A Crowd of Predictable Businesses in an Unpredictable Industry

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According to research firm Gartner, the global Software-as-a-Service (referred to as “SaaS”) market has delivered a high-teens growth over the past four years, becoming one of the hottest segments within the software industry. The rapid adoption of the cloud-based licensing model is attributable to several benefits on the client’s side, […]

According to research firm Gartner, the global Software-as-a-Service (referred to as “SaaS”) market has delivered a high-teens growth over the past four years, becoming one of the hottest segments within the software industry. The rapid adoption of the cloud-based licensing model is attributable to several benefits on the client’s side, including simplified budget planning, reduction in upfront investment and cost-saving. In terms of the SaaS provider itself, the management can focus more on the core business – software development – and is no longer required to manage offline distributions or hardware systems.

When it comes to investors, we think that the most value lies in the recurring cash flow resulting from the subscription sales, which provides some rare predictability in this highly uncertain tech world. In this regard, the retention rate (or churn rate) of subscribers is the key. We hope to see a high switching cost to lock customers in. Additionally, we look for stable profitability and robust free cash generation. Lastly, we favor SaaS businesses that grow faster than the market average and hence demonstrate the capability of gaining market share.

Below, we list three SaaS players that look particularly interesting to us. As usual, valuation is not part of the consideration here as we are picking businesses to follow, not necessarily to invest in currently. As you can see, all three names trade at hefty valuations in the market as of today. However, investors can always opt to wait patiently for entry points that make more sense.

Paycom

Oklahoma-based Paycom (NYSE:PAYC) develops comprehensive human resources and payroll software to cover a wide range of HR-related functions, from recruitment to retirement. Cloud-based solutions delivered as SaaS is the sole focus of the company. The management believes that the company’s single-database SaaS products would result in easier integration (or little need to integrate), faster delivery, fewer risks of compliance errors, more controllable costs and lower up-front capital requirement for the clients compared to on-premise or non-comprehensive products.

We observe that the retention rate increased from 91% in fiscal 2017 to 93% in fiscal 2019. Meanwhile, the client base expanded by almost 29% in aggregate, the operating margin improved from 18.2% to 30.7% and the free cash flow margin was in excess of 15% every year. The top line grew annually by 31% and 38% over the last three and five years, respectively, outperforming significant peers like Automatic Data Processing (ADP), Paychex (PAYX) and Paylocity (PCTY).

Technology One

Australia-based Technology One (ASX:TNE) develops customer-driven Enterprise Resource Planning (referred to as “ERP”) software mainly to government, financial services, health services, education and utility sectors. The management envisions a digital ecosystem for “any device, anywhere, anytime,” with a cloud-first, mobile-first focus. The company started as a traditional on-premise software business and later pivoted to become a SaaS provider.

Browsing through the financials, we notice that subscriptions represented approximately 28% of the fiscal 2019 revenue and grew by 40% year-over-year. The SaaS segment contributed to more than half of the annual recurring revenue. At the same time, the top-notch 99% customer retention rate is a good indicator of a substantial moat that can protect the profits at Technology One. Over the past five years, the operating margin improved from less than 20% to over 26% and the free cash flow margin stood consistently at around 15%.

ATOSS Software

Germany-based ATOSS Software (XTER:AOF) is the leading workforce management software provider in the DACH region (i.e., Germany, Austria and Switzerland). Although it only represented 37% of the total revenue in recent quarters, the “Cloud” revenue has been growing rapidly – from the first million Euros in 2015 to 17 million Euros ($20.2 million) last year. The company predicts that its cloud revenue will hit nearly EUR40 million by 2023.

We believe that ATOSS Software possesses a strong position in an attractive market, where the business can easily lock its customers in by embedded its products and services into the day-to-day operations at those customers. Between 2015 and 2019, the operating margin steadily went from 25% to over 27%, while the free cash flow margin ranged between 13.5% and 22.5%. We also see a superior return on assets at ATOSS that has been consistently outperforming the larger software peers, including Oracle (ORCL), Workday (WDAY) and SAP (SAP).

Disclosure: The mention of any security in this article does not constitute an investment recommendation. Investors should always conduct careful analysis themselves or consult with their investment advisors before acting in the stock market. We own shares of Technology One.

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