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This is the first of what I hope will be a series of articles on the software industry.  Why?  Quite simply, the software industry possesses very attractive economics.  The first company we will look at is Blackbaud, Inc. (BLKB).

Blackbaud Stock Performance, IPO – Present



Blackbaud makes software for non-profit organizations (NPOs).  This is a wonderful little niche. NPOs have unique needs requiring tailored software and services.  The recently deposed CEO described it thusly:  “First, we know more about non-profits and the relationship with their donors and supporters than anybody in the world. What drives non-profits, the relationships, and where they receive their funding is different from the for-profit world. If the non-profit knows you well, you will feel more connected to that organization, and therefore you will give more of your time and money. Bequests increase, lifetime share-of-pocket for donations increases, and if you are an advocacy-based organization, influence in advocacy increases.  Secondly, we offer specialized software that will help non-profits reduce their operating costs and help them be more efficient and effective in achieving their mission. People like to support organizations that are good stewards of their money.”  See Chart 1.

Chart 1 (Click to Expand)

Investor Presentation1

Source:  Company investor presentation

Their most popular product, Raiser’s Edge, helps NPOs manage their donor base.  This is known as donor relationship management (DRM) software as opposed to the more common customer relationship (CRM) management software made by companies like Salesforce.com.  The former CEO explained the difference:  “The typical CRM that is part of an ERP or the typical sales force automation program is about transactions and tracking sales opportunities.  Our programs are designed to help our customers follow their constituents longitudinally over the entire time that they are involved with an organization.”

Industry Economics

The economics of the software industry are reminiscent of what WEB said about the tobacco industry:  “It costs a penny to make. Sell it for a dollar. It’s addictive. And there’s fantastic brand loyalty.” A good software product is no different.  Successful software companies routinely have gross margins of 80-90% and operating margins of 20-30%.  Returns on invested capital (ROIC) can be 30% or higher.[1]  What drive such great returns?

  • Customer Captivity:  Successful software companies experience high levels of customer captivity through high switching costs – that is, customers pay a high price in time and money when switching programs.  The benefit of changing from Program A to Program B is dwarfed by the cost of doing so.  For example, imagine a large company using a complex accounting program system like SAP or Oracle.  Years of data are stored in the program.  The company relies on the system to do basis tasks throughout each and every day.  Hundreds, if not thousands, of employees have been trained on the program.  The system has probably been tweaked and customized to suit their specific needs.  This plus sheer institutional inertia make it virtually impossible to switch providers.  Software companies knows this, so they take advantage of their customers’ reluctance to leave by charging them a bit more each year.
  • Low Asset Intensity:  Software can generate high returns on invested capital because there are no fixed asset needs beyond furniture and PCs.  Capex needs are infinitesimal.
  • High Free Cash Flow:  The level of customer captivity in the software industry is so high that the most successful companies can require that their customers pay in advance.  This takes the form of subscription fees (more on this below).  This, plus the low capex needs, drive very high FCF.  For Blackbaud, FCF is routinely 2 or 3 times net income.  This frees up more cash to distribute to owners.
  • Scalable:  The incremental costs of “manufacturing” a copy of the software for each new customer is virtually non-existent.  This is a business with almost no cost of goods sold.

Whenever I espouse the virtues of the software industry, I hear Buffett’s voice in my head telling me to steer clear of tech.  The risk of dramatic technological disruption is high in the software industry, of course, but we avoid it by focusing on software that appeals to business customers, rather than consumers, and is embedded in their day-to-day operations.  Companies falling into this category include Microsoft, Adobe, Oracle, and, as we shall see today, Blackbaud.  We steer clear of consumer electronics companies like Apple and entertainment companies like Xynga which are more exposed to faddishness and the pressure to constantly innovate.

Does Blackbaud Have A Moat?

Quantitative Evidence of a Moat

  • High ROIC:  Blackbaud has been able to maintain high returns on invested capital.  ROIC has averaged 49% over the last 10 years.
  • Free Cash Flow:  Blackbaud’s business model is designed to produce large amount of FCF.  FCF averaged 387% of net income over the past 10 years and has increased at a CAGR of 8%.  However, it has been bouncing around a bit over the past 3 years (see Chart 2).

Chart 2 (click to expand)


  • Stability of Market Share:  One of the hallmarks of a great business is very little competition.  It is difficult to get market share data for this niche.  Based on discussions on the Internet, Blackbaud is considered the 800 pound gorilla in the industry and their software is the gold standard.
  • Here is how Blackbaud compares to our standard, Moody’s (MCO):

(All data except market cap as of 12/31/12.)





Market Cap as of 9/24/13



Net Debt









Op Margin






Net Margin












Klarman Factors
Barriers to Entry


Very High

Capex/CFOA -10 year avg,



Reliable Customers


Very High

FCF/Revenue – 10 year avg.






10 Year FCF CAGR



The comparison is skewed a bit because of a very poor 2012 for Blackbaud.  In fact, it was so poor that the CEO was fired.  The key problem seems to have been integrating a major acquisition, the purchase of Convio for $335.7 million (more on the below).

Qualitative Evidence of a Moat

Blackbaud has several sources of competitive advantage: network effects and switching costs complemented by economies of scale.

The Power of a Niche – Local Economies of Scale

Blackbaud affords an opportunity to look at a source of competitive advantage that we have not looked at previously:  local economies of scale.  By “local”, we mean either within a geography or within a product space.  Companies can often have moats if they dominate a small/niche market that is too small for competitors to justify the cost of competing.  The market may only have a large enough profit pool to support 2 or 3 players.  Potential new players are deterred by the decreased returns on capital their entry will cause.  A simple example illustrates this point.  Let’s assume that there is a market generating $100 million of revenue per year.  Lets further assume that given the capital requirements of the industry, a company can make a reasonable return with $25 million of revenue.  Thus, the market can comfortably support a maximum of 4 participants.  What if the market suddenly started generating $1,000 million of revenue per year?  It could then support 40 viable competitors.  A highly fragmented market of 40 competitors is harder to dominate than a small market of 4.

Ralph Wanger, a famous and successful money manager, described this dynamic at work in the hard disk drive in the 1980s:  “Remember back in the early ’80ʹs when the hard disk drive for computers was invented? It was an important, crucial invention, and investors were eager to be part of this technology. More than 70 disk drive companies were formed and their stocks were sold to the public. Each company had to get 20 percent of the market share to survive. For some reason they didn’t all do it . . .”[2]

This problem is particularly acute in the software industry where the minimum efficient scale is very low.  A firm’s minimum efficient scale (MES) is the lowest scale necessary to achieve the economies of scale required to operate efficiently and competitively in its industry.  In software, the minimum efficient scale is usually small relative to the overall size of the market.[3]  Many companies can co-exist, although none will make out-sized returns.  But in a restricted market, the minimum efficient scale is much more difficult to achieve because it may have to capture 20% to 25% of the market – a difficult threshold to reach when each each incremental gain comes out of the incumbent’s existing shares.  But unless the new entrant reaches those levels, its economies will not come close to those of the incumbent.  A niche is therefore particularly powerful in the software industry.

Taken as a whole, these advantages caused Prof. Greenwald to write, “Barriers to entry are easier to maintain in sharply circumscribed markets.  Only within such confines can one or several firms hope to dominate their rivals and earn superior returns on their invested capital.”

Blackbaud Has A Dominant Position In The Nonprofit Software Industry

As stated above, Blackbaud focuses exclusively on software and service to non-profit organizations (NPOs).  Blackbaud is entrenched enough that a new entrant would need to incur large losses (or at least minimal earnings) before getting to scale and establishing itself as a credible player.  Moreover, as described above, the new entrant would then need to split a relatively small profit pool with Blackbaud reducing its potential return on investment

This is a relatively small market, so large competitors like Microsoft, Oracle or Salesforce.com pass it by.[4]  This makes sense for several reasons.  The most obvious is that the potential profit pool is too limited to catch their interest.  But there are other reasons as well.  Because fixed costs are only relevant within the product market in question, economies of scale apply only within the same product market.   Thus, Microsoft’s fixed advertising expense for operating systems do not spillover to the non-profit CRM market where Blackbaud operates. Network Effects are also similarly limited.  The network effect that Microsoft Office has does not spillover to the non-profit CRM market.

There is no shortage of smaller competitors.  But, because Blackbaud is so much larger, it will be difficult for them to ever match Blackbaud’s per unit cost advantage in development expense, advertising and marketing.   For instance, Blackbaud spent a little over $64 billion on R&D in the past year, or about 14% of total sales. This large R&D spend, which has gone on for yearss, translates into a wider range of products that have more features and of higher quality than the products of their competitors.

If one of the smaller competitors does get large enough to pose a threat, a deep-pocketed market leader like Blackbaud can simply buy them .

Network Effects

I have experienced the network effect in software in my own life.  I used to work for IBM.  When I first arrived in 2002, all employees were issued a laptop with the Lotus suite of programs.  For those of you to young to remember, this was a competitor to Microsoft Office and owned by IBM.  A number of IBMers had learned spreadsheets or word processing on the Lotus products and preferred them.  But as the employee mix changed due to natural attrition, employees began clamoring for Office.  I was one of them.  I had never used Lotus 1-2-3 and had no interest in using it.  Within a couple of years, IBM switched to Office.

I am no expert on the NPO labor force, but I would think a similar phenomenon takes place.  As Raiser’s Edge or another Blackbaud product grows in popularity, more and more people are trained on it and become comfortable with it.  As they jump to non-Blackbaud NPOs, they clamor for the Blackbaud products they are more familiar with.

Switching  Costs

As stated above, switching costs increase based on two factors:  (1) the extent to which the software is embedded in the customer’s daily workflow and (2) the extent to which core data is stored in the software.  Blackbaud seems to score high on both factors.

Enhancing Customer Captivity

Blackbaud management seems to understand that the principal source of their competitive advantage is customer captivity and has worked to intensify it.  Why has customer captivity important?  A company can extract more money of its customers if those customers are unlikely to move to a competitor.

Blackbaud encourages habit formation among its customers by moving from one-time charge sales of software to a subscription based model.  Customers are automatically charged each year for the right to use the software.  Even better, the  annual subscription fee increases each year.  The subscription model “encourage(s) repeated, virtually automatic and nonreflective purchases that discourage the customer from a careful consideration of alternatives.”[5]

Blackbaurd amplifies switching costs by making their products feature-rich.  By extending and deepening the range of services offered, Blackbaud makes the seemingly basic task of switching to other systems and mastering their intricacies more onerous.

The tactic of adding more features also increases search costs.  “Comparison shopping is more difficult if the alternatives are equally complicated but not exactly comparable.”  Few short-handed NPOs want to take the time required to analyze the pricing and features of competing software products. (See Chart 3.)

Chart 3 (click to expand)


Source: Company investor presentation

Recurring Revenue

Another attractive aspect of the company is the increase of recurring revenues.   A key move for the company was the decision in 2006 to transition from a one-time charge model to a subscription or “Software as a Service” model.  Prior to 2006, Blackbaud charged its customers an up-front, one-time charge for perpetual use of its software.  This was similar to a conventional purchase of any tangible good, like when I buy an apple in a store.  Under the SaaS approach, customers are billed in advance for access to software over time.  Instead of actually taking possession of the software, they pay for access to it.

Currently, maintenance and subscription revenues make up about 67% of total sales, but over the coming years it will likely grow to an even greater portion. With a larger portion of predictable, annuity-like revenues and profits, Blackbaud will become a more attractive company.  (See Chart 4.)

Chart 4 (click to expand)

Recurring rev

Source: Company investor presentation

Deferred Revenue and Negative Working Capital

The SaaS model not only drives recurring revenue but high levels of deferred revenue as well.  Deferred revenue is advance payments or unearned revenue, recorded on the recipient’s balance sheet as a liability, until the services have been rendered or products have been delivered. Deferred revenue is a liability because it refers to revenue that has not yet been earned, but represents products or services that are owed to the customer. As the product or service is delivered over time, it is recognized as revenue on the income statement.

For example, a company that receives an advance payment of $100,000 for delivery of a product would book it as deferred revenue on its balance sheet. Once it delivers the product to the customer, the company would transfer the $100,000 from the deferred revenue account to regular revenue on its income statement.

Since 2006, the amount of deferred revenue on Blackbaud’s balance sheet has shot up – going from $75 million in 2006 to $174 million in 2012.  The presence of this large liability on the balance sheet as well as carrying no inventory and a relatively limited amount of accounts receivable drives Blackbaud into a negative working capital position.  That is, the cash tied up in assets is more than offset by advance payments from customers.  As a result, calculating working capital (which is simply current assets less current liabilities) yields a negative number.

What are the benefits of deferred revenue and negative working capital?

First, deferred revenue represents a large, interest-free loan from the customers to Blackbaud.  Obviously, an interest-free loan is far superior to other, expensive funding sources like debt and equity.  This very cheap cost of funding also gives Blackbaud a moat.  Blackbaud can fund its business at a much lower cost than its competitors.   As Buffett put it, the fact that deferred revenue is listed on the balance sheet as a liability is a great “accounting irony.”

In this way, Blackbaud’s deferred revenue is similar to the insurance float that has fueled much of Berkshire Hathaway’s gains.  “Over the last 45 years, Berkshire’s insurance float enabled the company to effectively borrow huge amounts of cash, with no set repayment date, and with no tangible collateral put up. Even more astonishing is the fact that this money costs Berkshire less than nothing,” wrote Professor Bakshi in an excellent presentation on floats and moats.

Second, the deferred revenue and the negative working capital drives very high returns on invested capital.  As stated earlier, I cannot use my normal ROIC formula because the negative working capital creates infinite ROIC.

Lastly, like pricing power, advance payments are a characteristic of a wide moat business.  The fact that Blackbaud can require payment in advance from its customers shows the strength of its bargaining position.  Only a company in a strong competitive position can get away with this.


While there is a lot to like about Blackbaud, management has been able to drive it right into the ground.  Revenue has increased at an impressive 10% CAGR over the last 5 years, expenses have risen even faster.  Operating margins peaked at 27% in 2005 and plummeted to just 4% in 2012.  Even if you want to dismiss 2012 as a mere anomaly, the operating margin was just14% in both 2010 and 2011.  The trend is not good.  (See Chart #2)  Concurrently, after being largely debt-free for years, the company borrowed $200 million of debt to fund the Convio acquisition.  Management compounded this problem by botching the integration of the new acquired company into their existing operations.  Management also spent heavily on growth investments and growth capex.  Capex jumped  to $20 million in 2012 almost double what was spent in 2010.  SGA also jumped – increasing  by 41%in 2012 over 2011.  SG&A was 35% of sales in 2012.  EPS dropped to just $.15 in 2012 compared ot $.75 in 2011.  Not surprisingly, all of this bad news culminated in the CEO being fired earlier this year.  In response, the stock has skyrocketed (more on this below).

Another gripe, under both the old CEO and the current interim CEO, is that management insists on using non-GAAP numbers.  The biggest adjustment is stripping out stock option expense.   If stock options aren’t a form of compensation, what are they? If compensation isn’t an expense, what is it? And, if expenses shouldn’t go into the calculation of earnings, where in the world do they go?

Management’s capital allocation track record is a bit mixed.  A regular dividend was initiated in 2007 and has averaged 31% of FCF over this period.  Management touts its share buybacks but the buybacks are only used to counteract the impact of generous stock option grants.  Buybacks only add value if there is an enlargement of the interests of all owners.  In other words, share buybacks to offset options given out to employees does nothing.  As for M&A, until 2012, the acquisitions were quite small.  While I remain open-minded about the Convio acquisition, it seems to have gotten the CEO fired, so it can be going to well.

Growth Opportunities Inside The Moat

As we have explored over and over again, growth investments are meaningless unless they are inside the moat.  Blackbaud estimates the total addressable market to be $16.5 billion, and Blackbaud has penetrated less than 3% of this market.  In our view, Blackbaud’s best prospects are in the $8 billion enterprise market, but, in any case, there is substantial room to grow.


While there is a lot to like about Blackbaud, the current valuation makes no sense.  This can be seen plainly without using any fancy metrics.  The current market capitalization is $1,753 billion and the P/E is 113.  For shareholders to earn a 15% pre-tax return, the company would have to generate EBIT of $263 million per year.  It has never come close to earning that kind of money.  In fact, it has never earned 20% of that t.  Last year Blackbaud had EBIT of $19 million.  To get to $263 million, revenues will have to more than double and the EBIT margin will have to increase 6X to levels not seen since 2006.  If you needed more proof that the shares are overpriced, insiders have been selling like crazy.  I don’t sell short, but this seems to be an interesting candidate.

[1] Because software companies have negative working capital, using my normal ROIC formula, ROIC is infinite.  To make comparisons between companies meaningful, I have modified my formula to ROIC = EBIT / Total Assets – Non-Interest Bearing Current Liabilities – Excess Cash.  The formula comes from Competition Demystified.

[2] Quote via Prof.  Sanjay Bakshi.  He is posting transcripts of his excellent lectures at http://fundooprofessor.wordpress.com/

[3] In other industries – such as telecom and basic materials – the minimum efficiency scale is quite large due to the high ratio of fixed costs to variable costs. In these types of industries, only a few major players tend to dominate the space.

[4] Compare this with the much larger CRM market where heavy hitter like Salesforce, Oracle, SAP and Microsoft along with numerous smaller players are all duking it out.

[5] Greenwald, Bruce and Kahn, Judd, Competition Demystified, p. 47.