The shift from packaged software to subscription based software as a service (SaaS) has led to the sector becoming one of the hottest areas for investment for many years now. Between new start-ups and old software industry stalwarts changing their business models, investors have a lot of potential stocks to sort through. We thought we’d use two screening methods to find out which SaaS stocks might have the most potential.
Balancing Growth vs. Profits
One of the popular tricks to quickly and easily assess the health of SaaS companies is the “Rule of 40”. The rule is simply that a company’s profit margin plus growth rate should be equal to or greater than 40. The rule is basically about assessing a company’s balance between growth and profits. For example, a company with -50% profit margins is fine so long as it’s growing at 100% (-50 + 100 = 50 which is more than 40). Likewise, slow growth is okay so long as a company is profitable. If a company has 30% profit margins, it’s fine if it’s only growing at 15% (30 plus 15 = 45).
While the Rule of 40 is typically used for early and mid stage SaaS companies, it can still be helpful in gauging the health and relative attractiveness of later stage public companies. There is also much debate on which measures of revenue growth and profit to use. In our example, we are going to simply use net revenue versus annual or monthly recurring revenue. For profit margin measures, things like EBITDA margin, net income, operating income, operating cash flow, and free cash flow have all been used. For our example, we’ll use free cash flow since it’s less susceptible to accounting gimmicks.
The table below shows the revenue (last fiscal year and TTM) and free cash flow (again last fiscal year and TTM) metrics and “Rule of 40” number for 31 of the largest public SaaS companies. We’ve highlighted in green in the “Rule of 40 Total” column all companies that pass the rule. For now, ignore the green highlights for the company name.
(Source: Morningstar, author’s calculations)
We can see about half of the companies pass the “Rule of 40” metric. When looking at free cash flow, it’s important to note that stock options need to be taken into account. Many SaaS companies pay out a significant portion of employee compensation as stock options which are not counted as a cash expense. For example, last fiscal year Atlassian (TEAM) reported free cash flow of $281M. However, that was partially due to $162M of share based compensation charges being reversed since they are considered non-cash. That’s not to say the practice is bad or Atlassian would be a bad investment, just that it needs to be factored into the evaluations of companies.
However, screening as a healthy SaaS company with a good combination of growth and profits doesn’t necessarily mean it will be a good investment. The price you pay matters as well. So, we further screened the companies in the list based on several valuation metrics. The table below shows the price to sales ratio, EV/FCF ratio, and price to free cash flow growth (a kind of modified PEG ratio so lower is better).
(Source: Morningstar, author’s calculations)
We highlighted the company name in green for any SaaS company that passed both the Rule of 40 metric and was in the cheapest third of the group based on our modified PEG or “PFG” valuation metric.
The list of ten or so stocks with combination of a healthy business with a good balance between growth and profits along with a lower valuation should give investors a good place to start further research if they are interested in owning stocks in the SaaS space. However, it’s not to say that every company in the list is good or those that didn’t make the list are bad. For instance, Autodesk (ADSK), which we own, is going through a business transformation, shifting from one time packaged software to subscriptions. Therefore its profits and revenue growth (we believe) are artificially low. So, even though the stock has potential, it screens poorly on many metrics because of the disruptions caused by the business model change. The list serves best as a guide to the most promising companies for further research.
Disclosure: I am/we are long INTU, ADSK, ADBE. 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.