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!