Read an interesting thread today from someone I follow on twitter regarding SAAS companies and their gross margins. I’ve linked the thread below for those interested in reading. My main take away from it is that it’s very important to know exactly what these companies are including in their cost of revenue in order to evaluate and compare their reported gross margins.
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Ivan, while I am all in favor of understanding a company’s financials as well as possible, I think there may be a questionable aspect to obsessing about the fact that company A does it slightly differently than company B. I think the root of the issue here is thinking that a SaaS company is a specific thing and thus that all SaaS companies should be directly comparable. Being a SaaS company is just a business model, one that can work and make sense with a wide range of different products and services. To be sure, the fact that many of them are based in software, the initial S, after all, tends to means that gross margins in software companies tend to be large. But, that is a vague sort of “large” because different products have different requirements and expectations.
Thus, while one can compare the gross margins of direct competitors, when two SaaS companies are in substantially different lines of business it doesn’t really make a lot of sense to compare them. There are quite likely to be differences which are associated with the lines of business which suggest that a particular item might be higher or lower or that a particular item should or should not be best included in cost of revenue.
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I read enough of the article to say that he is right and wrong. It’s not a question of “getting creative” but one of accounting standards.
GAAP was designed for old industrial enterprises. The Profit and Loss Statement is as follows:
Net Revenue: The money received for goods and services
Less: Cost of Goods Sold:
What Is Cost of Goods Sold – COGS?
Cost of goods sold (COGS) refers to the direct costs of producing the goods sold by a company. This amount includes the cost of the materials and labor directly used to create the good. It excludes indirect expenses, such as distribution costs and sales force costs.
https://www.investopedia.com/terms/c/cogs.asp
Gross Profit or Loss
Less: GS&A All your operating expenses
Operating Profit or Loss
Less: Taxes and all other non operating stuff
Net Profit or Loss
Keeping the above model in mind it is easy to see why SaaS MUST have very high Gross Margins. When you build a steel mill the cost of the mill is capitalized and if the useful life of the mill is 20 years this cost is spread over 20 years, 5% a year. If you build software, the R&D is expensed as an operating cost, it is not part of COGS! In other words, if you create iOS or Windows, it is on the books at value ZERO! That’s ridiculous. Microsoft and Apple have been milking these operating systems for decades but the eggheads at FASB, who never ran a business in their lives, have determined that R&D should be expensed. Software companies love it! They get to discount this long term investment as an expense saving millions on taxes.
But it’s not a free lunch for SaaS because instead of a large COGS, they have a large S&M cost which properly goes into operating expenses. The extra large Gross Margin is accompanied by a much smaller Operating Margin. This is not “creative (deceptive) accounting” but the application of industrial era accounting to 21st century SaaS businesses.
SaaS MUST have very high Gross Margins to cover the very high cost of acquiring customers (CAC). Successful SaaS is delayed earnings gratification in part due to industrial era GAAP accounting practices.
Denny Schlesinger
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My post elicited an email with two interesting “objections” to my presentation. Good points that might interest the board even if they are more about accounting practices than about stock picking.
Accounting is not an exact science, the reason for calling it “generally accepted” accounting practices (GAAP). In other words, not scientific or set in stone accounting practices. At a US Steel subsidiary in Venezuela, instead of the more usual LIFO and FIFO cost of goods sold calculation they were using Standard Cost for their inventory on the theory that it better measured the efficiency of their various cost centers by excluding price variation which could be explored elsewhere in the accounting. The primary purpose of accounting is to manage the business, not to inform stockholders. We investors are not managing the businesses. As an individual investor, if you don’t like management all you can effectively do is to sell your shares.
First objection:
The creative accounting comes in charging the “hosting” charges which are part of COGS into Sales and Marketing. This doesn’t change the underlying profitability, but artificially inflates the gross margin, which is prized in early stages for SaaS companies.
The highlighted part is debatable. If the company runs it’s own data centers then it would be true. But what if they outsource the hosting, say to Amazon, or Microsoft? Then it would be a pass through cost. In the industrial world you quote prices, for example, as “Freight On Board,” the cost of the product loaded on board the ship or train. You could quote the price at the factory door which would be lower or include the freight and insurance to the client’s door.
Of course, if you outsource hosting and account for it as Sales and Marketing you also have to deduct the cost of hosting from Gross Revenue to get Net Revenue. That could be where chicanery is taking place but you need to dig deeper into their accounting practices before accusing them of “creative accounting.”
Second objection:
Also, if you look into Datadog, they actually amortize their sales compensation over 4 years, so while you see a high gross margin and consider the high SGA is required as upfront costs, but it still doesn’t capture all the cash costs incurred.
This is not something I have run into before and it does sound a bit strange. Amortization and depreciation are standard accounting practices and they, in themselves, are not deceitful. “Cash Flow” and “Profit and Loss” are two separate concepts and unless you do cash accounting they run their separate ways.
The question to ask is “why do they amortize their sales compensation over 4 years? How is it justified?” If they are selling four year contracts it would be amply justified. If they estimate that the average lifetime of a contract is four years, it would be somewhat questionable. Dig deeper to find the reason.
Denny Schlesinger
BTW, thanks for the email!
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Amortize their sales compensation over 4 years
This is a 606 accounting thing. I see many companies who switch to the 606 accounting method, state that they now have to amortize sales compensation over time.
This is why I focus on cash flows for a profitability metric.
Jim
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Denny, a couple more thoughts to add to yours.
If one thinks of a traditional software company where they sell the customer a product and then the product is installed on the customer’s machine or on a cloud the customer pays for and then compares this to a SaaS model software company where the hardware is provided as a service along with the software, then it seems to me that it can make perfect sense to consider the cost of hosting as a cost of sales, particularly if it is a cloud-based offering where one buys incremental service to support the number of current customers.
Likewise, in a traditional software company, a sale made in year one has all the revenue in year one and so putting the commission all in year one as a cost of sales makes perfect sense. Conversely, with a SaaS model company a sale made in year one normally results in revenue for multiple years so spreading the cost of acquiring that revenue over multiple years makes sense to me. Why four years? Probably not because one only expects the customer to stick around for four year, but more likely because 4 years is about when the total SaaS revenue exceeds the total revenue one would have obtained with a more conventional sale.
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This is a 606 accounting thing. I see many companies who switch to the 606 accounting method, state that they now have to amortize sales compensation over time.
Thanks for that info! The more FASB messes with GAAP the weirder the accounting becomes. As I recall, 606 messes with revenue recognition and then it makes sense to also defer related costs and expenses.
Denny Schlesinger
Just to add a bit more clarification to this…
The creative accounting comes in charging the “hosting” charges which are part of COGS into Sales and Marketing. This doesn’t change the underlying profitability, but artificially inflates the gross margin, which is prized in early stages for SaaS companies.
The highlighted part is debatable. If the company runs it’s own data centers then it would be true. But what if they outsource the hosting, say to Amazon, or Microsoft? Then it would be a pass through cost. In the industrial world you quote prices, for example, as “Freight On Board,” the cost of the product loaded on board the ship or train. You could quote the price at the factory door which would be lower or include the freight and insurance to the client’s door.
They are moving the expense of the “free” users into sales and marketing, not the entire hosting. in some cases they move customer support expense and hosting expense.
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They are moving the expense of the “free” users into sales and marketing, not the entire hosting. in some cases they move customer support expense and hosting expense.
Again, there is a question of point of view. If one regards the option for free use as a marketing tool rather than as a currently unremunerative part of the customer base, then it seems reasonable to put any expenses of that “marketing” under sales and marketing.
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