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September 30, 2021 | GSAM Connect

Insights Into Software, 5G, and China Regulation

Tech Bytes Edition 3: Q&A with the Fundamental Equity Technology Team

In this edition of Tech Bytes, the Fundamental Equity Technology Team responds to a number of questions that are top of mind for clients. We start by covering the benefits and drawbacks of consumption-based pricing at Software-as-a-Service (SaaS) companies, highlighting the metrics that matter more now that the industry is moving in this direction. We turn to China, outlining the opportunities we see in its growing SaaS market, as well as its internet retail industry now that regulatory actions have been taken by the Chinese government. We also talk about how we’re approaching the global 5G rollout, and the types of companies that are garnering our attention. Finally, we examine the rising popularity of “buy now, pay later” software solutions and the growing importance of payment functionality at the point-of-sale.

The Fundamental Equity Tech team is comprised of 16 investors with an average of 15 years of experience, and it manages over $15 billion in dedicated technology portfolios (as of August 31, 2021).

Consumption-Based Pricing in Software

Q:  As companies increasingly look for tailored solutions to growing their enterprise, how has the Software-as-a-Service (SaaS) industry evolved to meet these needs?

Brook Dane: SaaS companies are being leveraged by a variety of businesses to scale their enterprise and have evolved their pricing models accordingly. Over the last 15 years, software has moved from a traditional licensing and maintenance model to one in which the customer pays a fixed subscription fee.

However, with the rise of the cloud, consumption-based models are coming to the fore. Under these models, the customer only pays for what they use, allowing them to try different services. This is helping companies leverage software in three important ways:

  • A customer will pay more if the software can be widely deployed across their organization, given the consumption-based nature of pricing. This means customers can experiment more easily with new technologies and align them to their needs while avoiding upfront commitments. In fact, most of these companies have a freemium model which materially lowers the cost to experiment.
  • The software vendor is closely aligned in enabling the customer’s success so that the software can be widely adopted. This generates better outcomes and faster return on investment for customers.
  • As customers grow, they usually want some flexibility around pricing. This could be in the form of decreased charges for overages, options to buy credits mid-year, or alternative pricing for scaled customers so that it is more predictable. Most vendors also provide a dashboard for monitoring consumption trends in close to real time.

In short, consumption-based pricing allows the software vendor to expand their top line, given the minimal customer acquisition costs and low barriers to adoption enabled by the freemium model. Furthermore, upselling and cross-selling with existing customers becomes easier as customers have a better initial experience.

Q: What are the implications for investors?

Brook Dane: Just like any other pricing model, there are benefits and drawbacks to consumption-based pricing, which we think is here to stay. On the plus side, the customers for these software companies tend to start small but rapidly expand, meaning their dollar-based net retention rate is much higher for them relative to traditional SaaS companies. Conversely, traditional metrics like billings and recovery point objectives (RPOs) go from being leading indicators to lagging metrics because most customers pay post usage.

These changes mean fundamental investors need to shift their focus a bit. In our view, the best metrics under consumption-based pricing models are new customer acquisition, net retention rate and the number of $1M+ revenue customers. Taken together, they allow us to gauge adoption across new and existing customers and whether the software monetization is scaling appropriately.

IT Software Investment in Emerging Markets

Q.  What growth potential do you see in the SaaS space in China and in broader EM countries, where such companies are still in the early stages of development?

Nathan Lin: A 2011 survey conducted by the Business Software Association showed that
66% of the China SaaS market did not pay for software. This number grew to 77% by 2017. The commercial value of unlicensed enterprise software could reach $6.8bn, according to
the survey.

We believe the growth of the SaaS industry within China and EM geographies will continue to be supported by three principal drivers. One, companies’ operations have become too complicated to be covered by simple software solutions. Two, the risk of cyber security threats is leading companies to pay for high-quality software and IT solutions. And, lastly, companies across every sector are accelerating their digital transformation, which is being enabled in part by the ongoing development of Cloud services by Internet service providers.

It’s true that SaaS companies in China have not yet adopted the subscription model that most of the US market has implemented, but that will change as these models are offered globally to customers. In 2020, software companies aggressively terminated the service on standalone software sales, migrating customers to SaaS subscription contracts. Similar trends are happening in other EM countries as well, bringing more investment opportunities.

How We're Looking at 5G

Q:  Throughout the COVID-19 pandemic, global investments in 5G have remained healthy as telecom operators continue to invest in their networks. Where are you currently seeing the most exciting investment opportunities within 5G?

Sung Cho: Most analysts believe 5G will have faster penetration as more operators around the world will be ready with 5G capability earlier than in the past¹. For context, we saw 4G LTE penetration rates of 13% in Year 1 and 25% in Year 2. In addition, many governments around the world are considering stimulus directed specifically at 5G to help offset the economic slowdown, which would give this space even greater momentum.

Currently, we believe there is an opportunity in the 5G space through the semiconductor sector, as these companies have differentiated competitive positioning and the potential for large volume gains but also pricing increases. Going forward, we will increasingly look for investment opportunities in companies that will benefit from 5G technology in a world in which the Internet of Things (IoT) will proliferate through more connected machines, virtual healthcare, smart automobiles, and other applications.

We continue to focus on companies with differentiated competitive positioning that we believe will benefit the most from the 5G technology upgrade cycle. We continue to monitor risks and opportunities and will shift our positioning to reflect any changes to our baseline thinking. For instance, we are keeping a close eye on US/China relations, as the US has banned several semiconductor companies from shipping to Chinese companies. There are large investment implications for market share depending on the outcome.

China Anti-Monopoly Regulation

Q:  The Chinese government has started to increase regulation on its local technology companies. What are some recent examples of this and how will it affect the sector?

Nathan Lin: While it’s true that Chinese technology firms are increasingly under the microscope there, we are constructive on the prospects of the overall internet retail industry over the medium-to-long term, for a couple of reasons.

One is the recent settlement of the government’s investigation into Alibaba. On April 10th, 2021, Chinese regulators imposed a record RMB18.2 billion fine on the company as a penalty for misusing its market dominance against merchants and competitors over the past few years. Along with this fine, the Chinese government asked Alibaba to make the following changes:

  • Remove unfavorable business principles on the platform, which created unfair competition as it made merchants choose just one platform;
  • Ensure the protection of users’ data and to not use this data to create unfair treatment to users and merchants; and
  • Implement a comprehensive revamp of its operations and conduct a self-examination compliance report every three years.

Alibaba announced they will comply. We believe the settlement of the investigation represents the lifting of a major overhang for the sector as it brings closure to the anti-trust regulatory scrutiny and will serve as a precedent as the Chinese government works with other companies including Tencent, Meituan and JD.com to address similar regulatory issues.

More broadly speaking, we believe the ongoing offline-to-online integration occurring in China will continue to be key growth driver for the sector as a whole.

Software's Role in Consumer Spending

Q:  The “Buy Now, Pay Later” (BNPL) method of payment has started to grow in popularity. What is it and how will it impact the competitive landscape and opportunity set as software companies look to integrate BNPL into their payment systems?

Sung Cho: BNPL is a type of consumer loan that is offered at the point-of-sale during the checkout process, most often in e-commerce transactions. These BNPL players generally maintain direct relationships with merchants and allow consumers to make payments for their purchases in installments over time, sometimes at a 0% interest rate. Merchants like it because it drives better sales conversion, and consumers are promised a more transparent, modernized lending experience.

Commerce-oriented software companies frequently sit at the point-of-sale and we are increasingly seeing lending and payment solutions bundled into these software products. We believe competition is intensifying in this area, evidenced by Square’s announcement several weeks ago that it intends to acquire the Australian-based BNPL lender Afterpay for $29 billion. We believe this trend will continue, and that software-led names that integrate payment functionality into broader offerings are uniquely positioned to benefit from it.

The payments market is vast, with an estimated $17 trillion in card volumes excluding China. There is still room for – and value provided by – legacy infrastructure, as BNPL players leverage existing networks to gain acceptance where they do not already have their own direct merchant relationship. This leads us to believe we are more likely in the early innings of disruption. We will be watching competitive dynamics around the point-of-sale closely.

Any reference to a specific company or security does not constitute a recommendation to buy, sell, hold or directly invest in the company or its securities.

 

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About the Authors

Sung Cho

Sung Cho

Portfolio Manager, Goldman Sachs Asset Management
Brook Dane

Brook Dane

Portfolio Manager, Goldman Sachs Asset Management
Nathan Lin

Nathan Lin

Portfolio Manager, Goldman Sachs Asset Management

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