Cloud stocks are flying in 2018.
Microsoft's $7.5 billion acquisition of GitHub this week only speaks to a bigger theme. From Okta and Twilio, which have more than doubled this year, to Zuora, DocuSign, Smartsheet and Zscaler, which have soared since their recent public market debuts, tech investors are pouring money into emerging software developers at an unprecedented rate.
More than 25 software-as-a-service companies (valued at over $1 billion), including Salesforce, Zendesk, New Relic, Atlassian and ServiceNow, are up at least 40 percent this year, well ahead of the Technology Index's 14 percent gain.
Multiples are rapidly increasing as well, suggesting that investors are getting more bullish on the sustainability of the business models. The 50 companies in the Bessemer Venture Partners Cloud Index now trade for an average of 7.8 times revenue over the next 12 months, up 27 percent from a forward sales multiple of 6.1 at the beginning of the year. The BVP index uses enterprise value to revenue.
Not included in the index are Microsoft and Adobe, which have also experienced extended rallies and are trading near record highs after pushing their businesses from desktop software to the cloud. Even Cisco made a giant bet on cloud early last year, purchasing AppDynamics for $3.7 billion just as the application monitoring company was about to go public.
Here's why so much money is flying into cloud companies.
Subscriptions: The high-level trend that's exciting Wall Street is subscriptions. Unlike the old days of software, when big vendors like Oracle and SAP would charge millions of dollars for multi-year contracts upfront and then tack on maintenance fees, this new generation of companies sell cloud-based services, generating some money initially but getting much more over time as customers renew their deals and demand more features.
"When you buy cloud or subscription software from a vendor, you can buy exactly how much you want: per person, per-employee, pay as you go," said Richard Davis, an analyst covering enterprise software at Canaccord Genuity. "It is a good business model and demand is strong, because everyone wants to buy software to make their companies efficient."
M&A potential: Investors also see big bucks from potential acquisitions.
Microsoft just paid 25 times sales for GitHub, a privately held company that has a relatively small business today but is practically ubiquitous in the developer community. In April, Salesforce made its biggest purchase ever, agreeing to buy MuleSoft for $6.8 billion — that's more than 15 times trailing revenue, which was the most expensive cloud software deal in history for a publicly traded company, based on a multiple of revenue. Cisco's purchase of AppDynamics was also for more than 15 times trailing revenue.
"You do have that multiple raise as a result of some of these larger deals," said James Fish, an analyst at Piper Jaffray who covers software, networking and storage. Shareholders are asking, "If Cisco or Salesforce are willing to pay more than 10 times, why as an investor can't I increase my outlook, as well?" he said.
And the acquisition spree may just be getting started.
"There is a lot of interest from large software vendors to consolidate pure-play cloud companies," said Steve Koenig, an analyst covering the software industry at Wedbush Securities. There have been some big deals, "but there are more waiting to happen," he said.
Koenig said that cloud companies are also benefiting from a more favorable tax environment, following President Trump's corporate tax cut, which gave businesses more money to spend on new software and IT systems as well as on acquisitions.
Earnings show real customer demand: Most importantly, cloud companies are putting up numbers.
In its first earnings report as a public company, Zuora beat analyst estimates and said that its customer retention rate, a key metric for subscription companies, reached 112 percent on a dollar basis. The stock jumped 19 percent the next day. Zuora's software helps businesses manage their subscription revenue.
Smartsheet, a developer of workplace collaboration software, rose over 9 percent on Tuesday after topping estimates in its debut earnings report. Cloud security vendor Zscaler soared 26 percent on Thursday on surging revenue, billings and a 120 percent dollar-based retention rate. And DocuSign climbed more than 6 percent on Friday after reporting revenue that beat analyst expectations.
Big market and solid economics: IDC projects that cloud services revenue will more than double to $276.8 billion by 2021 from $129.7 billion last year, as more large global enterprises push workloads to the cloud. According to Piper Jaffray's annual CIO Survey, enterprise cloud software spending comes second only to security spending within IT budgets.
SaaS vendors are valuable for more than just their recurring revenue models, Davis said. They also have lower overhead costs than on-premise software companies and require less customization for individual clients, keeping down development expenses.
Davis said that companies like Adobe, Salesforce and Atlassian, a provider of developer tools, are showing they can grow 15 to 20 percent or more and reach free cash flow margins of 40 percent (a measure of profitability), which puts them in the "top 1 percent of public companies."
There are some risks that could bring the cloud boom to an end.
More competition from the giants: A lingering concern for many SaaS companies is uncertainty as to how far and wide the massive cloud platforms plan to go in their own offerings.
Amazon Web Services, in particular, has stuck mostly to providing infrastructure and core computing services, rather than veering into applications. But since almost all of these vendors rely on some combination of AWS, Microsoft Azure and Google's cloud to host and power their data, there's always the risk that their partners could turn into rich and powerful competitors.
For that most part, that hasn't happened yet.
"Most software companies are seeing AWS, Azure and even Google, the major cloud platforms, as trends to be accepted and partnered with, as enablers of disruption," Koenig said. "They want to partner with major cloud stocks, not compete against them."
Macro: Any downturn in U.S. stocks, which are in year 10 of a bull market, could punish many richly valued cloud companies that have never had to weather significant economic strain. On Thursday, a slightly down day for the broader market, a number of cloud companies, including Okta, ServiceNow, Atlassian and HubSpot, each fell at least 4 percent.
But there's no turning away from the broader subscription model. It's a theme that Zuora CEO Tien Tzuo has been evangelizing since starting his company in 2008, after a long career at Salesforce. His company even has an annual conference called Subscribed, which took place this week in San Francisco, and he recently published a book under the same title.
Canaccord's Davis attended Subscribed and wrote up a report on June 5, based in part on a "dozen conversations with random attendees."
"Importantly, the phrase 'subscription economy' is more than just a marketing jingle," Davis said. "It is a fundamental change in the way leading businesses will thrive."