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Software-as-a-Service (SaaS) - successful companies with attractive opportunities

Why investors shouldn't be afraid of loss-making but fast-growing software-as-a-service (SaaS) companies.

As an investor, we, or rather our talented fund managers, try to identify whether a company's profitability is attractive. They ask themselves the following basic questions: can the company invest in acquiring new customers at an attractive rate of return? Does the business model have the potential to rapidly grow revenue for the company to achieve significant scale as soon as possible?

Successful Software-as-a-Service (SaaS) companies offer very exciting opportunities:

1) recurring revenue

2) strong growth

3) high margins

As with any business, there are two sales markets for SaaS companies:

(i) end users (e.g. Netflix and Spotify) or (ii) enterprises (e.g. Salesforce and Hubspot). We believe that B2B software companies are superior to B2C software companies. Enterprises view software as an investment and a partnership that helps their business become more efficient and effective, which ultimately leads to greater success. As a result, they have a higher willingness to pay and a higher lifetime value. B2B subscriptions tend to grow as the companies they are sold to grow. B2C companies, on the other hand, face a higher churn rate (competition) and lower lifetime value, and it is more difficult to get a consumer to upgrade.

Real-world example

Now consider a hypothetical software-as-a-service (SaaS) company. Let's assume it has exactly the same financial starting point as a trucking company: Revenues of CHF 200m and a profit of CHF 20m with an equity base of CHF 100m. Unlike the freight forwarding company, the SaaS company does not need to buy additional tangible assets at the end of the year to increase revenue because SaaS companies scale extremely efficiently. The beauty of this is that SaaS companies can only build something once and then sell it an infinite number of times. These companies generate most of their profit from acquiring and retaining new customers, who typically remain customers for many years (known as lifetime value). The cost of acquiring these customers will pay off significantly in subsequent years, as the cost of servicing the customer is minimal.

If the technology company can acquire new customers at attractive costs through marketing activities (i.e. the lifetime value of a customer is many times higher than the cost of acquiring a customer), the company would be motivated to increase its marketing budget by CHF 20m instead of spending CHF 20m on tangible assets like the shipping company. However, from an accounting perspective, the entire CHF 20m marketing expense will flow into the income statement in the year it is incurred, reducing the company's profit towards zero. In contrast, the trucking company's investment in additional trucks flows through the income statement and balance sheet and is ultimately treated as capital expenditure ("CAPEX"). The CHF 20m for the purchase of the trucks is recorded as depreciation expense in the income statement over the 10-year life of the trucks. Both companies make rational capital allocation decisions to grow their business, but in terms of their respective financial statements, the companies look quite different. The main difference is that the trucking company appears to be quite profitable, while the technology company is barely breaking even!

In today's digital economy, many technology companies operate exactly as described in the example above. In order to keep growth as high as possible, they increase their marketing budgets until profit drops to zero. This, although they could already show a profit long ago!

Gian-Luca Thalmann, 12.2021 inspired by the thoughts of Donville Kent AM, 10.2021


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