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Information Technology

Add Some SaaS to Your Portfolio

By Peter Staas, on Jul. 25, 2014

With the mainstream and financial media’s focus on Apple (NSDQ: AAPL) and social media darlings such as Facebook (NSDQ: FB) and Twitter (NYSE: TWTR), far too many investors concentrate on the consumer tech market and overlook powerful growth trends in the enterprise and commercial segments.

In the business world, the transition from the server to the cloud has enabled a corresponding revolution in the software industry.

Businesses traditionally run a combination of prepackaged, on-premises software such as Microsoft’s Office suite–which entails a hefty, up-front licensing fee–and proprietary applications that are developed and updated by an in-house information technology (IT) depart­ment.

This model requires companies to purchase systems and data-storage equipment to support business functions. Hiring an exten­sive IT staff to maintain and administer these systems adds to the cost.

In the software-as-a-service (SaaS) model, cloud operators host software applica­tions at a central location and provide access to enterprise users via the Internet for a subscription fee.

The appeal of SaaS solutions to cor­porate clients is simple: operational efficiency and lower costs.

This approach lim­its customers’ need to invest in data stor­age and server infrastructure and yields a highly scalable solution that doesn’t require massive capital spending to support new users or applications. Given these savings, uptake of these solutions has been particularly strong among small and midsize businesses.

Central hosting also ensures that all users within the organization can access the most up-to-date version of the soft­ware, relieving IT departments from the time-consuming process of updating the programs on each individual computer.

And delivering software applications over the Internet enables meets users’ increasing demand for access to mission-critical data and functions on smartphones and tablets.

This business model also has a number of advantages for software providers.

Rather than creating new applications and functionalities and then bundling them into a new version of an established product, the software company can introduce incremental enhancements to its offerings and immediately deliver those changes to the entire user base.

In other words, every subscriber will always have the newest version with the most up-to-date features.

In the past, not every customer would upgrade to the latest release; some preferred to save money and stick with older versions. By transitioning to this new model, the software industry swaps periodic, lumpy revenue for the consistency of recurring subscriptions.

The Opportunity

Research firm International Data Corp (IDC) estimates that global SaaS sales will increase at a compound annual growth of 19 percent over the next five years.

Growth investors looking to profit from this trend over the long term should consider a two-pronged strategy that includes:

  • Established, pure-play SaaS companies that should be able to maintain deliver outsized revenue growth as the win market share from traditional software packages; and
  • Names that produce specialized, on-premise software that have started to transition to the SaaS model, gradually building a stream of recurring revenue.

Here’s a look at our top picks.

Salesforce.com (NYSE: CRM)

Founded in 1999 by former Oracle Corp (NSDQ: ORCL) executive Mark Benioff and three developers, salesforce.com has emerged as the 800-pound gorilla in the cloud-computing space, accounting for about 10 percent of the SaaS market.

The San Francisco-based company was the first pure-play SaaS application provider to achieve $1 billion in quarterly revenue and ranks as the world’s eighth-largest enterprise software firm.

And with the firm growing its quarterly sales by more than 30 percent, the cloud-computing innovator stands out relative to industry juggernauts such as IBM (NYSE: IBM) and SAP (Frankfurt: SAP, NYSE: SAP).

Salesforce.com specializes in cloud solutions that enable businesses to engage with their customers through four core offerings that users can access on any device:

  • Sales Cloud: A sales-force automation platform that provides users with accurate customer and prospect information while enabling them to track leads and progress and collaborate with colleagues from anywhere.  
  • Service Cloud: A platform for companies to engage with customers and address their service and support needs.
  • Marketing Cloud: A platform that uses data from any source to help develop and deliver personalized messages to any customer on any channel–email, mobile, social media or within their own product.
  • Salesforce1 Platform: A cloud platform for developing custom applications. Customers use this service to connect all its apps and customer data and make them accessible anywhere on any device. Veeva Systems (NYSE: VEEV) is the first company that developed its SaaS applications on Saleforce1 to go public. The firm offers customers in the life-sciences industry a suite of cloud-based solutions tailored specifically to their needs.

At this juncture in its life cycle, salesforce.com continues to invest heavily in research and development and mergers and acquisitions in an effort to innovate and broaden its capabilities.

These investments compress profit margins, but are essential to staying on top in this highly competitive industry and winning contracts from Global 500 companies–usually the province of industry heavyweights such as IBM, SAP and Oracle.

Dislodging these incumbents, many of which are developing their own cloud-based packages, has proved to be a challenge; uptake of SaaS products has been particularly strong among small to midsize businesses, many of which had been priced out by the infrastructure expense associated with traditional enterprise resource management solutions.

Although salesforce.com boasts more than 100,000 total customers, only 700 pay more than $1 million annually for the firm’s services.

The addition of Keith Block, Oracle’s former executive vice president of North America sales and consulting, to head salesforce.com’s global sales efforts should help out in this regard.

We also like the company’s efforts to become even more customer-centric and build solutions targeted to six specific verticals: media and communications, the public sector, financial services, health care, automotive and retail. Speaking the language of these industries should help to drive sales and yield more big contracts.

At the same time, these efforts to target specific verticals and the growing number of customized solutions on the Salesforce1 platform continue to reduce customer churn–an issue given the number of small to midsize businesses that use the firm’s solutions. Cancellations now hover around 12 percent. And the company’s broad platform means that revenue from cross-selling easily offsets sales lost to customer defections.

Last year’s acquisition of ExactTargets not only enhanced salesforce.com’s marketing package but also created a huge opportunity to sell the company’s legacy solutions. We expect future acquisitions to have a similar effect.

Still the preeminent SaaS company, salesforce.com has the vision and execution to take advantage of its considerable growth opportunities. The stock rates a buy up to $58.00 per share, prospective investors should consider easing into salesforce.com and take advantage of any pullbacks to add to their position.

Autodesk (NSDQ: ADSK)

Earlier this year, we booked a 36 percent gain on former Wealth Builders Portfolio holding Adobe Systems (NSDQ: ADBE), a firm whose Creative Suite software package had built a dedicated following and faced little competition from rivals.

Not only did the stock trade at a reasonable valuation relative to the high-flying names in the SaaS space, but the company had also embarked on a well-planned effort to transition to subscription-based model.

Autodesk offers a similar value proposition for investors, albeit with some different wrinkles. The company has emerged as one the world’s leading design software and services providers, delivering a lineup of products for customers in architecture, engineering and construction, manufacturing and digital media.

The company’s wide range of software solutions, which includes the well-known AutoCAD family of products and services, enables customers to create and manipulate digital prototypes before they become real-world objects–a major time and cost saver and an absolute necessity.

Autodesk is pushing hard to transition to a subscription-based model from its legacy, on-premise solutions that amounted to a perpetual license.

But unlike Adobe Systems, Autodesk’s efforts to expand subscription revenue don’t rely primarily on SaaS and won’t occur overnight; rather, the company will implement this transition over the next four to five years and offer several options that cater to its user base’s diverse needs.

Autodesk’s growth strategy is twofold: to move customers to subscription-based models that increase revenue and to migrate more of its customer base to suites that include a wider range of products.

One of the company’s earliest moves in this direction was to offer a maintenance service to customers that had purchased software with a perpetual license; for an annual fee, these users receive regular updates, access to exclusive features and training modules and a higher level of customer service.

Other options include a so-called rental program, which features a lower price point than purchasing a perpetual license and boasts a high renewal rate.

Newer innovations involve consumption-based models that give enterprise customers access to a suite of products and is billed based on usage. A similar offering is available for individuals and smaller businesses that need access to AutoCAD’s tools for a specific project.

Autodesk has also attached cloud-based offerings to many of its standalone software solutions and product suites to enable long-distance collaboration and milestone tracking between the many parties involved in design project. The company is the first engineering and design software outfit to offer these cloud-based capabilities.

All told, Autodesk expects these efforts to increase its recurring revenue to 70 percent of annual sales while bolstering profit margins and average revenue per user. In the near term, improving manufacturing activity should also provide a tailwind for the stock. Autodesk rates a buy up to $60.00 per share.

Tyler Technologies (NYSE: TYL)

Tyler Technologies is a mid-capitalization software company that serves the public sector, with an emphasis on local government–a $12 billion market that has returned to normal levels.

With more than 11,000 installations, the firm is one of the biggest players in a highly fragmented market that offers ample opportunity to increase its penetration rate via organic growth and acquisitions.

The company boasts one of the widest ranges of software services for local government, with schools (40 percent of revenue) and the court systems (20 percent) representing two of its most important customer groups. All the firm’s software packages are available under traditional installation licenses or an SaaS subscription model.

In both instances, Tyler Technologies offers a comprehensive range of software options–from HR functions, student record tracking and transportation management for schools to jury selection, document management and fine collection for court systems.

The company’s school system revenue grows at an average annual rate of about 10 percent, while its court-related revenue is expected to increase by about 20 percent per year.

Tyler Technologies has emerged as the preeminent vendor for court systems, winning about 85 percent of its bids. In the first half of 2014, the company secured 25 of the 28 county court projects that were up for bid in California after a proposed statewide system failed to come to fruition.

E-filing systems represent another growth opportunity for Tyler Technologies, as an increasing number of jurisdictions agreeing to contracts that generate a fee for each transaction. In the second quarter, the company grew its e-filing revenue to $7.7 million, a year-over-year increase of 147 percent.

All told, recurring revenue accounts for about 63 percent of Tyler Technologies annual sales, with maintenance agreements on legacy installations and SaaS subscriptions renewing at a 98 percent rate. These contracts often include annual escalators of 4 percent to 5 percent, providing built-in growth.

The majority of new sales come from local governments replacing legacy systems that are no longer supported or don’t deliver the functionality that the modern world demands. SaaS applications account for about one-third of new sales.

With no debt and $90 million in cash, Tyler Technologies has the wherewithal to consolidate within its existing end-markets and add capabilities to broaden its range of services. The firm also continues to buy back stock and should benefit from pent-up demand in its recovering end-markets.

Tyler Technologies rates a buy up to $98.00 per share and is a solid long-term holding.

Peter Staas is managing editor of Capitalist Times Premium and Energy & Income Advisor.

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