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Software FCF Margin: Who Has Been Over-Earning?
An article by • Published May 25, 2021
Software / SaaS analysis largely comes down to competitive position, moat, revenue growth and free cash flow ("FCF") margin. One thing investors need to recognize is that the nature of software accounting including upfront payments and deferred revenue, among other items, can mask what the true FCF margin is.
Hyper-growth companies can 'over-earn' FCF margin in the short-term as upfront payments are made prior to deferred revenue recognition. Ultimately, however, FCF margin converges to GAAP margin profiles. Backtesting suggests longer-term FCF margin can be estimated with the following formula: Gross Margin % less Operating Cost % plus Stock Compensation $ less Capital Expenditures as % Revenue. Depreciation is missed as a non-cash expense but isn't material for many software companies. As will be shown the calculation tracks closely with a simple Cash From Operations less Capex approach to FCF and FCF Margin (divided by revenue).

** Note all the charts below are using prior quarters as the x-axis and FCF margin before any stock-based compensation adjustment.

$ADBE is a good example of the longer-term convergence; the company came out of its cloud transition at the beginning of this time period (2013/2014)
$ADSK shows what happens to FCF margin when going through an on-premise to cloud transition - divergence then convergence to cost-implied FCF margin estimates
$VEEV is another good example of FCF margin and cost-implied FCF margin converging
$NOW shows great FCF margins but is it really earning those or over-earning?

Likewise, $TEAM is showing reasonable longer-term convergence
$ZM has only 9 quarters to look at, but its clear the massive revenue growth and upfront payments allowed the company to over-earn on FCF; regardless, the margin-implied FCF profile is near the best in the group at ZM
Where are some of the biggest difference between FCF margin and margin-implied FCF? $CRWD would seem to clearly be over-earning FCF margin recently with a spread of 25% between the two
Perhaps transitory in nature, but the $COUP FCF spread discussed herein blew out to 44% this past quarter and has widened materially in recent quarters
The spread between FCF Margin and Gross Margin and Cost-Implied FCF Margin can vary drastically over the short-term but will converge over the long-term. Investors would be wise to track which companies have an attractive and sustainable FCF profile.

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