Seeking Alpha

Don't Call It A SaaS Bubble

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Includes: AAXN, ADBE, ALRM, AMBR, AMZN, APPF, APPN, AYX, BL, BLKB, BNFT, BOX, CLDR, COUP, CRM, CSOD, DBX, DOCU, EBIX, ECOM, ESTC, EVBG, FEYE, FIVN, HSTM, HUBS, INST, JCOM, LOGM, LPSN, MDB, MDSO, MIME, MOBL, MSFT, NEWR, NFLX, NOW, NTNX, OKTA, PAYC, PCTY, PD, PFPT, QLYS, QTWO, RNG, RP, SHOP, SMAR, SPLK, SPSC, TEAM, TLND, TRHC, TTD, TWLO, TWOU, UPLD, UPWK, VEEV, WDAY, WIX, WK, WORK, YEXT, ZEN, ZIXI, ZM, ZS, ZUO
by: App Economy Insights
Summary

In 2013, SaaS valuation multiples had more than doubled in a matter of months, and concerns over a valuation bubble emerged.

More than half a decade later, best-in-class SaaS businesses continue to be valued at high multiples that scare away most prudent investors.

Many investors have missed the investment opportunities of a lifetime by refusing to invest in the disruptors of our time (AMZN, NFLX) simply based on concerns over valuations.

The discussion shouldn't be about whether or not we are in a SaaS valuation bubble, but rather how to separate the wheat from the chaff.

Six months after picking a quality basket of 10 SaaS under $10 billion, the selection is delivering stellar results so far, nearly tripling the market returns.

It was the 22nd of October 2013.

At the time, Tomasz Tunguz, Venture Capitalist at Redpoint and renowned writer about everything SaaS, posted an analysis suggesting that there was a SaaS valuation bubble and that the trend was poised for mean reversion:

From about 2004 to 2011, the average publicly traded SaaS company held an EV/Rev multiple of 3 to 5x. Since 2011, that figure has been multiplied by 4 to 7 times. Today, those ratios stand at 12 to 20x. [...] There's no question that SaaS has brought a revolution to users and administrators in terms of software ease of use, accessibility and management. Today, that value is handsomely and disproportionately rewarded in the public markets. But these trends have a way of reverting to the mean over time.

Today, almost six years after this post, EV/Rev multiples of publicly-traded SaaS companies have maintained their 2013 level and remain close to all-time highs.

If you are wondering whether we are in a SaaS bubble, you're asking the wrong question. Why? Investors have called a SaaS bubble for years, and multiples could stay that way for years to come. While the downside risk is significant, so are the potential returns for those who can hold onto the disruptors and secular growers of our time for years.

Sure, SaaS businesses have inflated multiples today compared to where they used to be in 2011. But when you look into the individual companies driving these multiples higher, they often have outstanding stories and are disrupting entire industries.

Looking holistically at a group as diverse as cloud-software companies can be enlightening, but also misguiding. That's why investors need to dig into the details and separate the wheat from the chaff.

While we are well into a fantastic bull market that has driven the revenue multiples for software companies to a 10-year high, you might want to focus on individual stories and think twice before writing off this entire group from your portfolio.

The rationale of SaaS valuations in 2019 is simple:

  • The bull case: enterprises are moving to the cloud and shifting trillions of spend. All these companies will benefit, and the best among them will be life-changing investments.
  • The bear case: valuations for these businesses assume long-term continued success. Any shakiness in these growth stories could result in sharp corrections that could take years to recover, if ever.

Ultimately, where you stand comes down to your risk appetite and your time-horizon. But the potential rewards might be well worth the risks.

Let's review the details with an open mind, and don't call it a SaaS bubble.

Source

Average performance and valuation

I have kept my focus on a specific set of companies that can be considered part of the App Economy Insights "universe" via many filters such as culture, leadership, insider and institutional ownership, dollar-based net expansion and more.

For today's exercise, I expanded my research to a larger subset of SaaS businesses, looking into most of the companies tracked by Blossom Street Ventures to which I've added several of the recent IPOs (resulting in the 69 companies below).

Several key trends emerge for publicly traded SaaS companies in 2019:

  • Sales are still growing very fast: 32% yoy growth on average
  • Margins are still terrible: -7% operating margin on average
  • Yet, Cash flows are positive
  • EV/Sales multiple are very high: 12.7x on average, 9x median
Company Ticker

MCap (billion)

Sales Growth Op. margin EV/Sales
Zoom Video (ZM) $24 103% 2% 57
Slack (WORK) $18 67% -29% 39
Zscaler (ZS) $10 61% -9% 34
Okta (OKTA) $14 50% -32% 31
Shopify (SHOP) $34 54% -9% 29
Atlassian (TEAM) $32 38% -4% 28
Coupa Software (COUP) $8 44% -18% 27
Smartsheet (SMAR) $6 55% -32% 26
PagerDuty (PD) $4 49% -37% 26
Alteryx (AYX) $7 51% 8% 24
MongoDB (MDB) $8 78% -33% 24
Twilio (TWLO) $18 81% -21% 23
Veeva Systems (VEEV) $24 25% 27% 21
Trade Desk (TTD) $10 41% 20% 20
Elastic (ESTC) $6 63% -37% 19
ServiceNow (NOW) $52 34% -1% 18
AppFolio (APPF) $3 35% 8% 17
Everbridge (EVBG) $3 40% -28% 17
Paycom Software (PAYC) $13 30% 30% 17
Workday (WDAY) $48 33% -16% 16
Zendesk (ZEN) $10 40% -22% 15
Q2 Holdings (QTWO) $4 30% -14% 14
RingCentral (RNG) $10 34% -3% 13
Adobe (ADBE) $146 25% 29% 13
HubSpot (HUBS) $7 33% -8% 12
BlackLine (BL) $3 25% -13% 12
Five9 (FIVN) $3 27% 3% 11
Qualys (QLYS) $3 16% 19% 11
Wix.com (WIX) $7 27% -6% 11
Paylocity (PCTY) $5 25% 9% 11
DocuSign (DOCU) $9 37% -26% 11
New Relic (NEWR) $5 34% -7% 10
Workiva (WK) $3 17% -15% 10
Yext (YEXT) $2 35% -32% 10
Proofpoint (PFPT) $7 25% -14% 9
Splunk (SPLK) $19 36% -14% 9
Appian (APPN) $2 15% -23% 9
Zix (ZIXI) $1 76% 2% 9
Axon Enterprise (AAXN) $4 14% 4% 8
Salesforce.com (CRM) $119 24% 4% 8
Medidata (MDSO) $6 16% 7% 8
Mimecast (MIME) $3 26% 0% 8
Microsoft (MSFT) $1,036 14% 33% 8
LivePerson (LPSN) $2 14% -11% 7
RealPage (RP) $6 16% 9% 7
Instructure (INST) $2 21% -24% 7
Upland Software (UPLD) $1 53% 9% 7
Upwork (UPWK) $2 16% -4% 6
Cornerstone (CSOD) $3 5% 1% 6
SPS Commerce (SPSC) $2 13% 12% 6
Alarm.com (ALRM) $3 21% 13% 6
Blackbaud (BLKB) $4 6% 7% 6
Tabula Rasa (TRHC) $1 39% -2% 6
Dropbox (DBX) $10 22% -4% 6
Zuora (ZUO) $2 22% -32% 6
2U (TWOU) $2 32% -12% 5
Talend (TLND) $1 24% -22% 5
Benefitfocus (BNFT) $1 10% -14% 4
Box (BOX) $3 16% -21% 4
Amber Road (AMBR) $0 5% -11% 4
Ebix (EBIX) $2 32% 29% 4
j2 Global (JCOM) $4 7% 22% 4
LogMeIn (LOGM) $4 10% 5% 3
MobileIron (MOBL) $1 10% -21% 3
Nutanix (NTNX) $5 -1% -40% 3
FireEye (FEYE) $3 6% -22% 3
HealthStream (HSTM) $1 19% 7% 3
ChannelAdvisor (ECOM) $0 1% -5% 2
Cloudera (CLDR) $1 81% -40% 2
AVERAGE $26 32% -7% 12.72
MEDIAN $4 27% -7% 9.00

Source: Google Finance and Yahoo Finance 7/1/2019

Looking back at the valuation multiples over the last five years, the median EV/Sales valuation multiple is close to its highest point.

Source: Blossom Street Venture SaaS Valuations - August 2018

The median EV/Sales multiple was below 5x at the end of 2015 and reached above 9x in the second quarter 2018, before the market drawdown.

Risk vs. Returns

Many of the big winners in the SaaS category share the same attributes. They are small, fast growing, considered overvalued by most Wall Street metrics, and display very high volatility in their stock price.

Investors have to ask themselves:

  • What is my downside risk? Let's assume, to illustrate, that a fair valuation of publicly-traded SaaS companies is a median EV/Sales of 5x - matching multiples all the way back to 2011. Using the current median EV/Sales of 9x calculated previously, a mean reversion of all SaaS valuations from 9x to 5x would result in approximately a 44% drawdown in the share price to reach a fair valuation from 2011 standards. Of course, the downside risk can be 100% with any individual stock, but at least, this covers a hypothetical "bubble burst" scenario.
  • What are my potential returns? A simple look at the performance of the high flyers presented above should be enough to illustrate how compelling the returns can be over time. If you invest in a basket of SaaS companies, focusing on the inherent quality of their business such as dollar-based net expansion, culture, leadership, high insider ownership, and low institutional ownership rather than valuation multiples, chances are you will catch some outstanding winners if you give them enough time.

The wrong mindset

Calling something a bubble is - to a certain extent - a way to rationalize our fear.

How many investors have convinced themselves there was no way they would ever invest in Amazon (AMZN) or Netflix (NFLX) given their valuation? And, despite the evidence over the years, how many would admit today that they were simply wrong? After all, even Warren Buffett did.

The bias we are regularly subject to is anchoring. We all have a tendency to attach our thoughts to a reference point - even if it isn't relevant to the decision at hand.

When Tomasz Tunguz pointed out that there was likely a SaaS valuation bubble in 2013, he was anchoring valuation multiples to what they were in 2011. As a result of anchoring, we become obsessed with the downside risk of 20%, 30% or 40%, when the real discussion should be about which businesses are currently changing the world and worthy of a spot in our portfolio for the next decade.

People say things like "eventually, you will get obliterated." What do they mean? That a position will have significant drawdowns at some point? That's the very nature of a volatile investment.

If you are truly seeking alpha, you have to be able to look past volatility and be willing to underperform for an extended time. This is true of any style of investing.

10 SaaS Under $10 billion for 2019: Mid-year review

In early January, I posted a list of 10 SaaS businesses under $10 billion market cap that were all scoring very high on my small cap scorecard and were poised to be strong picks for 2019 and beyond.

Six months after picking this selection of small SaaS, the basket is delivering stellar results so far (+50%), almost tripling the returns of the S&P 500 over the first six months of 2019 (+17%).

While my time horizon is over five years or more, it's fascinating to watch such an outstanding source of alpha in a matter of months. It will be particularly interesting to watch how this group performs in a down market should the situation occur in the coming years.

Chart Data by YCharts

PRICE VARIANCE 6/30/19 YTD
OKTA 93.6%
PAYC 85.2%
TTD 96.3%
HUBS 35.6%
ESTC 4.5%
MDB 81.6%
AYX 83.5%
EB -41.8%
APPF 72.7%
ZUO -15.6%
AVERAGE 49.6%
S&P 500 17.2%

Source: Price performance 2019 YTD from Ycharts

I have shared before the rule of 40 map, breaking down my methodology and showing how to pit the performance of SaaS businesses against one another through the lens of sales growth and operating profit.

Important note: In the chart below, instead of using the operating margin of the most recent quarter as I did in previous articles, I'm using the operating margin of the past 12 months. This is meant to better reflect the performance of companies that have some seasonality to their sales and marketing or R&D investments. I believe that this adjustment, albeit a subtle one, is a better representation of the performance of these businesses, particularly when comparing them.

As illustrated below, with the most recent data pulled from Yahoo Finance, only a few SaaS companies manage to satisfy the rule of 40, the principle that a software company's combined growth rate and profit margin should exceed 40%.

Reviewing the 10 SaaS under $10 billion selected:

  • Winners of the rule of 40: PAYC, TTD, APPF, AYX, MDB
  • High-growth profile but large losses: ESTC, OKTA
  • On the right path with decent growth and reducing losses: HUBS
  • Laggers so far in 2019 with slowing growth and large losses: EB, ZUO

Source: Data from Yahoo Finance. Sales Growth from most recent quarter. Operating margin from last 12 months. Graph from App Economy Insights. Bubble size based on market capitalization as of 6/30/2019.

Now, how does this translate into valuations and how do we put them in perspective?

Source: Data from Yahoo Finance. Sales Growth from most recent quarter. Operating margin from last 12 months. Graph from App Economy Insights. Bubble size based on market capitalization as of 6/30/2019.

As explained in my previous posts, if we assume that the trendline represents what a "fair" valuation could be among this specific set of 40 SaaS companies, the companies that are overvalued are above the trendline, while the companies that are undervalued are below the trendline.

From that perspective:

  • OKTA appears to be the most overvalued company in the list (very high EV/Sales multiple above 30 despite below average KPIs).
  • ESTC and MDB are trading at a premium compared to the trendline.
  • The seven other companies from the selection appear fairly valued or undervalued (on the trendline or below).

Conclusion

Six months after picking a quality basket of 10 SaaS under $10 billion, the strategy is delivering stellar results so far (+50%), almost tripling the returns of the S&P 500 over the first six months of 2019 (+17%).

Is it too late to hop on the band-wagon? I don't think so.

While some specific companies like OKTA show nose-bleeding valuations compared to their fundamentals, many of them are trading at premiums that could be well deserved over time once you put them together in perspective and pit their performance against the rule of 40.

Before you call it a bubble, look at what pundits have been saying about SaaS valuation in 2013 and see for yourself. You can choose to ignore this entire group and call it a bubble. Or you can try to separate the wheat from the chaff and accept that the premium of several of these businesses might be justified after all. Only time will tell.

With close to 30% of the App Economy Portfolio allocated to some of the companies discussed in this article, I've made my choice. After all, they are part of the winners that enabled the portfolio to triple the S&P 500 returns since 2014.

Let's review in January 2020 how 2019 unfolded.

Disclosure: I am/we are long AMZN APPF APPN CRM ESTC HUBS MDB NFLX PAYC SHOP TTD ZUO. 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.