What is SaaS? Behind the Tech Stocks Taking Over the World

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What is SaaS? Behind the Tech Stocks Taking Over the World

What is SaaS? Behind the Tech Stocks Taking Over the World – We’re going to be talking about SaaS stocks. We’re going to be taking your questions, so go ahead and get those ready. As always, if you could give us a little thumbs up and like the video, it helps other people find the video. That’s what we’re trying to do, trying to help folks like you invest better. Let’s start. Joey, I’ll start with you. SaaS. Software-as-a-service. This is one of those things that has gotten bigger and bigger in the investing world. If you could walk us through the basic business model of a typical SaaS company.

What SaaS companies have done is, they’ve basically taken away needing to buy the disc. The prime example would be like a Turbo Tax. You used to have to go buy the CD, pass it along amongst your family members, everybody downloads it on their computer, and you log in. Now, you’re going directly to the site logging in, or you download it to your computer. That’s the service aspect.

I feel like there needs to be an S in there for subscription. It’s software-as-a-service, but the beauty of the model is the subscription revenue that it continues to generate over the course of years. If it’s a good business, you’re talking about potentially decades, even. The point that Joey is making there, it used to be somewhat cumbersome to keep on the cutting edge of technology.

Now, cloud computing, the internet has put this all out there at our fingertips. These companies can basically push a button and update to all of their consumers, all of their customers, at the snap of a finger, which is a very attractive business model.

To go completely into a different industry, we’ve seen this with businesses like Netflix. The subscription revenue, that’s easy for us as investors to track. That’s one metric that we like to see with SaaS. What are a couple of other crucial numbers that investors should be looking at, Joey?

The main things I’ll be looking for outside of the revenue growth rate are the gross margins, to make sure they’re not absolutely hemorrhaging cash to be able to grow this business. Usually, I’ll be looking over 70% if it’s a pure play SaaS company. But my favorite statistic’s definitely the net dollar retention rate, which can be expressed in a number of different ways, dollar based retention rate. That basically expresses a percentage where, if a consumer spent $1 with you last year, and your net revenue is 125%, then this year, they’re spending $1.25.

That’s probably my favorite and go-to statistic when you see how sticky a business is and that they’re actually upselling their consumers.

Yeah. One that Joey and I talk a lot about too is billings. That is a number that is used for a lot of these companies because it gives us an idea of what they have coming down the pike, what’s in store for them in the future. If you look at it on a quarter to quarter basis, sometimes those billings numbers can throw a little monkey wrench in the operation, cause a little concern, and the market will overreact.

We saw this recently, the company I’ll talk about a little bit later on DocuSign. Last quarter, the market was underwhelmed by the billings number they turned in. And the stock sold off to that. This quarter, it seemed like they righted that ship and the billings number was a little bit more optimistic, telling us that the company was certainly growing. Billings number, quarter to quarter, can be a little bit squishy. It’s a difficult metric to actually gauge precisely how well the business is doing in the short run.

But if you see consistent billings numbers quarter in and quarter out, that can paint a pretty good picture. And if you see a quarter here or there where that billings number underwhelms, if it’s a good business, oftentimes that can open up a little bit of an opportunity for investors. We certainly saw that last quarter.

Whether it’s software companies or SaaS companies, Joey, what should investors basically keep in mind? You already hinted at one thing. Some of these companies have done a tremendous job of growing their revenue. Some of them, when you look at the stock, they’ve earned a pretty lofty valuation, too.

Yeah. That’s what’s getting shaky in the market. These valuations are really getting extended. Back in 2016, 2017, companies were pricing their IPOs at 5X sales, maybe 10X. Now you’ve got 20X, 30X sales right out of the gate. Even if they pop more, you’re talking 40X, 50X times sales. It gets tough to grow in those valuations.

What else do you think investors should keep in mind, Jason?

Software-as-a-service, this SaaS acronym, has been thrown around for a while now. It’s presented a lot of neat opportunities for investors. So much so that we are seeing almost every company wanting to call itself a SaaS company now in some way, shape, or form. That’s fine, I get it. But we’re seeing a lot of these companies that are coming out now that are software-as-a-service and they’re solving for this particular problem. That’s great.

But we’re seeing a lot of little startups that are solving one or maybe two problems, to where it starts to become a little bit cluttered now. It makes me think of this transition from the bundle in video, the cable bundle. People are like, “I’m getting all of this stuff, I don’t want it. It’s too much. I want something simpler and streamlined.” And hey, there’s Netflix, the ultimate software-as-a-service.

It streamlines everything. It’s a simple one-shot bill. But now, we’re seeing this reemergence of the bundle. A different bundle, but a bundle nonetheless. I wonder if we’re going to get to a point where there’s so many different SaaS solutions out there that customers start to become a little bit more overwhelmed. They’re looking for a little bit more simplicity. Maybe we see some of these SaaS companies, they don’t end up making it, even though they might look a little attractive today.

We’ll get your stocks in a minute. Over the past 10 years, this has been a tremendous growth area. It’s been a great opportunity for a lot of investors. But, you hinted at this earlier, Joey. We’ve seen stocks recently in this space get whacked. Is that justified in your opinion? Having a lower valuation makes a little bit of sense? Maybe it’s some investors taking some money off the table? Or, is that a cause for concern?

These companies, a lot of them, they’re hitting it out of the park in their first earnings report. It’s weird. I was watching CNBC the other day, and they’re talking, “This company is tanking because they beat revenue and EPS expectations, but they didn’t beat by as much as expected.” It’s getting to the point where these companies can do everything they’re supposed to do, but I feel like investors finally realize, “Wait a second, we’re paying 30X sales for a company growing 40%.

Do we see a path to profitability?” I feel like a lot of investors have started questioning their positions and are blown out of them quickly.

Jason, to be on the side of some investors, that’s probably pretty fair. Investing is all about the future. If you’re looking at some of these SaaS stocks and thinking, “Wait a minute, I don’t want to pay 30X, 40X sales,” —

Some people do.

But, no, that’s a good point. I feel like we’ve been talking about this for close to 10 years now. Interest rates are low. The returns are in the stock market. We know the stock market is one of the ultimate studies in human psychology. Once you get that snowball rolling, and you see all of these opportunities, more money starts to flood in, new companies come to the market. SaaS is one of those buzzwords that’s bringing a lot of investors in who otherwise might have been sitting on the sidelines. That’s great.

But again, with these valuations, it’s not to say these companies can’t ultimately be worth as much as they’re trading for today, but when you see these lofty valuations, ultimately what that is, that’s the market bringing a lot of success down the road on into the present. That really stifles those potential returns that we as investors can realize down the road. That’s why, prices and everything, but it really does matter. When you get to these lofty multiples, it’s worth exercising a little patience, making sure you understand what the business does.

See if there’s a future there. Particularly, are they going to be able to solve more than one problem? If this is a one-trick pony, that could be a problem in a year or two.

Before we get to questions from the audience, and keep those questions coming, a lot of great ones coming in, let’s give investors a couple of stocks to put on their watch list in this industry. Joey, you’re up first.

One of my go-to’s lately has been Avalara. They do tax compliance solutions. The main growth engine for this will be e-commerce. As more purchases are made online, and these companies have to figure out — because of a ruling, South Dakota vs. Wayfair, these countries are going to have to start collecting sales tax on their net purchases, even if it’s cross-border.

Before, that wasn’t as much of a headache. Now, companies have to figure out, “OK, this consumer’s here. I need to collect this much sales tax to pay this tax authority.” The tax code here in the United States is an absolute joke and changes almost by the minute. I feel like this is one of those really sticky business models. I always like to look at my companies and think, “In a recession, would this be one of the first ones kicked out?” I don’t think any company wants to bring tax compliance to something that they’re doing in-house, and there isn’t another solution as efficient as they are.

I feel like that wouldn’t be what they’re trying to downsize or get rid of.

Jason, what about you?

I mentioned DocuSign a little bit earlier. It’s a stock that I own. I think the company is performing wonderfully and the stock is a real opportunity for investors who can look down the road in five, 10 years and envision holding onto the shares for a long time. I’d be willing to bet that we all here at the table have used DocuSign’s services at one point or another. You get an e-mail from someone or a company, something asking for your signature.

Now, DocuSign is turning into the go-to accepted method for that e-signature. As time goes on, we see more and more companies adopting e-signatures, DocuSign is doing something with this thing called the Agreement Cloud. It’s essentially taking this agreement, this signature, this e-signature, and managing that relationship from inception to signature to storage to execution to management.

Now they’ve got themselves in the position where they’ve got 537,000 paying customers. Just added 29,000 new customers last quarter. One of my favorite businesses, Ellie Mae, was acquired not all that long ago. Another good SaaS company. DocuSign is getting into the mortgage business. We’d already seen them pair up with Ellie Mae before Ellie Mae was taken private. The real estate business, the mortgage market, there are so many signatures and documents that need to be executed on a daily basis in that market.

A tremendous opportunity for DocuSign. Again, a stock that I own today and one that I plan on holding onto for quite some time, I hope.

I also own DocuSign. I recently closed on a house. I will say, that is the one space we really need this. I signed for my wife. I had to do my signature and then this whole extended signature. Power of attorney, all this stuff, and for her as well. It was an absolute nightmare. It must have been 120 different pages where I’m writing nonstop. I’m thinking, “Come on, DocuSign. We need you!”

If you have any grain of skepticism on DocuSign — Emily Flippen was telling me the other day, she recently moved and had to go to the DMV, the Department of Motor Vehicles, to get all of her stuff changed. Typically, you go to the DMV, and you’ve got to be in there, physically, show them your person, handwritten signed documents, notarized, the whole nine yards. She said, when she went to the DMV, they basically were asking for all of that, “Oh, but wait, we also accept DocuSign.”

If the DMV at this point is accepting DocuSign, that’s a pretty telling sign that these guys are doing something special.

I feel like if cursive writing were a stock, it would be going straight out down, and DocuSign is one of the reasons. Alright, thanks for all the questions that are coming in! Thanks again for giving us a thumbs up on the video! We appreciate it! It helps other people find the video. Let’s get to the questions, guys. A few people asking, many of the SaaS companies operate in niche spaces.

How do you guys get a feel for who is truly best in class in a given space? That’s a great question! I’m assuming at least one of the things is leadership at the company.

Definitely leadership. We always love to see founder leaders at the helm. You feel like the idea behind the business is still there, helping steer the business forward. But I think that raises a good point to the risk I was talking about before. You do have to start looking through these companies and understanding not only the problem that they’re solving today, but figure out if there’s the potential for them to add on another problem to solve tomorrow or down the road.

If you do run into one of these companies, they solve a problem today, and it’s a great problem they’re solving, but they’re stuck there and they’re spinning their wheels going forward, then all of a sudden, maybe they don’t look hot in a couple of years. Slack for me is one I come back to. Recent IPO. We talk a lot about Slack. I’ll couple Zoom Communications in there as well. Both companies that focus on a particular niche. Slack in the channel communication in the workplace and Zoom in the video communication in the workplace, although Zoom is now getting into the audio communication, and there’s going to be chat that goes in with them as well.

I do feel like, when I look at these two companies, Zoom at this point in the game seems to me to have a little bit more opportunity to solve some additional problems. They seem to be thinking a little bit more that way. Whereas Slack, I’m still a little bit concerned that they’re just focused on this channel communications, which is fine, but it’s going to be very limiting, particularly if they can develop a product that is super attractive to a tremendous customer base that will be willing not only to pay for it, but to pay more for it as time goes on.

Yeah, you definitely want to see the companies that, yeah, they might come public focusing on a niche, but they’re raising capital because they want to either make bolt-on acquisitions or expand organically into their own spaces. Atlassian is one that comes to mind. They have their JIRA, their main product when they went public, and they acquired Trello for the collaboration. They’ve made something like 18 bolt-on acquisitions since.

You can see, they come in, they’ve got their core customer base, and then they’re like, “Hey, we’ve also got this. We’ve also got this.” And that’s where you get that net dollar retention going up. They realize, “Our customers love us. They love our service.” And they know, if they do this as well as they’re doing that, they’ll trust them. Give them a chance on the collaboration side and they’ll continue to grow their product suite.

Question from Vladi, who asked, “It was a bit of a rough week for normally high-flying SaaS stocks, including Motley Fool favorites like MongoDB, CrowdStrike, Zoom, you name it. How do you guys handle these kinds of broad sell-offs?” Well, they’re not fun.

No. Nobody likes losing. That goes back to what we’ve been trying to hammer home since the beginning of our company so many years ago. Ultimately, time is how we deal with those types of stretches. When we are investing in these businesses, investing in its truest form is a long-term exercise. When we buy these businesses, we’re looking at owning them for three years, five years, hopefully 10 years and longer.

When you can look at things from that context, it makes dealing with — the day to day machinations of the market are very impossible to read. It’s very difficult to read. But when you look at that time frame, when you take that longer time frame, it makes dealing with these sorts of stretches a lot easier. Not to mention, of course, diversification.

A question from Paul, who asks, “A lot of SaaS companies seem vulnerable to disruption themselves as other companies come out with a better mousetrap. How do we determine how good of a moat these companies have?” Really good question. There’s no substitute for a good moat for any business.

Yeah. I’ll look at existing customer base, do a patent search to see if they have an extra patent over this specific bell or whistle that they just came out with. Being the first mover always helps. DocuSign has 537,000 customers. HelloSign, Adobe Sign, there’s competitors in the space. But DocuSign has such a huge customer base already. They’ve got the reputation for being great. That almost creates their moat.

Another little thing that I found in my research is looking at sites that do software review, and see what the people that actually use it, the developers — here at The Motley Fool, we use Avalara, we use a lot of the different softwares that I’m investing in. I’ll just go to those teams and say, “Hey, why do we use this? Did you try other ones? Why was this the best?” You’re almost getting it right from the horse’s mouth.

Question from Harley, who asks, “It seems like total addressable market is a big part of the SaaS story. How do you think about that for a company like DocuSign?”

Definitely, total addressable market is a consideration that I incorporate in every company I consider for recommendation. In the case of a company like DocuSign, which certainly is going global, has global aspirations. You look at what they do, their core competency, e-signature. Contracts are all over the world. Anywhere you go, contracts and agreements are being executed every day. Thankfully, technology, the internet, has made the world essentially smaller.

With a company like DocuSign, it almost becomes… I don’t want to say irrelevant, but the total addressable market can become so large compared to the size of the company today that it almost becomes an issue that you don’t have to worry about. But, understanding the core competency, and how well that translates globally, that can give you a good idea of how far the business can actually go.

Question from Marianne.”Most SaaS stocks are more in the high-flying growth realm. Those are the kinds of stocks that get beat up in a recession. Are there any SaaS stocks that you consider to be recession-proof?”

I don’t know if any stock’s recession-proof as much as you may like to think they are. But just like I was saying with Avalara, I always like to look at these companies and say, in a time where a company needs to reduce spending, is this something they will throw out first? Say your company’s going through some difficulty, you might stop renting a specific office space, a WeWork or something. I’m not a fan of WeWork personally looking at the growth rates there and some of the shady transactions within.

But, I always like to look at, tax compliance, OK, they’re not going to want to figure this out themselves. Figuring out their accounting processes. There’s a lot of headaches that go into switching software providers, especially if you have a lot of data stored within these systems. Again, that goes into the initial research process. Much like Jason was saying with total addressable market, I always like to take a 10-year stance. There could be a hiccup in the economy, but this company can last because it’s solving a problem for a lot of companies. The market is huge for them that they can figure it out.

You always want to look at, they have some cash on hand, how much debt they have. If they need to raise capital, they can. They’re not just rolled with debt to where they completely turn off future investors. That’s another key that comes into play.

I agree, I don’t think anything’s recession-proof. Everything is going to feel a pinch during tough times. But, profitable companies tend to do better when recessions hit. A lot of these SaaS companies today are not profitable. Keep that in mind. Some of them are. A company that you know I love, Chris, Autodesk. Recently switching its model over to that software-as-a-service, away from that legacy license. Ultimately, that is a business that, they work in simulation and CAD software.

A lot of businesses depend on their product day in and day out. Even in recessionary times, those businesses have their doors open, and engineers are still using that product. It’s not a business that necessarily would be recession-proof, but it’s one that’s still going to be needed in times of recession. It’s already got a proven business model that can be very profitable.

“Salesforce is an OG SaaS company. Is there a point where one of these companies becomes too big to be interesting? Seems like a lot of The Motley Fool favorites are more in the small to mid-cap space.” Good question! That’s certainly something that applies to any industry. There are certainly a lot of investors out there who just aren’t interested in a $200 billion company, no matter how good the business is being run. They’re much more interested in the small to mid-cap size.

Yeah. My investment style is looking for the next Salesforce. Personally, I always look for companies that can rise 10X over the next 10 years. Yeah, Salesforce might not be able to do that. But I’m looking for that next Salesforce. I think, “OK, this company can grow its $5 billion market cap to $50 billion much easier than a $200 billion company and go to $2 trillion.”

To go back to leadership, you look at Marc Benioff, the job he’s done running Salesforce, that’s one more feather in their cap.

Yeah. He’s always making those bolt-on acquisitions, exactly like Atlassian was. When you talk about the Mount Rushmore of SaaS, you definitely have a Marc Benioff on there.

Making money is never boring, right? Again, it’s a matter of how fast you’re making it. Personally, I think investing in some of those larger companies is a nice way to afford you the opportunity to build out your portfolio with some of those smaller — I don’t want to say more speculative plays, but maybe the businesses are yet unproven.

We go back to that diversification. Make sure you have a portfolio that’s well diversified. Throw some of those bigger companies in there. They will help you sleep at night when you run into those times like we saw here recently with a lot of these SaaS names witnessing a lot of volatility.

I like that Joey just created the Mount Rushmore of SaaS. That’s fantastic!

I’ll have to finish that one off.

A few people asking some version of this question. Everything going subscription oriented. Software, transportation, even clothes. Are we in a subscription bubble?

We were talking a couple of weeks ago; Bro and I were on here talking about personal finance and ways that folks could get started investing and find some extra money here and there. I said at the time, it’s worth anyone’s time to go through and give themselves a subscription audit. If you go through your bank account and your credit card statement and look at all of the subscriptions you have — you’re right. Whether it’s video or groceries, or, heck, Chris, shaving.

I’ve got a shaving subscription. Everything in the world now is trying to get you to subscribe to them. That’s a very good point there. It’s a very attractive business model. It is super convenient for consumers. Perhaps we’re a little bit saturated. That’s OK. The winners will prevail and the losers will go home. But, it is worth keeping in mind.

Another question. “Can we address high valuations of these SaaS companies? Are they in a new class of companies based on high growth, tremendous gross margins, and limited debt?”

Like I was saying before, IPOs used to be pricing at 5X sales. Then it was 10X. Now, some of these are coming out of the gate at 20X, 30X sales, where it might have a penny of profitability. It’s like, “Well, then, let’s throw a 1000X EPS multiple to go with 60X sales. This is a profitable SaaS company.” They’re definitely stretched. That’s where you want to be careful, especially on these IPO day ones with these huge pops. But, I almost need a graph to say, “OK, this company’s growing revenues at 80%,” where it used to be that people were OK paying 10X or 15X, now it’s almost OK to pay 30X sales.

You want to align the valuations with the growth, and look two or three years out based on that growth. Then you can say, “OK, it might be absurd that it’s 40X sales now, but based on that growth, it’s 20X next year, and then 10X the following year,” and it gets more reasonable when you put time into play. But if it has that path towards profitability, if it has great gross margins, like a Zoom or a Slack, where it’s over 80%, then you can see that there is a clear path to profitability.

And, if they have a lot of cash, no debt, then hey, they could be making acquisitions that further accelerate growth. That’s where growing into the valuations, you want to make sure that your companies can do that.

You mentioned WeWork earlier. For anyone who’s watching the way WeWork drama unfolds as they attempt to go public, it’s entirely possible that some of those high valuations that we see right out of the gate might be self-corrected because of what WeWork is trying to do.

Sometimes the market is not so forgiving. I’m happy to see that WeWork is being given such a hard time. I think it deserves it.

They should have called themselves real-estate-as-a-service. Either that, or partner with Beyond Meat, have some Beyond Burgers in all the locations.

That’s was in their S-1, right? “Space-as-a-service?” I’m pretty sure that was the term that they used in the S-1. That was my first sign, I thought, “Wait a minute!”

I thought they were trying to elevate consciousness.

That, too.

Which confused me altogether. I was like, “Wait! Is this meditation?”

Kaylee with a comment, not a question.

Oh, no!
“Joey, Peyton and Blake say hello.”

A question from Luis.

“Pardon my ignorance, but if a large tech company decides to buy DocuSign, what happens to my investment?”
That’s a good question!

Oftentimes with acquisitions, you’re going to see one of two things happening. Either the company is going to acquire the other company for outright cash, and you’ll be given cash for your shares. Or, they’ll use stock as the currency to buy the company and you’ll get stock in the company that is making the acquisition.

Either way, typically, if it’s a fair deal, and the board is on board with the deal, then the acquisition is going to happen. You just need to understand exactly how they’re going to fund it. Ultimately, you’re not going to have much say-so in a matter. So, you need to figure out, A, what you want to do with that extra cash, if it is going to be an all-cash acquisition; or B, if it’s going to be a stock acquisition, do you want to own shares in the acquiring company?

If not, then you’ll need to liquidate those shares once you actually inherit them when the transaction closes.

I had a similar situation. SendGrid was one of my holdings, they got bought by Twilio. I’m looking at it like, “OK, I definitely want to own Twilio. I’ll let those shares convert.” The cool thing is, because it was both cash and stock, I was given a little bit of cash. I believe that’s how the transaction happened. But Twilio’s stock went on to grow like 50%. I was locked in, I was getting [some percentage of] Twilio [shares] for each share of SendGrid.

And as that kept going, where the original purchase price might have been $42 a share, SendGrid just kept running and flying high. And yeah, it converts to Twilio, and we know how that’s turned out. It’s just continued to go up. So yeah, if you like the acquirer, then stay the course if they’re giving you stock. If it’s all cash, then hey. Congratulations!

Last question before we wrap up. A few people asking, “How do companies meaningfully grow that dollar retention number?” What goes into that?

If they’re trying to consistently grow that, that could be, they’re adding another solution. Let’s use BlackLine, one of my holdings. They do basically accounting-software-as a-service. What they’ll do is, you might buy a specific number of seats to use. Now, say, your company buys 10 seats. Then you hire five more accountants. They need access to that. You’re buying five more seats.

You can upsell using the existing product. Or, say they bought another company that does tax compliance or such. They can say, “OK, hey, we’ve got this accounting software. You’re paying this. But if you also want to have this side of it, and we’ll do all these filings for you, it’ll be this price, and we’ll set you up with that next time around.” It’s basically at broadening the product suite, or people basically adding more licenses or needing more seats to log in.

Churn is another thing to keep in mind. Ultimately, when these companies sign customers, they want to keep those customers. When they don’t keep those customers, that plays into that retention rate. When they do keep those customers, obviously, that is a positive. So, when you see net retention rate, churn is something that goes into that as well.

The ultimate key would be, if you can find a company that is adding a bunch of clients, the existing clients are spending more, that’s been the ultimate recipe to success. If the customers that have been around for five years have been increasingly spending $1.00, $1.25, $1.50 compared to year one, you can see, all these clients — like DocuSign adding 29,000 customers or something like that, those customers are year one.

Now, they could start growing to where they’re spending more and more. So, you get that cohort. Year one, year two, year three. New people in year two, and it’s growing from there.

It’s like a restaurant comp. That first year a restaurant opens, they’re getting their feet underneath them. Sales are going to be a certain base level. But once you get a mature restaurant base there, a few years down the road, you could see a meaningful increase in sales as time goes on. Certainly the same thing would come into play with customers of these software-as-a-service companies, just as Joey was saying.

They buy in for one product, but if they like what they’re seeing, they’ll add more. And they’ll become a very valuable customer over time.


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