During the pandemic, many businesses were forced to close but many software companies within the tech sector survived relatively unscathed. Their share prices rebounded quickly from the market downturn and their revenues were unaffected; in fact some even accelerated their growth! Quality software stocks such as Pro Medicus (PME) and Xero (XRO) have proven to be both defensive as well as high growth. Why? Because of 2 reasons: subscription revenue models and cloud delivery.
Subscription revenue model
A subscription revenue model prevents companies from losing their revenue stream due to an economic shock.
20 years ago, if you were going to purchase accounting software for your small business, you would probably have paid $350 for a MYOB CD key and used it for 10 years. MYOB as a business would have received that $350 at the point of purchase. In the ensuing 10 years, MYOB got close to nothing in revenue while you continued happily using their software. Imagine what would have happened if the pandemic hit the economy and no-one starts a new business? The demand for new MYOB software would suddenly drop which means revenues would have dropped and the company would have been applying for JobKeeper!
However, the modern MYOB (now owned by private equity) and its competitor Xero didn’t suffer from this problem during March 2020. Why? Because MYOB has long switched to a subscription revenue model.
They now charge you as little as $10 per month to use their software. As long as your business is still running, you are still prepared to pay for the software as it is an essential service to you. This demonstrates the defensive benefits of subscription revenues – as long as the software you provide is essential, there is no risk of any sudden loss of revenue caused by economic contraction.
Cloud delivery
When many people are working from home, a lot of work and communications now have to be handled online. Many technology companies have taken advantage of this demand.
Zoom is a perfect example of a product which many of you would have commenced experiencing during the pandemic. Zoom provides cloud-based software for video conferencing.
Before the pandemic, video conferencing seemed as merely a backup to in-person conferences. Because of the pandemic, Zoom has become the default conference option.
In the June quarter, there were 370,000 companies larger than 10 employees that used Zoom. That’s 5 times the number of companies from 12 months ago!
Demand for cloud does not fully explain why many software companies have performed so strongly. The other reason is that they were all able to meet that demand and start earning revenue without any lag.
Face mask factories have also faced great demand but as a group they would not be doing as well as most software companies. It takes time and effort to handle a sudden increase in demand. The company would need to purchase new equipment which takes weeks or even months to deliver.
In contrast, software companies are extremely scalable. If demand is there, software companies will meet that demand with little fanfare. Users access the Zoom software at home (often straight from their email browsers) with little assistance and Zoom gains new customers and revenues instantly.
Conclusion
Despite the rapid increase in share price valuations of the highest quality software companies on the ASX, we continue to build a shortlist of smaller earlier-stage software companies, many of whom are raising capitals to disrupt their larger competitors.
After all, software is a theme that we think will continue to endure and one that we would like to focus on.
Till next week happy investing,
Michael & Kenny
