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Remaining Performance Obligation: An Important Metric to Watch
Most software companies report remaining performance obligation, which is a nuanced backlog indicator to appreciate. But is it predictive? By Benjamin Tan
Emerging from the optimistic highs of 2021, the technology sector has witnessed rapid and massive derating that turned long-term bulls into pessimistic bears. Even established FANNG names like Netflix (NFLX 0.00%↑) and Amazon (AMZN 0.00%↑) attracted storms of negativity that drove their share prices from all-time highs attained in 2021 to record lows this year.
Bearishness in 2022, however, is not unfounded. From supply chain challenges and geopolitical instability to rapid tightening of monetary policies, growth companies are facing mounting challenges to meet hockey-stick projections. Many like Okta (OKTA 0.00%↑) and Twilio (TWLO 0.00%↑) have abandoned their prior multi-year revenue guides as macro conditions continue to distort visibility into future prospects. Investors have, in turn, become more skeptical of blue-sky scenarios presented by management and intolerant of losses incurred on expansive pivots to chase topline growth. Just witness the barrage of criticism that Mark Zuckerberg has encountered for trying to build a new metaverse business at Meta (META 0.00%↑).
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Amplified Multiplier Effect on Software Companies
The brutal business environment of 2022 has prompted many companies to curb corporate spend. Selling software tools has therefore become difficult, compared to prior years when almost every customer emerging from lockdown was on a mission to spend big on IT transformations. Few are immune to the current slowdown, whether SaaS platform giants like Salesforce (CRM 0.00%↑) and ServiceNow (NOW 0.00%↑) or next-generation DevOps players like Datadog (DDOG 0.00%↑) and JFrog (FROG 0.00%↑). Facing longer sales cycles and moderating IT budgets, technology companies are forced to rationalize overheads. Witness significant headcount reductions carried out by the likes of Salesforce (CRM 0.00%↑) and Amazon (AMZN 0.00%↑) in recent months.
Since technology companies themselves tend to be heavier users of modern software, multiplier impact on the sector is further amplified. The below quote from Endava (DAVA 0.00%↑ ) - a fintech consultancy - describes the dramatic shift in customer activity within the sector:
"...it would be around the 5% mark of our total business that is exposed to West Coast tech clients...It (had) been growing in the 20% to 30% range...probably shrinking 25%, 30% now"
Q1 2023 earnings call, Endava (November 15, 2022)
Remaining Performance Obligations: Looking into 2023 and Beyond
With all the bad news, rather than get carried away by day-to-day stock price fluctuations, it is far more important to track actual financial performance and operational development of each investee company.
An important metric for software companies is remaining performance obligation, or RPO. It is akin to backlog, representing non-cancellable future amounts to be recognized as revenues, pursuant to deals signed with customers. Such amounts can extend into years, depending on contractual duration. RPO is not reported in either the income statement or balance sheet but disclosed as a note, since it relates to future services not yet rendered. Once service is rendered, a portion of the RPO is reduced by an amount that flows into the income statement.
For example, when Salesforce (CRM 0.00%↑) signed a multi-year strategic agreement with AT&T (T 0.00%↑) back in March 2020, it was one of the largest transactions that Salesforce had ever done. Salesforce would only be recognizing fractions of the deal value (likely well north of $20mn) as revenues in the years that followed. RPO, however, reflected the entire contract value on signing in Q1 2021.
In a vibrant spending environment, customers are happy to commit to larger contracts (partly to get better pricing) over longer periods, so RPO rises in rapid fashion, much quicker than revenue inflection. Conversely, when business confidence is low, new customers become harder to sign up, and existing ones may downsize deals, demand pricing concessions, or disappear together. In which case, backlog will shrink faster than revenue.
RPO is hence a useful measure of business momentum. It gives an advance peak into potential revenues and cashflows to be recognized (or derecognized) in the coming quarters or years. Amid current uncertainty over the prospects of software companies, RPO is worth a closer look, beyond the rhetorics offered by management on earnings calls.
Illustrative Examples of RPO: Amazon and Zscaler
Each quarter, Amazon ( AMZN 0.00%↑ ) reports performance obligations related (primarily) to AWS. As of September 30, 2022, RPO was $104.3bn with a weighted-average remaining life of 3.8 years. AWS has a revenue run-rate of $80bn, so an RPO of $104.3bn (spread over 3.8 years) does not seem like much. This is because AWS has a significant usage-based component, so the bulk of its revenue is recognized as and when consumption happens, well above levels committed upfront by customers.
The above chart tracks the net RPO added each quarter, alongside year-on-year changes and revenue growth. Big picture, even at its vast scale, AWS continues to grow its backlog at more than a 50% pace, albeit with some slowdown in recent quarters. A weaker macro has resulted in some pricing concessions that have impacted RPO and revenue numbers. I had done a prior comparison of RPO between AWS and GCP (GOOG 0.00%↑) here.
Another example to illustrate RPO is Zscaler ( ZS 0.00%↑ ) which is closer to a seat-based model:
RPO at Zscaler shows more dramatic peaks and valleys since it is at a much smaller scale compared to AWS, and has gone through some ups and downs scaling the business in the last 5 years. Back in 2019 when it was experiencing organizational issues with go-to-market sales, RPO hit a snag for a few quarters in a row. Then, Covid-19 hit and accelerated demand for its cloud-based security solutions. From there, Zscaler capitalized on that paradigm shift from on-premise to cloud, before macro conditions started to slow down RPO some again. Notice that revenue growth has been far more stable in comparison. This is because revenue numbers are smoothed out via ratable recognition, compared to simple aggregation of contract values represented by RPO each quarter.
Nuances of RPO trajectories
In general, a slowing pace of RPO over consecutive quarters is not a good sign, but there are some nuances to take note of before making any conclusion about the underlying business. A few quirks to note about RPO:
Seasonality: The highest volumes for signing software contracts tend to happen in the second and especially fourth quarter of each year. As a result, sequential RPO jumps tend to be more pronounced in Q2 and Q4 during the calendar year, followed by large drops (or slower pace of adds) in Q3 and Q1, respectively. Year-on-year comparisons of RPO added may be more relevant
Consumption versus Seat-Based: As seen from the AWS example above, if the operating model is more dependent on actual usage, RPO become less informative, since a large part of software usage is spontaneous
Pay-As-You-Go versus Upfront: When the economic environment is uncertain, customers may prefer a pay-as-you-go monthly billing or sign short-term contracts that are less than 12 months. Even when offered pricing discounts, customers hesitate to commit (and pay more advances) upfront to multi-year contracts. As a result, RPO will suffer. But this does not mean that customers are lost or revenues will disappear. Datadog (DDOG 0.00%↑) is an example of this phenomenon, and I would recommend reading this article by Software Stack Investing
Monitoring RPO gives additional information as investors try to separate tech winners from losers in this tough environment. It is a far more sensitive indicator than revenue, and offers some predictive qualities.
The coming quarters are likely to display some extreme lumpiness in RPO, with difficult year-on-year comparisons, foreign exchange impact, sudden pullbacks on corporate spend, changes to usage patterns and more reluctance among customers on upfront commitments. A downturn in RPO does not have to mean an immediate red flag, but it does warrant further investigation to understand the reasons in this complex environment.
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