Software stocks can make great investments primarily because they tend to have high margins and many make great use of a recurring revenue model. These factors help create a highly profitable business (once it reaches maturity). Until then, many of these young software companies have no profits to show because of their growth-at-all-costs mindset.
Today, we are going to discuss two profitable software companies. Mature business Adobe (ADBE -0.77%) and up-and-comer The Trade Desk (TTD -0.54%) have achieved and maintained profitable operations. Their stocks both also happen to be on sale right now, suggesting that investors should consider taking a closer look.
1. Adobe
Adobe's suite of software targeted at creating much of what people see on the internet and in print is widely used and is often the default software taught to students in publishing and webpage design. As such, it often faces competition from upstarts trying to capture a piece of its wide-ranging operations. Adobe's answer to this has been to acquire the strongest competitors. The latest example is Figma, which was outperforming its Adobe XD software. Adobe bought Figma for $20 billion in September and that sent the stock price down dramatically over concerns about the acquisition's price tag.
The move was expensive, but the technology Adobe acquired (like real-time collaboration in the cloud) can be extended to its other products. The real-time collaboration feature could spur the next phase of innovation in Adobe's product catalog.
Even without Figma, Adobe generated revenue growth of 13% year over year to $4.43 billion during its third quarter (ended Sept. 2). Adobe turned that revenue into $1.14 billion of net income, which works out to a 26% profit margin. Despite economic headwinds, Adobe expects fourth-quarter revenue to come in around $4.52 billion, indicating 10% year-over-year growth.
But what attracts me to Adobe's stock is its valuation. From a free cash flow perspective, Adobe hasn't been this cheap since it switched its business to a subscription model.
ADBE Price to Free Cash Flow data by YCharts.
Adobe was trading at the bottom end of its valuation range before the Figma announcement. After the release, it dropped even further. This points to skepticism that many shareholders have about the acquisition, but I think the concerns are short-sighted. The technology Adobe acquired will be critical for its future product development and may be a crucial part of why Adobe will be a successful business in the coming decade.
2. The Trade Desk
The advertising industry is notoriously cyclical -- it's a great business when the economy is strong and a tough one when it isn't. However, The Trade Desk is a great way to invest in this industry without worrying about cyclicality. Its software is an adtech tool that analyzes and bids on the best locations for ads everywhere, be it connected TV, podcast audio, or webpage margins. While there has been increased scrutiny about tracking cookies and user privacy lately, The Trade Desk developed its own method: Unified ID 2.0, an open-source technology that keeps users anonymous, which many see as an upgrade to the previous system.
Despite the advertising industry having serious challenges in 2020 and now in 2022, The Trade Desk has retained 95% or more of its customers every year for the past eight. That's because The Trade Desk's software saves customers money through correct ad placement and is bought on a subscription basis.
While many advertising companies reported slow to negative growth in the third quarter, The Trade Desk's revenue rose 31% year over year to $395 million. In addition, it expects to generate at least $490 million in sales next quarter, indicating 24% year over year growth.
The Trade Desk is also profitable, posting $15.9 million in net income -- a 4% margin. The Trade Desk's CEO received a performance grant of $66 million during the quarter and, if you strip that out, net income margin rises to 21%. This expense is part of a long-term strategy to retain CEO and co-founder Jeff Green, and it won't continue forever.
As for a valuation, investors see The Trade Desk's potential and value the stock highly. The Trade Desk isn't a cheap stock, trading at 54 times free cash flow and 18 times sales. But with about $816 billion spent on ads worldwide in 2022, according to Magna Global, The Trade Desk could expand its reach and play a profitable role in placing those ads.
The Trade Desk makes an excellent buy today, and investors should get in on this stock before it starts producing large profits, as that will likely be a trigger point for many larger funds to buy into the stock.
