- In this Investor Guide we provide gross margin and opex/capex frameworks for estimating software companies' terminal FCF margins.
- In Part 1 we break down the factors driving gross margins, providing a framework and points of consideration for investors.
- In Part 2 we will cover the factors affecting opex, capex, and changes in working capital.
The chosen terminal or mature-stage Free Cash Flow margin significantly influences a company's valuation. This holds true whether an investor is performing a comprehensive DCF valuation or basing their valuation on anticipated FCF multiples. The maxim 'cash is king' resonates deeply with investors. When a company possesses or is projected to have ample cash reserves, it ensures adequate liquidity to cover liabilities, minimizes the need for excessive debt, and offers the agility to capitalize on investment opportunities. Moreover, cash acts as a safety buffer during economic downturns, safeguarding against the devaluation of other assets. For investors, a robust cash position indicates the company's potential to reinvest for future growth or utilize the cash for dividends and share buybacks, leading to enhanced investor wealth via capital appreciation and returns.
Estimating a terminal FCF margin can be somewhat complex, however. As growth investors, the companies under analysis are often generating a low or even negative FCF margin, which makes forecasting 10 or even 15 years ahead very challenging. Estimating the terminal FCF margin for these companies is even more important, because most of the value is at the long end. Furthermore, as tech investors, the companies under examination might have a unique architecture and be operating in a young market, making a comparables approach to forecasting terminal FCF margin non-applicable.
FCF margin can largely be broken down into revenue minus COGS, S&M, R&D, G&A, plus D&A and SBC, and minus changes in working capital and capex, and each of these components are impacted by a number of variables. Such analysis is particularly challenging for technology companies that have a number of additional tech-oriented variables that investors need to consider. This research aims to provide a framework for evaluating these components, and to provide a systematic approach to assist software investors in estimating terminal FCF margin. The scoring system incorporated into the evaluation framework is highly subjective and is based on little empirical evidence. Nonetheless, we've enjoyed writing this research and if it doesn't serve well as a systematic approach, it will at least serve well as a mind map for thinking about the various components of a software company's terminal FCF margin.
The purpose of this research is to provide an evaluation framework which can be applied to a company that is still in its growth stage, in order to estimate its terminal FCF margin. The evaluation breaks down FCF margin into the following components:
- Gross margin
- Changes in working capital
Although M&A spend is not included in the FCF definition, we will also incorporate it because 1) it is a regular cash outflow for many software companies, especially when they have reached maximum scale, and 2) the ensuing amortization of technology is recorded in COGS, negatively impacting gross margin. Thus M&A will be included in Part 3 of this research series.
Often, when calculating a company's FCF there are a few additional components; however, these core components largely account for FCF as they are the biggest, most common, and most consistent items.
To evaluate terminal gross margin, we've created a Terminal Gross Margin Framework. This framework provides a systematic approach to help investors contemplate how much a company's gross margin can increase by the time it has reached a mature stage. The factors in this framework are more driven by the technological choices made by the company under examination.
To evaluate S&M, R&D, G&A, D&A, SBC, and capex, we've created a Terminal Opex, Non-Cash, & Capex Framework. The Opex components are mainly influenced by the market dynamics in which the company operates, whereas Capex is impacted by architectural and infrastructure choices made by the company.
To evaluate changes in working capital, we haven't created a framework but will discuss differences between license-based and SaaS-based software companies and how they impact working capital.
The frameworks for gross margin, opex, non-cash, & capex, and changes in working capital, provide us with an anchor in which to estimate terminal FCF margin.
- Terminal Gross Margin Framework
- Terminal Opex, Non-Cash & Capex Framework
- Terminal working capital changes points of consideration.
Once we have this terminal FCF margin anchor, we will proceed through a number of additional aspects that we could not include in the frameworks, such as the level of product innovation, network effects, and whether the company leverages a freemium tier, and adjust the terminal FCF margin estimate, accordingly.
Terminal Gross Margin Framework
Objective: To estimate the potential terminal gross margin of a B2B software or infrastructure company by assessing its current strengths and future scalability in certain factors, and discerning how much these factors could influence its gross margin as the company grows.
Starting Point: Use the company's current gross margin as the baseline. This acknowledges the company's current positioning and the efficiencies or inefficiencies already factored into its operations.
Factors for Assessment:
- Marginal Costs (Potential +300bps)
- Reflects the company's ability to scale without significant incremental costs.
- Cloud vs. on-prem dynamics can be encapsulated here, with cloud-based models often having declining marginal costs with scale.
- Talent (Potential +400bps)
- Gauges the company's human capital assets.
- Talent can drive innovation, efficiency, and strategic direction, all of which can impact gross margin.
- Vertical Integration (Potential +500bps)
- Evaluates the company's control over its supply chain (or expanding into the most valuable parts of the value chain) and its potential to extract more value by reducing third-party dependencies.
- As the company grows, further vertical integration can lead to cost savings and margin expansion.
- Value Proposition (Potential +300bps)
- Assesses the company's current and potential value creation; review its pricing power, its current offering, and its potential to expand its product/service suite.
- A robust value proposition with the potential for platform breadth can drive customer retention, cross-sells, and up-sells, impacting the margin positively.
- For each terminal gross margin factor (marginal costs, talent, vertical integration, and value proposition), there are category labels: Very high, high, Mid-High, Mid, Low-Mid, Low, Very low.
- The company will be assigned one of these category labels for each factor of terminal gross margin.
- Each category label translates to an increase in basis points (bps) which is added to the current gross margin.
- If the company shows promising signs of being able to leverage a factor for margin improvement as it scales, it will receive a category label that translates to a high bps increment. This would suggest the factor can become a strategic advantage in the company's journey.
- Gross margin increments in bps are added together and added to the current gross margin to arrive at an estimate for terminal gross margin.
- Begin with the company's current gross margin.
- For each of the factors, assess the company's positioning and potential. Allocate a category label.
- Add the respective bps associated with each category label to the starting/current gross margin.
- The resultant gross margin post-assessment gives an estimation of the company's potential terminal gross margin, considering its strengths and scalability prospects.
- The company's potential in each factor can influence its gross margin positively as it scales.
- The company under examination must be in a growth stage with ample opportunity to further scale, otherwise, the assessment of each factor will already be factored into the gross margin.
- Current strengths in these factors may not be fully reflected in the current gross margin due to the company's present scale, revenue base, or strategic roadmap.
- There is a degree of overlap among these factors. For instance, the level of talent will influence the value proposition and marginal cost potential.
- This is a highly subjective process. The incremental basis point scoring system is highly subjective, and so is the assessment of a company against these factors.
Throughout the terminal gross margin work, we're going to use Cloudflare as a regular example, so we can round up the discussion at the end of the report by estimating Cloudflare's terminal gross margin in accordance to the framework.
Low marginal costs of a company, means that it doesn't cost much to sell to and onboard a new customer, which results in low COGS and high gross margin. In an interview in 2000, Bill Gates famously stated that the scale economics of technology companies are so profound that it is inexpensive to get the product in the hands of additional users. He went on to say that for software companies specifically, the marginal costs are practically zero. Perhaps at some level the marginal costs are, in fact, zero. However, at the business level there are non-negligible marginal costs, even for the software industry. It is just that they are considerably lower compared to other industries.
Marginal costs for the software industry are generally lower than elsewhere, though there is still substantial variation among software companies. Hence, here we've developed somewhat of a mind map combined with a systematic approach in order to think about a software company's marginal costs when they reach maximum scale. We've broken down marginal costs into the following components: 1) revenue model (license vs SaaS), 2) degrees of multitenancy, 3) information entropy, and 4) platform breadth. Thinking about these components and the marginal costs at max scale will contribute to the ultimate estimation of a company's terminal gross margin.