RPO - The superior metric for analyzing a software stock
Why common figures like revenue and billings are not enough to understand the health of a SaaS business
In the age of SaaS (Software as a Service), analyzing the fundamentals of software companies can be confusing. In the past, you usually had to deal with sales and orders. Now you need to be familiar with new terms such as bookings, billings and RPO in order to understand the health of a software business.
Most software companies today sell subscriptions, generating recurring revenue that is highly valued by the financial markets. You may have noticed in recent annual reports from SaaS companies that "RPO" is a new, ominous term that you should be familiar with. In this article, I will explain what "Remaining Performance Obligations" = RPO is all about.
But before I get into the topic of RPO, I would like to recapitulate some basic terms that are often confused in stock analysis:
Bookings
Bookings are very similar to traditional incoming orders. They represent the contractual obligation of customers to spend money on a company's services, for example as part of a software subscription. Bookings are independent of service delivery, which occurs at a later date. And they are also regardless of the payment method or frequency of invoicing.
Revenue
Customers often pay for 12 months of an annual SaaS contract in advance when the contract is signed. However, revenue is only recognized when the service (e.g. use of software) is actually provided. For subscription contracts, such as SaaS products, revenue is recognized ratably over the term of the subscription. In the case of an annual contract, 1/12 of the bookings are recognized as revenue each month.
Deferred Revenue
Money received from customers after invoicing (or at least after invoicing and when due) but not yet recognized as revenue becomes “Deferred revenue”
Deferred revenue therefore represents amounts billed to customers in advance of the rendering of services. When a subscription contract is entered into, the amount paid by the customer is initially recognized as a liability or deferred income in the balance sheet.
The deferred revenue is then recognized in the income statement over time as the monthly obligations are met, thereby affecting revenue. The development of this “Deferred Revenue” balance sheet item is one of the most important indicators of the future development of a SaaS company.
Billings
Billings represent the money actually billed to customers in a period. This can be at the time of booking if the contract is paid in advance, or at the time of revenue recognition, if monthly payment has been agreed.
Experienced growth investors have always paid particular attention to the development of Bookings and Billings. These are much better indicators than revenue of the future development of a subscription business.
RPO - Remaining Performance Obligations
Since the 2018 financial year, new US accounting rules for revenue from contracts with customers apply. This is Accounting Standards Codification (ASC) Number 606: 'Revenue From Contracts With Customers'. This binding guidance sets out precise requirements for the recognition of revenue from contractual relationships. This is particularly relevant for the recognition of subscription contracts, e.g. in the SaaS environment.
ASC 606 is based on some very simple principles for contracts between a customer and a service provider:
A contract between a customer and a service provider always contains certain rights and obligations.
The service provider's performance obligations, such as providing a certain software service over a fixed contract period, are identified.
The transaction price, which may include fixed or variable components and is not limited to monetary payments, is determined.
The transaction price is allocated to the contractual obligations of the contract.
Revenue is recognized when the service provider has fulfilled its obligations. In the case of a long-term service obligation, revenue is recognized ratably over time.
In addition to various other guidance that follows from the above logic, the new ASC 606 requires disclosure of an entity's remaining performance obligations (RPO) in the notes to the quarterly financial statements (10-Q).
What does RPO mean?
In simple terms, you can think of RPO as deferred revenue plus order backlog.
RPO = Deferred Revenue + Backlog
In contrast to deferred revenue, the backlog is not recognized in the balance sheet. This is because it represents future performance obligations that have not yet been invoiced to the customer.
An example will make this even easier to understand:
Suppose a SaaS company signs a 3-year subscription contract with a customer for $36,000 (TCV = Total Contract Value). Annual invoicing in advance is agreed. The first year's services are invoiced for $12,000 when the contract is signed. After the first quarter, $3,000, or 3/12 of the annual contract value, is recognized as revenue. A further $9,000 is recognized as deferred revenue in the balance sheet for the remainder of the first year. The agreed but not yet invoiced payments for the second and third years of the contract, totalling $24,000, are attributable to the order backlog and do not appear on the balance sheet.
However, according to ASC 606, the company must now disclose the total existing performance obligations as RPO in the notes to the balance sheet. For the above example, this would mean that these RPO would total $9,000 + $24,000 = $33,000 at the end of the first quarter of the contract term.
RPO as a key figure for communication with investors
Many SaaS companies are not just hiding their RPOs in the notes to their quarterly reports, but actively communicating them as a benchmark against which to measure performance.
And it makes a lot of sense. Together with deferred revenues on the balance sheet, the disclosure of RPO provides a comprehensive insight into the order situation and future sales development. For example, if an SaaS company's RPO is $500 million and deferred revenue on the balance sheet is $300 million, you know that there are another $200 million in contracts for services that have not yet been billed.
How will the RPO disclosure affect SaaS companies?
In former times investors have usually tried to understand the order situation of a SaaS company based on the development of billings and deferred revenues. RPO disclosure offers an improved opportunity to analyze the entire contractually agreed revenue.
In my opinion, RPO is a better indicator than billings for predicting future revenue as accurately as possible. So it makes sense that under ASC 606, SaaS companies will increasingly focus on RPO rather than billings.
RPOs contain more valuable information than billings. You can subtract deferred revenue from the RPO and get a good measure of the current strength of a subscription business, even for longer-term contracts.
Conclusion
The high valuations of many SaaS companies can only be justified by the very predictable recurring revenue from subscriptions, which are often extremely high-margin.
I am pleased that with the mandatory disclosure of RPO under ASC 606, we as technology investors can now track and predict the development of these recurring revenues even more comprehensively.
If you have actually read this somewhat theoretical article to this point, then you are probably very seriously interested in High Growth Investing ;-)
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