Can software service companies make further share price progress in 2021? We truly believe so, and here is supporting evidence about why.
Before we start diving into the subject, yes, there are concerns that the market may correct, and that it will occur in the same manner as in the past—unexpectedly and severely! Yet, we will provide evidence in the article that today’s IT service companies are related to our day-to-day lives, a stark contrast with previous periods of asset value ballooning.
Today, companies in the field of SaaS are mostly cloud-based entities and are facilitating interactions related to e-commerce, 5G, AI, big data, contactless payments, telemedicine, robotics and automation, amongst others.
In past years, the infrastructure and the technology at work have gotten more efficient, more user-friendly, and faster. This in turn has enabled the roll-out of new progressive and adaptative services which were not available in the past, thereby creating an ever-new cycle of innovation and progress. This in turn has improved sales of cloud-based software companies, and growth and profitability are now forecastable with a great level of confidence, which makes these companies valuable investment opportunities.
What is digitization?
In short, the answer is to register in a digital manner a repeatable process for an employment at scale at a given time in the future.
In detail, codifying and scaling are the two principal actions that underpin every digital project, with the ultimate idea to provide a) an excellent user experience, and b) increased manageability for the entrepreneur. The process requires extensive programming capacities that transform a physical action into a digital environment. The process will interact with sensors, transmitters, appliances, and end-users. The process can be deployed in a virtual environment and be made actionable from any point on the globe where an internet connection exists. The field of cloud-based service providers is important, and it is growing fast. The business model used by these companies is called SaaS, and the best definition of SaaS is that a company provides a software to users over its own or a three-party network and charges for that software based on either total usage or with a periodic fee for the services made available.
Salesforce was probably the first company in history to go digital with a truly SaaS-business model, and in the meantime a plethora of companies have followed. The key names to look at today include: CrowdStrike (CRWD), Datadog (DDOG), Elastic (ESTC), Shopify (SHOP), Teladoc (TDOC), Veeva (VEEV), Trade Desk (TTD), Snowflake (SNOW), Affirm (AFRM), ServiceNow (NOW), Workday (WDAY), Wix (WIX), and Zscaler (ZS), amongst others. In a second group, which is highly dependent on cloud-based infrastructures, we have: Amazon (AMZN), Citrix (CTXS), Google (GOOG), Dynatrace (DT), Manhattan Associates (MANH), PTC (PTC), ServiceNow (NOW), Commvault (CVLT), Pluralsight (PS), Tenable (TENB), Mimecast (MIME), Atlassian (TEAM) and historic player Check Point (CHKP). In a third group we have companies that sell software as a service but do not provide a central repository for data and content or have legacy applications. Names include companies like Alteryx (AYX), Open Text (OTEX), and by Teradata (TDC).
It is obviously impossible to accurately quantify the impact of the pandemic on the SaaS business model and the digital transformation. Yet, we observe very strong numbers with public cloud vendors that show growth resurging in Q4 has to do with this trend. And those vendors offering cloud native solutions have been seeing accelerating demand as well. Even some of the older and doggier companies saw substantial demand growth in Q4 as their customers and new users switched to cloud applications being offered.
Cloud Security
Cybersecurity has become a must have for almost all organizations, and the cybersecurity space itself is going through a striking shift in terms of how it is implemented. The architecture of cloud security, it turns out, is best deployed with different technologies than the traditional firewalls and end-points that marked the prior era. There are many cybersecurity companies, and of course all of them are attempting to secure a piece of the spend on re-securing data and applications.
The leading names in the next generation cybersecurity space are CrowdStrike, Zscaler, Cloudflare, Palo Alto Networks, Fireeye, and Okta. The SolarWinds (SWI) hack has garnered some headlines but even more consternation that a widely used software management tool could be hacked by groups supported by foreign governments. In some ways the hack was a wake-up call that what worked before just doesn’t have the same power to protect data anymore. The new threats are no longer focusing on breaking into the system up front but rather via sidelines. This is called supply-chain attack because it targets a supplier to an organization rather than an organization itself—and can affect all of a supplier’s customers. Handling security in this area, where an organization is dealing with recognized partners and their tariff, is an ever more complex undertaking.
Cybersecurity spending was most likely already a priority before this particular hack. But we believe that in the wake of the SolarWinds breach, the demand for new generation cybersecurity software has actually accelerated. There are, as mentioned, recognized leaders in this space: CrowdStrike, Cloudflare and Zscaler. There are many other companies who offer next generation cybersecurity as part of their portfolio. While Palo Alto (PANW), the leader in firewalls, is not going to enjoy the percentage growth of its newer rivals, and will lose share to them, it has just enough critical mass in next gen cybersecurity to maintain a respectable growth cadence.
IIoT
The concept of IIoT, also widely known under IoT, is perhaps still under-appreciated. If there is one single element in my forecast regarding growth in the cloud, it is that IIoT and digital transformation will be a pervasive technology whose implementation is still in early stages—pervasive the way automobiles and electricity, television, and semi-conductors have become pervasive. IIoT will even go one step further. Today our highways are dangerous because of speeding, congestion, or simply because of misbehavior. Think about tomorrow: with IIoT, the cars become guests on highways, the dangerous parts are being taken care of, and the full benefits can be enjoyed to you as tariff participants.
The pandemic led many businesses to rethink their strategies on everything: distribution, logistics, workflow management, and customer service/customer experience just to name a few prominent areas undergoing radical transformation. Most of this rethinking has led these enterprises to determine that convergence towards IIoT is really a critical component of remaining relevant and competitive.
There are sectors where the industrialization of process is advancing fast, such as in contactless payments. Key enablers include Shift4 (FOUR), Square (SQ), Affirm and PayPal (PYPL). The productivity gains that workflow management software can help develop are leading to strong demand for solutions offered by Asana (ASAN) and Smartsheet (SMAR). DocuSign (DOCU) has used the cloud to offer users a new way of negotiating and executing contractual agreements.
Obviously and naturally, these applications rely on important datacenter capacities, and entities that benefit from this trend include Datadog (DDOG), Dynatrace (DT), Nutanix (NTNX), Pure Storage (PSTG), NetApp (NTAP), and Fastly (FSLY),
Are valuations stretched?
Many of the companies mentioned in this report are in their early stages of business activity, and revenue streams may change rapidly as the cycle and the technology evolves. Yet, today’s IT companies, compared to the .com area, are profitable, and revenues are generated from physical deployments and subscription-based offerings, so there are recurring revenues.
In general, digital orientated companies are close to being debt free and are great FCF generators. These are probably the major reasons that valuation should not be considered as stretched. As we go further into 2021, we expect that trends in many areas should get validated, which in turn will generate further supporting growth and share price appreciation, i.e., the much-appreciated virtuous business cycle.