Quality Patterns – Recurring Revenue
Take a long walk down quality street
Take a long walk down quality street
As we have noted before, the defining characteristics of a quality company are: high, sustainable returns on capital; strong predictable cash flow generation and attractive growth opportunities. There are an assortment of factors or building blocks that contribute to a company achieving the above. These include effective capital allocation, available growth opportunities, strong management, the structure of an industry (often overlooked), competitive advantage and customer benefits – aspects that differentiate a company’s product or service that adds value to a customer.
Each block in isolation does not confer the status of quality for a company but when combined with other blocks, a pathway to quality emerges and you may just find that you are walking down quality street. The pathway is however not always clear and the journey can often be clouded due to diversity among industries and their respective competitive landscapes. This makes it difficult to apply hard-and-fast rules when searching quality. However, a thorough examination of companies that one might consider to be of the highest calibre in terms of quality reveals that there are numerous patterns knitted into their fabric that provide insight into what makes them stand out as a quality company. These patterns may come in the form of a strong brand, pricing power or an area we are going to discuss in more detail, recurring revenue.
Recurring revenue is different from one-off sales in that a company will earn revenue from a customer on a recurring basis, usually defined by a contract. The crucial link between quality and recurring revenue is that it can lead to predictable cash flow generation as well as sustainable returns on capital. The above holds true, even in cyclical industries. Predictable inflows can provide a company with a number of other advantages. By earning recurring revenue, a company will be less dependent on new products and limit the risk of constantly having to come up with “the next best thing”. Increased predictability also allows management to allocate capital more effectively as they are less likely to make errors in forecasting future sales when compared to estimates based on new, one-off product launches.
There are a number of different recurring revenue models but there are two in particular that are worth exploring:
Probably the first form of recurring revenue that would come to mind but is arguably one of the least effective models so far as quality is concerned. Whether a customer will renew their subscription will often come down to switching costs – how easy it is to switch to an alternative provider. Uncertainty can however be mitigated depending on how differentiated a company’s product or service is relative to its competitors.
Microsoft is an excellent case study in how a subscription model rejuvenated the software giant. Consider how one used to pay for and use Microsoft Office. Not too long ago, you would purchase a copy of Microsoft Office, pay a sizable upfront fee which in turn provides you with access to the various applications indefinitely and you might repeat the process a few years later when the next version comes out. Nowadays, this model still exists but more likely than not you are now paying for the same software but on an annual basis via a subscription fee. This dramatic shift in business model has introduced an element of stability for software companies such as Microsoft as well as enhanced their resiliency during difficult market environments leading to sustainable growth. Microsoft has successfully adopted a subscription-based model across many of its business lines including its cloud computing service Azure as well as its gaming business through Xbox Game Pass, which provides access to a catalogue of games as well as cloud gaming.
Contracts that require a company to maintain or repair a particular piece of equipment can be incredibly valuable. An area where these contracts are quite prevalent is that of jet engines. Pratt & Whitney, a subsidiary of aerospace and defence contractor Raytheon, manufactures jet engines for civil and military purposes. The jet engine is typically sold at a discount, which assists in creating a large install base. Thereafter, Pratt & Whitney will receive high-margin servicing revenue for performing regular repairs and maintenance on the jet engines sold. This type of model is also commonly referred to as a razor-and-blade model.
The appeal of this particular model is that it creates an incredibly “sticky” form of revenue for Raytheon that will repeat for a long period of time. Jet engines can be regarded as mission critical and customers such as Airbus, Boeing or even the US military are less likely to switch suppliers given the mission critical nature of jet engines. The cost of using an alternative engine can be significant as it could disrupt production and require recertification, which could take years. Adding to the “stickiness” is that servicing contracts are typically decades-long.
Companies that have consistently or sustainably earned high returns on capital are likely beneficiaries of recurring revenue models. When searching for quality, we are often on the lookout for companies that possess this particular trait. Below are companies that we have identified to benefit from recurring revenue models:
Amazon offers customers several subscription services across its e-commerce and cloud computing segments. Amazon Prime bundles an array of streaming and delivery services into an annual subscription fee. In addition, Amazon Web Services offers customers subscription-based options to access its cloud-computing platform, similar to Microsoft’s cloud computing offering.
ASML designs and manufactures the world’s most advanced tools and machinery used to produce semiconductors. As part of their service offering to semiconductor manufacturers (TSMC, Samsung and Intel etc.), ASML will enter into contracts to dispatch field service engineers to help improve yields from the manufacturing process and extend tool lifetimes. As the install base for ASML grows so does the contribution of service revenue to the overall group.
Disney offers streaming services such as Hulu, ESPN+ and most notably Disney+ (expected to launch in South Africa later this year). The streaming landscape has become increasingly saturated as the amount of available streaming platforms continues to grow. Customers will become pickier when it comes to choosing which platforms they will continue to use. It is likely that Disney+ will be top of the list given the quality of their content catalogue (Disney, Pixar, Marvel and Star Wars) and the appeal it holds for households with younger children (and adults young at heart).
Similar to Raytheon, Honeywell manufactures and services jet engines, along with various other aircraft components, using a razor-and-blade model.
Industrial gas companies such as Linde typically enter into long-term service contracts with customers, some extending for a period of two decades. Industrial gases are often a small portion of a company’s total cost structure but play a crucial part in the manufacturing process. Customers are therefore willing to pay a premium and enter into long-term contracts with suppliers to ensure supply remains uninterrupted.
S&P Global is one of the world’s largest providers or credit ratings and benchmark indices. Nearly two thirds of S&P Global’s revenue comes from recurring sources as the company operates a subscription model across a number of its segments. Active asset managers pay a subscription fee to use S&P Global’s various indices and the company provides financial professionals, on a subscription basis, with ratings, research and data for decision making purposes.
Note: For more detail on recurring revenue as pertains to quality investing one can refer to the following readings:
