Vertical SaaS: Industry-Specific Solutions Offer Customization and Long-Term Value

In recent years, Vertical SaaS has emerged as a powerful tool for businesses seeking specialized software solutions tailored to their unique industry needs. Unlike horizontal SaaS, which is designed for broad use across various markets, Vertical SaaS is highly focused and customized for specific industries. This precise focus enables companies to address niche requirements and deliver more impactful results.

What is Vertical SaaS?

Vertical SaaS is software developed specifically for certain industries or markets, designed to cater to the unique needs of these segments. While horizontal software platforms, like Salesforce, provide broad solutions such as CRM systems adaptable to any industry, Vertical SaaS platforms—such as Veeva Systems for the pharmaceutical sector—offer solutions explicitly tailored to their respective fields. Companies like Roper Technologies also offer numerous software solutions for targeted markets, emphasizing the industry-specific nature of Vertical SaaS.

Advantages for Clients

Vertical SaaS offers several benefits for clients:

• Customization: These platforms are often designed with greater functionality and broader capabilities for their specific industry.

• Simplified Implementation: Because the software is built with the industry's needs in mind, it tends to integrate more smoothly with existing workflows and systems.

• Industry Expertise: Many Vertical SaaS companies are founded by professionals from the industries they serve. A strong example is Bentley Systems, whose founders' industry experience helps them understand their customers' needs on a granular level.

However, there are some downsides:

• Vendor Dependency: Clients often rely heavily on one or two key vendors, creating potential vulnerabilities.

• Higher Costs: These specialized solutions can come at a premium.

• Limited Perspective: Vertical SaaS companies may become "closed-minded," focusing narrowly on their sector without considering innovations from other industries.

  
  

Advantages for Investors

From an investor’s perspective, Vertical SaaS companies present both opportunities and challenges:

• Market Leadership: These companies typically dominate their market, making them difficult to displace.

• High Profit Margins: Vertical SaaS firms often enjoy higher profitability, thanks to premium pricing and lower marketing expenses.

• Strong Customer Loyalty: These companies tend to foster loyal customer bases, often operating in markets with limited competition, which helps reduce the risk of disruption. Consequently, they often trade at a premium compared to more general software firms.

However, investors should be aware of certain risks:

• Market Limitations: Because Vertical SaaS companies are tied to specific industries, they are more susceptible to fluctuations within that market. For instance, Autodesk, which is exposed to the real estate and infrastructure sectors, can be affected by interest rate hikes.

• Growth Constraints: The Total Addressable Market (TAM) for Vertical SaaS companies is often smaller and more limited compared to horizontal SaaS firms, which can restrict growth potential.

Industry Characteristics and Opportunities

Despite some limitations, there are sectors where Vertical SaaS is thriving due to a lack of high-quality software solutions. Additionally, industries that have not yet undergone digital transformation represent significant opportunities for these companies.

A few examples illustrate this potential:

• E-commerce: Shopify identified a need in the market and delivered an effective solution that simplified online retail for small businesses.

• Restaurant Industry: The dominance of NCR and Oracle, which offered expensive and bulky solutions, left room for companies like Toast to disrupt the market with a more streamlined product.

• Real Estate: Despite the presence of Autodesk, Procore found an opportunity by addressing needs that Autodesk wasn’t fully serving.

In other sectors, such as pharmaceuticals, companies like Epic Systems and Veeva have successfully entered and dominated the market by providing industry-specific solutions.

Financial Insights: Vertical vs. Horizontal SaaS

When comparing the financials of Vertical SaaS to Horizontal SaaS, several notable distinctions emerge.

Marketing and R&D: Vertical SaaS companies generally spend less on marketing, as they target a specific audience and often have more focused, effective campaigns. On the research and development (R&D) side, the expenditure can vary; some companies invest more to maintain their edge in a highly specialized market, while others spend less due to their narrower focus.

Churn Rates: Vertical SaaS companies tend to have lower churn rates compared to horizontal providers. Most of their growth comes from existing customers rather than new ones, which is reflected in a metric called the Gross Retention Rate (GRR). This rate measures how much of a company’s revenue comes from existing customers, excluding any revenue from new clients or price increases.

For instance, Tyler Technologies boasts an impressive 98% GRR, signaling very low customer turnover. Tyler is projected to grow by 9% in 2024, largely through selling additional products to its current customer base of 13,000. Each customer currently uses an average of three products from Tyler's portfolio, out of a possible eight to ten.

The Long-Term Value of Vertical SaaS

Vertical SaaS companies offer an attractive business model for long-term investors. These companies benefit from strong customer retention, higher profitability, and lower marketing costs, making them appealing for investors looking for stability and long-term growth. However, these stocks tend to trade at a premium due to their unique market positioning, and finding a quality company at a reasonable price can be challenging. Once investors do identify such a company, however, they may be looking at a long-term compounder with the potential for sustained growth.

In conclusion, Vertical SaaS companies are well-positioned to serve niche markets with tailored solutions. For both clients and investors, these firms offer significant advantages, albeit with some market-specific risks. Investors looking for strong returns and long-term growth should keep an eye on these industry-focused firms, which continue to show resilience and profitability in their respective fields.

We have a few interesting names in our universe that we would like to own at the right prices, for example; Procore, AppFolio, and Veeva.

(Media is from softGist, Fractal Software, Procore IR)

Disclaimer: This article is for informational purposes only and should not be considered financial advice. Our hedge fund may hold positions in the companies discussed and may actively trade in these securities. Our views are based on publicly available information and our internal analysis, which are subject to change without notice. We encourage readers to perform their own research or consult with a professional financial advisor before making any investment decisions. We assume no responsibility or liability for any errors or omissions in the content.