The Other Side

“I never allow myself to have an opinion on anything that I don’t know the other side’s argument better than they do.”— Charlie Munger

“We all are learning, modifying, or destroying ideas all the time. Rapid destruction of your ideas when the time is right is one of the most valuable qualities you can acquire. You must force yourself to consider arguments on the other side.”— Charlie Munger

“The ability to destroy your ideas rapidly instead of slowly when the occasion is right is one of the most valuable things. You have to work hard on it. Ask yourself what are the arguments on the other side. It’s bad to have an opinion you’re proud of if you can’t state the arguments for the other side better than your opponents. This is a great mental discipline.”— Charlie Munger

Three quotes from Munger is probably overkill, but I just couldn’t decide.

The valuations of some software companies are for me a good example of “the other side of an argument.”   I want to understand how certain companies with large operating losses can be valued at multiples of revenues without, in my opinion, a clear path to profitability.  I may or may not agree with the other side of the argument, but I should at least put in the effort to understand the other side’s point of view.  Two recent IPOs (one completed and the other filed), both here in Utah, where I live, have given me that opportunity.

John and I both like simple ideas, me even more so.  I get lost when it gets too complicated.  While reading about these software companies, I continue to have a recurring thought:  Good business sell their products for a profit.  Said differently, good businesses are profitable.  I am not sure we can boil down Business 101 any further.

However, let’s take the argument from the other side.

Domo, as a quick introduction, does business intelligence software.  It’s sort of a black box in terms of what it actually does, but the best most people can describe is that it provides well-designed “dashboard” to monitor your business on a up to the minute basis.  Pluralsight is an educational software company that allows users, mostly enterprises, to learn technology skills through online training.

Let’s compare briefly the difference between profitability at Wal-Mart and Domo/Pluralsight.

If you take a company like Wal-Mart in 1972, it showed a GAAP profit.  Although it was investing in its business and growing its sales, the reason it was GAAP profitable was because its investments were capitalized.  These investments were new buildings.  Because GAAP allows for capitalization of an expense like a new building, Wal-Mart was able to only count a portion of the total cost the new building as an expense in its 1972 Income Statement.  For commercial buildings, this is 39 years, so only 1/39 of the cost of a new building built in 1972 counted as an expense.  Since the building is going to be standing for the foreseeable future, accounting practice allow you to treat it as a long-term asset and “assume” it will last the next roughly 40 years.  Wal-Mart still needed capital, which is gained through the debt markets, for its new buildings and inventory, but these capital requirements were not massive, which is important distinction I will discuss below.

Software companies, however, do not build buildings.  Instead, a company, like Domo, builds its software and goes out and gets customers.  Building its software is a research and development expense and its customer acquisition is a sales and marketing expenses.  GAAP accounting does not allow Domo to capitalize these expenses, but instead treats them as expenses to be expensed in the year they occurred.  If you are Domo, you might argue that the software built in 2018 along with the customers acquired through sales and marketing will last 39 years and should therefore be capitalized.  Obviously the truth probably lies somewhere in between.

For the fiscal years 2017 and 2018, Domo spent $195m and $209m on R&D and sales and marketing.  Furthermore, their operating losses in those years were $(182)m and $(175)m. (Pluralsight did $116m in revenues in 2017 and had $199m in expenses for an operating loss of $(82m)).  If we took a Wal-Mart approach to these line-items for Domo, these two expense lines would be capitalized and depreciated in subsequent years, thus providing Domo with approximately $40m annual line item expenses instead of the $209m in fiscal 2018.  Incidentally, this would make Domo profitable on a GAAP basis.

The second major difference between a Wal-Mart and Domo is the scale goal in the first few years of existence.  Wal-Mart operated 51 stores in 1972, having added 14 stores in 1972.  45 years later in 2017, Wal-Mart operated 11,695 stores worldwide.  For Domo, on the other hand, their plan is to roll-out their software platform on a global scale within the first few years of operations, thus requiring massive amounts of upfront capital.  Additionally, Pluralsight was being used in over 150 countries less than 10 years after its founding.  Software allows this sort of global delivery in the early years of its existence.  Wal-Mart could never have hoped to build 10,000 stores in its first 5 years of operations.

This crucial “scale at the outset” difference should show up in the early financials of a software company and make it harder for an early investor to understand why these companies are so massively unprofitable.

When you look at the financials of Domo, you can theoretically understand the math behind Domo’s argument that their software R&D expenses and customer acquisitions costs are investments in the long-term vision of the company, however, it is incredibly difficult to imagine a scenario in which a software company’s product is viable for 39 years and its customers are so sticky that the can be counted on to be there 40 years later.

The two key differences appear to be that software companies generally approach their business plan with a build for scale approach, requiring massive amounts of spend early on to match their scale ambitions.  Related, this early scale build approach is expensed instead of capitalized, and therefore GAAP profitability will not occur in the early years due to this mismatch of expensing vs. depreciation of “investments.”

In full disclosure, when I first read through Domo’s financials, I just laughed at how much money the company has spent (approximately $800m) to build a business with an annual revenue of around $100m.  However, as I sought to understand the other side of the argument, I can at least see some sort of reasoning.  The global scale from the initial roll-out period certainly requires much more capital and if you think your product has staying power with its customers, it makes complete sense to spend for its development regardless of whether that expense is capitalized or expensed.

My hold-ups continue to be the following three points.  A company like Wal-Mart can convince me early on that it is profitable.  If Wal-Mart didn’t add 14 stores and grow its sales by 77% in 1972, it could have been profitable both on a GAAP basis and a cash flow basis.  I can’t see that in a software company, like Domo.  You have to believe that global scale and stickiness (or even increased spend by customers) will someday outpace the current spend on R&D and sales and marketing.  Second, I can understand the argument that your R&D and sales and marketing spend will both have benefits lasting longer than one year, however, how far each of these spend categories will last is too hard for me to predict.  Reducing their benefit down from 40 years to 10 years makes more sense and if you do that, the GAAP financials become money losing again.

Finally, I still fall back on opinion, perhaps outdated, that good businesses are able to charge more for their product than the combined cost to produce the product and the cost to get you to buy the product.  It does not appear that Domo can do that.

I am sometimes confused whether I am a dinosaur in my viewpoints on profitability or the person in the audience asking, “Why isn’t the Emperor wearing any clothes?”  Thinking about these software companies and their “stories” for their valuation was a helpful exercise.  Workday and Atlassian are two of the best examples where I thought their products were sticky (more so with Workday) and customers were buying more services each year (both Workday and Atlassian), however, for the most part, these companies are still in my “too-hard” pile.

There are certainly companies that will operate with negative profitability for years before they reach scale or other companies whose customers will stick around longer than expected and spend more than initially anticipated (i.e. Amazon), however, for the most part, great companies can sell their products early on at a profit.  Microsoft, Google, Facebook, all of these companies were highly profitable early on in their history because they are great businesses.  Domo may or may not be a profitable business eventually, but it does not appear to be a great business and I prefer the simplicity of great businesses.


Matt Brice is the portfolio manager at The Sova Group and can be reached at matt@thesovagroup.com.

 

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