Quick Thoughts: SaaS-mageddon

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No one said it would be a smooth ride. The SaaS subsector hit a massive speedbump on Thursday night, as a sharp deceleration in contract signings by DATA and soft guidance by LNKD took 40%+ off of their market caps and hammered nearly every other company focused on serving enterprise applications from the cloud. We have argued in the past that the SaaS market was due for a shake-up, with greater separation between likely winners and also-rans. In the wake of this fairly comprehensive sell off, we believe that investors should shop for winners at bargain prices. Indeed, we see both DATA and LNKD as attractive, albeit without immediate catalysts, based on strong products well-positioned against substantial long term opportunities. We also see names like WDAY, CRM, ADBE, SPLK, ZEN and HUBS as oversold in the aftermath of Friday’s bloodletting. We note that none of these companies is relatively exposed to China and that the cost-savings associated with SaaS products makes the category somewhat insulated to recession.

  • Dark clouds – In a market already spooked by oil prices, the Chinese economy and the possibility of global recession, high multiple SaaS stocks DATA and LNKD dropped significant notes of caution into their 4Q15 results and forward guidance. A day later, both stocks were down more than 40%, with 19 other $1B cap SaaS stocks dropping double digits in sympathy. This fallout suggests investor concerns that the current economic uncertainty has shifted the trajectory of cloud adoption by enterprises.
  • SaaS should be recession resistant – Typically, SaaS applications offer significant all-in cost savings vs. legacy applications, arguably raising their attractiveness during economic slowdowns. Moreover, most cloud software names are not exposed to Chinese demand, or, for that matter, oil prices. Certainly MSFT’s strong quarter and confident comments belied no sign of weakness it its rapidly growing cloud business. We note that during the recession spurred by the 2008 financial crisis, high multiple growth tech stocks outperformed the overall market, and their slower growth brethren.
  • Still, a shake-up was due – With 35 SaaS application companies beginning Friday with caps higher than $1B, and cloud-based competition from increasingly desperate traditional software vendors, the field is almost certainly overcrowded. We expect a culling of the herd, with leaders like MSFT and CRM leading market consolidation. We believe that many SaaS companies, particularly those without well differentiated applications, will struggle with a transition from integrated in-house hosting to lower cost IaaS infrastructure.
  • What to buy – After the damage, we believe long term opportunity outweighs the risk of further devaluation in both DATA and LNKD, even though there is no obvious immediate catalyst to temper the aggressively negative sentiment around the stocks. Other companies will get the chance to speak for themselves – here we are positive on WDAY, ADBE, CRM, SPLK, ZEN and HUBs, with the first two in our model portfolio, along with DATA.

Conclusions – Of 34 SaaS stocks that began Friday with market caps greater than $1B, 21 of them fell by double digits during the day, led by LNKD and DATA which had sparked the sell-off with weak guidance and poor new contract signings respectively. While the poor tidings from the two reporting companies may have been a nasty coincidence, investors interpreted the data points as harbingers of a broader downward shift in enterprise IT spending and, in particular, an indictment of high multiple SaaS stocks with expectations of rapid future growth.

We believe that the group is oversold. In general, SaaS applications offer enterprise customers substantial cost savings vs. traditional software licenses, making these companies relatively resilient to recession. Moreover, the public SaaS names have lower exposure to the uncertain Chinese market that the technology establishment. Very strong 4QF15 cloud results from enterprise IT stalwart MSFT would suggest that a narrative of weakening enterprise cloud demand is unlikely to be the root cause.

Rather, we suspect that the cautious notes from LNKD and DATA were idiosyncratic. DATA has been facing more aggressive competition in its analytics strong hold from MSFT and rivals like SPLK and QLIC. Furthermore, with quarterly revenue of just $200M, new contract signings are likely lumpy in nature – a single contract deferral could easily sway the growth rate quarter to quarter at the levels observed in 4Q. LNKD appears to be going through a bit of a transition as it invests to grow its new Sales Solutions business, but the opportunity seems promising. Meanwhile, both companies took significant hits from the difficult FX environment, which made their products less attractive in international markets.

We will get better intelligence as other cloud names, like CRM and WDAY, report over the next month. We expect that their results will not support a story of widespread SaaS collapse. We believe that this selloff constitutes a substantial buying opportunity in the group. We see real value in both DATA and LNKD, which now trade at significant P/S discounts vs. other SaaS names with similar growth profiles. We are also interested in WDAY, ADBE, CRM, SPLK, ZEN and HUBS, all of which suffered double digit declines on Friday. Ultimately, we believe that all future enterprise growth will come from the cloud, with category leaders with SaaS applications well positioned to deliver strong sustained growth.

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