More thoughts on EV/S and SaaS companies.

Investment Analysis Clubs Saul’s Investing Discussions
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I’d like to go back to the high EV/S question for our SaaS companies that pulled up so many worried posts, and to add to, and greatly elaborate on, what I wrote before. Again I have to say I don’t have the answer to what is overvalued. I just know that:

Of course a company with 90% gross margins is worth a much higher EV/S ratio than a company with 30% or 40% gross margins because each million dollar of sales is worth so much more to the company.

Just think about this for a minute. If you have 85% gross margins, a million in sales is worth $850,000 to you. If you have 42% gross margins (still quite acceptable), a million in sales only brings you $420,000. Now really think about that. On that basis alone our company with an 85% gross margin is worth naturally twice the EV/S of a normal company with a 42% gross margin, other things being equal.

And a company with a 28% gross margin (believe me, there are plenty of those too, in the real world) only keeps $280,000 out of that million in revenue. Our company with 85% gross margin is worth naturally three times the EV/S sported by the 28% gross margin company, other things being equal… But… other things aren’t equal!

A company leasing software that becomes integrated into the core of the customer’s business, and with a subscription model that brings in recurring revenue, each million dollars of sales today is not just for this year. It’s for next year too, and the year after, and the year after that, and…. pretty much forever. No one, simply no one, is going to tear out a system that is core and essential to the smooth running of their business, and that would disrupt their entire business to pull out, to save a few dollars. It ain’t gonna happen folks.

Okay now, you have a million dollars of sales this year. When you put that million dollars into the denominator of the EV/S equation, what do you have to multiply that million dollars by to take into account all those future years of recurring revenue? By three? By four? By five? By more? That sure brings down the real EV/S for our SaaS companies, doesn’t it?

Compare it to a clothing manufacturer (just for instance). It sells 1000 coats this year, but has no idea if it will sell 1000 coats next year, or even 500, or maybe another brand will be in fashion. Recurring revenue on a subscription sure beats the heck out of that, doesn’t it?

But wait! Our companies also have a dollar-based net retention rate maybe averaging 125% or so. That means that this year’s sale revenue isn’t just going to recur next year, but it will be bigger next year, and bigger the year after that. Well of course a company with a 125% dollar-based net retention rate of recurring and growing revenue will have a higher EV/S ratio, than a normal company with the same revenue, the same S value down there in the denominator (duh).

And then there is growth rate! Well, of course a company consistently growing revenue at 50% to 70% is going to have very high EV/S ratios, because in just two years a consistent 60% growth rate means they will have more than two and a half times as much revenue as they have now. That’s in just two years!

And in three years, more than four times the revenue they have now!

And in four years more than six and a half times the revenue they have now! That will sure bring that EV/S ratio down, won’t it? I won’t go beyond four years but that’s enough. (You won’t believe it but a fifth year will bring the revenue to more than ten times what you started with. Obviously they don’t need to keep a 60% growth rate to really push up their revenue! That S in the denominator is going to grow rapidly.)

And finally, of course a company that is leasing a software solution that every enterprise on the planet needs, and that the vast majority don’t have yet, and that all those companies will keep indefinitely once they install it, will have a higher EV/S ratio than a company selling a product that anyone can put off getting a new model of, or stop buying for the duration of the recession, etc. (You can live another year with your old cell phone, or computer, or car, or raincoat, or refrigerator, or kindle, or ski jacket, or your old factory, or whatever, but once you lease this software, you keep leasing it indefinitely, no stopping for a year.)

And of course, of course, of course, companies that have all these features, companies with 80-90% gross margins AND a subscription model with recurring revenue AND 125% net retention rates AND growing revenue at 50% to 70%, AND selling products that all enterprises need …are going to have very high EV/S rates (…duh), and I don’t know what is high, but I will NEVER sell out just because the price has gone up, and because I think the EV/S is too high. I don’t know where these guys will ultimately end up. For example, Amazon went from $5 per share (split-adjusted) to $1000, and was “overvalued” all the way.

I hope that this has given you a different way of thinking about our SaaS companies.

Best,

Saul

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Beautifully stated Saul.

For those adept at spreadsheet and regression analysis you can probably use those categories and mathematically derive the multiple value for each category and you will rationally find that the market ain’t been so irrational after all.

Tinker

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Beautifully stated Saul.

Thanks Tinker, for your kind words.
Saul

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No one, simply no one, is going to tear out a system that is core and essential to the smooth running of their business, and that would disrupt their entire business to pull out, to save a few dollars.

Nevertheless, it does happen that companies replace one solution with another. The economics of this are very different for SaaS software than for perpetual license software. With the perpetual license, if one is 5-10 years in, if the software is just not cutting the mustard any more, then it is relatively easy to decide to purchase something new because the original cost of the old software has been expensed by then. With SaaS software, there is no big original cost to be amortized, but the annual cost is higher … but, it still matters whether the software is doing a good job for the company’s current business. When I was selling my ERP package, I was most often replacing software that was just not doing that good a job any more … and one of the really compelling things in my favor was that modifications which would cost $5000 in the old software would cost $500 in my software, massively tilting the ROI.

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At first glance that clothing company example may seem irrelevant But no, the EV/S of maybe 3 or 4 that it carries, has helped to shape the idea in your head of what a EV/S normally is. But if the clothing company’s EV/S is 3, what should the EV/S be for one of our companies? Four times that? Six times that? Ten times that? Go back and read again about the effect of 85% margin, subscription recurring revenue, 125% net retention rate, 50% to 70% sustained revenue growth, etc, and maybe you will change your mind.

Saul

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For example, Amazon went from $5 per share (split-adjusted) to $1000, and was “overvalued” all the way.

Saul:

Few points:

  1. Compared to the P/S of ESTC, ZS, MDB, AYX, OKTA…AMZN did not have a P/S above 20 other at the Y2K bubble timeframe in that single year. Other than that bubble anomaly…it didn’t happen and therefore the comparison is non sequitur.

  2. It is easy to fall in the trap of confirmation bias when you choose AMZN to compare your other stocks…first AMZN has been one of the best investments of all stocks and second using a very long holding time that is entirely inconsistent with your very high portfolio turnover rate.

  3. At the NPI, we have identified 5-6 stocks that have maintained a high P/S for just a 3 year period…think what that takes to do that from a revenue growth perspective. But guess what these same stocks did on subsequent 3 years?

Point being that for these ultrahigh P/S stocks in your portfolio listed above, for superior returns over the next 3-4 years, you must assume uncharted territory.

  1. Last point I will make, your superb gains these past couple years were near completely made by expansion of the stock multiples…not by initially buying and holding utra-expanded multiple stocks from the outset.

Best:
Duma

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The cost of retention discussion is also relevant.

Look at Zscaler. They pay sales commission in year 1 and then there is on boarding that takes less than a year. Thereafter the cost of supporting an existing customer is small and will continue to decline with scale.

Since Zscaler becomes the core enabling technology of your network to enable using the internet as your network, it is never going to come out. There will be very low churn other than cutting back on employees or going out of business or the like. But in the end, unhampered by stupid things, the economy will grow, thus so will the deployment at each company over time.

Years 2 - 10, 20, 25 (maybe 20 or 25 years is too long) will be nearly all profit as the fixed cost of overhead will be deployed over more and more customers over time. There is additional computing resources that must be added as you reach certain thresholds, so fixed cost will rise (but much slower than customer growth) but run an annuity with 17% ARR into perpetuity and find out the value.

From there add in growing at 50% per annum and from there add in optionality as to where Zscaler may expand their product.

This is one example. And if of course depends on Zscaler continuing to perform with a high competitive barrier to competition (which presently it has in spades), but I think the number you come up with, just using straight annuity math to see what the present value of that is will be quite substantial, but far less than Zscaler’s potential value as it grows and expands beyond the fixed numbers used for the annuity.

There are always threats of disruptive technologies that may make the need for Zscaler like capabilities less necessary, and thus things may not go on forever. Even Microsoft could not continue dominating forever once the internet disrupted the desktop OS monopoly. But the scale of increasing returns is nothing like a clothes company’s economics.

This is an example and I am not recommending to buy Zscaler or not to at this point in time. The only recommendation I have made about Zscaler is that it seems to have a hard floor at $3.5 billion enterprise value. That is where I bought all my shares at. Zscaler and Elastic are now the poster boys for too expensive. Yet I don’t feel any urgency to sell. Maybe Tuesday I’ll change my mind ;). Doubt it, too busy this coming week to change my mind (being busy does tend to increase my returns as I end up doing far less fretting and tinkering {as you might say} and just leave good enough alone).

I just don’t think most people understand this business model. near zero marginal cost to support each new customer beginning at year 2, with fixed costs declining with increased scale each year, with little churn, 117% or so ARR (despite an increase in selling all products at once upfront), well…I’ll just let it speak for itself.

What is that worth? Dunno. An awful lot until something disruptive comes along to make all less necessary. For some reason Zscaler has touted things like block chain as one of the future vectors internet technology will take. I would garner they did so because Zscaler believes they play a growing and more important role in the world’s economy as the internet itself morphs more and more into the entire corporate network as GE pioneered.

Again, I am just using Zscaler as an example. I went bonkers in November and December buying things and am paying back down to 100% (okay at 102% now) so I am not buying anything this month so I have no present opinion on timeliness.

Tinker

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Tamhas,
When you were selling ERP s/w what was the average size of your customer in terms of number of employees. I spent 30 years in IT at a large aerospace firm. Many of our applications had much longer lifespans than 5 years. When I retired (2010) we still had in house developed COBOL serial batch and IMS applications in production. Admittedly, these applications were specialized to the point that there were no COTS replacement and also certified by various regulatory bodies. Pulling them out of production would have been very costly (as a replacement would’ve had to have been coded in house), enormously disruptive and would have to have gone through a time consuming and costly certification.

But even those apps that could be replaced by COTS often had very long life spans. In the 70s I worked on an IMS replacement of a serial batch purchasing system originally developed in the 50s (which ran on an in house developed “database” and teleprocessing system). It was not replaced by COTS until the 90s. And that was not a smooth transition. I had been the lead analyst for QC receiving and transportation. The new COTS did not have a lot of the functionality that was in the in house application with respect to quality assurance requirements.

I think it’s safe to say, the larger the enterprise the more slowly new apps are swapped in for older ones. In the case of the purchasing system I mentioned, the driver for the first replacement was not functionality so much as it was a need to move to a newer technology base. The second replacement was a combination of drivers in that the new COTS purchasing system was part of a larger ERP package that replaced several in house systems. The move to the ERP s/w took years. The division president referred to the project as changing a flat tire while driving down the highway at 60 MPH. Production was at no time halted in order to make the transition to the new system.

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Saul, pure art. Like a picture with a story within, perpetual motion even. Beautifully described. Think my dog even understands:-))

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I understood Saul. Nice reading for my miserable Saturday at home, all events cancelled because of snow.

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Since Zscaler becomes the core enabling technology of your network to enable using the internet as your network, it is never going to come out

The ERP packages of Oracle or SAP were stickier. The switching cost is millions for the companies. Yet their renewal required sales effort and sales guys made commission on that.

Now, the companies that are touted as SaaS companies here, how many of them are truly sticky? Do you truly believe the renewal has no sales effort? May not as intensive as acquiring the customer but still there is going to be sales effort.

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Great discussion…

Possibly one other ingredient when you’re baking your EV/S cake to consider is the Billings effect (level and growth rates) on Deferred Revenues. Deferred Revenues may or may not be showing up in the sales growth rates or dollar based net retention rates at the same time but it is a very valuable ingredient in a high EV/S situation as:

  1. It lowers risk of any surprise quarter on quarter correction with future sales pretty much in the bag
  2. It helps enormously with cash flow which is pretty important to pre-proftability emerging players
  3. It offers forward visibility as a secondary to future sales rates

Some of our tech and cloud based plays have been building incredible levels of deferred revenues (multi year deferral levels), that I find consistently disregarded or under-rated by many including this community.

Cheers
Ant

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It lowers risk of any surprise quarter on quarter correction with future sales pretty much in the bag

If a company misses or disappoints on “bookings” it is still a risk and the deferred revenue doesn’t and will not help.

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If a company misses or disappoints on “bookings” it is still a risk and the deferred revenue doesn’t and will not help.
Deferred revenue de-risks sales disappointments not bookings disappointments. Bookings disappointments won’t necessarily show up in a sales disappointment and usually produces a more muted reaction than a hard revenue miss.
A

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Regarding sales efforts at renewal time - I own a small business, not an exciting client for many of the vendors we use, but maybe somewhat indicative of thousands of other small businesses.

Among the SaaS type vendors we use: HubSpot, Slack, Atlassian (Trello), DocuSign, Microsoft (Office 365). Many of these we’ve used for several years on auto renewal plans. These companies have spent on R & D and product enhancements, but at least in my case, haven’t spent a nickel on renewal sales efforts (other than accounting for my continued payments).

It is also true that we don’t have the time to carefully consider switching to another similar product, thus “stickiness” is real.

We also tend to expand our spend/usage in either product upgrades or number of users every year.

-Steve

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Because stickiness is a key to these companies, first mover advantage is even more important than other industries (except maybe social media). Disruption, rather than head to head competition, will ultimately prove to be the Achilles heal if our companies fail to invest in R & D and continue to innovate. But that, of course, can take many years to be realized.

Example: In a world where finger prints and faces (both unique) are read digitally, why is it necessary to have signatures at all? If DocuSign is not thinking about this and working on what is next, their business model will eventually be disrupted. I am not worried at all that some other company (e.g. adobe)will build a better signature mouse trap. I am vigilant to the idea that their technology will be disrupted.

Swift…
Long DOCU

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Brittlerock, I’m not sure of your point. For a sample customer, take SYBEX books, the computer self-help publisher. Prior to being acquired by Wiley, they were a customer for about 15 years. I don’t know that I have ever thought about their total head count, but I suppose it was a couple hundred overall. I do know that while they were a customer they expanded revenues by 10X with only about a 30% growth in warehouse staff and almost no growth in HQ operations staff, which was enabled by continuing software improvements to make them more efficient.

SYBEX was big enough to have some IT staff, but there was no motivation for them to do any development on the ERP package since my company and my tools could make changes extremely economically … and, frankly, better than any in house developer would have done.

To be sure, even companies smaller than SYBEX might have in-house developers, particularly if they were receiving poor support from their vendor. Some of these were what I used to call “over the transom” sales, i.e., the company got the source and doing anything with it was entirely up to them. Very often this meant customizing the code heavily enough that applying these customizations to new version of the software was seen as impossible, so the company was stuck on an old version of the software.

While I agree that these systems are sometimes incredibly sticky, especially if they are heavily modified and maintained in house, in most cases my prospects were ones where their existing software was simply no longer doing the job and there was no reasonable path to improve it sufficiently.

And, yes, the transition from one system to another can be daunting. Not the least problem is moving the historical data into the new system because the two systems typically parse the data in different ways. I have seen projects that ended up failing because a map could not be created which didn’t result in huge data loss.

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Deferred revenue de-risks sales disappointments not bookings disappointments. Bookings disappointments won’t necessarily show up in a sales disappointment and usually produces a more muted reaction than a hard revenue miss.

The point I was trying to make is sales figures are sort of not-important. Just like next quarter guidance dictates share price move during earnings more than the “meet or beat”, similarly next quarter sales or revenue numbers will be less or not important and “bookings” will be driving the share price.

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Regarding sales efforts at renewal time - I own a small business, not an exciting client for many of the vendors we use, but maybe somewhat indicative of thousands of other small businesses.

Actually that’s a helpful anecdote and in the spirit of crowdsourcing further intel, my own small company uses a number of free, freemium and paid SAAS type solutions including:

  1. Paid
    Microsoft Office 365
    GoDaddy email and SAAS hosted domain access
    Box.com file storage/content management/collaboration (which was a switch across from DropBox)
    BlueJeans (teleconferencing)
    A number of technical solution subscriptions for modelling software and online publication search platforms in the health/health economics space

  2. Paid Freemium
    Wordpress website design
    Skype (tele/video calling)

  3. Free / Free Freemium
    Sign Now (digital signatures - mobile app)
    Tiny Scanner (photo to pdf writer - mobile app)
    Card Cam (biz card scanner)
    HR.my (annual leave management)
    Slack
    Whatsapp
    Linkedin
    Adobe Acrobat
    Globafy

Other SAAS solutions previous employers of mine have used include: Sales Force, WorkDay, BTMeetMe, AT&T teleconferencing, Cisco teleconferencing. (My former company changed teleconferencing platforms about 8x in 14 years despite a global desktop presence of 10,000 employees).
Ant

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Regarding sales efforts at renewal time…
We also tend to expand our spend/usage in either product upgrades or number of users every year.

There is a sales effort involved in these renewals, perhaps you as end customer is not aware or realizing it. While the effort and commission for renewal’s are different, but certainly there is sales effort. Separately, if you are increasing spend/ usage and not really talking to anyone at the sales you may benefit from talking to the company. Often, new features, pricing, different bundles available. SaaS companies pricing are no different than your cable operator pricing and often you get better pricing, terms by just picking up the phone and talking. Your procurement person should be doing that.