OLD ARTICLE – Original posted on May 6, 2015
Analysts love to reference the quality of a business’s revenue streams, but what exactly is this “quality”? How does one find “quality” revenue streams?
Let me give you a fictitious scenario of Company A and Company B. Both companies are equal in every financial respect, for example, they have the same revenue figure, same margins, same cost, same profits, same balance sheet, same debt and same profitability, solvency and liquidity ratios.
In fact, Company A and Company B both produce the same product (Product X).
The only exception is that Company A and Company B have different business models based on Product X…
Company A sells Product X in large, lumpy, once-off contracts to a few major clients in deliveries of billions of units. On the other hand, Company B sells Product X as single units to billions of small customers on a contract basis.
Which company is better?
Essentially, the only difference between the two companies is how their revenue is constructed. This forces us to decide on either Company A or Company B based on which one has higher quality revenue streams.
Company A’s revenue is generated by selling Product X to a few select customers in large bulk orders. The pro’s of this is that Company A has less need for complex debtors and sales administration and might save some costs here. The con’s are much longer, though:
- The loss of single customer has a much larger affect on Company A’s profitability.
- The customers are all large customers of Company A and therefore will likely know that they have buying power and, over time, try to squeeze Company A for margin with a lower and lower sales price (or less and less price increases).
- Large customers often have special payment terms, which can lead to worse working capital as they customers push out their payment terms (legally or simply ad hoc), while the failure or bad debt from one of these customers will have a much larger negative affect on Company A.
- Finally, these are all sales based on once-off contracts, therefore Company B has no guarantee that a large customer will ever order again from them.
On the other hand, Company B’s sells Product X to billions of smaller customers that order single units on a subscription basis will have to have a very sophisticated sales and debtors system that may cost it plenty of time, money and resources. But, once this is in place, there are lots of benefits:
- The loss of a single customer has almost no affect on Company B’s sales and the loss of absolutely all its customers is far less probable.
- Because the loss of a single customer has immaterial impact on Company B, it’s customers have no buying power with it and cannot realistically demand discounts or squeeze the Company’s margins over time.
- Small customers are price takers, which includes the above points as well as payments terms that tend to be shorter (if not cash!) that improve Company B’s working capital.
- Finally, as these billions of units are held on a subscription basis, this means that once the unit is sold, steady revenue is coming in each month or year (or whatever time period the subscription runs for). I.e. One sales, many revenues.
Intuitively, I hope you can see that Company B has far superior quality revenue to Company A.
Selling units on subscriptions? Surely this is a bad example?
Well, I am using an extreme example to prove my point, but this particular example does in fact exist: Mix Telematics (MIX) and Cartrack (CTK) versus (old) Digicore (DGC).
Digicore originally made most of its revenues selling its telematics units, while Mix Telematics and Cartrack both focussed on selling telematics subscription services. Digicore has subsequently seen the error in its ways and begun to focus on building its subscription base.
Any way, that history lesson aside, I hope you take note of the key characteristics that make a revenue stream “high quality”:
- Fragmented with no concentration risk,
- Structured with reoccurring or annuity-like characteristics, and
- Built with pricing power in mind.