In recent years there have been a relatively high number of research reports, blog posts, and comments that mischaracterize the profitability of software companies. Often times a high profile SaaS business will be slated for an IPO and naysayers will comment that the business “is not profitable”. This statement embodies a common misconception about the profitability of many businesses in today’s economy. Technology companies, and software businesses in particular, have created a new breed of business that grows “above the line”. What exactly does that mean? Below is an explanation of this phenomenon and how it benefits investors.
A New Growth Paradigm
For decades companies around the world had a standard blue print for growth: 1) Manufacture goods, 2) Sell the goods, 3) Pay taxes, and 4) Expand by reinvesting profits. The expansion of the business typically involved the purchase of additional facilities, equipment, or inventory; which allowed for an increase in production and the sale of additional units. These investments were made by reinvesting after-tax profits and were capitalized on the balance sheet and then depreciated over time. For this reason highly profitable manufacturing companies that were experiencing growth posted large pre-tax profits, paid taxes, and then re-invested the after-tax profits into expansion.
In today’s world there are thousands of businesses that operate under a new paradigm, many of which reside in the software sector. Growth for a software business is not accomplished by adding plant, property, and equipment, but by adding additional sales personnel. In order for a software company to grow, pre-tax profits are invested in salaries, not property. Salaries are an expense line item in the Consolidated Financials of a business and appear above the tax line. For this reason software companies in growth mode that are highly profitable do not show reported profits. This creates a major difference between the manufacturing companies of yesterday and the technology businesses of today.
To help illustrate this concept here is an example. Imagine a manufacturing business and software business that are identical in size and profitability. The two companies have the same revenue, same expense structure, and same pre-tax operating profit. Below shows what the profit and loss statement of these identical companies would look like:
The above table shows that the pre-tax profit for both businesses is $50 million dollars. If each business were to reinvest the $50 million into growth, what happens to the Consolidated Financials? The answer to this question is relatively straight forward for the manufacturing company. Under the current tax code (2017), the business would pay roughly 40% taxes on the $50 million in operating profit, or $20 million dollars, and then reinvest the remaining $30 million into expansion. The company would show a GAAP reported net income of $30 million.
The software company is a much different story. Growth for the software company is accomplished by hiring additional sales and marketing personnel. The hiring process occurs continuously throughout the year and has the effect of altering the year-end financial statements. The $50 million in pre-tax profit that would have been realized is instead expensed as sales and marketing. The table below shows how the profit and loss statement for the software company changes when the decision is made to reinvest for growth:
The updated profit and loss statement shows no pre-tax profit, because the potential cash generated by the business was reinvested into additional personnel. Growth for the software company actually altered the profit and loss statement in real-time, whereas the manufacturing business had to report profits, pay taxes, and then reinvest. Check out the difference between the two companies side-by-side on a GAAP basis:
Remember that these two companies are identical in all aspects – the only exception being how the company grows. The software company is able to reinvest for growth above the tax line, whereas the manufacturing company has to reinvest for growth below the tax line. Notice that the software company is able to reinvest $50 million in potential profits back into the growth of the business, whereas the manufacturing company can only invest $30 million due to taxes. This has a profound impact on the future profitability of both businesses as they grow. It is far better to invest above the line.
It is important for investors to realize that hiring more sales personnel is a choice. There are professional investors that understand this dynamic and actually purchase software businesses with the intention of removing the sales & marketing expense. They effectively ‘pancake’ the business, keeping the minimum number of sales reps required to offset revenue churn and lay off the remainder. Once pancaked the profitability shines through. This has been repeated with great affect by public firms, such as Constellation Software, and private equity groups, such as Vista Equity Partners. When analyzing a software business it is important to carefully calculate both the maintenance sales & marketing (required to offset churn) and the growth sales & marketing. This will help reveal the actual profitability of the business.
Whether or not to reinvest in sales & marketing can be answered by one question: “What’s the ROI on my sales and marketing efforts?” This is a simple calculation based on revenue retention rates, sales productivity, gross profit margins, and tax rates. If the ROI is excellent then the company should continue to allocate resources into this channel and show no reported GAAP net income. Once the ROI becomes unattractive it is time to pancake the business and start generating free cash flow.
The ability to reinvest for long durations on a pre-tax basis is a huge advantage for these software firms. Going back to our example, image the manufacturing business and software business reinvest for 10 years and then we pancake the sales and marketing at the software firm. What happens?
The tables below illustrates the future profitability of each business over 10-years:
The software company is able to compound Pre-Tax profits from $50 million to $176 million. This compares to pre-tax profits of only $108 million for the manufacturing company. The 62% improvement over 10-years is derived solely from the advantage of growth above the tax line. This growth advantage is often understood by business operators, but misunderstood by investors. Firms frequently publish investment reports stating that a software company “is not yet profitable” when the business is reinvesting all profits into sales & marketing. This statement couldn’t be further from the truth and is a huge advantage for long-term owners of software businesses.
This communication shall not constitute an offer or an invitation to trade or invest. No party should treat any of the contents herein as advice. This document expresses the views of the author at the time of publication and such views are subject to change without notice. Selective Wealth Management (“Selective”) has no duty or obligation to update the information contained herein. Investing contains risk and loss of original principal may occur. Selective does not solicit in any state in which such solicitation or sale would be unlawful prior to registration or qualification under the laws of any such state. Past performance is not necessarily indicative of future results.