Resuming our discussion of profitability.
A recent episode of a technology-finance podcast covered valuations of software firms, the effect of interest rates, and how profitable well-known tech companies can become.
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Investor Chamath Palihapitiya made an intriguing comment while riffing off a graph that demonstrated the negative relationship between rising interest rates and tech company revenue multiples:
Since all of these are unprofitable software companies, I don’t think this chart is very useful. So, in my opinion, looking at the broad-based index is more crucial.
The problem with these businesses is that the trick is up whether rates are at 6%, 3%, 2%, or 1%. Until they discover genuine product-market fit, how to stop churn, and how to increase medium- to long-term profitability, these companies won’t be able to escape this cul-de-sac. Unfortunately, the majority of them lack a direct route to doing it.
Except for Salesforce, none of the old, legacy software companies have achieved profitability, which is the problem.
Therefore, the early teens who went public are still losing money and sucking wind.
So, the notion that software companies make money over the long run is, sadly, untrue.
The concerned chart is shown below:
Since it is clear from the branding on the chart that it was created by Altimeter, Brad Gerstner, the company’s founder, entered the discussion through Twitter after the podcast had finished airing.
Thoughts from Gerstner were more upbeat: “Are software businesses poor business models? So I requested that the group put together a few charts. In the index’s 61 companies, just 6 have [negative free cash flow] margins.
Gerstner continued by pointing out that throughout the course of the most recent several quarters, the basket of companies has alternated between growth and free cash flow margins.
Another graphic (included below) shows that group of businesses will see median revenue growth of 26% and median free cash flow margins of 6% in 2022.
These indicators almost reversed positions in 2023 as median free cash flow margins shot up to 12% and median growth rates fell to 19%.
Gerstner claimed that there are good reasons to be hopeful about software companies because these businesses also frequently end up with greater money over time.
He did concede that share-based pay need to be taken into account when determining the profitability of tech companies.
