How to quickly understand a SaaS company?

Despite significant fluctuations in the Cloud market in recent times, with EMCLOUD Index's total market value dropping to $1.4 trillion in May 2022, half of its peak in 2021, we believe that the consensus on the SaaS business model should not be affected. The cloud-based business model is the most important paradigm shift since the invention of the Internet, and the prospects and potential of the SaaS/Cloud industry still exist and will continue to grow, even if the market's fluctuations may persist for some time.

This article is from BEDROCK member Barry and is based on his discussions with the team.

How to quickly understand a SaaS company?

Collection of important basic information of the company

Q1：Who in the client company is using this SaaS software? Who made the decision to purchase this SaaS?

Q2：What are the different SaaS solutions used for in the company? What solution did the client use before using this SaaS?

Q3：Why does the client need to use this SaaS? What are the underlying trends and driving forces behind it?

Q4：Collecting client-related information.

The Source of Competitive Barriers for SaaS Companies - Deep Dive

Why study and differentiate the different competitive barriers of SaaS companies?

The research is for investment decision-making, and decision-making requires pricing. Currently, most SaaS companies have not yet turned a profit. One of the important factors affecting the pricing of SaaS companies is the achievable operating profit margin when a company's revenue grows at the rate of inflation. There are many factors affecting the operating profit margin, but we believe that the biggest factor is the level of a company's competitive barriers. The differences in net profit margins that each company can achieve have not been fully discussed in the market. Therefore, it is necessary to distinguish the potential net profit margins of different companies, and the basis for this is the different companies' competitive barriers.

Some mature software companies have significant differences in operating profit margins over the past decade.

For some background, here is a look at the performance of some long-standing software companies:

1. Oracle (ORCL), in order to maintain a 1% revenue compound annual growth rate (CAGR), spends around 20% of its revenue on sales and marketing (S&M) expenses and around 17% on research and development (R&D) expenses, achieving an operating profit margin of around 35%.

2. SAP, in order to maintain a 6% revenue CAGR, spends around 25% on S&M expenses and 15% on R&D expenses, achieving an operating profit margin of around 24%.

3. Autodesk (ADSK), in order to maintain an 8% revenue CAGR, spends around 40% on S&M expenses and around 30% on R&D expenses, resulting in significant fluctuations in operating profit margins, which are around 10%.
   

As for Adobe (ADBE) and Microsoft (MSFT), both have successfully transitioned to the cloud, found new growth businesses, and maintained double-digit growth in FY2021.

• ADBE achieved around 20% revenue growth, 27% in S&M expenses, 16% in R&D expenses, and 37% in operating profit margin.

• MSFT achieved approximately 17% revenue growth, with both expenses at around 12%, and an impressive 41.5% in operating profit margin, thanks to its larger scale and stronger competitive barriers. While ORCL's growth rate has fallen below inflation, ADBE can still maintain double-digit growth, and MSFT has achieved over 40% in operating profit margin with a larger scale and stronger competitive barriers. With so many SaaS companies in the market, there will likely be significant differences in operating profit margin in 10 or 20 years.

Sources of SaaS Switching Costs:

For the software industry, the biggest source of competitive advantage is generally considered to be switching costs. However, the differences in switching costs between each company have not been fully discussed, and some commonly used metrics such as LTV and CAC only reflect the final competitiveness. The following is a summary and ranking of the sources of switching costs for SaaS companies, and the strength of each source for some companies in the cover. This is only a qualitative analysis and thinking framework, not a quantitative assessment. The darker the color, the higher the strength of this source compared to others.

Lack of SMB exposure：

1. Small customers may not strictly be a "switching cost" in the traditional sense, but natural customer churn is one of the direct reasons for customer churn rate. According to data from the U.S. Small Business Administration, from 1994 to 2018, 32.4% of SMBs in the United States went bankrupt within two years, and 51.2% went bankrupt within five years.

2. The choice of market and product determines the users of each SaaS company, and when the company's customers are small businesses, there is a risk of customer churn due to natural business failure.

   1. NOW and SNOW's product focus is to solve problems for enterprises, so their exposure to SMBs is relatively low (although this also limits their runway to some extent).

   2. In comparison, MDB and DDOG, which spread through a freemium model and can be used immediately, have very impressive growth rates and S&M efficiency when their products gain consensus among SMBs and cross the chasm. However, in the long run, they face the risk of customer churn due to natural business failure among these SMBs.

Heavy Deloyment:

The installation cycle of a product is also related to the needs that a company chooses to meet. For example, NOW solves the problem of isolated IT workflows in large enterprises, and the deployment cycle is long. Similarly, SNOW also has a long deployment cycle because it needs to integrate various data sources into the snowflake platform. Other products, such as CRM, are relatively easy to install and use, and can be deployed and used by SMBs themselves. The nature of these products is clearly different from that of NOW and SNOW.

Training Cost:

The training cost is sometimes divided into two groups of people: one group is the IT personnel who use products like NOW or the security personnel who use CRWD; the other group includes all employees who use NOW for tasks like reporting issues and all employees who install CRWD.

The training cost is lowest for DUCO and OKTA because there is little training required and the usage habits are simple. The highest training cost is for ADBE, while the differences in training costs for other companies' products are not as significant.

Data Consolidation：

The highest ones include SNOW (which literally involves moving data and costs money), CRM (which involves the accumulation of customer information), MDB (as a non-relational database), and products like ADBE, CRWD, and OKTA which may not involve much data accumulation.

Of course, the importance of data content is also a very important measure. For example, compared to MDB, ORCL's database is a mission-critical database and has a higher switching cost.

Comprehensive offering & synergy:

For example, if a customer of NOW uses more than 3 products, the gross retention rate for these customers is 99%. When multiple products are used together to provide synergy, the switching cost is definitely increased, enhancing customer stickiness.

Looking at CRM, we believe that there must be synergy between sales, customer service, and marketing products, all of which are related to acquiring and serving customers, or what the company calls "customer 360". However, we feel that the data analytics tool Tableau and collaboration tool Slack, which were acquired, have little synergy with the company's original products.

PLG companies like DDOG may rely on continuously launching new products and achieving comprehensive offerings in the future to reduce customer churn rate.

Customer Conservativenss：

Many "Product Led Growth", "Freemium", and "open source" software are for programmers, and this growth strategy seems to be more successful when programmers are the users, as seen with companies such as DDOG and MDB. When demand rapidly increases in the background, the best product will be discovered, spread and used. However, the problem is that when there are new products on the market, customers who like to try new things may move on to the next product. In contrast, for example, police departments and cybersecurity personnel should be more conservative when making decisions, and will not actively try new things unless there is a significant issue.

Lack of Potential Alternatives：

Competitors can generally be divided into four categories:

• New startups aiming to provide SaaS products in the same space.

• Other established SaaS companies entering the same market.

• Legacy players transitioning to cloud-based services.

• Tech giants entering the market.

Supply-side know-how barriers can also be reflected here:

For example, SaaS in the front office is generally relatively easy to develop. NOW has entered the customer service and HR fields of CRM and Workday, respectively, and ADBE has also entered the marketing field of CRM. However, it is difficult to imagine CRM and Workday developing products to solve enterprise IT workflows.

UBS customer check on NOW's product:

Network effect：

• The strongest network effect is seen in ADBE. Since the company requires designers who know how to use ADBE, designers tend to learn it early on and relevant courses are also available in universities. This network effect helps achieve lower CAC when facing SMB and individual customers, compensating for the lower LTV caused by SMB churn rates.

• Other companies have weaker network effects. For example, SNOW is building a data marketplace and there is a slight workflow improvement when both companies use DUCO, resulting in a weak network effect.
  

Competition barriers are only one of the factors that affect the final operating profit margin, and the scale that a company can eventually achieve also has a great impact on the margin. Overall, due to strong competition barriers and the potential for achieving a larger scale, companies such as NOW, SNOW, and CRWD have strong confidence in achieving higher long-term operating profit margins. In contrast, companies such as DOCU, OKTA, and MDB, although they can achieve gross profit margins of 70-80%, may have smaller final scale due to lower competition barriers and fewer opportunities to enter new markets, resulting in potentially lower operating profit margins.

Reminder: The discussion of these individual stocks should not be taken as investment advice.