While industry dynamics remain healthy and growth prospects exist, current enterprise software valuations look stretched.
The March Toward SaaS Continues
One of the clearest and most powerful technology trends in recent years has been the digitalization of the enterprise and reduced computing costs for data capture and analysis. These massive shifts have coincided with the rise of cloud computing platforms and the breaking down of data silos across organizations. The enablers, beneficiaries and victims of these developments are wide-ranging within and outside of the technology sector, but one key source of investment opportunity into this theme has been in enterprise software and, specifically, in the new generation of companies offering Software-as-a-Service (SaaS).
SaaS companies have so far succeeded in offering many of the tools that companies across all industries use to improve operational processes as well as garner new insights into their customers and services. Importantly, compared with traditional license-based on-premise software providers, where software is bought and installed on individual computers, SaaS services are sold and consumed in a much more efficient and scalable manner due to the software being consumed from the cloud and paid for on a rateable subscription basis. This tends to have the desirable effect of lowering earnings volatility. In our view, we are still in the early stages of harnessing the power of this digitalization trend and the real benefits to labor and capital productivity are yet to come.
The Valuation Dilemma
We find many great quality companies in this space which look set for sustained growth in the years to come. However, the bridge between a great company and a great investment is clearly valuation, and here we need to pause and reflect. On the most common metric to measure the software space, Enterprise Value / Next 12 Months Revenues (EV/NTM Sales1), valuations have sharply bounced back from the lows of December and through the previous peak seen in 2014.
Global Software Equities are at 5-Year Valuation Highs2
What is perhaps most noteworthy in the chart above is not that the multiples compressed so significantly in the two years following the 2014 peak, but that this was not due to poor execution on the part of the companies. In fact, the multiple halved despite the sector beating sales forecasts by a mid-teens percentage in annualized terms. The lesson we remind ourselves of is that while higher valuations driven by price momentum can be supported by greater earnings and sales for extended periods of time, sentiment can switch rapidly, highlighting that valuation discipline is of paramount importance. This change in price momentum was particularly stark in the 2014 derating: capital flows became price insensitive as hedge funds with leveraged positions in software names faced redemptions and, in some cases, closures.
How Healthy is the Industry Today?
While it is difficult to argue that the sector had not run ahead of itself back in 2014, we see the health of the industry as better today and therefore more able to support premium valuations. The SaaS model now has proven scale and there are a number of profitable businesses, such as Adobe, Salesforce and Workday. A greater proportion of the industry has transitioned to a subscription model away from perpetual licenses, which lowers revenue and earnings volatility. Furthermore, as technology and digitalization become more pervasive, software is seen less as an “IT budget” that can be cut in weaker end market environments, but more as a business-critical investment.
At Barings, we aim to capitalize on the rich pool of investment opportunities in the SaaS sector and elsewhere in the wider technology ecosystem across a variety of strategies including in our global and international equity portfolios. Despite the industry being healthy and full of opportunities, we believe it is important to remain disciplined on valuation and continually refocus on companies where the underlying trends and company execution are still not fully reflected in share prices. In a number of cases, this has meant waiting for better opportunities to invest in what are often excellent companies. By adopting an active, bottom-up approach to security selection, we aim to pick the companies that will best position our strategies to generate attractive risk-adjusted returns over the long term.
1. A valuation metric that reflects the phase of their evolution whereby they invest heavily to grow their revenues.
2. Morgan Stanley, Thomson Reuters as of April 2019