One of the most attractive features about a potential investment can be its recurring revenue.
If you can see that a business will retain most of its revenue year after year (and grow with new revenue) then it's easier to get your head around a valuation.
Every business worth investing in creates revenue one way or another. Transurban Group (ASX: TCL) makes revenue from tolls. Sydney Airport Holdings Pty Ltd (ASX: SYD) makes revenue from passengers, car parking and so on. Ramsay Health Care Limited (ASX: RHC) makes revenue from patients. There's not much of their revenue you could describe as reliably recurring, but they're all good businesses.
Banks like Commonwealth Bank of Australia (ASX: CBA) receive monthly repayments from borrowers, but at a very low net interest margin (NIM) and huge balance sheet risk. Real estate investment trusts (REITs) receive monthly rental but usually with the 'cost' of high gearing and slow growth.
But there are some tech businesses that boast of high levels of recurring revenue with high retention rates and high gross profit margins. Three of the names that spring to mind are Xero Limited (ASX: XRO), Volpara Health Technologies Ltd (ASX: VHT) and WiseTech Global Ltd (ASX: WTC).
There are some unsavoury allegations being thrown at WiseTech at the moment, but the revenue from CargoWise One is 99% recurring with a customer attrition rate of below 1%.
Xero's revenue is based on monthly payments made by its subscribers with a gross profit margin of 85.2% as of September 2019.
Volpara's business model is based on annual recurring revenue with the gross margin increasing to 89% in the HY20 result announced this morning.
For any business, a retention rate of 90% suggests the customer base needs to be replaced every 10 years. A retention rate of 80%, which still seems high, means the customer base needs to be replaced every five years.
High gross profit margins means that most of the new revenue falls to the next profit line, like a profit waterfall. Eventually a business reaches a scale where profit grows much faster than revenue, like what we're seeing with businesses like Altium Limited (ASX: ALU) and Pro Medicus Limited (ASX: PME).
There's a lot to like about software as a service (SaaS) businesses.
Foolish takeaway
The difficult part these days is finding these businesses at a good price. If you can identify them early on in their growth journeys then you can be onto a big winner, but if you overpay you could be waiting a long time before seeing capital growth for your portfolio, even if the business is still growing strongly.
