Secret SAAS Businesses

Reading Time: 4 minutes

SAAS stocks are all the rage. While the S&P500 is up ~12.5% at the time of writing, the Tech-Software ETF is up 41%. Over the past 4 years, the gap is +215% for Software and +88% for the S&P.

It makes some sense. These are companies that have long runways of growth, are FCF generative (if you count stock-based comp as an addback, but point is they tend to be people-heavy, but asset lite), and a good portion of them are really sticky businesses through the subscription model.

A sticky business is important. Imagine you’re a business owner trying to prepare shifts for your employees. You don’t know if a customer will come into your store or if you’ll be bombarded that day. If you are bombarded, you might lose sales because you don’t have enough staff. Recurring revenue companies can plan much more effectively and align costs with revenues appropriately.

I’ve outlined this before, but the subscription models also tend to spend a lot of money on just acquiring the customer. So the first year, the business isn’t that profitable, but on renewal it is highly profitable.

Also think about this dynamic in COVID-19 impacted world. Economies were literally locking down. I was running scenarios on companies that I’ve never had to do before – “how would these businesses look with ZERO revenue for the next 3 months.” If you’re in a business where you are mission critical to the customer and get paid a small monthly fee for that service, then you weren’t sweating it as much.

Therefore, I think there was a changing of the guard this year. Well, maybe it actually happened in the 2015/2016 recession scare. (The latter would make more sense because that’s when we saw the atmospheric launch of FANG and SAAS.)

Investors had long been valuing recession proof businesses at much higher multiples than more cyclical peers. Think Utilities, Consumer Staples, large Healthcare companies. I think following the great financial crisis (the GFC), it had a big psychological impact on investors – “try not to own things that can get crushed like that again.” And therefore, the discount rate on these cash flows went lower (due to perceived lower risk).

SAAS combines those attractive characteristics with ultra growth. But the subscription really made it easy to count on what was going to be in the bank account. So low discount rate + hypergrowth = highly valued.

Secret Subscription Models

Something I’ve been thinking about the past few years is “secret SAAS” or really, “secret subscription” businesses. These have very similar characteristics to SAAS, but aren’t in software.

Some of these companies have highly recurring revenue, but may not have a monthly subscription. Some of these names are also dominant and will own their category, but it might be niche and many people just don’t know about them.

The only thing missing from my list is the hypergrowth. But you also aren’t paying 10-100x sales for any of them…

Perhaps I’ll do a post on each of these, but please feel free to reach out, comment below and comment on Twitter (@DollarDiligent) names you think should be added to the list.

Secret Subscription Business Models (no particular order):

  • Flavor and Fragrance Names such as Sensient Technologies and International Flavor & Fragrances
    • I really like names that are critical to an end product’s use, but are a very low cost input. This typically translates into limited switching and little pushback from some price increases
    • Flavors & Fragrance names provide the products that impart taste, texture, or smell to consumer end products.
    • These are mission critical. They also are sold into pretty recurring end market – food and fragrance.
  • WR GraceAre you a refiner that wants to upgrade that barrel of oil into higher value products like gasoline or jet fuel? Well – you need a catalyst. The catalyst creates a chemical reaction to start the process. This is also true in creating plastics.
    • Unfortunately for you, refiner, you can only get this catalyst from 3-4 companies. But they are very high touch, high R&D businesses and the cost of the catalyst is very little compared to the cost of a refinery.
  • Beacon Roofing and Carlisle Roofing segmentThere is a large installed base of roofs. And many were put in place 15+ years ago. As they age, the roof needs to be replaced.
    • No matter what the economy looks like, if the roof is leaking, it needs to be replaced ASAP.
    • This leads to very high recurring revenue (albeit storms can make some years lumpy)
  • Moody’s / S&P Global / MSCINeed to refi your bond? S&P and Moody’s are the gatekeepers. Need to access the ratings? If you want to access detailed reports, investors need to pay a fee. In a large market, this adds up to highly recurring revenue (in addition to other platform services the companies offer, such as Platts and Cap IQ)
    • For MSCI and S&P – Having managers benchmark to your indices provides a highly recurring fee each year. Changing your benchmark tends to be a “no no” and the more recognized the benchmark company, the more circuitous it is
  • Apollo and Blackstone and other asset managers.
    • Earn management fees on a large, mostly locked up capital. Sure, there are incentive fees that may not be highly recurring, but the bulk is actually just management fees
  • Franchisors – many come to mind like Domino’s, Planet Fitness, McDonald’s etc. These names take little capital to run themselves and earn recurring royalty fees from the franchisees

MSCI Reminds Me Why I am a Long-term Bull on SAAS Stocks $MSCI $IGV $DBX $NOW

Reading Time: 3 minutes

I’m taking a look at MSCI stock. It’s an interesting one and pretty easy to understand. The bulk of the business is a subscription revenue tied to the indices MSCI  creates. These indices are then used by asset managers for their benchmarks. It’s kind of funny how similar it seems to a SAAS stock.

MSCI’s business is growing well (though not gangbusters) which you can see below and ~97% of it is tied to recurring subscriptions. The thing that sticks out to me is the EBITDA margins!  In total, the company has ~55% EBITDA margins. If you were to just take the Index business they have, that segment is >70% EBITDA margins.

Given capex is so low, this results in a ton of FCF. MSCI can’t really invest it all back into the business, so they pay a reasonable dividend and do share repurchases. They also have levered the balance sheet ~3.5x to juice returns, which makes since on a highly recurring business.

The table below shows how much in share repurchases + dividends MSCI has done. I also put the market cap at the end of the year for context. Obviously, buying MSCI would’ve been a great call back in 2015. But also just look at how much capital has been returned. It’s around $4BN and if you bought at the end of 2015, that’d be nearly ~60% of your capital back. 

Why does that make me bullish on SAAS stocks?

For one, its still early days. And as these names get scale on their costs, I think they too will be generating a significant amount of FCF (some already do, but I think it will be higher).

Some names will eventually reach a “maturity” point. Take Dropbox for example, which I did a post on recently. Arguably, they are reaching maturity and their margins are exceptional, as is the FCF.

If you made it to the end of my Dropbox post, you would’ve seen some analysis I did for long-term margin potential which I’ll repost here (saved you a click). This is a template I typically use to evaluate SAAS names. In some cases, like for ServiceNow, I arrive at “mature” operating margins of near 50%. The main reason is that the typical first sign up is actually negative margin, but the following renewal is very high margin (i.e. lots of costs in to win your business, then I just need to keep you).

Fast forward ten years: Some SAAS stocks will still be plowing every dollar back into the business. Some will still be very nascent and growing quickly, but not have much earnings. Some SAAS stocks will be more mature, be willing to take on debt like MSCI, and will likely gobble up shares and pay dividends.

Remember when Apple shifted to this strategy after generating so much cash? That makes me excited.