Tales of the Economic Hydra

Lots of companies boast that a big slice of their revenue is recurring, and with good reason. Just like a steady paycheck speaks to most workers, steady profits speak to most long-term investors.

Where things get slippery is that the definition of “recurring” is very open to interpretation. A grocer and an enterprise software company both might tout recurring revenue, for example, even though the quality and value of those customer bases is very different.

A grocer might lose a customer over a rival’s Vegemite coupon while an embedded piece of enterprise software might cost a customer millions of dollars to strip out and replace. Changing grocers is like changing shampoo. Changing databases is like getting a liver transplant.

Little wonder that the world’s largest retailer, Walmart, has a net profit margin of only 2.8% while the world’s largest pure enterprise software company, Oracle, registers at 23.8%.

I have a strong affinity for businesses whose products and services are as vital as organs to their customers. They tend to have high margins and are very difficult to displace, both because of the value to their individual customers and the ecosystems that encircle them.

Most such sticky businesses have strong pricing power and choose to flex on their customers, sometimes with annual price increases at or even above inflation. The wiser players, though, don’t overplay their hands and risk disruption. Instead, they underprice relative to what they could squeeze from their customers in order to better cross-sell other services, winning more wallet share in the process, deepening the relationship, and better ensuring their role in the ecosystem.

Here’s where the nuance kicks in, and it’s the nerdy part I enjoy most. It doesn’t take much effort to understand a company’s margins, however, the other crucial driver of lifetime customer value – average customer life – tends to get either overlooked or just plain misunderstood by most investors. Here’s how it breaks down, and where I tend to think a significant, consistent variant perception hides in markets for long-term investors.

Let’s say we’re looking at two companies, Spacely Sprockets Services and Cogswell Cogs Catalogues. Spacely has a very loyal base of small- and medium-sized enterprise customers and retains an outstanding 85% of them year to year. Meanwhile, let’s say that Cogswell retains 90% of its base of large enterprise customers.

The difference between annual retention of 85% and 90% looks trivial at first blush but the economic difference is enormous. The average customer life of Cogswell and its 90% annual retention rate amounts to 10 years – 50% longer than the average customer life of Spacely and its 85% retention.

Few companies have such loyal customers, however, the ones that do tend not to make a secret of their success. For example, hiding in plain sight in the WiseTech Global prospectus was the factoid that the company’s 10 largest customers by revenue had been with the company for an average of more than 10 years.

Such a loyal customer base has allowed WiseTech to deepen its relationships even further by rolling out new, related tools for its customers over time, not unlike a smaller-scale version of Amazon.com’s progression from selling to books to CDs to DVDs and beyond.

Remarkably, WiseTech actually has negative churn on a revenue basis for customers of its flagship product, CargoWise One, which is a fancy way of saying that sales growth per customer is more than offsetting customer losses from the same vintage. It’s a bit of an economic hydra: For every head that gets chopped off a new, slightly larger one grows in its place.

Again, not many customers can lay claim to hard-and-fast recurring revenue dynamics, and fewer still can lay claim to average customer lives of 5 years, let alone 10. The ones that do jump to the top of this long-term investor’s watch list, though, and if nothing else make for illuminating historical case studies. You know, if you’re into that kind of thing…

Joe Magyer owns shares of Amazon.com. The Lakehouse Small Companies Fund owns shares of WiseTech Global. This report contains general financial product advice only under AFSL 400691. All of the commentary, statements of opinion and recommendations contain only general advice and have not taken into account your personal circumstances. 

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