The Treachery of Profit
"Ceci n'est pas une pipe' Rene Magritte wrote on his painting of a pipe. "This is not a pipe." In 1929, this was an upsetting thing to write on a painting of a pipe.
To the backlash against his pipe painting Rene said "how people reproached me for it! And yet, could you stuff my pipe? No, it's just a representation."
Financial statements are like Rene's pipe. You can't stuff them. They're just a representation of a company. A company represents itself in its financials through the murky lens of accounting (yes this will be a piece a bit about accounting, feel free to close your browser tab now, I dare you).
Bits and Pieces
Accounting does an OK job of representing profit for companies that sell things that you can stuff, like pipes. It does less well for companies that sell things that you can't stuff, like bits.
When a factory makes a pipe, an accountant can look at the pipe, pick it up, measure how much wood or metal or whatever the company used to make it, how many hours of labor it took etc. and figure out how much that pipe cost. She can tell easily how much the company sold it for and when it sold it. The sale price minus the cost equals the profit for that pipe for the month, quarter or year when it was sold.
When it comes to digital things, that formula goes up in smoke.
A software engineer writes a line of code. A year later, once all the code is done, a customer buys that line of code. But then uses it over and over again. Another customer also buys that line of code and another and another. A year later the software engineer updates the code. And so on. It’s tough to draw a line between a dollar of revenue, a dollar of expense and when that particular dollar of expense should run through the books.
So, for things that you can't touch, expenses often don't track to a particular dollar of sales or a particular point in time.
Pity the accountants trying to figure this out. They've sort of thrown their hands up and said, "just run it all through now!"
But this is a practical solution, not an economic one. It's one reason why Google and Meta and Microsoft are so profitable. Things that should be treated as investments, they treat as costs. Investments are things that produce returns over time — like a pipe making machine or writing a line of code. Costs are things you use as you pay for them — like the electricity running the pipe machine or your accountant preparing the books.
The "just run it all through now" approach makes companies spending a lot on bits look less profitable today and more profitable once their businesses start humming.
Method to the madness
The challenge has grown as more and more of the economy busies itself making bits rather than pieces. In 2001, companies invested about the same amount into physical things and non-physical things. In 2021, they invested twice as much in bits and software and stuff as physical things.
What's an analyst to do?
Thankfully, there are very smart people doing work to find a solution, or, at least, do better. The gist is to treat all of research and development expenses and some of sales and marketing expenses the same as accountants would treat a regular investment — to match those expenses to when they line up with the returns they create.
Is this even worthwhile?
When researchers applied this technique to US companies, the ones that tipped over from losses to profit did exceedingly well. So, Lamplighter thinks it is.
The approach works for large groups of companies, but what about specific examples. How do you actually apply this technique in the wild?
Since Lamplighter recently visited Planet Labs on its journey to profitability, we'll stay with the company for this profit analysis adventure.
Does Planet look any better through a lens treating its expenses as investment?
World building
Planet does lots of investing. It builds physical things — satellites — so, things that you can touch. But it's spending far more on the non-physical stuff.
It's investing in processing code — in tools to enable customers to get more value from its service — in relationships to open new markets. Those expenses fall firmly into "research and development" and "sales and marketing." These are exactly the "investments" that accounting struggles with.
Planet also loses a lot of money. Over the past five years, it's burned through close to $700M.
A heavy R&D spend, its effort to create new markets combined with losing money makes Planet a good candidate to throw into our "expenses as investment analysis" machine.
So, how does it do?
Planet's accounting loss last year was $140M. Putting its R&D expenses and some of its Sales & Marketing expenses into an "investment" bucket instead lands the company a loss of $74M. It reduces Planet's loss by almost half. Better, but still a loss.
Planet debuted as a public company in 2021. This limits our exercise. Some of the investments it made before then are still paying off. Some of the investments it's made since have yet to kick in. Lamplighter can't move expenses around as much as might make the picture as accurate as possible (go here for the full treatment).
But directionally, the result is useful to investors. The economic loss last year was likely half of the accounting one. A richer analysis would paint an even rosier picture.
Both the strict accounting view and the interpretative investment view of Planet are valid. For investors looking for value, though, the latter provides a lot more insight into what's happened and offers a better way to frame how the company might deliver that value to shareholders going forward.
Disclaimer: None of this is investment advice. It's meant to illustrate ways LCM thinks about investing. Things that LCM decides are good investments for LCM and its clients are based on many criteria, not all of which are covered here. Some or all of LCM's ideas may not be suitable for other investors. LCM does not recommend investing either long or short any position mentioned. LCM may own positions in some of the companies mentioned. Some of its ideas will lose money — investing entails risk. See full disclaimer here.