The Tyranny of Software Margins

Software is an amazing product because the cost of “manufacturing” and distribution is essentially zero. With this business model, software companies can be run with incredibly high margins, and can be excellent generators of cash. The investment community certainly recognizes these characteristics for software companies and rewards them with higher multiples in the public equity markets. However, it is also true that many of these same companies have difficulty with building new innovative products.

Why?

The answer is that high margins have a down-side.

For most software companies, one of the highest costs on the P&L is R&D. With efficient markets, the P&L of software companies is optimized at some base-line level of R&D spend. Thus, for any public software company to invest heavily in innovation, they must increase R&D spending, and thus directly impact the P&L in a material manner. Note, manufacturing companies do not have this issue because the costs of R&D are typically a fraction of the costs of manufacturing.

What is the impact of these characteristics?

1. Public Software Companies tend to accumulate cash on balance sheet instead of investing in R&D for fear of the EPS impact.
   
2. They tend to use the balance sheet to buy technology (with appropriately higher costs).
   
3. They tend to have a difficult time rationalizing all the acquisitions because they were not built organically.