It would shock you how many people own, short, or just speak with authority about Hubspot stock HUBS 656.56 +11.95 +1.85% without really understanding how the business makes money. Or maybe it wouldn’t, but it’s shocking to me. That’s why in my last post I tried to explain the business in a clear and concise way, in the context of a (hypothetical) written stock pitch.

For fundamental, long-term investors, I think the next key question that needs to be asked is: what’s the capital productivity of the business? How good is HUBS at taking $X from its capital providers and turning that into more money over time? Approximately how much more can it turn that $X into each year, and how long can it go on for? In other words, how successfully does HUBS invest and return capital for its stakeholders? This is the essence of an ROIC analysis, and that is what I am going to do in this post.

Before we get going, let’s remember that Hubspot is a SaaS company, so it’s not going to have a lot of capital expenditures, at least not the traditional kind, which we would be able to track via the GAAP cash flow statement and balance sheet. Instead, as is typical of software companies, HUBS is “investing” in what are essentially intangible assets through its income statement – more specifically, the R&D, S&M, and G&A expense line items, which HUBS very conveniently breaks out for us. Given the tremendous amount the company invests HUBS still has negative operating income, which means we can’t calculate ROIC because there is no NOPAT to use as the numerator of the ratio that is ROIC.

**Intangible Investments**

But as discussed here, in this hypothetical pharmaco ROIC analysis, and in this Semrush ROIC analysis, to get a truer read on a company’s ROIC we can adjust certain GAAP income statement expense items by treating portions of them as investments because…they *are* investments. This means the expense item comes out of the income statement, is replaced with an amortization amount, and the amortized investment is put on the balance sheet and included in invested capital for the denominator of the ROIC calculation. So now we have positive NOPAT, and an invested capital level that more closely reflects HUB’s economic investments. This gets us to a recast ROIC number, which is a lot more helpful in thinking about capital productivity for the business. So, what ROIC does that come out to for HUBS?

Well, here is what it looks like:

Let’s call it something **around 8-12%**. Clearly, there is a lot of guestimation involved here and all of the assumptions involved can be debated, but this range suggests Hubspot is not exceeding its cost of capital by much. Or put another way, it’s not generating a ton of economic profit. Let’s walk through the adjustments and all the math used to get to these numbers, and then spend some time on ways to think about the results at the bottom of this post.

**Calculating** **Hubspot ROIC: Adjustments For Intangible Investments**

To begin, let’s look at HUBS’ income statement as-is:

You can see how the amounts of three operating expense categories have grown tremendously over the past few years in absolute dollars. The percentage of revenue has stayed about the same – HUBS is not taking its foot off the pedal. The company reported its most recent quarter ended June 2023 this past August, and Y/Y revenue growth was about 25%, so the revenue growth continues. This spending causes GAAP operating income and earnings to be negative so, no NOPAT. To adjust HUBS’s income and invested capital to more closely approximate economic reality for purposes of thinking about ROIC, I use the methodology described here and make the following adjustments:

**Percentage Of Expense Items Capitalized**: Some of the three GAAP expense categories should remain expenses while the rest should be treated as investment capital. I assume 100% of R&D to be investment, 20% of G&A is investment, and 80% of S&A is investment. These are certainly arbitrary assumptions, but based on how HUBS has discussed these categories and how SaaS companies think about these expenditures generally, they are as good as any for my purposes. Remember, this entire exercise is about estimates; there are no certainties, and we can play with assumptions in Excel later.**Start Year:**2014. This is the year I started accumulating each expense on the balance sheet for purposes of getting the right net asset value (i.e., net of amortization) for each. You can see the progression over time in the Excel sheet I have attached at the bottom of this post.**Amortization Periods:**R&D: 3 years, G&A: 5 years, and S&M: 5 years. HUBS has a gross retention rate of 80%, and 1/(1-.8) = 5 years. So, we are assuming the number of years each customer lasts to be about 5 years and that guides the amortization period. The nice thing about the spreadsheet is that you can easily adjust these assumptions. But note the interplay between the amortization period’s impact on NOPAT (numerator) and invested capital (denominator) and the starting year amount of each item: it’s not necessarily the case that increasing customer retention and therefore the amortization period increases ROIC. See for yourself by changing assumptions in the Excel sheet.

Here is what the now-adjusted HUBS income statement looks like:

Now we’ve got some operating income! But we need to back off the amortization of the capitalized investments per the aforementioned assumptions to get to NOPAT, and I have done that below in the AFTER section:

Where did the amortization numbers come from? Answer: the financial modeling in the Excel sheet at the bottom. It incorporates the assumptions above and HUBS GAAP expenses to calculate amortization for each year since 2014. So, though EBIT surged when we took out a lot of expense (no surprise there) it comes back down when we also take out the amortization cost associated with those same expenses being capitalized. Since HUBS is spending significantly more each year and those amounts are amortized over only 3-5 years compared to say 20-30 for classic tangible assets, the amortization expense is going to be meaningfully large and take a nice-sized bite out of NOPAT.

That Excel sheet also generated corresponding intangible investment (net) asset levels for 2019-23 used in the schedule below where you can see invested capital calculated both before and after the addition of the capitalized intangibles item:

Let’s think about these ROIC numbers against the backdrop of HUBS’ cost of capital. Bloomberg says HUBS’s WACC is about 14%:

I am by no means saying that CAPM is the proper way to think about it here – clearly HUBS stock’s beta (1.9!) is driving this high number – but it is fair to say that even with a meaningful lower cost of capital, HUBS is not chugging out economic profits. So am I way too low on the ROIC?

In thinking about this, we might want to play with some of the intangibles assumptions I made. For example, maybe the amortization period should be longer because HUBS products are so sticky and they will keep customers for longer than 5 years. If we change S&M and G&A amortization to 10 years, the difference is negligible: LTM ROIC goes from about 10% to 12%. This is because, while NOPAT (numerator) increases with lower amortization, invested capital (denominator) stays higher for longer. But assumptions aside, there is no way around the fact that HUBS is spending a large and ever-increasing amount on investments, and if the relationship between investment and return tracks close to what it has been in the past, it’s hard to see lots of economic profits in HUBS’ future.

**What Could Change Out Year Returns?**

The value of a business is the present value of its future cash flows, so if HUBS really does crush it in terms of economic profits in the out years, ROIC levels for a given set of years in the near term like what we are looking at now can admittedly be pretty meaningless. Surely some growth investors would say that’s why the kind of analysis I have done is a waste of time and a misleading way to think about a growth stock. So, what could happen that would make us look back and say that the normalized ROIC levels we ascribed to HUBS were…way below normal? Here are some ideas:

- Gross Margin Improvement – Gross margin is already pretty high, but surely a higher margin would increase NOPAT and likely not involve too much investment, thereby increasing ROIC
- Pricing Power Flexed – HUBS has lots of locked-in users – if it can successfully raise prices this would also lead to higher NOPAT without much capital investment
- More Share Of Wallet – Again, HUBS has hundreds of thousands of users, if it can get them to spend more without too much investment in R&D it could increase HUBS’ NOPAT and ROIC. Payments revenue growth and cross-selling new hubs to existing accounts come to mind here and are clearly areas of focus for the company. Essentially this means higher customer LTV.
- CAC (Customer Acquisition Cost) Decrease – HUBS spends a lot through S&M and G&A to acquire customers, mostly through digital means. If the economics of this become more favorable for HUBS in the future, NOPAT increases with relatively lower capital investment, which means relatively higher ROIC
- Customer Lifetime Increases – This was touched on in the assumptions tweak above – longer LTV means higher ROIC
- Lower Customer Maintenance Cost – Of course, we don’t know exactly what HUBS spends to maintain existing customers, we have assumed it is about 20% of S&M and G&A – if this is lower in the future, ROIC increases

In the 2023 Hubspot Analyst Day in September, the company actually guided to *lower* target operating margins than it had provided in 2022 for a few years forward – presumably because of increased investments vs. what they had expected the year before. This would push economic profits out further into the future.

To be fair it is still early days for HUBS, and ROIC certainly needs to be looked at in the context of where a growth company is in its life cycle. To get some perspective on this with numbers, I also ran a similar ROIC analysis for two HUBS competitors that are in both earlier (Freshworks) and later (Salesforce) life cycle stages. I will discuss these in a future post. But where I stand on HUBS right now is that, for a company that is 17 years old with $2 billion in revenue, I would like to see substantially higher ROIC.

I love this company and its products, and the stock has been great for investors so far. But I guess you could say I need more proven economic profit-earning power to own the stock, regardless of what I concede to be a bright future for the business. This is especially true here because I think these kinds of software companies and their competitors are prone to spending way too much for revenue growth as part of a never-ending arms race for customers and can easily lose sight of the returns (or lack thereof) on those expenditures.