Fundamentals: Revenue and Sales
Accounting, Revenue Recognition, Sales Terminology, and Okta Case Study
Understanding company fundamentals is essential to effectively analyze a company.
While sales may seem like a straightforward concept, there are a number of nuances which can lead to valuable insights.
Investors with a comprehensive understanding of the underlying fundamentals will be well positioned and better informed in their decisions.
Accounting
To begin, it is important to understand that financial reporting is not an absolute science.
Nearly all of the concepts in financial reporting, with the exception of “cash in the bank,” are agreed-upon concepts.
Accounting regulators, securities regulators and auditors need a set of standards to work with, allowing investors, lenders and regulators to compare accounts across companies and for the same company over time.
That being said, revenue and sales are not the same thing.
Sales are the proceeds a company generates from selling goods or services to its customers. While all sales are revenue, all revenue doesn't necessarily derive from sales.
Revenue is what the US Generally Accepted Accounting Principles, or GAAP, permits companies to recognize as revenue.
Revenue Recognition Principle
“Revenue recognition is a generally accepted accounting principle (GAAP) that stipulates how and when revenue is to be recognized.
The revenue recognition principle using accrual accounting requires that revenues are recognized when realized and earned – not when cash is received.”
Revenue, according to US GAAP, can be recognized when the customer accepts delivery of the product or service; and is recognized in proportion to the period of time over which the customer derives value from the delivery.
The following example, from Cestrian Capital, illustrates how this principle works.
So if you sell a computer to someone, you deliver the computer, the customer accepts delivery, and your responsibility is over and done with (you haven't agreed to maintain or operate the computer, once the customer has it in their hands it's their problem), then you can recognize the revenue the minute you get the handshake or the signed delivery note.
Computer is say $1k, you can put $1k in that month's revenue.
If you also sell a support agreement for the same computer, let's say over 12 months, for $120, then you can't recognize any of that revenue when you get the signature.
At the end of each month, when the customer has derived one month's value from the delivery of your maintenance contract (even if you haven't lifted a finger), you can recognize $10. Then the same each month until the end of the contract.
If you were smart, you billed the customer upfront, so you were paid $1,120 for the computer and the maintenance contract on day 1
You invoiced (sold) $1,120. But month 1, you had revenue of $1,010 only.
You were paid $1,120. So the missing $110 has to go somewhere in your financial statements.
You'll find the $110 in the liabilities section of the balance sheet, called Deferred Revenue. It represents the amount of prepayments you have received for revenue you can't recognize yet. At the end of month 2 you recognize another $10; so, revenue up by $10, deferred revenue down by $10. And so on until the deferred revenue balance is zero (you only ever sold one maintenance contract - should have worked harder).
The Revenue Recognition Principle is useful in that it helps show profits and losses accurately, by recording revenue when it is earned as opposed to received. It also allows businesses to more accurately project future revenues.
Sales Terminology
A lot of valuable information can be gleaned from data points beyond revenue, such as payments and contracts. The following terms are often used to describe the ongoing sales efforts.
Bookings represent the commitment of a customer to spend money. Consider booking as the contract — a customer signed, but hasn’t used the service nor paid yet.
Revenue is recorded when the service is provided. In the case of a subscription contract, such as software-as-a-service products, the revenue is recognized ratably over the life of the subscription. More on this below.
Billings occur when the customer pays. Customers may pay in advance (i.e. at the time of booking) or as they go.
Deferred revenue is money that has already been billed, is already in the bank, but can’t yet be recognized as revenue because the product or service hasn’t been served. Deferred revenue is constrained to the next 12 months.
Remaining Performance Obligation (RPO), like deferred revenue, gives visibility into future revenue, extending beyond the next 12 months. RPO represents the total future performance obligations arising from contractual relationships. More specifically, RPO is the sum of the invoiced amount (deferred revenue) and the future amounts not yet invoiced for a contract with a customer. The latter obligation is also referred to as the backlog. RPO is not a GAAP number and, therefore, does not appear on the balance sheet. Many companies do comment on it in public filings.
While these are some of the core concepts, it is not an exhaustive list. There are many more terms such as annual recurring revenue (ARR), dollar-based net retention (DBNR), amongst others that can provide additional insights.
Revenue and Tech Companies
Cestrian Capital goes on to explain how these principles are applied in the real world.
This is exactly how cloud software companies work.
The customer takes on say a 3 year contract. They get the benefits over 36 months.
Let's say they prepay 12 months worth of the contract but commit to the full 3 year term.
Let's say it's a $3.6m contract.
Day 1 you have zero revenue; you have $1.2m in cash; $1.2m in deferred revenue; and you have $2.4m in "remaining performance obligation" which doesn't appear anywhere in the financial statements, helpfully (it's usually in the SEC filings, somewhere).
This means, you are on the hook to deliver $3.6m of value to the customer; they have paid you $1.2m so that is cash on your balance sheet and a matching deferred revenue liability. And then you owe them a further $2.4m under the contract which they have yet to prepay - that's your remaining performance obligation. If you don't deliver, they can sue you; if they don't pay, you can sue them.
Now, when it comes to valuing revenue, as in, what multiple of revenue "should" a stock trade at - naturally, the more certain the future revenue, the more highly you would value it.
If a company is telling you they will achieve $1bn of revenue next year, but they have to win all those contracts from 1 January onwards, well, you would say that's contingent revenue and therefore risky and therefore lower value.
If a company is telling you they will achieve $1bn of revenue next year - and you look on the balance sheet and you see $800m of current deferred revenue - then you know the company only has to find another $200m of revenue to recognize, and they will hit their $1bn number. Because $800m is already in the bag. And so that revenue is not contingent and is therefore more valuable.
The above example connects the sales numbers with the the quality of revenue.
High quality revenue is revenue that is predictable, stable, and certain. That is valuable.
Case Study: Okta
Okta is a cloud-native leader in the identity access management space. Beginning with workforce Identity Access Management (IAM), they created a consolidated single-sign on experience for employees to access to all of their company’s applications. More than just convenience, this is a critical security need, as it allows companies to effectively monitor and control access.
Okta has been significantly investing in their core offering, as well as expanding into a new offering for Customer Identity Access Management (CIAM). This offering allows developers to use Okta as the backbone for their own applications. That is, Okta powers the log in experience users. As an example, when a user goes to MLB.com and creates an account, that experience is powered by Okta.
They sell their software offerings as a service, leading to recurring revenue.
They provide important and sticky services. Companies that implement IAM are making a significant investment — it is not easy to move a system’s entire authentication and authorization services to a new system.
These dynamics are reflected in Okta’s numbers.
From Okta’s 2021 Q2 earnings release, they are guiding for roughly $1.25 billion in sales for the year.
The financial statements show revenue of $566 million for the first half of the year and current deferred revenue of $721 million.
Additionally, they reported RPO of $2.24 billion and current RPO of $1.10 billion.
Current RPO represents expected obligations over the next 12 months. At 88% of their 2021 annual sales, their current RPO positions them well for additional growth as the sales and marketing team continue to acquire new clients.
Okta is not only well positioned for this year and next. Their RPO, extending out into future years, is significant. This level of visibility, certainty, and predictability in revenue growth is appreciated, and therefore highly valued, by the market. Okta shares currently trade near 26x sales over the next twelve months.
Closing
While recognized revenue is important, there are many more aspects of the sales efforts than can provide valuable insights into the quality and durability of a business. The growth rate of recognized revenue, the deferred revenue and how it changes over time, and the remaining performance obligation showing the total book of contracted revenue are all critically insightful metrics.
Companies with high growth, high levels of deferred revenue as a percentage of recognized revenue, and/or high levels of remaining performance obligation as a percentage of recognized revenue often fetch higher valuations.
References and Additional Reading
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Torre Financial is an independent investment advisory firm focused on emerging and established compounders.
Federico Torre
Torre Financial
federico@torrefinancial.com
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