‘Super Sub’- in sport, it’s bittersweet. You’re a legend to the fans scoring a goal off the bench, but is it really a tag you want as a player? Ole Gunner Solskjaer is one of the best known examples of a super sub. He seems to be about to play the role again at Manchester United, this time as a manager. But when it comes to business models, the ‘Super Sub’ is different- I believe it should always be one of the top picks on a fund manager’s team sheet.
Subscription based business models have grown in prominence over the last two decades. Tech companies are now leveraging the scalability of software and are using global internet distribution to capture value. But knowing this doesn’t guarantee success, so how do we identify the good ones? The ‘Super Subs’ – if you will. Software-as-a-service (or SAAS) companies, are one of the areas where the economic bounds of this model are being pushed the most – look at Netflix, for example. So what are the attributes that we’re looking for in this segment of the market?
High retention rates are a great sign for a subscription business. With SAAS businesses, a retention rate of >95% indicates strong product-market fit. This is a signal of demand. In essence, ‘product-market fit’ is when a customer is actively seeking the very solution that the business provides. The product is bought rather than sold and the virtuous effect of this is that the customer acquisition cost is low and customers therefore have a high lifetime value. With a scalable product like software this can have huge economic consequences, especially when reliable monthly/annual payments are made before a product is delivered, thus generating reliable cash flow.
Desire to improve
Next- the rate of product innovation. Most SAAS businesses have a core product. It is important to understand how this product is evolving and whether the company is successfully attaching new functionality to it. This is often referred to as the ‘attach rate’ and can be a strong source of cheap revenue growth. A strong attach rate can mean net retention rates are >100% (i.e. the company can effectively grow its revenue without winning new customers). So product innovation drives new sources of revenue, the incremental cost of which is very low. It also means great revenue visibility.
Willing to grind out results
Sales strategy is also vital. Attaching new sales to existing customers is usually done by a ‘farmer’ but when there is still opportunity to find new customers, the ‘hunters’ are key. With many SAAS businesses, it makes sense to invest most of the profits in additional hunters and farmers. The goal is to leverage the scalability of software. But sales people don’t come cheap and measuring sales productivity and targeting the right markets/segments can make or break the economics of growth. As such, the sales motion needs to adapt to different customer types and be willing to evolve as the business grows.
No shortage of ambition
When a company reinvests most of its profits in growth it initially looks low quality and very expensive on traditional profit multiples. But this is a choice. The trade-off is that if successful, the future scale and dominance (thus value) of a subscription business will be greatly enhanced. Whilst income statement profitability during growth can be negative this can often be flipped by simply limiting the sales team numbers. We focus on profitability at maturity which can be fairly easy to estimate based on this arithmetic. We also spend more time building up the free cash flow margins rather than profits. Cash generation can be surprisingly high, even during the growth phase as software capital intensity is usually low and working capital can be negative due to being paid so early by customers and not having any inventory to manage.
Plays the percentages
But how do we know when the business is mature? This will ultimately determine whether reinvestment in growth today is economic and how we value the business. Here, accurately assessing the total addressable market (TAM) is key. We often see very large and vague numbers being projected by management. As such, we like an unambiguous and detailed bottom up analysis of the TAM to be clearly articulated.
In summary, as a rule of thumb we must assess retention rates, rate of innovation, sales motion and capital intensity and then have a clear view of the trade-off between the TAM and near-term profitability. If the TAM is large, reinvesting your profits can deliver high and fairly predictable rates of growth for a decade or more. Execution is never guaranteed and growth is rarely linear, but if you think you spot a Super Sub, it’s probably a good idea to have it in the starting line-up.
Opinions and views from the Equities team at Kames Capital are not an investment recommendation, research or advice and should not be considered as such. Content discussing investment strategies and stocks is derived from and solely relates to the investment management activities of Kames Capital.