The Attractiveness of Recurring Revenue
Our investment process at Cook & Bynum is guided by four criteria: circle of competence, business, people, and price. We spend countless hours performing deep research to learn as much as we can about the businesses in which our investments are engaged. As business analysts, we use our proprietary research and experience to pinpoint what we believe makes a particular business poor, good, or great. Great businesses have a deep and lasting economic moat that can protect excess profits from competition for long periods of time. Assessing the depth and longevity of an economic moat is critical to determining the intrinsic value of a business, as we discussed in depth in 2013. Companies with no moats do not have predictable cash flow streams and are worth low multiples of current earnings. Companies with deep, lasting moats, on the other hand, can be worth large multiples of current earnings because investors can have confidence in the persistence and growth of their profits. The eight companies in our portfolio, and the thousands that do not qualify for investment, reflect these opinions on business quality weighed against the daily market price of these companies on public equity exchanges. Take a look at the chart below. Though we might correctly predict the next five years of Companies A, B, & C to be identical, the real intrinsic value of each might be radically different depending on the depth of their respective moats and how that depth enables an investor to predict the more distant future.
We would like to expand on one characteristic of many great businesses: recurring revenue. Recurring revenue has become popular in recent years as it is an important characteristic of many subscription businesses. Over the last decade many software businesses have transitioned their revenue models from non-recurring license revenue to recurring software-as-a-service (SaaS) revenue. In doing so, these companies have created stickier and bigger profit streams which increase the intrinsic value of the business. Wall Street places such an emphasis on recurring revenue that many SaaS businesses are valued on multiples of annual recurring revenue (ARR). Recurring revenue is an attractive element of many subscription businesses, but it is not a magic recipe for profits. In the past two years, an index tracking the unprofitable subset of the technology sector, where nearly three quarters of constituents are subscription companies, experienced a speculative boom (up 294% from Jan 2020 – Feb 2021) and a spectacular bust (down 68% from Feb 2021 – June 2022). Some of the loftiest valuations since the dot com bubble were being justified by rapidly growing recurring revenue that will never translate to profits. Predictable revenue is one of our favorite characteristics of great businesses, but a predictable revenue stream does not necessarily translate into a profitable enterprise.
Though underappreciated by the market currently, branded consumer staples often have revenue that is even more likely to recur than subscription businesses. Consumer staples are characterized by small purchase sizes, high frequency of purchases, and their non-cyclical nature. The value of brands in consumer staples varies significantly. Brands may signal a high-quality product, offer a different taste or preference, foster aspirations, or carry a long and rich heritage. Brands like these are worth a lot to consumers and thus to shareholders. Often, companies with the strongest brands can build the best and most pervasive distribution networks, reaching consumers where competitors cannot. The most common reason (41%) why U.S. consumers try a new brand is a lack of availability of their preferred brand, so the advantages in distribution, market penetration, and out-of-stock execution are self-reinforcing to brand loyalty. Similar to a subscription business, the best consumer businesses in the world grow by “acquiring” new consumers through marketing, product placement, promotions, etc. and engender loyal customers that generate a predictable revenue stream. For example, Coca-Cola was the “most-chosen” fast moving consumer good in the world last year with 44% of global households purchasing Coca-Cola an average of 12.3 times. The four branded consumer businesses in our portfolio manufacture and distribute beverages with demonstrated consumer preference and dominant market shares. Their product portfolios contain brands with decades of heritage and span the pricing spectrum from premium to affordable to leave no room for competition to gain a foothold. As Peter Kaufman says, if you leave crumbs, you get rats. Because beverages are difficult to transport and often consumed on-the-go, our companies’ brands are complemented by distribution advantages that accrue to the market leaders, particularly in less formal retail environments. Because of these characteristics of the beverage industry, we observe that the equilibrium market share for the market leader is greater than 60% in developing economies. Currently, our beverage businesses enjoy market shares of 95%+ in Peru, 78% in Mexico, and 63% in Chile.
We believe that the economic moats of our four branded consumer businesses are getting deeper, but we have observed the competitive advantages for the entire consumer staples industry globally actually erode over the last decade. While the consumer staples sector outperformed the S&P 500 by nearly 200% from 2000 to 2015, it has trailed the index by more than 30% since. We postulate two primary reasons: 1) increased consumer acceptance of private label brands and 2) the expansion of digital advertising. We expect the rise of private brands to continue, as it is simply a reflection of retailers exercising more market power to capture margin from their suppliers. Some product categories are being decimated by private label, but others like alcohol, soft drinks, and candy have proven resilient. We expect this resilience in these categories to continue. While the expansion of digital advertising has been a headwind to large brands, recent changes in digital advertising will be favorable to established brand owners. Over the last few decades, global digital advertising has grown to an incredible 62% share of total advertising spend, representing $432 billion in 2021 . Digital advertising is highly concentrated with Google and Meta having more than half of global share. As the world’s population spends more time on screens, digital advertising offers a vastly more effective and measurable impression on consumers. The effectiveness of digital advertising and its targeted nature has led to the rise of a generation of direct-to-consumer (D2C) brands in nearly every industry including razors (Dollar Shave Club), corrective lenses (Warby Parker), clear aligners (SmileDirectClub), shoes (Allbirds), mattresses (Casper), meal kits (HelloFresh), medical scrubs (Figs), etc. Digital advertising has reduced the significant advantages of scale that large consumer brands had in advertising. The effectiveness of digital advertising is largely based on the ability to track users across their digital devices and target them with specific ads that might influence a particular consumer. However, as privacy has become an important concern among technology users, governments such as the EU have responded with regulation. Tracking users across the internet is unwinding. The internet giants are closing their “walled gardens.” For example, in 2021, Apple unveiled privacy changes in its iOS 14 software update that prompts users to allow or reject apps from tracking their activity across Apple devices. Most users are rejecting this tracking. Additionally, Google is on track to block third-party cookies from Google Chrome in 2023, which will eliminate third-party tracking on the world’s largest web browser. These changes are dramatically reducing the effectiveness of targeted digital advertising and increasing the costs to acquire customers. Increasing customer acquisition costs have upended the attractive unit economics that existed in building a D2C brand, shifting the balance of power back to established brands that can profitably acquire customers with more traditional broadcast style advertising. This change is starting to flow through business models, and if it persists, many current disruptors will be hindered.
Predictable, recurring revenue is a positive element of any business and one that we seek in our investments. But like most good things, the market took it too far and gave outrageous valuations to any subscription business. While we admire the predictability of subscription revenue, we see similar positive characteristics in strong consumer brands like those in our beverage investments which we can buy at much more attractive valuations. Last year, while many unprofitable subscription businesses were trading at double-digit multiples of revenue, some of our investments traded at single-digit multiples of today’s earnings.
 Goldman Sachs Non-Profitable Tech Index
 MoffettNathanson Advertising Spend Model, Mar 2022