Recurring revenue and moats

A friend on twitter, Andrew who runs https://www.fundhunter.co/ asked an interesting question: is recurring revenue a “moat” in itself?  That is, do all companies that have recurring revenue / customers who stay for years, have competitive advantages (and by implication report high returns on capital).  After thinking about it for 10 seconds I replied with an unambiguous “NO!” *

I thought I’d write up a paragraph on each example, companies and products with recurring revenue and no economic moat:

Mortgages– well before the financial crisis I published a SELL note on Northern Rock.  I didn’t predict a bank run, or the problems with wholesale funding.  But I was interested in how the dynamics of the UK mortgage market had changed over the previous 5-10 years.  Bank customers used to be put on the Standard Variable Rate (SVR) after their initial introductory offer came to an end (often a 2 year fixed rate deal).  The mortgages were priced to include a period of inertia, when customers didn’t bother to move away from the SVR – a lot of financial services profits come from customer inertia – life is just too short to switch bank account and chase the best deals every few months, or even every year.  But as interest rates fell, and the size of the average new mortgage increased, the rewards for switching became greater, and so the market became more competitive – as soon as customers were put on the higher SVR rate they immediately re-mortgaged away…or if they didn’t their loyalty was rewarded with a much worse deal than new customers.

In my view, despite Virgin often touted as an iconic brand, Virgin Money (the old Northern Rock) has no moat on its mortgage business.  This is demonstrated by the negative returns on equity and capital employed (5 year average) even before the corona virus dented revenue and increased bad debts.  The share price performance has not been impressive, even before the corona virus hit in February, the shares were trading below their 2016 price.

RoCE (%) -0.2 2 10.4 16 25
RoE (%) -4 -2 24.7 30 45
P/FCF (x) 0 4.2 5.4 31 20
P/B (x) 0.3 0.7 0.8 9.0 9.8
P/TB (x) 0.3 5 13 n/a n/a
P/E (x) 11.8 20.3 5.7 23.6 19.4
Source: Stockopedia

In the noughties banks tried to increase their returns by using Payment Protection Insurance (PPI) to offer attractive headline rates on loans, but then make enormous excess profits on poor value insurance.  This ended badly, with banks having to repay tens of billions of pounds to their customers. The contracts may well have been legal – the behaviour went on for at least 10 years under the eyes of the regulator- but it certainly was not treating customers fairly.

Broadband – Another example of recurring revenues is broadband (at least it seems to work like this in many countries).  Customers are put on a deal for 2 years, and then when the deal expires, the amount the customer pays doubles.  Companies then make it really painful and annoying to switch, involving phone calls to call centres, different customer numbers.  I thought I might get round this by going into a Vodafone shop on the high street, and ask them to switch for me.  But there’s no point in having a high street presence if it allows your customers to get a better deal.  So the girl in the shop (who I think was genuinely trying to help) said she couldn’t do anything, but tried calling the call centre for me. We spent half an hour on hold before I got bored and walked out of the shop.

Vodafone also makes poor returns on capital (2% ROCE, and negative Roe, both 5 year average). Vodafone shares have roughly halved in value in the last 5 years.

BT is somewhere in the middle, but that is more because it is an old government monopoly, an entirely different form of moat, because customers have little choice but to use their service.

By contrast companies like Diageo (RoCE 16% and RoE 30%), which sells Guiness and spirits, or Unilever (RoCE 25% and RoE 45%) do not have contractually recurring revenues and no one is forced to buy their products.  But customers do buy their products because they like the brand.  They stay loyal out of choice.  Maybe Unilever’s strategy of convincing us that bog standard bleach (Domestos) is somehow worth paying a premium for compared to the supermarket’s own brand is a bit deceptive.  I really don’t know if their bleach is better, or more or less environmentally friendly.  Same goes for their other products like deodorant, I don’t know if it really is better than other products, but I’ll pay a small premium for peace of mind.  I trust the brand and that’s it.  

Diageo and Unilever (and many other businesses) have substantial economic moats, with no recurring revenue. Their shares trade at a substantial price/book value 9.0x and 9.8x respectively, and price to tangible book value is actually negative, because once you deduct goodwill and intangible assets from the balance sheet, there is no book value.  But the assets and future economic value is real, as demonstrated by the high price/free cashflow investors are prepared to pay.

I suspect there’s a more general heuristic that we can draw from this.  If a business relies on using contracts to lock customers into recurring revenue, and that is their only strategy, it’s probably a poor business.  Management of companies often seem to think it is good business to screw their customers with small print and rely on inertia to make high returns, but actually their reported returns and stockmarket valuation suggests otherwise: investors don’t reward recurring revenues per se, and they certainly don’t reward companies who rely on unfair contracts.  Poor returns seem to be meting out justice.



* NB the examples listed may differ by country.  For instance in the UK mortgages have tended to be 2 to 5 year fixed rate, in the rest of Europe mortgages tend to be fixed for 10 years.

Photo by Andy Watkins on Unsplash

13th Century Caerphilly Castle in Wales, second largest castle in Britain with concentric castle defences and moat.