Not all growth is equal

The merits of investing in companies with intangible driven competitive advantage are well known today. Despite this being observable for many years, the anchor of traditional finance weighs heavy on many valuation models. The concept of growth not being constrained by how much retained earnings could be re-invested into physical assets requires some adjustments, but there is no free lunch here.

Investing through the P&L, through say research and development or long-term investment in brand is not new. In the past five years this has become the dominant model most growth companies pursue. In 2024 we would make a couple of observations:

• Just because investment is in intangibles, doesn’t mean it can be turned off to unlock high margins. Investors are well versed in the model of traditional companies who have to invest and maintain their physical capital stock. Return on capital is anchored by these required investments, and companies choosing to under-invest often report near term benefits but suffer longer term detriment to their business. Companies building their advantages through the P&L, whether by attracting and retaining customers through sales and marketing spend, or through winning new business and keeping current customers through product improvements funded from R&D, the investment must continue. With so many competitors pursuing the same customer using the same business model, attempts to “release margin” by reducing P&L investments can quickly result in a loss of competitive advantage and customers (revenue) to peers.
• Despite strong revenue growth, a capital heavy model with low returns on incremental capital employed will not grow shareholder wealth. There are short term financial engineering tricks that can be used to mask unfavourable economics, however it is hard to grow wealth in the long term (at say 15% per annum) when the underlying asset generates a 5% ROE.

Three years ago, companies were given the benefit of the doubt that competitive advantages being built were real and sustainable, not just hopeful. Now investors are more discerning.

Technology One (TNE) was founded in 1987. FINEOS (FCL) was founded in 1993. Both companies sell enterprise software and have been doing so for over three decades. Despite this, the ability of these two companies to produce sustainable economics on an intangible basis differs markedly. As technology businesses, one of the most important investments is R&D, to develop software and sustain competitive advantage. We look at some simple variables across the P&L to highlight the differences between these two companies.

Gross Margins: for every dollar of revenue, TNE incurs about 13% variable cost, leaving 87% gross margins to fund the business and generate profit. FCL incurs 30-35% variable cost, leaving 65-70% gross margin.

Total R&D: To properly capture the cost of R&D, we look at both the expensed R&D and the amortisation of prior period capitalised R&D. We give management the benefit of the doubt in this simplified example on the amortisation policy being appropriate. TNE spends 30-35% of revenue on total R&D. FCL spends 60-65%.

What is left? After paying variable costs and funding R&D to sustain the business, TNE has 50-55% of each dollar of revenue for the rest of the operating costs and to generate a profit margin for shareholders. FCL has 0-5% on the same basis, which has meant in recent years there has been nothing left for shareholders. Indeed shareholders have been required to fund the losses via new equity capital being raised pretty much every year since FCL went public in 2019. The TNE share count is largely unchanged over 25 years. FCL shares on issue have more than doubled in just five years.

The market always tries to discount the future and for FCL (and their nearest comparable Guidewire in the US) there is a view that many (many!) years of poor unit economics will dramatically improve. There is some merit to this view – they are solving real and complex business logic issues for highly regulated insurance companies and have limited competition.  To achieve this either the intensity of R&D needs to drop significantly with scale, or they must double the selling price. Neither of these are particularly easy to do.

Between the time of the FCL IPO (Aug 2019) and the end of 2021, both TNE and FCL delivered +30% p.a shareholder returns as the market ignored the differences in unit economics. However, from 31 Dec 2021 to 30 Apr 2024, TNE has delivered +12% p.a and FCL -33% p.a total returns respectively. Eventually it matters.

CSR Ltd (CSR) and NextDC (NXT) couldn’t appear to be more different business. CSR was founded in 1855 as the Colonial Sugar Refining company, although today it’s core business is in building products. NXT was founded in 2010 and is a data centre developer and operator. Despite very different industry exposures, which is most starkly highlighted by revenue growth rates, the business models of these two companies have one thing in common. In order to grow, both companies need to put capital into the business. Real hard dollars that go into building plasterboard plants or data centres.

Over 169 years, CSR has learned the hard way that growing at low returns on capital is not a great way to compound shareholder wealth, and a clear plan in the last 15 years divest and focus on better business divisions with higher sustainable capital returns was a better path. Despite low and cyclical revenue trends, sustainable returns of above 20% in their core operations have created shareholder returns similar to the return on capital (~20% p.a) even before the recent bid for the company by Saint Gobain.

NXT is much earlier in its journey, and in stark contrast to CSR, the revenue growth and customer demand appears seemingly endless. Underlying trends suggest  demand is very real – whether it is the adoption of cloud computing or the demands from artificial intelligence (AI). NXT has certainly invested to capture the growth – total assets have increased from about A$111m in F2011 to almost A$4bn in F2023 and probably over A$5bn within a couple of years. This growth has been funded entirely externally by a mixture of debt and new equity totaling about A$4.5bn (including the recent capital raising completed in April 2024) – with the retained earnings balance being negative since 2010.

In most years since inception, the reported profits for NXT have been negative – which is problematic in trying to calculate a return on equity that accounts for all the real costs incurred. In the absence of this number, the market uses asset level returns from early data centres and EBITDA metrics (wildly inappropriate for a capital-intensive business with obsolescence risk) to try and estimate what the returns may look like in the future. According to consensus, NXT will still be loss making after interest expenses (at the pre-tax profit line) for every forecast year out to F2027 so this doesn’t help. For what it’s worth, we think these may be mid to high single digit return on equity assets in the long run making it hard to warrant 3-4x price to book multiples. None of this has stopped NXT generating total shareholder returns of 20-25% p.a since IPO.

We admit there are lots of investments in the market where we just “don’t get it”. We can understand the narrative, and the short-hand models the market uses to link a variable to the share price (such as adding A$3 of market cap for every A$1 of equity raised), but when we work through the economics of the business it remains a puzzle how sustainable returns are likely to be generated. We have also seen over many years these heuristics collapse back to traditional valuation anchors in a very unpredictable manner.

Given our goal is to invest in businesses we understand and have the highest probability of generating strong long-term returns based on the price we pay, we don’t take risk where others may have a better understanding of why it is “different this time” for these companies.