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At the risk of getting steamrolled by a beast of a trade and blowing my reputation on a thematic call, I believe that many SaaS software stocks are in a bubble. I’m trying to choose my words carefully here and not be hyperbolic. I say “many” and “most” because I suspect that there will be a couple of companies that will prove to be great businesses that can justify their valuations with earnings and cash flow, though with one exception I’m not smart enough to figure those out. I avoid snark. SaaS isn’t like dot-com where companies with no business plans had multi-billion dollar valuations. That’s what makes SaaS much more difficult, because these companies have nice products, generate meaningful revenues, are run by good and honest people, and selling software generally can be a great business. It’s difficult to conclude something legitimately interesting and adding value of being in a bubble. So, is this a bubble? Let’s take a step back and look at some of the big picture issues in simple terms. I think there are two ways to approach this. First, what are the fundamentals for these companies and what can we reasonably predict for the future? Second, to what extent do SaaS stocks exhibit characteristics found in other bubbles?

SaaS companies either lose money or at best make immaterial profits. All of them. The cold reality is that in spite of all the positive channel checks and investor-speak about these companies, they don’t make money. The logical conclusion I draw is that SaaS companies materially underprice their products in order to grow. Meanwhile, AWS generates 30% pre-tax margins and it’s run by the patron saint of sacrificing short-term profitability, so we know profitability is possible for this type of company, yet none of these companies can pull it off.

There is not one example of a SaaS company significantly expanding margins after revenue growth tapers. More relevantly, there isn’t an example of one expanding margins enough to justify its valuation. This is the entire thesis for owning these stocks, yet not one example of it being true can be found. Scale, always undefined, is perpetually on the horizon. Salesforce has been at it for two decades and they have a 5% profit margin and 7% ROE. Where is the evidence that this is by choice and not just a competitive reality? Furthermore, if AWS has 30% margins and a reasonable person can conclude that it is the high water mark for this industry, how likely is it that these other SaaS companies will be as (or more) profitable than AWS? Whatever normalized profitability might be one day, I think we already have a good signpost that something far less than 30% is likely.

Customer retention hasn’t been adequately tested and I believe critically important issues of pricing power and churn rates for most companies over the long-term will prove worse than people are assuming. If returns are high it will attract more capital and competition. Companies and entrepreneurs have no trouble accessing capital and the software itself isn’t difficult to create, as evidenced by the very low amounts of contributed capital (often bordering on immaterial) of many of these companies. At best this will suppress pricing power, at worst it will cause churn rates to grow, which is deadly for SaaS. Only a small group companies with extremely wide moats will do well.

There is an 800lb gorilla in the room: AWS. Amazon is going to do to these SaaS companies what they did to brick-and-mortar retailers. They’re already doing it, but the rising tide is masking it. Pick a SaaS company and there’s a good chance that AWS has a competing service at a fraction of the price. Admittedly, AWS probably won’t have the same functionality, but Amazon is into things that scale (ie make money). But the trend isn’t good, and recent AWS moves muscling in on MongoDB and Elastic have shown increasing aggressiveness to more directly compete against many of these companies on functionality as well as price. Amazon always gets better, which means life is only going to get worse for these SaaS companies over time. When the market eventually slows, many SaaS companies are going to realize they’re inside AWS’s orbit, with AWS’s gravity sucking up growth and eroding pricing power just like they did in the retail world.

High growth companies don’t make smooth transitions to low/no growth companies. How has it worked out for Marin Software, Amber Road, Brightcove, cars.com, Pandora Media, Groupon, Carbonite, et al? The fact is that when growth significantly slows or stops, profits are elusive and spending increases as spastic management teams try to reinflate the company. Look at Box as a real-time example of this. As a preemptive measure, companies will inevitably compete more with each other by developing adjacent products in order to grow. (eg Tripadvisor)

No CEO has been battle-tested and demonstrated an ability to generate economic returns for shareholders. None. It’s unclear whether all of these CEO’s are both great product people and great businessmen, or just the former. It highlights how Steve Jobs was in a league of his own for being able to scale while being insanely profitable. Things tend to settle at the level of expectations – if no CEO is expected to generate economic returns, none of them will. This is worrisome for those 30-year DCF’s used to justify stock valuations. I think a lot of these guys are going to wind up like Elon: great at creating a product but no idea how to make a killing from it. It’s just not part of their DNA.

And what about general bubble characteristics?

Bubbles form after massive inflows of capital. By any measure, VC funding has been distressingly high with 2018 setting yet another record with over $130 billion in deals, up 57% from 2017 and eclipsing the prior record from 2000. The number of deals has decreased while the size per deal has increased. Within the VC world, software has seen by far the highest levels of investment at $45 billion in 2018, up 65% from 2017 and up over three-fold from 2012. Since 2010, over 2,000 VC firms have been founded. (That’s not a typo) The world is awash in money, and software is taking a disproportionate share of it.

Bubbles form with benign capital markets. Incentives for SaaS companies are perverse. Companies are rewarded for growth and punished for profits. Stocks with the highest revenue multiples are the best performers. IPO’s frequently see gigantic first day pops while sell-side analysts trip over themselves to justify price targets 30% higher than whatever the stock price happens to be.

Bubbles enable and normalize alarming megadeals. Uber wants a $120 billion valuation. Palantir wants a 40x revenue multiple. Softbank has a $100 billion “venture” fund (see: inflows of capital) that valued WeWork at $45 billion (20x revenue).

Bubbles form with new paradigms in strategy. Previously we’ve had platforms, conglomerates, a million biotech flavors-of-the-week, shale, crypto, and today we have “reinvesting for growth.” Criticize this and you risk getting dismissed as myopic or an old fogey. Every investor believes the SaaS stocks they own “could be profitable today if they wanted to” but not even the CEO’s can articulate specifically how this is possible. No one can connect the dots. “Reinvesting for growth” has become dangerously synonymous with being smart and more strangely, highly profitable.

Bubbles form with greater fool mentality. Value creation among SaaS companies has entirely been from selling to someone else at a higher valuation. There are no economic cash flows, no dividends, no share buybacks. Worryingly, this is true without exception. I have no doubt that these companies are far from worthless, but the fact remains that so far they’ve relied on this greater fool mentality to create value.

Bubbles have absurd valuations. The valuations of SaaS stocks are discounting years if not decades of wildly optimistic expectations. Of a group of 55 SaaS stocks, I calculate a combined $56 billion in revenue in 2019 and a combined market cap of $575 billion. The top half of the group has a combined revenue multiple of 15.1x and average P/E of 260x. Nevertheless, multiples could continue to expand, in fact it wouldn’t shock me.

Bubbles form because there’s a good idea behind it. For SaaS stocks, that idea is (perhaps ironically) Amazon, the pioneer in long-term thinking and reinvesting for growth. Who wouldn’t want to be the next Amazon? Saying you’re focused on the long-term makes you sound smart. Besides, SaaS generally is a much easier and better way of delivering software today, although ironically this will likely work against these companies over the long-run.

Bubbles form when people with no relevant experience start jumping in. As Amazon has replaced Berkshire Hathaway as the value investing north star, fund managers are eager to apply the Amazon template to SaaS stocks. Voila, you can keep your brand as a value investor and start buying nothing but profitless software companies. Mutual fund houses, hedge funds, pension funds, and everyone else is now involved with venture capital and often setting new funding records. This is just anecdotal but I’ve seen an awful lot of investors start playing the SaaS game and evangelizing things like Stratechery despite never being into this stuff previously.

Bubbles cause smart investors to get carried out and made fun of for being too early. Robertson with dot-com, Einhorn with SaaS.

I don’t like how any of this looks. SaaS has eerie similarities to the E&P business. You spend a lot of money upfront on an asset with recurring revenues, you suffer through a period of losses during the growth phase, then hopefully enjoy a long tail of recurring profits during harvest mode. But there are a lot of assumptions in this strategy and you need to be right about a few key variables over a very long period of time. What if expenses grow, or pricing power erodes, or customer churn increases? The CAC/LTV and retention figures look like shale well decline curves and high well IRR’s against the backdrop of company ROE’s in the low single digits. Investors acquiesce to new and dubious valuation methods in lieu of actual profits. Something once scarce has become abundant. I admit that SaaS isn’t nearly as bad as drilling shale wells (is anything?) but like E&P’s I believe it will likely prove true over time that competitive forces will cause most of the economic gains to accrue to customers rather than shareholders. I do not think this will be like dot-com where most of the companies vanish, it’s not that level of foolishness, but I do believe that most of these stocks are extremely overvalued. Personally, I wouldn’t own any of these stocks other than Amazon. Juxtaposing AWS against the entire field of SaaS companies, I can only conclude that AWS has to be the greatest business in the world, maybe second only to Google’s search engine.

I admit to the obvious risks of my potential mistiming or being flatly wrong. Admittedly, my thoughts will take a relatively long time to be proven right or wrong, and that presents a risk that multiples could continue to expand and there isn’t much to stop the stocks from going higher. In the debate of being right vs making money, I worry I am just trying to be right, although I am long a lot of Amazon.

Catalyst

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