All Revenue is Not Created Equal #140
Reflecting on a few interesting reads and listens over the past week
All Revenue is Not Created Equal #140
This thread by Bill Gurley has been making rounds on the internet as tech companies continue to take a beating in the public markets.
Investors who were able to benefit from the bull run over the past several years will need to pay more attention to revenue and earning quality.
Gurley's post from 2011 is a great read on the key factors that you should be looking into when valuing a company from an investment perspective. He explains how there are very few companies that truly warrant a 10x+ revenue valuation; an idea that many of us can consider laughable when looking at the valuations of companies that sold/raised money over the past couple of years.
Here are the characteristics that Bill uses to differentiate high vs. low revenue quality businesses.
Sustainable Competitive Advantage
How easy is it for someone else to provide the same product or service that you provide?
"If high price/revenue multiple companies have wide moats or strong barriers to entry, then the opposite is also true. Companies with little to no competitive advantage, or companies with relatively low barriers to entry, will struggle to maintain above-average price/revenue multiples."
This will likely be demonstrated over the next 12-18 months via pricing power. Companies with a legitimate advantage won't be concerned about keeping customers while operating in an inflationary environment.
Presence of Network Effects
In a system where the value to the incremental customer is a direct function of the customers already in the system, you have a powerful dynamic that tips towards winner take all.
Unfortunately, the term 'network effects' gets thrown quite freely these days. The ability to scale needs to come from the customer in order to be considered a 'network effect' - otherwise you're simply scaling.
Visibility/Predictability
Investors favor pricing models that provide a high level of predictability and consistency in the future.
Given the value associated with recurring revenue, there's a tendency for companies to pitch their business as having 'recurring-like' revenue (e.g. re-occurring). It's important to go a layer deeper and understand whether there's true predictability in revenue streams or the appearance of predictability.
Customer Lock-in / High Switching Costs
If investors value predictability, then retaining customers for long periods of time is obviously a positive. Conversely, if customers are churning away from your company, this is a huge negative. This, to me, goes hand in hand with having a sustainable competitive advantage.
Gross Margin Levels
There is a huge difference between companies with high gross margins and those with lower gross margins. Tying into the next point, the goal is to make each additional revenue dollar as valuable as possible.
Marginal Profitability Calculation
Investors love companies with scale. In order to measure how a business is scaling, many investors look at marginal incremental profitability. This can be done on a quarter-over-quarter basis, or a year-over-year basis. Simply look at the change in revenue versus the change in costs, and then calculate the incremental operating margin of the two results.
Customer Concentration
All things being equal, you would rather have a highly fragmented customer base versus a highly concentrated one. Customers that represent a large percentage of your revenue have “market power” that is likely to result in pricing, feature, or service demands over time.
Major Partner Dependencies
Investors will discount the price/revenue valuation of any company that is heavily dependent on another partner is some way or form.
Organic Demand vs. Heavy Market Spend
All things being equal, a heavy reliance on marketing spend will hurt your valuation multiple. It's interesting how Gurley uses Netflix as an example that is able to execute despite a heavy marketing spend - while it helped Netflix scale quite quickly, we've recently seen that the model wasn't necessarily sustainable.
I found this excerpt from Bezos/Amazon to be quite telling as well.
"For a period of time, Jeff Bezos was a heavy investor in marketing, but after a while he retrenched. “About three years ago we stopped doing television advertising. We did a 15-month-long test of TV advertising. And it worked, but not as much as the kind of price elasticity we knew we could get from taking those ad dollars and giving them back to consumers,” said Bezos. “More and more money will go into making a great customer experience, and less will go into shouting about the service. Word of mouth is becoming more powerful. If you offer a great service, people find out.”
Growth
It's quite natural to believe that higher growth = higher valuation. However, until recently, there's been less attention paid to whether it was profitable growth. Gurley explains a few scenarios where growth can be misleading:
"While growth is quite important, and even though we are in a market where growth is in particularly high demand, growth all by itself can be misleading. Here is the problem. Growth that can never translate into long-term positive cash flow will have a negative impact on a DCF model, not a positive one. This is known as profitless prosperity.
There is another situation where growth can be misleading. If a company stumbles on to a hot new market, but lacks “barriers to entry” or does not have a sustainable competitive advantage, there will eventually be trouble. In fact, the very success of the first company in the field will act as a siren inviting others into the market, which, in the absence of a competitive advantage, will lead to margin erosion."