Making sense of RPO, ARR and deferred revenues

As we kick of a new earnings seasons (is it that time already?), I thought a quick refresher on this topic would be appreciated by this board. If you are an investor in a SaaS company, you likely have heard these terms bantered around…RPO, ARR and deferred revenues.

What the heck are they? Why are they important? How are they different from normal revenues? Which one is more important versus the others?

Here is my approach to understanding and tracking them:

RPO = Remaining performance obligations. This is a leading indicator of a company’s future revenues and, imo, is the best indicator to track. RPO is the total of all the $s that current clients have contractually agreed to spend with the company in the future. These are signed contracts and they tell you what the revenue pipeline is going to look like. We (investors) are not given insight into the duration of the contracts, but sometimes the company will indicate the timing of when these revenues will hit the books. As the sales team signs on new clients or extends the contracts of existing clients, they add $s to the RPO total.

ARR = Annual recurring revenue. If we do not have RPO, then I prefer ARR as a leading indicator for future revenues. ARR is the value of all contracted recurring/subscription revenues that are “normalized” for a 1-year period. E.g. If a client signs a 3-year $36,000 cloud hosting service contract, then ARR is $36,000 divided by 3 = $12,000. Meaning, the company will receive $12,000 in recurring revenue from the client for each year in the contract. ARR is the sum total of all such calculations for all the current signed contracts. There is no way to calculate ARR directly from RPO and vice versa because these numbers involve multiple contracts of varying durations and contracts might contain one-time non-recurring spend items that are not to be included in ARR.

Deferred revenues = $s that current clients have pre-paid in lieu of services that they expect from the company. These funds are shown on the company’s balance sheet in the Liability section. The firm holds the $s on behalf of the client and as services are rendered, those $s are recognized as revenue (on the income statement) for the quarter in which the work/service was completed. Deferred revenues are my least favorite leading indicator, although, often, it is the only future metric we are given in a quarterly report.

RPO = Deferred revenue + backlog

Backlog is the remaining $ value of the contracted services that the client has not paid in advance. Backlog is not useful to me as an investor…I would rather pay attention to RPO trends.

If you compare these metrics, usually…

RPO > Annual revenues > ARR > Deferred revenues

This is because:

  1. RPO represents the multi-year contracted revenue pipeline
  2. ARR is a 1-year revenue projection and does not include non-recurring revenue such as consulting fees
  3. Deferred revenues only include what clients have pre-paid in advance of services rendered.

If all this still has your head spinning, then I don’t blame you.

What makes things worse is that most companies do not report RPO or ARR and we are left to depend on deferred revenue numbers on the balance sheet and future guidance provided in a quarterly earnings report.

Beachman (@Iwannabeontheb2)

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What makes things worse is that most companies do not report RPO or ARR and we are left to depend on deferred revenue numbers on the balance sheet and future guidance provided in a quarterly earnings report.

Under ASC 606 all SaaS companies are required to report RPO. You will find it on the 10Q or 10K by doing a search on REMAINING PERFORMANCE. If you are only looking at the 8K you will not find it or if the company is not a SaaS company you will not see it.

https://flgpartners.com/the-remaining-performance-obligation…

Andy

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Thank you Andy! You made my day…

I did a few scans of a handful of 10-Ks and 10-Qs and I was able to find the RPO information on them. This is going to be very useful to me going forward.

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Your Welcome BeachMan, that was an excellent post that you made. A lot of very useful information.

Andy

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Agreed Andy and thanks BeachMan.

Probably a few of other metrics that certainly are informative if not critical to understanding the underlying health of a business particularly with certain SaaS business models and in particular with any businesses going through a cloud technology or business model transition could also include:

  1. Annual contract value (ACV and run rate ACV as opposed to Total Contract Value)
  2. Average Contract Term (ACT)
  3. Current vs Total RPO

Obviously these are additional to DBNER, Customer Growth, Customer Acquisition Cost (CAC), Gross Margin and Net Promoter Scores. Personally I also try to keep an eye on total annual revenue as a % of the Total Addressable Market (TAM) to help me understand how early in the innings they are, how long the run way is and where they might be in the S curve. As growth investors we might agonise whether the market cap of some of our investments are reaching points that might no longer yield another 10x but that’s not really something that can be concluded without looking at the TAM being addressed. Terminal growth rate of the TAM is also relevant here and why Amazon and Microsoft etc didn’t just go from $50bn to $500bn but went on to $1-2 trillion.

Very often companies will want to point out to analysts which measures they believe are most relevant and why. Some of the very best in this regard publish these definitions and why they are and why they are not useful/relevant their ER presentations. I would say it is totally fine to hold an individual investor preference for these metrics but I would definitely listen to what individual companies are directing us to and why.

Whilst not a metric in itself I also listen out to how sales incentives are aligned with or directly targeting certain metrics.

Ant

Some definitions are below…

Annual Contract Value, or ACV, is defined as the total annualized value of a contract, excluding amounts related to professional services and hardware. The total annualized value for a contract is calculated by dividing the total value of the contract by the number of years in the term of such contract, using, where applicable, an assumed term of five years for contracts that do not have a specified term. ACV Billings, for any given period, is defined as the sum of the ACV for all contracts billed during the given period. ACV Billings is the sum of New ACV Billings and Renewals ACV Billings.

Annual Recurring Revenue, or ARR, for any given period, is defined as the sum of ACV for all non life-of-device contracts in effect as of the end of a specific period. For the purposes of this calculation, we assume that the contract term begins on the date a contract is booked, unless the terms of such contract prevent us from fulfilling our obligations until a later period, and irrespective of the periods in which we would recognize revenue for such contract.

Run-rate ACV, at the end of any period, is the sum of ACV for all contracts that are in effect as of the end of that period. For the purposes of this calculation, we assume that the contract term begins on the date a contract is booked, irrespective of the periods in which we would recognize revenue for such contract.

Average Contract Term represents the dollar-weighted term, calculated on a billings basis, across all subscription and life-of-device contracts, using an assumed term of five years for life-of-device licenses, executed in the period.

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