ARR, or Annual Recurring Revenue, has become a buzzword in many company presentations. Some market bulls tout it as a magical formula of modern capitalism, claiming it offers companies significant downside protection, provided they can demonstrate high ARR. Today, we’ll take a closer look at this concept. Is ARR truly the new holy grail that every company should strive for? The answer isn’t so straightforward. Although ARR is a helpful metric in many circumstances, not every business is well-suited to employ a subscription-based approach, and ARR alone doesn’t capture the full picture of a company’s potential in even the most clear-cut cases. In my view, only by pairing ARR with additional analytical frameworks can we gain a truly comprehensive understanding of a company’s underlying performance and long-term prospects
Before we explore this, I’d like to share an update on my activities in the market over the past week. I’ve received positive feedback from my readers, who have expressed that they look forward to this segment of my blog. As for the broad market perspective, there’s nothing new to report: the bulls remain firmly in control.
I added to AbbVie
I am currently expanding my positions in a select group of key stocks: Uber, Salesforce, and Nasdaq, with Nasdaq representing the smallest holding among them. I’ve observed that Nasdaq’s relative strength currently exceeds 70, and historically, whenever this metric approaches 75, the stock tends to peak before entering a consolidation phase. For this reason, I’ve opted to wait for a period of consolidation before increasing my Nasdaq stake, rather than adding to my position at what appears to be an intermediate high.
As a result, my focus has shifted to my pharmaceutical holdings. I maintain positions in four companies: Novo Nordisk, Amgen, Gilead Sciences, and AbbVie. Novo Nordisk is notably volatile. Meanwhile, Amgen and Gilead Sciences are range-bound and lack clear catalysts at present. In contrast, AbbVie is trending upward within a broad channel, making it the most compelling candidate for additional investment at this time.
I have previously detailed AbbVie’s strengths. In brief, AbbVie enjoys a wide moat in neuroscience and immunology and is demonstrating promising progress in oncology. The company exceeded market expectations in its Q1 report, and I expect similarly strong results for Q2, which could further boost its share price. My investment approach is long-term oriented, and AbbVie has been part of my portfolio for nearly five years. By increasing my stake in AbbVie, I am bringing my healthcare sector allocation back to approximately 15%, following the sale of Merck in mid-June.
Back to the main theme: ARR!
Nothing new
Software, cloud computing, and platform economics have put the term ARR on the map. Microsoft was a trailblazer due to its size and early transformation into a subscription-based model. In 2011, Microsoft’s Office suite transitioned from a one-time purchase to a subscription-based model with the introduction of Office 365.
With the onslaught of virtual technology and the example of Microsoft, the subscription-based approach has been the go-to business model for Software as a Service (SaaS) companies. Relatively new companies like Crowdstrike, ServiceNow, and Zscaler are exclusively cloud-based, and not surprisingly, ARR is the metric they focus most on. What you see when studying these companies is that they sport ARR’s above 100%. This means that their customers not only renew their subscription but also are using increasingly more functions within the software package.
The brilliance of cloud computing is that customers only pay for what they use. Consumers don’t need to spend a lot of money on hardware, and costs move from the capital side to the operational side. It can be described as a utility. When you use energy at home, you only pay for energy usage; you don’t spend any money on installations. Capital costs are baked into the price.
In this respect, the model is nothing new. Numerous older businesses have used subscriptions to generate steady income. Besides utilities, we have newspapers, cable TV, Gym memberships, credit cards, and many more.
Looking at ARR in context, it’s clear that a subscription-based model alone doesn’t guarantee business success; other factors are also important, if not more so. Still, investors favor subscriptions because they see these services as “sticky”—users are less likely to cancel them during economic downturns compared to cutting one-off purchases. Investors may be right about this advantage.
Growth and Margins
Let’s not forget that newspapers were a great business once upon a time. Buffett’s investment in the Washington Post is considered one of his most successful. From 1973 to the end of 2007, his original $11 million stake had grown to nearly $1.4 billion. The Washington Post was the Netflix of its time, supported by ad sales and subscribers.
Still, Netflix excels far beyond the Washington Post in growth potential. Netflix addresses a global market, while newspapers are mainly regional in their reach. A global market is a key factor that explains why these types of software businesses are significantly more successful than their analog counterparts. Here we are with a clue of sorts. As investors, we do ourselves a disservice if we only chant for a high ARR. We also have to follow the revenue growth. This is why I recently deemed Zscaler and Crowdstrike overvalued. It’s nothing magical going on here. When revenue growth falters, it means they have problems selling new subscriptions.
Profit margins are also essential. When a utility company wants to expand, it often has to acquire its neighbours' grid or power plants. If a newspaper gets one more subscriber, it must run the printing presses harder. For software companies, expansions entail minor fixed costs. Generally, SaaS is accessed via a web browser, and the initial connection occurs through a sign-up or registration process on the company’s website or platform.
Due to lower costs of goods sold, tech companies have substantially higher operating profit margins than traditional businesses, but watch out. This doesn’t mean that these companies don’t have a lot of expenses. Remember, when Wall Street cheers the margins of these businesses, they exclude cost items like stock-based compensation and R&D expenses. If these items get included, most software companies are not profitable under generally accepted accounting practices (GAAP).
Generally speaking, tech companies need a huge scale to achieve GAAP profitability. Naturally, stalwarts like Microsoft, Meta, Amazon, Uber, and Salesforce have reached mega profitability by all accepted standards. Newer editions, such as Snowflake, Zscaler, and Crowdstrike, are burning cash on their employees, and are not GAAP profitable. ServiceNow, as an example, just recently achieved GAAP profitability, and it has a total yearly sales of over $10 billion. This says something about the scale needed. Investors who are seeking quality compounders must, therefore, analyze how long the runway for growth is. If growth stalls before a humongous scale is reached, it's not good.
John Deere wants ARR
Returning to Nasdaq, excitement about a wave of new listings has fueled its recent bull run. However, beneath this optimism, Nasdaq has developed a robust SaaS business focused on financial management and crime detection. Today, annual recurring revenue (ARR) accounts for 60% of Nasdaq’s total revenue, providing stability and helping to offset the cyclical nature of its listing services.
Uber is also embracing ARR with its Uber One membership, adopting a business model similar to credit card companies. For a monthly fee, customers gain access to exclusive offers and benefits. With 30 million paying members, Uber One appears to be meeting customer needs
Even John Deere is embracing ARR. While it may seem surprising for a tractor manufacturer to adopt a subscription model, Deere offers a precision agriculture software solution. As agricultural machinery becomes increasingly autonomous, the technology managing these machines could become highly valuable.
It’s clear that subscription models are extending into areas once dominated by the traditional goods sector. The question now is who will control the autonomous vehicle tech stack, and whether consumers will prefer to subscribe to or buy these software solutions. We know that Tesla wants to own not only the software but also the hardware.
Conclusion
While ARR has become a central metric for many modern companies and is often celebrated for its ability to provide stability and predictability, it is not a cure-all or a guarantee of business success. ARR is valuable, especially in subscription-based and technology-driven industries, but it must be evaluated alongside other factors such as revenue growth, profit margins, and the scalability of the underlying business. Ultimately, ARR is an important piece of the puzzle—but not the whole picture—when assessing a company’s true potential.
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