Software Primer, what Everyone Must Know

Welcome to the 104th Pari Passu Newsletter,

Today, I have a very not-contrarian topic for you: a primer on the software industry. While the software model is generally considered a high-quality business, recent times have shown us that things can go bad quickly when you put 10x leverage at S+800 on a great company.

Therefore, even restructuring professionals need to be knowledgeable in this sector. After all, software is undoubtedly one of the most important industries, impacting nearly every aspect of the global economy. From the software that powers our phones and laptops to the software that helps NASA launch and operate its rockets, software is ubiquitous. Much of the rapid innovation and technological advancement of human civilization in the past few decades can be attributed to the growth of the software industry.

Let’s get to it.

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Overview

The software industry comprises firms that employ software developers to write code in order to develop software with a variety of business applications. The firms then distribute their software through a variety of different channels. Software firms have no raw materials, packaging costs, or inventory as their product is entirely digital [4].

Structure

There are two main types of software that firms develop: application software and infrastructure software. Application software performs a specific task that is unrelated to supporting other software. Infrastructure software provides an environment for other software applications to run and interact cohesively. Examples of application software include productivity apps such as Microsoft PowerPoint and Excel, customer relationship management software (CRM) such as Salesforce Automation, and enterprise resource planning platforms such as SAP ERP. Examples of infrastructure software include security systems such as firewalls, network software such as Cisco's Internetworking Operating System, and operating systems such as Microsoft Windows [5].

Market Share

Relative to other industries, the software industry is quite diversified. Leading the pack is Microsoft with 26% of revenue market share, significantly higher than second place Oracle with 6% and third place SAP with 4%, followed by Salesforce and Adobe. In fact, there are 72 public software companies with market caps greater than $5bn, a testament to the diversity of the industry [5] [11].

Software is characterized by low barriers to entry, so the formation of new businesses is high. This is in large part due to the versatility and reproducibility of software, meaning there are effectively infinite software packages for infinite applications that theoretically anyone with a computer can produce. These factors make it difficult for a few firms to capture a majority of the market [5].

Firm Strategy

Product Delivery

Software firms have delivered their products through a variety of different channels. Here is a list of the most common methods [2] [5]:

• Perpetual license: clients are sold a perpetual license to the software, incurring a one-time fee; updates are infrequent

• Term license: clients are sold a license for a specific period of time; there are no updates

• Subscription: clients “subscribe” to the software, much like a streaming service subscription; updates occur regularly

• SaaS: similar to subscription delivery but the software is delivered via the cloud as opposed to residing on customer premises; updates occur frequently

• Open source: software freely accessible by anyone on the Internet

Companies will typically offer multiple delivery options for their software, such as selling both perpetual licenses and SaaS delivery. This provides their clients with the flexibility to choose the method of delivery that best suits their needs. The distinction between purchasing a recurring subscription versus a perpetual license is much like that of deciding between renting or buying [5].

Why does everyone love Software as a Service (SaaS)

The SaaS model was first introduced in 1999, when Salesforce launched its customer relationship management (CRM) platform. This was the first SaaS solution ever developed, and seeing that Salesforce is now the fourth-largest software company by market cap, it was a revolutionary advancement. Ever since, SaaS has become the dominant delivery model in the industry, for the huge upside that it provides to both the vendors and customers of software [9].

From a vendor perspective, the SaaS model provides a high degree of revenue visibility due to the recurring nature of subscription-based revenues. Additionally, vendors only have to maintain a single code base, of the software’s latest version. Any new updates can be rapidly introduced in just days or weeks as the software is entirely cloud-based. These factors help companies maintain lower upfront costs, allowing for rapid market expansion [5].

From a customer perspective, an SaaS model also helps reduce upfront costs by replacing a large, one-time cost with smaller, recurring subscription fees. The software can very easily be set up and running since everything is via the cloud, and customers always have the latest version due to rapid updates [5].

However, the SaaS model is not flawless. For vendors, delivering their software products via the cloud means that they have to support higher initial costs for software hosting. This is not a concern with most other delivery methods, in which the software is hosted on customer premises. Additionally, subscription-based revenues means slower revenue recognition. For customers, dependence on the cloud poses greater data vulnerability and security risks [5].

Capital Allocation

Company maturity dictates capital allocation. In early-stage software firms that are still pre-revenue, product development is the main priority. These types of firms invest heavily in R&D in order to rapidly develop a market-ready product. Newer companies that have a marketable product will shift their capital towards sales and marketing (S&M) spending, in order to create a sustainable and growing client base. S&M spending is a major contributor to the high CACs (customer acquisition costs) that software companies typically incur [5].

As a software company matures through securing a reliable client base and beginning to generate steady cash flows, it may begin allocating capital towards share buybacks and M&A. Share buybacks are a strategy employed by firms, not just in software, as a way to elevate investors’ returns and boost performance metrics such as earnings per share. M&A, specifically in the form of acquisitions, is also common for larger software companies. These are typically strategic purchases, used to expand product scope and capability. However, software deal value and volume have fallen off in recent years due to less clear macroeconomic conditions [5] [6].

Software companies cultivate growth via different strategies. Newer firms depend on organic growth, such as through product development and benefiting from open source contributions, while established firms depend on M&A and various market strategies in order to pull for growth [5].

In 2023, according to PitchBook data, the median R&D allocation for software companies was 24%. The median allocation on share repurchases was 9% and on M&A was 1%. However, large firms such as Oracle, Shopify, and Snowflake had much larger M&A spend, with the firms allocating 55%, 31%, and 18% of revenue respectively to acquisitions. The median dividend allocation was 0% as very few software companies offer dividends [5]. This would theoretically imply that software companies see attractive internal capital allocation opportunities (or are too afraid to admit they have no use for incremental capital).

Financials

Tailwinds and Performance

Software’s growth can be attributed to a few key factors [10]:

• Increased Internet access: in 2007, just 7% of the world had Internet access; today, over half the world has Internet access. Similarly, half of Americans had internet access in 2000, but today, over 90% have access. This development created a rapidly growing market for software to cater to.

• Development of the personal technology industry: unlocking one of software’s largest markets, the consumer, was dependent on the development of the personal tech industry. The advancement of cellphones, laptops, and other personal devices by companies such as Apple, Blackberry, Dell helped proliferate tech, and naturally software, into the homes of millions of consumers.

• Improved business operational efficiency: early software also catered towards business applications, and early adopters of software often saw significant improvements in operational efficiency and thus overall performance. As the world became increasingly “online”, software integration quickly became a necessity for any competitive business.

Over the past year, the industry is up an average of 23.7% with an average annual earnings growth rate of 19% over the past three years. The average P/E ratio of software companies is currently 49.3x, significantly lower than the three-year average of 61.0x. Experts forecast the industry will grow by an average revenue growth rate of 10+% through 2027 [1] [4] [5].

Software has historically remained quite shielded from global economic downturns, and actually often expands during recessionary periods. During the 2008 financial crisis, software growth fell, from a high of 9% to a low of 3%. However, U.S. GDP growth saw red, steadily declining from a growth rate of 7% in 2006 to a low of -2% in early 2009. During the 2020 pandemic, U.S. GDP growth once again went negative to around -1%, but the software industry actually experienced significant growth due to the mass transition and dependence on the digital world, plateauing at 7% in 2019 before climbing to 13% by 2022 [5].

Financial Statements and Metrics

Financial statements of software companies contain their own nuances and distinctions that make them unique from those of companies in other industries. While these trends are not present in all software companies, they are important to keep in mind when analyzing these types of companies [5].

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