June 17, 2024

Are software companies good businesses?

We are back talking about profitability.

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

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Coming off a chart that showed the inverse relationship between rising interest rates and tech companies’ revenue multiples, investor Chamath Palihapitiya said said interesting thing:

I think this chart is not helpful, because this is all unprofitable software companies. So I think the most 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 find true product-market fit, how to eliminate bottlenecks, how to drive medium and long-term profitability. And most of them, unfortunately, do not have a clear path to that.

The problem with it all is that the legacy software companies of old, except for Salesforce, have not grappled with profitability. So, the ones that went public in their early teens are still floundering, losing money. So, unfortunately, the idea that software businesses generate long-term profits is a fallacy.

This is the chart in question:

Image Credits: Altimeter

As you can tell from the branding on the chart, it’s by Altimeter, of course founder Brad Gerstner joined the conversation after the podcast aired, tweeted his own thoughts.

Gerstner took a more positive view: “Are software companies bad business models? So I asked the team to draw a few charts together. Of the 61 companies in the index there are only 6 of them [negative free cash flow] margins.”

Gerstner went on to point out that the basket of companies has grown and exchanged free cash flow margins over the past 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 almost switched places in 2023 — median growth rates decreased to 19% and average free. cash flow margins increased to 12%.

Gerstner argued that software companies tend to generate more money over time, so there is reason to be optimistic about software companies. He allowed that share-based compensation should also be a factor to consider for the profitability of technology companies.

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