billion. It also reported employee attrition of 17%.
3 To grow sales again by
26% in 2012, assuming the same sales
productivity, Infosys must hire 34,000
employees plus another 22,000 to replace departures!
Other numbers help explain why
gross margins can be high and operating profits low: general expenses that
come after the direct cost of sales (but
still before taxes). For software products and SaaS companies, and for Internet service companies like Google
and Facebook, these expenses can be
huge. Salesforce.com spent a whopping 63% of 2011 revenues simply on
sales, marketing, and general and administrative expenses. Add to this 11%
of sales spent on research and development (R&D) and we get 74%. Combined with a 20% cost of sales (the inverse of the 80% gross margin), we can
see why Salesforce.com managed a
profit rate of only 6% (see Table 2). The
company was indeed investing heavily
to achieve a 27% growth rate.
Similarly, LinkedIn spent 46% of
revenues on sales, marketing, and
general and administrative expenses,
and 25% on research and development: 71%. This total, combined with
16% direct cost of sales ( 100 minus
84% gross margin), and another 9% of
sales in other expenses,
4 explains why
LinkedIn shows just 4% of sales as
operating profit. But investors seem
to like LinkedIn nonetheless, possibly due to high growth and because
it does not simply rely on advertising.
Fifty percent of last year’s revenues
came from job placement fees paid
by corporate clients and another 20%
from premium subscriptions (“
We can also understand Apple’s operating profit rate of 31% more clearly,
as well as its low valuation. Apple’s
growth has been so high (66%) that
revenues have probably outpaced pri-or-year plans for expenses, leaving a
surprisingly low percentages for sales,
marketing, and administration costs
(7% of sales) and research and development (2%). Only Infosys (2%) was
in Apple’s territory for R&D spending.
But, as a service company, with merely
5% product sales, we expect Infosys to
do little research and development.
We expect Apple to do a lot, and its
expense ratios will rise quickly if and
the obvious unknown
is how much and
how fast Facebook
will continue to grow,
and how much that
growth will cost.
when growth slows. Perhaps investors
do not believe Apple can continue to
grow so fast so cheaply.
The last column in Table 1 points
to percentage of revenues coming
from new product sales. The balance
of revenues comes mainly from services or maintenance, including software license renewals. New product
sales or subscriptions in software and
some hardware businesses (like the
iPhone) have high gross margins and
high growth potential without adding
costly headcount or expensive factories. It is a useful metric for Microsoft,
Oracle, SAP, and Salesforce.com, and
even for Apple and IBM, but has little
meaning for Google and Facebook.
Their “products” are free automated
services like searching the Internet
or connecting with friends. What they
sell is primarily advertising. Facebook
logged some virtual goods and technology sales (mostly to Zynga), but
these amounted to only 15% of revenues.
1 SaaS companies are hybrids
with a product delivered and priced
like a service, with some technical
support and maintenance bundled
into a monthly fee. But they still can
have very high gross margins and scale
economies. This is why Salesforce.
com and LinkedIn should have high
valuations as long as they are growing
fast. But their high expense ratios are
worrisome for the future.
The Facebook IPO price seems very
expensive in retrospect and assumed
a continuation of extremely high
growth (and profit) rates. But there re-
ally is no way to determine what the
price should have been in advance.
On “objective” measures like sales
growth as well as operating profits,
gross margin, sales productivity, and
expense ratios, the company looked
very strong prior to the IPO and sol-
idly in the class of Microsoft, Google,
Apple, and other elite performers. The
obvious unknown is how much and
how fast Facebook will continue to
grow, and how much that growth will
cost. User behavior with mobile ads
is apparently different and less prof-
itable than with PCs, and Facebook
will have to adjust. Investors must
also adjust their expectations as they
speculate about the future. For ex-
ample, if Facebook can average 32%
annual growth for the next five years,
and if the stock price and market cap
recover to the IPO level, then the mul-
tiple will be a Google-like 7x in 2016.
Facebook will then seem much less
expensive. But these are big “if’s.” The
bottom line? There may be no science
to IPO pricing, but even a quick look
at the economics of the business, with
some reasonable extrapolations and
comparisons to peer firms, does shed
some light on what a company is likely
to be worth in the future.
1. Facebook, Inc. Form s- 1. united states securities
and exchange Commission, Washington, d.C., Filed
February 1, 2012.
2. hulbert, M. Facebook’s stock should trade for $13.80.
The Wall Street Journal
Marketwatch.com (May 25,
3. Infosys technologies ltd. Form 20-F. united states
securities and exchange Commission, Washington,
d.C., Fiscal year ending March 31, 2011.
4. linkedIn Corporation. Form 10-k. united states
securities and exchange Commission, Washington,
d.C., Fiscal year ending december 31, 2011.
5. raice, s. and letzing, J. Parsing the Facebook fallout.
The Wall Street Journal (May 30, 2012), b5.
6. saitto, s. et al. Playing the Facebook blame game.
Business Week (May 28–June 3, 2012), 45–46.
7. selyuk, a. and baldwin, C. linkedIn IPo prices at $45,
but risks real. Reuters (May 18, 2011); http://www.
8. sengupta, s. Facebook shares plummet in an earnings
letdown. The New York Times (July 27, 2012), b1.
Michael A. Cusumano ( firstname.lastname@example.org) is a
professor at the MIt sloan school of Management and
school of engineering and author of Staying Power: Six
Enduring Principles for Managing Strategy and Innovation
in an Unpredictable World (oxford university Press, 2010).