How do you measure the “growth” of a supposed “high growth” company? And why does it matter if its “recurring revenue”?
The fundamentals…
On Feb 12, ironically the high mark of the portfolio year to date, I summarized the 20 fundamental metrics I typically utilize to analyze the stability, performance and excellence of a high growth company that I may choose to invest in. Today I will focus on just the first two most basic, but critical, metrics that I usually look at first:
- Rapid Revenue Growth (Q/Q & Y/Y): Greater than 35% and/or accelerating
- ARR – Annual Recurring Revenue Model (usually subscription based)
But first, I need to cover one small topic: Unfortunately, upon hearing the words “financial statements” many people’s eyes immediately glaze over, they put their hands over their ears, and start yelling “nah, nah, nah, nah, NAH!!”.
The financial statements, however, are the language of every company’s results. If you go to Germany and expect to go to school, work or thrive, you must learn at least basic German. Similarly, if you want to manage, invest in, or understand a company, you must first understand the basic language of business. The financial statements are that language and, luckily, they are a heck of a LOT easier and faster to learn than German…indeed they are even in English. The financial statements are really quite straight-forward and they are uniform (the same) in nature across the world, allowing us to compare many different styles and types of companies to one another, against similar uniform metrics, and to tell us whether the company is a strong thriving company…or not.
If you don’t know anything about the financial statement at all, I would like to share with you three basic tenets; principles that will put you far ahead of 99.9% of other people in the US and in the world (if you already know how to read financial statements, feel free to skip this section):
- There are only three (3) financial statements to track the performance of every public company. Quite simply, they are the:
- Income Statement (also called the P&L or Profit & Loss statement),
- Balance Sheet
- Cash Flow Statement
- Each of the above statements have exactly three (3) main parts (or sections) and tell us the following:
- Income Statement (or P&L for “Profit & Loss”) show us how much a company makes (or loses) from selling their products in a given period. It is broken into just three parts:
- Revenue (minus)
- Expenses (equals)
- Profit or Loss
- The Balance Sheet shows what the company owns vs what they owe and stretches over the entire life of a company (vs a specific period).
- Assets
- Liabilities
- Equity
- Cash Flow Statement shows cash generated during a period from:
- Operations
- Investing
- Financing
- Income Statement (or P&L for “Profit & Loss”) show us how much a company makes (or loses) from selling their products in a given period. It is broken into just three parts:
- Finally, without understanding any details of a company, its product or service, one can review the financials (and often just a few parts of the first two statements) in a relatively short period and determine enough to know whether to delve deeper, whether to even consider investing in it…or whether to run away as quickly as possible!! Don’t forget the following!
“If you think you can, or you think you can’t — you’re right!” -Henry Ford
Both of my children can tell you the above basics of financial statements and have been able to do so since the age of 12. I sincerely wish I had known about them at that age. Both of them will study whatever they want in college, but as long as I am financing their education, they are also required in the first year to take at least one accounting class, one finance class (stocks, bonds, compounding, interest…the basics) and one real estate class. Whether you are an artist, a nuclear engineer, a fireman, an lawyer, or a teacher, you owe it to yourself to understand the language of money. Whether we like it or not, we all live in a world that revolves around money on a daily basis. Money matters and even if you want to “swear it off” the reality is that having it simplifies a lot of other things and allows us to have the experiences we desire and to embrace the very freedoms that are advocated and promised in our rich history.
I was not fortunate to have a financial education at a young age. Growing up poor, I was not exposed to even the most basic of lessons that the affluent and rich expose their children to through the shear osmosis of nightly dinner conversations and daily actions surrounding money. And I admit that is difficult WITHOUT money. But an ostrich sticking his head in the sand is neither facing reality, nor doing itself any favors. Likely it is making it even easier to be eaten by the lions! Do yourself the lifelong favor of learning the three financial statements listed above. It will likely make the difference between struggling financially your entire life…or else building wealth over time and creating the opportunities to allow yourself to live the life and have the experiences you dreamt about as a child. And no, it is never too late.
Now, what about the original purpose of this blog, the first 2 of 20 fundamental metrics of analyzing a company and its performance:
- Rapid Revenue Growth (Q/Q & Y/Y); greater than 35% & accelerating
- ARR – Annual Recurring Revenue Model (usually subscription based)
Revenue is the money received in exchange for a product or service that a company sells to a customer.
“Annual Recurring Revenue” is revenue from the same customer that recurs year after year without the need by the company to go out and sell the product or service again. The difference between these two is simple…the latter is “recurring”. The former is NOT.
Typically, Recurring Revenue is the result of a multi-year contract between the company and customer in which the customer has agreed to purchase the product or service over several or more years. It is very important to understand that this is very different from a company that has to find new customers to sell their product or service to every year in order to keep growing. A quick example:
Company A sells a widget (whether product or service) to 100 new customers in year one. In order to achieve 30% growth in year 2, they must start from scratch in year 2 at zero (0) sold widgets and sell 130 more widgets to 130 new customers. This is non-recurring revenue.
Company B sells 100 widgets (whether product or service) along with a multi-year contract to provide those customers the same widgets or service over the next 2-5 years at the same or increasing prices. At the end of year one, the company has sold the same 100 widgets, but have contracts in place such that at the beginning of year 2, they start off already having sold 100 widgets to the same customers from year 1 (contractually) and they must then only sell 30 more widgets to new customers to attain the 30% growth in our example. Each year, they start where they left off the previous year, rather than going back to zero. This is “recurring revenue” and is exponentially more valuable over time than “non-recurring revenue”.
Every viable business has revenue (or else the IRS calls it a “hobby” and quickly disallows it). BUT, every business is not necessarily growing…and MOST businesses do not have recurring revenues and are not growing rapidly. If you want the stock price to increase, it must reflect the underlying fundamentals of a company that is growing…the faster, the better. I admit when I was learning finance and accounting in the 90’s, we were lucky to find companies that grew 15-25% per year over several years. Now with companies who produce monthly subscriptions to software, magazines, digital storage space, or a plethora of other products and services sold in multiyear contracts and paid annually, it is not uncommon to find companies in their early years regularly achieving 60-100% growth each year…doubling…and then doubling again. When you find these companies, they are rare and you should pay attention and research them further.
- Rapid Revenue Growth (Q/Q & Y/Y); greater than 35% & accelerating
I compare a company’s most recent quarterly revenue results to the same quarter one year prior. This allows one to compare apples to apples (you don’t for example want to compare the fast growing Summer quarter to the slower growing winter quarter, if seasonality varies significantly). If the revenue growth exceeds 35%, then the company is worth at least investigating further. If it does not, I usually stop looking at it unless I see it is moving in the right direction over several quarters. If it does already exceed 35%, I then look at the prior quarters to see how many quarters has it exceeded 35% and has it increased or decreased compared to prior quarter’s revenue “growth” (i.e. percentage). I want a company that has gone quarter to quarter from 20%, 25%, 30%, 35% to 40% growth in the latest quarter. To be clear, we are not talking about dollars. We are talking about percentage growth. And obviously, I do NOT want a company that started at 40% growth 4 quarters ago and is dropping to 35%, 30% 25% in the latest quarter. The former is accelerating growth. The latter is decelerating growth…slowing down. The stock price will eventually follow the fundamental performance over time.
2) ARR – Annual Recurring Revenue Model (usually subscription based).
The company usually MUST have an annual recurring revenue model. That is to say, they must be able to sell the same product/service over and over again to the same customers the following year. In June 2000, as VP of finance, we built one of the first cloud companies around this model with a company called Corio that hosted software; we filed the S-1 and took them public in the dot.com era. It represented both of the above fundamental requirements and is the reason I have focused on similar software, hosting, service or platform companies that sell multiyear contracts and have recurring revenue. Similarly, to touch on one other metric of the 20 fundamentals, typically these Software-as-a-Service (SaaS) companies have extremely high gross margins (sometimes netting 90% for every dollar) also and they are subscription based, meaning quite simply, the customer signs up to pay for the product or service on an annual recurring basis and usually over multiple years; without any need for additional sales or marketing costs to find a new customer, set up costs to get them running, etc. They become a locked in and ongoing customer, often for many years if the company continues to provide a great product or service.
The companies in which I have the absolute highest conviction (and corresponding highest amount invested and largest percentage of my overall portfolio) are those companies whose quarter over quarter (q/q) and year over year (y/y) percentage % growth is either growing the fastest in any one quarter (compared to my other high growth companies), or in which it is accelerating from prior quarter to more recent quarter, or both when possible!!
My highest conviction holding currently is a stalwart cyber security company that no other company seems to be able to match pace with the past 4 quarters. Crowdstrike’s (CRWD) customers sign multi-year contracts for CRWD to protect their data from security breaches. Following are its revenues in millions and % growth compared to the prior years same quarter (q/q). It is worth saying that companies with this many quarters of growth at this rate are extremely rare…likely 1 in 1,000 (given there are only about 4,000 public companies in the US)
| CRWD | ||
| Q3 2020 | 125.1 | 88.5% |
| Q4 2020 | 152.1 | 89.1% |
| Q1 2021 | 178.1 | 85.3% |
| Q2 2021 | 199.0 | 84.0% |
| Q3 2021 | 232.5 | 85.8% |
Conversely, one of the best example of a company “accelerating” in growth from quarter to quarter and which you will no doubt recognize (and probably use yourself these days) is Zoom (ZM), which is also why the stock price skyrocketed in 2020. Note that the bottom number of the table is the “estimate” or guide that ZM management gave for the next quarter…coming up . Needless to say, it represents a huge drop in growth and is a major reason that I sold half of my position in ZM and am now watching it closely. The other reason is that going forward, the revenue comparisons against prior quarters results (which have been absolutely unbelievable the past three quarters during Covid-19) are extremely hard “comps” or comparisons that will inevitably reflect a slow down. How could they not? Much of this is now being reflected in the stock price which has fallen recently far below its all time high of $588 and all the way down to $350 today. Zoom has shown phenomenal fundamental revenue growth, though…I would be elated to find another company able to repeat this feat!!
| ZM | ||
| Q2 2020 | 145.8 | 95.7% |
| Q3 2020 | 166.6 | 84.9% |
| Q4 2020 | 188.3 | 77.9% |
| Q1 2021 | 328.2 | 169.0% |
| Q2 2021 | 663.5 | 355.0% |
| Q3 2021 | 777.2 | 366.5% |
| Q4 2021 | 882.5 | 368.8% |
| Estimated (Guidance) | 905 | 175.8% |
