In the past, technology companies would release software that clients needed to purchase as a one-off product. If upgrades or updates were required, the company would then release a new version of the product that the customer would have to purchase all over again. This practice pushed up overall costs for clients, as they found it both expensive and troublesome to keep repurchasing similar software to what they had originally bought.  With the advent of the internet, cloud computing systems, and smartphones, business models began to evolve and change. A more successful and robust business model emerged, known as "Software as a Service" (SaaS). SaaS involves a subscription model whereby clients pay an annual fee to gain access to the software, rather than having to continually purchase the license for new software updates or patches. 

These SaaS companies have huge advantages over traditional product development companies. Firstly, they create stronger customer loyalty by introducing high switching costs for users, as it would be difficult to disengage from a software provider in order to switch to another without it being massively disruptive to one's business. Secondly, SaaS companies enjoy recurring and predictable subscription income that enables the business to make more effective capital allocation decisions. Finally, the SaaS model also eliminates the need for companies to constantly come up with upgrades or new products in order to sell to customers. This ensures working capital flow is smooth and that staff can concentrate on the software and platform aspects of the service provided.

Here are two SaaS companies on my watchlist that show great future potential.

Image of laptops linked to a cloud

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Alteryx

Alteryx (NYSE:AYX) provides a subscription-based software platform that enables clients to merge, blend and scrub data from multiple sources to attain meaningful insights. Clients who use Alteryx will find it much easier to gain insights even though the data may be from disparate sources.  Through the use of data science and analytics, Alteryx's platform provides analytical flexibility to a variety of users such as business analysts and data scientists. Its platform is powerful because it eliminates complex code and uses drag and drop tools to allow users to analyze data easily.

Data can be processed from a variety of sources, such as spreadsheets and other cloud applications, and the software allows the user to also customize, schedule and publish analytics. Through the first nine months of 2019, the company reported a loss  due to interest expense on its convertible senior notes but generated around $7.3 million worth of free cash flows during the period.

The company is still adding customers at a rapid rate, as it ended Q3 2019 with 5,613 customers, a 30% year-over-year increase. Its dollar-based net expansion rate hit 132% for the quarter, an impressive statistic as it shows that the same customers are spending about a third more than a year ago. 

Okta

Okta (NASDAQ:OKTA) provides cloud software that assists companies in managing and securing user authentication into modern applications. Organizations use Okta to coordinate and manage user access to different applications and systems within the business.  Okta not only helps organizations to manage software-access among their employees and partners but also allows them to manage their customers' access to the organization's own products. The company has over 6,000 pre-built integrations to applications and infrastructure providers and counts JetBlue Airways Corporation, Nordstrom, Twilio, and Slack Technologies as some of its reputable clients . 

Okta demonstrated strong revenue growth in Q2 2019, with sales rising 51.6% year-over-year. Gross margin expanded slightly to hit 79% from 78.4% a year ago. However, due to elevated spending on both research & development and sales and marketing, the company continued to report a quarterly loss. On the bright side, for H1 2019, Okta was free cash flow positive, generating a small yet significant free cash flow of $1.7 million.

Also, Okta added 450 new customers during Q2, for a 7% quarter-over-quarter increase. CEO Todd McKinnon also emphasized that Okta's enterprise customer base with an annual contract value greater than $100,000 had risen 46%.

Adding customers and growing recurring revenue

These two SaaS companies have been consistently adding new customers over time. As new customers are brought on board, these businesses also witness growing recurring revenues. Though both companies are currently unprofitable, both have begun to generate positive free cash flow. As they add more customers and increase their flow of recurring revenue, there will come a tipping point where these companies will turn profitable and start to generate strong, consistent free cash flow. These two companies still have a long runway for growth, and investors should keep a close watch on them.