Gross Margins and Growth
Understandably, there is a lot of hand wringing around (relatively) depressed public market valuations of mega companies like Uber, Lyft, Peloton, etc. and the outright rejection of companies like We. But enterprise SaaS companies have performed dramatically better. Fred Wilson wrote more here on the topic and he makes a key point about the difference in gross margins between the two groups.
But why are gross margins so important? And why do high-margin, high-growth companies get ultra high valuations irrespective of high opex and deep negative operating profits?
“High gross margin and high growth” holds a lot of potential because once the fixed cost is covered, every additional customer translates directly to operating profits at the GM percentage.
But to know if something is a high margin, high growth business that is a real star, ask the following questions:
At what revenue threshold will the fixed costs be fully covered and how long will it take to reach that point?
How is CAC calculated? How is it allocated to COGS? Creative accounting that counts some CAC as S&M or G&A is more commonplace than you might expect. Dig deep into the financial statements and question assumptions aggressively.
How much of the growth is a) organic vs paid, b) net new vs existing, and c) compensating for churn? if companies obfuscate these numbers (and they damn well do), it is hard to know which is what.
If the gross margin is calculated correctly, includes the right CAC, and is still high (>70%) and growth is high without disproportionate over-reliance on paid channels, and the product is showing signs of stickiness with no unreasonable retention issues, the company can likely see its way to operating profitability when it is ready (i.e. accept the profit to growth trade offs)
If growth is high but gross margin is not great (say 40-60%), ask what will bring down the CAC to acceptable levels? This needs a deeper understanding of promotions and incentives and the possibilities for expanding growth through organic means. Or maybe it is not viable to boost gross margin beyond a point because there is a hardware component (or) third party costs.
This is exactly why the street is valuing pure software/SaaS companies substantially more than: a) marketplaces with high CAC for both supply and demand (Like Uber or Lyft), b) companies that bundle hardware with software that increases COGS, or c) pseudo-tech companies (Like We) with fundamentally unsustainable gross margins because of huge lease obligations.
Understanding the mechanics of gross margins and growth is at the heart of valuing tech companies accurately and finding alpha.