Are software companies good businesses?

We’re back to talking about profitability.

A technology-finance podcast recently talked about software company valuations, the impact of interest rates, and just how profitable well-known tech companies can become.

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Riffing off a chart that showed the inverse relationship between rising interest rates and tech company revenue multiples, investor Chamath Palihapitiya said something interesting:

I think this chart is not that helpful, because this is all unprofitable software companies. So I think the more important thing is to look at the broad-based index. The thing with these companies is that even if rates are at 6% or 3% or 2% or 1%, that trick is over. These companies are not going to get out of this cul-de-sac until they figure out true product-market fit, how to eliminate churn, how to drive medium- to long-term profitability. And most of them, unfortunately, don’t have a clear path to that.

The problem is all of the old, legacy software companies, except Salesforce, have still not gotten to profitability. So, the ones that went public in the early teens are still sucking wind, losing money. So the idea that software businesses generate long-term profits is so far unfortunately a fallacy.

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Here’s the chart in question:

As you can tell from the branding on the chart, it’s by Altimeter, so its founder Brad Gerstner joined the conversation after the podcast was aired, tweeting his own thoughts.

Gerstner had a more positive take: “Are software companies bad business models? So I asked the team to pull together a few charts. Of the 61 companies in the index only 6 have [negative free cash-flow] margins.”

Gerstner pointed out that the basket of companies has swapped growth and free cash-flow margins in the last several quarters.

According to another chart (embedded below), that group of companies had median revenue growth of 26% and median free cash flow margins of 6% in 2022. Those metrics nearly switched places in 2023 — median growth rates declined to 19% and median free cash-flow margins soared to 12%.

3/ And it appears they have traded off some growth to “get more fit.” pic.twitter.com/2ONWQsvg7S

— Brad Gerstner (@altcap) July 15, 2023

Gerstner argued that software companies also tend to generate more cash over time, so there’s reason to be optimistic about software companies. He did allow that share-based compensation should also be a factor to consider for tech companies’ profitability.

Let’s sort out what all that means.

Lies, damned lies, and profitability

Palihapitiya is correct. Software profitability has been rather curiously weak in recent years.

This is due to a number of factors, including a general bias toward growth and away from profitability during the past few years. Software companies focus on growing annual recurring revenue (ARR) by spending more on sales and marketing today so they can collect more revenue in the future. This results in them trying to maintain an unprofitable posture for longer than you might expect for a business with largely recurring revenues and strong gross margins.

This weird issue with software companies — we actually mean SaaS companies here — was what Box has dealt with through the years. After spending heavily on growth when it was private, the corporate data and productivity company had to initially put its IPO on hold until it got its expenses under control. And after it went public, Box had to deal with slowing revenue growth during a revamp of its product mix. It has become more profitable since, though its growth remains uneven. Still, the company posted a GAAP profit in its most recent quarter with nine figures’ worth of free cash flow. So, it is possible for software companies to improve.

Palihapitiya is right that the market allowed tech companies to be unprofitable for a while, and that era is now ending. But I would hazard that the matter is more nuanced if you think more long-term.

The recent shift toward greater free cash flow at software companies has meant they are, on average, now generating cash faster than they have since mid-2014. So, provided we stick to analyzing simple cash metrics, this switch implies public software companies canin fact change their tune to favor profitability. And if we consider tech layoffs, the industry-wide attempt to trim costs is likely boosting aggregate profitability at companies big and small.

Things get a bit sticky, though, when we look beyond cash. Free-cash-flow generation is somewhat of a canard because software companies love to pay their staff partially in stock, which, conveniently, is a non-cash expense. This lets such businesses shift a portion of their employee costs to shareholders directly via dilution and exclude that expense from their cash-flow calculations.

Such accounting mathmagic is acceptable at startups. Young tech companies tend to burn cash to grow quickly, which is encouraged by how they are valued by private-market investors. Also, startups are growth machines by nature, and cash is what they consume to do it.

But such tricks aren’t attractive at bigger companies. After all, public companies are expected to be more mature and so are judged by more traditional metrics. When we consider software profitability, we would be better served to take into account all costs and lean more on GAAP net income results than on free cash flow. Using baby startup metrics to judge adult companies is like saying it’s impressive for a college student to be able to write with a pencil.

Palihapitiya was a bit harsh on software companies and their ability to be more profitable over time, but his complaint about the rampant unprofitability in the space is warranted. The Altimeter view, that free cash-flow improvements answer the joust, only partially addresses the more general point. To resolve this polite disagreement, we simply need to see public tech companies improving their net margins. And I suspect that we will in the back half of 2023.

In closing, let’s look at how a couple of the most richly valued software companies are balancing growth and profitability today:

• CrowdStrikereported that revenue rose 41% to $692.6 million and said, “GAAP net income attributable to CrowdStrike was $0.5 million, compared to a loss of $31.5 million in the first quarter of fiscal 2023. […] Net cash generated from operations was $300.9 million, compared to $215.0 million in the first quarter of fiscal 2023. Free cash flow was $227.4 million, compared to $157.5 million in the first quarter of fiscal 2023.”
• Snowflakesimilarly reported that revenue increased 48% to $623.6 million, saying it had “$283.1 million worth of free cash flow, and a GAAP net loss of $226.1 million.”

CrowdStrike shows that it’s possible to increase revenue at a rapid clip while maintaining GAAP profitability. Snowflake’s results and revenue multiple indicates that many investors are content to buy into growth stories.

Put another way: Some software companies are managing to post profits, even if investors are still content to buy into interesting — and unprofitable — growth stories.