11/06/2007

The "Software as a Service" SaaS) industry, which enables users to access software applications via the Internet, is in the midst of a five-year period of 43 per cent average annual compound growth, and is expected to own a 23 per cent share of the $120 billion U.S. software market by 2010, according to a report released today by RBC Capital Markets, "SaaS Primer - An Emerging Asset Class."

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With the number of public SaaS companies expected to double by 2010, RBC sees this fast-growing market as an attractive opportunity for investors.

"Although it is quite early in the evolution of SaaS, we believe this business model is more stable and sustainable than the traditional enterprise software model, which makes it significantly more attractive for investors," said RBC Capital Markets equity analyst Brad Whitt, who authored the new report. "Impressive growth, predictable revenue streams, scalable sales models and strong margins and cash flows are reasons why investors who have avoided software companies should consider investing in the SaaS market opportunity."

Sometimes known as "software on demand" or technology-enabled services (TES), SaaS provides software that can be sold, delivered and maintained purely over the Internet. With their Web-based platforms, SaaS-provided software products are well-suited for supporting online functions such as customer relationship management (CRM), communications, Web analytics and e-services. Unlike traditional software, which usually is purchased outright through capital budgets, SaaS is typically procured through operating budgets using monthly subscriptions or transaction-based pricing, which allows the service purchased to be matched to actual use.

Today, there are just 16 public pure-play SaaS companies, with a combined market capitalization of $17.5 billion. An expected series of IPOs during the next few years could result in 34 public pure-play SaaS companies by 2010 with a combined market capitalization of approximately $32 billion. Pure-play public companies are expected to have about 23 per cent of the SaaS market by 2010, with the rest going to private pure-play SaaS companies and hybrid companies that sell through both SaaS and traditional channels.

RBC Capital Markets' public company SaaS universe has significantly outperformed not only the firms' traditional small-cap software universe but also the overall NASDAQ market, generating average returns of 37 per cent in 2004, 37 per cent in 2005 and 23 per cent in 2006 versus NASDAQ gains of 9 per cent, 1 per cent and 10 per cent, respectively, over the same time period. With faster growth, better operating leverage and more consistent execution, RBC expects SaaS companies to continue to outperform their traditional software peers.

While some observers anticipated that SaaS growth would stall due to relatively low switching costs, limited large enterprise adoption and security concerns, SaaS companies have evolved addressing each of these issues. SaaS companies are "born to serve," writes Whitt, leading to exceptional customer renewals and substantial up sell/cross sell opportunities.

Nevertheless, potential roadblocks remain for this emerging asset class. "While we are optimistic about SaaS, the sector is not without risks," said Whitt. "SaaS is purchased out of operating budgets, but many large enterprises still prefer to buy software outright using their capital budget. Also, many CIOs prefer to buy ancillary applications from their primary software provider rather than from a niche SaaS provider. And SaaS companies face other potential perils, including limited liquidity, volatile bookings and the challenge of consistently renewing customers."