The Long-Term Valuation of Microsoft SaaS Clones
If junior SaaS companies can ever resemble Microsoft, in terms of revenue growth and profitability, they're considerably under-valued in today's market.
The Software Series1 outlined the attractiveness of the SaaS business model. The analysis presented below, builds on the idea that as SaaS companies evolve, they enjoy greater bottom-line profits. This will support their current valuations.
What Share of the Gross Margin becomes Net Income?
A key assumption is that a SaaS company’s ~80%+ gross margin will evolve to a ~40% net income margin over time. Currently, the average Net Income Margin of Lessep’s favourite SaaS companies2 is just 3.0%3 (10.9% if Atlassian is excluded). As can be imagined, a quadrupling in Net Income Margin would improve (justify) valuations.
The key assumption supporting this improvement in net income is that in a steady-state, mature SaaS companies will lower Research and Development, and Selling, General, and Administrative Expenses as a share of total revenue.
This can occur through the process Justin Ross outlines in the tweet below, Chainsaw Al Dunlap style transformation, or revenue growth that is faster than expense growth via maturation and economies of scale.
Long-term Investors Want R&D and Sales Spending
Spending on R&D and Sales is essential to SaaS companies reaching their potential. Lessep does not advocate for cutting these budgets.
R&D spending should be self-explanatory for a technology company. Research spending supports continuous improvement, identification of new use cases, and the management of competitive threats.
Sales is equally important. There are two basic sales models in software; top-down and bottom-up. The top-down relies on relationships with company leaders with the authority to approve investments. The bottom-up model targets end-users of software. Either way, software companies need a sales process that demonstrates to potential clients the productivity of the software solution.
Atlassian is an outlier, and will be considered as such in the data analysis below, because it focuses its sales efforts through its engineers and the R&D budget.
What the Data Shows
The data shows there is considerable room for SaaS companies to improve profitability over time through a falling share of revenue spent on R&D and Sales. To demonstrate this, Microsoft is used as a benchmark for efficient, steady-state, spending on these two items. Atlassian, as an outlier, is removed from the average of SaaS companies.
By way of a baseline, five-year revenue growth and average five-year profit margins for the stock universe are presented below. Microsoft, as the most mature company, has the slowest revenue growth (16%), Atlassian the fastest (34%). The average4 was 27%. Microsoft’s Net Income Margin is the highest, and reflects its maturity (Adobe is not far behind). But Microsoft’s Gross Margin is the lowest. This reflects its hardware businesses, including the X-Box gaming franchise.
Over time, it can be expected that the average SaaS company will approach Microsoft’s steady state: slower revenue growth, and higher net income margin. The key element in this process will be the decline in R&D and Sales expenses.
SaaS company R&D spending is, typically, seven percentage points higher in less mature companies, than it is at Microsoft. This reflects a combination of Microsoft’s maturity, dominant market position, and economies of scale.
Sales5 spending is typically twenty-six percentage points higher at less mature companies than at Microsoft. Again reflecting Microsoft's market position and scale.
The data shows that, as a share of revenue, Microsoft, a mature SaaS, currently spends thirty-three percentage points less on R&D and Sales than a typical SaaS company. This would imply that over time, as these companies mature, they will earn close to forty-four percentage points in net income margin (33 plus 11 of existing NIM).
What ifs …
What if … Number One … Private Equity with a Magic Wand
What if a private equity manager could purchase Microsoft, slash spending on R&D and Sales, in return for Microsoft’s five-average revenue growth? What would these companies and their valuations look like then?
The current valuations of Intuit, ServiceNow, Adobe and Autodesk suggest they would make attractive targets for Private Equity. By contrast, the smaller, faster growing companies are likely too expensive for Private Equity with current profitability too low.
What if … Number Two … Long-Term Adjustment
What if investors are prepared to wait a decade for these companies to reach Microsoft levels of profitability and revenue growth? It’s assumed that at a steady state, these companies earn forty-four percentage points of net income margin6, with 15% annual revenue growth7.
The single-digit forward PE multiple would reflect substantial long-term returns for investors, if these companies are valued as Microsoft has been since 2018. For instance, Adobe would be six times higher in 2032, were it to trade at 32x 2032 earnings, as estimated above. The long-term investor would be particularly attracted to DataDog.
Conclusion
As with all investments with a long horizon any number of risks may arise to de-rail the positive outcome. But the history of productivity created by software (exemplified by Microsoft) and the demonstrated stability of growth in the sector, makes it worthwhile. Even with a steep discount rate, the returns remain positive and very attractive.
Here are some of the pieces in the series.
Microsoft, The Trade Desk, Intuit, ServiceNow, Adobe, Atlassian, Autodesk, DataDog, Xero
Five Year Average
Excludes DataDog at 75% per annum.
Includes General and Admin as well.
Potentially too low as gross margins are higher at pure SaaS companies than at Microsoft.
It is assumed that growth in the intervening period slows, constantly, from the current growth to 15% in 2032.