With inflation and interest rates on the rise, investors are paying more attention than ever to intrinsic value, rather than the revenue growth and momentum we’ve seen over the past few years. .
Diehard value investors generally refer to free cash flow as the “holy grail” metric for valuing a stock. This is because a company’s cash capital expenditures and working capital investments often exceed non-cash depreciation, either due to growth or simply inflation. When this happens, the amount of cash left for shareholders after these investments may be less than the overall profit would suggest.
Yet while free cash flow might be the conservative metric to use, say, in a manufacturing company, in the software world, free cash flow can be really, really misleading.
In fact, free cash flow often seems better than overall revenue in software, and in a misleading way. Unsurprisingly, many tech CEOs often point to their free cash flow generation, when in fact the actual earnings going to shareholders are far lower…even negative.
Here’s an example of what I’m talking about, and it’s something every investor in the software space should recognize.
25% free cash margin? Not really.
Let’s take the cybersecurity business Palo Alto Networks (PANW -4.05%) for example.
First, Palo Alto is a big cybersecurity company. Management has done a great job of transitioning from its old on-premises firewall business to cloud-based threat detection solutions and more modern software. The company has managed to continue strong revenue growth, even while matching new disruptors in this fast-paced space.
While I applaud Palo Alto for product execution, investors should probably ignore the high (non-GAAP) adjusted free cash flow margin that management touts in company presentations.
Last quarter, Palo Alto’s adjusted free cash flow was $351 million on revenue of $1.39 billion, good for a free cash flow margin of 25.3%. Awesome, right? Well, investors have to reconcile that with the company’s GAAP net loss of $73.2 million. That’s a $425 million difference, and that makes a big difference when trying to value the company. So what metric to use?
Unfortunately for investors, they would likely have to store net GAAP losses on this one, for two big reasons.
Value killer #1: Stock-based compensation
Palo Alto uses the relatively simple equation “operating cash flow minus capital expenditures” to calculate free cash flow. Software companies don’t have to spend a lot of money on buildings or manufacturing plants, so their capital expenditures are usually very low.
However, operating cash flow drives two major distortions in software, the first being stock-based compensation.
Virtually all companies compensate their employees with stock to some degree. However, in the software world, stock-based compensation tends to be very high, especially in high-growth companies that prefer to conserve cash. In Palo Alto’s case, the company paid out $247.3 million in stock to employees in the last quarter alone, and about $1 billion in the past 12 months.
While stock-based compensation doesn’t cost the company cash, it dilutes existing shareholders — in other words, you. Palo Alto is a $50 billion market capitalization company, so the trailing 12-month stock mix equates to 2% dilution on an annual basis.
Warren Buffett has had a word or two in the past for management teams that tout “adjusted” earnings and free cash flow, while omitting stock-based compensation. In his 2015 letter to Berkshire Hathaway (BRK.A -2.76%) (BRK.B -3.02%) shareholders, he writes:
[I]It has become common for managers to tell their owners to ignore some all-too-real expense items. “Stock-based compensation” is the most glaring example. The very name says it all: “compensation”. If remuneration is not an expense, what is? And if actual, recurring expenses have no place in the calculation of income, where in the world do they belong?
Value killer n°2: deferred income
The second way that free cash flow distorts the real income of ISV owners is through deferred income.
Software companies that operate on a subscription basis often collect the value of a contract in cash upfront, whether it’s one year, two years, or whatever the term. However, when it does, the company’s deferred revenue and cash flow increase, and the change in deferred revenue shows up in operating cash flow. Deferred revenue is revenue that has been received, but will not be recognized immediately, but rather pro rata over the term of the contract.
Last quarter, Palo Alto saw a sharp increase of $410.2 million in deferred revenue. To be fair, Palo Alto also deducted an item called “deferred contract costs,” which are likely upfront investments made at the start of a contract, but that cost was only $105.9 million. Subtracting that, the “net” increase in deferred revenue was still over $300 million.
Undoubtedly, there are positives to this. The increase in deferred revenue shows that Palo Alto is recruiting new customers or selling current customers; however, should it really be counted in free cash flow?
Deferred revenue means the business is paid before it has actually provided the services. Essentially, it’s like taking out a cash loan that you have to repay later along with infrastructure, sales, and support – although some cash should remain as profit. Still, you wouldn’t expect a company to take out a loan that has to be repaid in the future and then call it “cash flow”, would you?
Worse still, companies sometimes offer deep discounts in exchange for upfront payments. Therefore, without knowing the length of the term or the discount, it is difficult to know how profitable all this deferred “income” could be.
There is no doubt that deferred income is an advantage for growing businesses. This shows that the company is recruiting new customers and that the available cash can be used for expansion or acquisitions without going into debt. But what about getting that money to go to the shareholders of the company? This is simply not the case.
Be careful in the software world
We’ve just gone through a period where investors primarily value software stocks based on revenue and/or other “adjusted” measures of profitability. But with interest rates rising, these shortcuts could come under scrutiny, as investors are now in a “show me” state, in which they want to see profitability… real profitability.
So if you hear a software CEO talk about free cash flow as if it’s all the cash left for shareholders, remember to look up stock-based compensation and deferred revenue from company in the statement of cash flows. Palo Alto is just one example, but most high-growth software companies typically report some sort of non-GAAP adjusted profit measure these days.
In the meantime, don’t forget to look at the boring old GAAP net income (or loss), which should provide a much more accurate picture of true profitability. You may realize that the high-growth software company in your portfolio is not as attractive as you first thought.