How to Be a Value Investor in Software

Is It Possible to Be a Value Investor in Software Companies?

When you think of software companies, images of fast-growing tech giants with skyrocketing revenues come to mind. Traditionally, growth investors have dominated the software space, focusing on companies promising ever-accelerating revenue. But is there room for value investors in this world?

Value investors seek companies underpriced relative to their intrinsic value. However, in the software industry, slow or stagnant revenue growth often brands a company as a "value trap" or an irrelevant player. Yet, by using a value-oriented framework, it’s possible to find software companies that offer long-term value. Let’s explore how.

Section 1: Understanding the Software Business Model

Software companies typically operate under two main licensing models: Perpetual Licenses and Subscription/Term Licenses.

• Perpetual Licenses: The customer owns a particular version of the software indefinitely. The strategy relies on releasing upgraded versions every few years, prompting customers to purchase new licenses. While perpetual licenses provide one-time revenue, companies often charge for ongoing maintenance, generating recurring income.

  
  

• Subscription/Term Licenses: In the SaaS (Software as a Service) model, customers pay a monthly or annual fee to access the software. This model bundles licensing and maintenance fees together, creating more predictable and consistent cash flows.

From an investor’s standpoint, subscription services offer more stability, as the revenue is less lumpy and more predictable than perpetual licenses. Moreover, the lifetime value of customers under a subscription model is generally higher, as renewal costs are lower and customer retention tends to be stronger.

Section 2: A Framework for Margin of Safety in Software Stocks

A crucial concept for value investors is the margin of safety, which means buying a stock at a discount to its intrinsic value. For software companies, this requires a different approach compared to traditional industries. Here’s a simple screening framework to identify potentially undervalued software stocks:

• Free Cash Flow (FCF) positive or neutral: A company that generates positive FCF has proven its ability to scale and sustain operations.

• Annual Customer Retention >90%: High customer retention rates indicate a loyal customer base and consistent recurring revenue.

• EV/(Maintenance or SaaS Revenues) < 3.0x: For smaller companies (market cap under $1 billion), an enterprise value to recurring revenue ratio under 3.0x could signal a bargain.

This framework ensures you’re investing in companies with predictable, high-margin maintenance revenue streams and relatively low operational risk. If the company is large, you can adjust the EV/Revenue ratio upwards, but the key is finding firms with sustainable, recurring revenues and a path to profitability.

Section 3: Underused Valuation Metrics for Software Stocks

When valuing software companies, conventional metrics like Price-to-Earnings (P/E) can be misleading, especially for early-stage or high-growth firms. Here are three more suitable metrics for software value investing:

• EV/Software Recurring Revenues: This metric focuses on the recurring revenue portion of a software business, which tends to be more stable and higher margin than one-time sales. Most high-quality software companies trade at 6x-7x recurring revenue. Anything below 3x suggests an undervalued company with potential upside.

• EV/Gross Profit: For companies with mixed revenue streams (e.g., software, hardware, services), this metric is useful. It normalizes companies based on gross profit, which can be a better indicator of operational efficiency than sales alone. A company trading below 4x gross profit could be interesting for value investors.

• EV/FCF: This is a more traditional metric, but it works well for mature software companies. Free cash flow is a direct indicator of a company’s ability to self-fund growth without relying on debt or equity raises.

Section 4: Cost Structures (COGS, Sales & Marketing, and SG&A)

Understanding a software company’s cost structure is key to value investing. Here's how I break it down:

Section 4.1: Cost of Goods Sold (COGS)

COGS reflects the direct costs involved in delivering a software product or service. In a software company, this usually includes:

• Hosting costs for cloud products (servers, storage, etc.).

• Maintenance costs: These are related to support teams and maintaining software for existing customers.

• Implementation costs: Includes setup fees and any work required to integrate the software with a customer’s systems.

• Training costs: The expenses associated with training users to operate the software effectively.

• Depreciation: If the company owns server infrastructure, depreciation can be part of COGS.

For software companies, the gross margins on recurring revenue should be very high—70-90%—as their costs typically decline as they scale.

Section 4.2: Sales & Marketing (S&M)

Sales and marketing expenses are critical for driving growth and include:

• Fixed costs: Salaries for the sales team and marketing personnel.

• Variable costs: Sales commissions and discretionary marketing spend for customer acquisition.

• Customer Acquisition Cost (CAC): S&M expenses are often analyzed in relation to the number of new customers acquired. The Lifetime Value (LTV) of a customer should ideally be at least 3x the CAC.

It’s important to distinguish between growth and maintenance S&M costs. Growth S&M focuses on acquiring new customers, while maintenance S&M targets retaining existing customers. Efficient spending here can drive profitability.

Section 4.3: General & Administrative (G&A)

General & Administrative (G&A) expenses cover overhead costs and include:

• Management salaries: Compensation for top executives and general staff.

• Office expenses: Rent, utilities, and office supplies.

• Legal and accounting costs: Fees for external consultants or compliance.

• Technology expenses: Costs related to maintaining essential tools like ERP systems.

In a well-run software company, G&A costs should decline as a percentage of revenue as the company grows and achieves greater operational efficiency. A lean G&A structure can enhance profitability and free up resources for growth.

Section 5: R&D as Invested Capital in Software

In the software world, Research and Development (R&D) plays a critical role. It’s the equivalent of capital expenditure for traditional industries. While companies can often reduce other expenses during downturns, R&D investments are crucial for long-term innovation and competitiveness.

Here’s why R&D is the real "invested capital" for software companies:

• Capitalizing R&D: Some companies capitalize R&D instead of expensing it, artificially inflating EBITDA. When comparing two companies, it's essential to normalize this for a fair comparison.

• Growth vs. Maintenance R&D: Not all R&D is created equal. Growth R&D focuses on building new features or products, while maintenance R&D sustains existing offerings. Identifying how much of a company’s R&D is dedicated to growth versus maintaining current software is critical for understanding its potential to expand market share.

A company with well-invested R&D capital is positioning itself for future growth, making it a key component of software value investing.

Section 6: Free Cash Flow (FCF)

Free cash flow is a key indicator of a company’s health. It shows that a company has scaled enough to cover its operating costs, with money left over for growth or returning value to shareholders. Software companies that are FCF positive demonstrate financial discipline and long-term sustainability, making them attractive to value investors.

Section 7: The "Voss Sauce" of Software Value Investing

The real secret to value investing in software comes from spotting companies where both revenue growth and margins improve simultaneously. This often happens when a company simplifies its business through asset divestitures or management changes.

To find such opportunities:

• Look for companies divesting weaker assets to focus on their core, higher-margin operations.

• Ensure the company’s financial health remains stable without the divested asset. If the company is selling assets to survive, it could signal desperation.

By simplifying their business models, companies can become more focused, improve profitability, and ultimately become attractive acquisition targets. The best outcomes occur when a company’s revenues start to grow while margins rise—a potent combination that often leads to outsized returns.

Section 8: The Key Attributes of a Great Software Play

The ultimate value software investment exhibits several critical attributes that make it a strong candidate for long-term profitability and possible outsized returns. These attributes include:

• High Recurring Revenues: The company's revenue base is composed primarily of recurring revenues (either SaaS or maintenance), which tend to have higher margins, greater predictability, and lower customer acquisition costs than one-time sales.

• High Customer Retention: A company that retains 90% or more of its customers annually indicates it offers a product that is essential to its users, leading to strong customer loyalty and low churn rates. High customer retention minimizes the need for aggressive sales strategies to replace lost customers.

• Positive Free Cash Flow (FCF): A software company that is FCF positive shows that it has achieved scale, meaning its operating expenses are covered by its revenue, and it can invest in growth without needing outside capital.

• Low Customer Acquisition Costs (CAC): A company that efficiently acquires customers and retains them over time can generate a high lifetime value (LTV) to CAC ratio. Ideally, the LTV should be at least 3x the CAC, signifying that each new customer generates significantly more revenue over their lifetime than it costs to acquire them.

• EV/Recurring Revenue Below 3.0x: Software companies trading at an enterprise value of less than 3.0x their recurring revenue offer a margin of safety, as such companies tend to be undervalued relative to their revenue potential.

• Strong Unit Economics: The company demonstrates a clear understanding of its cost structure, especially in areas like hosting costs for cloud products and maintenance costs for support. A high gross margin on recurring revenue (70%-90%) indicates that the company’s core business is highly profitable and scalable.

• Clean Financials: The company avoids excessive capitalized R&D or stock-based compensation that could artificially inflate its earnings metrics. Clean financials make it easier for investors to gauge the true profitability of the business.

• Opportunities for Margin Expansion: The best software plays are not just focused on revenue growth but also improving operational efficiency, which translates into rising EBIT margins over time. Margin expansion creates more room for earnings growth without requiring aggressive revenue increases.

• Potential for Divestitures or Strategic Refocus: Companies that divest non-core or struggling assets to focus on high-margin, high-growth businesses often experience margin improvements and simplify their business model. This refocus can make the company a more attractive acquisition target or lead to better long-term performance.

A great example is QHR Corporation, a Canadian provider of electronic medical records (EMR) software. In 2015, the company traded at around 2x recurring revenue with strong customer retention and high margins. After divesting a struggling U.S. business, QHR became a "pure play" EMR company, which improved both profitability and investor sentiment. Over the following year, the stock appreciated, showcasing the power of simplifying a software company’s story.

Conclusion

Value investing in software companies is both possible and potentially rewarding. By focusing on recurring revenue, disciplined cost management (COGS, S&M, and G&A), and smart R&D investment, you can uncover hidden value in a field dominated by growth investors. Look for companies that balance innovation with financial discipline, use key metrics like EV/Recurring Revenue and EV/Gross Profit, and have a clear path to profitability and margin improvement.

The best opportunities come when companies strategically refocus on their strengths, divest weaker assets, and streamline their operations—creating a perfect blend of growth and profitability.

(Source: Moiglobal)