, SaaS is a superior model. That's why Wall Street values these companies so much higher than their perpetual-license peers. It's why this is the hottest sector in the market... Despite the massive returns these SaaS companies have generated already, they are no more expensive today than they've ever been.
This trend isn't going away anytime soon. Moving forward, we'll identify the best opportunities in the SaaS space in our publications. You'll see new recommendations in this sector in the months and years to come... smaller SaaS companies in our Stansberry Venture Value publication and larger SaaS companies in Stansberry's Investment Advisory.
Regards,
Mike DiBiase and Bryan Beach
Editor's note: You could have done far better investing in SaaS companies than almost anything else over the past 15 years. But the thing is, these are still young companies. The best ones could still grow 10-fold or more from here. And every year, more are popping up.
Mike and Bryan recently identified three tiny – and essentially "hidden" – opportunities in this powerful sector. These stocks could potentially soar as much as thousands of percent over the long term. So our publisher Brett Aitken put together an urgent presentation to explain all you need to know about SaaS – and to introduce you to these opportunities. Get the full story right here.