Morgan Stanley
  • Research
  • Feb 22, 2018

Taking Software-as-a-Service at More Than Face Value

The software universe is quickly shifting toward Software-as-a-Service subscription models, but conventional valuation metrics may be hiding the true potential of companies in this rapidly growing group.

The software universe is laser-focused on Software-as-a-Service (SaaS) subscription models, which tend to drive higher lifetime value per customer and lower volatility in revenues and earnings.  SaaS companies, which provide software applications to clients on a subscription basis from a centrally hosted cloud, are poised to dominate the software segment and should continue their strong growth trajectory as more enterprises move to subscription-based cloud services.

Findings showed that the SaaS group's enterprise value could more than double over the next four years.

But based on traditional valuation metrics such as price-to-earnings multiples, this group has always looked expensive. Chalk it up to high customer acquisition costs, which tend to mask the long-term value of sticky and recurring revenues. This dynamic is magnified by the fact that most SaaS companies are still in the early days of growth.

To understand the true earnings potential of SaaS companies, Morgan Stanley Research created models to more accurately value these recurring revenue companies. One model, developed last year, removes the negative impacts of growth on margins, to focus instead on the underlying economics of subscription businesses.

The second model, introduced in a recent report “Margin Medicine' — A Prescription for Undervalued SaaS Names" (Jan. 30, 2018), assesses how the unit economics of subscription businesses can change over time, typically for the better.

On the Upswing

Morgan Stanley estimates that the SaaS companies it covers are positioned to grow earnings before interest and taxes (EBIT) at about a 40% compounded annual growth rate over the next five years, thanks to a combination of revenue growth and improving margins.

“Today the SaaS group generates $3 billion in EBIT against a revenue base of $28.5 billion, or a 10.7% margin," says Keith Weiss, who leads Morgan Stanley's software research team. “However, 80% of that profitability is generated by just three vendors, as the average operating margin across the SaaS group is just 0%."

In fact, 13 of the 32 companies covered by Morgan Stanley are not profitable at all, which is indicative of the high upfront cost of acquiring new customers, particularly at the enterprise level.

That trend is about to change course. Weiss and his team estimate that 30 of those companies will be profitable by 2022, with an average operating margin of nearly 18%.


The Evolution of SaaS: A Strong Potential for Leverage Across the Group

Source: Morgan Stanley Research

More Valuable Over Time

Recognizing that SaaS company earnings follow a different earnings trajectory than most companies, Morgan Stanley's software team began building and testing new valuation models last year.

Their first framework, outlined in a July 2017, report “The Margin Frontier – Finding Value with the 'SaaS X-Ray,'" separates the cost of new business acquisition from the contribution margin of renewals. “This makes it possible for investors to estimate and compare the underlying unit economics of these subscription businesses at a 'steady state' growth rate," Weiss says.

The team initially indexed its SaaS coverage group against a standardized growth rate of 10% to identify the most and least efficient subscription models and isolate each company's enterprise value based on existing recurring revenue versus expected growth. With this as a starting point, they could better predict margin trajectories in long-term forecasts and make apples-to-apples comparisons of companies growing at different rates.

The newest framework builds on that index to assess how the unit economics of a subscription business can change as companies scale and shift to more profitable areas.

Margin Medicine Operating Margin % Drivers
2017 2022 Terminal Year Improvement:
2017 to Term Year
Total Margin Medicine Group Op Margins 0.4% 18.2% 30.9% 30.5%
S&M % 38.7% 30.5% 24.3% 14.4%
Gross Margin % 72.0% 75.1% 78.0% 6.0%
R&D % 19.4% 16.8% 14.4% 5.0%
G&A % 12.5% 9.0% 7.8% 4.6%
Renewal Rate 90.1% 90.7% 90.9% 0.8%
Source: Morgan Stanley Research

Based on that analysis, the software team is forecasting an average 30 percentage point increase in operating margins between 2017 and their terminal year of analysis, with improvements coming from the following core drivers:

  • Sales and marketing: As employee headcount growth slows and overall sales productivity rises, increased efficiency could contribute 14.4 percentage points to total margin improvements.
  • Gross margins: As revenue mix shifts from professional services toward highly profitable subscription revenues, gross margin gains could contribute 6 percentage points to margin improvement.
  • Research and development: Spreading R&D investments across a broader set of customers delivers another 5 percent points of margin leverage.
  • General and administrative: As SaaS companies scale, these costs are spread across a wider base, adding another 4.6 percentage points.
  • Renewal rates: As more business mix shifts toward enterprise customers, improving renewal rates stand to add an additional 0.8 percentage points of margin improvements.

Applying this framework against Morgan Stanley's 32 covered subscription names conservatively forecasts a 21% revenue CAGR across the group, while bringing average operating margins to nearly 18% over the next five years from roughly 0% today.

Combine revenue growth with margin improvements and it adds up to about $16 billion in EBIT by 2022, or a 40% EBIT CAGR. Bottom line: The SaaS group's enterprise value could more than double over the next four years.

For more Morgan Stanley Research on the outlook for SaaS companies, ask your Morgan Stanley representative or Financial Advisor for the full report, “'Margin Medicine' — A Prescription for Undervalued SaaS Names" (Jan. 30, 2018). Plus, more Ideas.