From Jet Engines To Apps - Companies Are Finding New Ways To Create Recurring Revenue
By Greg Fuss
Equity Portfolio Manager
More than a century ago, K.C. Gillette came up with a plan: give customers the razor and sell them the blades. Of course, Gillette didn’t exactly give away his safety razors. They retailed for the relatively substantial sum of $5 in 1903, the equivalent of about $140 in 2014. Still, the real money was in the blade — that thin, inexpensive, disposable piece of stamped steel that people around the world have bought over and over in various forms ever since.
This built-in demand creates an ongoing stream of what is called recurring revenue, and it’s become the Holy Grail for many companies operating in industries ranging from technology to consumer products. The “razor blade” model Gillette perfected applies in some unexpected ways, and it’s a factor Capital Group analysts pay close attention to when evaluating potential investments.
Companies that adhere to a recurring revenue model can remain relatively stable in challenging economic environments, riding out portfolio volatility during periods of stock market turbulence. In fact, we frequently refer to them as “global champions.” They often have wide moats of protection around their business models and defensive characteristics because demand rarely ceases.
Maintenance costs can generate seven times the price of a new engine.
The engine business is a good example of the recurring revenue model in action. A handful of companies supply the vast majority of engines for commercial jets, fighter planes, helicopters, ocean liners and power plants. But selling the engine is just the beginning, and it’s not necessarily where manufacturers make most of their money. Instead, these companies sell the engines for relatively modest profit, knowing that maintenance, repairs and engine overhauls will keep them busy and ringing up revenue for 20 to 30 years. The outlook is particularly favorable for jet engine makers because demand for air travel is poised to put more than 35,000 new jets in the air by 2031.
The recurring-revenue model is a key part of the business plan for today’s tech companies.
The technology sector, once associated mostly with high-flying growth companies that disdained paying dividends, may be headed for its third straight year as the top dividend-paying sector in the S&P 500. That is partly attributable to the decision by Apple to begin paying a dividend after more than 30 years as a public company. Companies like Apple have put something of a twist on the razor blade model by tapping into a variety of recurring revenue streams by creating mobile devices that use a variety of applications and content. Once consumers have the device or the platform for recurring revenue, they buy content through the company’s app store.
More broadly, the sector’s rise in the dividend column is partly due to the transition of some companies away from a sales model to a subscription and service model able to generate significant recurring revenue. Because technology can rapidly become commoditized, some companies have moved away from a reliance on the one-time sale of a product — often hardware — in favor of ongoing revenue from software and services. Some software companies now generate what’s called sequential revenue by encouraging customers to consistently upgrade to the latest versions.
Similarly, mobile devices create recurring revenues for data providers. By the end of 2018, there will be an estimated 8.2 billion wireless subscribers in the world. Those subscriptions are expected to generate an estimated $1.2 trillion in total mobile service revenue by 2018. Phone companies may be one of the classic examples of recurring revenue, with many telecoms providing plans that combine voice, text and data services into a single price point on a recurring monthly basis.
Biologics offer hope for patients and ongoing revenue for manufacturers.
Because the barriers to entry are so high, biotechnology drugs (or biologics) represent an unusually secure revenue stream for certain companies. Biologics are incredibly complex and used to treat maladies ranging from rheumatoid arthritis to breast cancer. They can be composed of sugars, proteins, nucleic acids or a combination of those substances. Others are living entities — cells and tissues that can come from humans, animals or microorganisms.
For those afflicted with certain ailments, biologics, when taken regularly, can slow the progression of a disease or in some cases cure a condition outright. The outcome has resulted in a remarkable track record for biologics. Of the best-selling prescription drugs in 2013, seven of the top eight were biologics. Combined, these drugs had sales of about $62 billion.
Research is crucial for investors in any industry, but biotechnology is among the most complex. Biologics have a long, risky and expensive development cycle, sometimes taking a decade or more from discovery to approval. Once approved, though, some of these drugs can command premium pricing and lead to significant long-term demand.
Recurring revenues can help companies weather difficult economic environments.
Given the favorable characteristics of these global champions, it’s no wonder portfolio managers hold many companies with recurring revenues in client portfolios. These companies tend to march along regardless of the general economic environment or whether the market is up or down. These durable franchises can thrive in many different business environments, playing an important role in protecting capital and generating long-term income for investors.
Greg Fuss is a Global, U.S. and Non-U.S. Equity portfolio manager for Capital Group Private Client Services. Based in Los Angeles, he has 28 years of investment experience and has been with the firm since 2006.