SaaS Applications: [Subscription] Software is Eating the World!


SaaS enterprise applications make up a more than $31B market that is growing at more than 30%, and is projected to sustain 20% growth through 2018. SaaS products are a bundle, displacing not just the application, but also the enterprise infrastructure and personnel needed to deliver the service to users. With prices for IaaS hosting rapidly falling, infrastructure investment is no longer an entry barrier, enticing start-ups and threatening SaaS pioneers. In this context, having an excellent application with strong customer support in an attractive, cloud ready sector; exploiting low cost cloud infrastructure; and achieving relative expense efficiency are the critical factors separating winners and losers. We evaluated 43 SaaS focused public companies, considering their category market share and sales growth, their gross margin and capex-to-operating cash flow, and their sales cost to new revenue and R&D to new revenue ratios as indicators of positioning. Our framework reveals, DATA, PCTY, TNET, and VEEV as particularly well positioned, but shades CTCT, CVT, EPAY, ININ, QLYS, RP, and ULTI as relatively vulnerable longer term. We also subjectively valued the SaaS initiatives at traditional software leaders, with MSFT, ADBE, ADSK and INTU standing out against disjoint offerings from rivals like IBM, ORCL and SAP.

SaaS is big and growing fast. According to Gartner, SaaS applications will be a $31B+ market in ’15, already 21% of the global enterprise application software market, but we note that by bundling data center costs into subscription fees, SaaS actually addresses the $1.1T spent annually on enterprise data center software, hardware AND services, with further savings in customer IT personnel as well. Gartner is expecting 20% forward growth in SaaS apps, a forecast that we believe may be conservative, given the growing rivalry fueled by falling IaaS prices.

Not all SaaS is created equal. Valuations for public SaaS companies are all over the map, with WDAY’s 20x EV/Sales nearly 3x the 7.2x median in our universe of 43 public SaaS companies with market cap >$1B, and more than 9x the cheapest, CTCT at 2.1x. We used a framework to assess the relative positioning of the companies in this universe and also subjectively assessed the SaaS initiatives of several traditional SW players.

SaaS is a bundled product. SaaS applications displace more than just packaged software applications, they also displace the hardware, infrastructure/platform software, communications services, and IT personnel necessary to deliver and support the application from the customer’s internal data centers. These elements are provided in a bundle with the application, and thus, winning long term SaaS solutions must succeed on both application functionality and data center cost/performance. This greatly increases the spending pool addressed by SaaS, and, until recently, has been a key competitive barrier for SaaS pioneers who have invested heavily in their own data center infrastructure.

IaaS levels the playing field. The steep downward price trajectory for cloud-hosted computing and storage has opened the door wide for SaaS startups, who no longer must contend with playing infrastructure catch-up against the likes of CRM, N, IBM, ORCL and SAP. Indeed, we believe that those early leaders will find themselves disadvantaged in the long term by their commitment to sub-scale internal data center operations that are much more costly, lower performance, and less flexible than the IaaS offered by AMZN, MSFT and GOOG and purchased by their rivals. We assessed our universe of SaaS companies for PP&E and lease obligations relative to sales preferring companies without firm commitments to costly internal data center operations. Smaller, newer companies, such as GWRE and EGOV rated well, while older or larger SaaS names, like CRM, BOX, and CVT, trailed.

The right product in the right market. As infrastructure investment fades as a barrier and scale becomes somewhat less critical, SaaS success will be more driven by the quality of the application itself and the attractiveness of the market niche that it targets. We created a compound metric to balance application and market attractiveness, multiplying SaaS category market share by the relative growth rate of company revenues vs. the category growth rate, then adding a market category attractiveness factor determined by the projected 5th year category market size. Here, CRM, ZEN, HUBS were the leaders, while QLYS, RP and SPS rated lowest.

Operations matter. Over time, we expect falling barriers to entry to drive SaaS prices lower, potentially squeezing profitability for many players, even those already taking advantage of low cost IaaS infrastructure. As this happens, operating efficiency will become an increasingly important differentiator for SaaS companies. We looked at R&D and sales costs relative to next year revenue growth as an indicator of this efficiency for the companies in our universe. VEEV, SNCR, WDAY were the most efficient, while RP, ININ, and CTCT were the least.

Considering all 3 factors reveals likely long term winners. 5 companies from our universe of 43 SaaS vendors appear in the top half of all of our metrics – infrastructure flexibility, application quality and operating efficiency. These are DATA, TNET, VEEV, HUBS, and EIGI. Another 18 companies missed the perfect rating by one category. For the companies that are carrying above average infrastructure costs, the answer will be an eventual transition to an IaaS host, something that most will find challenging. For companies that are not gaining traction or that are addressing a modest target segment, the answer likely lies in building a defensible and efficient niche business. For companies that trail in operating efficiency, most are small and fast growing and the answer is obvious – get more efficient.  The framework also reveals 6 companies challenged on all of these fronts – CVT, EPAY, ININ, QLYS, RP, and ULTI.

Most traditional SW players will struggle w SaaS. The large enterprise software competitors do not break out costs for their SaaS operations, so it is difficult to evaluate them in our framework. However, most of them rely on their own data centers, with MSFT the only one that we believe can boast a modern, web-scale, cost competitive infrastructure. Most also face Clay Christensen’s “Innovator’s Dilemma”, propping up lucrative packaged software franchises while simultaneously trying to build and buy SaaS product lines to compete with them. We looked at the issue, measuring each company’s cloud share vs. its traditional share, preferring companies with a strong relative showing in SaaS. With this perspective MSFT, ADSK, ADBE and INTU rated as the most attractive.

Please see our published research page for the full note.

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