When Tailwinds Vanish: The Internet in the 2020s (John Luttig)

[Liberty]

https://luttig.substack.com/p/when-tailwinds-vanish

 

Thought-provoking piece.

[Nomad]

Excellent article, thanks for posting.

 

Software spending is not invincible - it can and will decrease in a recession. Corporate IT departments cut back, consumers re-evaluate their subscriptions, and demand for e-commerce and cloud solutions falls as small and mid-sized businesses fail.

 

Since 2008, the tech sector has enjoyed one of the most favorable interest rate environments ever. Easy money has flooded into the system, propping up dubious "tech-adjacent" ventures with terrible unit economics like Uber, WeWork, and the scooter companies. It's hard to see how any of those companies get off the ground in a higher interest rate environment, if one returns someday. Investors have been all-too willing to slap nosebleed multiples on anything SaaS-related. It will be interesting to see if multiples on the public companies re-rate or if Greater Fool Theory and Buy the Dip prevail as the coronavirus lockdown persists.

 

Big Tech has also largely escaped antitrust regulation in the US - we haven't seen another US v. Microsoft type of case since 1998. A change in administrations or in public sentiment could lead to pressure to break up the titans. Anecdotally, I've already heard people say that Amazon should be split up and AWS separated from the retail segment of the company. If wealth inequality increases, it's possible that the public starts to view the FANGs as this century's Standard Oil. All of this is speculative, of course, but it gives me lots to think about.

[BG2008]

Liberty, thanks for posting this.

[Liberty]

[Broeb22]

For what its worth, I found this work to be highly opinionated without much in the way of actual data to support their perspective.

 

My personal experience having worked in finance in a mid-large city and now manufacturing in a more rural area is that many, many work processes continue to need to be improved/automated from the status quo, and the wave of adoption is adoption is a long, slow process.

 

I believe the author states that TAMs are wildly overstated, and I would agree that the founders' need to paint a pie-in-the-sky growth outlook to get VC dollars results in these wild TAM estimates.

 

To be clear, I'm not arguing tech SAAS companies are under- or even fairly valued, but simply that this author did not provide interesting or compelling evidence that there is some kind of competitive environment phase change happening that would cause SAAS companies to grow more slowly.

 

If the argument is that coronavirus somehow causes tech to be hurt anymore than any other industry, I could argue the exact opposite; namely, that the distance created by coronavirus and remote working validates the prior investments in software and cloud-based apps, and moving away from on-premise, paper-based work processes. Almost every half-decent software business probably accelerates its growth medium-term and pulls forward adoption because of this pandemic. 

[Liberty]

For what its worth, I found this work to be highly opinionated without much in the way of actual data to support their perspective.

 

My personal experience having worked in finance in a mid-large city and now manufacturing in a more rural area is that many, many work processes continue to need to be improved/automated from the status quo, and the wave of adoption is adoption is a long, slow process.

 

I believe the author states that TAMs are wildly overstated, and I would agree that the founders' need to paint a pie-in-the-sky growth outlook to get VC dollars results in these wild TAM estimates.

 

To be clear, I'm not arguing tech SAAS companies are under- or even fairly valued, but simply that this author did not provide interesting or compelling evidence that there is some kind of competitive environment phase change happening that would cause SAAS companies to grow more slowly.

 

If the argument is that coronavirus somehow causes tech to be hurt anymore than any other industry, I could argue the exact opposite; namely, that the distance created by coronavirus and remote working validates the prior investments in software and cloud-based apps, and moving away from on-premise, paper-based work processes. Almost every half-decent software business probably accelerates its growth medium-term and pulls forward adoption because of this pandemic.

 

I didn't get any of that from the essay, but that's why we have a market.

[Jurgis]

For what its worth, I found this work to be highly opinionated without much in the way of actual data to support their perspective.

 

My personal experience having worked in finance in a mid-large city and now manufacturing in a more rural area is that many, many work processes continue to need to be improved/automated from the status quo, and the wave of adoption is adoption is a long, slow process.

 

I believe the author states that TAMs are wildly overstated, and I would agree that the founders' need to paint a pie-in-the-sky growth outlook to get VC dollars results in these wild TAM estimates.

 

To be clear, I'm not arguing tech SAAS companies are under- or even fairly valued, but simply that this author did not provide interesting or compelling evidence that there is some kind of competitive environment phase change happening that would cause SAAS companies to grow more slowly.

 

If the argument is that coronavirus somehow causes tech to be hurt anymore than any other industry, I could argue the exact opposite; namely, that the distance created by coronavirus and remote working validates the prior investments in software and cloud-based apps, and moving away from on-premise, paper-based work processes. Almost every half-decent software business probably accelerates its growth medium-term and pulls forward adoption because of this pandemic.

 

My opinion about the article is similar to yours.

[Kaegi2011]

Does anyone have a good resource to read about the framework for how to think about these SaaS companies from an investor's perspective?  I get that incremental margins are super high and customers are sticky, and ROIC can be extremely compelling, but most analyst models I see are based on some model where profitability and cash flows don't come in until 5 years from now and then shoot through the roof.  While I certainly acknowledge that as a possibility, the key aspect that I don't understand is the stickiness of the customer base, or the moat around these businesses.  Low capital intensity and high margins are great, but doesn't that mean that the next company doing something in the space will have similar advantages?  I feel like i'm missing something in this puzzle that's critical to understanding at least how some portion of the investing public thinks about these opportunities...

[thowed]

To put it most simply, I believe 'stickiness' comes purely from human laziness. 

 

If you're an IT manager, changing software provider means a whole lot of hassle - putting the new system in, training employees who are rubbish with computers etc. etc.

 

Of course, it's a case by case situation, but I think this is quite a common situation.

[Broeb22]

Does anyone have a good resource to read about the framework for how to think about these SaaS companies from an investor's perspective?  I get that incremental margins are super high and customers are sticky, and ROIC can be extremely compelling, but most analyst models I see are based on some model where profitability and cash flows don't come in until 5 years from now and then shoot through the roof.  While I certainly acknowledge that as a possibility, the key aspect that I don't understand is the stickiness of the customer base, or the moat around these businesses.  Low capital intensity and high margins are great, but doesn't that mean that the next company doing something in the space will have similar advantages?  I feel like i'm missing something in this puzzle that's critical to understanding at least how some portion of the investing public thinks about these opportunities...

 

I think human laziness as commented below is part of it, but what company would you want to work for if every 6 months you had your IT department telling you, hey, this core part of what you do that I spent weeks teaching you and troubleshooting for you, we're changing it again. Unless a software is dramatically better than its competitor in terms of performance or cost or both, the incumbent has a huge advantage because if you're expending all this effort as an organization for some minor incremental gain, its not worth it to most people.

 

Unfortunately, the best advice I can give on this is to find helpful anecdotes, i.e. talk to customers who did and didn't make the switch.

 

I'll give a few examples that may be helpful.

 

I work at a manufacturing company where we have an ERP system that is a low-cost solution because mgmt doesn't want to invest millions in SAP. The IT director has said she has seen companies literally go out of business due to poor ERP implementations (these are generally smaller companies), so the barrier to changing that system for us is high.

 

As an example of a technology that is dramatically better that has gained acceptance, I would point to expense reporting. We use Rydoo, an app that I can simply take a photo of my receipt throw the receipt away, fill in some simple categories (rental car, airline ticket, etc.), and then submit, and I throw the receipt away right there. It's dramatically easier for users and for the payables clerk than whatever paper-based system we used before. When Bill.com went public, I read it and immediately compared it to Rydoo in understanding whether the solution is better. Based on what I read, Bill.com could be better because it handles all payables, not just expense reporting. So Bill.com solves a much larger problem than Rydoo and thus could be displaced.

 

You see Workday and Ceridian and a few other Human Resources IT systems taking share from incumbents, such as Paychex and ADP. When you read some of the stories comparing the functionality of payroll processing for these various services it becomes immediately obvious why the change is happening. For ADP/Paychex, payroll processing was a pretty manual, time-intensive process that was incapable of providing real-time visibility into the payroll period. By comparison, and I might be falling for the marketing bluster of Workday/Ceridian, as a payroll specialist at any company, you can run a report at any time to understand where payroll is trending, who is maybe abusing overtime, etc. From what I understand, this was simply impossible in the old system. With that said, we used Ceridian last year, and they fucked up big time once, which led us to switching to Paycom. Ceridian double-paid every employee in the company once. For most companies paying payroll is their largest expense so you can imagine the huge red flags this created within the company. With that said, the rollout of Paycom was not very smooth. They struggled to get the log-in terminals at each site working on time (which taxes plant mgmt., IT, HR, etc.) and I personally got pissed when the 401K integration between Paycom and our 401k provider was not working, so none of my 401K contributions were showing up in my account for 2 months. That snafoo could be a huge liability for a company because as a fiduciary of the plan they are responsible for depositing those funds in a timely manner, or else my company is on the hook for any gains in the investments I had requested in my 401k plan.

 

Finally, during my days as an analyst, while trying to understand CDK before it spun out, I was able to talk to the IT director at a local dealership, and in short every question I asked him was basically responded to with well that department would have to completely learn a new way to process a loan application, or the service department would have to completely change. So, rightly or wrongly, there was huge internal resistance to change, despite CDK baking in inflation+ price increases.

 

With those anecdotes as examples, the final point I would make is that the software company financials are somewhat reflexive in my opinion. This is kind of leadership-team dependent, but I would say broadly that everyone learned a lesson from Jeff Bezos, which is that you should spend aggressively to continue digging the moat around your product and expanding the use cases for the product. This makes it even more challenging to identify the winners from the losers ahead of time based on traditional consolidated financial metrics because if someone is succeeding they will push the gas pedal on expanding their business. So those 5-years from now projections can sometimes be elusive because a really, really successful company might push out that day of fully monetizing their customer relationships whereas a less successful company that sees its growth stall out may face pressure from investors to monetize the product more in the present, which can be a self-fulfilling prophecy of mediocrity. I think each management team needs to come to that realization themselves and understand "Am I a niche product?" or "Am I a platform for several technologies"? Most VC-funded founders will obviously do everything they can to avoid the "Shame" of just being an app, but in reality many will end up there or be swallowed up by the platforms like Salesforce, Google, Amazon, Facebook, Microsoft, etc. 

[Kaegi2011]

With those anecdotes as examples, the final point I would make is that the software company financials are somewhat reflexive in my opinion. This is kind of leadership-team dependent, but I would say broadly that everyone learned a lesson from Jeff Bezos, which is that you should spend aggressively to continue digging the moat around your product and expanding the use cases for the product. This makes it even more challenging to identify the winners from the losers ahead of time based on traditional consolidated financial metrics because if someone is succeeding they will push the gas pedal on expanding their business. So those 5-years from now projections can sometimes be elusive because a really, really successful company might push out that day of fully monetizing their customer relationships whereas a less successful company that sees its growth stall out may face pressure from investors to monetize the product more in the present, which can be a self-fulfilling prophecy of mediocrity. I think each management team needs to come to that realization themselves and understand "Am I a niche product?" or "Am I a platform for several technologies"? Most VC-funded founders will obviously do everything they can to avoid the "Shame" of just being an app, but in reality many will end up there or be swallowed up by the platforms like Salesforce, Google, Amazon, Facebook, Microsoft, etc.

 

Thanks for the long post.  I appreciate it.  :)

 

I guess maybe asking a related but different question - when I look at MSFT financials in 1992, it showed a company with 2.8bn in revenue and 1bn of EBIT/OI.  Obviously it was still growing quickly, so it's not like they were sacrificing revenue for profitability.  When I look at the a huge SaaS player like CRM now, I see 17bn of revenue and 450mm of EBIT/OI.  Obviously a bit of apples and oranges since lots has happened in the past thirty years, but I'm trying to figure out why these scaled SaaS companies are not more profitable at this point.  So is there a SaaS company that has shown what "normalized" P&L might look like?  I'm really curious to the trade off between topline growth and bottom line profitability, and to your point, are they building a castle like Bezos or substituting growth to mask an unprofitable (or not very profitable) business model? 

[Jurgis]

You see Workday and Ceridian and a few other Human Resources IT systems taking share from incumbents, such as Paychex and ADP. When you read some of the stories comparing the functionality of payroll processing for these various services it becomes immediately obvious why the change is happening. For ADP/Paychex, payroll processing was a pretty manual, time-intensive process that was incapable of providing real-time visibility into the payroll period. By comparison, and I might be falling for the marketing bluster of Workday/Ceridian, as a payroll specialist at any company, you can run a report at any time to understand where payroll is trending, who is maybe abusing overtime, etc. From what I understand, this was simply impossible in the old system. With that said, we used Ceridian last year, and they fucked up big time once, which led us to switching to Paycom. Ceridian double-paid every employee in the company once. For most companies paying payroll is their largest expense so you can imagine the huge red flags this created within the company. With that said, the rollout of Paycom was not very smooth. They struggled to get the log-in terminals at each site working on time (which taxes plant mgmt., IT, HR, etc.) and I personally got pissed when the 401K integration between Paycom and our 401k provider was not working, so none of my 401K contributions were showing up in my account for 2 months. That snafoo could be a huge liability for a company because as a fiduciary of the plan they are responsible for depositing those funds in a timely manner, or else my company is on the hook for any gains in the investments I had requested in my 401k plan.

 

Partially OT: It seems that W2s from Ceridian cannot be autoimported to TurboTax unlike the ones from ADP. Not that businesses care about what their employees have to do during tax time.  ::)

[Broeb22]

With those anecdotes as examples, the final point I would make is that the software company financials are somewhat reflexive in my opinion. This is kind of leadership-team dependent, but I would say broadly that everyone learned a lesson from Jeff Bezos, which is that you should spend aggressively to continue digging the moat around your product and expanding the use cases for the product. This makes it even more challenging to identify the winners from the losers ahead of time based on traditional consolidated financial metrics because if someone is succeeding they will push the gas pedal on expanding their business. So those 5-years from now projections can sometimes be elusive because a really, really successful company might push out that day of fully monetizing their customer relationships whereas a less successful company that sees its growth stall out may face pressure from investors to monetize the product more in the present, which can be a self-fulfilling prophecy of mediocrity. I think each management team needs to come to that realization themselves and understand "Am I a niche product?" or "Am I a platform for several technologies"? Most VC-funded founders will obviously do everything they can to avoid the "Shame" of just being an app, but in reality many will end up there or be swallowed up by the platforms like Salesforce, Google, Amazon, Facebook, Microsoft, etc.

 

Thanks for the long post.  I appreciate it.  :)

 

I guess maybe asking a related but different question - when I look at MSFT financials in 1992, it showed a company with 2.8bn in revenue and 1bn of EBIT/OI.  Obviously it was still growing quickly, so it's not like they were sacrificing revenue for profitability.  When I look at the a huge SaaS player like CRM now, I see 17bn of revenue and 450mm of EBIT/OI.  Obviously a bit of apples and oranges since lots has happened in the past thirty years, but I'm trying to figure out why these scaled SaaS companies are not more profitable at this point.  So is there a SaaS company that has shown what "normalized" P&L might look like?  I'm really curious to the trade off between topline growth and bottom line profitability, and to your point, are they building a castle like Bezos or substituting growth to mask an unprofitable (or not very profitable) business model?

 

 

Microsoft is probably one of those platform companies I should have included that are so dominant they almost can't help but be profitable. For what its worth, they might have evaded antitrust scrutiny for longer if they weren't so damn profitable.

 

Salesforce is one I've wondered about for some time. I would expect them to be more profitable, but if you look at their free cash flow, they generate 4.3 billion minus 1.8 billion for stock options minus 650 million CapEx. So ~$2 billion is not nothing. I would add back their D&A to EBIT (and subtract Capex) (D&A is ~3x CapEx) because they have done a lot of acquisitions so Amortization would be high. I don't necessarily think those acquisitions are bad if you think about them as line extensions in the same way you would Diet Coke as a line extension of Coke. To me, and after looking up these numbers again, Salesforce is just overvalued at about 70x EV to FCF. But 50% south of here with the double-digit organic growth they likely have and that's more interesting, but you still have to look at it like a Nifty Fifty type company to justify 35x. I'd be willing to bet they're growing organically about 12%, so that 35x multiple looks pretty attractive if you assume growth continues for 5 years. That is closer to a time frame I can bet on, whereas at 70x, I need 10 years of 12% growth just to get to a terminal multiple north of 20x. The one thing I ignore is that at 2 billion in FCF they're at a 12.5% margin. If there is a company not named Amazon that can compete with Microsoft in the enterprise Saas space, its probably Salesforce. If you look at Salesforce and get their margins in the direction of MSFT, you could justify long-term margins doubling to 25% or higher. I'm not saying I'd bet on that, but clearly some market participants are by valuing CRM that high.

 

I've made the point elsewhere on COBF but the accounting distinction of expensing employee costs vs. capitalizing CapEx means that looking at Saas companies on GAAP profitability will always leave you way behind. If I asked you what year Walmart went FCF positive after going public in Oct. 1970, would you be surprised that the answer was around Y2K? But they showed GAAP profitability the whole time so no one questioned that they were a legit business.

 

Sorry, got on a tangent there.

 

[Kaegi2011]

Microsoft is probably one of those platform companies I should have included that are so dominant they almost can't help but be profitable. For what its worth, they might have evaded antitrust scrutiny for longer if they weren't so damn profitable.

 

Salesforce is one I've wondered about for some time. I would expect them to be more profitable, but if you look at their free cash flow, they generate 4.3 billion minus 1.8 billion for stock options minus 650 million CapEx. So ~$2 billion is not nothing. I would add back their D&A to EBIT (and subtract Capex) (D&A is ~3x CapEx) because they have done a lot of acquisitions so Amortization would be high. I don't necessarily think those acquisitions are bad if you think about them as line extensions in the same way you would Diet Coke as a line extension of Coke. To me, and after looking up these numbers again, Salesforce is just overvalued at about 70x EV to FCF. But 50% south of here with the double-digit organic growth they likely have and that's more interesting, but you still have to look at it like a Nifty Fifty type company to justify 35x. I'd be willing to bet they're growing organically about 12%, so that 35x multiple looks pretty attractive if you assume growth continues for 5 years. That is closer to a time frame I can bet on, whereas at 70x, I need 10 years of 12% growth just to get to a terminal multiple north of 20x. The one thing I ignore is that at 2 billion in FCF they're at a 12.5% margin. If there is a company not named Amazon that can compete with Microsoft in the enterprise Saas space, its probably Salesforce. If you look at Salesforce and get their margins in the direction of MSFT, you could justify long-term margins doubling to 25% or higher. I'm not saying I'd bet on that, but clearly some market participants are by valuing CRM that high.

 

I've made the point elsewhere on COBF but the accounting distinction of expensing employee costs vs. capitalizing CapEx means that looking at Saas companies on GAAP profitability will always leave you way behind. If I asked you what year Walmart went FCF positive after going public in Oct. 1970, would you be surprised that the answer was around Y2K? But they showed GAAP profitability the whole time so no one questioned that they were a legit business.

 

Sorry, got on a tangent there.

 

Great info, thank you.  YOu're right that MSFT is probably an outlier, but I went back and looked at Oracle and ADBE, and they were profitable long before they reached the scale of CRM now.  From this filing it seems that ADBE reached ~30%+ OI margins at $300mm of revenue in 1990.  Granted, it grew from there from a topline perspective and bottom line did not improve.  https://www.sec.gov/Archives/edgar/data/796343/0000912057-95-000843.txt

 

Has there been material accounting changes to how software R&D is expensed?  New to the space so I don't have a lot of background on the history. Regardless, your point on FCF vs. EBIT/OI is fair - it probably does cut out the accounting noise between businesses to make better comparisons. 

 

I'm still trying to get my head around the moatiness of these businesses.  I think if you gave me 5bn dollars to replicate a Moody's or a Facebook or whatever, I don't think it can be done.  But it seems that a lot of these businesses trading at 10-20bn can be recreated with 5bn (maybe substantially less?)?  Am I way off as someone who's not dealt with software whatsoever in life? 

[Broeb22]

I guess I would guess that's where I would attribute lower margins for longer to founder preferences.

 

I wonder if older companies like Oracle maybe faced less competition from less well-capitalized competition, which allowed them to price things for profit earlier.

 

If you think about it, why would you go and compete directly against maniacs like Bill Gates and Larry Ellison if there was a profitable segment of the market that you could exploit without getting in their way.

 

Purely speculation, but if you view all of this in the lens of the wild west, the 90's was probably the time when a significant portion of people figured out that there was gold there. They saw the profits of Microsoft and Oracle and said I want some of that.

 

Now the gold is still there, but you have to be a lot smarter about avoiding the gaze of the giants while you're small so they don't crush you, because a lot of the landscape has been or is being settled.

 

Idk...I'm just spitballing here. Hopefully I'm a half-decent devil's advocate.

[Jurgis]

I guess I would guess that's where I would attribute lower margins for longer to founder preferences.

 

I wonder if older companies like Oracle maybe faced less competition from less well-capitalized competition, which allowed them to price things for profit earlier.

 

If you think about it, why would you go and compete directly against maniacs like Bill Gates and Larry Ellison if there was a profitable segment of the market that you could exploit without getting in their way.

 

Purely speculation, but if you view all of this in the lens of the wild west, the 90's was probably the time when a significant portion of people figured out that there was gold there. They saw the profits of Microsoft and Oracle and said I want some of that.

 

Now the gold is still there, but you have to be a lot smarter about avoiding the gaze of the giants while you're small so they don't crush you, because a lot of the landscape has been or is being settled.

 

Idk...I'm just spitballing here. Hopefully I'm a half-decent devil's advocate.

 

I disagree that Oracle did not have competition. They did. So did Microsoft.

 

Why were they still profitable? Perhaps because before the Internet bubble nobody financed profitless growth much or for long. 20+ years ago it would have been difficult to sell huge potential TAMs to investors. Some companies could but it was likely more difficult and rare than it is now. (I am not saying that selling huge TAMs and profitless growth is bubble or irrational on the investor side, I'm just saying that the attitude towards this has changed a lot.)

[Kaegi2011]

I guess I would guess that's where I would attribute lower margins for longer to founder preferences.

 

I wonder if older companies like Oracle maybe faced less competition from less well-capitalized competition, which allowed them to price things for profit earlier.

 

If you think about it, why would you go and compete directly against maniacs like Bill Gates and Larry Ellison if there was a profitable segment of the market that you could exploit without getting in their way.

 

Purely speculation, but if you view all of this in the lens of the wild west, the 90's was probably the time when a significant portion of people figured out that there was gold there. They saw the profits of Microsoft and Oracle and said I want some of that.

 

Now the gold is still there, but you have to be a lot smarter about avoiding the gaze of the giants while you're small so they don't crush you, because a lot of the landscape has been or is being settled.

 

Idk...I'm just spitballing here. Hopefully I'm a half-decent devil's advocate.

 

I disagree that Oracle did not have competition. They did. So did Microsoft.

 

Why were they still profitable? Perhaps because before the Internet bubble nobody financed profitless growth much or for long. 20+ years ago it would have been difficult to sell huge potential TAMs to investors. Some companies could but it was likely more difficult and rare than it is now. (I am not saying that selling huge TAMs and profitless growth is bubble or irrational on the investor side, I'm just saying that the attitude towards this has changed a lot.)

 

I kinda agree with both here.  A few decades ago the "new" tech back them is now the backbone of everything now, so the most pressing needs of the day were solved that way (e.g., database).  But because the cost of starting up something is fairly enormous, only a few were able to make it to be a decent size, and dominated the markets.  Now, startup costs are very low, so more competitors, and going after more niche spaces (or competing with giants with a totally diff product like Slack), with investors who are willing to fund burn rates further at the name of growth (the last one TBD - something I believe in, but don't have empirical evidence is happening). 

 

So... I'm still trying to find how to value these damn things.  :)

[Guest cherzeca]

Does anyone have a good resource to read about the framework for how to think about these SaaS companies from an investor's perspective?  I get that incremental margins are super high and customers are sticky, and ROIC can be extremely compelling, but most analyst models I see are based on some model where profitability and cash flows don't come in until 5 years from now and then shoot through the roof.  While I certainly acknowledge that as a possibility, the key aspect that I don't understand is the stickiness of the customer base, or the moat around these businesses.  Low capital intensity and high margins are great, but doesn't that mean that the next company doing something in the space will have similar advantages?  I feel like i'm missing something in this puzzle that's critical to understanding at least how some portion of the investing public thinks about these opportunities...

 

stratechery.  a subs newsletter.

[vinod1]

Kaegi2011,

 

So much has changed in software with rise of cloud computing and SaaS.

 

1. In the past, packaged software sales era, companies used to get paid a lump sum right up front when they sold the software. SaaS companies get paid over a long period. When there is rapid growth it can obscure profitability.

 

2. Costs also were different in the past when companies used to do a big waterfall releases. Also for many SaaS companies costs are much more incremental than in the past due to use of cloud.

 

So I would not use 1980s or 90s earnings multiples, operating metrics to compare with SaaS.

 

Also you would want to differentiate between consumer based SaaS provides with enterprise focused SaaS providers. They have different types of moats. Enterprise SaaS is lot more sticky for reasons mentioned in the thread.

 

Just pick 30-40 SaaS companies and go through the AR's and presentations. You would pick up from the links. I used to work in enterprise software so it is a bit easier for me or not (tough to get rid of biases).

 

Vinod

[vinod1]

It is tough to value these companies even accounting for growth and come up with a price. So I create more of an upper bound, lower bound and a more realistic one based on my expectations of what operating margins such a business is likely to generate, what its addressable market would be and what it might expand into, likely dilution, etc.

 

A huge amount of value is being created by this industry and it would be good to keep an eye out even if you do not end up buying something right away.

 

Vinod

[Kaegi2011]

It is tough to value these companies even accounting for growth and come up with a price. So I create more of an upper bound, lower bound and a more realistic one based on my expectations of what operating margins such a business is likely to generate, what its addressable market would be and what it might expand into, likely dilution, etc.

 

A huge amount of value is being created by this industry and it would be good to keep an eye out even if you do not end up buying something right away.

 

Vinod

 

Vinod - Thanks for the response.  I have gone through some S1/10K/IR materials for some of them, but the one thing I struggle to really figure out is how much of their expenses are "growth" vs. "maintenance."  This is further complicated by the fact that when you have negative churn, which many of these guys have at cohort level, it's close to impossible to figure out true LTV.  This means whenever I try to put something in excel the outcomes are a mile wide as I don't have enough intuition or experience to put in numbers I believe in (or right now, when backing into a valuation, margins and growth rates that I don't know how to get comfortable with). 

 

It would be incredibly helpful given your experience if you can lay out an example of how you go figuring out the boundaries for a specific co.  What I read from analyst research seems to just be growth + opex declining and viola - fantastic business in 5 years (and then I look at CRM and I don't see the same margin profiles for the out years!).

[vinod1]

Kaegi2011,

 

I think you have identified the key problems. I do not think I would be comfortable putting up an excel to model the vast majority of these companies.

 

The main thing for me would be to nail down the competitive advantage. So it is a case by case basis. Why it it sticky? What are the switching costs? What is the alternative?

 

I am still learning about many of these and filling in the missing pieces. So for some I have someone I know who works at the company or works at company that uses this product and that is the only way I am able to make progress. So it is slow going.

 

So it is easier for me atleast if the company had a software license or some legacy background that is transitioning to SaaS. These which have a longer history are a good starting point. Adobe being the canonical example.

 

So a firm like Guidewire is a good example. The company provides software for P&C companies. So pretty niche. Leader in the space by a smallish amount. A couple of competitors. If you read up it is not too difficult to see the competitive advantages.

 

So you are really talking about what % of market it can capture and what normalized operating margins would be at some time x in the future. That is the extent of my modelling to see if it makes sense. I get a wide range and even in this case not really actionable most of the time.

 

Vinod

 

 

[Spekulatius]

^ Good comments from Broeb22 above. My  company started to use Workday and it is for better then the system we had before (Kronos and some SAP integration) just from a user experience perspective.

 

Another thought - most of the benefits of new technologies over time should accrue to the users over time. Maybe that’s already happening, but it doesn’t quite feel that way.

[Kaegi2011]

Vinod - appreciate the response.  Gonna try to dig deeper to find someone who can explain how this all works b/c I feel like I'm really missing the forest here.  :)