Denny Fish, Portfolio Manager on the US-based Technology Team, discusses the growth of cloud-based software companies and why they have the potential to rise in value despite what initially appears to be high valuations.
The information technology sector of the S&P 500 Index surged 37% last year, almost double the advance of the benchmark index.
Driven by strong financial performance, the technology sector is currently trading at a modest price-to-earnings (P/E) ratio premium to the S&P 500. Given elevated market valuations, corrections are always possible, particularly in growth tech stocks, as seen most recently when the sector dropped 10.6% from 26 January 2018 to 8 February 2018 — in line with increased volatility in the S&P 500 — only to rebound almost 9% the following week as investors’ focus shifted back to fundamentals. Over the past few years, these corrections have created buying opportunities for higher-multiple technology stocks.
Some of the more interesting opportunities are in sub-sectors such as software as a service (SaaS) where valuations appear stretched on the surface. However, the multiples of high-quality cloud-based SaaS providers are more attractive than initially meets the eye.
Salesforce.com, a cloud-based computing company, surged 49% in 2017, while the stock has quadrupled since the start of 2012. Over that time, the company has had cumulative net losses of $535.8 million, including a $169.3 million net profit in fiscal 2017.
As a result, Salesforce.com is currently trading at a P/E of 85 for 2018 and 65 for the year after. This makes the stock look extremely expensive compared with 2019 P/E ratios of 23 for Microsoft, 15.6 for Oracle, and 17.4 for Germany’s SAP SE, legacy software companies that each generate substantial net income.
Other SaaS companies have similar multiples. For 2019, Zendesk trades at a P/E well north of 100, Workday has a P/E of 106, ServiceNow is at 53.6 and Ultimate Software Group is at 37, all optically much more expensive than their profitable legacy counterparts.
The difference between under-earning subscription-based software providers and on-premise companies is that sales at the former are rising at a much faster clip and the companies are investing aggressively to capture that demand. Cloud-based SaaS companies generate subscription gross margins of around 80% and lose a relatively low number of customers each period through so-called churn. This givies them attractive underlying unit economics and makes it logical for them to spend to generate demand where the returns are understood.
In fiscal 2017, Salesforce.com spent $3.92 billion, or 47% of its $8.39 billion total revenue, on sales and marketing. By contrast, Microsoft allocated 17% of $90 billion in revenue in to sales and marketing in the same period.
That investment by SaaS businesses is converting to top-line growth. While revenue forecasts for Microsoft call for a 24% gain for the five years to 2019, Salesforce.com’s sales are projected to surge 130% during the same period.
As sales increasingly come from large enterprises, Salesforce.com’s guidance suggests aggregate churn around the high single digits and falling, which translates into an average subscription life of 12 years. Such stickiness among users allows for greater confidence in longer-term forecasting for the company. At its most recent analyst day, Salesforce.com suggested that Sales Cloud, its largest and most mature product, is already generating what the company terms economic profits — akin to operating margin — of 30%.
Salesforce.com’s growth is being matched or exceeded by others in the space, with revenue forecast to more than double in the five years to 2019 at Ultimate Software; to more than triple at Workday, ServiceNow and Zendesk; and to more than quadruple at Coupa Software and MuleSoft. At Okta the consensus is for revenue to surge almost eightfold over the same period.
On other measures, some SaaS companies don’t look expensive when compared with their on-premise peers. On an enterprise value to revenue basis, Salesforce.com comes in at a multiple of 6.38 for 2019, versus 5.62 for Microsoft and 9.3 for Adobe Systems which is in the middle stages of transforming from an on-premise to subscription-based model.
Legacy operators understand the underlying economics of SaaS, as they have seen the benefit of generating revenue synergies and extracting costs from their acquisitions. In one of its biggest purchases, Oracle in November 2016 paid $9.3 billion, or nine times revenue, for NetSuite. SAP spent $15 billion on business software companies Ariba, Concur and SuccessFactors between 2012 and 2014, and last month said it planned to acquire Callidus Software for $2.4 billion. Salesforce.com itself bought Demandware for $2.8 billion after reportedly rejecting an offer from Microsoft in mid-2015.
Proof points such as these suggest that, with companies now able to repatriate cash held outside the US at a lower tax rate, Microsoft, SAP and Oracle may be among those that seek to further consolidate the SaaS sector, providing a further tailwind for the stocks. Microsoft has $113 billion overseas, while Oracle has $52 billion, according to Moody’s Investors Service. Private-equity firms have also shown an appetite for growth assets, with Vista Equity Partners buying Marketo in May 2016. Alphabet, Amazon, and Cisco Systems are other potential acquirers.
Even without mergers and acquisitions, cloud-based SaaS providers that continue to grow rapidly with attractive unit economics have a long runway to create value as stand-alone subscription-based businesses. As a result, when examined through the right lens, we think equity values in the SaaS sector still look reasonable for long-term investors.
Note: all figures were sourced from Bloomberg on 23 February 2018.
These are the manager’s views at the time of publication. They may not reflect the views of other managers at Janus Henderson. The views expressed within this article do not qualify as investment advice.
The examples in this article are intended for illustrative purposes only and are not indicative of the historical or future performance of the strategy or the chances of success of any particular strategy. Janus Henderson Investors, one of its affiliated advisors, or its employees, may have a position in the securities mentioned in the article. References made to individual securities should not constitute or form any part of any offer or solicitation to issue, sell, subscribe or purchase the security.