Wednesday, November 20, 2013

The misleading economic cycle

The macroeconomic cycle has a very predictable impact on most businesses.  Revenue growth slows (or reverses).  Net income drops.  And, of course, valuations move in the same direction.  Not exactly rocket science.

But a curious thing happens in subscription-based information businesses.  While sales may move in the wrong direction, net income often soars.  Wait, what?

One of the great virtues of subscription-based information businesses is the revenue visibility afforded to management and investors.  Said more simply, everything in a subscription business (remember our discussion about SaaS?) happens in slow-motion.

Let's look at an example.  Take a look at the chart below, which plots net income for my former company, Forrester Research.

Explore more FORR Data at Wikinvest

See anything that looks out of place?  Like, say, a big jump in net income at the bottom of the economic cycle in 2008?

Here's the explanation: when the economy hits a bump, bookings may slow very quickly, but revenue (from prior contracts) keeps flowing strongly for a while.  A savvy operator, therefore, cuts expenses immediately to reflect lower bookings.  Ta-da!  Instant profit bubble.

But investors should beware - there's nothing sustainable about such a bubble.  And that makes a downturn a risky time to value an information business.

On the flip side, a rising economic tide has the opposite effect.  While bookings (and their associated expenses!) may grow quickly, revenue will trail behind.  That will artificially depress net income in the short run, leading some investors and managers to under-value the business.

So, what's the lesson in all this?  Simply this: deferred revenue is what really matters.

Make sense to you?  Please share your thoughts in the comments!

Friday, November 1, 2013

The world needs another blog. No, really.

OK, so there's a blog for everything.   Cats with their faces stuffed through a piece of bread (  Hung-over owls (  Partying pandas (  

Make that almost everything.  

Believe it or not, there's no really good blog about the information services market.  Go ahead, google it.  I'll wait.

Hard to believe, right?  Well, sorta.  It isn't exactly sexy, but it is a pretty important market, comprising tens of billions of dollars in revenue.  Lots of money has been made in info services - and we've barely scratched the surface.

Hence, this blog.

I've spent the better part of the last two decades managing companies and studying the information services business.  Along the way, I've made a lot of mistakes.  And, perhaps, learned a few things along the way.

Most recently, I was the COO at Forrester Research.  We had a great run there - over about 7 years, we doubled the size of the company ($150 -> $300m), more than doubled earnings, and beat the NASDAQ by a wide margin. 

Over the last several months, I've been chasing information services deals with a variety of investors - giving me a front-row seat to today's deal flow, valuations, and the like.

Thanks for stopping by.  And please - let me know what you think!  Monologues are boring; conversations are interesting.

What makes a great information business?

There are a million (mostly small) information businesses - they seem to pop up in every industry, every geography, every segment.

And here's the brutal truth: most of them are lousy businesses.

Why lousy?  A variety of reasons.  Some, for example, have fundamentally screwed up their pricing models, leaving most of the value they deliver in their customers' hands, rather than their shareholders.  Others are intensely nice-to-have...but not need to have.  Still others have readily available substitutes in the market, leading to a lack of market/pricing power.

All of which leads us to the question: what makes a great information business?

Having spent many years investing in and studying the information services market, I've come to the conclusion that great information businesses have three things in common:

1.  Proprietary data or insight...  This one is fairly obvious - but too often overlooked.  To be clear, proprietary means that the core intellectual property is both (a) hard to replicate and (b) has no easily applied substitute.  The most potent substitute?  Gut instinct (or said another way, sometimes the biggest competition is using no information supplier at all).

2.  ...embedded in a business process...  This is the single most important element of great information businesses.  Embedded means that the data or insight is weaved into a business process such that the removal of it causes the process to fail to work appropriately.  In shorthand, embeddedness is best characterized by (a) high frequency of use and (b) high importance to the business process.

3.  ...and delivered through software.  At the end of the day, what is software?  Simple: it's the instantiation of a business process.  So, where better to inject data or insight to improve the business process?  For example, supplying spreadsheets of data to prioritize prospective buyers can be useful - but injecting that data into the CRM system your salespeople use is much more powerful.   And, of course, software provides great operating leverage.

In a nutshell: great information businesses are built on proprietary data, embedded in a business process, and delivered through software.

What do you think?  Anything to add to this mental model?

Common problems in information businesses

As I've mentioned in previous posts, there are so many information businesses that have the potential to be great...but just aren't.

In fact, most of the information services deal flow I see these days falls into this category.  Often small-ish ($10-25m), often run by their founding management team, often undercapitalized, and often lacking clear/coherent strategy, these firms have wasted a great opportunity.  

Sometimes they can be fixed.  But they're mostly not worth the time it would require to do so.

Some of the most common problems I see:
  • Faulty pricing (often hard to fix).  When executed properly, pricing in information services businesses is a very sophisticated undertaking, rooted primarily in a clear assessment of the value delivered to the buyer.  But all too often, mediocre information businesses have set their pricing far below the real value to the customer.  And when that disparity is too large, it's very hard to fix.
For example, I looked last year at a potentially interesting healthcare informatics business.  It ticked all the boxes for me - proprietary data, embedded in a business process, and delivered through software.  By my calculus, the value - in terms of revenue generation and cost avoidance - was measured in thousands of dollars of month.  But the firm had priced their offering at hundreds of dollars a month - and I could see no way to make a 10x price increase stick.
  • Wrong allocation of resources (quite fixable).  Great information businesses are zero marginal cost businesses - once the product is produced, there should be little to no cost involved in delivery.  That, in turn, implies an appropriate allocation of resources - specifically, relatively small expenditures in creation of the product and relatively large expenditures in distribution.  Note that I didn't say that it must be inexpensive to produce the product - rather, that the cost to do so should be a fraction of the money spent on distributing it.
For example, I recently looked at an information business that spends approximately 55% of revenue on producing their information product - and less than 20% of revenue on sales/marketing.  By my estimation, that ratio is backwards.  The fix?  An injection of capital and a rapid expansion of the salesforce.
  • Lack of embeddedness (nearly impossible to fix).  Lots of information products are really nice-to-have.  But nice-to-have doesn't cut it when the economy takes a downturn - and it conveys little or no pricing power to the business.  In other words, it's a product that will produce only modest, cyclical returns.  Again, not worth the time invested.
For example, I once was part of an information business that was intensely nice-to-have.  But it wasn't need-to-have, because it wasn't embedded within a customer's business process.  The result?  A 40% drop in revenue during the next recession.

There are many more problems of course - but these are the most common ones I see.  How do these observations compare with your own?

Metrics that matter (or why great info businesses are essentially SaaS businesses)

In a previous post, we talked about what makes a great information business.  In a sentence: great information businesses (1) have proprietary data or insight, (2) embedded within a business process, and (3) delivered through software.  The combination of those three factors tends to yield defensible, profitable, scalable businesses.

But how do those factors translate into the financial statements and metrics that we use to operate and value information businesses?

First, a bit of a primer on accounting in subscription-based businesses.  After all, who doesn't love an accounting lesson?

Wait - come back!  I promise, it won't take but a moment.  

Let's say you've got an information business which sells a subscription-based product.  When a customer signs a non-cancelable contract for, say, 12 months of service for $120k, no revenue is generated up-front.  Instead, the revenue is equally recognized over the life of the contract - in this case, $10k per month.

Until recognized, the revenue remains on the balance sheet as deferred revenue.  Remember that metric - it's the single most important thing to look at in an info business.

Now, let's presume that the customer pays up-front - which is typical in info businesses.  The cash balance of the business, therefore, is enriched immediately - allowing the further re-investment of that cash into the business.

OK - enough accounting.  Let's back back to the metrics that matter.

If you were able to look at only three metrics to assess an information business, what would they be?  Here are mine, in priority order:

1. Deferred revenue.  Did you skip over the accounting section above?  If so, go back and read it.  For those still with us, deferred revenue growth is the best forward-looking indicator of revenue performance.  Want to know whether an info business is trending upwards or downwards?  Don't make the mistake of looking at past revenue performance - deferred revenue is all that matters.

2. Operating cash flow.   Great info businesses shouldn't need ongoing injections of capital. Instead, customers fund the growth of the business with up-front payments.  Therefore, operating cash flow should be growing in lockstep with the growth of the business overall.  

3. Renewal rates.  A growing deferred revenue balance is terrific - it means customers are continuing to invest more and more in their relationship with you.  But which customers?  Renewal rates - on a dollar basis, in particular - are the best indicator of client satisfaction with the offering.  And satisfaction = stickiness = goodness.

On to my final point.  If you've spent time looking at SaaS businesses, some of these metrics might look familiar.  In fact, very familiar.  

To put a fine point on it: great info businesses look, act, smell, and taste just like great SaaS businesses.  The physics are the same, the business dynamics are the same, the cash generation abilities are the same...etc etc etc.

So that's it.  Of course, there are hundreds (thousands?) of other metrics we could consider - especially when we start talking about valuing information businesses.  But for my money, deferred revenue growth, operating cash flow, and renewal rates are the right place to start.

What do you think?