Valuing Software Companies Getting Tougher As Firms Trade Short-Term Profits for Growth

There is little doubt that the technology sector is so dynamic today that investors trying to identify the big winners of the next decade or two are probably correct to be engaging in such an exercise. The proliferation of software-driven innovation is truly staggering, as are the number of new companies trying to capitalize. The IPO market is bringing new software companies to the public exchanges, ensuring there is no shortage of investment candidates.

So while there is enormous potential with these companies as we look over the next 10 years or more, it is also getting more difficult to analyze these stocks from a valuation perspective. There are hundreds of examples of investors who buy the right company – just for the wrong price – and wind up being disappointed with their return.

I say it is getting harder to determine what a fair price is for these small, high-growth companies because they have adopted what I call the “Amazon model.” The Amazon model is simply the idea that you should sacrifice short-term profitability for growth, especially in nascent industries where the first mover can oftentimes distance themselves from the competition.

Before Amazon came along very few companies were willing to have public shareholders and purposely avoid making material profits. The consensus view was that once you IPO, profits matter. And while Amazon bears tried to debunk their model for many, many years, the company’s success has proved that it can work. Simply put, if you grow fast enough and come to dominate a particular market, investors will eventually assign a fair value to the franchise you have built. If Amazon’s stock price performance in recent years does not reinforce that view, I don’t know what could.

Not surprisingly, tech companies are now copying the Amazon model and investors are okay with it. There are dozens of public tech stocks today that are growing at 20% plus annually (some much faster) and are losing money or simply breaking even. Maybe they are marginally profitable if you wave your magic wand and pretend that stock-based compensation is not a real expense (some firms have positive cash flow but if you then subtract stock-based compensation you realize they really aren’t profitable).

Valuation conscious investors who look at the financial statements of these companies cannot help but scratch their heads when trying to understand the Wall Street valuations. After all, it is hard to explain why a money-losing software company is worth 10 times forward-looking revenue.

A closer look at the income statement reveals that in addition to stock-based compensation there is another line item that is impacting profitability to a huge degree; obscene sales and marketing expenses. Why is this number so high? Because according to the Amazon model growth and market share are crucial in the short-term. As a result, the amount of money these companies are spending on sales and marketing dwarf anything we have really seen before.

Consider some of the largest, more mature software firms. Below is a list of several, along with what percentage of sales each spends on sales and marketing:

Google 12%
Microsoft 17%
Oracle 21%
Intuit 27%
Adobe 33%

Given how high the margins are on software itself (especially now that it can be downloaded rather than boxed and sold at retail), these kinds of numbers (sales and marketing costs of no more than one-third of revenue) make it relatively easy for companies to earn net profit margins of 10-20% or higher. And once investors can see those profits it is easier to assign a fair value to share prices.

The tricky part is what we see with today’s newer companies.  Below is a list of smaller, higher growth public software companies,. along with their sales and marketing expenses as a percentage of revenue:

Workday 37%
Zillow 45%
Salesforce.com 47%
Zendesk 54%
Palo Alto Networks 56%
Splunk 69%

I don’t care how cheap it is to make your software or how high of a price you charge for it, if you are spending 50% of your revenue on sales and marketing, you aren’t going to be able to make a profit. And that does not even account for the fact that these same companies are paying out a ton of stock as compensation (instead of cash) in order to be able to cover the cost of sales and marketing.

As long as investors are willing to give these companies a pass (which is likely as long as revenue growth continues), there is nothing wrong with spending money in this fashion. The bigger problem for investors comes when they try and figure out how much to pay for the stock of a company they want to invest in. In order to do you need to have some idea of how profitable the business model is. And with this much money being spent on sales and marketing, in order to maximize growth, there is no way to really know what a “normalized” level of profitability will be when the business matures and most of the market share has been divided up. Some firms might be able to earn 25% margins at that point, whereas maybe others will be 10%. There is just no way to know.

So what happens when you find a small company and love the story but look at the financial statements and see that they are losing money and then you look at the stock price and it trades for 10 times annual sales? Do you close your eyes and buy, or cross your fingers that they miss  a quarter or two and the stock falls to 5 times annual sales?

For me, it is hard to justify the former option. Amazon and Apple trade for 3x forward sales. Google and Microsoft: 5.5x. Facebook and Netflix: 11x.

For something to be worth 10x sales it really needs to be the second-coming of these tech giants. Sure, there will be a handful that make it into that exclusive group, but will most of them? How hard is it to pick and choose correctly? It is a very tough task.

So what should value-oriented investors do? Well, try and find companies that trade closer to 3-5x sales. If they will fetch a similar multiple once the businesses mature, and you think they have a lot of growth ahead of them, the growth itself will boost the stock (in the absence of multiple compression). Also look for companies that are growing quickly but maybe are only needing to spend 20-30% of revenue on sales and marketing. That could indicate they are more efficient with their spending, or perhaps they have fewer competitors (and therefore less need to hundreds of salespeople hunting down prospective customers).

Those are some ways you can reduce your risk with high multiple stocks.

 

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