Portfolio Update: New Position - 4th Ind. Revolution Theme: Enterprise SaaS (Part I)

Our Man has talked a lot about software over the last 12mos+, yet the theme is not in the portfolio.  This was due to professional considerations; he was researching and allocating to a Software-as-a-Service (“SaaS”) focused fund for a client portfolio as well as writing an insight piece into Unicorns and software.  With both complete, Software can be added to the portfolio and the rationale is below.   Much of OM’s early drafts of this piece were subsumed into the second half of the aforementioned Unicorn paper (let OM know if you want a copy!), so what follows is a shortened version. 

The rise of software is not new, it was foreshadowed in Marc Andreesen’s seminal Wall Street Journal article - “Software is Eating the World " - in August 2011.  Software, and its key role in the 4th Technological Revolution, is also one of the drivers of Our Man’s bullish long-term view (more on that another time!).

The Rise of Software

Over the last dozen years, the world has transitioned online driven by increased computing power, cloud storage and mobile usage. This has increased accessibility and vastly reduced delivery costs (i.e. an internet download, or app).  This transition provides a secular tailwind for software companies, allowing them to scale and quickly generate substantial revenues, and to become entrenched in consumer’s lives and companies’ business.  These same technological transitions have also enabled many software-driven companies to change their business models from a traditional product sales/licensing (i.e. remember those floppy disks/CDs) to a cloud-based subscription model that generates recurring revenues.  Though the subscription model sees a smaller monthly fee, it leads to both higher recurring revenues and higher retention rates for the company.  Finally, the smaller regular subscription cost increases the size of the potential market and helps margins, as the marginal cost of providing a new cloud-based software product approaches 0% as the customer base grows (e.g. imagine the marginal cost of the 10,000th stream of TV show, or the millionth download of a song, etc.). 

Enterprise or Consumer?

Our Man has a strong preference for enterprise (i.e. business) focused companies rather than those that focus on the consumer.  It is only natural that the consumer market developed first, given the speed of the different decision-making process - you making a decision vs. your firm making one – and that in consumer-world the limiting factor was marketing and distribution.   Before the Internet almost all consumer business was either (i) local or (ii) space-constrained (shelf-space, channels on your TV, etc.).  The Internet resolved this - websites are accessible across the country/world, Amazon has unlimited shelf-space and cloud-based product is infinitely divisible (Netflix can let you watch everything and anything on its menu at any time, irrespective of how many others are watching it). 

The approaches to data in the consumer and enterprise environments are necessarily different, which impacts the business models.   For a company, its internal client data is a key part of its business (and often covered by regulations) which means it cannot have its software partners collect and share that information.  This contrasts with the consumer-side, where collating personal data is often key to the business model whether the data is used to help target advertising or to try and create network effects.   This difference in approach to data has further driven enterprise software towards a paid subscription model, whereas the consumer side remains a mixture of different models, including advertising driven (Google, Facebook, Pinterest, etc.), subscription (Spotify, Netflix, etc.) or models focused on the delivery of a physical good/service (Uber, Lyft, Amazon, etc.).

The value proposition to the client of the subscription model is centered on the greater flexibility that it provides. This flexibility comes in many forms;

• Easier Administration: The client can better control and match the number of licenses that are used. Since the subscription model is a pay-as-you-go system, subscriptions can be increased/decreased as required.
• Greater Compatibility & Security: As the software is hosted in the cloud, all users are using the same version of the software, ensuring compatibility across a firm. Furthermore, the software provider is responsible for updating, patching, and security, and these are done automatically rather than on a user-by-user basis.
• Cost affordability: The steady price and recurrent nature of subscriptions means that they can be budgeted for more easily.
• Global Accessibility: Users can access their software from any device as it is hosted in the cloud. This has increased in importance as the prevalence of mobile has expanded.
• Integration & Scalability: Most SaaS applications are designed to support some level of customization, and vendors allow connections to both internal applications, but also other external SaaS applications. This means that information is available in a more accurate and timelier fashion than before, which has notable impacts on productivity. For example, sales people in the field can immediately check real-time data (via an application on a mobile device) on inventories before committing to a sale, rather than going through a longer and more manual process of speaking to head office directly to get the information.

The biggest benefit of this increased flexibility for clients is that using a cloud based SaaS solution leads to increased productivity, as the clients can focus on their core businesses.

Companies’ transition to subscription models has also led to significant benefits for investors;

• Higher Recurring Revenues: The subscription model means that the firm’s revenue stream is more predictable due to the steady income from subscriptions, which helps management in planning and investors to value the business.
• Higher Retention Rate: The model changes the nature of the sales process from one where the firm is looking to complete a solitary transaction (e.g. sell X number of licenses) to one where it’s selling a long-term relationship with the client. The model also changes the nature of the client’s behavior; clients must make the decision to leave a provider rather than make a new purchase. The behavioral nature of this change has been important for software providers as it has led to increased client retention.
• Increases Total Addressable Market: As the recurring subscription cost is small (relative to the prior cost of purchase under the licensing model), the SaaS model helps increase the market size through greater accessibility for small businesses and non-core usage within large firms.
• Uniformity of Updates: As the implementation of updates is driven by the provider, not the client, and is done in the cloud, this helps ensure that updates tend to be done more frequently and that all users are utilizing the same version of the software.

For investors, the first three of these benefits - higher recurring revenues, higher client retention, and a larger market - has changed the long-term profitability of software companies, making them a more attractive long-term business. In addition to improving profitability, it has also meant that SaaS companies are less prone to changes in the economic cycle. This is a function of the productivity benefits that the SaaS model offers customers, which results in higher client retention. Given these productivity benefits and the substantial switching costs of changing software providers – including retraining employees and linking the new software into existing systems – SaaS companies often enjoy a “sticky” customer base. Typical retention rates for successful SaaS companies have been around 90% of annual revenues. This strong retention rate reflects the benefits of the SaaS business model; software subscriptions are now targeted (rather than company-wide) and at an affordable recurring cost (rather than substantial one-off license fees), which means that customers are more willing to retain subscriptions during any softening in the market.

While software is indeed eating the world, OM thinks we’re still in the earlier innings on the enterprise side.  In part II, we’ll talk a little about valuation and how to invest….