As this theme is a little complex, and more speculative than most of OM’s positions, I thought I would invert this post by starting with the conclusion and then walk through some of the underlying valuation parameters and rationale. There’s a small bonus for readers who make it to the end…
Conclusion
Our Man has taken a small(ish) position in the iShares Expanded Tech-Software Index (IGV), a broad US software index. In time it will be replaced with the recently launched Global X Cloud Computing Index (CLOU), which better represents the Enterprise SaaS market. OM took this position, despite the high valuations in the Enterprise SaaS market, as it reflects:
- OM’s flaws as an investor; he is better at following and adding to positions when already invested as opposed to just tracking it. In this case, OM believes it’s a multi-year secular theme and so is comfortable with a small position that he will add to at lower prices.
- It is a more speculative position. In short, despite the moves of recent days, OM believes that there’s a significantly underappreciated chance of a melt-up market (think S&P 4,000 within 18 mos), and in such a scenario software is likely at the epicenter of it*. This would see valuations go from the current expensive to ridiculous!
However, as noted this is on the speculative end of OM’s positions and at these valuations…caveat emptor! Our Man has expressed his queasiness at stocks, let alone an entire industry, trading at over 10x revenue; it’s rarified air, for only those stocks that have (or will have) BOTH good revenue growth and great margins. The margin for error in these stocks is small, as this 2002 quote from Scott McNealy, the former CEO of Sun Microsystems (which traded at 10x revenue in 2000) reminds us.
“At 10 times revenues, to give you a 10-year payback, I have to pay you 100% of revenues for 10 straight years in dividends. That assumes I can get that by my shareholders. That assumes I have zero cost of goods sold, which is very hard for a computer company. That assumes zero expenses, which is really hard with 39,000 employees. That assumes I pay no taxes, which is very hard. And that assumes you pay no taxes on your dividends, which is kind of illegal. And that assumes with zero R&D for the next 10 years, I can maintain the current revenue run rate. Now, having done that, would any of you like to buy my stock at $64? Do you realize how ridiculous those basic assumptions are? You don’t need any transparency. You don’t need any footnotes. What were you thinking?”
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“At 10 times revenues, to give you a 10-year payback, I have to pay you 100% of revenues for 10 straight years in dividends. That assumes I can get that by my shareholders. That assumes I have zero cost of goods sold, which is very hard for a computer company. That assumes zero expenses, which is really hard with 39,000 employees. That assumes I pay no taxes, which is very hard. And that assumes you pay no taxes on your dividends, which is kind of illegal. And that assumes with zero R&D for the next 10 years, I can maintain the current revenue run rate. Now, having done that, would any of you like to buy my stock at $64? Do you realize how ridiculous those basic assumptions are? You don’t need any transparency. You don’t need any footnotes. What were you thinking?”
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SaaS Valuation
Rather than inundate you with excerpts from my crappy badly formatted spreadsheets, I will let the below chart from the HighPeak Financial blog succinctly tells the story of SaaS valuations (~51 cos) over the last half-decade.
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| Source: High Peak Financial - Cloud/SaaS Public Company Valuation - Q2 2019 |
The chart shows a very visible step-change in valuations since the start of 2018; before this date, the group had rarely traded over 8x sales and since it, they’ve rarely traded below 8x. This is not something that’s gone unnoticed with numerous newspapers (e.g. WSJ) and finance sites commenting on the high valuations.
The justification from public investors has largely been as follows;
- The Q4-18 swoon had no major impact on the businesses of market leading/best in class SaaS companies, providing further evidence of the resilience of the SaaS model. This is a further sign that the business model is proving out.
- The largest SaaS companies - especially Salesforce (CRM) and ServiceNow (NOW) – continue to show strong growth and meet the ‘Rule of 40%’. The Rule of 40%, is an industry rule of thumb for a healthy software company that states your Growth Rate + Profit (typically EBITDA is used, but that’s a whole separate debate!) should add up to 40%. As a rule of thumb it is of course imperfect (the trade-off between growth/profit is not linear, unit economics are vital but not included, etc.) but nonetheless the spirit is a good one. The strength of the growth/profitability of ServiceNow and Salesforce, which are $50bn+ enterprise companies that are 15+ years old, is viewed as particularly given data shows the difficulty of meeting the Rule of 40% as companies age and grow.
However, this less impressive than it seems. Visa is the poster child of a company that has traded at more than 10x Sales, it has done so for the last half dozen years and is currently at 17.7x Sales. It’s Revenue Growth (12%) and EBITDA Margins (67.4%) come in at over 79%, rather higher than the Rule of 40%!
- Recent M&A is used to justify current multiples, such as the recent deal where Salesforce acquired Tableau Software at 11.2x TTM Sales.
- Low interest rates and limited growth, means companies with real organic growth deserve a premium valuation.
- Finally, the number of recent IPOs means that only a small portion of the shares are available to be traded (as some investors remain locked up, and unable to sell). As such, demand to own these stocks is outstripping supply (available shares) leading to higher valuations and in the medium-run this will likely moderate as locked-up shares become available for sale.
However, in the short-run there is the possibility that SaaS stocks might act like Giffen goods. That is that the high stock prices from the current excess demand will lead to an increase in the float (shares available for sale, as investors sell them and crystallize these valuations after the post-IPO lock-up ends) AND increased demand from programmatic or rules-based buyers (e.g. ETFs) that automatically increase demand as the float increases and the stocks became eligible for inclusion (or larger position sizes) within indices.
The justification from public investors has largely been as follows;
- The Q4-18 swoon had no major impact on the businesses of market leading/best in class SaaS companies, providing further evidence of the resilience of the SaaS model. This is a further sign that the business model is proving out.
- The largest SaaS companies - especially Salesforce (CRM) and ServiceNow (NOW) – continue to show strong growth and meet the ‘Rule of 40%’. The Rule of 40%, is an industry rule of thumb for a healthy software company that states your Growth Rate + Profit (typically EBITDA is used, but that’s a whole separate debate!) should add up to 40%. As a rule of thumb it is of course imperfect (the trade-off between growth/profit is not linear, unit economics are vital but not included, etc.) but nonetheless the spirit is a good one. The strength of the growth/profitability of ServiceNow and Salesforce, which are $50bn+ enterprise companies that are 15+ years old, is viewed as particularly given data shows the difficulty of meeting the Rule of 40% as companies age and grow.
However, this less impressive than it seems. Visa is the poster child of a company that has traded at more than 10x Sales, it has done so for the last half dozen years and is currently at 17.7x Sales. It’s Revenue Growth (12%) and EBITDA Margins (67.4%) come in at over 79%, rather higher than the Rule of 40%!
- Recent M&A is used to justify current multiples, such as the recent deal where Salesforce acquired Tableau Software at 11.2x TTM Sales.
- Low interest rates and limited growth, means companies with real organic growth deserve a premium valuation.
- Finally, the number of recent IPOs means that only a small portion of the shares are available to be traded (as some investors remain locked up, and unable to sell). As such, demand to own these stocks is outstripping supply (available shares) leading to higher valuations and in the medium-run this will likely moderate as locked-up shares become available for sale.
However, in the short-run there is the possibility that SaaS stocks might act like Giffen goods. That is that the high stock prices from the current excess demand will lead to an increase in the float (shares available for sale, as investors sell them and crystallize these valuations after the post-IPO lock-up ends) AND increased demand from programmatic or rules-based buyers (e.g. ETFs) that automatically increase demand as the float increases and the stocks became eligible for inclusion (or larger position sizes) within indices.
How to Express the Enterprise SaaS Theme?
There are approximately 100 Enterprise SaaS companies in the US, of which just over 50 are publicly listed. This makes gaining exposure to the theme via public markets relatively easy.
a). The optimal way is a concentrated portfolio of 5-8 well-researched positions, utilizing the liquidity of the public markets to adjust position sizes, and buy/sell positions with a long-term (i.e. multi-year) horizon. Professional friends will recognize this as a fairly typical hedge fund co-investment strategy, where a skilled manager can take advantage of a secular trend, in-depth research, concentration and a longer-term horizon to outperform an index. The difficulty of such co-investments is that the best managers for it are ‘true believers’ and so the decision to exit lies entirely with the allocator. Typically, this is the most difficult decision professional allocators face as there's no perfect answer and most decisions lead to job risk as they entail:
(i) The allocator admitting they got the theme wrong (i.e. should never have been in Enterprise SaaS), which is embarrassing and job threatening (especially when there are committees and boards involved, which were likely initially skeptical).
(ii) The allocator getting the theme right, but picking the wrong manager (i.e. would have been better going with a passive option). This is frustrating but not typically job threatening; making good money is better than no money!
(iii) Dealing with the consequences of being right and choosing the right time to redeem a successful investment is, ironically the hardest and most risky proposition for the allocator. This is as it is emotionally difficult and likely heretical since most people find it hard to sell things that have made them a LOT of money. To get it right requires both a clarity of thought and a certain ruthlessness. It also will almost certainly lead to the professional investor getting marginalized or fired. Why? Nobody remembers that the allocator was right to exit the investment unless the theme performs just averagely post-redemption, and things that do exceptionally well rarely then perform just averagely! If the theme collapses after the exit then it was just “lucky timing”, and if it continues to rise rapidly then the investor was overly conservative/foolish/scared and cost the firm $X by redeeming when nobody else wanted to. Generally, Our Man hopes to be lucky often, but will settle for being called conservative/foolish/scared.
b). There is an index just for SaaS companies, the Bessemer Venture Partners Nasdaq Emerging Cloud Index which tracks the performance of ~51 SaaS companies. Sadly, there’s no ETF based on this index though that’s not for OM’s want of trying (he was politely told ‘interesting idea, now go away’ by more than one ETF provider when he suggested it)
c). Sadly this only leaves imperfect solutions of which two standout. The iShares Expanded Tech-Software Index (IGV) is a $2.8bn broad software ETF where SaaS companies make up around 1/3 of the exposure. Secondly, Global X launched a Cloud Computing ETF in mid-April 2019, in which SaaS companies make up around 2/3 of the exposure.
There are approximately 100 Enterprise SaaS companies in the US, of which just over 50 are publicly listed. This makes gaining exposure to the theme via public markets relatively easy.
a). The optimal way is a concentrated portfolio of 5-8 well-researched positions, utilizing the liquidity of the public markets to adjust position sizes, and buy/sell positions with a long-term (i.e. multi-year) horizon. Professional friends will recognize this as a fairly typical hedge fund co-investment strategy, where a skilled manager can take advantage of a secular trend, in-depth research, concentration and a longer-term horizon to outperform an index. The difficulty of such co-investments is that the best managers for it are ‘true believers’ and so the decision to exit lies entirely with the allocator. Typically, this is the most difficult decision professional allocators face as there's no perfect answer and most decisions lead to job risk as they entail:
(i) The allocator admitting they got the theme wrong (i.e. should never have been in Enterprise SaaS), which is embarrassing and job threatening (especially when there are committees and boards involved, which were likely initially skeptical).
(ii) The allocator getting the theme right, but picking the wrong manager (i.e. would have been better going with a passive option). This is frustrating but not typically job threatening; making good money is better than no money!
(iii) Dealing with the consequences of being right and choosing the right time to redeem a successful investment is, ironically the hardest and most risky proposition for the allocator. This is as it is emotionally difficult and likely heretical since most people find it hard to sell things that have made them a LOT of money. To get it right requires both a clarity of thought and a certain ruthlessness. It also will almost certainly lead to the professional investor getting marginalized or fired. Why? Nobody remembers that the allocator was right to exit the investment unless the theme performs just averagely post-redemption, and things that do exceptionally well rarely then perform just averagely! If the theme collapses after the exit then it was just “lucky timing”, and if it continues to rise rapidly then the investor was overly conservative/foolish/scared and cost the firm $X by redeeming when nobody else wanted to. Generally, Our Man hopes to be lucky often, but will settle for being called conservative/foolish/scared.
b). There is an index just for SaaS companies, the Bessemer Venture Partners Nasdaq Emerging Cloud Index which tracks the performance of ~51 SaaS companies. Sadly, there’s no ETF based on this index though that’s not for OM’s want of trying (he was politely told ‘interesting idea, now go away’ by more than one ETF provider when he suggested it)
c). Sadly this only leaves imperfect solutions of which two standout. The iShares Expanded Tech-Software Index (IGV) is a $2.8bn broad software ETF where SaaS companies make up around 1/3 of the exposure. Secondly, Global X launched a Cloud Computing ETF in mid-April 2019, in which SaaS companies make up around 2/3 of the exposure.
* Well done for reading all the way down here! If it does come to pass that software is the epicenter of a melt-up in the markets, then the savvy investors amongst you will recognize that cryptocurrency (i.e. software-as-a-currency? Software as money?) will likely be at the whip end of that move. Who knows, in that environment we might even see Tim Draper prices for bitcoin in the next year or two!
Disclaimer: OM holds crypto assets outside of this portfolio, and IGV in this portfolio (obviously!).
