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Recurring revenue counts in industries far beyond software
The recurring revenue (“RR”) business model gets a lot of attention in software M&A and growth investment, and for good reason. Most growing subscription/ software-as-a-service (SaaS)-based software companies trade in the public markets for north of 6x revenue and many of those fortunate few with annual revenue growth over 40% trade for over 10x revenue. The value of the recurring revenue service model in the software industry is indisputable. But what about other industries? Telecom, healthcare, distribution, banking, music and video, even large capital businesses such as jet engines, have all incorporated recurring revenue in their “business-as-a-service” model.
The predictability of revenues and earnings is inherently better in a business with recurring revenues. Subscriptions, razor / razor-blade models, rentals, leases, monthly fees, ongoing maintenance and support contracts, customized consumable products, etc. all drive more predictable revenues than, say, capital equipment sales. The RR business starts each year with a set of returning customers, purchasing a contracted or otherwise predictable level of products or services. These customers return for reasons well beyond mere convenience – they rely on the RR business for their own operations and cannot easily switch to another vendor or service provider, or are contractually obligated to continue with the vendor for a period of time. For virtually all elements of competitive advantage that relate to customers, the recurring revenue business model enhances that advantage, creating more value for the RR business’s shareholders.
Examples of recurring revenue models outside software include:
- contracts for IP phone services,
- healthcare regulatory-driven services and products consumed in GMP environments,
- vendor managed inventory,
- wealth management,
- Spotify and Netflix, and
- GE Aviation’s parts, maintenance, financing and service contracts.
These are all examples of recurring revenue business models applied to industries beyond software.
It’s our experience that businesses incorporating recurring revenue in a significant way can trade for multiples well above those in their respective industries that do not. While the software industry may trade on multiple of revenues, much of the rest of the word focuses on some combination of EBITDA, free cash flow, and growth (and cost of growth). The value from a RR model can be seen in the more modest sales effort necessary to maintain and grow the business, and the better margins that can be achieved for the same level of growth. The company with little in the way of recurring revenue starts each year at $0 and builds from there; 100% of the sales effort is aimed at bringing in new customers and perhaps the first 11 months of the year are spent getting to the same revenues as the prior year, so that the last month generates 8% annual growth. The RR business starts with a base of business. For some of our clients that has meant zero or negative churn – the expansion of returning customers – with a modest sales effort aimed at those clients – more than makes up for any customer attrition. It’s our experience that these companies grow faster with less sales effort, and therefore drive more profit margin, than companies lacking a recurring revenue component. For closely-held companies, this can mean achieving double-digit revenue growth while maintaining 20%+ EBITDA margins, something only about one in sixteen public companies has managed (without acquisitions) in non-tech, non-financial industries this past year.
We welcome talking with companies who have successfully incorporated recurring revenue into their business models.