From 0% To 10% In Free Cash Flow Margins For The SaaS Sector; $30 Billion Market Cap Considered Small
67 WALL STREET, New York - December 8, 2010 - The Wall Street Transcript has just published its Internet Services Report offering a timely review of the sector to serious investors and industry executives. This Special feature contains expert industry commentary through in-depth interviews with public company CEOs, Equity Analysts and Money Managers. The full issue is available by calling (212) 952-7433 or via The Wall Street Transcript Online.
Topics covered: Asia Vs. US Gaming Growth - Demand Drivers For Software As A Service - Social Networks And Microblogs - Social Media And The Internet - Virtual Gaming Trends
In the following brief excerpt from the Internet Services Report, expert analysts discuss the outlook for the sector and for investors.
Gregory Dunham is a Vice President in the equity research group of Credit Suisse Group, where he covers small-cap software companies. Previously, Mr. Dunham covered application software for Deutsche Bank. At Deutsche Bank he was instrumental in building the firm's software-as-a-service coverage and was part of the team that was selected "Best on the Street" by The Wall Street Journal in 2007. Before working as an Analyst, Mr. Dunham worked in the software industry implementing packaged applications in the late 1990s. Mr. Dunham received his MBA from New York University and a B.S. in mechanical engineering from the University of Wisconsin, Madison.
TWST: You have some "neutral" ratings and some "outperform" ratings on your stocks. Valuations are at historic highs and the stocks are also pretty volatile. Why is this a good time to invest in the space?
Mr. Dunham: I believe it's still a good time in general for long-term investors because while valuations are high, total SaaS market cap is still about $30 billion in total. I think putting that in perspective, that's a fifth the size of what Oracle (NYSE:ORCL) is. So we're still very early days. I also believe there is DCF analysis supporting current valuations for many companies. I believe that with growth these SaaS companies will show much more leverage than investors perceive because contribution margins on the renewal streams are very high.As the mix of renewals increases, these companies will generate significant cash flows. Now having said that, yes, relative valuations have moved to historic highs in the past few months. I think some of that is really due to two things. One, I think it's just a market phenomenon where you have very low interest rates, which increases the value of long duration growth stocks, number one.
So fundamentally you have lower discount rates, which make these growth stocks more valuable. So that is just a fundamental reason why. And I think the number two, the second thing that has helped some of the software-as-a-service stocks, is that they have exhibited good leverage on a free cash flow line through the recession. And I think that has increased investor confidence and the leverage, and the sustainability of that leverage going forward. They went from basically making 0% free cash flow margins in 2008 to on average posting close to 10%, so I think that is something that I think has garnered these companies to get a little bit more of a valuation multiple than historically. But that said, I don't believe you have the same level of near-term upside as you did in August when I launched on these names.
TWST: Are there any IPOs or M And A activity on the horizon that investors should keep an eye out for?
Mr. Dunham: I think there will be IPOs for sure. There are a lot of private software-as-a-service companies. I think the timing of that could vary, but there are many different interesting smaller software-as-a-service companies that will become public over the next few years, and some of the private companies may be acquired potentially by companies that are already public. Concur Technologies, Taleo, SuccessFactors - all three of these companies have raised significant amounts of cash to do M And A internally within the SaaS space. I do believe that you also may see companies like Oracle and SAP (NYSE:SAP), and other bigger software companies buy into software-as-a-service companies via acquisition. Having said that, I don't believe it's going to be as near term as perhaps other investors believe, and that's where I may differ than some others on the Street.
TWST: What are your top-rated names and why?
Mr. Dunham: My top two ideas right now are SuccessFactors and Ariba. SuccessFactors is growing the fastest. They will post probably north of 30% billings growth on an organic basis this year. They generate $0.20 on the dollar in free cash flow. So they generate good cash flow, they are growing the fastest, and they are releasing - they are evolving the product portfolio to really address a very big market opportunity. They've got pretty much five products that are coming out that each on its own could be a billion-dollar market in Inform, or their workforce analytics product. They also bought a company called CubeTree, which is a social collaboration platform for the enterprise. In addition, they have a new recruiting module that they've built with the help of their relationship with Siemens (SI) that has the potential to be very big. And the final pieces of that product that I mentioned earlier, the Employee Central product, which has the potential to be a full-scale HRIS system, which has a very big market opportunity.
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