20 Dec 2023
The economics of any business starts with revenues. Yet all too often, investors fail to account for the different types of revenue when evaluating and valuing companies. Not all revenue models are created equal; some are much more resilient to market and economic forces than others.
We spend considerable time analysing the revenue models of companies in our universe. The reason for this focus is simple. Higher quality revenues typically translate into more predictable and sustainable free cash flow generation, which ultimately drives shareholder returns over the long term. Investors who solely focus on the magnitude of revenue growth, rather than its quality, can misjudge intrinsic value in both directions (often overpaying for high growth companies, whilst passing on stable but lower growth companies).
The importance of revenue resiliency was laid bare during the COVID-19 pandemic. Many businesses saw revenues all but disappear overnight, while others sailed through the turmoil as if nothing had really changed. Most remarkably, some companies remained fundamentally resilient despite being directly exposed to shuttered industries. This was, in large part, down to their advantaged revenue models.
At a high level, we can classify revenue types into four categories. The first two, subscriptions and ‘habitual’ transactions, are recurring in nature. The second two, royalties and commissions and discretionary transactions, are non-recurring sources of revenue.
Figure 1: Simplified breakdown of revenue models
For illustrative purposes only.
A business with a purely discretionary or transactional model relies on customers returning and buying a similar quantity of goods/services just to maintain their revenue base. If they want to grow, customers must buy more than they did previously. And if those customers don’t return, the business must constantly recruit new customers to stand still. Consider, for example, a manufacturer of heavy capital equipment, like power generators. Such a business is dependent on macroeconomic conditions remaining stable for revenue growth momentum to persist1. If the economic outlook changes for the worse, customers will likely reassess investment plans, tighten their belts and ultimately purchase fewer generators. The knock-on effect on our hypothetical business may be severe: if they can’t find new customers, revenues will go backwards, decremental margins start to bite and profits shrink materially. This is the definition of an economically sensitive business, and it primarily stems from having non-recurring transactional revenues.
At Ninety One, our quality investment philosophy means we generally steer clear of this sort of business. Instead, we focus on companies which have primarily recurring revenue streams. We prize the subscription model above all others. Many Software-as-a-Service (SaaS) companies, which provide mission-critical infrastructure and workflow solutions for their corporate customers, charge on a subscription basis. With this model, revenues are already locked in at the start of the year, with pre-paid contracts an attractive ancillary feature which benefits cash generation2. Rather than having to generate revenue from a base of zero, these companies start where they left off in the prior year and can instead focus on growth.
Autodesk, an architectural design software provider, is a quintessential subscription business. Architects and engineers rely heavily on Autodesk software to perform their daily tasks; we simply couldn’t design buildings to modern standards without their solutions. With few competitive alternatives, customers typically only cancel an Autodesk subscription when they go out of business. The COVID-19 pandemic was a perfect illustration of this. With building sites grounding to a halt across the world, many firms in the construction industry suffered, but Autodesk continued to grow its revenues at a double-digit rate. Architects weren’t going out of business and, in fact, had already paid for a year’s subscription upfront. In short, despite serving an economically sensitive sector, Autodesk’s superior revenue model results in far more predictable compounding over time. Although admittedly crude, a comparison with Caterpillar (the world’s largest manufacturer of construction equipment) neatly illustrates the downside protection a subscription model provides during periods of economic stress.
Figure 2: Autodesk’s sales have proven more resilient than Caterpillar over the same period
Source: Company filings, as at 31 December 2022.
We hold several other subscription businesses in our portfolio. Adobe3 (graphic design software), Microsoft (enterprise productivity software and cloud infrastructure), ADP (human capital management software and services) and Intuit (small business accounting and consumer tax software) all sit within our top ten holdings, as does market intelligence and ratings platform S&P Global. We put these companies in a league of their own given the visibility and consistency their revenue models provide.
Figure 3: Revenue models of the top 10 American Franchise holdings
Source: Ninety One, as at 31 October 2023. The portfolio may change significantly over a short period of time.
A second form of recurring revenue are ‘habitual’ transactions. Our power generator company was an extreme example of a big-ticket, discretionary purchase. Other transactions can be more recurring in nature, and therefore attractive to us as quality investors. Consumer staples businesses are at the other end of the spectrum from power generators. Whilst they also have transactional revenues, purchases are so consistent they almost behave like subscriptions. This is underpinned by the strength of their brands, established in the minds of consumers over decades or even centuries, along with superior distribution and route to market capabilities. When you combine these attributes with frequently purchased, non-discretionary products – we consume roughly the same quantity of food/beverages regardless of the state of the economy – the revenue stream becomes quasi-recurring in nature.
These revenue models exist in other sectors besides consumer staples. One of the more unexpected examples is O’Reilly Automotive3, a leading auto parts retailer. The automotive sector has a well-deserved reputation for being highly cyclical. However, rather counterintuitively, O’Reilly’s revenue model exhibits strong countercyclical properties, with vehicle owners more likely to fix up their cars in a bad economy, driving demand for spare parts. This inherently defensive revenue model is complemented by O’Reilly’s market leading distribution capabilities and a consistent history of market share gains, making the business a compelling proposition in an otherwise attractive sector.
Finally, there are royalty or commission-based revenue models, where a company’s revenue is derived directly or indirectly from the revenue of other companies. We hold several businesses in this category, including Visa (collects an effective royalty on merchant payment volumes), Booking (receives a commission on hotel stays) and Dolby (collects a royalty on consumer electronic sales which incorporate its audio-visual technology). Whilst these are undoubtedly non-recurring revenue streams, the scale and diversity of ultimate customers, coupled with secular growth drivers (conversion from cash to card for Visa, or penetration of online hotel bookings for Booking, etc.) make these relatively less volatile and easier to predict over time than non-recurring transactional revenues.
The positioning of American Franchise reflects our long-standing preference for recurring revenue models. More than 60% of the portfolio’s revenue is recurring in nature, with highest-quality subscriptions accounting for more than a third. Whilst it is difficult to replicate our bottom-up revenue analysis at an index level, we are confident that American Franchise has much higher exposure to recurring revenues than the S&P 500. To this point, the S&P 500’s economic exposure to cyclical sectors and industries is approximately 57%, a metric which likely understates the proportion of non-recurring transactional revenues. Whilst the long-awaited, much-prophesized US recession has not yet materialised, we believe our focus on revenue quality, and the resulting composition of the portfolio, positions us well should material economic weakness ultimately emerge.
Figure 4: American Franchise portfolio revenue breakdown
Source: Ninety One, as at 31 October 2023. The portfolio may change significantly over a short period of time.
As the chart above shows, about a quarter of the portfolio is exposed to nonrecurring transactional models. Whilst generally an inferior model, in our view, there are some high-quality companies in this category, which can have other attractive, compensating features. We pay particularly close attention to a company’s market position and secular growth outlook. Texas Instruments, for example, falls into this category. As makers of analog semiconductor chips – used in everything from cars to fridges to smartwatches – their business has natural economic sensitivity. Offsetting this, though, is the sheer diversity of their business: Texas sells more than 80,000 different products to thousands of individual end customers. Tellingly, 50% of revenue is derived from products that are more than a decade old, which illustrates the durability of its franchise.
1 Other forces are often at play, for example the company might be benefitting from a supernormal product cycle which boosts demand.
2 Subscription businesses recognise revenues rateably through the year, but often collect subscription dues from customers upfront, resulting in structurally superior cash generation.
3 No representation is being made that any investment will or is likely to achieve profits or losses similar to those achieved in the past, or that significant losses will be avoided.
General risks. The value of investments, and any income generated from them, can fall as well as rise. Where charges are taken from capital, this may constrain future growth. Past performance is not a reliable indicator of future results. If any currency differs from the investor’s home currency, returns may increase or decrease as a result of currency fluctuations. Investment objectives and performance targets are subject to change and may not necessarily be achieved, losses may be made. Environmental, social or governance related risk events or factors, if they occur, could cause a negative impact on the value of investments.
Specific risks. Geographic/Sector: Investments may be primarily concentrated in specific countries, geographical regions and/or industry sectors. This may mean that the resulting value may decrease whilst portfolios more broadly invested might grow. Equity investment: The value of equities (e.g. shares) and equity-related investments may vary according to company profits and future prospects as well as more general market factors. In the event of a company default (e.g. insolvency), the owners of their equity rank last in terms of any financial payment from that company. Concentrated portfolio: The portfolio invests in a relatively small number of individual holdings. This may mean wider fluctuations in value than more broadly invested portfolios.