We’re back to talking about profitability.
A recent tech finance podcast talks about software company valuation, the impact of interest rates, and how profitable high-profile tech companies are.
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Unraveling a chart showing the inverse relationship between rising interest rates and tech company earnings doubling, investor Chamath Palihapitiya said something interesting:
I don’t think this chart is very helpful, because these are all unprofitable software companies. So I think what’s more important is looking at broad based indexes. The problem with these companies is that even if the rates are 6% or 3% or 2% or 1%, the trick is over. These companies are not going to get out of this impasse until they figure out the true product-market fit, how to eliminate churn, how to drive medium to long term profitability. And most of them, unfortunately, do not have a clear path to it.
The problem is that all the legacy software companies, with the exception of Salesforce, are still not making a profit. So, those who go public in their early teens are still fad, losing money. So the idea that the software business is profitable long term is sadly a fallacy so far.
This the graph in question:
As you can tell from the branding on the chart, it’s based on the Altimeter, so that’s it founder Brad Gerstner joins the conversation after the podcast went live, tweeted his own thoughts.
Gerstner has a more positive view: “Is a software company’s business model bad? So I asked the team to put together some charts. Of the 61 companies in the index, only 6 have [negative free cash-flow] margins.”
Gerstner points out that a basket of companies have traded off growth and free cash flow margins in recent quarters.
According to another chart (embedded below), the group of companies had an average revenue growth of 26% and an average free cash flow margin of 6% in 2022. Those metrics have nearly switched places in 2023 — the average growth rate has fallen to 19% and the median free cash flow margin jumped to 12%.
Gerstner argues that software companies also tend to make more money over time, so there is reason to be optimistic about software companies. He allows that share-based compensation should also be a factor to consider for technology company profitability.