Investing in SaaS

-- Software as a service (SaaS) companies have been among the best performing stocks over the last decade.

-- The SaaS market will continue to grow over the coming decade due to tailwinds like digital transformation, cloud computing, and remote work.

Favorable Traits of SaaS Businesses

-- Large markets: Of 45 recent SaaS IPOS, the average reported TAM was ~$15B.

-- Profitability: Many SaaS companies report gross margins in the 70% ballpark.

-- Recurring Revenue: Stable and predictable revenue from subscription model.

Some Key Data Points

1/ Revenue Growth

-- Many SaaS businesses are not profitable and their valuations are based on growth prospects.

-- Constant revenue growth is key. For example, $SNOW recently reported net income of (-$168M) but it grew revenue an extraordinary 118% YoY.

-- For private SaaS companies with over $20M in recurring revenue in 2019, the average annual growth rates was 43%.

-- For a SaaS company going public, the expectation is minimum annual recurring revenue greater than $100M and growth rates of at least 25%.

2/ Customer Retention Rates

-- Dollar-based net retention describes how much money a company makes from a cohort of customers.

-- It reflects increased and decreased spend as well as customer churn. It provides insight on the success of a company's products.

-- Dollar based net retention greater than 100% means that a company can grow revenue even without adding new customers.

-- For top SaaS companies in 2019, the median net revenue retention rate was ~117%. For a high-flier like $SNOW, net revenue retention was 162%.

-- Dollar-based net retention is a helpful way to assess the relevance and appeal of a company's offerings. The rates should be increasing or staying constant.

3/ SG&A Expenses

-- Early on SaaS companies often invest heavily in sales and marketing to fuel growth.

-- These expenses facilitate customer acquisition, but they should decrease over time as a company's products gain recognition.

-- For example, as a percent of revenue, $CRWD's SG&A expenses were 77% in Oct. 2019. In Oct. 2020, they were 62%.

4/ Margin Expansion

-- As a company grows its customer base and improves cost management, its operating margins should expand.

-- For example, $CRWD's operating margin in Oct. 2019 was (32%) but in Oct. 2020 it had improved to (10%).

5/ CAC Payback Period

-- Simply defined, this is the cost of acquiring a customer (CAC) compared to the customer's expected lifetime value (LTV).

-- If LTV exceeds CAC, the company has positive unit economics and, on balance, makes money from each customer.

6/ Sticky Products

-- Ideally the company makes products that have high switching costs or serve essential functions.

-- For example, $ADBE has high switching costs. Its design software is the industry standard and it's what many designers learn on.

-- $ADSK is another example. It's computer assisted design software is also industry standard.

-- $BL exemplifies an essential function. Its software automates the financial close process. Once a customer integrates the software, they'll be unlikely to switch.

In Closing

-- Many SaaS companies appear positioned to continue to outperform the market over the coming decade. But given the competitive and fast-evolving landscape, it is essential to monitor a company's performance to make sure it's still on the right track.