Software as a service (SaaS) has been a growing segment that has generally delivered huge returns for investors. Many high-flying SaaS stocks, however, have hit a brick wall recently giving back large portions of their gains.

Anirban Mahanti still believes in his SaaS holdings and he joined the May 19 “7investing Now” to explain what’s happening. It’s a lesson in long-term investing, patience, and knowing why you own shares of a company in the first place.

A full transcript follows the vide0.

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Dan Kline: Welcome back to 7investing Now. I am joined today once again by our very own Anirban Mahanti, Anirban, how are you? How are things? What day? Is it? What time is it? I don’t even know what time it is here. I can’t tell you what time it is there.

Anirban Mahanti: Well, probably Thursday for you. And Friday morning for me. It’s just a little past 6 a.m, but I’ve been up since 4 a.m. If people have seen my Tweets today.

Dan Kline: Yes, we have noticed that and I saw you pretty active on our Slack board just to give people a peek behind the curtains. So we have a really active Slack and poor Matt Cochrane who, who has a regular job in addition to this, and, and poor Anirban, who’s on a different time zone. I was gone for an hour, I went to the gym for an hour and I came back and just one thread had 61 messages in it like before we taped this, I was just taping something.

So before we taped this, I literally throw up a note and just said, hey, if I didn’t respond to something you expected me to respond to, you’re gonna have to draw my attention to it. So all of this like great communication, we almost need a tool to prioritize some of these great tools we have like, it can be overwhelming.

And I only mentioned that because we’re going to talk about software-as-a-service. And that is absolutely something that could happen. It wouldn’t shock me if somebody created something I could subscribe to, that organized my Slack and looked for, you know, things where I’m expected to respond. But they didn’t message me like so. Let’s talk about software-as-a-service. You frame this. You said my software-as-a-service. That is some people go by SaaS businesses currently losing money. Yes, they all right now, they’re all getting hit in share price there. When you say losing money, do you mean share prices dropping? Or do you mean that the companies aren’t making money?

Anirban Mahanti: Well, right now they’re losing money both ways. Like a lot of the software-as-a-service, SaaS businesses are actually losing when I say losing money, I mean, on an operating basis, like look at their operating earnings is negative. Right? So they’re not, they’re not positive operating earnings, they might have high growth, but they have negative operating earnings, which basically means they’re losing money right now. And the stock stocks are down. So it’s losing money both ways. So I meant the former but yeah, it’s true that they’re losing money both ways right now.

Dan Kline: Now, is that largely because you’re taking whatever you would make an investment? This isn’t a pizza place, the goal isn’t to get to a million dollars and make $300 grand, it’s to get some to some sort of grand scale, right.

Anirban Mahanti: Absolutely, so one of the things with software, right, and it’s different for different types of software, right. So if you think about software that serving consumers that’s different from serving enterprises. If you serve enterprises, typically it means you’re getting into the workflow of the enterprise, I tend to take Slack (NYSE: WORK), Slack is an enterprise software, we have so much data on Slack. Like it’s really hard right now. And instead of investing as a young business right, but for 7investing to actually change from Slack to something else, as their primary comms tool is really hard.

And that’s the beauty of, of enterprise software is that it’s very sticky, likely that over time, we’re going to use more of it. And that’s what the enterprise software guys are gunning for. They’re basically saying, Well look, our opportunity is is huge, humongous long runways, we can invest, as you said, for growth, we can get more of that, you know, greenfield opportunity, and then we’re gonna make money in the future, right? So it’s all about growth and scalability. And they all have high margins, right, they support, gross margins, typically around 75%-80%, maybe in some cases, 85%. So there is an opportunity to make money,

Dan Kline: But they also have a significant marketing cost, which you know, the goal is to attract customers. And in theory, you keep them like, yes, we’re not going to switch from Slack, They’ll be very difficult to do. But Slack can attract us because they have a free product, we can upgrade to a low-cost product. But for Slack to get a giant organization that already say has Microsoft, you know, in some of its other areas, that’s a big get, that’s an expensive thing. And that’s dragging on profits for all of these as well right?

Anirban Mahanti: Absolutely, so look, you’re right. So if, if it’s to go to market strategy that you’re talking about, and really, for some companies, they so I mean, the way to think about Slack, we will be using Slack as an example, right. But Slack is now owned by Salesforce (NYSE:CRM) [techically, the sales has not closed]. But Slack is basically thought of as an email replacement, it’s basically going for that. It’s killing email or is right trying to kill/supplant email with something else.

Now, of course, there are organizations which are going to not use Slack, but they think about the number of organizations that have email that want to reduce their email usage, and then essentially, change Slack to be the new email, lots of opportunities. So this can be competition. But yes, you need marketing to, to get there.

You know, one of the things that, you know, I was going to talk about here is this idea. So I once spoke with, actually, I’d interviewed once a CEO of a small software company, listed here in Australia, and he used a nice analogy. His analogy was that you can think of the sales and marketing as consisting of two parts. One is you’ve got hunters, and then you’ve got gatherers, right. And hunters, the idea is a hunter space to go and find new customers, right. And the idea behind gathers, these are people who actually sell existing to the existing client, basically keep them happy, and upgrade them to new things.

This is the big deal. With most of the enterprise software-as-a-service businesses, right, they’ve got multiple modules that they can sell. And once you’re in, the idea is to sell you more, I will get you to buy more seats get you to buy new modules, but it gets you to buy something else. You think about Slack as an example, Slack is now owned by Salesforce, well, if you already had Salesforce marketing software, maybe we can sell you Slack as well. If you own already Slack, maybe we can sell your Salesforce marketing or something else. Right. So Salesforce has got a wide range of products that can sell.

So another way to think about profitability, which I think people generally don’t do, is, is to think about dollar-based retention, which is basically saying, Well, how much money did I make off the customers that I had last year, this year. So we basically those customers that they did not lose? What is the extra money I can generate from them. So that is the money that you’re actually generating from your gatherers, right? These are people who are expanding your sales. And if your expansion is 20%, typically 15% to 20%, that’s basically let’s call it, half of your salesforce is basically generating that the remainder is generating the sales.

So you could, in theory, reduce your sales and marketing expense, by say, 30%, and you’d compromise on your growth rate, but you could all of a sudden become profitable. Right. And I think that’s the I think, as long as the retention rates are high, and the dollar-based expansion rates are high, I think they actually have the license to lose money, which is, you know, I think it’s counterintuitive, but at scale, these things will make money.

Dan Kline: There’s also a customer number, where they take their foot off the pedal, right like so if your Amazon, which is obviously not a software-as-a-service business and their core business, but a lot of their early money was spent on just getting your credit card, getting you into the system, once they hit, I don’t know what the number is, but let’s say it’s, you know, 150 million people in the US, you know, as regular members and maybe two-thirds of those as Prime members. They’re going to see diminishing returns on their marketing dollars.

I think we’re seeing Netflix (NASDAQ: NFLX) in the US getting to the point that customer retention is more important than customer acquisition, obviously, with software-as-a-service companies like Slack, they must know what the penetration point is, right? And when it becomes defense, when they can start saying, okay, we want to keep these people, and that just becomes a business. And they’re the stock story is what else can they sell you? What else can they add? Where can they expand?

Anirban Mahanti: Absolutely. So, great example with Netflix, and this is not really, I mean, technically Netflix is a subscription service, right? It’s not a software service, it’s a subscription service, like many of the software businesses. And if you look at how Netflix reports, its numbers exactly to your point, when it reports US numbers, it says, well, we’re making a profit in the US, they have a contribution profits, if you think about, you know, the cost to sell to the U.S., the products that they’re actually streaming in the US, or the video shows that they’re showing in the US, for that they’re actually making significant profits. They’re not making a profit on the international component of the business, but that’s where the growth is. Right?

So exactly, you know, you figured out very quickly where you’re, you know, the tipping point is, and in many of these software businesses are very early in that game. So, therefore, they you know, even a company like Salesforce is a very big company. You know, it’s, it’s about $22 billion, or $22 billion, it’s projected to $25 billion this year in sales, it’s still growing at 25%, 20% to 25%, right? So think about that, at $25 billion, you’re growing at 20% to 25%, new roughly doubling every maybe four years, three to four years, right, your sales, you could easily stop spending money on acquiring new sales, and just basically say, Well, I’m gonna generate a 30%, 35% operating margin on that, on that $25 billion, right. That’s, that’s a lot of money that you could be generating. Right? Right there. So I think again, these companies know what the opportunity is exactly to your point. And they’ll switch whenever necessary.

Dan Kline: So let’s close on a theoretical question here. So high flying software-as-a-service company stock at crazy multiples, but really valuable, really easy to raise capital. Stock prices down 60%, 70%, 80%, whatever the numbers are, it’s not that much for everybody. At some point, as a CEO, do, you have to flip the switch and say, Hey, right now, it’s not going to be easy to raise money, we need to slow down growth, which is then going to make it harder to raise money. But we need to actually think about survivability, like you can be a really big company with a lot of customers. And if you run out of money, you still go out of business.

Anirban Mahanti: Yeah, so that that’s a fantastic, I love that question. So here, so we’ve been talking about operating profits, right? And operating profits depend on you know, how, for example, you’re recognizing revenue.

Now software, businesses typically would sell a contract say, or the you know, or sell a contract for three years out, they might actually receive the funds well ahead of time, but they might not have actually recognized it because they can’t recognize revenue. Well, in most companies would would say like a business like Salesforce would say, we have what’s called remaining performance obligation, it’s almost a direct visibility into what the future revenue is, because they have basically been contracted to receive those funds in the future. Either they received it or they’re going to receive it.

I think what’s what’s interesting for many of these software companies is to think about free cash flow, just cash from operations, how much money is coming into the door, and how much money is going out in say, CAPEX, right? If you look at that, for most software businesses can run at breakeven. And many of these companies that high-flying stocks were very smart, they raise capital when the stocks were high. So most of these businesses are cashed up, they have a billion dollars plus, in their balance sheet, they actually don’t need money right now, and they can continue growing, losing money, because you’re technically not losing money, because you know, they’re breakeven in a cash flow basis, or they’re even cashflow positive.

So there’s a lot of nuance going on here. Which, you know, what, if people are looking just at, you know, earnings per share, they’re just missing that out, because they’re missing the nuance that, well, this is actually generating a lot of money, they don’t need to raise capital. If there’s a business that needs to raise capital, though, that’s in a tight spot. And if their shares have been battered, they’re in a tight spot. And you usually see some strong correlations as a high short interest in those cases, because even the people shorting it know that their balance sheet is in a, in a tight spot. So yeah, I mean, there’s a point to that.

Dan Kline: Yeah, and there’s some nuance and it’s, you know, it’s something that we look at, like there are often non-cash expenses booked as cash expenses, like executive compensation through stock, it doesn’t actually cost you any money, but it’s booked as cash I, I always go back to my days at the toy store, where, technically when you sell a gift card, you have the money, but you’re not actually supposed to record the revenue until the gift card is redeemed.

The problem is a crazy percentage of gift cards don’t get redeemed. That’s why Starbucks really wants to sell you a gift card. Because you know, not that they hope it won’t get redeemed but they know it’s gonna get forgotten, that the $10 gift card, somebody is going to use $7.83 and they’re not going to get the whole thing. It became very tricky from an accounting point of view, especially at Christmas, we might sell $100,000 worth of gift cards. And the reality is those are a liability to a point. But technically you can take a percentage of them over. There’s a lot of different accounting tricks there. I won’t belabor it

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