Michael V
Thesis
Veeva Systems (NYSE:VEEV) is the highest Quality Software as a Service (SaaS) company I know of, delivering a combination of strong growth, a clean balance sheet and strong profitability. The company enjoys a deep and widening moat with a very sticky product a non-cyclical industry (life sciences) expected to grow around 6% annually. Most SaaS companies are plagued by low profitability, some appear to be highly profitable but after looking deeper, stock-based compensation often eats into shareholder value. In this article, I’ll compare Veeva to some other (former) high-flying SaaS stocks and explain why I prefer Veeva’s way of doing business and the general problems of SaaS companies.
This article focuses on a sector comparison and advantages that Veeva has, if you want to read a more in-depth article about Veeva’s business, see my previous article on the company.
General problems with SaaS
Software as a Service companies have been on a crazy run-up in recent years until the bubble burst in November of 2021. The ISE CTA Cloud Computing Index (CPQ) returned 200% from August 2017 to November 2021 , which significantly outperformed the S&P 500 and Nasdaq. Since November 2021 the index has fallen by 38% though, down to 46%.
ISE CTA Cloud Computing Index (google)
SaaS companies are fast-growing software companies that spend aggressively on marketing and are often unprofitable or barely profitable. Valuations on most popular names are still stretched, leading to severe sell-offs in a higher interest rate environment, when earnings are more heavily discounted and especially future earnings. is no longer popular. To summarize the problems I want to talk about:
- Aggressive spending on S&M
- Low profitability
- High stock-based compensation
- High appreciation
Aggressive spending on S&M?
Aggressive S&M is a common occurrence in SaaS companies. A good way to measure the effectiveness of marketing spend is the Magic number, below is the definition from ‘The SaaS CFO’:
The SaaS Magic Number is a widely used formula to measure sales efficiency. It measures the output of a year’s worth of revenue growth for every dollar spent on sales and marketing. To think of it another way, for every dollar in S&M spend, you generate several dollars of ARR.
I calculate this by dividing the incremental 12-month revenue increase by the last 12 months’ sales and marketing spend. You want to have a fairly high number, anything less than 0.75 should be a yellow flag to consider if the cost of marketing is worth it. Salesforce (CRM), one of my investments, and ServiceNow (NOW) fall into this bucket. Both companies have huge marketing spend and should probably look at reducing it.
Veeva Systems has a very healthy magic number of 1.48 and the lowest S&M/Revenue ratio among the 10 companies. We can see that most companies have a relatively high ratio with some spending more than 50% of their revenue on marketing. This requires a very high growth rate to make the expenditure worthwhile. Companies that stand out in this comparison are Bill.com (BILL) and Datadog (DDOG) due to high Magic numbers near 3 and the aforementioned CRM and NOW with Magic numbers under 1.
The rationale for this disciplined approach to S&M can be found in a 2017 interview with CEO and Founder Peter Gassner. In it, he mentions that he wants sustainable growth and doesn’t like desperate salespeople. Instead he hires fewer salespeople and sacrifices some extra ill-gotten gains for higher quality customer relationships.
SaaS S&M spending (Koyfin)
Low profitability and high stock-based compensation?
Because of the previously discussed high customer acquisition spend, SaaS companies often operate at or near a loss. If we just look at the Free Cash flow margin, it’s not that bad. 7/10 of companies with margins between 18 and 39%, only 2 companies with negative FCF margins. The problem is that most SaaS companies include stock-based compensation programs as a major component of employee compensation. In a highly competitive landscape, these incentive packages are necessary to retain quality employees, a major costly issue in the SaaS business. I added a SBC/Revenue column and we can see that each company is heavily diluting existing shareholders. From 10% of revenue (Salesforce) to 44% of revenue (Snowflake) it’s a wide range. Veeva is on the low end with 13% of revenue. When evaluating a company’s profitability, we need to consider these costs, even though most companies don’t in their investor relations. This dilution is a true cost to shareholders because, after all, we want to maximize value per share. For that reason, I subtract SBC from FCF to arrive at FCF margin excluding SBC. This paints a different picture and suddenly 2/10 companies have a margin above 10% (with ServiceNow at around 11.38%). Veeva really holds its own with an impressive 26% FCF margin ex SBC, leagues ahead of the competition. The same picture is shown in the Net income margin and especially in the Return on Capital, where Veeva is the only company that achieves an ROC higher than its WACC (weighted average cost of capital), according to GuruFocus, the ROC of the company is also higher. at 26%.
CEO Gassner is a thrifty investor who from the ground up ran Veeva with a hurdle rate for everything he did, a rare sight in the SaaS world and a differentiating factor for Veeva.
The profitability of SaaS comparison (Koyfin)
High Appreciation?
At this point, we’ve established that Veeva is an outstanding company, but even the best company can be a bad stock if we buy too high. If we look at the valuation of the list we can see that all have a high valuation, Salesforce being the cheapest. PE ratio is elevated for all companies and FCF yields are also not very juicy after accounting for SBC. What makes Veeva worth investing in however is the high visibility, durability and longevity of revenue growth this company is likely to experience. With most of the revenue recurring and a Net retention rate of over 120% in addition to long-term contracts with a sticky ecosystem, it is highly likely that this company will be around for a very long time.
SaaS comparison comparison (Koyfin)
Another way I like to look at valuation is through the inverse DCF model. Assuming a 2% annual dilution, the current share price of $219 assumes 18-19% FCF growth over the next decade. This is higher than Seeking Alpha’s Consensus Earnings growth projections, but I think it is achievable.
Veeva Systems inverse DCF (Authors’ model)
Conclusion
To conclude, Veeva Systems is an outstanding SaaS company with the best management team in my opinion in the sector. Profitable growth has a long runway, but it’s hard to rate it as a buy at this still-high valuation. I own shares and I continue to slowly enter it into DCA every month, but I’m not going to put a lump sum of money into the stock right now. I like the growth estimates to be around 15% for a larger one-time investment on top of my current position.