Written by Alex Hughes
First published in StocksInValue on 15 September 2015
All Hail Recurring Rev!
Some of the best businesses to own are those that have a high proportion of recurring revenue.
Recurring revenue exists when the revenue incurred in one year is highly likely to repeat indefinitely, often as a result of recurring demand for the product and the contractual arrangements agreed to. Subscription businesses like software companies that provide their products through the cloud ‘as a service’ are a good example.
Recurring revenue is attractive, for both investors and managers alike, because it improves the predictability of future earnings. If the majority of company X’s earnings are recurring, there is less risk that future profit will fall short of expectations. Businesses with high proportions of recurring revenue are often rewarded for this with higher multiples of earnings due to their greater predictability and lower risk of surprise. For business managers, recurring revenue gives greater line of sight about the future, which improves planning of expenses and investment outlays. Its much easier to manage your cost base when you know what your revenue will be; it’s much harder to manage your costs when your revenue can change on a dime.
As an example, contrast the difference in earnings certainty between a telecommunications business, with a relatively stable customer base paying a fixed monthly fee, and an oil and gas producer, whose earnings are a function of the production quantity, cost of production, commodity prices and currency rates; its chalk and cheese. Worse still is a contract business like a mining service contractor, who must continually win new work to refill their order book, akin to a bathtub with the tap on and the plug out.
We think investors should always be on the lookout for recurring revenue businesses. To provide a live example, the following companies have some recurring elements to their businesses.
Interactive Brokers Group, Inc.(IBKR.OQ)
Interactive Brokers operates a unique model that ensures that the company generates revenue of at least $10 per customer per month, either through transaction commissions or subscriptions fees. This can be thought of as a recurring floor in their potential revenue. Just consider if every investor did no trading for the entire year, a highly unlikely outcome, Interactive Broker’s would still generate revenue of $120 per customer. This model helps with modelling future earnings and shows why the market reacts favourably when the company announces growth in customer numbers. Further, as many traders and investors make a similar number of investments each year, the additional revenue Interactive Brokers generates from this habitual activity is also somewhat recurring revenue and highly favourable.
McDonalds Corporation (MCD.N)
We like franchise businesses. Part of the reason is the recurring franchise fees that the franchisee pays to the franchisor. At McDonalds head office, management can estimate their franchise revenue many years in advance with a high degree of certainty, based on the existing contractual arrangements and assumptions over franchisee numbers. Instead of worrying about securing next year’s revenue, management can focus on building the business for the long term. McDonalds also generates a lot of its revenue from rent, another revenue source with recurring dynamics.
QUALCOMM, Inc. (QCOM.OQ)
Qualcomm has become a global semiconductor power on the back of royalty revenue streams from its CDMA chips. Since inventing the technology in 1990, Qualcomm has generated a highly lucrative royalty based on each handset sold. Qualcomm has essentially been so strong and so profitable, that its customers had an enormous incentive to replace it. While its future appears more challenging due to the rise of competing technology, there is no denying how strong their business has been for many years on the back of the recurring royalty streams.