Friday, March 30, 2007

Cash Flow of Subscription Businesses

RHT just reported their earnings. Wall Street is starting to understand the power of their subscription business model, but not quite enough yet. When the press release was done at 4:00PM, the stock dove because earnings per share only met analyst estimates. It seems Wall Street is still watching the earnings line way too closely. Of course the stock rallied in after-after hours trading, and will probably be up today because Charlie Peters (the super-CFO) said that cash for for this coming year would be $250-260M. That is well over $1.10 per share of free cash flow on a stock that trades around 24 - a a multiple of about 22-23. On a company where annual revenue rose 44% last year!

A subscription can not be counted as revenue immediately by a company. It has to be spread out over the course of the year (or however long the contract is), with the customer paying up front. This is why it is a great cash flow business. Cash flows in before the expense. In a steady-state company (one that is not growing or contracting), the cash flow would be exactly the same as profit since every quarter a company would book as much revenue and they would report for that quarter. And since expenses would be level, the cash flow would equal the profit.

But RHT is a growing business. If RHT stopped investing in growth and turned to be a steady-state business overnight, the $250-260M cash flow that Charlie predicts would be a very close approximation for profit. But the RHT story is better than that since RHT is actually continuing to invest for growth - more products, new versions of products, more sales, more service, better management visibility, better renewal rates thru the channel, etc. So the top line will continue to grow - and so will the future stream of cash flow (and talk about the stickiness of the subscription with RHT achieving such a high rate of direct renewals). And even with this investment (and corresponding cash needs), the growth of cash flow continues.

Now, I am biased. I worked at JBoss for several years and think the combination is a good one. I own a good number of RHT shares, so I do cheer for great quarterly reports like this one. However, this is the same logic that we used at JBoss to build the business. It is the same logic that people still do not entirely understand about other fast growing, cash flow-based subscription business models where earnings is not all that meaningful of a measure of success. Salesforce.com is the other mid-cap that comes to mind here (yes, I invest in them as well).

2 comments:

Richard Friedman said...

I agree with Bob tremendously about this, not because I work at Red Hat ;) but about a year ago in my MBA program I built out comparison models of software companies. Comparing Red Hat (before I worked at Red Hat) to some other software copmanies which have been around for quite some time. I found that a straight forward comparison based on GAAP was not very revealing, it does not tell the real story and in some cases paints the wrong story.

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