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Market's top software stocks

Photo of Roger Montgomery By Roger Montgomery

min read

Software companies a long-term bright spot on ASX.

Long ago, when I first began investing, one of the analytical steps we covered was analysis of the assets on the balance sheet.  And while that step is still followed today, it can be argued that we conduct the analysis for a different reason.

Back then, the purpose of the analysis was to ask whether, in the event of a catastrophe or liquidation, there were enough hard, or tangible, assets to support a satisfactory return on the price being paid for the shares.

Australian investors, however, eventually cottoned on to the fact that a company with a lot of hard assets also needed a lot of money, thanks to the ravages of inflation, to maintain those assets.  Inevitably they wear out, or are superceded and more money needs to be reinvested just maintaining the competitive position of the organisation.

And because a machine that was purchased a decade ago needs to be maintained in 2017 inflated dollars, the asset becomes a liability.

But, perhaps more recently, time has wrought a new force with which to ravage the old-economy business: the advent of the digital economy has replaced, threatened or changed the value of bricks and mortar and manufacturing to such an extent that investors are seeking shelter in those businesses whose major assets can only be described as intangible.

For me, it is curious that it is was technology that caused investors to see value in the intangible.  Twenty years ago, I had to use the example of owning the licensing rights to a brand or a trademark to convince investors that the intangible had tangible value.  Today investors are having that reality thrust upon them.

What is SaaS?

Software as a service (SaaS) is a model for delivering and licensing software that is usually centrally hosted (for example, in the cloud) rather than distributed via a packaged product (for example, a disc) to individual desktop computers, which is still known as “on-premises” and which is conventionally sold with an up-front cost (and an optional ongoing support fee).

In essence, the user or purchaser permanently “rents” the software instead of buying it outright.

For an instant understanding of SaaS think about how Microsoft Office is now purchased and maintained compared to the old days. Previously a user purchased a packet of discs from a reseller such as JB Hi-Fi and each had to be inserted into the computer and “loaded”. Then Microsoft insisted on CDs with online registration. And today there are no discs; online registration is purchased; credit card details are uploaded and updates and payments occur automatically.

A win-win

Importantly, once the software and the delivery model has been established, the marginal cost of adding an additional user is minimal or even zero.

Then, by employing a monthly or annual subscription fee, SaaS providers can offer a lower initial set-up cost than the equivalent on-premises enterprise software. It’s simply a superior business model offering a variety of superior revenue models as well.

SaaS vendors therefore typically offer a carrot, pricing the initial set-up as cheaply as possible, and undercutting competitors who have not moved their ecosystem to a centrally hosted solution.

The “freemium” offer is a common example of this offer in action; the provider charges nothing to join and start experiencing the product, perhaps with limited scope or functionality, and later usage is gauged and a charge commences or additional features are charged for.

Being centrally hosted, the SaaS provider can monitor all customer data and is then afforded the opportunity to additionally price the application on a usage parameter, which may include the number of users, a charge per transaction or event, or any other number of units of value.

For the customer, the advantages of SaaS over on-premises are hard to argue against: SaaS is cheaper to install and support.  It takes less time to implement, thereby lowering the TTV (time to value). No hardware maintenance or repairs are required, therefore IT overheads are lower.  Space requirements are lower and system upgrades are taken care of automatically by the provider.

Perhaps most importantly, a customer has the option of trying and ditching without the capital expenditure that forces commitment to an unsuitable product.

It’s a win-win.

Background and the mechanics

SaaS is sometimes referred to as "on-demand software" and Microsoft formerly referred to it as "software plus services".  SaaS has become a common delivery model for many business applications.

The list is extensive and includes office and messaging software, accounting and payroll processing software, DBMS software, management software, CAD software, development software, “gamification”, virtualisation, collaboration, customer relationship management (CRM), management information systems (MIS), enterprise resource planning (ERP), invoicing, human resource management (HRM), talent acquisition, content management (CM), and service desk management.

SaaS has been incorporated into the strategy of nearly all leading enterprise software companies because it creates a much “stickier” customer base and delivers recurring revenue streams – both superior features compared to on-premises software.

Importantly, the low marginal cost of an additional user has opened the market much wider for the solution provider.  Where once the economics of distributing and maintaining a desktop solution meant only large customers were lucrative, now even the smallest SME provides valuable incremental revenue.

The advantages for the investor or owner of a business providing SaaS are many.  First, the marginal cost of adding additional users is virtually nil.  Second, valuable network effects can be produced.  This occurs where, for example, the 1000th user receives even greater benefits thanks to the larger number of people already using the software or platform.

Third, distributing upgrades and updates is cheap and ensures all customers have a better experience.

Further, successful SaaS companies tend to earn greater revenue over the customer’s life even though initial SaaS revenues are lower than product sales.  This is due to the recurring nature of the revenue streams over the life of the customer which, when present-valued, is higher.

Investing in SaaS

Finally, and perhaps most importantly, the valuation of SaaS companies is much higher than software product sales companies.  According to Software Equity Group’s 2015 Software Industry Financial Report, and remembering it could be temporary, public SaaS companies have an enterprise value-to-revenue median ratio of 5.7 times compared to 2.9 times for software companies.

And the median growth for SaaS companies is estimated to be more than three times that of software product companies.

SaaS has become a disruptive force and early success stories are growing rapidly – at the expense of incumbents.  Indeed, the premium prices being commanded by the shares of SaaS companies may be a reflection not only of the recent superior growth profiles, but also that these companies are gaining market acceptance, and even preference, by customers.

The rapid pace at which valuations change in today’s market means that investors desirous of the highest returns need to identify emerging leaders early.  This is not easy to do and the risks can be high. But, of course, the returns from a sensible portfolio approach can be extremely rewarding.

Australia punches above its weight in incubating world-class technology companies and while not all of them are pure SaaS offerings, many enjoy the benefits of some elements of a model with SaaS characteristics.

Some of those that can be categorised as SaaS companies include Xero, Aconex, WiseTech Global, 3P Learning. Vista Group and Class.

Xero is a true software as a service (SaaS) company, providing an online accounting and business services platform to small businesses and their advisers. The vast number of users has recently seen the company launch a small business survey that will rival the traditional NAB business sentiment survey, which surveys about 500 businesses.

Headquartered in Melbourne, Aconex is also a true SaaS company, providing cloud collaboration software that connects owners, contractors and their project teams in the construction, infrastructure, energy and resources sectors.

Like Xero and Aconex, Wisetech is also a pure SaaS company offering a cloud-based software solution for the international and domestic logistics industries.

3P Learning is a global online education company with cloud-based, software as a service products in numeracy, literacy and science for school students.

Vista Group International is a New Zealand-based company that develops, sells and supports software for the film industry.  Its Veezi SaaS offering provides cinema management software, which is designed and developed specifically for the small-circuit cinema market.

Finally, Class’s Class Super product is a Self-Managed Superannuation Fund (SMSF) account administration platform that draws in hundreds of data feeds from financial service providers and includes extensive support for multiple asset classes. The software streamlines all aspects of SMSF account management, from initial set-up to annual filings with the ATO.

About the author

Roger Montgomery @rjmontgomery is chief investment officer at The Montgomery Fund and The Montgomery Global fund. You can join his blog and purchase his best-selling value investing book, Value.able.

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