Wanna Reduce Risk?  Invest In Recurring Revenue

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Includes: ABT, BVNXF, DHR, EGOV, GGG, RHHBF, RHHBY, SICRF, SICRY, SIEGY, SMAWF
by: Steven Chen
Summary

Minimizing losses is more important than maximizing gains.

Businesses generating recurring revenue produce less risk to owners.

Four stocks from different areas with recurring revenue are discussed in detail.

Source: Pixabay.com.

Background

For value/quality-focused investors like us, minimizing losses is more important than maximizing gains. Consider the following for example: to compensate for a 10% loss, you would need an 11% return; and for a 50% down in your portfolio, you would need a 100% return to bring the total value back to the original level. It is just difficult and/or takes time for investors to make up for incurred losses, which should be prevented as many as possible.

Source: Capital Alligator.

Then it comes to the question of how we find stocks with the business economic producing less risk (i.e., uncertainties) to owners. One dimension of the answer lies in the business model - I prefer to own businesses generating recurring revenue due to the following characteristics:

  • Reliability: recurring revenue is generally stable over time thanks to the switching cost of the installed base in particular (one source of the moat);
  • Predictability: outsiders (e.g., financial investors) could, with a higher degree of certainty, estimate the volume of recurring revenue than of one-off sales;
  • Cost-effectiveness: recurring revenue is usually high-margin, positively impacting the bottom-line and leading to cost advantage (another source of the moat);
  • Customer Value: because of the above 3, the recurring revenue model would increase the lifetime value of the customer acquired by the business.

Below are some examples of businesses generating recurring revenue with consistently superior profitability and capital efficiency.

NIC Inc. (EGOV)

NIC Inc. is the leading provider of digital government services that help governments use technology to provide a higher level of service to businesses and citizens and increase efficiencies.

Source: Govloop.com.

NIC takes a flexible approach to funding digital government solutions. Most enterprise partnerships are funded through a transaction-based funding model, which saves taxpayers' money on upfront development cost and generates recurring revenue later on whenever users enjoy efficiency through digital/online services provided by NIC (e.g., renewing vehicle registration, purchasing national park tickets) - just like a transaction commission.

As shown below, the recurring portion of the total sales to state enterprise clients is over 95% recently.

Source: Investor Presentation, Q2 2019.

Such recurring transactions are well protected by the long-term contract, high switch cost, B2G (business-to-government) relationship and niche-market play by NIC, which, as the result, contributes to the stable and high profitability and returns on capital (see below) over the years.

Source: Morningstar; data as of 5/23/2019.

It is also worth mentioning that the revenue stream is recession-resistant. The company demonstrated the ability to generate highly attractive growth rates through the Great Recession (see below).

Source: Investor Presentation, Q2 2019.

The share seems to trade at a discount to its historical levels (in terms of price multiples below), largely due to the impact of losing the Texas website contract. The long-term prospect of the business should remain strong, supported by the continuous penetration of digital government services with existing states/agencies and acquisition of new state/agency clients. I would recommend a buy rating to those long-term buy-and-hold investors.

Source: Morningstar; data as of 5/23/2019.

SimCorp (OTC:SICRY) (OTC:SICRF)

Publicly listed on the Nasdaq Copenhagen Stock Exchange (under primary ticker SIM), SimCorp is the leading provider of investment management software solutions for the world's leading financial organizations, such as banks, national banks, pension funds, and insurance companies.

Source: Amarketresearchreport.com.

The company's strength lies in the fact that its modules can handle virtually any task that is relevant to an investment manager. While the first sale (i.e., new licenses) generally only includes a few of these modules, Simcorp can add on more modules (i.e., add-on licenses) as and when the investment manager requires them.

Having that said, if SimCorp purely replied on its license sales, its value would have been 70% less at least. As demonstrated below, around 3/4 of the revenue is coming from aftermarket maintenance and services, which are mostly recurring. Moreover, the recent annual increase of 63% in new license sales should lead to a long-tail positive impact on recurring portions, which are growing at between "only" 8% and 9%, sooner or later.

Source: 2018 Annual Report.

Thanks to the high switching cost of installed software and the recurring revenue model, the business generates consistent growths in the top line with decent margins and superior returns on invested capital (see below).

Source: Morningstar; data as of 5/23/2019.

As a matter of fact, the annual revenue never decreased for a single year for the past decade at least (see below).

Source: Morningstar; data as of 5/23/2019.

According to GuruFocus below, the share of SimCorp looks pricy at the level no matter what price multiple is referenced. The management forecasts a high-single-digit to a low-double-digit annual increase in sales moving forward, which I believe is doable and even conservative in light of the growth in recurring revenue to pick up as well as potentials in the North America region and integrated solutions in the investment management technology area. However, for the share, I would wait till P/FCF drops at least below 40x for more favorable entry points.

Source: GuruFocus; data as of 5/23/2019.

Bioventix (OTC:BVNXF)

Founded in 2003 and based in the UK, Bioventix PLC specializes in the development and commercial supply of high-affinity monoclonal antibodies for applications in clinical diagnostics. Although the science behind that so-called "high-affinity monoclonal antibodies" is a complex one, which most of us should not bother a lot with, the concept of applications here is quite simple: diagnostic companies reply on those antibodies to detect diseases and health status in various domains.

Source: Fool.co.uk.

Regardless of the complicated science behind the products, Bioventix has a simple but powerful business model: licensing the use of antibodies it developed to global healthcare companies, including Danaher (DHR) Siemens (OTCPK:OTCPK:SIEGY) (OTCPK:OTCPK:SMAWF), Abbott (ABT), and Roche (OTCQX:OTCQX:RHHBY) (OTCQX:OTCQX:RHHBF), in exchange for royalty payments, which are recurring. As more patients take the test and more of the Bioventix antibody is consumed, the business earns more money.

Source: Bioventix Presentation, April 2019.

The antibody products (see above) launched for the past few years help the company generate double-digit annual growths in sales, which are expected to last for at least some while.

Source: Morningstar; data as of 5/23/2019.

Benefiting from a high switching cost of the diagnostic machines, which require a huge number of resources to develop and obtain regulatory approval for, the recurring revenue in place would not get competed away easily, and most of it would fall directly into the bottom line without costing Bioventix a dime on aftermarket operations.

We know that the demand for clinical diagnostics should not be affected by the economic cycle and would be driven by the tailwind coming from the aging population. So technically, Bioventix spends equity capital (and some customers' money as well) on the R&D to, upon successful product launches, provide risk-less "bonds" with rising coupon payments (i.e., royalties) for the shareholders for free. The pipeline in development as of 2018 is shown below. Source: Bioventix Presentation, April 2019.

With the powerful recurring revenue model with a moat in a growing industry, there should be no surprise that we see the stable and high returns on capital at the company (see below).

Source: Morningstar; data as of 5/23/2019.

Shares of Bioventix do not appear cheap, with all TTM price multiples hitting near all-time highs (see below).

Source: GuruFocus; data as of 5/23/2019.

However, in consideration of the profitability and efficiency driven by the recurring revenue model with reinvestment opportunities (i.e., the R&D pipeline) and durable competitive advantage that Bioventix can offer, I would regard the stock as a low-risk investment (unlike most of the other names in the biotech space). In such a case, I would take the risk of buying the stock that could earn me at least 3% on FCF (well above the 10-year treasury yield) while waiting for any upside arising from the international expansion (e.g., in China), more existing antibody applications and/or any new product coming out of the pipeline.

For a more detailed analysis of Bioventix, please see my previous article - Bioventix: A Low-Risk Biotech Franchise Business.

Graco (GGG)

Based in Minneapolis, Minnesota, Graco is an American manufacturer of fluid handling systems and products for painting, anti-corrosion, fluid transfer, gluing and sanitary applications for markets like automotive, aeronautic, body refinish, wood, building, and construction. The company distributes through a global network of equipment dealers and retail stores.

Image result for graco fluid handling

Source: Graco.com.

Graco is a niche market player providing premium equipment to solve the difficulties of handling a wide variety of materials with viscous, abrasive and corrosive properties that may require precise ratio control for a broad number of end markets.

This product-driven business does generate some recurring incomes. Approximately 40% of total sales are coming from the aftermarket, as quality-conscious customers keep coming back to Graco for parts and accessories for the products they purchased in the first place. The returns on capital, with no doubt, have been consistently high (see below), except for a drop in 2016 due to the non-cash impairment charges regarding its Oil and Natural Gas reporting unit.

Source: Morningstar; data as of 5/23/2019.

One thing different here from the above three companies is that even with the help of recurring revenue, the business overall is not recession-proof, demonstrated by a double-digit decline in top line in 2009 (see below) due to the highly cyclical nature of the industry.

Source: Morningstar; data as of 5/23/2019.

Below was the reply from Mark Sheahan, Chief Financial Officer & Treasurer, when I asked about the risk coming from the next recession -

We have the same business model that was in place during the last recession and I see no reason why things would be materially better or worse if we went through a similar period today. We manage the business for the long term so there would not be any big changes in our resource commitments. Decremental margins in our business are pretty ugly when revenues decline.

Moving forward, the management set a growth target of 12% with a clear plan (see below), mainly supported by new products and geographic expansion. I would think that this figure is rather a bit conservative, given that the above-average R&D spending (i.e., 4.3% of sales vs. peer average at 1.6%) could generate more recurring revenue in the medium-to-long term. Plus, the company earns its good reputation for the quality of its products - a source of the moat to protect the recurring sales.

Source: Investor Presentation, Q1 2019.

Assuming a low- to mid-teens growth rate, I think the share is fairly valued, especially if we compare the price multiples below to their respective historical averages as well as industry and market averages. So far I like the management with a customer focus and long-term thinking. However, for those who believe that we are at the late stage of the economic cycle, a more favorable entry point may lie ahead.

Source: Morningstar; data as of 5/23/2019.

Summary

Recurring revenue model could mitigate business risks (e.g., future sales uncertainty and volatility). Such businesses, as a result, are good candidates for those long-term buy-and-hold investors who would like to reduce equity risks (without sacrificing long-term returns of course).

In this article, we covered 4 businesses demonstrating the power of recurring revenue in 4 different industries - government service, financial technology, health care, and industrials. As always, while I think that they are good candidates of high-quality businesses to outperform in the long run, investors should always conduct careful analysis and patiently wait for favorable entry points before investing.

What is your favorite business generating recurring revenue? Feel free to comment below.

Disclosure: I am/we are long EGOV. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.