Disclaimer: This post should not be taken as investment advice. It just represents the opinions and perspectives of someone who’s been in finance over two decades.
If you’ve ever analyzed enterprise software companies, you’ve heard of SaaS. (Or PaaS, or IaaS). Actually, even if the company you’re analyzing isn’t an enterprise software company, you’ve probably heard the management team claim they have a SaaS product.
So what is it? SaaS stands for Software as a Service. What this essentially means is that the software is all or partially cloud based (computations are run on a data center somewhere far away) and the user runs the application on a web browser or downloads the client onto their computer. Customers are billed on a per license, per month basis in a subscription format.
This arrangement benefits both the software companies and their customers.
Customers benefit by:
- Always having the latest version of the software and never needing to pay up for next year’s upgraded version,
- Not having to pay the upfront cost of buying the entire software license ($249 for Office 2019 vs. $6.99/month for Office 365 home),
- And having predictable and consistent cash flows.
Software companies benefit by:
- Expanding the pool of customers that can purchase the software,
- Getting more accurate user metrics and lowering piracy,
- And also having predictable and consistent cash flows.
And what’s with all the hype? There has been a massive move towards enterprise SaaS over the past 10 years. And one of the reason that SaaS companies have seen their stock prices massively outperform the market is that the cash flow generation is even more impressive than revenue or EPS growth.
Let’s take a simple example.
A typical software license sale of $100k + 10% annual service charge leads to revenues of $150k over a 5 year period ($100k + $10k x 5). A SaaS version of of that software may go for $3000/month, which leads to revenues of $180k ($3000 x 12 x 5). If you look at cumulatively revenues by year, the traditional license model has a large bump in year 1 and the growth tapers off. In contrast, the SaaS model has steady increase every year and overtakes the license model over time.
Of course in the traditional license model, there will be a renewal many years later (between years 7 -10) and there will also be a spike up in revenues from that customers. But you have to remember that there will have to be another sales process with the renewal which increases expenses. In the SaaS model, because there isn’t a follow-up sale, there is not spike up in expenses.
So back to those impressive growth rates. Fast growing SaaS companies are growing revenues between 20%-40% annually. That actually means that cash flows are actually growing 50+%, due to the slow ramp in cash flows and the way billing is done.
Bonus. So an interesting market phenomenon is when software companies transition from a license model to SaaS. There have been a handful and their stock prices are very impressive to say the least. Below are each of the company’s total returns vs. that of the S&P500. Owning a basket of these stocks would have beat any of the top fund managers over the past 5 to 10 years.
Happy investing everyone!