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Why are ASX SaaS shares going gangbusters?

Many popular sell side brokers were tipping resources shares to be the star performers over the August reporting season, but the likes of BHP Billiton Limited (ASX: BHP) and Rio Tinto Limited (ASX: RIO) actually fell flat on mildly disappointing results.

Moreover, the medium-term outlook for these miners is moderate at best given their capital-intensive nature and vulnerability to falls in commodity prices.

In fact the stars of the reporting season (once again) were technology businesses in particular in the software-as-a-service (SaaS) space.

For example shipping logistics business WiseTech Global Ltd (ASX: ASX) rocketed around 45% in the days after reporting its profit result, while electronic circuit board software provider Altium Limited (ASX: ALU) lifted around 30%. Both these businesses have roughly tripled in value over the course of the past year.

Other SaaS players such as medical imaging business Pro Medicus Limited (ASX: PME) and online accounting player Xero Limited (ASX: XRO) have more than doubled in value over just the past year.

These are the kind of returns serious investors cannot ignore, so how is SaaS powering their success?

It’s called software-as-a-service as it delivers a service (such as an online accounting platform rather than desktop Excel spreadsheet) that users can subscribe to use in return for a monthly fee.

For SaaS providers the business model has several big advantages over the business models of traditional blue chip companies.

Probably the biggest advantage is the recurring revenue model, whereby once a customer is signed up they’ll pay the SaaS provider indefinitely to use the service, without the provider incurring much in the way of additional costs down the line.

Compare this recurring revenue model to a miner like BHP. The miner that must invest sometimes billions of dollars in capex every time it wants to dig a giant new mine to generate additional sales revenue.

Or compare the model to a business like hearing aid manufacturer Cochlear Ltd (ASX: COH), which many rightly consider to be one of the best on the local market.

If Cochlear sells 100,000 hearing aids in FY 2019, it will have to sell another 100,000 hearing aids to new customers in FY 2020 just to reach breakeven assuming an equal selling price.

This is like pushing rocks uphill compared to a recurring revenue SaaS model where every new customer added goes on top of the prior year’s total subscribers.

SaaS businesses that deliver software platforms online also don’t have to incur the cost of goods sold like Cochlear in having to absorb manufacturing costs before trying to sell another product.

In fact the beauty of SaaS is that updates to platforms (services) can be delivered online to millions of subscribers via not much more than the click of a button. This is much like your iPhone can update software or its operating platform online via the click of a button. Whereas, when Cochlear for example is about to launch a new hearing aid practitioners or bulk buyers may hold off from buying existing ones in anticipation of a better one being around the corner.

The SaaS model of online updates is also important as it fuels innovation and product development with SasS providers constantly working to improve product features or functionality that help clients save time and money via increased efficiencies, data, AI, or customer management for example.

In not much more than 10 years, Salesforce, has grown from almost nothing into a US$116 billion business by providing online customer management platforms to large enterprises around the world.

Part of its strength is its high client retention rates (logically critical to the success of a recurring revenue model) that are the result of its platform’s deep integration into the daily operations of a large business (such as a telco, retail bank or insurer) that faces hundreds of thousands of customers.

Evidently, an enterprise SaaS user is unlikely to uproot such a critical system unless it believes there’s a far better alternative. The stickiness also gives successful SaaS businesses some pricing power in that clients are usually happy to accept price increases as they are still getting value for money. I have covered before why pricing power is a fundamental driver of successful businesses and rising share prices.

Notably, Australia’s most successful tech business ever in the US$21 billion Atlassian is also largely a SaaS-based business.

So what’s not to like about SaaS businesses?

Commonly trading on more than 10x trailing sales to enterprise values SaaS businesses are not going to smoke out the value investors.

Indeed, critics claim they’re wildly overvalued with the likes of WiseTech (29x sales) and Pro Medicus under the strongest suspicion.

I’d have to agree that all of the above-mentioned businesses look overvalued for now and you can count me out as a buyer until we see valuations return to saner levels.

Another SaaS business I mentioned yesterday in Nearmap Ltd (ASX: NEA) is also on an expensive looking 11.8x EV/ to sales multiple, but valuations are relative to growth rates and future earnings. As such Nearmap’s smaller base may allow it to justify this valuation.

While there’s even a SaaS business on the ASX that has fallen out of favour with investors. It’s selling for just 3x trailing sales and still growing nicely.

This ASX SaaS Share Could Set Your Portfolio on Fire

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Motley Fool contributor Tom Richardson owns shares of Altium, Cochlear Ltd., Nearmap Ltd., Pro Medicus Ltd., and Xero.

You can find Tom on Twitter @tommyr345

The Motley Fool Australia's parent company Motley Fool Holdings Inc. recommends Pro Medicus Ltd. The Motley Fool Australia owns shares of and has recommended Nearmap Ltd. and Pro Medicus Ltd. The Motley Fool Australia owns shares of Altium, WiseTech Global, and Xero. The Motley Fool Australia has recommended Cochlear Ltd. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy. This article contains general investment advice only (under AFSL 400691). Authorised by Scott Phillips.

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