Stock Comp in Software — Hidden Margin Deterioration?
Voss Capital is a Houston hedge fund founded by Travis Cocke in 2011, running value-oriented, bottom-up strategies focused on underfollowed small- and mid-cap special situations through long/short and long-only funds, increasingly turning activist.
In plain words
This report argues that many software companies are hiding real profit deterioration by using stock-based compensation (paying employees with shares) and capitalizing R&D (treating research costs as investments). For regular investors, this means some beaten-down software stocks might still be overvalued. It's worth reading because it shows how to use a more honest profit measure—like subtracting stock compensation—to avoid hidden risks.
Voss Capital research notes that software stocks' EV/Sales multiple has compressed from 4.7x in March to the current 3.2x, while expected revenue growth remains at historical highs, but adjusted EBITDA margins have stagnated, and the traditional Rule of 40 stays at 34%. The report reveals two hidden
Theme and Background
This chapter focuses on the persistent compression of software stock valuations (EV/Sales multiple declining from 4.7x in March to 3.2x currently), and the possibility that management may be using accounting methods to mask the deterioration in real profitability. The report questions the validity of the traditional Rule of 40 metric and reveals two major factors eroding hidden profits: R&D capitalization and stock-based compensation (SBC).
Core Thesis
The author's core judgment is that adjusted EBITDA margins for software companies are systematically overstated, with the median real operating margin (adjusted EBITDA minus capex and stock-based compensation) standing at just 1%, and the gap to adjusted EBITDA reaching a record high of 12%. This implies that, even when accounting for growth, the fundamental deterioration of the industry is being significantly masked. The counterintuitive point is that while the market generally believes software valuations have corrected substantially, the author argues that the decline in profit quality has not yet been fully priced in.
Key Arguments and Data
1. Stalled Traditional Metrics: Expected revenue growth remains at historical highs, but adjusted EBITDA margins have stagnated, with the traditional Rule of 40 stuck at 34%.
2. Hidden Erosion Factors:
- R&D Capitalization: Current Capex/Sales is slightly above the 2%-2.5% level of the 2000s, but has retreated from its 2015-2016 peak of 5%.
- Stock-Based Compensation: Median SBC as a percentage of sales for software companies has risen from 4% in 2016 to 9%, representing a hidden margin compression of 500 basis points.
3. Deterioration in Real Margins:
- The gap between adjusted EBITDA and real operating margin (adjusted EBITDA - Capex - SBC) has widened from a historical low of 4% to the current 12%.
- The median real operating margin for software companies is only 1%.
| Metric | Historical Low/Early Period | Current |
|---|---|---|
| Capex/Sales | 2%-2.5% (2000s) | Slightly above 2.5% |
| SBC as % of Sales | 4% (2016) | 9% |
|---|---|---|
| Gap between Adjusted EBITDA and Real Margin | 4% | 12% |
| Median Real Operating Margin | — | 1% |
|---|
4. Rule of 40 Comparison: The Rule of 40 calculated using real operating margins shows a steeper decline, indicating that fundamentals are still deteriorating even when growth is considered.
Companies/Assets Involved
- Major Offenders (High SBC, Low Real Margins):
- Bill.com: 14x NTM sales, traditional Rule of 40 ~44%, but SBC is 34% of sales, Capex is 3%, real Rule of 40 is only 7%.
- Zscaler: ~15x sales, 38% growth, 15% adjusted EBITDA margin, but SBC is 39% of sales, Capex is 8%, real Rule of 40 is only 7%.
- Others: Confluent, Coupa, Okta, SentinelOne, Palantir, Snowflake.
- Better Performers (Real Margins Still Reasonable):
- Datadog: 18x NTM sales, 46% growth, 19% adjusted EBITDA margin, SBC is 17% of sales, real Rule of 40 above 44%.
- Others: Paycom, Veeva Systems, Qualys.
Investment Implications
- Beware of High SBC Companies: Investors should re-evaluate companies that rely heavily on stock-based compensation, especially those with SBC exceeding 20% of sales. Current valuation multiples may embed unsustainable profit assumptions.
- Focus on Real Operating Margins: It is recommended to use the "real" margin (adjusted EBITDA minus Capex and SBC) as a valuation benchmark, rather than traditional adjusted EBITDA.
- Potential Risks: In the event of an economic recession, management may be forced to cut SBC, leading to a short-term increase in margins (similar to the post-2008 period). However, before that, the valuations of high-SBC companies could face further compression.
- Specific Direction: Short or underweight companies like Bill.com and Zscaler, which have very low real Rule of 40; long or overweight companies like Datadog and Paycom, where real margins remain healthy.