Cloud Revolution: Software-as-a-Service
08/01/2014 10:00 am EST
Software-as-a-Service is a revolution in the tech industry according to Peter Staas of Capitalist Times. Here, he explains this trend and highlights his favorite ways to play this growth.
Steven Halpern: Our guest today is Peter Staas of Capitalist Times. How are you doing, Peter?
Peter Staas: Doing great. Thanks again for having me, Steve.
Steven Halpern: Well, thanks for joining us. In your latest research, you note how the transition from servers to the cloud has created a revolution in the computer software industry, in particular, the market known as software-as-a-service. Could you explain what that is to our listeners?
Peter Staas: Basically, there's been a revolution in the software space. I know a lot of consumers have probably heard about the cloud, you know, maybe that's where you keep your music. If you're like me, you've backed up your computer to the cloud, because the last time you spilled water on it, you lost everything.
But there's a lot of stuff-and exciting stuff-that's been happening in the enterprise space over the past, oh, I would say, you know, five to six years, and, basically, every player benefits from this. You have, especially small to medium size businesses have been quick to adapt to this technology.
In the past, businesses have run a combination of like pre-packaged software, so, for example, Microsoft Office, that's something that everybody's probably familiar with. You install it once. You have a lifetime license and because of that model, you know software companies had really, you know, lumpy sales.
It was, "Okay, when we've added enough features to roll out a new version of the software package that we can sell off the shelf or sell via download, we're going to get an influx of money." And those were usually very high-price.
When you're talking about enterprise resource management software and some of the programs that are used by larger businesses-I mean, you're talking about a major expense, not only for the software itself, either to build it in-house, or purchase it from a vendor and then customize it to your purposes, but then, also, all of the server infrastructure and all that kind of stuff that you would need to have on site in order to support that.
Software-as-a-service outsources the server side of things. It's all hosted on the cloud, so it enables these small to midsize businesses to really have access to some of these tools and it's more of a-you're paying a monthly subscription.
Whenever there's an update to the product, it automatically goes out; everyone has access to it, so you don't have to go to your IT department and that cuts down another cost, and so it's a really interesting space.
Over the past, I would say, three years, we've seen a lot of these software, the service names do really well. They're producing really, really huge revenue growth and we also had, back in 2012 and 2011, you had a lot of the larger traditional software companies-Oracle, IBM, SAP, those kinds of names.
They're looking to get exposure to the space, because some of this software, the service stuff, I mean, it's not really taking away their really, really big customers, because those guys have made huge investments in their systems and they're not going to just throw that out the door.
But, like I say, it really enabled them to tap into the small to mid-size business and so you've seen a lot of these larger companies taking over smaller names. For example, SuccessFactors is one that was taken out-and Taleo was another one that was taken out-so, that's another part of the story. I'm going to cover that in a future article for Capitalist Times Premium, though, but that's kind of the gist of this revolution that's going on.
Steven Halpern: So, you suggested growth investors should take a two-prong approach to this sector. Could you explain the two different strategies that you would recommend?|pagebreak|
Peter Staas: Sure, and I think that this two-pronged approach-I mean, there's actually a third prong-but I was kind of focusing on what I would call a more conservative and valuation conscious approaches.
One of the things that we've seen in this space is there are a lot of smaller players. I mean, if you look at the Russell Small-Cap Index, I mean, that's underperformed this year, but if you break it out by sector, and you factor out the information technology sector, which has a lot of smaller-cap software-as-a-service plays, those things did incredibly well last year.
You had names like ChannelAdvisor (ECOM) and some other ones that were up 100% to 200%-which was crazy-and that priced in a lot of execution and a lot of those had sold off this year. So I was trying to focus-not on the fast moving plays-I wanted to look at some of the bigger, more established players, because I think that they have an opportunity that is in two areas.
One is going to be trying to move into the market that's dominated by some of these more established players, some of the really big enterprise contracts; trying to win some of those, and that's an uphill battle, because you have to first convince these companies to move away from a software package that everybody is, everybody in the same enterprise is familiar with.
They've invested a lot of time and money in and there is also the security issues, because these software packages are hosted via the Internet, so that's another issue. But I think that there's an opportunity to move into that space.
And then, also, some of these larger peer play software-as-a-service companies, they've also got an opportunity to really hone their industry specific offerings, which I think is going to really help them to increase their penetration rate and in certain verticals. That was one leg of the strategy.
The second leg is also very interesting and this has more of a relation focus; it's kind of saying that, "okay, you know what, these pure play software-as-a-service companies have done very, very, very well"-and everybody gets excited when they see the size of the addressable market-but just because you have a large addressable market doesn't mean the software that you're offering is a slam dunk, right?
So, if you can find a company that is a traditional software company-that has a very wide moat-one of the names that did really well for us last year in our Wealth Builders portfolio was Adobe Systems (ADBE).
You probably know them because they created Acrobat Leader for PDFs, but they also make the Creative Suite, which is a software package that's really the hands-down, the best one for, like, graphic design, all kinds of stuff like that, and they have a huge installed base.
They switched over completely to a software-as-a-service model and I mean that stock has been going like gangbusters. I mean, that transition has worked really well for them, because they have already established the creditability in the market.
So, now they're getting a steady stream of subscription revenues rather than every two years when they roll out a new Creative, getting a huge influx of cash flow, and it also brings out some buyers that-they don't want to invest the $600,000, $800,000 for a new software package-and who will just stick with the previous version.
Steven Halpern: Are you still bullish on the outlook for Adobe?
Peter Staas: Yeah, we are still bullish on the outlook for it. We took our profits off the table. It's definitely a name that I would, you know, would be worth looking at on a pullback.
I think that there are some other names out there where the story isn't as well understood yet, because they are earlier in that transition, or that transition is going to take place over a longer timeframe and, therefore, you can get a better valuation.
One of the names in particular for investors that you might want to take a look at is Autodesk (ADSK). They are a leader in computer aided design. They have a wide range of AutoCAD software. Some of it's for the building industry, some of it can be used for animation.
It's very, very useful for product development. You can do a digital prototype, kind of, stress test it, so you're not wasting money on materials. This software is widely used; it's the industry leader and it has a very sticky base.
People are trained on AutoCAD and Autodesk's other products and they tend to stick with it throughout their life and they're going to be making a gradual transition to a software-as-a-service model.
In general, they're trying to ramp up their subscription revenue, so they have a couple different strategies to do that. There's one you can get the traditional software package, pay for maintenance, which you get some training courses throughout the year. You have access to all the updates.
I think the software-as-a-service part is the most exciting realm. When you think about, like a building project, for example, or a design project, you're going to have parties that are involved with that. I mean, it takes a long time to turn these things out and there's a lot of parties involved.
The Autodesk software-as-a-servicing add-on-which they've started to roll out-is designed to communicate over the course of the project, between all the parties. It's kind of ridiculous, but I know that my nephew won his soccer game over the weekend from Facebook.
But I don't know exactly where the building project stands or where this one party is on the project. I've got to give them a call to find out. So, Autodesk now works this out for them.
Steven Halpern: We're out of time, but could you briefly touch on a couple of other names in the sector that investors could take a look at.
Peter Staas: Oh, sure. Yeah, sure. I mean, kind of the 800-pound gorilla is Salesforce.com (CRM), which is a customer resource management. They're one of the largest software companies in the world; it's a pure play on software-as-a-service.
They have a new focus on specifically targeting certain industries. I think that's going to really pay off for them and, of all the names, they've got the best chance to win the larger enterprise contracts.
There is also a mid-cap name that people might want to look at. I think this is a great long-term holding. It's going to be a slower grower, because it's focused on the public sectors, especially, local governments and municipalities.
They really have a wide range of products and software, but some of their big ones are full of, kind of, technological automation packages for court systems; some doing very, very well for them and-
Steven Halpern: And that's Tyler Technologies (TYL) you're talking about?
Peter Staas: Tyler Technologies, yes. I think that one of the big growth drivers for them over the next few years is going to be their e-filing systems that they offer.
Basically, they give this to local governments for free and then they sign a contract where there's a fee charged for every transaction, but that business has grown, it grew 147% in the second quarter.
I think that's something that could really be a driver for this company that has always, I mean, even during the 2008, 2009 challenges, you know, they've always turned in a steady revenue growth and they're buying back stock. I don't know, it's a great name. Again, it's slower than the other names we talked about, but I think there's still a lot of interest there.
Steven Halpern: Well, we really appreciate the time you've taken today. Thanks for talking with us.
Peter Staas: Thanks, Steve, I appreciate it.