If you jumped in a time machine and went 20 years ahead, what would you find?
Some people believe you'd see that Americans barely own any of the things we traditionally have called "ours" as a the result of the sharing economy. In this hypothetical future, autonomous fleets of electric cars will replace the need for garages, and you will no longer need to own tools for random fixes around the house because they'll be provided in a moment's notice by a drone.
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The goods and services a person needs will be secured because of access, not direct ownership. There is one area of the economy where this has already happened: software.
As recently as a decade ago, you needed to buy an expensive software license to download an operating system or add other applications to your computer. Today, you pay a small monthly subscription fee for access to software that exists in the cloud, where it is maintained and seamlessly updated. It's called software-as-a-service, and it has the potential to create impressive results for investors. There are several software-as-a-service companies worth investigating.
What is software-as-a-service?
To explain this business model, let's break it down to its most basic pieces. What is software? It is any program that can run on a computer or smartphone. The device you hold in your hand is the hardware; the programs and apps you use on them are software.
In the past, download licenses, CDs, or floppy discs with the software on it were fairly expensive one-time purchases. You then installed that software onto your computer, and shelled out the cash for a new version when an important update came out for the software.
That all changed with the onset of the internet and the growth of cloud computing, which uses servers in a separate, centralized location to house and handle large computing tasks. Cloud computing then allows the necessary data to be accessed on demand with a simple internet connection. That change allows companies to give people access to its software programs easily, for a fee, through the internet.
That's the basis of software-as-a-service, or SaaS. The new business model has a host of attractive features for SaaS companies, their customers, and shareholders. Companies benefit from improved efficiencies by not having to manufacture any physical products, customers love that they can use a program or platform at lower subscription prices and benefit from real-time updates to software, and investors enjoy the reliable revenue streams that come with a subscription model.
Perhaps most importantly, the economic moat -- or sustainable competitive advantage -- a SaaS company enjoys is much wider than before. In the past, software companies needed large sales and marketing budgets to advertise each new iteration of their software. Every time a product cycle came up, customers could potentially choose a new provider.
Now, customers are more locked in with a company because of high switching costs. With the ability to update software instantaneously via the cloud and the introduction of monthly subscription fees, there are no "update cycles" to worry about. The more a customer uses a SaaS provider's software, perhaps adding new applications along the way, the more embedded it becomes in that person or company's workflow and daily needs. Switching away to a new provider not only becomes expensive (there's likely lots of data to migrate), it also has the potential to become an enormous headache as people need to learn an entirely new interface and ecosystem. That's a headache most customers want to avoid -- and it's a huge boon to SaaS investors.
What are the key metrics for evaluating SaaS businesses?
Assessing a SaaS company's ability to find new customers and keep them within their ecosystem are critically important. While traditional metrics including price-to-earnings (P/E) or price-to-free-cash-flow (P/FCF) play a role, these stocks are frequently richly valued on that basis, so digging deeper offers a better picture.
When it comes to making sure customers stay with a business, some companies use revenue retention rate (RRR), and others use dollar-based net expansion rate (DBNE); both measure the same thing. The figures consider all of the revenue from existing customers in the first year, and compare it to all revenue from the same set of customers in the second year. This approach ignores the effect of new customers to look at churn, or the loss of a customer, and how effectively new customers are purchasing new services.
This helps give clarity as to whether customers are sticking with an SaaS company -- and whether those who do spend more money on additional products. If a DBNE or RRR is below 100%, that means customers are leaving the platform. If it's at 100%, that means customers are staying, but not adding new products. If it's above 100%, that means not only are customers staying, they're also incorporating new services over time. This makes the lifetime value of each customer even greater.
Because the SaaS model largely locks customers in, a well-functioning company should be spending less and less of its revenue on sales and marketing over time. That's because convincing existing customers to add new products shouldn't require an entire sales department. If a product speaks for itself, it should sell add-on products itself.
The best way to measure this is to compare growth in revenue versus growth in sales and marketing from year to year. As long as the former grows faster than the latter, it means customer acquisition costs are going down.
The subscription business model also includes the use of another specific metric: annual recurring revenue, or ARR. When a new customer signs on to a service, they may have only paid a month or two of fees when the quarter ends. Those payments don't reflect the full value of the subscription. ARR takes the monthly payments that are made at the end of the quarter and tells you what the full year's subscription revenue would be if carried out the full 12 months. ARR gives a better view into the health and growth of an SaaS company's revenue streams.
Top software-as-a-service stocks
What It Does
Axon Enterprise (NASDAQ: AAXN)
Makes stun guns and police body cameras, and created Evidence.com platform for analyzing body camera footage.
Zuora (NYSE: ZUO)
Helps existing companies transition into subscription-based ones.
Veeva Systems (NYSE: VEEV)
Provides cloud solutions for pharmaceutical drug companies to store their data.
Paycom Solutions (NYSE: PAYC)
A business platform that tracks all human-resources-related functions including paychecks and health benefits.
Zendesk (NYSE: ZEN)
Has created a suite of customer service software tools for businesses.
AppFolio (NASDAQ: APPF)
Helps track data for property management companies and small legal firms.
New Relic (NYSE: NEWR)
Runs application performance management (APM) software, which helps companies monitor how well their own apps are running.
Technically, Axon is not a pure-play SaaS company. It was known as TASER International previously, and its stun guns still account for the lion's share of sales. The company's pivot toward body cameras and creation of a SaaS platform -- Evidence.com -- is the real story here.
The website serves as a storage database for all of the footage shot on body cameras by police officers. The footage can be searched, analyzed, and shared with other districts. Subscription revenue from the SaaS offering jumped 76% in the most recent quarter, and gross profit from the same division jumped 97% -- showing impressive leverage.
While Axon doesn't provide RRR or DBNE statistics, the number of total software seats booked on Evidence.com is a great indicator of the health of the offering. At the end of 2015, there were 45,900 seats booked on Evidence.com. As of the most recent quarter, that number has sky-rocketed to over 300,000 -- thanks in part to Axon acquiring its main rival, Vievu.
The company is already field-testing its second SaaS offering: Axon Records Management, which is expected to be released in mid-2019. The application aims to record unstructured video and audio files and transfer them into accurate and detailed police reports. The end result would be that police officers spend less time on paperwork and more time doing other parts of their jobs.
Zuora's mission is to bring every company into the "subscription economy." While this isn't technically the same as transitioning every company to SaaS, it has a shared goal of locking customers into an ecosystem via high switching costs and giving companies much more reliable, recurring revenue streams.
Legacy enterprise resource planning (ERP) software, Zuora believes, is ill-suited to handle the back-office and billing demands required by subscription-based companies. At least, that's the view that founder and CEO Tien Tzuo got when he was working at SaaS behemoth Salesforce.
While Zuora technically gets revenue for both subscriptions and professional services, the former is the only one worth paying attention to. Professional services are just an on-boarding service offered to new users; the division actually runs at a loss and doesn't reflect any underlying strength at the company.
Since the end of 2015, annual recurring subscription revenue has increased 91% to $130 million. Even more important is that during the first quarter of 2018, Zuora's DBNE came in at 112%, meaning not only that customers were staying with Zuora's subscription billing software but adding more functionality over time.
Like Zuora, Veeva's founder and CEO Peter Gassner is a former Salesforce employee. Gassner realized that pharmaceutical companies had very specific needs when it came to cloud software -- needs Salesforce wasn't able to meet.
Veeva has two primary offerings: its legacy customer relationship tool, Veeva CRM, which is a cloud-based customer relationship management tool, and its newer, more robust offering, Veeva Vault. Vault has been a real coup for the company as it adds new functionality every year that helps drug companies keep track of everything necessary to bring a compound from the idea stage, through clinical trials, and to the market.
Revenue at the company has jumped 77% to $724 million since the end of 2015. At the same time, existing customers keep adding more and more solutions over time -- primarily through Vault's numerous offerings. The RRR at Veeva was a whopping 121% at the end of last year. And the company's solutions have become so popular that Veeva is now testing out a secured cloud solution for companies outside of the pharmaceutical sector as well.
Paycom is attempting to disrupt the legacy model of payroll simplification being a company's main focus by offering paycheck solutions within an SaaS solution, and expanding the scope of what can be tracked on a single platform. Instead of only monitoring paychecks, human resources departments that use Paycom can track recruitment, hiring, health benefits, planned time off, and various other tasks by adding on other software at an additional charge.
The company has been winning over small and medium-sized businesses in droves. At the end of 2013, it had 10,000 customers. By the end of 2017, that client list had jumped all the way to 20,600. Recurring revenue has followed suit, quadrupling over the same time frame to $433 million.
Perhaps the most important factor for investors to know is that the company has been able to keep its RRR steady at 91% for the past three years. On one hand, this may sound ominous. The company is losing 9% of its business every year? On the other hand, it's important to remember that Paycom serves small businesses, many of which naturally have a high failure rate. That's to be expected in a healthy capitalist economy, and it shouldn't count against what Paycom has accomplished.
Zendesk's software makes easily customizable methods for companies to handle customer service, including options such as chat and call centers. Zendesk Guide helps a company track all of its interactions with customers to allow for more seamless communication over time, and Zendesk Insights takes all of the data a company accumulates about these interactions and analyzes it in one easy-to-use interface.
The number of companies using Zendesk has grown rapidly -- up 72% over the past three years to 118,900 -- and it has some major companies using its platform such as Netflix, Airbnb, and Stanley Black and Decker.
At the same time, revenue has quadrupled since the end of 2014 to $508 million. As with the other companies on the list, Zendesk's DBNE has been very impressive, clocking in at 119% at the end of 2017. As customers get familiar with Zendesk's offerings, they are not only happy with what they have, they are also adding more and more tools to their subscriptions.
AppFolio was the brainchild of two California technology gurus who realized that SaaS would be the wave of the future. They went looking for industries that would benefit from customized SaaS solutions and set about creating the perfect product.
AppFolio got its start by offering property management companies a platform where they could track payments potential renters, host websites, monitor maintenance requests, and track leads. The number of property management clients on its roster has grown from 4,000 in 2013 to over 12,000 today. All the while, the company has done a great job of retaining customers and having them add more tools -- the division's DBNE was 112% last year.
With the acquisition of MyCase in 2012, the company added support for attorneys and small legal firms. Those who use AppFolio's SaaS are able to organize things such as case information and record billable hours on a single platform. While this part of the business is much smaller, it also sports a very strong DBNE of 113%.
Put together, these two SaaS solutions have helped AppFolio double its revenue since the end of 2015.
Thirty years ago, information technology departments were primarily responsible for making sure a company's desktop computers were working and communicating effectively with the in-house servers. Those days are long gone, and the list of responsibilities is now much longer.
New Relic aims to help these beleaguered departments handle the volume of work they have to cover by taking all of a company's software applications and monitoring them on a single platform. The technology is impressive, and customers are signing up in droves. Over the past five years, New Relic's paid accounts have grown 87% to 17,000. Gartner estimates that the market for this type of APM software is growing roughly 18% per year, and that it could continue to expand.
Recurring revenue, though, has grown even faster, sextupling to $355 million over the past 12 months. That's largely because existing customers have been adding more and more functionality over time. Last year, the company's DBNE clocked in at an eye-popping 141%!
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Brian Stoffel owns shares of AppFolio, Axon Enterprise, Netflix, New Relic, Paycom Software, Veeva Systems, and Zendesk. The Motley Fool owns shares of and recommends Axon Enterprise, Netflix, Paycom Software, Salesforce.com, and Veeva Systems. The Motley Fool owns shares of AppFolio and Zuora. The Motley Fool recommends Gartner, New Relic, and Zendesk. The Motley Fool has a disclosure policy.