The SaaS COVID-19 Pressure Cooker

Plunging stock markets, accelerating unemployment, a total shut down of Main Street America… what does it portend for SaaS companies?

Faced with a new reality, Software as a Service (SaaS) operators are asking for the first time: Can we survive the pressure cooker of a down market? SaaS companies, for the most part, have never faced market adversity. All they have known is growth. The longest historical period of economic expansion has allowed for unprecedented valuation creation among both public and private SaaS companies. Let’s not forget, just prior to the Great Recession there were a grand total of 18 public SaaS companies and only 59 SaaS acquisitions for all of 2007. Fast forward to 2019, there were approximately 100 publicly traded SaaS companies on US exchanges and 1,248 SaaS M&A deals for the year!

Testing the Thesis:

SaaS operators are now testing the very thesis that has made SaaS companies attractive investments for over a decade. Simply put, attractive SaaS companies possess a high percentage of contractually recurring revenue, strong gross profit margin, and high retention rates. Equally important, 70% of the typical SaaS company’s operating expenses are attributable to labor, providing the company flexibility to reduce headcount to bring costs in line with decelerating or declining revenue growth. When factoring in mission criticality, low debt ratios, strong unit economics, and multi-year annually paid contracts, many believe SaaS businesses are in a comparatively stronger position to weather any slowdown in economic activity much better than most other industries.

So how are SaaS companies faring a mere four weeks into the Covid-19 bear market?  First, let’s look at our winners.

Public SaaS Company Winners:

These ten companies have clearly benefited from insatiable end market demand for SaaS communications and collaboration platforms. Zoom leads the pack and is up over 114% year to date (YTD). The clear winner, Zoom has seen millions of people flock to its offering for all types of business and non-business events. The Company indicates daily users have jumped from 10 million at the end of December to more than 200 million at the end of March. It’s unlikely Zoom ever scenario planned for such a massive demand increase over such a short period of time. We should all be grateful. 

However, this has not come without cost. While there have been some performance issues, Zoom has found itself struggling with security issues as it has, unfortunately, found a large target on its back and attracted the attention of hackers.

While not in the same stratosphere as the demand these collaboration companies have experienced, we expect many SaaS companies will benefit greatly from a similar demand driver. For all too long, a massive number of businesses have continually kicked-the-can on upgrading from on-premise to cloud software. Today, these businesses find their employees locked out of mission critical applications and productivity plummeting. It’s unfathomable twenty years into SaaS.

A Closer Look:

No surprise, the team at Software Equity Group often works with SaaS companies that evolved from an on-premise heritage. In such cases, it’s not uncommon to see 20% of the company’s annual recurring revenue (ARR) comprised of annual maintenance and support fees. What’s more, many clients see a 2.5x to 3.5x lift in ARR as customers move from our client’s on-premise to cloud offering. Assuming a $4,000,000 maintenance and support base, a 75% conversion rate, and a 3x lift; this equates to $5,000,000 of expansion ARR. We can only assume this is a catalyst that will benefit many SaaS companies in the very near term. 

Flipping the coin, it’s not all roses. The vast majority of public SaaS companies experienced a Covid-19 sell-off that has their stock trading at 2017 levels. On a median enterprise value to revenue (EV/Rev) basis, Public SaaS companies were trading at 5.8x on April 3, 2020, about where public SaaS companies traded in 1Q 2017.

Taking the Cooker’s Temperature:

When compared to the S&P 500, Dow, and Nasdaq-100; public SaaS companies are down 16.4% vs. 25.0%, 18.2%, and 17.0% for the S&P 500, Dow, and Nasdaq-100, respectively. Segmenting public SaaS companies for those with revenue greater than $1 billion, this cohort is only down 14.9% year to date. 

There’s no denying SaaS companies are buoyed from the economic undertow by significant amounts of recurring revenue through annual or multi-year contractual agreements. Couple this with high gross margin and strong retention, a SaaS company’s recurring revenue is a quintessential survival tool. Recurring revenue gets respect when the economy is strong, but in lean times, when new subscriptions are scarce and upgrades slow, recurring revenue is the ultimate life raft most other industries lack. Do businesses rely on software more than software providers rely on their customers? The ultimate pressure test currently appears to be underway.

For more timely articles on the current state of public SaaS markets, check our research page. We recently published our SEG SaaS Index: Current Valuation Update.

Financial Data provided by YCharts. Price percentage change is calculated as the median stock price change among constituents in each index.

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