Looking at Xero Limited's (ASX: XRO) earnings report from last week there's one metric that stands out among plenty of impressive ones.
Let's consider how the software-as-a-service (SaaS) online accounting business reported its 'gross profit margin' lifted 2.4% to 85.2% for the year ending September 30 2019.
Xero and other cloud-based SaaS businesses calculate their gross profit margin as total operating revenue minus the direct cost of that revenue.
According to Xero: "Cost of revenue consists of expenses directly associated with securely hosting Xero's services, sourcing relevant data from financial institutions, and providing support to subscribers.
The costs include hosting and content distribution costs, bank feed costs, personnel and related expenses (including salaries, benefits, bonuses, and share-based payments) directly associated with cloud infrastructure and subscriber support, contracted third-party vendor costs, related depreciation and amortisation, and allocated overheads."
In other words the majority of other costs cloud-based SaaS businesses are wearing are directly related to sales, marketing, investment, or new product development.
Spoiler. These are all costs likely to generate more top-line growth.
For the six months ending September 30 2019 Xero spent NZ$146.07 million on 'sales and marketing', with NZ$108.8 million on product development costs.
Of the product and development costs NZ$49.3 million was capitalised (i.e. spread out over time) as the cost is expected to bring benefits into the future.
Software companies commonly either expense or capitalise development costs under accounting standards, with expensing them the more conservative approach.
The point I'm getting to is that a SaaS business boasting a gross profit margin above say 70+% has potential to deliver high compound profit growth long into the future if it keeps growing its top line.
It's the attractive economics and scalability of SaaS businesses that has powered some outrageous share price growth as investors look past today's lack of profits towards tomorrow's big potential.
Let's take a look at six more SaaS businesses, their high gross profit margins, and ridiculous share price growth.
Salesforce.com (CRM) is arguably the best SaaS business of all time. The shares are up from US$8 in 2009 to US$161 today. Gross profit margin is around 75%.
WiseTech Global Ltd (ASX: WTC) boasts an 81% gross profit margin. The stock is up from a $3.35 2016 IPO price to $27 today.
Alteryx Inc. (AYX) boasted a scary 92% NON-GAAP gross profit margin for the September 2019 quarter. The stock is up 6x since March 2017 from US$15.50 to US$93 today. It hit as high as US$147 in August 2o19.
Workday Inc (WDAY) is the online-based recruitment platform with a 70.2% gross profit margin. Shares are up 3.5x since 2012.
Nearmap Ltd (ASX: NEA) is delivering a 69% gross profit margin, although this is a scalable business and as it adds subscribers over time the gross profit margin should grow. Shares have climbed 5x in value since 2017.
Intuit (INTU) is relevant as it's Xero's big online accounting rival. The bad news for Xero investors is that Intuit's Quickbooks cloud product is reportedly strong and growing subs quickly.
The good news is that Intuit shares are up 10x since 2009 from US$25 to US$256 today on a US$66 billion market value. The gross profit margin is 83%. Below that of Xero. We can see Xero has room to run miles yet on these comparisons.
Foolish takeaway
I'd rather own a marginally profitable SaaS-based business like Xero operating on sky-high gross profit margins over a business that might look 'cheap' on conventional value investing metrics but is struggling to grow.
Of course not all SaaS businesses will be winners though so you must identify those capable of growing subscribers on a financially sustainable basis.
