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Which SaaS stocks and ETFs are on cloud nine?

Software-as-a-service (SaaS) stocks spent most of 2020 in the clouds. The global shift to working from home accelerated digital transformation and the adoption of platforms such as Zoom [ZM] and Twilio [TWILO]. After reporting exponential user base growth, these software companies’ share prices soared to new heights last year. 

ETFs tracking the SaaS theme have outperformed the broader market in the last 12 months. The Global X Cloud Computing ETF [CLOU] has climbed 63.4% in the last year and has gained 5.7% since the start of 2021 (as of 17 February’s close).

The SPDR S&P Software & Services ETF [XSW] grew 57.7% and 13.5%, respectively, during the same periods, while the WisdomTree Cloud Computing Fund [WCLD] was up 99.5% and 10.2%. For comparison, the S&P 500 has risen 16.3% in the last 12 months. 

 

99.5%

WisdomTree's Computing Fund's gains in last 12 months

 

Furthermore, corporate spending on SaaS products and services is showing no signs of letting up. Many businesses have realised the cloud enables workforces to be more productive and collaborate from anywhere in the world. 

 

The software rockstars’ rivalry

Salesforce [CRM] had a solid performance in 2020.

After ending 2019 valued at $144.2bn, the stock’s market cap rose to $204.2bn by the end of last year and was $227.3bn at the close of trading on 12 February 2021.

Even though Salesforce’s share price has climbed just 30.4% in the last year (through 17 February’s close), it has risen 114.8% since falling to a 52-week low of $115.29 during the market sell-off in March. The stock was added to the Dow Jones Industrial Average index at the end of August. 

Despite posting weaker-than-expected guidance for the fourth quarter fiscal year 2021 in December, analysts are bullish on Salesforce’s prospects going into the next fiscal year. Kash Rangan, a software analyst at Goldman Sachs, thinks it can become “one of the most strategic application software companies in the cloud industry”. 

 

"[Salesforce could be] one of the most strategic application software companies in the cloud industry" - Kash Rangan, Glodman Sachs

 

In a note to clients, seen by Barron’s, Rangan wrote: “In spite of its size at about $25bn estimated revenues in FY22, the company’s current revenue performance obligation is organically growing in the high teens.”

The company’s $27.7bn purchase of Slack [WORK] — the acquisition is expected to be completed by the end of the second quarter — is poised to help Salesforce challenge Microsoft’s [MSFT] cloud-based communication and collaboration tools, including Teams. 

 

Value in the subscription model

In an effort to not be left behind by those already reaping the rewards of the cloud, companies like data analytics software provider Splunk [SPLK], are transitioning to a subscription model.

Splunk’s share price has spluttered over the 12 months, dropping 1.2% as of 17 February and up just 0.4% since the start of this year. Revenue growth has been sluggish too. The company reported year-over-year declines of 5% and 11% for the second and third quarters of the fiscal year 2021, respectively.

The company’s recent earnings have been slightly hampered by its ongoing transition from licensing enterprise software to offering access on a subscription basis, which has meant lower upfront payments.

However, cloud (i.e. subscription) revenue is gradually growing. It was up 80% in the third quarter, compared to the year-ago quarter’s $145m, which accounted for 24% of the total revenue of $559m. 

Despite disappointing earnings, Jack Andrews, an analyst at Needham, likes the stock. He recently reiterated a buy rating and gave Splunk’s share price a $275 target, which would represent a 61.3% climb from its 17 February close.

“In our view, Splunk represents one of the few open-ended growth stories in technology, since the more customers use the company’s software, the more those customers want to use it. We view Splunk as an industry leader with strong products attacking a huge market opportunity,” Andrews wrote in a note to clients, according to TipRanks. 

 

“In our view, Splunk represents one of the few open-ended growth stories in technology" - Jack Andrews, Needham

 

As more players transition to a subscription model, the SaaS market could become oversaturated. Product differentiation could become key to attracting and retaining customers as well as satisfying investor appetite. 

 

Beware of overvalued newcomers

With SaaS being such a hot investment theme, it’s no surprise that the recent IPO of Unity Software Inc [U] garnered a lot of attention, especially from retail investors. Shares in Unity Software may be down 20.8% so far this year to 17 February, but the stock was still up 77.8% since debuting on the Nasdaq at the end of last September. 

Its financials seem to be attractive too. The company is debt-free and, according to Seeking Alpha, has one of the highest non-GAAP gross profit margins out of all SaaS stocks.

It reported revenue of $220.3m on a loss of $0.10 per share for the fourth quarter on 4 February, beating analysts’ consensus estimates of $204.2m and $0.14, according to CNBC. Revenue for the fiscal year 2021 is forecast to be between $950m and $970m, roughly 22% up on the $772.4m reported for 2020, which itself was up 43% from 2019. 

However, there are concerns that Unity’s hot streak is cooling off and that any long-term tailwinds are already baked into the current share price. 

In a note to clients, seen by Benzinga, Ryan Gee, vice president of equity research at Bank of America, argued that Unity Software’s long-term position remains unaffected, but “most of the near-term upside is already priced in”.

 

"[M]ost of [Unity's] near-term upside is already priced in" - Ryan Gee, vice president of equity research at Bank of America

 

He added that the company is likely to face headwinds related to non-gaming subscriber growth. While Gee downgraded the stock from neutral to underperform, he raised his price target from $102 to $127.

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