Not all revenues are created equal

Investors typically like revenue growth. This makes sense: the faster revenues grow, the faster profits typically grow. So what’s not to like? Well it turns out that some forms of revenue growth are more valuable than others. Below we examine four key drivers of revenue growth and assess the economic profitability of each.

Price inflation – This is the most valuable source of revenue growth. Any increase in price – assuming no loss of volume – accrues directly to the bottom line of the business. As such, any business with genuine pricing power is a high-quality business. Pricing power is highly sought-after, however. So without very strong barriers to entry, pricing power will typically be eroded away by competing firms.

One business owned by Montaka with significant pricing power is REA Group (ASX: REA). In July 2016, the company implemented a price increase of approximately 12 percent.

Mix benefits – Growth via mix is associated with selling a larger share of higher-valued goods. While this drives top line growth, this growth is typically not as potent as pure pricing growth. Selling higher valued goods typically comes with higher costs of goods sold. As such, the profitability of growth via mix is less than that associated with price inflation.

One business owned by Montaka that has benefited from positive mix is Foot Locker (NYSE: FL). The sale of higher priced signature basketball shoes has been a key source of the company’s revenue growth over recent years.

Volume growth – Volume growth could be associated with higher traffic in a store; or even growth in the store base itself. While these are both positive drivers for the top line, they typically require investment to achieve. To drive more traffic in your store, you will likely need to spend more on marketing and advertising. Or to build additional stores, you will need to incur significant additional capital investment. As such, the economic profitability of volume growth is typically not as high as the two sources of growth described above.

One business Montaka is short is Hexagon (Stockholm NASDAQ: HEXAB). While the business appears to be growing “organically”, this excludes the cost of significant R&D that the business capitalizes. Taking this into account, the business needs to spend approximately $1.15 in R&D to achieve $1.00 of incremental growth. This essentially renders the value of the growth as neutral.

Growth via acquisition – Finally, growth via acquisition can go either way. When two businesses are combined, the result is obviously higher revenues. But the economic profitability of this growth depends entirely on the price that is paid for the new business; and the size of the revenues that can be generated as a result of the combination.

One business Montaka owns that has benefited from acquisitions is Playtech (LSE: PTEC). As a technology platform, it is able to distribute acquired technology to all members of its platform immediately. In other words, assets are more valuable to Playtech than they are to others.

What should become clear from the above discussion is the following: while all forms of revenue growth look the same in the headline numbers, the economic profitability of said growth is entirely a function of its source. Understanding the source of growth – and the magnitude of any investment required to achieve it – allows us to assess the value of that growth.

Screen Shot 2015-11-11 at 12.08.48 pmAndrew Macken is a Portfolio Manager with Montgomery Global Investment Management. To learn more about Montaka, please call +61 2 8046 5000.

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