Back from the Rabbit Hole: Profits Beat Growth

Back from the Rabbit Hole:
Profits Beat Growth
March 10, 2003

"Would you tell me, please, which way I ought to go from here?", said Alice.

"That depends a good deal on where you want to get to," said the Cat.

Lewis Carroll, Alice's Adventures in Wonderland

The exchange between Alice and the Cat parallels the current debate in many technology boardrooms.

The tech bubble created an Alice-in-Wonderland world. Surreal ruled. Nothing looked or worked like before.

However poor the current results, far too many tech companies still struggle with a strategy born in the Alice-in-Wonderland days.

Goals for revenue, not profits, still drive tactics. Even though investors no longer concur, many executives refuse to make the hard decision to grind out profits and cash, one quarter at a time.

Also in the
March eBulletin

- A Rising Tide Lifts All Ships: The Importance of Using Competitor Performance in Setting Executive Goals

Last Month's Survey Results
- Alternative Work Schedules

Other Recent Articles
- Q4 Revenue and Profits Looks Better (2/03)

- The Ten Fastest Growing Public Software Companies: Managing Sales and Marketing Expenses Wisely (1/03)

- Boiled Frogs (12/02)

Our analysis this month, an update of one done a year ago, focuses on how revenue growth and profits drive market valuations. As there are so many profitless companies, we use the Price/Sales ratio, and not Price/Earnings, for our valuation metric.

In the second quarter of 2000, as the bubble was bursting, investors paid a startlingly high premium for revenue growth. The 12 fastest growing companies in the Culpepper 100+ enjoyed a P/S ratio of 47.0, some 8.8 times that of the average member of the group, and over 3 times that of the most profitable members (Table 1).

Six quarters later, the high-growth group dropped to a P/S ratio of 5.3, and now a year after that, their multiple rests at 2.5, quite close to the overall group average of 2.3.

Investors, who returned to post-Wonderland normalcy quicker than many tech executives, again place their money where it belongs: on profits. The 10 most profitable companies, who last year grew revenues only 3%, now sport a P/S ratio of 5.0, double that of faster growing peers.

Table 1: Trends in Valuing Income and Growth
	Revenue Growth: Year over Year	Net Income for Trailing 4 Quarters	Price/ Sales Ratio	P/S Ratio as a % of Average P/S Ratio
2000, 2nd Quarter
12 Cos. With Highest Revenue Growth (>70%)	136%	-1%	47.0	534%
14 Cos. With Highest Profit (> 17.5%)	32%	33%	15.0	170%
All Companies in the Culpepper 100+	23%	-29%	8.8	100%
2001, 4th Quarter
10 Cos. With Highest Revenue Growth (>35%)	64%	-230%	5.3	77%
10 Cos. With Highest Profit (> 17.5%)	11%	24%	7.9	114%
All Companies in the Culpepper 100+	5%	-55%	6.9	100%
2002, 4th Quarter
10 Cos. With Highest Revenue Growth (>24%)	39%	-66%	2.5	109%
10 Cos. With Highest Profit (> 17.5%)	3%	26%	5.0	217%
All Companies in the Culpepper 100+	-4%	-27%	2.3	100%
Source: The *Culpepper High-Tech Financial Ratios* Database as of August 15, 2000, March 15, 2002 and March 4, 2003. Q4 2003 results based on 120 (out of 132) U.S. public software companies who reported Q4 results.

While only a small minority of companies can generate fast revenue growth, most can generate profits if management so decides. Perhaps, in Alice's words below, more executives just need to be happy with "handsome pigs."

- Warren L. Culpepper

So Alice set the little creature down, and felt quite relieved to see it trot away quietly into the wood. "If it had grown up," she said to herself, "it would have made a dreadfully ugly child: but it makes rather a handsome pig, I think." And she began thinking over other children she knew, who might do very well as pigs, and was just saying to herself, "if one only knew the right way to change them..."

Lewis Carroll, Alice's Adventures in Wonderland

Back from the Rabbit Hole: Profits Beat Growth March 10, 2003

Back from the Rabbit Hole:
Profits Beat Growth
March 10, 2003