With the COVID-19 pandemic continuing its path across the globe and lock-downs affecting most parts of the global economy, many commentators are expecting a material reduction in valuations across sectors. However, we are not seeing that in the technology sector. All software companies, in particular those providing mission-critical solutions to their customers and using recurring revenue business models, are generally remaining resilient and many may even emerge stronger.
Investors are rewarding the sector accordingly. Our SaaS index shows EV/revenue multiples are now above pre-COVID-19 levels at 11x current year revenue (compared to a median of 6.3x since we began tracking the index six years ago).
Similarly, the main index of record for our sectors, the NASDAQ Composite Index has risen above 10,000 for the first time in its history and is up 11% for the first six months of the year.
Why are we seeing this comparatively bullish sentiment?
- Government intervention: building on the success of policy during the Global Financial Crisis, across the world governments have provided short-term relief to businesses with job retention schemes, loans, tax payment holidays and quantitative easing. So far, in all but the worst-hit sectors, these interventions have worked well and in most countries prevented the extreme levels of unemployment, bankruptcy and financial distress which seemed inevitable only a few months ago.
- Sector bias: NASDAQ is 60% comprised of technology, life sciences and healthcare companies. COVID-19 is a healthcare crisis with a healthcare solution – businesses working in life sciences tend to be less impacted by near-term economic woes than those in other sectors, in this situation, many of these companies are seeing stronger trading and investor appetite as they seek vaccines and treatments for the disease. Similarly, the ‘digitisation of everything’ agenda that has been driving strong performance across the technology sector is being accelerated by the realities of lock-downs and remote working.
- Flight to quality, 2020 style: traditionally at times of turbulence, investors shifted asset allocation to gold. Today, data is the new gold, and technology stocks are viewed as having the long-term growth prospects to both weather the storm and prosper on the other side.
- The software business model: software has gone a long way to “eating the world” and has done so with a strong model of recurring revenue. Coupled with the real-world difficulties of removing software packages from embedded workflows, the subscription revenue model is creating a very significant level of downside protection for most software businesses.
From the technology businesses we work with at Results, we are generally seeing strong performances against a difficult backdrop. Whilst new business remains more challenging (both logistically and in gaining access to budgets), most of our software clients have seen normal levels of retention and at least some new business flowing through. For some, where their products enable success amongst the new rigours of a dispersed workforce, for example, the level of new business has been markedly higher.
Comparisons with the Global Financial Crisis
Whilst in Europe the pandemic appears to be easing, the risk of a global recession remains real. The last time this happened was in 2008/9 following the Global Financial Crisis. In 2009, US unemployment reached 10%, and across sectors M&A activity slowed and valuations were negatively impacted. The software industry was not immune, but the impact was far less significant than for other parts of the economy:
- The impact was negative but short-lived: The largest ten listed software companies by revenue in 2007 were Microsoft, Oracle, Adobe, Amdocs, Intuit, SAP, VMWare, Synopsys, Activision, and Autodesk. Despite the global recession brought about by the financial crisis, the total revenue from these ten businesses dropped in only three quarters of 2008 before resuming a steady growth rate. After 18 months the ten were already posting materially higher revenues than their pre-crisis levels.
- The NASDAQ Composite bottomed out within 207 days and took 603 days to return to pre-crash levels; so far in the COVID-19 situation, NASDAQ dropped by 30% in just 33 days, but reverted to pre-lock-down levels within just 111 days (see graph below). The profile of the NASDAQ Composite response to COVID-19, very clearly shows confidence in a V-shaped recovery amongst investors.
- The impact on software valuations was also short-lived: comparing the median EV/revenue multiple for all software deals over $50m in value (see graph below) shows that the average deal multiple halved in 2009 from pre-crisis levels, but swiftly rebounded to exceed 2007 levels by c. 15% in 2010. In other words, the negative impact on software valuations, lasted between 12-18 months for the ‘average’ software business.
Software valuations post COVID-19
In comparison to 2008/9 there are two key factors which support the continuation of compelling software valuations and suggest even the short-lived valuation hit of 2009 will not be experienced by many software businesses in 2020:
- The SaaS revolution: in 2009, Salesforce was the only listed SaaS business of any note (and at the time it produced less than $1bn of revenue). The subscription business model and cloud-delivery were innovative concepts. In 2020 the level of recurring revenue in the sector is so much greater, and the penetration of software across industries so much more profound, that we will go out on a limb to suggest that the largest ten software companies by revenue in 2019 will not experience the same level of revenue declines even that their 2007 peers did in 2009;
- Private equity: we continue to see private equity and private equity-backed trade buyers making the running in completing acquisitions during Q2 2020. The vast amounts of dry-powder and the high percentage of the software industry owned by financial sponsors will, most likely, drive continued appetite for consolidation within, and exposure to, the sector.
As a result, we remain bullish on the prospects for the global software industry and for those companies within the sector, large and small, that provide mission-critical solutions to their customers. We have completed several deals during 2020 (including one started and completed during lock-down) and we are not seeing valuation reductions for the high-quality software businesses we tend to work with.
We do however, expect to see a clear split between those software businesses able to demonstrate (i) resilience through the pandemic and economic aftermath, (ii) the ability to up-sell to existing customers, and (iii) the continuation of some level of new business momentum. These businesses will be in a strong position to complete transactions and do so at compelling valuations, in line with those seen before COVID-19.
The road ahead will undoubtedly be bumpy, but the software industry is likely to find its path smoother than most and to reach its destination stronger than ever before.