How to Analyse Growing but Loss-Making Software-as-a-Service (SaaS) Companies
Talk about a multi-bagger!
However, Shopify has been unprofitable all these while.
In 2015, it had a net loss of around US$19 million, and that has widened to US$125 million in 2019.
Shopify isn’t the only tech company showing this phenomenon.
DocuSign (NASDAQ: DOCU) is another company that comes to my mind.
In fact, there are stories abound of unprofitable SaaS companies that are making fortunes for investors. Especially after the stock market crash in March this year.
How we do reconcile this?
Traditionally, what we have learnt is that we have to look out for profitable companies that have the potential to grow over the long-term.
But even those companies that are not making money are growing their share prices.
How is that even possible?
This show that the stock market knows something that we have not wrapped our mind around, yet….
What Are SaaS Companies?
Software-as-a-service (SaaS) is an online software distribution model where a third-party provider hosts applications for customers.
For that service, the customer pays a subscription cost on an ongoing basis. This compares with the traditional software model where users purchase a perpetual licence to the software.
An example is how Adobe‘s (NASDAQ: ADBE) applications such as Photoshop and Illustrator are sold over the internet now, compared to how they were sold previously through CD-ROMs.
The advantage of having a SaaS business model for companies is that there’s a recurring revenue element and companies are better able to predict their future sales.
As of the customers, instead of having a huge upfront cost to purchase a product, the cost is now broken down into more palatable bits.
It’s a win-win model.
The Problem With Traditional Income Statements for SaaS Companies
Here’s an example of the income statement from a fictitious company, Seedly Chicken Rice Limited:
The traditional income statement is perfect for old-economy companies because the timing of revenue and expenses are perfectly aligned. And they are all historical.
For the software companies that sell a perpetual software license to their customers and then later sell upgrades, the income statement above is useful to understand their businesses.
However, for the SaaS companies, the customer signs up for software on an ongoing basis and the contract can last anywhere from 12 to 24 months.
Therefore, due to accounting rules, the company is not allowed to recognise the revenue upfront but has to break it down according to the contract time frame.
For example, for a 12-month contract, revenue is recognised per month at 1/12 of the total contract value.
To add on to the “woes”, the company incurred almost all its costs to acquire that customer much earlier. Such costs include sales and marketing, research and development, and hosting.
These upfront expenses aren’t recognised over time just like revenue, causing misalignment of the timing of revenue and expenses.
The income statement alone, therefore, doesn’t tell us everything we need to know about valuing a SaaS business (more on that later).
Enter The Subscription Economy Income Statement
Instead of relying on the traditional income statement, we have to wear a different lens to analyse SaaS companies.
That’s where the “subscription economy income statement” comes in handy.
And it’s a forward-looking statement, unlike the income statement that we all are familiar with.
The “updated” income statement term was coined by Tien Tzuo, founder and CEO of Zuora, and was described in his book, ” Subscribed”.
|Subscription Economy Income Statement|
|Item||Amount ($' million)|
|Annual recurring revenue (ARR)||100|
|Cost of Goods Sold (COGS)||(20)|
|General & Administrative (G&A)||(10)|
|Research & Development (R&D)||(20)|
|Sales & Marketing (S&M)||(30)|
|Net Operating Income||10|
|New ARR (or Annual Contract Value, ACV)||30|
Let’s explore what each of the terms means:
- ARR is the amount of revenue a SaaS company expects its subscribers to pay for the period
- Churn is the projected amount of money that leaves the business when customers stop their subscriptions for whatever reason
- Recurring costs such as COGS, G&A, and R&D are the money needed to be spent to service the ARR
- Recurring profit is the difference between net ARR and recurring costs, and it gives the intrinsic profitability of a SaaS business
- S&M is a growth cost as this expense is matched to future revenues, unlike traditional companies, as discussed earlier
- ACV is the amount of subscription revenue from new customers and the existing ones who upgrade their service or pay more for a service
- Ending ARR is the amount of money available for the next period
Other Metrics to Know About to Analyse SaaS Companies
To help us further evaluate SaaS companies, there are also a number of other terms we have to understand.
Gross Profit Margin: Similar to a traditional company which shows the amount of gross profit a company makes for every dollar of subscription revenue generated.
Gross Profit = Subscription revenue – COGS
Gross Profit Margin = (Gross profit/Subscription revenue) * 100%
Anything above 80% is great as this shows the company has pricing power over its rivals.
Customer Acquisition Cost (CAC): Shows how much a SaaS company spends on S&M to acquire a single customer.
To calculate it, we can simply divide S&M costs by the number of new customers acquired during the period. This will give us an approximate value for CAC if the company doesn’t publicly reveal it.
CAC = S&M / Number of new customers
Customer Lifetime Value (LTV): Measures how much each customer is contributing to a company’s revenue over the course of the business relationship. It also gives a guide on how much the company should be spending to acquire the customers.
A good proxy for LTV is to take the total subscription revenue divided by the number of total customers.
LTV = Total subscription revenue / Number of total customers
LTV-CAC Ratio: Shows how much a customer is worth to the business versus how much it cost to bring the customer on board.
LTV-CAC Ratio = LTV / CAC
Anything above 3x is the benchmark and it means that the business model is working.
Rule of 40%: Helps to measure a “healthy” SaaS company at scale.
Rule of 40% = Subscription revenue growth rate + EBITDA (Earnings Before Interest, Taxes, Depreciation, and Amortisation) margin
Anything above 40% is great.
Dollar-Based Net Retention Rate (DBNRR): It measures the change in spending for all of a SaaS company’s customers a year ago compared to the same group of customers today. It includes positive effects of upsells and negative effects customers who leave or downgrade.
Some SaaS companies may have a different definition so it’s always best to check with the company on how they measure DBNRR.
I found this spreadsheet which shows some SaaS companies’ net retention rates and their definitions as detailed in their IPO prospectuses.
Anything above 100% is great as that means the company’s customers, as a group, are spending more.
This is an example from DocuSign’s second quarter of its fiscal year 2021 earnings call (emphasis is mine):
“This brings our total customer base to nearly 749,000 worldwide with over 99,000 direct customers. Strong eSignature expansions and upsells into our existing customer base led to a record dollar net retention rate of 120% in the quarter. Customers with ACVs greater than $300,000 grew 41% year over year to a total of 520 customers. Total non-GAAP gross margin for the second quarter was 78%, consistent with a year ago.”
Deferred Revenue: Deferred revenue is revenue that is not recognised yet by the SaaS company, but is already paid by customers.
This revenue is slowly recognised as time goes by and the service is delivered. For example, for a 12-month subscription service, deferred revenue drops by 1/12th and revenue increases by 1/12th as each month goes by.
This figure can be found on the company’s balance sheet.
Billings: This metric is like “future revenue” as it shows how much revenue will be recognised quarters down the road since customers pay in advance for subscription services.
If a SaaS company is growing its bookings — whether through new customers or upsells/renewals to existing customers — billings will rise.
Billings is usually calculated by taking the revenue in one quarter and adding the change in deferred revenue from the prior quarter to the current quarter.
Billings = Revenue + Change in deferred revenue
Billings can also be defined differently between companies. This is how DocuSign defines billings:
“We define billings as total revenues plus the change in our contract liabilities and refund liability less contract assets and unbilled accounts receivable in a given period. Billings reflects sales to new customers plus subscription renewals and additional sales to existing customers. Only amounts invoiced to a customer in a given period are included in billings.”
It is also revealed by the companies when they report their earnings. Below’s an example from DocuSign:
Free Cash Flow Margin: Free cash flow is operating cash flow minus the purchase of property and equipment. It is an important liquidity measure for businesses.
Free Cash Flow Margin = Free Cash Flow/Revenue) * 100%
Anything above 20% shows that the company is producing stable free cash flow.
Upcoming Tech IPOs for 2020
Recently, we discussed the top tech IPOs to watch this year.
You might have noticed that many of the SaaS companies such as Asana and Palantir are still unprofitable.
Hopefully, with this guide on evaluating growing, but loss-making SaaS companies, you would be able to better appreciate the upcoming IPOs.
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Disclaimer: The information provided by Seedly serves as an educational piece and is not intended to be personalised investment advice. Readers should always do their own due diligence and consider their financial goals before investing in any stock. The writer may have a vested interest in some of the companies mentioned.