Last week, I received an email from Janet, a recurring client asking to have a discussion with me about the value of recurring revenue.  The question was interesting and stimulating and, I believe, of interest to many readers of this blog.  This is a “first look” at recurring revenue. I plan to take at least a couple of other looks in the near future.

I’ve changed the text to keep the client’s information confidential, but the essence of the email is unchanged.  Janet wrote:

I am working with a few others to put together a presentation for our managers who develop products and lead the thinking around our e-commerce products.  We are talking to them about subscription/recurring revenue streams and how that type of revenue is seen as more valuable to investors; thus, driving stock value.  Do you have time this week for a call to discuss some questions I have so I can make sure I am giving them good information as it relates to our company’s stock value with these types of revenue streams?

Of course, I made time for the conversation.  And I’m sure we will continue the discussion in the future.

First Principles

Janet asked if there was anything she could say to her e-commerce managers about a direct link between building recurring revenue and the stock price.  I said there was no direct link, but then went on to say that there are a number of indirect links.

The value of any business is the present value of all future expected benefits (cash flows) to be expected from the business discounted to the present at an appropriate discount rate.  In the post, Valuation Basics for Business Owners, I discussed this concept at some length.

For now, let’s look at what we called the basic valuation equation, which discounts all future cash flows to the present, assuming that CF1 grows at a constant rate, g, and that all cash flows are either reinvested in the business at the discount rate, r, or distributed to shareholders:

Janet and I talked about this equation.  We can note a few things and then talk about recurring revenue.

• Value, or V in the equation above, is a function of cash flow, of course.  That’s CF1.  Other things being equal, more beginning expected cash flow means more value.  This is intuitive.
• Value is also a function of the expected growth in cash flows, or g.  A cash flow stream that is expected to grow at, say 8% per year into the indefinite future is worth more than a stream that will grow only 4% per year.  Why?  Because there will be more cash flow in future years with the 8% growth rate.  The g is in the denominator with a negative sign, so increasing g decreases the denominator, thereby increasing value.
• Finally, value is a function of the expected risk associated with the expected and growing cash flow stream, or the discount rate, r.  If risk is decreased, the denominator is decreased, and value increases.  And vice-versa with increasing r.

These concepts may seem obvious to some readers and not-so-obvious to others.  For all of us, it is a good idea to go back to first principles from time-to-time.

Recurring Revenue

With this valuation primer in mind, we can begin our discussion of recurring revenue.

Recurring revenue is revenue that is, well, recurring.  That is, it is revenue that is received in one period that is expected to be received in the next – and future – periods.  Janet’s question was, why is recurring revenue viewed favorably by stock analysts?

Customers

Let’s begin by thinking in terms of customers.  Revenues come from selling products or services to customers.  Any company can increase revenue by selling more products/services to existing customers and by selling products or services to new customers. Check out these StarTrack shipping labels if you’re searching for labels that have a matte finish.

If a business has a customer this year, and can reasonably expect to do business with that customer next year, there is an element of recurring-ness to the expected revenue from that customer.

It takes money, effort and other resources to gain a customer.  This is obvious.  Companies that manufacture or distribute often have sales forces who work to maintain existing customers and to gain new ones.  Retail businesses advertise.  Professional services firms have senior professionals who develop business and also help them in building a better website .  And all companies, of course, have websites through which they hope to attract or to retain customers.  But all companies must sell to customers.

Customer Attrition

If I have learned anything in business, it is that no customer relationship is indefinite.  Every customer relationship has a beginning, a duration, and an end.  This is a more profound statement than it sounds like, especially if there is customer concentration in a business.  But that is another topic.

It makes sense that if a customer relationship lasts a long time, that relationship is more valuable than one that is of shorter duration.  Why?  Because the longer relationship will generate more cash flow for a business over time than the shorter relationship.

Make no mistake.  Every company will experience losses of customers over time.  Things change.  Customers go out of business or are acquired.  Some customers have relationships with certain people and when they leave for whatever reason, they may change vendors.

The normal loss of customers is called customer attrition.  Good companies are always working on customer retention to reduce customer attrition.

Think conceptually for a minute.  A business works hard to develop new customers, spending money and resources in the process.  If customer attrition is low, then it is easier for a company to grow, because every new customer relationship has more relative benefit.

A Simple Analytical Look at Customer Acquisition and Attrition

I described a matrix for Janet, because I hadn’t prepared it in advance of our conversation. The matrix shows the net impact of customer attrition on growth potential given an assumed rate of new customer acquisition.

The table assumes that a company gains 12% new customers each year.  The analysis is simplistic.  It begins with $1.00 in sales as a convenient reference point.  It implicitly assumes that all customers contribute equally to the growth (or attrition) in sales.  A more robust example would take into account that customers are gained and lost over the course of each year.  But the example suffices for our purposes.

Along the left-most column, we track assumed customer attrition, ranging from 1% per year to 12% per year.  The right-most column calculates CAGRs or the compound annual growth rates that result from an assumed customer acquisition rate of 12% and customer attrition rates ranging from 1% to 12%.

We can make a few basic observations from the matrix above:

• It is necessary to gain new customers in order to mitigate the impact of customer attrition and to grow.
• The slower the rate of customer attrition, the greater the ability of a company to grow given an assumed level of customer acquisition.

Impact of Net Customer Retention on Value

These may seem obvious, but we can relate the results of this simple analysis to the basic valuation equation and begin to see the impact of recurring revenue on value.

• Slower customer attrition, given a constant rate of customer acquisition, means higher expected growth of sales and earnings (cash flow) in the future.  The better the ability of a company to retain customers, other things being equal, the greater its expected growth and therefore value.
• We only show one example with a 12% rate, but we can infer that the greater the rate of new customer acquisition, again, other things equal, the greater the expected growth and therefore value.
• The next point is not obvious, but can be inferred.  A company that can retain customers better has to spend less on its selling effort to achieve a target growth rate, say 8.0%, than one who is losing customers at a higher rate.  This lower cost of selling could translate into higher margins, higher cash flow, and higher value.
• The last point is perhaps even less obvious, but it can also be inferred.  A company with a lower customer attrition rate would likely be perceived as less risky than one with a higher customer attrition rate.  Less risk translates into higher potential value.

The title question is, in effect:

Why is recurring revenue so valuable?

Recurring revenue is valuable because it has an impact on the three factors in the basic valuation equation that create business value. Recurring revenue can increase cash flow, enhance growth, and reduce risk.

Janet and I will continue the conversation about recurring revenue and I’ll share the results in future posts.

Before Leaving

If you need something to take your mind off of the recent stock market craziness, read my latest book, Unlocking Private Company Wealth ($25 plus s/h).  Regardless of what is happening in the public stock markets, private business owners must stay focused on building and realizing value from their businesses.  One way to do so is to focus on the relationship between customer acquisition and customer attrition in your business.

If you would like to talk about any valuation-related matter during this period of “correction,” please give me a call (901-685-2120) or email (mercerc@mercercapital.com).

Until next time, be well!

Chris