Please ensure Javascript is enabled for purposes of website accessibility

Why Software-as-a-Service Is a Winning Strategy in 2018

By Nicholas Rossolillo - Aug 13, 2018 at 9:00PM

You’re reading a free article with opinions that may differ from The Motley Fool’s Premium Investing Services. Become a Motley Fool member today to get instant access to our top analyst recommendations, in-depth research, investing resources, and more. Learn More

Service for a recurring fee is a win-win-win situation.

Small-cap stocks have been one of the best-performing asset classes in 2018 so far. After years of barely keeping up with large-cap stocks, investors are finally seeing some benefits from owning smaller, up-and-coming businesses. Even in spite of a rough start to the year, small-caps have been resilient and are sporting double-digit gains compared to the S&P 500's 5% return this year.

VIOO Chart

Data by YCharts.

Software-as-a-service (SaaS) providers are leading the charge. SaaS isn't new, but over the last couple of years the business model has begun to show its value. Even industries outside of tech have begun to test the waters with similar business models -- like the auto industry, for example. Critics of SaaS cite things high customer acquisition costs and higher cost to customers over time due to recurring subscription fees. Despite these concerns, SaaS is a winning strategy for everyone involved.

Why would anyone want it?

For starters, let's define SaaS. SaaS in all of its forms -- like data-, transportation-, and AI-as-a-service -- shares a few things in common. The software is hosted and maintained on a central server (the cloud) by the developing company, and customers access it via an internet connection. Users pay a monthly, annual, or other type of term fee for access to the software.

An artist's illustration of computers getting connected to a cloud, representing a central server.

Image source: Getty Images.

Salesforce (CRM 1.73%) was an early pioneer of this business model when it migrated its services to the cloud in the early 2000s. There were several benefits, including no need to install software on individual machines, service scalability with a business's growth, and instant updates to all users. The biggest benefit of all, though, is the cost savings over time with the pay-as-you-go model.

If a company in need of a technological upgrade needs to pay for the project up front, a conflict often arises. A company needs to borrow money or use its cash reserves to fund the project, which could mean other projects are put on hold. Under a subscription model, the customer gets to keep its cash and gets the benefits of the upgrade immediately. Investors are familiar with the concept of cash now being more valuable now than cash later -- the time value of money. Here's that same concept applied to a payment structure over a 10-year period. In scenario one, a $100,000 project is funded up front; and in scenario two, it's paid for in equal annual installments of $11,000 (customers pay a little extra since payment is strung out over time instead of paid in full up front). Let's assume a rate of return on cash of 5% compounded annually -- the opportunity cost for parting ways with the money. Scenario one -- paying up front -- is by far the more costly option even though the annual installments add up to more than the up-front initial payment.

Metric

Scenario 1

Scenario 2

Amount paid over 10 years

$100,000 one-time up-front payment

$110,000 (10 equal payments of $11,000 per year)

Total cost of payments assuming 5% annual cost of money

$155,133

$138,356 

Chart and calculations by author.

The biggest winners

End users of SaaS benefit from the business model, but so do the software companies selling the service. Many of the costs (with the exception of selling and marketing) are fixed since the software is centrally located on a server. Once a service acquires enough users, profits are scalable. The result is typically a high-profit margin business. Salesforce, an early adopter and now one of the biggest cloud companies in the world, is a prime example, but there are other smaller companies that are benefiting, too. 

Company

Number of Customers

Gross Profit Margin

Salesforce (CRM 1.73%)

More than 150,000 (multiple users per customer)

80%

Shopify (NYSE: SHOP)

Over 600,000 businesses

56%

Splunk (NASDAQ: SPLK)

Over 15,000

75%

Twilio (NYSE: TWLO)

54,000

54%

Atlassian (NASDAQ: TEAM)

Over 125,000

82%

New Relic (NYSE: NEWR)

16,000 paid accounts

83%

Appian (NASDAQ: APPN)

356

59%

Chart by author. Data source: company specific quarterly and annual filings.

Because of those high margins, shareholders can be some of the biggest beneficiaries from the SaaS model. That's a lot of cash generation that these businesses can funnel into product improvement and innovation, marketing, and acquisitions, leading to even more growth. Just as important, though, is the consistent revenue generated by recurring fees, smoothing out results, and making future cash flows more predictable. An added bonus that has helped small-cap stocks out-perform this year is U.S. corporate tax reform passed in December 2017, making these high-margin businesses even more lucrative.

SaaS companies are on fire, but investors should still be aware of risks. Many still run at a net or operating loss as they plow all of their extra cash and then some into sales and marketing. As a result, accelerating and decelerating customer growth figures can cause these stocks to be unpredictable. Volatility aside, though, as cloud-based software companies continue to grow their customer bases in this digital-first world, it looks more likely that their market-beating performances will continue over the long term.

Invest Smarter with The Motley Fool

Join Over 1 Million Premium Members Receiving…

  • New Stock Picks Each Month
  • Detailed Analysis of Companies
  • Model Portfolios
  • Live Streaming During Market Hours
  • And Much More
Get Started Now

Stocks Mentioned

salesforce.com, inc. Stock Quote
salesforce.com, inc.
CRM
$159.65 (1.73%) $2.72

*Average returns of all recommendations since inception. Cost basis and return based on previous market day close.

Related Articles

Motley Fool Returns

Motley Fool Stock Advisor

Market-beating stocks from our award-winning service.

Stock Advisor Returns
322%
 
S&P 500 Returns
116%

Calculated by average return of all stock recommendations since inception of the Stock Advisor service in February of 2002. Returns as of 05/26/2022.

Discounted offers are only available to new members. Stock Advisor list price is $199 per year.

Premium Investing Services

Invest better with The Motley Fool. Get stock recommendations, portfolio guidance, and more from The Motley Fool's premium services.