Wednesday, February 23, 2011

SaaS Multiples: Recovery or Bubble?

With companies like Saleforce and SuccessFactors trading north of 8 times 2011 revenues, SaaS valuations are just back to the 2007 peak, but what is remarkable however, is that, after a period of strong correlation in 2008/2009, SaaS companies (represented by the SaaS 13 Index) have massively outperformed the overall technology sector (Nasdaq) in the past 12 months, creating a gap of more than 60%!

What happened? It would have been easy to explain the difference by changes in the 2010/2011 revenue growth projections but unfortunately that is not the case. SaaS companies projected to grow 18% over this period in January 2010 and this projection moved up only to 20% today. In comparison, the overall technology sector growth was projected at 9-10% in early 2010 and this forecast did not change significantly today.

So if the difference cannot be explained by short term projections, we need to look over an extended period. To justify a 60pts difference, we have to believe that the current growth rates of 10% for technology and 20% for SaaS will continue to hold for the next 9 years before converging. So the question becomes: "Can SaaS outperform technology growth by 2x over the next decade?" Not unreasonable.

Scale matters

To drill down further and better understand how public markets value SaaS companies, I split the SaaS 13 Index into two groups: companies above $1B in market cap (large cap) and below $1B (small cap) and compared the performance of both indices to the Nasdaq:

The result is very interesting: small caps are highly correlated to the Nasdaq but the large caps have taken off sharply, and on average, small caps are trading at 3.5x revenues while large caps are trading at 6.4x. The relative growth rates partially explain the difference as large caps are growing on average 3-5pts faster, but they do not seem to account for the entire gap.

The sales productivity ratio (measured with the Customer Acquisition Cost or CAC ratio) are also fairly similar for the two groups (except for a small cap dip in Q4 09) and therefore do not explain the difference

Why is scale so much rewarded by public markets? Scale is usually correlated with market leadership and large market size, and Wall Street is rewarding with a premium multiple these large SaaS companies because (1) their growth is supported by a secular trend (now it is clear that Cloud Computing is here to stay!) and (2) their leadership position in multi-billion dollar markets will likely make them dominant players in the software landscape, even though they are still small today (SuccessFactors $2.5B market cap or even Salesforce at $17.5B seem tiny compared to the $223B of Microsoft). Unreasonable? Time will tell!