By Beth Kindig
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Investors are abandoning cloud-software stocks amid a lack of profitability and high valuations for what had been the best-performing industry group.
The cracks began last quarter as many cloud-software, or software-as-a-service (SaaS), companies saw their shares plummet even as they beat analysts’ financial estimates. It most recently happened with Slack Technologies /zigman2/quotes/212180539/lastsale WORK -4.86% and Zoom Video Communications /zigman2/quotes/211319643/lastsale ZM -3.15% .
For 2020, the winners will be further separated from the losers by posting stable earnings growth.
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Sentiment started shifting in the third quarter for SaaS companies. As a result, the First Trust Cloud Computing ETF /zigman2/quotes/205187458/lastsale SKYY -1.41% has now risen 21% this year, underperforming exchange traded funds that track the broader technology market, such as the Vanguard Information Technology ETF /zigman2/quotes/207654339/lastsale VGT -1.96% , which is up 36%.
Mature cloud companies are reaching the laws of scalability, or what IDC calls the “ growing base of comparison ,” which says a company or a market cannot sustain high percentages of growth relative to an expanding, large market.
It’s commonly reported that slowing sales growth means cloud is slowing. Many will confuse the slowing pace of IT spending with cloud spending, but those are separate issues. For instance, the public cloud services growth rate was 4.5 times more than the IT industry overall, as reported in July 2019.
Amazon.com’s /zigman2/quotes/210331248/lastsale AMZN -0.72% AWS is a great example of a how the growing base of cloud infrastructure as a service (IaaS), along with consistent profitability, is more investable than sheer revenue growth. For instance, it would be nearly impossible for Amazon to expand its current $36 billion in annualized AWS revenue at the same growth rate as when it first opened for business. In Amazon’s case, growth has gradually slowed from a peak of 81% in 2015 to a low of 35% in the most recent quarter. Some would say this is a cause for concern, when the opposite is true: AWS contributes over 71% to Amazon’s operating income.
Startups are bred to grow fast, with the average company forecasting a growth rate of 178% in revenue in the first year. Therefore, pivoting from rapid sales growth to stable profitability is not easy for tech companies as they go public.
Cloud SaaS is nearly double the market of cloud infrastructure-as-a-service and four times larger than platform-as-a-service, and this is with few large-cap heavyweights.
The large addressable market coupled with low barriers to entry has created a gold rush of SaaS startups, which is one reason Salesforce /zigman2/quotes/200515854/lastsale CRM -3.92% is under more pressure than is the case in the IaaS or PaaS spaces. Salesforce, which has been on an acquisition spree, has issued lower guidance than analysts expected for the upcoming fiscal fourth quarter.
According to a survey by PriceIntelligently , competition across SaaS has increased three-fold from an average of 2.6 competitors per company five years ago to 9.7 competitors per company today. The supply of SaaS startups is driven by a voracious appetite for SaaS applications.
Companies with more than 250 employees use an average of 124 SaaS applications, while companies with up to 10 employees use an average of 26 SaaS applications. The growth rate of spending is expected to increase by 118% between 2017 and 2020. The number of subscriptions per company will increase by 95%.