High-Quality Growth Software, Part 2
We started the sequence of work to discuss different perspectives of a high-quality software business last week. You can find Part 1 here, where we kicked off the series with "sales efficiency." In Part 2, we are going to talk about "Gross Margin." To reiterate, we like names that grow consistently, in an efficient manner, and without sacrificing profitability.
What is gross margin? Gross Margin = Revenue – COGS. Standard COGS items for SaaS include:
Third-party hosting services and data center costs;
Fees related to network infrastructure, third-party royalty fees, amortized purchased intangibles;
Personnel fees associated with customer success, implementation, training, and ongoing support.
A high gross margin implies that the management has more money to spend on the company's operations. For example, the company can choose to spend more on sales and marketing to sell more products. If the market worsens, they also can scale back the investment and let money flow to the investor, which explains why SaaS commands higher multiples than traditional industries like Automobiles. The average gross margin in SaaS is 70-80%, but for companies that require a lot of computing resources and professional services, the margin can often go down to ~60%.
What drives gross margin, and why is it essential to track it? Gross margin is important because it is a reflection of the pricing environment and competitive landscape. A high gross margin often signals premium products, while a decreasing gross margin often suggests pricing pressure and a deteriorating competitive landscape. How the margin trend has fared can say a lot about the company's competitiveness and pricing power.
In addition to the competition, gross margin can be impacted by many other things such as revenue mix (product 70-90% vs. professional services 20-30%), deployment model (cloud hosting will have a lower GM than on-premise because of infrastructure tax paid to cloud giants. Splunk is a good example where its gross margin dropped from ~82% to ~76% as it went through the cloud transformation), business model (free trials often drag down margin because free users cost infrastructure resources but do not contribute any revenue. ZM is a great example where its gross margin has improved as it shifted away from free retail users to enterprise).
Judging from the market, it is evident that investors favor companies with at least 70% gross margin. Of course, the higher the margin, the better.
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