SaaS Revisited: Still Growing After All These Months

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SaaS Revisited: Still Growing After All These Months

The dramatic cost and performance advantages of web-scale cloud platforms over private data centers have lowered the barriers to entry for “Software as a Service” (SaaS) application developers – opening the door to innovation and competition in enterprise applications, pressuring SaaS pioneers with older architectures, and posing an existential threat to traditional application vendors. Sales of applications delivered from the “cloud,” are expected to more than double to nearly $56B by 2018. New SaaS companies continue to emerge with 6 companies having gone public in the US during the last 6 months. More SaaS IPO are likely into 2015. SaaS names have performed relatively poorly since our last note on SaaS in March, with an average decline for US listed SaaS companies with market cap in excess of $500M of 6.6%, This presents buying opportunities for companies, such as WDAY, SPLK, ULTI, and VEEV, that are innovating, executing, and building scale economies. This, rather than locking-in customers or depending on product life-cycles, will win share. Winners will also include old paradigm companies that are successfully transitioning to the cloud, e.g. MSFT, ADBE, and ADSK.

The cloud offers dramatically lower costs than traditional data centers. Public cloud distributed data center platforms have huge cost and performance advantages vs. private data centers based on several factors: 1) Use of commodity components vs. value-added configured systems; 2) Extraordinary power efficiency; 3) Much higher utilization; 4) Higher system availability; 5) Superior backup and redundancy; 6) Flexibility, scalability, power and convenience; 7) Substantial economies of scale. All-in comparisons give the top cloud hosts a 50-75% cost advantage vs. in-house enterprise data centers, and with cloud pricing dropping at roughly 30%/yr, the gap is widening. This a particular advantage for AMZN, GOOG, and MSFT, which employ cutting edge data center design, sophisticated software, and massive scale, driven by demanding consumer franchises. With rivalry intensifying, service offerings have expanded along with lower pricing, squeezing smaller competitors.

SaaS applications offer advantages beyond cost. By bundling the costs of the data center, SaaS vendors offer substantial savings vs. the all-in costs of running an application in house. SaaS applications also offer significant functional benefits. First, SaaS is scalable and predictable – costs grow proportionally to use on a transparent basis. Second, SaaS reduces complexity – expert user support is included, upgrades are automatic, costless and painless, and expert system/software maintenance is included. Third, access to SaaS applications is ubiquitous and availability is superior. Finally, inherently mobile SaaS applications tend to be far more easily implemented on mobile platforms. With switching costs falling rapidly – most SaaS vendors have sophisticated transition tools, support traditional data formats, and mimic familiar user interfaces – and incumbent stoked security/reliability fears proving unfounded, adoption of SaaS is accelerating.

Lower barriers to entry may leave SaaS margins below traditional software. The rise of AWS and the aggressive response from MSFT and GOOG will change the competitive dynamics of the SaaS market. Historically, SaaS vendors have made substantial upfront investment in building out data centers ahead of product launch – CRM, N, et al. were built this way. IaaS allows new players in with minimal capital investment, bringing a flood of new would-be entrants to the market. However, we see ample opportunity for profitability where SaaS companies can differentiate: 1) functional innovations; 2) community-based network effects; 3) cross-product ecosystem synergies; and 4) system learning. Loss of customer switching friction will pressure margins across the industry, particularly players carrying private data center infrastructure, as newer rivals leveraging increasingly low cost web-scale cloud hosts are able to undercut established prices based on fundamentally lower COGS.

Life cycle business model is very different for SaaS. The subscription model spreads SaaS sales recognition fairly evenly, while expenses are front end loaded. For growing companies, this gives the appearance of severely squeezed operating profit. However, as customer contracts age, they grow continually more profitable without sales expense of pushing upgrades. As the relative investment scales back in a normal growth environment, operating margins will rise. Ultimately, SaaS profitability will depend on product differentiation, and leveraging data center scale advantages. This last factor will be a strong advantage for IaaS operators competing in SaaS apps. We do not expect SaaS only players to approach the 30%+ margins earned by software leaders in the last cycle, as it will be difficult for them to make margins on the infrastructure costs embedded in their business model.

Attractive SaaS IPOs have and will hit the market. With at least 20 SaaS IPOs since 2012 offering a range of applications, stocks in the SaaS space ran high until early 2014. Since then, some SaaS names have taken a beating, notably: CSOD, BNFT, MDSO, ATHN, and ININ, which are all off at least 30% since March. ATHN was subject to an activist investor short despite the company nearing a $1B revenue run rate and S&M expenses well below cloud peers. Since March, 6 SaaS companies have IPOed, 2 of which are in our model portfolios: ZEN and OPWR. There are 15+ SaaS companies that have each raised over $100M, likely to IPO in the next 18 months. SaaS is not a zero sum game and we expect more intriguing names to emerge as they create value through differentiation.

Some old paradigm players are making successful transitions. While many traditional application companies are struggling to reposition themselves as SaaS vendors (ORCL, SAP, IBM, etc.), a few (MSFT, ADBE and ADSK) appear to be successfully migrating to the cloud. These players have adapted their core products to take advantage of the benefits of the cloud and have implemented an easy path for their customers to transition. This reduces competitive vulnerability and smoothes revenue recognition across product life cycles, increasing the predictability of both revenues and expenses.

Invest in sustainable differentiation. Differentiation will be on the basis of functional innovation, network effects, ecosystem effects, and system learning. We are pessimistic for those traditional software vendors struggling with SaaS, and are cautious about many of the SaaS pioneers – e.g. N, CRM and others – concerned that subscale in-house data centers will be a long term liability. We are enthusiastic about differentiated SaaS players that have embraced 3rd party hosting – such as WDAY, DATA, ZEN, PFPT and OPWR. Well adapted incumbents – like MSFT, ADBE, and ADSK – are likely to surprise against pessimistic market expectations. Finally, we expect the IaaS market to break into haves and have-nots, with AMZN, GOOG and MSFT on track for long term dominance.

For our full research notes, please visit our published research site.

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