More thoughts on EV/S and SaaS companies.

Investment Analysis Clubs Saul’s Investing Discussions
21

Interesting discussion. The attached video which is from a consultant that has analyzed 3000 SAAS businesses makes some interesting points:

SAAS companies are facing lots of competition now compared to the past.
They are losing pricing power. Free things are expected like CRM integration which used to cost $400/month in the past, so relative value of features going down. Companies expect more things.
Switching costs lower as software is relatively easy to build,
CAC is rising

Just a different take. Does this guy have a point? He is a consultant and has inside knowledge of 1000s of SAAS businesses.

https://m.youtube.com/watch?v=BT9hUusNKQ8

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22

I don’t see what the big dilemma is here. Certainly companies with 85% margins and high net retention levels will demand higher valuations than the traditional clothing company referenced. The question is how much? For that reason, I think it is important to look at valuations. They can provide relative comparisons to companies with similar metrics and ranges for a specific company.

Why is that a bad thing? Valuations for different sectors have always varied and this is no different.

Lastly, multiple expansion accounts for the fastest growth. Otherwise, we are looking at stock price appreciation mirroring sales growth less dilution. Certainly many on this board experienced price appreciation well beyond sales growth and that is the definition of multiple expansion.

Again, I just don’t see the dilemma. Certainly, one can make a case for completing ignoring valuations. But one can also make the case for using them to help reinforce buying and selling decisions. It is just a matter of preference. And either stance used incorrectly can result in poor decisions and vice versa.

A.J.

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23

Texmex,

Such an informative video, thank you! Not surprised to hear about how acquisition seems to be the main focus with most (see video for stats) SAAS companies, and less about customer development. (Is that the capitalist way… Consume our way to the top?)

His main advice seems to be, SAAS Companies… talk to your customers! Understand their needs and which features they most value! Very cool, and also, yes, a bit scary based off the research he presented in the first few minutes.

I have confidence in most of the companies discussed on this board (TWLO, AYX, TEAM, TTD), but are there any SAAS companies that come to mind when you think about hyper focus on acquisition?

Thanks again for the share.

24

Just a different take. Does this guy have a point? He is a consultant and has inside knowledge of 1000s of SAAS businesses.

https://m.youtube.com/watch?v=BT9hUusNKQ8

He reinforces what this guy says

David Skok of Matrix Partners: Driving SaaS Success Using Key Metrics

https://www.youtube.com/watch?v=bCBccKfG9U0

Denny Schlesinger

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25

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.

I was the systems architect for the data conversion team (well over 200 people) for my company’s transition to COTS PDM/ERP. Several COTS vendors were involved and numerous apps were being decommissioned and replaced (almost all in house developed apps). As I mentioned before, the project spanned years. The single highest budget item for the program was data conversion. As you are most surely aware, older systems tend to collect and retain corrupt data. Older systems are brittle and hard to modify. As a result users develop the “empty field syndrome.” I want to save this information related to this record, but there’s no place to put it. However, in this situation, field X is otherwise empty, so I’ll stuff it in there. Data conversion is difficult when you don’t know what data you might encounter, yet it remains of value to the end user.

We created “maps” (elaborate conversion routines, often parsing text and trying to determine which disciplined field it belonged to in the new system). A lot of the conversion could not be programmed and was given back to the user community as a manual effort (this is where a lot of the cost came from. This was labor intensive and not part of the user community budget, it became an IT expense funded by Data Conversion).

People forget that the cost of swapping out systems is not just s/w. Process redesign, training (both IT and user organizations), data conversion, developing in house support teams, etc. are all part of the cost.

A cheaper s/w alternative is seldom sufficient motivation for moving from on embedded application to a different one if the functionality is more or less on a par. It usually requires capabilities that don’t exist in the current systems in order to drive a s/w change (you mentioned this).

Getting back to the investments we favor on this board, it’s not just the subscription model or even XaaS implementation. It’s the new capabilities. Alterys, Okta, Zscaler, Nutanix, etc. pretty much do stuff that simply isn’t available elsewhere.

Mongo is a special case because middleware tends to be far stickier than applications. If Mongo were another RDBMS I wouldn’t think twice about it no matter how good it was. MySQL is not driving wholesale replacement of Oracle. It never will. Mongo won’t replace Oracle either (except where it’s struggling to address a noSQL use case). Mongo offers new functionality and it’s (IMO) already the hands down winner.

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26

Brittlerock, I feel the pain. None of the conversions I have done have been of the same magnitude, but have been painful enough to sympathize. All but one of the conversions I did were from an old system into my system and there one of the big problems was the lack of data, i.e., the older system was very limited compared to mine so a lot of detail had to be invented or guessed at because it simply wasn’t there. The one exception was SYBEX when Wiley purchased them and they insisted on moving SYBEX onto the same system they used for all other divisions. There the problem was that my Royalty Contracts system was far superior to theirs and so the data loss was stunning.

27

Maybe, but maybe not.

So let’s say there are 10 ultra high P/S stocks that are held 10 years.

Does anyone realistically think that all 10 are going to keep sky rocketing up?

You’d be a fool to think so, but…

Just as an example of what may occur.

You hold all 10 for the next decade.

4 go under. 2 underperform. 2 get acquired along the way. 1 beats the market.

Oh but one has the type or run that lets say Oracle had in it’s early years. One turns out to be that one great investment that we all dream about. Like holding AMZN or MSFT or ORCL for their best decade of performance.

It takes one holding like those names to give a portfolio market beating gains for a long term portfolio.

Better to be in a basket of great names to start with.

Saul and this board point out and invest in a list that all possibly have that kind of longer term potential. Chances are that one of them will be very well worth holding longer term. Hey if there happens to be two from thst list, it’s just icing on the cake.

In the meantime it’s nice to be able to be part of this ride as they all seem to have caught the same amazing wave.

Chris

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28

For those looking at a way to consider what is “reasonable” to pay for growth, I have previously found these articles illuminating

https://medium.com/@alexfclayton/how-much-is-your-saas-compa…

https://www.capshare.com/blog/anything-other-than-growth-eve…

https://catalyst.com/research_item/saas-valuation-redux-sane…

https://seekingalpha.com/article/3981986-saas-investors-mind…

and this

https://seekingalpha.com/article/4207106-fomo-vs-foji-greed-…

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29

Phil Fisher was the ‘grandfather’ of growth stock investing and many decades ago, he wrote a book called ‘Common Stocks and Uncommon Profits’.

Legendary investors such as Buffett, Lynch and Anthony Bolton (Fidelity manager from the UK) have often stated that this book taught them about growth stock investing.

In this book, Phil Fisher clearly wrote that for MINIMUM diversification, an enterprising investor must have exposure to at least 5 large cap/institutional grade stocks from DIFFERENT industries (max. 20% exposure to one company).

He went on to state that if one’s portfolio is comprised of upcoming/younger companies, then it must have exposure to at least 10 such stocks from DIFFERENT industries (max. 10% exposure to one company).

Finally, he also wrote that if one’s portfolio is comprised of unprofitable/speculative companies, then it must have at least 20 stocks from DIFFERENT industries (max. 5% exposure to one company).

ON VALUATIONS…

Stocks represent claims on the long-term cash flows of operating businesses and the higher the price you pay for those cash flows, the lower the subsequent investment return over the full stock market/business cycle.

Sure, stocks can be bid up to dizzying heights during a raging bull-market but history has shown that when the music does stop, the market darlings of a bull market are the hardest hit and they lose 50-80% of their value in a matter of months.

At least this is how things have played out since the beginning of time and if SaaS turns out to be a truly novel industry which is totally immune to economic and monetary conditions, then it will be a first.

Having said all of the above, I’d like to clarify that I’m not anti-Saas (I have positions in DOCU, SHOP, TWLO and ZUO) but this sub-sector represents perhaps 20% of my total portfolio and the rest of my cash is invested in dominant/high growth companies from other sectors (e commerce marketplaces, fintech, payments, medical equipment, video gaming, audio and video streaming etc).

Best,

GM

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30

tchalla, I loved the links you posted, especially the last one from Seeking Alpha. I never considered using cost-basis instead of current value to decide whether or not to add to my position. That way, my best performing stocks don’t get punished for being good companies.

If you focus on your investment risk allocation from a cost-basis perspective rather than your current value, you will benefit from two leverages:

It will prevent you from adding too much to your losers.
It will encourage you to add to your winners.

I love it!

CloudAtlas

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31

Legendary investors such as Buffett… have often stated that this book taught them about growth stock investing.

Maybe, just maybe, that is why Buffet (Bershire Hathaway) is up all of 0.6 of 1% in the past 12 months (from $298,940 to $300,770) while so many of us are up 70.0% or more. (Just half kidding).

Saul

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32

Sure, stocks can be bid up to dizzying heights during a raging bull-market but history has shown that when the music does stop, the market darlings of a bull market are the hardest hit and they lose 50-80% of their value in a matter of months.

Hey GM, you must be talking about the raging bull market we had last year when the five market indexes averaged down 8.5% (all of them were down), and lots of us were up in the range of 70% give or take.

Oops, the music stopped! It doesn’t stop much more emphatically than it did from August to December of 2018, especially in December, when every financial publication was screaming “Bear Market!” so we must have lost 50-80% of our value in a matter of months!!! Oh well, another good book down the drain.

Saul

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33

Saul,

First and foremost, Buffett now manages one of the largest companies on the planet so he is no longer an investment manager. For years, he has also publicly stated that his future returns won’t be as good due to their sheer size so no surprise here.

Second, last year’s pullback in the stock market was not caused by an economic slowdown/recession, yet the SaaS stocks fell MORE than the broad market.

The SaaS stocks’ top tick to bottom tick declines during last year’s stock market pullback are presented below :

Adobe - down 27%

Alteryx - down 33%

Docusign - down 49%

Husbpot - down 33%

MongoDB - down 27%

Okta - down 44%

Salesforce - down 30%

ServiceNow - down 29%

Shopify - down 34%

Trade Desk - down 36%

Twilio - down 30%

Workday - down 26%

Zendesk - down 37%

ZScaler - down 37%

Zuora - down 60%

Even without a business slowdown and/or recession, during a normal stock market correction, these SaaS stocks fell way more than the broad market.

Yes, many have bounced back since because of the Federal Reserve changing its tune but the pertinent question to ask is that if a garden variety stock market pullback (20% decline) caused these stocks to lose 27-60% of their values, how will they fare during a business slowdown/recession when their revenue growth rate slows or top-line shrinks?

Best,

GM

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34

It was “shocking” when Mongo actually hit a new 52 week high during the near historic market crashes of October and December 2018. The very crashes we were warned about…luck, must just be luck…yeah that is it.

Tinker

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35

Saul, To be fair that $300,000 stock was less than $300 in 1980…

Oh and Warren had averaged over 20% annually for the 20 years before that. Taking nothing away from your performance, but Warren is working with 200 Billion dollars. Warren couldn’t put more than 4% of his capital into TWLO because he would own the company. :slight_smile:

But back to the subject at hand, it is very interesting and clearly hard to say what is the right valuation to these companies, i think your arguments are strong. But the question will always stand, what is too much?

I think Tinker also has a valid point, if the EV/S is very high, any whiff of slowdown will cause a big hit. And that doesnt have to be revenue growth, it could be just the rumour of slowdown will cause a drop. And therein lies the problem, if you aren’t able to see it quickly you can get burned.

Now let me be clear, i have no doubt you will see it. In fact you might not see it, but feel it and get out. Me, i’ll be the guy who took a few days off and found out everyone got the message except me…

Finally, to be very clear, i am in these stocks, if i combine them, i have well over 20% in them (SAAS growth companies that is). But it makes me nervous to go higher. I really do want to retire soon so…

Randy
An ardent admirer of Saul but someone who also thinks Warren walks on water even if his stock never goes up another dollar which by the way, is another difference, you were quoting the value of his stock, not the value of his various company investments.

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36

Phil Fisher was the ‘grandfather’ of growth stock investing and many decades ago, he wrote a book called ‘Common Stocks and Uncommon Profits’.

An excellent book first published in 1958, 60 years ago. My dad used to read the stock quotes in the evening, about 28 hours after the close, the evening of the following day. The WWW was still about 40 years in the future. Reporting is under stricter supervision. A lot of things have changed.

I do agree that a certain level of diversification is healthy. I own four industries but in three of them I only have one stock each. I’m more diversified in high tech with younger companies. I’m not saying Fisher is outdated, I’m saying that his numbers need to be adjusted to modern realities.

The one lesson that stayed with me the most, and I paraphrase, is “give your stocks a chance.”

Denny Schlesinger

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37

Texmex,

I went through the video you linked about the consultant that has analyzed 3000 SaaS businesses. I’m not worried at all about what he said in regards to our companies. Here is why:

If you get to the end of the video you will notice that his whole speech is basically a sales pitch for his SaaS pricing product. So that already explains why he discussed this problem so much and tried to create some urgency. Nothing wrong with that but worth noting.

He is talking about problems discovered from analyzing 3000 SaaS businesses. Naturally many of these businesses will be quite small compared to the public companies we invest in. When he is talking about the threat of SaaS death and commoditization of software I think he is addressing smaller up-starts and not mature public companies with billion dollar market caps. Only the most successful SaaS businesses make it to the public markets and among those publicly traded we selected the companies with the very best traits. The companies that this speaker is addressing are not comparable at all to the companies we are invested in.

Software commoditization or pricing pressure are no issues for our companies at the moment. I’ve heard this argument often: Software is so competitive, everyone can make it, it’s much easier to integrate, this will become more and more of a problem for the sector. That sounds scary and it probably impacts some SaaS businesses. But it certainly does not affect the businesses discussed here. If there was any problem in that regard we would not see the kind of quarterly reports we are seeing every 3 months with revenue growth of +50%, dollar-based retention rates above 120% and rapidly improving margins and cash flows. If that materially changes we might have to talk again but until then I think commoditization worries are not warranted.

Best,
Niki

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38

GM said: Phil Fisher clearly wrote that for MINIMUM diversification, an enterprising investor must have exposure to at least 5 large cap/institutional grade stocks from DIFFERENT industries…

Marc Andreessen said: “Software is eating the world…”

https://a16z.com/2011/08/20/why-software-is-eating-the-world…

Phil Fisher could not have imagined this concept.

Best, Swift…

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39

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

Sounds familiar to me. Too bad there aren’t more hours in a day.

https://discussion.fool.com/work-in-progress-valuation-methodolo…

Perhaps this could end up being a decent summer project for some TMF interns later on in 2019.

volfan84

40

Niki,
Agree in general. But it is in the nature of capitalistic enterprise that great profit margins will attract competition. AYX clearly has good competition. Is it resulting in lower pricing, lower value for features and higher CAC? How high is the switching cost really? Not all SAAS business has high switching cost. I think ANT said his company went through multiple vendors for web conferencing over a short time frame. Does ZS have no competition? Yet, the Okta survey did’nt mention it even though it talked about Cisco, PANW etc. in hybrid cloud security - I did’nt read that closely so may not have understood the details. It will be fruitful to think about these types of issues for each of the companies we discuss.

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