“Software is eating the world.” Marc Andreessen, a heavyweight in the venture capital scene, said this years ago and it still rings true today. Every company these days uses some sort of software. Whether that be for their taxes, payroll management, an operating system like Windows, or automating business processes. Software is so integral to business and it is only becoming more important.
Historically, software was proprietary and companies licensed it and made a lot of money in support contracts. Picture a Fortune 100 company back in the day buying a licensing contract from Microsoft so it could use Windows on all of its computers. However, software is changing rapidly. The move is towards a delivery system called SaaS or software-as-a-service. Think of the cloud, no not cumulonimbus, the Apple Cloud or Google Docs. With the advent of the cloud (think a huge data warehouse), companies could deliver their software on a subscription basis through the cloud.
Rather than you having to burn software on your computer via a hard-disk CD (what are those?) you can just buy software online and then use it (as-a-service). So the delivery system has been simplified even further than the licensing. Google Docs is a cloud-based service. You don’t have to download it onto your computer, you just use it when you want.
If you think about it, software seems like it would be nearly impossible to have a competitive advantage in. Millions of people write code all around the world. Especially with the rise of open source software, what is stopping people from copying great ideas from other programmers? Innovation rates. By the time someone is copying a great idea, the original group of idea makers is already ten steps ahead.
However, once software companies reach a critical mass, they can become the de facto standard. Think Microsoft, Adobe, Intuit with TurboTax. These companies all have huge competitive advantages because they have the brand name and they have customers locked in. Business people know Excel, designers know Photoshop, dads and moms know TurboTax. But these companies aren’t safe forever. Software moves quickly and these companies can be disrupted. This is why investing in technology is difficult. Because it moves fast. So competitive advantages are not cemented but they are not impossible.
Valuation and Financials
Software companies have a very interesting financial structure. The upstart costs are big because you have to hire a bunch of wicked-smart developers and then build the software. After that though, delivering it is simple.
Think about a toy maker. Every toy that a kid wants, the toy maker has to make a new toy. In software, every time someone wants to buy your software, you can deliver it to them for basically no cost because it has already been built. Therefore, the gross margins for software companies are usually very high (60-90%).
However, many of these software companies post negative earnings. How can that be? It is because they are spending a ton of money on sales and marketing as well as investing back into research and development and hiring. Sometimes SaaS companies can spend upwards of 50% of revenues just on sales and marketing. Over time, this number usually falls but since the delivery is inexpensive, the marketing becomes very important. If customers don’t know about it, what good is the software?
So if a software company is not posting positive earnings, look for free cash flow generation. But sometimes all of the free cash flow is due to huge stock-based compensation (SBC) expenses. Most software companies, when they are starting out, are short on cash so they pay employees on stock. This is not a cash expense but it affects earnings which is why a lot of companies post negative earnings. As a hard and fast rule, any company with SBC over 15% of revenue should be red-flagged. This is because the SBC dilutes your value as a shareholder since these companies have to issue more shares to pay employees.
Some of these software companies can trade from 7-15x sales. If they don’t have earnings, a popular valuation metric is price-to-sales. Essentially, the market cap/revenue. Depending on revenue growth rates, recurring revenue (how much is subscription-based), and gross margins, a software company can be valued towards the higher end of that 7-15x spectrum or the lower end. On a traditional valuation basis, software companies look horribly expensive. But it is more nuanced. These companies have totally different cost structures than typical businesses. Therefore, they are extremely hard to value.