SaaS: Handicapping the Unicorn Races

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SEE LAST PAGE OF THIS REPORT Paul Sagawa / Tejas Raut Dessai

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January 24, 2019

SaaS: Handicapping the Unicorn Races

Software-as-a-Service (SaaS) applications are a $145B+ market growing at nearly 31% YoY. While Gartner pegs the packaged enterprise application market at just $250B, SaaS – which bundles datacenter, networking and support costs and better addresses custom homegrown applications – addresses a TAM of more than $600B, leaving substantial further runway. We count 124 different SaaS businesses – public, private and contained within larger companies – each valued at more than $1B and collectively valued at ~$1.1T or 8.7x TTM sales. On average, these businesses are not profitable – the mean EBIT margin is -5% – but consensus expects the mean public pure-play to turn cash flow positive by 2020, a projection that seems reasonable given trends. The SaaS businesses are scattered across 11 horizontal business functions and 9 different industry vertical segments of varying size and rivalry. We evaluated the public companies for the attractiveness of their target opportunities and their competitive positioning. Separately, we also assessed them for the efficiency of their OPEX in generating sales growth. Within this framework, companies that we believe are poised to deliver the strong growth and progress toward profitability needed to justify their premium valuation emerged. This group of 15 companies has established a sales growth trajectory much more robust than forecast by consensus, suggesting strong potential for upside surprises and revisions. Moreover, scale economies and other operating synergies suggest substantial potential for consolidation, further supporting valuation premiums.

  • The $145B SaaS market is growing 30%+ with plenty of runway. We compiled a list of 124 SaaS players – 62 publicly traded pure-plays, 50 private companies, and 12 SaaS business units – each valued at least $1B. In total, these businesses had sales of nearly $127B and delivered 30.7% TTM sales growth. Often, the addressable market for SaaS is assumed to be the $250B or so spent annually on packaged application software, but this shortcut ignores the potential for SaaS to address custom developed applications, and the bundling of very significant datacenter and support costs bundled with SaaS but not included in packaged app sales. All in, we believe that TAM is likely greater than $600B even though SaaS solutions tend to be deflationary.
  • SaaS players must hit growth/profitability bogies to justify valuation. The 124 businesses in our model delivered ~31% sales growth over the last 12 months at a median (-5.0%) operating loss and an 8.7x sales multiple. If on average, they were to grow at a 20% 5-yr CAGR and build to 20% EBIT margins over that time, the industry is trading at less than 17.6x 2023 EBIT. This collective valuation seems reasonable given prevailing prices for companies sporting similar performance profiles as the average SaaS company. Still, consensus is expecting a turn to profitability by 2020 and investors may grow impatient if clear progress is not made. In addition, consolidation via M&A, justified by operating and strategic synergies, could also drive valuation premiums.
  • Opportunities across horizontal and vertical dimensions. Most of the 124 businesses have a focus on a specific business function (e.g. CRM, ERP, business intelligence, office productivity, security, etc.) or vertical industry (health care, financial services, education, etc.), with a few of the largest players (e.g. MSFT, CRM, ADBE, etc.) spread across several segments. Companies may now be in tightly focused siloes within each category, but rivalry will intensify as solutions expand to address adjacent customer needs. This parallels the development of packaged software 15-20 years ago.
  • Rated public SaaS names by opportunity attractiveness and position. The categories of SaaS applications are not equal opportunities. We estimated TAM by category based on their current size and growth, as well as market-level threats, such as the potential for AMZN and GOOGL to squeeze independent e-tail vertical solutions. Within each category, we rated the public companies based on their current market share and their growth relative to the group. Melding the two yields our assessment of the attractiveness of each player’s position. At the top? CRM, TWLO, ZEN, YEXT and HUBS.
  • Considering intangibles. Quantitative analysis is fraught in a market with as little history as SaaS applications. Powerful competitors can emerge. A market leader might set its eye on your niche – like AMZN, MSFT and GOOGL are doing to BOX. A new substitute might emerge to put your market at risk – virtual telephone systems are becoming less important as mobile smartphones win out. An integrated competitor could weaken your customer base – as AMZN and GOOGL are doing in the e-tail vertical. We looked at the top-rated names and made some adjustments.
  • Operating efficiency points to future cash flow. Most SaaS businesses now have negative cash flow, as they invest for future growth. However, inherent economies of scale – i.e. infrastructure, OPEX – suggest potential for strong double-digit EBIT margins, even if none of the pure play SaaS companies have reached that stage. MSFT and ADBE have seen their 30%+ margins improving as they transition more and more of their traditional software customers to the SaaS model. In a sea of red ink, we prefer the companies that appear to be making progress toward sustainably positive cash flow. To that end, we used sales growth generated in the year after OPEX outlays to assess efficiency. The most efficient public SaaS names in our universe are SSNC, ENV, EBIX, ZUO, SHOP and ZS.
  • The winners will easily beat consensus. Separating the SaaS universe into their growth prospects and operating trajectory, we look for the companies that have the greatest cushion vs. expectations. Of the stocks that rate above average in both position and efficiency, ZUO, SHOP, TWLO, OKTA, AYX, SMAR and SPLK appear to have the biggest gap between their performance trajectory and consensus.
  • Our top SaaS names. Of the broadline players with significant SaaS business, MSFT, GOOGL, and ADBE stand out for us. In the pure plays, AYX, ZEN, NOW and CRM are all in our model portfolio, with ZUO, OKTA, TWLO, SPLK and DATA worth candidates for inclusion.

Will the Herd Be Culled?

SaaS applications is a crowded field. We count 124 different businesses – some public, some private, some contained within larger companies – that carry valuation of at least $1B. These companies are chasing a sizeable market, already generating nearly $127B in TTM sales, growing at a 30.7% annual clip. While packaged enterprise applications have peaked at about $250B per year, the addressable market for SaaS is much larger for two main reasons. First, SaaS solutions bundle a swath of expensive functions – e.g. datacenter operations, networking, infrastructure software, security, user support, regular upgrades and others – that are borne by the customer if using a packaged application. Second, the inherent performance advantages of SaaS – e.g. automatic updates, coherent security, diverse datacenter locations, etc. – make it more competitive for customized applications that had developed internally. All in, we believe this more than doubles the TAM for SaaS applications, even accounting for the deflationary impact.

The market seems to think so too. These 124 SaaS businesses – 62 public pure plays, 50 private Unicorns, and 12 SaaS business units in diverse IT companies – are collectively valued at roughly $1.1T or 8.7x TTM sales. This despite average operating margins underwater at (-5%). Consensus expects the public SaaS names to hit profitability by 2020, reasonable given profitability trends, but easier for some than for others. If the average company on the list can make it to 20% margins and deliver 20% annual growth through 2023, the group is trading at 17.6x 2023 earnings. That’s okay, IF the growth and profitability materialize.

The SaaS market is not monolithic. We count roughly 11 business function segments and 9 vertical industry markets that have attracted significant play. A few major players (i.e. MSFT, ADBE, CRM, NOW, ORCL, SAP) compete in several silos, but most competitors remain very focused. Several of the segments – e.g. CRM, ERP, Security, and BI – are a bit crowded, with competitors trying to define sub-segment niche markets. We evaluated the size and growth potential of each of the horizontal and vertical segments, adjusting for potential future strategic threats, such as the likely entry of major competitors or threats to the targeted end market. We then assessed the competitive positioning for each of the public companies, combining that with the segment attractiveness for a single rating.

We believe operating trajectory is important too. As many companies turn the corner to profitability, the laggards are likely to be punished. We looked at OPEX efficiency as a key indicator – does R&D and sales investment in year one drive growth for year two? Contrasting this with business attractiveness begins to separate likely winners from losers. We took the 15 companies deemed above average on both axes and looked at the trajectory expected in consensus estimates. Here, a few names popped out – ZUO, SHOP, TWLO, OKTA, AYX, SMAR and SPLK. These companies would also seem likely candidates for acquisition, with strong synergies supporting reasonable deal premiums. At the same time, we expect losers, with the less attractive/less efficient quadrant the most likely candidates.

SaaS Solutions Are Just Better Than Packaged Software

Traditionally, enterprise software applications were sold as a license. Customers identified the number of users that they needed to support and the set of functions that they wanted to license. The supplier provided the code, and for a fee supervised the installation and customization of the software. There might also be an annual maintenance fee for technical support and minor updates. Periodically, the developer would write a new version of the application, introducing significant new capabilities, and start the sales and implementation cycle once again. In this model, the application would run on the customer’s own datacenter infrastructure hardware and software, users would access the software via the customer’s own network facilities, and the customer’s own IT department would handle user support and security.

Gartner estimates the global packaged application market at under $250B annually, not including those support costs and not including the development costs for the many customized internally-developed applications in use by enterprises. Including this additional spending, we believe that total annual spending on enterprise applications might be more than $1T, given the $3.6T per year that we estimate is being spent on enterprise datacenters world-wide (Exhibit 1).

Exh 1: Global Enterprise Data Center Spending Forecast, 2017 – 2022E

In contrast, SaaS applications are run on a hyperscale datacenter in the cloud, accessed via the internet, with support and security included. Those periodic upgrades? Included and updated automatically as part of the ongoing contract. In most cases, the cloud datacenter and networking costs will be a fraction of the equivalent in-house costs, capturable as internal datacenter operations are downsized. The SaaS application

Exh 2: Global Public Cloud Spending in all 3 Categories Forecast, 2017 – 2021E

Exh 3: SSR Estimate for SaaS Total Addressable Market, 2018 – 2023E

may also have much better up-time, faster processing, and other significant performance advantages. These benefits position SaaS options to compete for internally developed and/or highly customized applications as well. There will be a clear deflationary effect, but we believe that the global TAM for SaaS enterprise applications is north of $600B per year (Exhibit 2, 3).

The Unicorn Herd

We count 124 different businesses with market values in excess of $1B competing in the SaaS space. 62 of them are public, pure-play SaaS companies. 50 are privately held companies whose most recent funding implied “unicorn” status. Another 12 are SaaS-based business units of much larger IT companies (Exhibit 4). Together, we estimate these businesses generated nearly $127B in sales during 2018, up 30.7% from the previous year (Exhibit 5, 6). The public companies reported EBIT margins of (-5.0%), as they furiously invested in OPEX to chase growth and to gain the scale that would make profitability possible.

Collectively, these businesses are valued at about $1.1T, or 8.7x sales (Exhibit 7). The reasonableness of this industry valuation is up for debate. If growth can be sustained at a 20% CAGR over 5 years, and if the average company can deliver a 20% EBIT margin, we would argue that a valuation of 17.6x 2023 earnings is reasonable (Exhibit 8). The real question is whether that trajectory is more likely than not.

Companies will have to find the answer soon. Consensus expects the average SaaS company to be profitable by 2020, a hurdle that will likely catalyze real separation between winners and losers. Getting there will take two things: continued strong sales growth and operating efficiency. Strong but inefficient growers could be bailed out by acquirors confident in their ability to impose discipline, but growth laggards could be in existential trouble.

Exh 4: Snapshot of 12 public enterprises with sizable SaaS application business

Exh 5: Snapshot of 62 public SaaS pure-play companies with Market Cap > $1B

Exh 6: Snapshot of 50 private SaaS startups funded at >$1B valuation

Niches in Niches

Of course, the unicorn races are not a free-for-all – a business analytics platform does not compete with education vertical solution. We divided the market up into 11 horizontal (i.e. CRM, ERP, Security, Enterprise Data Management, BI, IT operations management, Office Suites, Cloud Communication, Team/Social, Project/Portfolio Management, and Other) and 9 industry vertical segments (Exhibit 9)

Exh 7: Valuation summary for SaaS businesses categorized by type

Exh 8: P/EBIT multiple matrix for all SaaS companies with >1B valuation

(i.e. eCommerce, Education, Healthcare, Real Estate, Investment Management, Insurance, Manufacturing/Resources, Supply Chain, and Non-profit). Within these segments, companies have typically looked to dominate a distinctive niche, but in most cases, we believe the long-term growth path will inevitably bring them into competition with rivals that occupy adjacent niches.

Based on the size of the packaged software market in each category and by the estimated sales and growth of the SaaS players each has attracted, we made rough estimates of the 2022 addressable market for the segments. Combining this with a qualitative assessment of potential obstacles and risk – for example, independent solutions for the eCommerce vertical must account for Amazon’s growing domination of the target market – yields an assessment of the overall segment attractiveness (Exhibit 10). We then compared each public company’s size and growth to the segment averages to derive a rating for their position. A company gaining share in a large, vibrant segment is more attractive than one that is losing ground in a less exciting market.

Exh 9: SaaS app segment taxonomy and count of companies in each category

Waste Not, Want Not

For each of the public companies, we assessed their progress toward sustainable free cash flows. During this period of extraordinary growth, companies are understandably investing to build their competitive position with spending on development and building sales relationships in advance of expected revenues. We measured the effectiveness of this OPEX investment in driving growth, lagging sales spending by a year and R&D by two. This ranking was then used in combination with the market position measure to plot the companies on the two axes (Exhibit 11).

We believe that the companies above average on both measures are the best bets to deliver sustainable growth and consistent earnings, while those below average on both are likely laggards (Exhibit 12). The companies with strong market position but poor operating efficiency COULD succeed, either by gaining discipline on their own or by being acquired by a larger company interested in their growth. The companies in poor position but with excellent spending discipline COULD be in trouble, particularly if there is no plan for product expansion. Note that we dropped LOGM and SSNC from the top quadrant, as the growth of both was boosted by M&A. While we are concerned that SHOP faces a long term threat from the success of the Amazon Marketplace and from an aggressive Google eCommerce strategy, we decided to keep them in the upper group. At the same time, we promoted DATA and SPLK to the A Quadrant based on our subjective assessment of their potential for cash flow improvement (Exhibit 13-17).

Exh 10: Pure-play public SaaS companies ranked by Application Attractiveness

Exh 11: Pure-play public SaaS companies ranked by Operating Efficiency

Exh 12: Pure-play public SaaS overall rankings and performance quadrants