Recently I wrote an article on why a high return on equity is an important quality to look for in companies and why it explains in part the rocketing share prices of Magellan Financial Group Ltd (ASX: MFG) and the a2 Milk Co Limited (ASX: A2M) over the past couple of years.
Another group of businesses in the cloud-based (online) software-as-a-service (SaaS) sector have also soared in value over the past couple of years to the surprise of many professional investors. After all if you use popular valuation metrics like price-to-earnings ratios, book value, or price-to-earnings growth (PEG) ratios these stocks look on ridiculous valuations.
Those regularly criticised include enterprise-facing Wisetech Global Ltd (ASX: WTC), Pro Medicus Ltd (ASX: PME), Xero Limited (ASX: XRO), Altium Limited (ASX: ALU) and Nearmap Ltd (ASX: NEA), but they keep rising, so what's going on?
I've previously covered how one key advantage is that the enterprise-facing SaaS business model involves recurring revenues where once the cost of signing up a subscriber is met the revenues are ongoing at potentially very high gross profit margins.
For example if a popular business like Cochlear Ltd (ASX: COH) sells 10,000 hearing aids in FY 2019 it has to sell another 10,001 to new patients in FY 2020 just to beat revenues year on year assuming a same selling price.
Whereas a SaaS business can sign up customers indefinitely and simply add customers on top of customers which provides strong operating leverage and compound profit growth potential.
This of course is all well and good in theory, but the SaaS business model of subscription software is risky in that an enterprise client can cancel at any time.
Whereas, before the cloud, an enterprise client would pay a big upfront fee for software that it was then stuck with whether it liked or not.
The changing business model is important as it means churn (or percentage of customer losses over a period) is a critically important metric for SaaS investors for many reasons.
Not only due to the basic cashflow economics, but also because it shows whether a SaaS provider has a market-leading (popular) product or not, which may provide it with pricing power down the line.
In other words taking a glass half full approach if a SaaS business like Nearmap, Wisetech, or Xero boasts falling churn it might have the opportunity to seriously crank profits via price rises in the future once the market grab game is up.
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 reduces churn and help clients save time or money via increased efficiencies, data, AI, or customer relationship management for example.
Nearmap for example is now taking its product offering to another level via big data, AI technology, and 3D mapping. It may be able to reduce churn and eventually lift prices on the back of this.
While a business like Xero can now offer an online product that lets users invite their accountant, lawyer, or banker to login to their accounting platform, which is a massive step-up from the desktop accounting that's still employed by the vast majority of small businesses worldwide.
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.
Finally, I'd like to cover 'scalability' as a feature that these companies boast that should be attractive to growth investors.
To understand why 'scalability' is important let's consider other 'tech' companies like Uber or UberEats for example.
Although UberEats is popular it's not really scalable as every time it signs up a new restaurant it needs a new delivery rider, while an Uber driver cannot drive more than one car at a time. Something like AirBnB though is more scalable as a landlord could potentially rent out any number of properties.
Market leading SaaS businesses though are the leaders of scalability, as they can keep adding customers without having to grow their infrastructure or capex compared to some other tech or digital companies. 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 a lot better than other tech companies and is a million miles ahead in terms of scalability compared to mining or infrastructure companies more commonly favoured by many investors.
Scalability is important then as it offers huge profit growth potential if a company genuinely possesses it.
Xero looks very scalable in the way it can update its platform and now has 1.81 million subscribers as at March 31, 2019. It is now targeting 1 million customers in the UK alone (currently 463,000), while growing average revenue per user globally.
We can see then why some investors will label Xero shares a "bubble" based on its small profits and $9 billion valuation, while others may see value based on its economics and compound growth potential.
It's not just Australia where SaaS shares are flying either, with the likes of Splunk, Shopify, and Okta also going absolutely gangbusters in the U.S.
Interestingly, the SaaS sector on the ASX only really took off after U.S. tech giant Oracle Inc. made a takeover offer in December 2017 for ASX SaaS player Aconex at a 47% premium to the market price that ASX investors valued it at.
Outlook
One key takeaway for investors is that it's important to find market leaders capable of posting low or falling churn given how easy it is for enterprise-facing SaaS subscribers to leave these days.
To me Xero and Altium look the most scalable and are producing strong organic growth, while Wisetech has very low churn, but it's growth is partly coming about via acquisition which is something I'm not so keen on.
Even considering the attractive economics, the valuations of all theses businesses are clearly being supported now by lower risk free rates, while it goes without saying all of them could be in for huge valuation falls if they don't meet investors' growth expectations.
In all honesty I wouldn't rate Wisetech or Pro Medicus shares anywhere near a buy on existing valuations as they look too expensive, however Xero, Nearmap and Altium could still produce reasonable returns from here.
