This article takes a first attempt at developing a scorecard / framework to better assess the impact of COVID-19 on enterprise software companies. While enterprise software stocks has fared better than rest of the economy, it is clear that various sub-segments will have a different exposure to the short-term impact of COVID-19 as well as the subsequent economic decline.
SaaS — Share Price Performance Over Time
The BVP NASDAQ Emerging Cloud Index has significantly outperformed the wider market over the last five years. While the index declined significantly in March-20 to levels last seen in Dec-18, it has rebounded strongly since then. The stellar performance of cloud companies is driven by the multi-decade structural shift from on-premise to the cloud as well as several advantages of the underlying business model.
The current pandemic and the subsequent recession will have a negative impact on the economy and the technology sector. Gartner’s recent forecasts imply a contraction of worldwide IT spending by 5% this year.
As not all SaaS companies are equal, they will be impacted differently by the current events. In order to better assess the potential threat of disruption, I have collated a framework to assess the short to medium term risk of companies in the SaaS universe.
Potential Framework to Assess Short to Medium Term COVID-19 Risk
The framework is built on 4 different factors (1. revenue resilience, 2. industry focus, 3. go-to market strategy and 4. segment exposure) to assess the resilience of the company’s business model and then puts it into the context of the key financial metrics, which ultimately drive valuation.
A short summary of the factors is provided below.
- Revenue Resilience
Recurring revenue mix
Firstly, SaaS companies, with a high portion of recurring revenues, have a high degree of visibility and hence are more resilient to economic shocks. However, even such a prevalent relationship has to be scrutinized today. As Gavin Baker states in his recent post: “no revenue is truly recurring”. The quality of the recurring revenue will depend on other factors of the framework, including industry focus, go-to market strategy and segment exposure.
New logo wins
Secondly, the short-term impact of COVID-19 will be a significant reduction in new logo wins as customers defer/cancel new IT projects and implementation due to general economic uncertainty and travel restrictions. A recent Gainsight survey suggests that “from a new bookings perspective, most CEOs are contemplating a 20–50% decrease in bookings from a y-o-y growth perspective.” This implies that companies that rely on new logos wins as the main source of topline growth will struggle more than companies relying on (a) upsell and/or (b) “land and expand play”.
Thirdly, pricing model will be key factor in determining revenue resilience. As Gavin Baker points out “seat based, transaction and workload based pricing models will obviously immediately feel the changes in the economy and naturally be more cyclical — one way or another”. As an example, Twilio’s usage-based revenue model allows companies to quickly ramp up its capabilities based on business demand. It’s pricing model, coupled with it’s customer footprint in travel vertical (Uber, Lyft, Airbnb), could potentially have a negative impact on its financials in the short to medium term. Another company with a similar pricing model risk is Shopify as c.60% of revenues tied to merchant GMV transactions.
Finally, SaaS players with a multi-year contract duration are in a better position relative to players with shorter contracts. It should be noted that potential churn could be amplified by other factors of the framework such as when the SaaS solution is not considered mission-critical etc. However, all players would need to be prepared for contract renegotiation with existing customers, which will negatively impact the revenue base as well as liquidity, explored further in the financial metrics section.
2. Industry Focus
Horizontal vs. Vertical / Industry Exposure
We are already seeing contraction of IT spending in certain industries (e.g. airlines, hospitality, oil and gas) that are particularly hit during the crisis. As already mentioned, end-customers in these verticals are generally re-negotiating their existing software subscriptions to restructure their cost base. In the worst cases, customers have stopped paying software providers due to liquidity constraints. Overall, SaaS businesses in these verticals will be severely affected and their recovery will be dependent on the recovery in the respective end markets.
There are also categories within horizontal software, which will also be impacted more severely than the rest of the SaaS universe due to second order effects. Illustrative categories include payroll (lower interest rates affecting float revenue) and marketing automation (decline in overall marketing budgets).
Working from Home Benefit
There are some sectors that have experienced tailwinds due to COVID-19. Current enterprise IT spending is very focused on ensuring that organisations have sufficient remote access capabilities to operate in a seamless manner. Obvious beneficiaries include application and infrastructure providers in sub-sectors including collaboration software, video conferencing, identify and access management and VPN services etc. SaaS players in these segments will display strong topline growth during COVID-19 but the question will be if they can continue these newly formed relationships after the period of crisis. The positive impact will be amplified by other factors in the framework including product-driven growth, short implementation cycle etc. A great example is Zoom, which ticks most of the boxes in the rest of the framework.
3. Go-to Market Strategy
Sales Cycle and Implementation
While it is not easy to sell over the phone / Zoom / WebEx, companies with shorter sales cycles and lighter touch sales models will be more resilient during the period of uncertainty. They will be able to pick up new logo wins to support growth. Companies with product-led growth will do particularly well in the current environment. Illustrative companies with longer sales cycle include Guidewire, QAD and Veeva Systems.
Sales channel mix
There are two considerations in relation to sales channel mix: (a) field sales vs. inside sales and (b) direct vs. indirect channel.
SaaS companies, with a predominantly direct channel, will find it harder to sustain the current cost base as pipeline have naturally deteriorated and there are less logos to chase when people are adjusting to the new environment. This has already led to significant redundancies in the tech sector and companies will continue to right-size the teams, including the in-house sales force. In addition, businesses that rely on field sales representatives, coupled with heavy sales implementation, will particularly struggle due to the travel restrictions.
In relation to indirect sales channel, there has been an interesting development, which was highlighted by Coupa Software’s CFO in a recent interview. On a few deals, channel partners are paying the software fees while negotiating and arranging payment terms for its customers. This is part of channel partners’ strategy to adjust to the new environment and keep utilisation rates high within their organisations.
4. Segment Exposure
ACV — large vs. small deals
It will be challenging to get larger deals signed during the current period of uncertainty. Larger deals are typically accompanied by a go-to-market strategy that is unfavourable at the current time (long sales cycle, heavy implementation). Therefore, the ACV ($) can be used to confirm for the implications drawn in the previous section.
Revenue by segment exposure
SaaS companies with significant end-market exposure to SMEs will be at higher risk of churn as SMEs will be increasingly liquidity constraint. Based on the Gainsight survey, “Software companies catering to the SME are expecting churn to increase 19 points. Those selling to large enterprises are expecting, on average, a c.3 point increase in churn.” Illustrative examples of SME-focused vendors include Alarm.com, Avalara, Shopify etc.
Mission critical vs. underutilized software (shelfware)
I would distinguish between mission critical software as a stack that is needed to run the business in (a) normal times and (b) during COVID-19. Firstly, mission critical software in normal times will benefit from more resilient retention rates. However, other factors of the framework, including focus on affected verticals (hospitality etc.) as well as SME focus, will adversely affect even mission critical software providers.
Secondly, software that facilitates remote work, will be viewed as mission critical during the current crisis and will benefit from incremental demand. Clear beneficiaries include collaboration software, video conferencing, identify and access management, VPN. It will be interesting to see if there is a structural shift towards remote work and these companies can keep the incremental demand on the platform once the crisis is over.
Furthermore, customers will reassess the budget spent on under-utilised software (shelfware), which will lead to churn or increased payment renegotiation. Henry Ward, CEO of Carta, sums up the typical cost reduction strategy at firm level in his recent note: “once we modeled a slower growth rate in 2020, the first things we looked at reducing were non-headcount related expenses like non-essential software, AWS, travel, real-estate costs, and so on.”
5. Financial Metrics
Revenue Growth and Profitability
The resilience of a SaaS company, as analysed using the 4 factors, will be reflected in the KPIs and financial metrics (topline growth and margins) over time. These metrics should be used as an indicator to confirm the outcome of the analysis. It is expected that companies will preemptively right-size their cost base and shift from aggressive growth to profitability to reduce cash burn. However, SaaS companies with less attractive unit economics will particularly struggle during this shift as the weakness of their business model will be apparent.
Liquidity and Working Capital Cycle
Liquidity will be a critical factor that needs to be assessed as a separate point. It will be impacted by (a) leverage / cash as of today, (b) FCF over time. Cash is king — particularly as credit and equity markets have tightened in the past month. As I mentioned above, companies will aim to offset potential loss of revenue and decline in revenue growth by rightsizing the organisation.
In regards to leverage / cash position as of today — a net cash position puts companies in a great starting position. In contrast to that, companies with leverage, coupled with negative cash flow, will be particularly vulnerable in current environment.
In regards to notable FCF items to focus on — working capital will be particularly negatively affected by the current crisis. It is expected that software provides will need to offer customers flexibility on payment terms — this can be amplified by other factors in the framework, including SME and focus on certain verticals (hospitality, transport). More specifically, it will cause account receivable balances to increase and result in the days sales outstanding to also shoot up. Investors should pay close attention to how working capital evolves in the coming quarters.
In public markets, software valuations have been principally driven by (a) topline growth and (b) profitability. This has led to the “Rule of 40”, which puts an equal weighting towards revenue growth and FCF margins. In reality, the weighting shifts with investor sentiment over time. Over the last twelve months, coinciding with the disappointing performance of the 2019 IPO cohort, investors have been increasingly focusing on companies that display profitability / clear path to profitability. The shift has been greatly accelerated by the current crisis.
Furthermore, investors are taking into account the resilience of SaaS companies into the investment decision — the proposed framework aims to provide a structured way to do so.
Due to the shift towards profitable growth as well as perceived resilience / vulnerability of a company in the face of COVID-19, valuation have recently reset for several high risk companies. However, fundamental value dislocations continue to exist and offer investors attractive risk-adjusted returns in the public SaaS universe.
Applying the Framework to HubSpot
As a small exercise, I have applied the framework to HubSpot for illustrative purposes. I will leave it to the reader to draw conclusions from the information provided. :)
Disclaimer: all views are my own. It is written purely for information only and is not intended to be investment advice.