Big entrenched players now dominate software, but there’s always room for disruption. Morgan Stanley analysts identify three keys to finding the next app giant.
The first step to identifying the next $100 billion software company is figuring out the fundamentals needed to support such a valuation. On average, investors will pay a multiple of 18 times price-to-earnings to own stock in a large, well-positioned software company. That means the company needs to yield about $6 billion in net income. Adding back taxes, at an average 25% tax rate, yields $7.5 billion in operating income. Software names have pretty good operating margins—around 30% on average at scale—so the magic number is around $25 billion in annual revenue. Here’s a simple equation with round figures:
What is the path toward $25 billion in revenue for a software company? Two ways:
- Go Broad: Start with Forrester’s estimate of around 865 million information workers worldwide, the pool for any potentially large base of enterprise software users. For example, a company that creates a must-use application that gains a 20% share of this global user base, charging $145 per user would reach annual revenues of $25 billion. In other words, look for a company that can leverage a very broad tool set that becomes essential to a relatively high percentage of users in that big base of information workers
- Go Deep: According to IDC, around 85,000 companies globally, each with more than a 1,000 employees, comprise the pool of those buying significant amounts of technology. To get to $25 billion in revenue, a software company would need to reach approximately $1.5 million a year per customer, assuming 20% share of that large corporate pool. Such a company would have to offer a platform that drives significant value to be able to sell that kind of deeper value proposition.
How can investors go about looking for candidates to be the next $100-billion-market-cap software giant? Three potential opportunities:
- The Likeliest Candidate: software-as-a-service (SaaS) applications. Data has gravity, and it is inexorably attracting the business workflows in need of software automation. “Ultimately, business users want all their workflows to be well-integrated and working off a single version of data,” says Keith Weiss, head of U.S. software coverage. The push and pull between best-of-breed functionality and broader application suites kept peak market shares in the low-to-mid-twenties for companies selling software applications that were installed and operated in-house. Cloud-based SaaS applications’ faster innovation cycles and easier integration of new functionality are challenging older rivals to sustain differentiation, while allowing app-suite vendors to build broader ecosystems and higher market share.
- Stretch Goal: security consolidation. Companies are spending around $55 billion a year on security, with no noticeable dent in the cybersecurity problem. “Chief Information Security Officers are looking for systems that actually boost security, not just add more layers,” says Melissa Gorham, who covers enterprise software. The keys to this increased security effectiveness are better visibility within an organization and outside into the threat environment, and increased automation of potential responses, given this greater visibility. Both push the industry toward consolidation into broader security platforms. To achieve greater revenue scale, any company in this space will need to expand its focus beyond network security to the broader—and growing—pool of overall security spending.
- App Development for the Masses. “We see a long-tail of business processes with more limited user bases that have yet to be automated by applications,” Weiss says. Large companies that sell package software are unlikely to target these sorts of smaller user bases, thereby creating opportunity for enterprising app-developers. If a vendor can make app development easy enough for information workers—865 million globally, and counting—to automate their own business processes, and the components of these applications were shareable among users (drawing them toward fewer vendors), a very large software player could be supported.
Happy hunting…
For more Morgan Stanley Research on the software industry, ask your Morgan Stanley representative or Financial Advisor for the full report, “Where Will We Find The Next $100 Billion Software Company?" (May 24, 2016). Plus, more Ideas.
