“It was the best of times, it was the worst of times.” — Charles Dickens
It has been over a year since the Covid-19 pandemic hit our shores in sunny Singapore.
Covid-19 has been described as the first global pandemic of the Information Age, with a record of more than 210 million global infections to date. Many countries have been forced into lockdowns to contain the pandemic. This has driven many venerable brands and iconic retailers into bankruptcy, including stalwarts JCPenney, Hertz and Gold’s Gym (though the first two have managed to exit bankruptcy).
Covid-19 has also radically altered our lifestyles and what we define as normal. Facebook is now allowing employees to work from home permanently. The founder of Twitter and Square, Jack Dorsey, has given the green light for his employees to work from home indefinitely.
But as the old adage goes, one man’s crisis is another man’s opportunity. This pandemic has serendipitously fast-forwarded the prospects of SaaS (software as a service) companies.
What is SaaS?
SaaS is a business model of distributing applications as a service over the Internet and Cloud. Instead of downloading and managing software, users access whatever application they want through the Internet, eliminating the need for complicated software and hardware installations.
SaaS solutions range from sales management to customer relationship management, financial management, human resource management billing and collaboration.
SaaS in the new normal
“Customers won’t care about any particular technology unless it solves a particular problem in a superior way.” — Peter Thiel, co-founder of PayPal, Palantir Technologies and Founders Fund
In the new normal, SaaS providers are expected to assist organisations in their thrust towards digitalisation and remotisation. This is because most SaaS solutions are designed for and are hosted in Cloud space rather than on premises. Remote workers are able to access their companies’ documents via virtual private networks (VPNs) and stay in touch with one another in meetings via remote connection software.
Curious to see whether this industry growth has so far translated into growth in returns in financial markets, we plotted the normalised returns of the Global X Cloud Computing ETF alongside those of the S&P 500, Hang Seng Index, FTSE Straits Times Index and FTSE Bursa Malaysia KLCI, from March 1, 2020, to June 1, 2021 (see Chart 1). Global X holds companies that generate 50% or more of their revenue from one of five business models:
- Licensing and delivery of SaaS;
- Providing a platform for creating online software apps, known as platform as a service (PaaS); • Providing online, virtual computing infrastructure, known as infrastructure as a service (IaaS);
- Owning and managing data and server storage facilities, including data centre REITs; and
- Manufacturing or distribution of infrastructure and hardware components used in Cloud and edge computing.
Global X invests in many notable SaaS/PaaS companies such as Salesforce, Dropbox, Zscaler, Zoom Video and Akamai Technologies.
As shown in the chart, Global X has outperformed the four indices!
Finding the next winning SaaS company
Finding the next 10-bagger investment is the pipe-dream of many investors. The question is, given limited time and energy, how does one sift through the entire haystack to find the golden nugget?
Not to worry, the Rule of 40 can help you spot winning growth companies! The Rule of 40 is: Revenue growth rate + Ebitda margin > 40%.
Generally, tech start-ups will not be profitable in their gestation phase. Think PayPal or Tesla in their early stages. This is because start-ups prioritise market share over margins in the short term.
Much of their capital as a percentage of revenue has to be spent on marketing to capture market share and R&D to produce new innovative products. This is to stay ahead of the game. In this phase, they typically have high revenue growth but negative operating margins (Ebit or Ebitda margins).
At a certain point, their high revenue growth outpaces their operating expenses. This is when they turn profitable.
The above implies that if their revenue growth rate+Ebitda margins exceed 40%, even if their Ebit or Ebitda margins are negative, the company is growing at a high rate. Financial markets, being forward-looking, will price that information into their stock prices. Which explains why their stock prices surge even though they are not yet profitable or are constantly in need for new capital.
Now comes the next question: sustainability.
Picture this. You own a digital payment company. Your platform charges merchants a service fee of 1%. To entice customers to use your platform, you run a campaign offering a $5 cash deposit for every user referred to your platform. Assuming that on average, a customer only uses your platform to pay for services amounting to $50. Your customer acquisition cost is $5 + marketing fees and average service fee of $0.50 per customer collected from merchant.
Your expenses in the long run will grow at a rate greater than your revenue, and cost spent on acquiring customer ($5) is greater than service fee collected from merchant ($0.50). Your company will be unprofitable and you will need to raise more capital from shareholders. There will come a time when you will be unable to raise more capital via debt and/or equity.
Therefore, it is crucial to watch the rate of increase in revenue for start-ups or growth companies with respect to their operating expenses. It is also very important to break down their revenue and analyse the niche they are expanding into in order to ascertain their business sustainability. For instance, PayPal started by being a niche service payment provider to eBay, while Alipay started by being a niche service payment provider to Alibaba, which paved the way ahead to achieve sustainability.
We recommend investors to use the Rule of 40 as a first principle for analysing SaaS or new listings of growth stocks, before diving into the drivers of their margins and revenue. This framework is applicable to both fundamental and technical analyses.
Rule of 40 scorecard
We were very curious to see how popular SaaS companies stack up using the Rule of 40 (see Table 1). For our analysis, we used their three-year average y-o-y revenue growth rates plus their latest Ebitda margins.
In our opinion, companies that have high revenue growth rates and high operating margins will have the majority of their future information priced into the financial markets. If one believes in their long-term sustainability and fundamentals, then it would be ideal to buy at the dips.
Trading SaaS with Contracts for Differences
Contracts for Differences (CFDs) are versatile investment tools. They are particularly ideal for people who wish to take a more active approach to investing.
CFDs can be used for hedging, short-selling or leveraged trading. They only require a minimum sum upfront, which is known as the margin requirement. CFDs are also ideal tools for investors without much capital outlay but who wish to capitalise on the growth potential of thematic investing.
The example in Table 2 illustrates how CFDs can amplify returns with an initial margin paid upfront. We illustrate with two scenarios for Mike on June 17, 2021 (see Scenarios 1 and 2).
A word of caution, though: Leverage is a double-edged sword. Although CFDs can magnify your gains through leverage, losses will also be amplified! Therefore, it is always crucial to use leverage responsibly, manage risks effectively and cut losses promptly when you feel that the market is turning against you.
SaaS is the new normal!
Based on current economic and social trends, SaaS platforms could be here to stay and be part of the new normal. In fact, they appear destined to play an increasingly critical role, given that the pandemic is likely to become endemic.
POEMS offers myriad investment instruments — equities, CFDs and ETFs — that you can use to capitalise on this exciting growth industry. Be sure to check out our other articles and courses on fundamental and technical analysis, thematic investing and how to utilise CFDs. To explore further, email us at cfd@ phillip.com.sg or speak to our consultants today.
Edwin Chin is a senior dealer with Phillip Securities
Photo: Austin Distel/Unsplash
