The key to investing is buying good stocks. Sounds simple enough, right? If it’s so simple, why isn’t everyone a great investor?
Because what constitutes “good stocks” to buy is widely debated across the entire financial media landscape. Are the best stocks to buy cheap stocks, with price-to-earnings multiples below the market average multiple? Are they stocks with big yields, that pay you regardless of how the stock performs? Or are the best stocks momentum growth stocks, with 50%-plus revenue growth rates and huge trailing twelve month returns?
Arguably, it’s all of them. What makes a good stock isn’t a particular characteristic, but rather a combination of favorable characteristics which, when mixed together, create a winning recipe for long-term success.
With that in mind, here’s one favorable characteristic of a “good stock” in the internet era: lots of high margin recurring revenue.
Why is that a favorable characteristic? Recurring revenue means high visibility revenue since — barring some sea change of subscription cancellations — that revenue will come back next year. By the same logic, high margin, recurring revenue means high visibility profits, and as we all know, as go profits, so goes a stock.
Because of this, stocks with a lot of high margin recurring revenue are often set up for long-term success. That’s why I’ve put together a list of five growth stocks to buy with a lot of high margin, recurring revenue.
Stocks to Buy With High-Margin Recurring Revenue: Netflix (NFLX)
How Much of Revenue Is Recurring: Essentially 100%
At What Gross Margin: Over 35%, and climbing rapidly
Arguably the most well-known growth stock with a ton of high-margin recurring revenue is Netflix (NASDAQ:NFLX), the streaming service giant which collects nearly 100% of its revenue from annually recurring subscription fees, at a 35%-plus and rapidly rising gross margin.
Despite that attractive business model, there are two big concerns weighing on NFLX stock right now — competition and profitability. Both concerns are overstated.
On the competition front, linear TV packages are so expensive (upwards of $100 per month) and subscription TV packages so inexpensive ($10 to $15 per month) that consumers cutting the cord can afford to bundle together multiple streaming services. Indeed, at a $10 to $15 price point, most Americans would be willing to subscribe to two to three streaming services, according to a MorningConsult survey. Thus, Netflix doesn’t need to beat Disney (NYSE:DIS) or AT&T (NYSE:T). It just needs to be No. 2 or No. 3, which it unequivocally is and will remain to be given its data and reach advantages.
Competition concerns are also overstated. Yes, Netflix burns a ton of cash right now, and gross margins are just 35%. But, let’s zoom out and look at the business model. Netflix has relatively fixed content costs. Regardless of how many subscribers Netflix has, if it costs $10 million to make an original movie today, it will cost the same in five years, net of inflation. But, revenues rise with subscribers, so while costs are fixed relative to sub growth, revenues are not. Thus, the model is built to benefit from tremendous leverage at scale.
Net net, despite recent operational concerns, Netflix is still a winning growth company with a stable, high-margin recurring revenue base, that will one day produce huge profits at scale. Those huge profits will inevitably lead to big gains for NFLX stock in the long run.
How Much of Revenue Is Recurring: Roughly 85%
At What Gross Margin: At least 75%, probably above 80%
Another consumer-facing growth stock with a ton of high-margin recurring revenue is Chegg (NASDAQ:CHGG), the digital education platform which collects about 85% of its revenue from annually recurring subscriptions to its Chegg Services ecosystem, at a gross margin that is likely north of 80%.
The secular bull thesis here is simple. Most of the consumer economy has become all-digital, all the time. The academic world has not. Chegg is changing that, building a connected learning platform that gives high school and college students across America the digital education companion they’ve needed for the past several years.
Demand is huge — Chegg has grown subscribers at a near-40% compounded annual growth rate since 2012. That demand is paying up — Chegg Services revenue has grown at a 45% compounded annual growth rate since 2012. All that money is of the high margin quality — total gross margins are north of 75%, meaning the Services gross margin is likely north of 80%. And, above all else, the opportunity is huge — 3.1 million Chegg subscribers out of 36 million high school and college students … in the U.S. alone.
Big picture, this is a high-quality company supported by secular growth drivers. The company has a long runway for growth ahead of it, and produces tons of high margin, annually recurring revenue. That’s a winning recipe for long-term success.
How Much of Revenue Is Recurring: Around 40%
At What Gross Margin: Above 80%
Although subscriptions aren’t the bulk of its business model, e-commerce solutions provider Shopify (NYSE:SHOP) nonetheless collects about 40% of its revenue from subscriptions, and collects those revenues at a gross margin north of 80%.
Taking a step back here, Shopify is a Canadian-based company that provides e-commerce solutions to merchants of all shapes and sizes. In so doing, they’ve become the equivalent of a digital store front, or the commerce backbone for hundreds of thousands of merchants all across the world. The company makes money two ways — those e-commerce solutions are sold in subscription packages, and Shopify takes a cut of the sales processed through its merchants’ stores. Merchant sales make up the majority of revenue, but the subscription business is higher margin and, therefore, equally important to profits.
The bull thesis here is as follows. Shopify presently accounts for less than 1.5% of global e-retail sales. That’s a very small piece of this pie. But, Shopify’s share is rapidly growing, because of underlying secular trends promoting entrepreneurship and do-it-yourself mentalities among consumers globally. Those secular trends will remain in play for the foreseeable future. So long as they do remain in play, Shopify’s share of the global retail sales pie will rapidly expand. As it does, Shopify’s revenues will continue to march higher, and because the business operates at such high gross margins, that big revenue growth will lead to even bigger profit growth.
Long term, then, Shopify projects as a big-time profit growth company. All that profit growth should push SHOP stock higher in the long run.
How Much of Revenue Is Recurring: Almost 90%
At What Gross Margin: Over 90%
Perhaps the king of the subscription model, Adobe (NASDAQ:ADBE) collected 88% of its revenue in fiscal 2018 from annually recurring subscriptions, and those annually recurring subscriptions have yielded a gross margin north of 90% for the past several years.
Adobe didn’t earn the title of subscription model king for no reason. We all know the Adobe name — they are the only relevant name in the creative solutions world for photo editing, video editing, so on and so forth. But, back in 2010, Adobe didn’t really know how to maximize its monopoly in the creative solutions game. Then, a light bulb went off — pivot everything to the cloud, make everything a subscription and collect high-margin, annually recurring revenue from now until forever.
In 2012, they did just that. Consumers were upset at first. Their favorite creative solutions program went from being available forever for a one-time-fee, to being locked behind a subscription paywall. But, because Adobe has no competition in this space, those complaints eventually drowned out. Within a few years, everyone and their best friend had pivoted to the subscription model. Further, Adobe expanded its reach because — perhaps by luck — the world simultaneously became more visually obsessed, so more and more consumers and enterprises had a need for Adobe’s creative solutions.
These trends will remain in play for the foreseeable future. Adobe’s revenues will continue to rise as the world becomes more and more visually-obsessed, meaning more consumers will tap Adobe to edit and amplify their photos. At the same time, more enterprises will tap Adobe to create visually pleasing marketing and product/service experiences that relate to their visually-obsessed consumers. All that revenue will come in at high gross margins, so profits will simultaneously rise by leaps and bounds.
Net net, then, Adobe’s profits will continue to roar higher over the next several years. That will power equally robust gains in ADBE stock long term.
How Much of Revenue Is Recurring: Over 90%
At What Gross Margin: Over 80%
On the enterprise side of things, identity cloud pioneer Okta (NASDAQ:OKTA) generates over 90% of its annual revenues from subscriptions it sells to cloud security customers. Those subscription revenues generated gross margins north of 80% in fiscal 2018.
Let’s zoom out here. Okta has created something called the Identity Cloud. The idea behind the Identity Cloud is pretty revolutionary and genius. Essentially, instead of building a “castle” around a company’s workflows and processes, Okta has outfitted each individual in a company’s workflows and processes with “armor”. That is, Okta focuses on protecting the individual, not the whole. But, if everyone in the ecosystem has “armor”, then the whole ecosystem is safe. It also means that there is no “weak link”. Because everyone is wearing this “armor”, individuals can securely do almost anything without compromising the integrity or safety of the ecosystem.
Enterprises have found this identity-based approach to cloud security compelling. At its core, it allows individuals to securely access any technology at any point. This seamless adoption curve is critical in a world where new technologies are being rapidly adopted and deployed every day.
As such, Okta’s growth trajectory has been very impressive. We are talking “50%-plus revenue growth” impressive. Over 90% of that revenue comes from annually recurring subscriptions. That subscription-based revenue has 80%-plus gross margins.
In other words, this is a big growth business with high visibility and robust margins. Ultimately, that’s a long-term winning recipe.
As of this writing, Luke Lango was long NFLX, DIS, T, CHGG, SHOP, ADBE and OKTA.