September 18, 2020

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Business is the best

Latest Craze or Long-Term Growth Opportunities?

During the beginning stages of the Covid-19 pandemic, office workers and most other employees who were able to work from home shifted to remote operations. At first, these measures were expected to be temporary. However, as it has become clearer that the virus is here to stay (much like the 1918 flu), a growing number of jobs are shifting to more permanent at-home positions.

One reason for this may be to reduce the spread of the virus, but the work-from-home industry is gaining another unlooked-for boost from this trend: more people are discovering that their teams work more quickly and efficiently from home than they ever did in an office. Instead of commuting and travelling longer distances to meet some clients and business partners, employees and executives alike can now spend that time either working or relaxing, both of which increase the efficiency of their work far more that sitting in a car or public transportation ever could.

As a result of this, a study conducted by Gartner found that nearly three out of every four chief financial officers and other finance leaders surveyed intend to shift at least 5% of on-site employees to permanent at-home positions even after the pandemic crisis is over.

The shifting of more employees to work-at-home positions has always been in the cards, but in some ways, it is in human nature to resist change. People become accustomed to certain ways of working, and they also could be reluctant to take on the up-front costs of shifting to more tech-based operations. One example of this occurred in 2013, when Yahoo’s then-CEO Melissa Mayer infamously decreed that there would be no more working from home at the company.

However, the pandemic effectively forced many companies to eat the up-front costs of work-from-home solutions years ahead of schedule. This has unsurprisingly lead to sky-high valuations for the stocks of companies that provide work-from-home solutions, including software-as-a-service giants such as Alphabet (NASDAQ:GOOG)(NASDAQ:GOOGL) and Microsoft (NASDAQ:MSFT) as well as more niche companies like Zoom (NASDAQ:ZM) and DocuSign (NASDAQ:DOCU).

In 2013, mid-size businesses (with 250 to 1000 employees) were paying approximately $25,000 per year on average for SaaS solutions, a number that grew to approximately $225,000 per year by 2019. Now that more clients have started paying for these services and realized the work efficiency benefits as well as the potential to move out of some of their office and living spaces in high-cost cities, the growth of the industry is expected to be accelerated by several years.

Given the potential for an industry-wide fast-forward of at least a few years for companies that provide the remote work solutions, could any of these stocks present potential value opportunities for investors, or are the high valuations destined to collapse? Let’s take a look.

Large-cap moats

Tech giants such as Microsoft, Alphabet, Amazon (NASDAQ:AMZN) and Apple (NASDAQ:AAPL) are some of the first names that come to mind on the topic of SaaS. These companies all provide top-of-the-line remote work solutions, cloud-based business tools and other web services. Their names attract talent, funding and consumer mind share to help cement their competitive moats.

As shown in the chart below, their price-earnings ratios have increased in 2020 compared to 2019 levels, but these valuations are actually down considerably from pre-2019 levels, especially in Amazon’s case.

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However, while these companies generate high profits, SaaS and work-from-home solutions are only part of these tech giants’ vast operations. The broader the range of businesses, the less likely it is that one product becoming obsolete will wipe out the company, providing a safety net. As long as these companies can remain leaders in innovation, they are good picks for a broad bet on the tech industry. On the other hand, investors looking for a pure-play on work-from-home solutions may need to look elsewhere.

Small-cap niches

Newer small-cap companies that have relatively niche offerings include Zoom, DocuSign, Salesforce (NYSE:CRM) and Slack (NYSE:WORK). These companies do not have the same extensive range of products. Instead, they focus on one thing or a handful of things, such as Zoom’s video communications, DocuSign’s secure signing products, Salesforce’s marketing and sales platforms and Slacks’s office communications products.

In the top chart below, we can see that most of these companies (with the exception of Slack) saw a lot of love for their stock over the past year. These valuations were achieved despite the fact that net income has either been in the negatives or growing slowly (bottom chart).

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In terms of valuation, you could say that these stocks are mostly still in the speculative stages. Salesforce’s net income was in the negatives for a good chunk of its history, and DocuSign has yet to post an annual profit. Zoom has seen steady net income growth in its history, but the stock also has a price-earnings ratio of 1,421 and operates in a market space where other tech players face a low barrier to entry.

Often overlooked

There are some potentially overlooked names that make working from home easier. These companies don’t have as much media buzz as big tech or upstart small caps.

For example, Dropbox (NASDAQ:DBX), a widely used file-hosting service founded in 2007, facilitated the world’s first “smart workspace.” The biggest direct comparison to Dropbox’s productivity tools is probably Microsoft’s OneDrive, but Dropbox has the advantage of automatic syncing to your desktop without having to utilize a web browser. The stock price has been relatively flat, even as revenue and net income have skyrocketed.

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Another player that often takes the media back seat to competitors is Oracle (ORCL), a company that sells database software and management systems, cloud engineered systems and enterprise software products. Almost two-thirds of the company’s revenue is recurring, and it offers the world’s first and only autonomous database. Oracle has seen its share prices grow along with its revenue and net income, but as of June 19, the stock trades with a price-earnings ratio of 17.6, which is far lower than most of its competitors.

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Conclusion

Many businesses have been pushed years ahead of their original schedules in terms of moving to software-based remote working and communications solutions. This has mostly been reflected in stock prices. Some of the more overlooked long-term players such as Oracle and Dropbox may potentially provide investing opportunities, as could large caps like Alphabet whose dominant market positions and index fund backing help protect prices from volatility. However, I would be wary of more speculative stocks that have yet to show consistent earnings.

Disclosure: Author owns no shares in any of the stocks mentioned. The mention of stocks in this article does not at any point constitute an investment recommendation. Investors should always conduct their own careful research and/or consult registered investment advisors before taking action in the stock market.

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This article first appeared on GuruFocus.