It is hard not to like the long-term prospects for companies that provide Software As A Service (SAAS). Although there is plenty of hype, the move by companies worldwide to license software on a subscription basis and have it centrally hosted has a long way to run.
Instead of investing heavily in software and in-house hosting, a company can access software applications over the internet, paying only for what they use, and saving on upfront capital expenditure. With software applications hosted in the “cloud”, the potential cost savings and efficiency gains are enormous.
This trend, of course, is well known and priced into financial markets. It is so powerful, in fact, that loss-making companies such as Xero, a cloud-computing provider of accounting software, can have a $2.6 billion valuation and attract huge investment interest.
SAAS companies have almost text-book perfect business models, when the work. They deliver fat profit margins, recurring annuity-like income, and can rapidly scale the business worldwide without large extra investment in fixed assets. They are also sticky businesses: product-switching costs are high once the organisation embeds the software.
The best SAAS companies typically report heavy losses in their formative years as they expand rapidly to seize the opportunity. Xero is a good example. Investors will tolerate heavy losses to a point, because the SAAS company is ploughing surplus cash flow back into the business.
Valuing SAAS companies is the real challenge. Because many are unprofitable, traditional valuation metrics, such as Price Earnings (PE) multiples do not apply. Valuation methodologies such as a multiple of revenue to sales, or a price per subscriber, seem to be back in vogue to justify valuations. The last time they were used so heavily was before the dot.com crash.
Prospective investors need to think more laterally about SAAS winners. The easy approach, going straight for SAAS stgelopers, can overlook better opportunities elsewhere. For example, all the data from cloud-computing and SAAS needs to be hosted, and companies need service providers than can help “lift and shift” data to the cloud.
Take NextDC as an example. It listed on ASX in late 2010 through a $40 million float at $1 a share, and now trades at $2.39. NextDC is racing to cement a first-mover advantage as an independent data-centre operator with state-of-the-art facilities in Sydney, Melbourne, Brisbane, Perth and Canberra.
Chart 1: NextDC
NextDC also enjoys a stronger barrier to entry than the market realises. Data centres are much more than big industrial buildings with stacks of computer storage, and easily replicable by new entrants. Sophisticated technology is required and securing inner-city locations that access large amounts of energy, and water for cooling, is difficult.
NextDC’s 2014-15 guidance is revenue of $55-60 million and underlying earnings of $6-8 million. It is benefiting from strong growth in cloud computing and hosting: 45 per cent of Australian organisations are deploying cloud infrastructure architecture, according to Datacentre Dynamics. About 35 per cent of organisations worldwide are doing the same. Cisco Systems predicts global data-centre traffic will nearly triple over the next five years.
Another beneficiary is NEXTDC spin-off Asia Pacific Data Centre Group (APDC), which I first wrote about for The Bull in June 2014 at $1.07. APDC, an Australian Real Estate Investment Trust, now trades at $1.31, well above its latest Net Tangible Asset of $1.11 a unit.
Although I am wary of AREIT valuations after stellar gains in the last 18 months, APDC is a lower-risk way to play the cloud-computing and data-hosting trend, compared with NEXTDC or emerging software providers. It will benefit as NEXTDC signs up more customers, thus reducing APDC’s underlying tenant risk, as demand for hosting facilities keeps rising.
Chart 2: Asia Pacific Data Centre Group
Bulletproof Group, another cloud-related company, has recently caught my eye. The leading cloud-computing service provider raised $2.85 million and listed in January 2014 through the shell of Spencer Resources, in a so-called “backdoor listing”.
Such listings often suffer from lower market profile, and Bulletproof has fallen from 29 cents in March to 22 cents. Capitalised at $24 million, Bulletproof was the market’s first pure-play cloud-computing service provider. It has a good reputation and client base.
Chart 3: Bulletproof Group
Unlike most emerging SASS stgelopers, Bulletproof helps companies move to the cloud, meaning it is a lower-risk play on the cloud-computing trend. It is also profitable: underlying earnings in 2014-14 were $2.9 million and revenue is growing strongly.
Bulletproof is ideally placed as more companies need help to move to the cloud, but does not have the excessive valuation that characterises so many SAAS companies. As a micro-cap company, it suits experienced investors who are comfortable with higher-risk plays. Nevertheless, Bulletproof is among the more interesting long-term cloud-computing ideas at current valuations.
Tony Featherstone is a former managing editor of BRW and Shares magazines. The column does not imply any stock recommendations. Readers should do further research of their own or talk to their financial adviser before acting on themes in this article. All prices and analysis May 6, 2015.