Always Buy Companies With Recurring Revenue

With the market riding pretty high and stock buying opportunities limited, I wanted to take some time to put together a series of articles going a little more in-depth on the GreenDot Stocks investing process.

As laid out in the Help page, we start by using the Green Screens to mechanically filter the entire investment universe of over 5,000 stocks down to just a handful of companies that have strong revenue growth and free cash returns on capital. That gets us started in the right direction.

After that, we want to take a closer look to find in those screens the truly great companies, that would make awesome investments at the right price. While this is part science, part art, in general the diligence process comes down to 4 check boxes. In this series, I'm going to go in-depth on each of these and tell you what to look for to either give a company a "pass" or "fail" on each.

The 4 "Check Boxes"

Those 4 "check boxes" are (articles are linked):

1) Recurring Revenue (this article!)

2) Long-Term, Organic Revenue Growth

3) A Strong Economic Moat

4) Business-focused Management Teams (coming soon)

When a company "passes" all 4, then we move to a stock price valuation - which is separate from business analysis. We can cover that a different day!

What Does It Mean To Have Recurring Revenue?

Recurring revenue means that the same customer pays a company on a regular, predictable basis, for an open-ended amount of time. I want to see at least 70% of a company's revenue coming from recurring sources, and the more, the better.

Can you think of some companies that you send money to in this manner?

There are plenty of obvious ones. Your cable company and/or streaming service(s). Your cell phone service provider. Your grocery store (and, by proxy, the product brands you tend to buy there every week). Your home, auto, and health insurance companies. The government (via taxes and maybe tolls).

There are also plenty of negative examples here. You don't pay your car dealer (or the brand they sell) on a regular, predictable basis. Similarly, you only buy appliances, homes, furniture, and other hard goods once every so many years (and frequently not always from the same sellers). Airplane trips and hotel stays are not regular and predictable.

There are also a few "in-betweens". While you may love eating at McDonald's weekly, most customers probably do not, so it isn't really a recurring revenue business. A shoe brand like Nike may get a purchase from you once a year... or it may be once every 3 years... or you might decide to buy a pair of New Balance this year. If it's not regular AND predictable, it isn't recurring revenue.

The Recurring Revenue Business Models

The most common and obvious recurring revenue business model is the subscription model. Here, a company provides a service that is open-ended and ongoing, and you pay for it until you no longer want or need it. There are more of these than I could ever list. Some we mentioned above (cell phone / cable / streaming). Businesses generally require several ongoing "B2B" services. Whatever it is though, a subscription model is the epitome of regular, predictable payments from the same customer over and over again.

Another one is the "toll booth" model. Imagine the nearest toll bridge, and how many cars cross it daily. The bridge takes a small fee for every single one of those cars. Many are the same day after day, week after week, having to cross to get to work, or to see family, or access necessary services. A lot of really great business models are built out in a similar way. Take Visa (V) or Mastercard (MA), for example, who take a small fee for every transaction on their network. Or oil and gas pipelines like Kinder-Morgan (KMI). Or credit rating agencies like Moody's (MCO). Or your gas & electric company.

The key difference between a "toll booth" model and the subscription model is that a toll booth is volume-based, while a subscription is time-based. For example, you pay the same fee for monthly access to Netflix (NFLX), but your bill to the electric company varies based on the amount of electricity you used over a given period.

The final true recurring revenue model is the short-term consumable product model. Here, a company sells a product that is consumed in short intervals, requiring consistent repeat purchases to replenish supply. For example, my family goes through a case of Coke Zero and a quart of Fairlife milk every 3 days, so I'm paying Coca-Cola (KO) that frequently to replace them. I'm sure plenty of examples come to your mind of these kinds of things. Doctor's offices pay McKesson (MCK) to regularly replace their gloves, gauzes, needles, etc. Lots of companies pay 3M (MMM) regularly for stuff ranging from sticky notes to safety glasses to cleaning supplies.

One note about the short-term product model, though. This one usually has to be backed up by a strong BRAND moat to meet the "predictable" requirement. While there's a pretty good bet that consumers will replace Coke with Coke (and not Pepsi), it is less certain that the same brand preference would apply to something like, say, paper towels. We will talk more about brand moat in the "moats" article.

Why Recurring Revenue Matters

Recurring revenue is a MASSIVE advantage in business. With it, a management team can more accurately forecast future revenues and cash flows, which allows better expense management, debt management, growth planning, etc.

In fact, I'd go as far to say that NON-recurring revenue has been one of the key reasons for a lot of high profile business failures. Car companies have notoriously non-recurring sales, which leaves them open to huge sales declines in recessionary conditions. When you combine this with the large amounts of debt some companies must carry (to build out and re-tool expensive factories), it can quickly lead to scenarios where paying back creditors becomes impossible, opening the door to bankruptcy court.

The same scenario above can be applied to other industries that seem to fall on hard times frequently, like airlines and "bricks-and-mortar" retailers.

Recurring revenue is also very helpful for investors. When estimating the value of a company, we are making a lot of assumptions about the future. When revenue is recurring, it makes it a lot easier to model future sales and cash flows with a reasonable amount of confidence, leading to more accurate fair value estimates for buying and selling stocks.

Last, there's the metaphysical angle. Stay with me here! Newton's first law of motion states that "an object at rest stays at rest and an object in motion stays in motion unless acted upon by an unbalanced force". This is a universal law that also applies to spending habits. People will continue paying for their existing subscriptions, or buying the same consumable products, unless there is some unusual circumstance to change that behavior. This sets up companies for YEARS of repeat purchases.

Conclusion

Recurring revenue is just one of the four "check boxes", but it is an extremely important one. It creates a certain level of predictability around a business and our estimation of its value as an ongoing concern, and eases the sharpness of revenue declines in a recession. In the next article, we will take a look at how to analyze for long-term, organic revenue growth potential.