Now that we know a little about Semrush SEMR 13.68 +0.10 +0.74%, let’s get to work recasting its intangible investment, so that we have a truer look at the company’s operating profit and invested capital base vs. what we see by simply looking at GAAP financials.
As discussed here, we make these adjustments so that we can understand the underlying economics of the business from a capital productivity standpoint, which in this case is a very different story than the one told by the GAAP.
As usual, the full excel sheet for all of the numbers used in the post is embedded at the end of this series of posts, where it can be easily viewed by clicking on the two windows in the bottom right. The excel can also be downloaded.
Spoiler Alert: After adjusting for intangible investment, SEMR’s ROIC goes from negative for 2020 – 2023 to 25%, 31%, and 23% for each of those years, respectively. This is well in excess of SEMR’s cost of capital. So if ROIC is an important factor for you in considering stocks as investments, you probably want to understand the adjustments made here to get to these high ROIC numbers.
Calculating ROIC Using GAAP Numbers
Let’s start with the GAAP income statement:
We see that on a GAAP basis, SEMR is not profitable, due largely to the S&M expense. SEMR is spending close to half of its total revenue on S&M alone. The company has a high and improving gross margin (though some hard-core growth tech investors might demand closer to 85% and be willing to pay anything for the stock if it can hit that number…) but that gross profit is still swamped by S&M and other operating expenses, leading to negative EBIT. So NOPAT is negative. We need NOPAT for ROIC!
GAAP invested capital is also negative. This is due to the negative working capital nature of this business (that’s a good thing, for the most part) and the very limited investment in tangible long-term assets needed to run this business – also generally good. But because of this, we now have negative numbers for the numerator and denominator of the ROIC ratio.
So as it stands under GAAP, SEMR’s NOPAT, invested capital, and ROIC numbers look like this:
*Note cash, for purposes of invested capital, is calculated at 2% of revenue. All of the calculations and the source income statement and balance sheets can be found in the excel sheet at the bottom
Adjusting For Intangible Investments
But are S&M, G&A, and R&D really operating expenses for this company, and therefore correctly allocated to the income statement? Let’s look at S&M. Semrush spends a lot of money to attract potential customers to the top of its sales funnel. Here is one of the ways they describe this process in the 2022 10K:
Our customer acquisition model is focused on promoting our brand, increasing market awareness of our platform and products, and
driving customer demand, and a strong sales pipeline. We utilize our products to manage our online visibility and reach our prospective
customers. Additionally, we use several other online marketing initiatives, including online advertising, webinars, blogs, podcasts,
ebooks, customer success studies, and the Semrush Academy to build our brand and engage with our customer community.
The Semrush Academy is a free online learning program that has enrolled over 700,000 students and issued over 260,000 certifications with 52 courses across 5 languages as of December 31, 2022. The Semrush Academy increases our brand awareness within the marketing community and helps us crowdsource best practices and innovations that we use to improve our existing offerings, advance new products, grow our brand, and engage with the marketing community. After attracting a prospective customer to our site, we utilize a highly efficient, low-touch sales approach focused on driving
customers to our platform through a self-service model. Customers often begin using our products either on a free basis or immediately
become paying customers.
When SEMR converts some portion of the top-of-funnel users to paying customers, it keeps those customers for some period of time, collecting subscription fees, and it also may sell those customers new products during that time – not to mention the potential for price increases. So the S&M expense is in period 1, but the income that expense generates comes in many periods into the future. This makes the marketing expense seem a lot more like investment than expense, especially for a subscription model like SEMR where there is a pretty clear relationship between these expenditures and the revenue they tie to. In my mind, it is this direct relationship between S&M/the funnel and subscription revenue via customer conversion that makes viewing S&M as an investment rather than an expense reasonable. For more general sales and marketing initiatives for other kinds of businesses that may (or may not) lead to customers purchasing products/services via one-off transactions, I don’t think that capitalizing S&M is a great idea, or at least not very much of it should be capitalized – the relationship between the “investment” and the return in many of those cases is too tenuous.
But what about S&M expenses that are for existing customers?
Yes, SEMR might put on an annual conference for existing customers for example, and that seems more like an expense because it is tied to revenue from existing customers in the same period – the company is spending to maintain customers and the revenue they throw off. Yes, that amount is properly characterized as an expense and should stay on the income statement. So S&M seems to be a combination of investment and expense in a ratio that is different from company to company.
In the table below I show the percentages I used for separating R&D, S&M, and G&A between intangible investment and expense. You can see that for S&M I kept 20% of the expense as income statement expense to account for ongoing customer maintenance expenditures and capitalized the other 80%.
| Expense Category | % Capitalized (i.e., moved to B/S) | % Expense (i.e., stays on I/S) |
|---|---|---|
| Sales & Marketing | 80 | 20 |
| General & Admin | 20 | 80 |
| Research & Development | 80 | 20 |
In a future post I will get into the specific thinking behind the percentages I used for each item (note 100% of R&D was capitalized in the PharmaCo example) but for now, let’s just focus on the mechanical implications of these assumptions. Below is a look at what happens to these line items in the income statement post-adjustment. Note that this adjusted income statement also includes amortization of the capitalized intangibles as an expense – I will get into that later:
You can see the massive changes in the main 3 expense items in the adjusted version – for example, S&M in 2022 went from $127mm to $25mm. Even though we are now carrying an amortization expense, the reduction in the other expense items swamps this incremental expense, leading to positive PBT for the company. We also see 2022 proforma earnings of 38 cents. Putting aside everything we are discussing related to intangibles, one takeaway from this exercise is that these adjustments – if one deems them to be more reflective of economic reality – mean that now screens at a fairly reasonable earnings multiple given that the company has been growing revenue at 35-50% per year: the stock has traded lately in the range of $7 – $9, with 2022 earnings of 38 cents.
In the next post, I will get into calculating amortization for the capitalized expenses – we need to do this to get the amortization number for the income statement, but also the amortized value of these investments for the adjusted balance sheet, which will drive the new version or ROIC for this company. Of course, these numbers are just driven by assumptions, which are anyone’s subjective opinions and wrong or right, depending on one’s point of view. But at the very least, these assumptions introduce another perspective on the quality (or lack of quality) of the business, which I think makes the overall exercise probably worthwhile.