Are SaaS Stocks Overvalued?

This is a guest post by Bernard Lunn of SaaS Insights Report who has produced a fascinating report analyzing public & private SaaS Ventures to reveal the metrics & trends that drive their performance and valuation.

Aimed primarily at Traders, VC/Angel and Management looking for market intelligence, this post provides fascinating insight, particularly in light of yesterday's Salesforce numbers, of the state of the SaaS marketplace which is surrounded by so much noise and froth in the current climate.

SaaS Insights, a new report on the SaaS market (available here) analyzes 14 publicly traded SaaS companies to shine a light on the question 'Are SaaS Stocks Overvalued?'.

The 14 companies in the SaaS Index are:

Price Earnings Growth (PEG) For The SaaS Index

SaaS Insights tracks the Price Earnings Growth ratio for all 14 companies and for the Index as a whole. SaaS Insights uses Price Earnings Growth (PEG) as the best single metric for investors in SaaS companies. Price Earnings (PE) alone is not very useful, as investors will clearly pay a higher price for a fast-growing company. The average for the Index (on Feb 8th) was 1.94. The classic investor yardstick is that any stock below 1.0 is a bargain. Growth stocks are seldom bargains and SaaS is considered a growth sector.

As a comparison, SaaS Insights created another Index, the Big Tech Index. There is no point comparing SaaS stocks to the broad market. But companies in the Big Tech Index (Apple, Google, eBay, IBM, HP, Dell, Infosys, Microsoft, Cisco, Amazon and Yahoo) are comparables.

PEG for the Big Tech Index on the same date was 1.16. . That indicates a SaaS model premium of 70%.

The case for this premium is strong:

1. The SaaS model is demonstrably better for clients
2. We are still in the early days of transition from legacy models to SaaS so the upside for companies that can become market leaders is very big.
3. SaaS revenue visibility is better than in traditional models so the projected earnings on which PEG is based will be more reliable.

However, these facts have been known for a while. The PEG for the SaaS Index fell from 2.80 in the Q3 reporting season to 1.94 in the Q4 reporting season.

At close of trading on Wednesday Feb 24th, just before Salesforce.com (CRM, the bellwether of the SaaS market) reported their quarterly earnings, the SaaS Index PE was 1.94.

The M&A Impact

Stocks are of course worth what people will pay for them. So the M&A market may drive that price for a while. There are four types of companies on the buying trail for SaaS companies: 1. Big Tech companies that need more revenues from the SaaS model and cannot get there fast enough organically. 2. Public SaaS ventures that want to separate from the “small cap pack” and move closer to Salesforce.com in size. That is a big gap. Salesforce.com is over $1 billion in revenues and few of the other SaaS companies have tipped over $200 million yet. 3. Private SaaS companies with big VC backing that want to accelerate their IPO plans and need to “bulk up” before doing that. 4. Salesforce.com, a category all of its own in the SaaS market that has a big war-chest of cash and a highly valued stock. In SaaS-world they are Goliath. In the broader tech market they are still David.

The M&A impact is likely to keep the valuation of SaaS companies (both public and private) high for a while.

Are There Any Bargain SaaS Stocks?

SaaS is a growth story. The subscription model makes for better revenue visibility. So we don’t expect to find an old-fashioned “cigar butt” cheap stock in this index. But we may find one that is priced low compared to it’s peers, that has a strong balance sheet and where there is no evidence of a major problem causing the low valuation.

We start by ranking the Index by PEG. The ones at the top are candidates for value play:

50.88

It looks like somebody already figured out that SKIL is a value play:

February 12, 2010 6:52 AM EST

SkillSoft PLC (NASDAQ: SKIL) today announced that it has reached agreement on the terms of a recommended acquisition of the Company by a new company formed by funds sponsored by each of Berkshire Partners LLC, Advent International Corporation and Bain Capital Partners, LLC (together, the “Investor Group”). Under the terms of the recommended acquisition, SkillSoft shareholders will receive $10.80 in cash for each SkillSoft ordinary share or American Depositary Share (“ADS”), representing a 26% premium to the average closing price of SkillSoft’s ADS over the one-year period ended on February 11, 2010 and a 49% premium to the average closing price of SkillSoft’s ADS over the five-year period ended on February 11, 2010. The fully diluted equity value of the transaction is approximately $1.1 billion.

SaaS Insights Report digs deeper to look at cash balance in relation to market cap and identifies the top 5 value candidates.

Finding The Momentum Play In The SaaS Index Investors in SaaS are usually looking for growth more than value. The accepted wisdom is that over-paying in the short term for the stock of a company that has great momentum is usually OK as there is a positive feedback loop when customers, management and investors are all having good “animal spirits”. We can hunt for these momentum plays in three ways:

1. Cyclical rebound (stocks that do well when the economy rebounds). This is unreliable today as a) the market has already priced in recovery and b) the predictions on the economy have huge variations, nobody can really predict what will happen.
2. Secular trends. What stocks are on the “right side of history” and are benefiting from long-term market growth. This is not helpful today as every company in the SaaS Index benefits from the secular shift to SaaS. This is already priced in.
3. The quarter-to-quarter growth rate. This is what we focus on. We are looking only at Revenue and only at the last 2 quarters (momentum plays are short term in nature).

In the traditional model, the 4th quarter would be stronger than others as licensed deals were crammed into the last quarter of the year. The way SaaS subscriptions are recognized this is not a significant factor. So the quarter-to-quarter (Q-Q) growth rate % is the simplest indicator of short-term momentum.

So here are the top SaaS companies 5 by Q-Q revenue growth rate %:

_ Note: Salesforce.com exceeded the estimate by $12m, showing a Q-Q Growth % of 7.11%, which is very good given their size.

The market is clearly rewarding momentum. KNXA is showing a Q-Q decline of -2.98% while the competitor SFSF is showing a growth of 9.04% and the divergence in the stock price shows that.

The strong showing by LOGM, one of the few tech IPOs in 2009 will strengthen the case for an IPO rebound in 2010.

The full SaaS Insights Report is available for $725 here.