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Free Cash Profiles: The Software Makers

Among the biggest companies, Google lags way behind Microsoft and Oracle in terms of its ability to produce cash as it grows. But two smaller firms, Verisign and Advent Software, exceed the giants.
David M. Katz, CFO.com | US
October 7, 2011

In almost every respect, the computer software industry is a model for how even the nation's fastest-growing companies can yield huge amounts of free cash flow as they expand. True, their up-front and research and development costs can be high. But once the software is created, it costs virtually nothing to make copies of it.

Software makers thus have a high ratio of fixed to variable costs — meaning they're not subject to the volatility that other companies face in terms of materials costs, energy, and the like. They have a clear picture of how much they'll have to spend in order to generate growth. So as sales grow, costs remain relatively flat. (Of course, if sales seriously lag, such companies have less leeway to cut costs.)

The tendency for costs to trail far behind revenues produces high gross operating margins. And since software makers have little need to dole out cash to warehouse their tiny store of inventory, their finance chiefs tend to have a lot of freedom to allocate cash to enrich their shareholders with dividends and buybacks or invest in still more growth.

Perhaps even more significant, the industry, which features such household names as Google, Microsoft, and Oracle, as well as a hard-charging segment of middle-market players like Verisign and Advent Software, tends to work under contracts that bring in large amounts of revenue before it's fully earned. "People fall all over themselves to pay them in advance," says Charles Mulford, a Georgia Tech accounting professor.

Put all those factors together, and you get a growth industry tantamount to a cash machine. CFO's Free Cash Profile (FCP) snapshot of software makers, developed by Mulford using company data for the 12-month period ended nearest to June 30 provided by Cash Flow Analytics LLC, tends to substantiate that picture.

Overall, the 238 software firms studied show a median FCP of 23.05%, meaning it can generate that percentage of free cash flow per dollar of sales as it grows. (To learn how FCPs are calculated, see "How the Free Cash Profile Works," below.)

Relatively speaking, the industry far exceeds the median free cash profile of 4.95% for the 44 public nonfinancial companies Mulford has studied.

Out of all the software companies studied, Mulford zeroed in on the 31 firms that reported revenues of between $300 million and $800 million for the period covered. Also included in the study, for purposes of comparison, were the three largest software makers: Microsoft, Oracle, and Google. (Each month, CFO looks at the FCPs of a different industry or sector group.)

While the targeted firms' median FCP of 34.44% comfortably exceeded the software industry median of 23.05%, it lagged behind the 49.72% that Oracle, the median company among the three industry giants, recorded. "The larger firms have more pricing power, and they have products that people want," explains Mulford.

At 59.22% and 49.72%, respectively, Microsoft and Oracle had especially high FCPs.  Surprisingly, however, Google recorded an FCP that, at 17.33%, was below the median for the entire industry. Mulford suspects the reason for Google's low score is that its business model includes more advertising revenue and less sales from software itself than the models of its peers do. Companies tend to pick up less up-front money from advertising sales than they do from software deals, thereby leading to scantier amounts of free cash flow, he thinks.

Outpacing even Google and Microsoft were two software companies in the targeted group: Verisign, which generated $1.50 in free cash for every $1 increase in revenue, and Advent Software, which produced 70 cents.

Speaking about Verisign in particular, Mulford attributes its stellar FCP to the fact that a whopping 98.81% of its revenue is deferred. That compares with a median of 21.88% for the target firms. "The company is clearly paid well in advance for the services it renders," says Mulford.

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