Investing In SaaS Stocks: The Trend Remains Strong

Includes: CSOD, ULTI, WDAY
by: Graycell Advisors

The purpose of this article is to briefly look at the SaaS industry and the overall business strategy of the three vendors in the Human Capital Management (HCM) segment of the industry.


For the past few years, the enterprise software market has been undergoing a marked shift from on-premise deployed licensed application software, installed and managed on-premise, towards a cloud-based service model, where installation and management is the software vendor's responsibility in return for a monthly usage charge.

This shift toward cloud-based Software as a Service (SAAS) model is only going to accelerate with newer technologies and broadening capabilities delivering equivalent or superior cloud performance compared to on-premise performance, the compelling time-to-market edge, and total cost of ownership considerations that in many situations can sway the Buy vs. Rent decisions in favor of the cloud industry. The strongest growth opportunities for SaaS vendors lie in new implementations. At the same time, existing enterprise implementations of on-premise licensed software will continue to shift towards cloud offerings as they approach their upgrade/replace cycle, a trend that will only gain pace.

The cloud application software model initially was a generic solution model, and consequently more eminently suitable for installations which didn't require heavy customization. But with growing vertical and horizontal capabilities, and application configurability, cloud computing is now reaching a wider spectrum of enterprise license base. Broader penetration of the small-and-medium business (SMB) segment, the upstream climb into larger enterprises, tapping into international markets, willingness of enterprises to unify and simplify in order to boost competitiveness, and rising enterprise technology spending on cloud initiatives will continue to maintain strong growth momentum for cloud application providers through 2015.

Enterprise software is an over $250 billion market globally. The SAAS market was approximately a $15 billion opportunity in 2012, representing about 6% of the Enterprise Software market. As per Gartner, SaaS is expected to grow to a $32 billion market in 2016, with a five-year CAGR of 19%. From a data perspective, Cisco has forecasted that the traffic from the cloud will represent more than 64% of total data center traffic by 2016, up from about 39% in 2011. Cloud computing is rejuvenating the enterprise software market. Most likely, all these forecasts will prove to be conservative in the end.

The SaaS industry has mushroomed with companies targeting various verticals and horizontals. Today, we have pure-play cloud computing SaaS providers in enterprise Customer Relationship Management (CRM), Enterprise Resource Planning (ERP), and Human Capital Management (HCM), among others. No company is more synonymous with SaaS cloud computing then the biggest provider, with a focus on front-office or customer-facing functions. There are many fascinating SaaS business models from companies like NetSuite (NYSE:N), Workday (NYSE:WDAY), Cornerstone onDemand (NASDAQ:CSOD), Ultimate Software (NASDAQ:ULTI), WageWorks (NYSE:WAGE), to name a few. Today, we look at three public SaaS companies in the Human Capital Management (HCM) space - CSOD, ULTI, and WDAY.

SaaS Driven Human Capital Management Market

Corporate customers have begun to rapidly embrace cloud HCM offerings. Many vendors have come forth with strong cloud solutions, which are transforming the manner in which human capital is managed. An integrated human capital management strategy is being given the same importance as customer relationship management or supply-chain management. One of the segments of HCM is Talent Management, which is estimated to be an over $4 billion software market in 2013, as per Bersin (Deloitte). Some key public participants in the overall HCM arena are Cornerstone, Ultimate Software and WorkDay. Many earlier market leaders like Kenexa, Successfactors, and Taleo have been acquired and absorbed within larger companies.

There are multiple segments to the HCM market. Here is one way to breakdown the HCM market, although some segments can be combined.

HR Management - Unified People management

Talent/Performance Management

Payroll & Benefits


Time Management

Education & Training

Cornerstone onDemand is a cloud software provider with roots in education and training. Its enterprise cloud offerings include Training, Talent or Performance Management, Recruiting, and Extended Enterprise. However, the Training and Extended Enterprise clouds are quite unique amongst its peer group, and in our opinion the most valuable of the company's portfolio offerings. Due to its uniqueness and strengths, the Training cloud provides the company with sales opportunities in larger, global enterprises. Cornerstone is focused on the SMB market. It has clearly benefited from a competitive shakeup in the SMB market thus allowing its Talent Management solution to gain greater traction. Over the last two years as on-premise software providers Oracle, SAP and even IBM have strengthened their portfolios by acquiring cloud competition, Cornerstone, which was competitively smaller, has found a new wind in its sails. While the acquired competition went through the integration and realignment process, it changed the competitive dynamics in the SMB segment with Cornerstone able to strengthen its market position. In addition, the company has shown astuteness in crafting partnerships to expand its market reach, including partnerships with other cloud vendors. This is a resourceful company that is driving hard to grow its footprint. Strategically speaking it should have scarcity value for a few larger companies in-and-out of the SaaS space.

Ultimate Software is a seasoned company in the HCM market that has transitioned very effectively from its enterprise license model to a per employee per month (PEPM) service rental or SaaS model. It's the largest cloud-only HCM company, with a focus on SMB market and larger organizations. The company has a broad suite of HCM offerings, which include HR Management, Talent Management, Payroll and Benefits, Recruitment and Time Management. It has a great track record of growing revenues consistently while improving operating margin. Ultimate Software is the closest to reaching its steady-state operating model with non-GAAP operating margins approaching 21%. In the second-half of 2010, Ultimate Software launched a sales strategy of fixed-cost implementations. Since the company performs most of its implementations, the idea was to drive customer loyalty and ease cost-creep customer concerns on implementation. However, with a fixed price implementation model it will be hard to attract third-party implementation partners, who mostly prefer the lower-risk T&M implementations. The fixed-price implementation is great for customers, although it costs the company ~10% in service revenues, if one is to observe the service margin trendline. Since virtually all SaaS companies in the HCM segment are reporting 90+% renewal rates, and none of the competitors have moved to offer such a fixed-price implementation in order to counter competitively, the long-term tangible benefits of this fixed-cost strategy remains to be seen.

Nonetheless, an in-house only professional services organization assures consistency of implementation, and control over time-to-live cycle, implementation cost and customer experience. But one would suspect that an in-house implementation function also makes it harder for Ultimate to focus aggressively on business development since the implementation bandwidth needs to almost pre-exist prior to Sale, and the Company will have to closely align the high cost base of professional services to the expected revenue pipeline. A hybrid implementation strategy with a combination of in-house and third-party service providers, in an appropriate mix, can allow for a meaningful portion of the professional services cost-base to shift to the implementation partners. Strategically, we feel a hybrid strategy can free the company to more aggressively focus on its business development within the largest companies, where the implementation cycles are longer, with the realization that there is sufficient third-partly implementation bandwidth to support the sales pipeline.

Workday listed as a public company in October 2012. Based on the lineage of its co-founders, one can metaphorically describe it as the reawakening of the famed PeopleSoft. Workday is targeting a much broader functional market with its cloud offerings. The company's business strategy is geared towards mid-sized and large, global organizations. HCM is the largest segment of its business offerings, which also include Financials and Expense Management. Workday's HCM suite comprises HR Management, Talent Management, Payroll and Benefits, and Time Management. It has a broader focus in multiple very high-growth segments, and perhaps possessing co-CEOs can be considered an asset at this point. It's interesting to note that the company's implementation strategy is focused on partnering with service providers. This assists in creating a scalable implementation infrastructure, without over-burdening Workday with the high cost base of professional services that accrues in a high-growth environment, particularly when the revenue cycles are subscription-oriented over multiple years. Further, the service partnership model broadens market reach as well.

Perhaps the focus on large, global organizations creates an easier and more unique opportunity for Workday to engage service partners, since the implementation cycles are longer and consequently more meaningful revenue-wise for the service providers. We would suspect that there is a strong brand-heritage effect that Workday benefits from when it comes to both customers and investors because of its enterprise-software and PeopleSoft roots - the strong, proven ability to execute in an enterprise software environment.

As many enterprise software folks would be aware, PeopleSoft had a passionate enterprise customer base. Workday is pursuing a more global sales strategy that encompasses both US and international opportunities. This further boosts growth rates. The Company appears to be highly focused on aggressive growth and is casting a wide net from the viewpoint of both service offerings and market reach. However, one has to note that a build-out for rapid growth is expensive as it requires a substantial and upfront investment in sales and delivery infrastructure. Furthermore, the company's large and global enterprise target market puts it squarely within the intensely competitive enterprise software applications market dominated by the likes of SAP and Oracle, and their SaaS offerings. The best early opportunity for Workday lies in new implementations, or where the organization wishes to shift to a native cloud offering. In situations where an existing implementation exists, it will take much longer and most likely even be harder to displace the cloud offerings of incumbent legacy software providers. The win-rates will naturally be lower in such situations, compared to greenfield opportunities, although the tremendous opportunity on such win rates will still provide compelling growth.

There is a mega shift underway in enterprise computing. SaaS plays into that trend. According to a 2012 report by Saugatuck Technology, 75 percent or more of new enterprise IT spend will be cloud-based or hybrids involving clouds. It's abundantly clear the enterprise software model is in the midst of a generational shift. Today, companies like CRM, N, WDAY and WAGE participate in the pure play SaaS models. Unencumbered by the legacy installed base transition issues, these companies are aggressively upscaling their innovative SaaS offerings and penetrating a broader spectrum of the enterprise market. For investors the choice right now is not particularly whose cloud is best. The market is young enough that the entire SaaS industry will witness significant gains. Eventually there are certain characteristics that will hold greater value for a successful and dominating SaaS model, including Business Analytics and the time-tested Suite approach.

Presently, growth is most important. A revenue platform that can be leveraged further into incremental revenue streams is being created by the SaaS companies. It's fairly simple to understand the profitability of a SaaS recurring revenue model. The right level of scale can push operating margins to 20% to 25%, and even higher. With renewal rates across the industry in the 90%, once a SaaS business has a customer the chances of losing the customer are slim, and the opportunity to sell additional cloud offerings is high, at least for sometime. It's easy to understand that the business model can generate substantial profit margin over a period of time. Thus, the focus in this phase has to be on growth and adding new customers, particularly when the financial markets are permissive on a gradual path to profitability. A SaaS model that is already achieving high profitability may not be taking full advantage of the opportunity on hand, and find itself in a weaker position competitively in terms of new client growth while managing high-margin expectations. In other words, the game's being played with growth in mind along with a slow-and-steady march to higher profit margins.

P/E and sales multiples can mislead, when an emerging market is pursuing a huge opportunity. We like SaaS as a group. In the HCM space, we prefer WDAY simply because of its ability to be highly disruptive in enterprise software, its bigger market opportunity, its deep enterprise software experience, and its hybrid implementation strategy. The lock-up overhang for WDAY will work its way through the market. At the $60 level, WDAY is still worth investing to participate in the SaaS opportunity for 2013 and 2014. The stock can move higher into the $80 to $100 range within the next 12 months.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

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