The information-technology sector of the S&P 500 Index surged 37% last year, almost double the advance of the benchmark index.
Driven by strong financial performance, the tech sector is currently trading at a modest price-to-earnings ratio premium to the S&P 500 SPX, +0.34% Given elevated market valuations, corrections are always possible, particularly in growth tech, as seen most recently when the sector dropped 10.6% from Jan. 26 through Feb. 8 — in line with increased volatility in the S&P 500 — only to rebound almost 9% in the following week as investors’ focus shifted back to fundamentals. Over the past few years, these corrections have created buying opportunities for higher-multiple technology stocks.
Some of the more interesting opportunities are in sub-sectors such as software as a service, or SaaS, where valuations appear stretched on the surface. However, the multiples of high-quality cloud-based SaaS providers are more attractive than initially meets the eye.
Salesforce.com Inc. CRM, +0.50% surged 49% in 2017, while the stock has quadrupled since the start of 2012. Over that time, the company has had cumulative net losses of $535.8 million, including a $169.3 million net profit in fiscal 2017.
As a result, Salesforce.com is trading at a P/E of 85 for 2018 and 65 for next year, making the stock look extremely expensive compared with 2019 P/E ratios of 23 for Microsoft Corp. MSFT, +0.80% 15.6 for Oracle Corp. ORCL, +0.42% and 17.4 for Germany’s SAP SE SAP, -1.08% legacy software companies that each generate substantial net income.
Other SaaS companies have similar multiples. For 2019, Zendesk Inc. ZEN, +0.54% trades at a P/E well north of 100, Workday Inc. WDAY, -0.82% has a P/E of 106, ServiceNow Inc. NOW, +0.12% is at 53.6 and Ultimate Software Group Inc. ULTI, -0.10% is at 37, all optically much more expensive than their profitable legacy counterparts.
The difference between under-earning subscription-based software providers and on-premise companies is that sales at the former are rising at a much faster clip and the companies are investing aggressively to capture that demand. Cloud-based SaaS companies generate subscription gross margins of around 80% and lose a relatively low number of customers each period through so-called churn, giving them attractive underlying unit economics and making it logical for them to spend to generate demand where the returns are understood.
In fiscal 2017, Salesforce.com spent $3.92 billion, or 47% of its $8.39 billion total revenue, on sales and marketing. By contrast, Microsoft allocated 17% of $90 billion in revenue in fiscal 2017 to sales and marketing.
That investment by SaaS businesses is converting to top-line growth. While revenue forecasts for Microsoft call for a 24% gain for the five years through 2019, Salesforce.com’s sales are projected to surge 130% during the same period.
As sales increasingly come from large enterprises, Salesforce.com’s guidance suggests aggregate churn somewhere in the high single digits and falling, which translates into an average subscription life of 12 years. Such stickiness among users allows for greater confidence in longer-term forecasting for the company. At its most recent analyst day, Salesforce.com suggested that Sales Cloud, its largest and most mature product, is already generating what the company terms economic profits — akin to operating margin — of 30%.
Salesforce.com’s growth is being matched or exceeded by others in the space, with revenue forecast to more than double in the five years through 2019 at Ultimate Software; to more than triple at Workday, ServiceNow and Zendesk; and to more than quadruple at Coupa Software Inc. COUP, -0.42% and MuleSoft Inc. MULE, -3.03% At Okta Inc. OKTA, +3.41% the consensus is for revenue to surge almost eightfold over the same period.
On other measures, some SaaS companies don’t look expensive when compared with their on-premise peers. On an enterprise value to revenue basis, Salesforce.com comes in at a multiple of 6.38 for 2019, versus 5.62 for Microsoft and 9.3 for Adobe Systems Inc. ADBE, -0.15% which is in the middle stages of transforming from an on-premise to subscription-based model.
Legacy operators understand the underlying economics of SaaS, as they have seen the benefit of generating revenue synergies and extracting costs from their acquisitions. In one of its biggest purchases, Oracle in November 2016 paid $9.3 billion, or nine times revenue, for NetSuite Inc. SAP spent $15 billion on business software companies Ariba, Concur and SuccessFactors between 2012 and 2014, and last month said it planned to acquire Callidus Software Inc. CALD, +0.00% for $2.4 billion. Salesforce.com itself bought Demandware Inc. for $2.8 billion after reportedly rejecting an offer from Microsoft in mid-2015.
Proof points such as these suggest that, with companies now able to repatriate cash held outside the U.S. at a lower tax rate, Microsoft, SAP and Oracle may be among those that seek to further consolidate the SaaS sector, providing a further tailwind for the stocks. Microsoft has $113 billion overseas, while Oracle has $52 billion, according to Moody’s Investors Service Inc. Private-equity firms have also shown an appetite for growth assets, with Vista Equity Partners buying Marketo Inc. in May 2016. Alphabet Inc. GOOG, +0.44% Amazon.com Inc. AMZN, +1.13% and Cisco Systems Inc. CSCO, +1.10% are other potential acquirers.
Even without mergers and acquisitions, cloud-based SaaS providers that continue to grow rapidly with attractive unit economics have a long runway to create value as stand-alone subscription-based businesses. As a result, when examined through the right lens, equity values in the SaaS sector still look reasonable for long-term investors.
Denny Fish is co-manager of the Janus Henderson Investors Global Technology Fund.