Our previous article—the first in a three-part series—provided overviews of five areas that have been experiencing tremendous growth through strong technological innovation or by leveraging advances in the internet and discussed each area’s key growth catalysts. We refer to these five areas as SCODI, which stands for:
- Software as a Service (SaaS)
- Online retail
- Digital payments
- Internet of Things (IoT)
Today, we take a deeper dive into the “S” and the “C”—SaaS and cloud services—and cover key reasons the market, from our perspective, may be underappreciating the full growth potential of SaaS and cloud services companies.
SaaS is a software distribution model in which software vendors provide a full suite of cloud-based services they’ve made available by subscription to client companies. Many companies—and even multiple business units within the same company—have been shifting to SaaS solutions, which are projected by information technology (IT) research firm Gartner, Inc., to grow 22.3% in 2018 alone.
Some SaaS vendors offer broad solutions that are applicable across a range of industries, while others focus on providing industry-specific products. Some of the largest and fastest-growing areas within SaaS include customer relationship management and human capital management—enabling a wide variety of companies to more effectively target their end markets and optimize their workforces.
Businesses in certain areas that are subject to greater regulatory and compliance requirements—for example, health care and financial companies—need solutions specifically designed to help them adhere to these requirements. SaaS companies providing these types of targeted solutions may, due to their niche positioning, offer compelling growth opportunities. Other areas in which SaaS targeted solutions have been experiencing growth include helping merchants with their online retail efforts and providing software security solutions as applications increasingly move to the cloud.
Gartner has projected that the public cloud services market will grow at an 18.5% five-year compounded annual growth rate, reaching $302 billion in 2021. It has plenty of room to expand, considering that even with its rapid growth in recent years, public cloud services represent less than 10% of total IT spending worldwide (based on 2018 Gartner estimates).
Companies of all sizes have been benefiting from cost savings by shifting their network systems to the cloud. Smaller businesses, in particular—for example, venture start-up IT companies—stand to benefit tremendously from using a cloud services vendor to supply hardware and software instead of spending large sums of money building in-house solutions. Cloud services companies typically use a pay-as-you-go pricing model: Start-up costs for new clients are minimal compared with launching their own in-house networks, and clients can easily increase their level of services over time as they grow and their IT needs expand.
Peer-group analysis of SaaS and cloud services companies reveals strong fundamentals overall
In order to evaluate the fundamental strength of companies in these areas, we analyzed a group of companies within the Russell 3000® Growth Index that met the following criteria: over $500 million in annual revenue (as of December 31, 2017) and significant business ties to SaaS and/or cloud services.
The two charts below illustrate the consistency and overall magnitude of sales and earnings-per-share (EPS) surprises these SaaS and cloud services companies have delivered compared with U.S. growth stocks in general and the broad U.S. stock market (represented by the Russell 3000 Growth Index and Russell 3000® Index, respectively).
Overall, SaaS and cloud services companies have been successfully displacing legacy IT companies that offer outdated technology solutions, and this success has helped drive more consistent sales and EPS surprises for many of these companies compared with the sales and EPS surprises for U.S. growth companies in general or for the broad equity market.
A number of SaaS/cloud services companies analyzed have been actively investing in building their salesforces and have implemented internal initiatives to increase market share and expand into other available markets. For example, SaaS companies focused on specific industries, such as pharmaceuticals and life sciences, have greatly enhanced the potential longevity of their growth potential by innovating their products in order to expand into new industries. Although related costs for these internal initiatives have sometimes constrained profit margins, a number of the companies analyzed have demonstrated an ability to drive higher profitability—as shown by the magnitude of their sales and earnings surprises compared with growth stocks in general and with the broad stock market.
Chart 3 shows the overall change in market value over time of the SaaS/cloud services companies analyzed compared with the 12-month EPS estimates for this group. With the exception of a few periods (such as in late 2013), fundamentals generally have trended upward. However, despite rising EPS estimates (an indicator of improving fundamentals) in multiple periods from 2014 to 2016, the group’s market value declined.
More recently, the SaaS/cloud group has experienced both rising market values and significantly improving fundamentals. As a result, the SaaS/cloud group has beaten estimates on a fairly consistent basis and has enjoyed rising EPS estimates; this combination has been a key catalyst for the group’s favorable stock performance since early 2017.
What might the market be missing?
From our perspective, market estimates of the growth potential for many SaaS and cloud services companies underestimate the impact of important catalysts, including these:
- Beyond helping client companies save money through reduced IT expenses, SaaS and cloud services companies also may increasingly contribute to clients’ revenues. Today, software is no longer behind the scenes. Most companies are (or have moved toward) interfacing with customers through software—perhaps in addition to face to face—and many customers prefer this method. For example, call-center agents using cloud-based capabilities can connect with customers via phone, email, chats, and social posts—whichever way the customer prefers. This flexibility can help drive sales. Companies also are recognizing that using next-generation technologies can more effectively position them relative to less-nimble competitors, and many are pursuing SaaS and cloud-based solutions in their efforts to gain market share.
- The durability of SaaS and cloud services companies’ growth potential may be longer than many people estimate. According to International Data Corp., business spending on cloud-related services has been growing at a rate four times faster than the amount being spent by businesses on traditional software to set up their own in-house computer systems. With less than a 10% share of global IT spending today, SaaS and cloud services companies have a long runway for future growth—especially if they continue the trend of innovating to expand into new industries.
In our third article, we’ll focus on growth that’s taking place in online retail, digital payments, and IoT—including why the market may be underappreciating the full growth potential of companies in these areas as well.