Why You Shouldn’t Underestimate This Industry’s Potential

I wrote this from the fifth annual SaaStr conference in San Jose, California, surrounded by 12,500 other attendees, sharing time with executives representing more than 200 software companies, from Twilio (Nasdaq: TWLO) CEO Jeff Lawson, to Atlassian (Nasdaq: TEAM) President Jay Simons, to HubSpot (Nasdaq: HUBS) CEO Brian Halligan, to leaders at smaller businesses just starting to make waves. For three days, we heard how Software-as-a-Service (SaaS)—that is, providing software to customers over the Internet for a subscription fee—is changing how businesses run, communicate, serve customers, and more. Let’s review some promising themes relevant to investors.

The Cloud Is Just Beginning

Years from now, if someone stumbles upon this article, what should jump out at them in the first sentence are the words “fifth annual.” Cloud software is still just getting started. Even executives from some of the most valuable SaaS companies still speak as if they’re in phase one of building a business, because they are. Few companies have yet surpassed $500 million in annual revenue, let alone $1 billion, while many address potential markets several times larger.

This doesn’t mean you can buy any SaaS business and succeed, but it could mean that select leaders are going to grow handsomely for a long time. Be sure to have the right perspective: When investors years from now look back on 2019, they’ll marvel at how many SaaS companies were newly public, and how small many were compared to how large they became.

The Business Model Is Powerful

I’ve never witnessed so many diverse companies offering so many myriad services, but all espousing the same general business model. The industry recognizes that a subscription to cloud-hosted software can be fast to initiate, economical to maintain, steadily upgraded, and makes for reliable financials. There was no reason at the conference to question how the product is being sold: The model works beautifully for companies addressing a need. If any single risk stands out for many SaaSers, it’s their confessed reliance on Amazon.com (Nasdaq: AMZN) and its Web Services business.

But the relative ease and versatility of the SaaS model means that the breadth and depth of future software offerings will grow, not only for enterprises, but for individuals. Nearly 140 million households subscribe to Netflix (Nasdaq: NFLX), a form of SaaS. Specialized SaaS offerings could help us manage the connected devices in our home, our transportation and healthcare needs, social life, family communications, and more. In fact, most activities could have a SaaS solution. Companies are mostly focused on enterprises today, but expect a second wave of SaaS offerings targeting consumers, including very inexpensive, niche products.

The First Big Wealth Generators Are Here

With tens of thousands of intelligent people focused on providing nimble software solutions using an attractive business model, it’s not surprising to see early value creation. Atlassian, Twilio, and Veeva Systems (Nasdaq: VEEV) lately have market values of $26 billion, $13 billion, and $17 billion, respectively; while smaller companies such as Appfolio (Nasdaq: APPF) and Zuora (NYSE: ZUO) are worth above $2 billion.

From zero just a decade ago, today 55 privately-held SaaS businesses qualify as Unicorns (meaning they’re valued at $1 billion or more), and many of these are on track to go public, including Slack. Thankfully for investors, the multitude of companies arriving to Wall Street helps spread out share demand, and may keep initial share prices on some within the realm of reasonable.

Management Is Focused on Appealing Growth Metrics

Almost all SaaS businesses have in common a focus on growing recurring revenue. We couldn’t be more pleased. Call it Annual Contract Value (ACV), Annual Recurring Revenue (ARR), Dollar-Based Net Revenue Retention (NRR), or some other name; the bottom line is management is focused on metrics that, when executed, favor long-term value creation.

By signing customers on subscription contracts, and improving or expanding the software being offered, SaaS companies are able to grow the annual value of the relationship with a majority of customers. This has led to net retention rates at subscription software seller Zuora (NYSE: ZUO) of 112%. They’re bringing in 12% more dollars per average customer a year later. Twilio recently reported a dollar-based net expansion rate of 147%. Customers are using the service more, and pay usage fees. Coupled with new customer sign-ups, this can drive incredible growth. Meanwhile, Bessemer Venture Partners estimates that every 1% increase in net retention can increase an average SaaS company’s valuation by $100 million.

Then there’s the possibility that leading SaaS companies can leverage results into new, related markets. Veeva Systems mainly sells software to the life sciences industry, but it seeks to add about $1 billion per year in incremental market opportunity; today, management says it enjoys a $9 billion market opportunity, up from $8 billion last year. Soon it will surpass $1 billion in annual sales.

Simplicity—and Speed—Can Be Key

Atlassian does not rely on a salesforce. The software is so easy to use that customers sign up from Atlassian’s website. Ease increases your odds for success, reduces sales lead time, and lowers costs. The trend of turn-key products subscribed to online will continue.

Overall, SaaS can offer predictable and growing revenue; large and expanding end markets; strong and rising profits; and increasing utility to customers. The reality that almost every business needs to go digital suggests SaaS as an industry is bound to thrive for years. Investors who haven’t yet should take note. We’re focused most on companies with strong retention rates, rising sales per customer, large end markets, and usage revenue as well as subscription revenue.

—Jeff Fischer

Jeff owns shares of Amazon.com, Atlassian, Netflix, Twilio, and Veeva Systems.

The content in this message is provided for informational purposes only, and should not be relied upon as recommendations or investment advice. We encourage you to seek personalized advice from qualified professionals regarding all personal finance issues. The mention of specific securities does not constitute a recommendation with respect to these securities.