Less than bliss
There are countless entrepreneurs trying to start – and private equity firms seeking to acquire – companies that have recurring revenue models. I am perplexed by this. Part of the problem is that the phrase is ill-defined. After all, if a company doesn’t have recurring revenue, they go out of business right away, right?
I mean, I understand the cost of customer acquisition, and that constantly trying to find new customers would be an exhausting undertaking. But I am hard pressed to think of a business that doesn’t eventually sell to its past customers again, except perhaps for certain lower middle market investment banks, present company excepted, and home renovation general contractors. Even car manufacturers sell more cars to their old customers if their cars made them happy. Customer loyalty programs are all about this. Lower middle market investment banks and home renovation general contractors should take note.
Some investors attempt to clarify by saying that they want “sticky” revenues. But revenues are only sticky if customers are happy, your product offering continues to be competitive, or there are significant switching costs. So it starts to sound like customer satisfaction and switching costs are really the metrics to follow, but these aren’t new.
Investors will then add that they want contracts in place with customers, that contracts equate to recurring revenues. If that is so, go get a contract as a subcontractor for Comcast as service technicians and see how far that gets you. And look where mobile phone contracts have gone. Market competition has caused them to evaporate. So much for contracts. It was nice while they lasted, but competition has a way of making them disappear.
Looking back at my tender youth, I don’t recall a single reference to recurring revenues in any of my finance or marketing texts or in any of the financial models. Nothing in CAPM, DCF, efficient frontier, Sharpe’s Ratio, The Five Factor Model, nothing, not a word on how recurring revenue creates a competitive advantage, allows you to beat the market, or how it improves risk/return in a portfolio.
Beta, from the weighted average cost of capital model, is as close as I have come to this elusive, if not mythical recurring revenue. Companies whose stock performance correlates with the market have higher betas, and thus, higher cost of capital. If that is the gig, then isn’t this really about the correlation with the market, or a lack thereof? Remember, anything that can be diversified away in a portfolio isn’t a value driver.
We note that many of these recurring revenue companies are software and tech related. These are growing markets, and stocks performing well in growing markets in nothing new.
Some PEGs argue that part of the secret sauce of their recurring revenue models for their SAAS companies is that they offer a free version to get us to try them, and then we’re hooked. Wa ha ha ha ha, they cackle. This reminds me of the ladies at the grocery store giving out free samples of cheese and sausage on little toothpicks. Again, nothing new here. Test drives have been around for quite awhile. Ben Hur probably took one.
Proponents argue that recurring revenue increases predictability. But my own understanding of finance is that predictability in the short run is a not a variable incorporated into any valuation model. DCF is a perpetual value model with its last step reaching out to infinity. Performance in the long run is what matters, at least according to Warren Buffett, whatever that’s worth.
I’ve seen numerous articles about how you will never miss a quarterly earnings announcement if you have recurring revenues. Again, I have yet to see any research that says that this increases shareholder returns in the long run. And while never missing an earnings release sounds tempting, the flip side is that you will never exceed an earnings release either. That’s like robbing Peter to pay Paul, mama used to say.
While there is indeed a mania about recurring revenues and how companies that have them trade for significantly higher multiples than those that don’t, my sense is that I am seeing the dot-com days reincarnated. After all, AOL had recurring revenues. They flew high until they were disrupted. And that, my friends, is where I think we are headed with recurring revenues.
Remember Bally’s, the gym? They were one of the original recurring revenue models, started in 1983. They had all the bells and whistles, like contract receivables and recurring monthly income, and where did that get them? Liquidation. Why? Others built better mousetraps while Bally’s was counting its money like Richie Rich . What goes around, comes around mama used to say.
In chasing short run predictability, myopia is bound to set in. That will make the brick wall all that more unpleasant when a disruption causes recurring revenue models to hit it. Investors will be dazed and heard muttering wtf? in hushed tones.
I don’t believe that any of the fundamentals have changed. Meeting a market need in a large market, having high customer satisfaction, capturing market share in a market where switching costs are material, running efficiently and producing high operating margins, these are the value drivers that matter. Adding contracts only makes one feel falsely safe, like taking refuge in a basement fallout shelter in Manhattan during the Cuban Missile Crisis, or practicing Duck and Cover once you see a mushroom cloud.
A recurring revenue model with contracts is like marriage. After all, marriage is a contract and switching costs are high. But without solid customer satisfaction and constant renewal, it is destined for the scrap heap in the long term.
Recurring revenue models aren’t going to go away, but their premium to market will. When sufficient longitudinal data permits analysts to compare long term rates of return, investors will find they overpaid for what they got back.
