Intangible assets need maintenance too
“Soft” assets like brand and software are typically (but not always) created by investing through the income statement where the investment in the assets is expensed rather than capitalised as an intangible asset. This concept is widespread in investing and well understood.
What I find really interesting is how this plays out in the explicit comparison between “asset-light” and “capital intensive” businesses made by every investor. I feel like investors often overlook the amount of reinvestment that is required to maintain intangible assets.
Capital-light
Yes, capital-light businesses have the primary advantage of not needing large amounts of money up-front. It’s a true advantage, but focusing on capital alone limits our perspective. At many capital-light businesses, the “asset” is perpetually “under construction”. It’s not immediately obvious that a significant amount of expenditure is required to “maintain” that asset.
I would suggest that, unlike a factory, there will never be a time at which these businesses do not have to pay substantial maintenance on their intangible assets. The rate of decline of intangibles appears to be much faster than on physical assets. While you can run a software business with a handful of people, obsolescence is typically rapid and you can’t neglect reinvestment nearly as long as you can with an oil tanker.
Brand and software are two obvious examples, and at software companies, this is particularly acute. Most of the costs of building a software company are paying the people to build the digital factory for the digital products you want to sell. (this is a complicated field that I am grossly oversimplifying – think about branded or software products that are manufactured, physical assets that are high-maintenance, & “evergreen” intangible assets like art or music or royalties).
Depreciation
Once the software is built and as it scales, an ever-larger number of engineers and support staff are required to maintain it. I would bet the implicit rate of depreciation on a software asset runs a hell of a lot higher than the ~4% per annum on a factory or an aircraft engine (i.e. an implied 25-year asset life). For illustration, 25 years takes us back to 1996 and Windows 95. Since then we’ve seen Windows 98, Windows 2000, Windows ME (Millennium), Windows Vista, Windows 7, Windows 8, and Windows 10.
Capital-light businesses are generally favourable, but they’re not exempt from maintenance expenditure, and intangible asset maintenance is much more significant than is widely accepted.
It is true that you didn’t need capital to create the asset in the first place, so we’re not initially talking large sums of money for maintenance. However, once you reach scale with your intangible asset, the maintenance costs are high and they don’t go away. Most software businesses need to invest heavily in improvements to fend off younger competition that would otherwise obsolesce the incumbent solution.
I am thinking mostly about software here but I suspect this is true for brands and intellectual property as well. My best guess when I was evaluating Xero (ASX:XRO) was that about 30-40% of its annual marketing spend was basically “stay-in-business” marketing for supporting the brand, which implies a short shelf life on that asset. On the plus side, at least brand investment compounds over time. Coca-Cola could stop advertising tomorrow and be comfortable for a few decades. Marlboro hasn’t advertised since 1971(!) and is still the world’s 25th most valuable brand. (the Forbes methodology is not perfect, but as an illustration, it gives us a talking point)
Measuring the rate of decline of intangible assets
One of the most interesting ways I’ve seen of valuing intangible assets involves taking the income statement expenditure, calculating what proportion of it is “investment”, capitalising that on the balance sheet as an asset and then amortising it at the appropriate rate. This understates costs in the P&L but provides a reasonable picture of how much value exists in the asset versus value which requires ongoing output from employees. The estimated amortisation expense on this asset ballparks how much of the investment is going to maintenance.
(This is a paper exercise at best because nobody knows the “true” rate of decline of an intangible asset. I doubt even the company itself knows what % of the cost base is truly building the asset vs being short-lived output. Still, it gives us a useful starting point).
It might be a moot point, because software companies are always going to employ engineers and invest in their assets. Brands are always going to employ visionaries and marketers. However, it provides an interesting lens for looking at companies that don’t reach scale (for example, local businesses with a finite TAM). Are there scenarios where these assets can be created and then operated with low to no cost and low risk of obsolescence? Does the focus on companies solving big problems lead to less interest in smaller, capital-light businesses that can be created faster with higher and more sustainable levels of profitability?
Food for thought.
I have no position in any company mentioned. I may have positions I am unaware of via my superannuation fund. This is a disclaimer and not a recommendation.
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