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Talking Tech is produced by the Progressive Tech Team of George O’Connor, Ian Robertson and Gareth Evans. Our aim is to bring you up to date with the tech news cycle each week. We comment via blog and podcast on the slings and arrows of the sector at a time of huge change.

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March 7, 2024

ARR – Honey, I broke the metric

Public market equity investors love metrics – in the case of ARR (Annualised Recurring Revenue) it is probably too much for their own good. What is a truly valuable metric for high growth SaaS businesses is being mangled and abused in the UK small cap market. The reinterpretations of what ARR is and what it implies may well have the best of intentions, but when top line growth is only single figures shouldn’t these companies be focusing on profit and cash?

Investors love metrics – sometimes too much for their own good

For time-hungry fund managers, anything that saves time is to be welcomed.  Focusing on one variable for a sector makes life easier. These metrics change over time, but they are a feature of many sectors, whether that be pubs, insurance, gambling, semiconductors, software or oil and gas.

All too often the company’s definition and application of these metrics has provided more insight into the real quality of the company and management than the numbers themselves.

ARR (Annualised Recurring Revenue) is particularly appealing for UK equity fund managers. ARR is seen as the passport to understanding Software as a Service (SaaS), the most exciting and important thing in tech (before AI came along of course), along with the transition to SaaS that traditional software companies had to make.

Two of the more mainstream definitions of ARR are the sum of subscription revenue in the last month x 12, and the sum of the annualised committed subscription value of every contract for which the company is entitled to recognise revenue.

The focus is on subscription software revenues.  It’s a SaaS metric after all. In broad terms, recurring requires the revenue from the customer to be regular and committed in some way rather than just repeating, which just means that the customer happens to come back.

The attractions of SaaS vs traditional on-premise licensed software model are many and well documented, but ARR is not top of the list for founders, developers or customers.  But investors love(d) it.

ARR is still the best for some investors

For most early-stage tech investors, the ARR is more useful than the traditional revenues figure because the ARR gives the latest update on the company’s take-off growth path. The early-stage investors can see that customers are coming back for more, there is product traction and that cashflow might be predictable.

For very early-stage investors, ARR is also important because recurring revenue excludes products that may not have worked, or the work the investee company has been doing to pay the bills and perhaps even the paid development work that the company is now trying to resell to others on a subscription basis.

These early-stage investors might look with some bemusement at the public market investors getting excited about ARR and recurring revenues when the public market software companies they are investing in are often decades old, with software of clearly proven value.

For most public and mature companies, ARR’s time has passed

ARR really came to the wider UK public market awareness as part of the great SaaS transition.  The transitioning of established software companies across to SaaS to ensure their survival was a far greater issue than the appearance of speculative SaaS companies on AIM.

Measuring the ARR as a % of total revenues gives an idea of progress from traditional to subscription (SaaS) revenues.

But it’s hardly a precise guide when it may be unclear whether 100% is even a desirable or achievable goal. For example, if one-off work is required to lock in the recurring element of the revenue, 100% clearly makes no sense. You do what is best for the customer, not what is best for the investors’ favourite metric.

It’s easy to understand why brokers and financial PRs love ARR and want their clients to talk about it.  In a company transitioning from traditional to SaaS, ARR is almost certain to be impressive, at least at the start of the process, while ‘recurring’ creates an illusion of resilience that simply isn’t justified.

Consideration of more mature or post-transition SaaS business requires a bit more than just the headline ARR.

The company has to be winning new customers and/or adding new paid features to be really growing as a business.

ARR does not reflect what is being delivered to the customer. An appeal of SaaS for a software company’s management may well be that you can upgrade your customers all the time but if these customers are not paying extra for this functionality, then your real, rather than nominal, ARR is in decline.

And a growing ARR is of little merit if you are spending too much money trying to sell or charging too little for the product.

Time for another easy metric?

The SaaS metrics industry does offer up an Annualised Recurring Revenue 1.1 and 1.2 in the form of Net Revenue Retention (NRR) and Gross Revenue Retention (GRR). Net revenue retention shows how much ARR is retained and grown. Gross revenue retention shows how much ARR is retained.

But with these new revised metrics, we are still not really getting much extra.

The next stops down the SaaS metrics line are churn and customer acquisition costs. But no one wants to talk about churn in public and customer acquisition costs are difficult enough to identify in a simple, young SaaS business, let alone among the fruit salad of a UK-listed software company’s products and customer base(s).

If ARR growth is not much different to revenue growth, ie low teens % and below, then we should also be seeing, if the analysts are to be believed, EBITDA margins of some substance.

The conversation should be about profit and cash generation, not misleading and muddled metrics.

Where are we now?

It makes sense at this point to consider what the UK-listed software companies are doing.

The application of ARR among UK-listed software companies is mixed.  Some use a textbook definition and apply it clearly, even though for some it might not be that relevant. For some it is not relevant, and they don’t use it.

But some use ARR and their own homebrew definition.

Sage, Darktrace, Trustpilot and FD (within its KX business) define ARR in mainstream ways.  The current unspectacular growth at Sage means that there is not much value in the metric even though it gets headline billing (no pun intended), but Darktrace, Trustpilot and KX should still be very much in the realms of rapid growth SaaS revenue.

Accesso and Auction Technology Group have transactions as drivers to their revenues and so ARR is hardly appropriate. Idox makes reference to repeating revenues, but along with Alfa the nature of their business, whether cloud delivered or not, makes ARR a poor measure of market position or customer relationships. Dotdigital clearly wants to make something of the fact that recurring and repeating revenues are over 90% of revenues but its management is very clear on the repeating bit.

Other companies, however, choose to present ARR as part of their investment case and seem happy to ‘move away’ from the definition that tech investors might expect.

IQGeo – adds in maintenance and support on top of its SaaS revenues.

WindwardAI – doesn’t use ARR at all but presents ACV.  ACV includes all contracts divided by the contract life in years of the contracts, so can include those not started. The revenue growth suggests ARR and its growth would still be impressive.

Bango – calculates ARR from contracted repeating revenues.

Eckoh – takes the standard ARR and adds on contracted revenues that have yet to start and an element of UK and Ireland revenue that has proven to be repeatable. Quite why foreign repeating revenue isn’t good enough is unclear.

Cerillion – takes the SaaS plus support and maintenance definition one stage further with the addition of managed services.

Tracsis – gets it right with recurring revenues excluding those that have not gone live, but then includes annually repeating hardware revenue from framework agreements.

Time for a new metric – profits, cash anyone?

These company managements may well be trying to give investors a better understanding of their business, but extra insight is not provided by reducing the detail, and trust is not built by using a standard metric and then changing its definition.

The very fact that sensible managements with good businesses are mangling definitions to get the metric to make sense suggests something is wrong with the metric, or the advice.

It’s time to focus on the fact that the quality of the revenue and the business depends on the quality of the product, the service, the ability to translate revenues to profit to cash. ARR doesn’t capture that, no matter what definition you choose.

Ian Robertson

irobertson@progressive-research.com

07768 276595

 

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