In the software industry, the big, horizontal “platform” companies tend to attract the lion’s share of attention from investors and the financial media. Firms like Microsoft and Salesforce are household names at this point; other companies like Workday and ServiceNow are less familiar to the average person but quite well known to the investment community. These firms are appealing for many reasons. They serve huge total addressable markets (TAMs), often reaching $100 billion or more. They drive their results with massive sales teams. Nine-figure contracts with a single enterprise customer are not uncommon.
Although our world is increasingly dominated by these large horizontal tech firms, we believe that investors should not ignore the potential of more narrowly focused vertical software companies. Many of these firms offer attractive earnings and cash flow growth potential—more than enough to make up for their smaller scale and addressable markets.
What are the success drivers for these vertical players?
- Focused research and development: With a focus on a single industry or sector, these companies can concentrate their efforts on the features and analytics that their vertical specifically needs. In many cases, this allows them to outpace horizontal firms that need to serve many masters.
- Pricing power: Being a “price maker” (vs. a “price taker”) in software usually requires either proprietary features or proprietary data sets, and the best vertical companies can often provide both. With respect to data, these firms are working with many of the leading competitors in a given vertical, allowing them to gather valuable market-wide datasets; they can provide that data back to their customers in an anonymized fashion, which gives those customers invaluable information about best practices in their industry and how they stack up against their peers.
- Lower customer acquisition costs: Vertical firms typically exhibit notably lower sales and marketing expense than the average software company. One primary reason is referrals and/or reference accounts: Once a software company proves its mettle with a few admired firms in an industry, the other players in that industry are typically much more open to doing business with them. Additionally, these firms can tightly tailor their sales approach to dovetail with the unique vocabulary and operating models processes within a specific industry.
Taken together, these advantages can help vertical companies build leading—sometimes dominant—market share, and achieve enviable operating margins. As shown in the chart below, vertical software firms generated better gross margins and lower sales & marketing costs than the broader industry in 2017. The end result: Vertical firms were almost twice as profitable as the industry average as measured by EBITDA.
Source: Bloomberg. “All Software” refers to NYSE- and NASDAQ-traded companies categorized as Prepackaged Software under the Standard Industrial Classification (SIC) system. “Vertical Software” refers to a subset of those companies whose revenue is predominantly sourced from a specific vertical industry, according to Brown Advisory analysis.
There are a variety of examples that demonstrate the ability of these firms to gain primacy within their verticals: AspenTech serves the energy and chemicals industries, Tyler Technologies serves state and local governments, and Blackbaud works with nonprofits; all of these companies have leading market share in their respective markets, and report winning as much as 80% of the new contracts for which they compete. Veeva is notable as a CRM competitor in the pharmaceutical industry; the CRM market is increasingly dominated by Salesforce, but within this vertical, Veeva retains a 70%+ market share and its position is so strong that Salesforce has chosen to partner with Veeva rather than compete head-to-head.
The software universe will likely always have a group of titans that cast a long shadow over many industries, but vertically focused companies continue to prove their ability to carve out defensible positions, generate value for customers and perform well for shareholders. 
The views expressed are those of Brown Advisory as of the date referenced and are subject to change at any time based on market or other conditions. These views are not intended to be and should not be relied upon as investment advice and are not intended to be a forecast of future events or a guarantee of future results. Past performance is not a guarantee of future performance and you may not get back the amount invested.
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