Recurring Revenue Models and Predictable GrowthSubmitted by Stone Run Capital, LLC on July 31st, 2019
Recurring Revenue Models and Predictable Growth
Equity investors prize companies with sustainable growth and predictability. These companies tend to be awarded the highest earnings multiples and valuations. While the best companies have both high and predictable growth rates, high growth is usually accompanied by the high risk of disappointment. Many investors happily exchange at least some growth for predictability. In Stone Run Capital Partners, we seek to manage the latter risk by identifying companies with moderate yet sustainable growth built within highly defensible competitive moats. Further, these companies tend to have a recurring revenue model, which means a company sells products or services that are consumed or utilized in the course of a customer’s ongoing business activity. The customer repurchases the product or service on a regular recurring basis, often through multi-year contracts.
In the following essay, we review the attributes that empower a business to enjoy recurring revenues. We highlight five such companies owned by Stone Run Capital Partners. In total they comprise about 15% of Stone Run Capital Partners equity exposure. To begin, we compare two model companies. Company A is an example of a company that sells capital equipment and is more subject to a boom and bust cycle. Company B is an example of a business with a recurring revenue model and with steadier more predictable growth.
• Our example starts with both companies ending year 1 with $100 in revenues.
• Company A grows rapidly in year 2 and year 3, 20% and 15%, respectively. Its revenues then contract in year 4 and year 5, down 25% and down 5%, respectively—perhaps due to a recession. Company A’s revenues then bounce back strongly in year 6 at 15%. Through this roller coaster, Company A revenues end up at $113—a compound growth rate of 2.5%.
• Company B grows more modestly in year 2 and year 3—at 6% each year. With the same recession impacting years 4 and 5, Company B’s revenues grow at a 2% rate each year. Company B’s revenues then return to a 6% growth rate in year 6. Throughout this steadier progression, Company B revenues total $124 at the end of 6 years—a compound growth rate of 4.4%.
Businesses like company A can compound their results year after year, building considerable business value over time. Stone Run Capital Partners has less exposure to companies where a large portion of revenues are tied to major one-time capital investments by customers—a business model which often leads to the classic boom and bust cycle. While the stock market experiences bull and bear cycles, we strive to invest your capital in businesses that build value throughout the economic cycle—not just during the bull cycle. Through the power of steady compounding—and despite the much higher growth rates for Company A in years 2, 3, and 6—Company B ends with revenues 24% higher than year 1 versus Company A, which ends with revenues only 13% higher than year 1. While company fundamentals do not always translate to stock price performance in the short term, a company’s above-average revenue and earnings growth do ultimately lead to a premium valuation over a multi-year period. Also important in the selection of more predictable and sustainable business enterprises is avoidance of customer concentration. In instances where one customer may represent a large portion of the business, a decision by this customer to go with a competitor will wreak havoc.
We now review five companies owned by Stone Run Capital Partners. These are all long-term investments and companies with strong recurring revenue models or predictable growth. While all companies have some sensitivity to the business cycle, our research on these companies has shown their revenues to be predictable and sustainable. These attributes are likely to continue into the future.
More limited cyclicality enhances the opportunity for an enterprise to compound cash flow and builds confidence for management to be prudently aggressive in investing back into the business. Stock prices may go through boom and bust cycles, but companies with recurring revenue models are more likely to build value incrementally, year in and year out. We are committed to the long-term business investment horizon as long as our conviction in the long-term investment opportunity continues. Table V lists the following data for each of the five listed companies: the total enterprise value, recurring revenues as a percentage of the company’s total revenues, the recurring revenues in dollars, and the EBITDA margin—a good profit margin metric for assessing the profitability of a business. The five companies have an average EBITDA margin of 27% versus an average EBITDA margin of 20% for the S&P 500.
Ecolab (ECL) tops the list with recurring revenues representing 90% of its $14 billion in total revenues. Ecolab is the global leader in water, hygiene, and energy technologies and services that protect people and vital resources. Their millions of customers use their products on a daily basis to promote safe food, maintain clean environments, optimize water and energy use, and improve operational efficiencies. Ecolab’s customers span hospitality—restaurants and hotels—hospitals, food processing, and a diverse array of industrial facilities. Consumable products used in the process of enabling hygiene and process efficiency make up the vast majority of Ecolab’s sales, and customers reorder the blend of chemistries and services on a weekly, monthly, or quarterly basis. At heart, Ecolab is a chemical company and it layers services on top of this platform, making it vitally important to its customers. While Ecolab’s products and services are a small part of its customers’ cost to operate, it ensures customers’ ability to operate effectively and protect their brand equity. Ecolab therefore impacts a large part of a company’s profit profile. A strong example of Ecolab’s resilience as a recurring revenue model business is performance in 2009. Overall sales were flat, as compared to a decline of over 12% for the average S&P 500 company during that time. While there was a 3% decrease in volume, Ecolab offset that decline with a 3% increase in prices. The company’s ability to initiate a 3% price increase in the midst of the Great Recession demonstrates just how important Ecolab products are to its customers.
Kraft Heinz, the fifth largest food and beverage company in the world, utilizes Ecolab’s products and services across its hundreds of food processing facilities. Food safety is paramount, so it is crucial to Kraft Heinz to ensure hygiene and bacteria prevention. In the past year, Kraft Heinz managers worked with Ecolab’s food experts to utilize 3D TRASAR™ Clean-in-Place (CIP) Technology to oversee a number of systems at food processing and packaging facilities. The technology continuously monitors the controls that track the plant’s cleaning and sanitizing performance and sends data to on-site managers, which use the information to take corrective actions as needed. Use of 3D TRASAR™ has enabled early identification of thousands of potential food safety problems, has reduced energy requirements, and improved productivity. This results in hundreds of thousands of dollars in direct savings, and priceless protection of the Kraft Heinz brand. We see why Ecolab has such a powerful recurring business.
IHS Markit (INFO) is a leading information services company that provides critical information, insight, and support to more than 50,000 customers, including the world's largest corporations and government organizations. The merger between IHS and Markit in 2016 created a global information business with industry-leading data, software, and technology platforms. Our investment in the original IHS goes back to 2007. With over $4 billion in revenues, IHS Markit utilizes an annual subscription model and 84% of these revenues are recurring, which helps generate high free cash flow—at over 25% of revenues, a rate 3-times higher than the average S&P 500 company. IHS Markit’s databases focus on five industries: energy and natural resources, chemicals, transportation, electronics, and financial services. Several thousand staff members in product development create original content. The company also aggregates information from third-party sources. No other company can provide the breadth and depth of information across these areas.
Customers rely on IHS Markit data to inform and make decisions, and they renew the data subscriptions at a 90%+ rate. The recurring subscriptions provide stable and dependable growth in both revenues and free cash flows, which management uses to acquire additional recurring revenue businesses. The business has grown at a 5% organic growth rate since the merger, and we expect roughly this rate over the next several years. A global recession would lead some customers to cancel subscriptions, but revenue growth would be unlikely to decline significantly. The recurring portion of revenues has increased sequentially each year, and we expect this trend to continue. One example of IHS Markit’s extensive and proprietary product set is Jane’s, the leading global open source intelligence agency. With a 120-year history, Jane’s has extensive content covering military platforms and systems, threat intelligence and security, and forecasts and budgets for defense markets. This information is critical for many organizations, and it is one of the last products a customer will cut in difficult economic times. The accompanying diagram exhibits how Jane’s products enable users to drill down into detailed information on terrorism—very few companies can provide data and insight to illustrate the business implications of terrorism. In 2009, IHS revenues were up 3% organically and 15% including acquisitions through the deployment of free cash flow. While the stock may not always be predictable, we look forward to future years of reporting progress in our IHS Markit holding.
Fiserv (FISV) is one of the world’s leading financial technology companies and serves over 12,000 clients worldwide, including banks, credit unions, investment management firms, and leasing & finance companies. Fiserv is now merging with the First Data Corporation (FDC), which is a global leader in payment technology and enables millions of merchants to process approximately 100 billion transactions annually—over 3,000 per second—for over $2.5 trillion in total payment volume. The two companies combined will have over $14 billion in revenues and free cash flow of over $3.5 billion—a 25% free cash flow profit margin. Both businesses have highly recurring revenue models with 80% to 85% of total revenues coming from recurring sources. The merger of the two companies is expected later in 2019. The global trend towards digital payments provides a growth boost to both companies.
Fiserv has two major lines of business: a payments segment and a financial segment. The payments segment enables financial institutions and other companies the ability to process electronic payment transactions. If you have paid a bill online, your transaction has been enabled by a Fiserv product. The financial segment provides software and services that allow financial institutions to run their operations—from processing customer deposits to running an institution’s general ledger accounting system. Both these businesses have contracts with customers of generally three to five years and have high renewal rates—financial institutions depend on Fiserv products to run their businesses. While there are competitive options, switching rates are very low and Fiserv revenues grow with the recurring and growing transactions, and through the cross-selling of additional products and services. Fiserv revenues are tied to the number of accounts in their systems and to the number of transactions occurring in these systems. During the financial crisis, the payments business grew revenues 1%, and financial segment revenues declined 3% due to regional bank closings. Apart from another financial crisis, these two businesses should grow sustainably at 3% to 5% organically, and through continued improving profit margins, drive earnings growth near 10%.
First Data has a #1 market position in two global businesses and a #3 position in a U.S. focused business. First Data’s Global Business Solutions segment is the leader in helping merchants accept and process credit, debit, and prepaid payments. Their system connects the merchant to an array of financial institutions, and First Data revenues are driven by the number of transactions and the dollar amount of the sales volume. In the U.S., First Data processes four out of ten point-of-sale transactions and is a leader in eCommerce where it is a single-source partner for offering scalable solutions to create secure, frictionless, online shopping experiences. Further, an ongoing secular shift away from cash to credit and debit payments increases their transaction volumes. This dynamic is causing digital payment volumes to grow at a high single to low double-digit rate. First Data is also the #1 global technology provider to financial institutions for issuing and processing credit and debit accounts. FDC has over one billion individual accounts in its system. Over 1,300 financial institutions rely on its technology to enable customers to transact. In 2009, First Data’s transactions and processing revenues declined in the low-single digits on a directly comparable basis to 2008, while the business actually grew slightly due to merchant alliance agreements signed with Bank of America and Wells Fargo. While a recession would lead transactions and dollar volumes to decline among individual customers, First Data is growing globally and increasing the number of merchants that use it systems. The more commerce develops in emerging markets, the more merchants will come to use First Data’s products.
Fiserv’s CEO, Jeff Yabuki, will be CEO of the combined corporation. We have met with Mr. Yabuki over the past ten years and have confidence in his ability to integrate the two companies successfully. Management has stated the intention to fund an additional $500 million in innovation investments over the next five years, with the dollars coming from cost synergies. We look forward to seeing how the two companies can leverage their recurring revenue models and build further shareholder value.
Discussion of two food-related companies completes our review of predictable or recurring revenue businesses. With $5.4 billion in 2018 sales, McCormick (MKC) dominates the market for spices, bottled herbs, seasoning mixes, condiments, and other food preparation products. Through its Flavor Solutions segment (38% of sales), it is also a leading innovator and supplier of flavor chemistries to large food manufacturers. Customers range from the largest retailers, like Walmart and Amazon, to the largest packaged food companies, like Pepsi Co. and Coca Cola, to your local grocer or even natural bread baker down the street. Organic growth at the company has averaged 3.8% over the past 11 years (2008-2018). While this rate may not seem superior, its reliability is. In 2009, at the height of the Great Recession (GDP decline of >5%) organic growth was +2.1%, EBIT margins rose 170 bps, EPS rose 17%, and FCF increased nearly 50%—all of this in a year in which many companies’ sales and profitability numbers dropped more than 50%. In recent years, with the company cutting costs faster than inflation, EBIT margins have improved 50 BPS annually and free cash flow has compounded at 10%. This steady and improving profitability is founded on MKC’s vast network of farmers and ingredient purveyors. Impossible to replicate, this supply chain serves as an insurmountable obstacle to upstart competition. It also shields the quality of MKC’s products, the trust consumers render the brand, and the company’s associated pricing power.
While MKC stock is unlikely to triple over the next five years, the company will stand the test of time. Secular trends are favorable. For economic, health, and cultural reasons, younger Americans are eating at home more, and they are also showing a growing desire to experiment with new flavors and recipes. Greater U.S. ethnic diversity has led to accelerating sales of spices and other flavorings. Demand for clean labels and natural ingredients has played to McCormick’s quality proposition, and the company is increasingly taking share in the fast-growing “natural” or “organic” category. Finally, McCormick has 20% exposure to fast growing developing markets, where demand for high quality branded packaged ingredients is accelerating. All of these trends bolster growth in what are inherently recurring sales, built as they are upon the daily consumption by consumers around the world of healthy spices, herbs, ingredients, and flavors.
Figure V: U.S. seasoning and spice market size, by application, 2014 - 2025 (U.S. $ - billions)
With $4 billion in annual sales, International Flavors and Fragrances (IFF) is, after Givaudan (GVDNY), the second largest innovator, manufacturer, and supplier of flavor and fragrance solutions in the world. Like McCormick, its customers include food manufacturers around the globe. In addition, through its fragrances segment, IFF has as its customers the largest producers of cleaning, bathroom, and other household products, as well as the finest perfume manufacturers like Chanel and Hermes. IFF is deeply imbedded in customers’ operations. With 100 innovation centers located strategically around the world, it serves as an outsourced R&D operation. Once IFF chemistries are included in products, removing them is difficult and unlikely. This “stickiness” results in highly recurring revenues, as the company’s chemistries are added to millions and millions of products day after day. Customers reorder the IFF products in order to manufacture their own products—from a Lay’s potato chip to a box of Tide detergent. Like MKC, IFF has a critical supplier network that safeguards quality and performance. Any manufacturer will hesitate to switch out IFF ingredients, for fear of tainting its brand. Not coincidentally, IFF has shown similar financial qualities to MKC. Since 2008, organic growth has averaged 4.2%, and operating margins have risen 50-60 basis points each year, from 14.2% in 2008 to 19-20% in 2016 and 2017. Free cash flow, meanwhile, eclipsed 13% of revenues in 2016. During the Great Recession of 2009, organic growth was flat and then rebounded sharply by 13% in 2010. Meanwhile, EBIT margins improved in 2009, rising 40 BPS to 14.6% from 14.2% in 2008, showing that the company became more profitable during a year in which most companies saw margins plummet. The market for flavor and fragrance ingredients remains robust, with smaller producers and innovators driving a 5% global CAGR. IFF’s year-end 2018 acquisition of Frutarom (FRUT) increased its base from 5,000 to 33,000 customers, giving it access to fast growing consumer product upstarts focused on natural and organic ingredients.
Since stock markets began to peak in March and April—and with worry about a global recession mounting—investors have tended to favor higher quality, moderate growth stocks like MKC and IFF. Since mid-March, MKC shares have risen 14.2%, and IFF shares 16.7% versus the S&P up 6.8%. MKC shares, which have had a strong run over multiple years, now trade at 30-times 2019 expected earnings. While we view the stock as fully valued and have looked to hedge the position and take advantage of near-term trading opportunities, we also believe that holding this predictable, moderate growth company with proven profitability levers is the best way to hedge against uncertainty. Indeed, an argument can be made that consumers will eat at home more and purchase more packaged foods for home consumption during poor economic times, benefitting both of MKC’s segments during even the worst economic periods. Until the recent run, IFF shares were held back by its Frutarom acquisition. Investors have viewed the purchase, at $7.1 billion, as too expensive and filled with integration risk. Although investors are now returning to this high-quality company, there is likely to be continued volatility in the share price as integration hiccups materialize. With the stock trading at a reasonable 22-times 2019 projected EPS, we can be confident that this moderate-growth, but predictable company will, like MKC, stand the test of time.
In conclusion, these five companies are all leaders in their industries, led by capable management teams, and offer differentiated products and services. What we find most distinctive though is the basic business model resulting from customers needing the products and services on a recurring basis. This predictability enables the companies’ management teams to have the confidence to make further investments to push the companies’ leadership position and enable an ongoing virtuous cycle. While predicting the future is impossible, and the stock market can be volatile, we find companies with recurring revenue models to offer strong risk-adjusted investment opportunities over the long term.