# A Little Thought Experiment

A Little Thought Experiment

I enjoyed figuring out a few things for myself and I thought I’d share them with you. Here they are:

Question 1. - How can it be that Crowdstrike’s subscription revenue grew at 98%, but total revenue only grew at 88%.

Subscription revenue was 87% of total revenue a year ago. It grew at 98%.

Service revenue was 13% of total revenue a year ago. It grew at 25%.

Here’s what happened. For simplicity let’s imagine we started with \$100 revenue last year:

\$87 of last years revenue grew by 98% so \$87 x 1.98 = \$172 so the subscription revenue growth alone accounted for \$172 revenue this year.

\$13 of last year’s revenue grew by 25% so \$13 x 1.25 = \$16 so the service revenue growth accounted for the other \$16 of this year’s revenue.

Putting them together we have \$188 or 88% growth in total revenue. (It was actually slightly above 88% growth, but we rounded off).

Are you with me so far? Obviously it’s the slow growing service revenue that makes the total revenue growth smaller than the Subscription revenue growth.

Question 2. - So what happens as subscription revenue grows faster and becomes more and more of total revenue?

Just for fun, let’s assume that they have the same growth rates next year (they probably won’t, of course) and see what we get. Let’s start again with \$100.

\$91 of this year’s revenue was subscription revenue and only 9% was service revenue.

So \$91 of this year’s revenue will grow by 98% in our little thought experiment, and \$91 x 1.98 = \$180.18. This means that the subscription revenue growth alone will account for \$180.18 of revenue next year.

\$9 of this year’s revenue will grow by 25% so \$9 x 1.25 = \$11.25. This means that the service revenue growth will account for another \$11.25 of revenue next year.

Putting them together we have \$191.43 next year, or 91.43% growth of total revenue, and we see that with the rates of growth for subscription and service revenue remaining unchanged, total revenue growth would accelerate by 3 points, just because of less service revenue.

Clearly, it’s the slow growing Service Revenue that is holding back the total revenue growth (service revenue is only growing at 25%, after all.) However service revenue becomes a smaller and smaller part of total revenue each year, because subscription revenue grows so much faster, and thus each year the total revenue growth rate will look more and more like the subscription growth rate.

Now, with the law of big numbers, subscription revenue probably won’t grow as fast next year as this year, but the diminishing role of service revenue will help to cushion and offset some of that law of big numbers effect, and the amount of slowing of growth will be somewhat smaller than expected.

Question 3. – So what will happen with the “Law of Big Numbers.”

Well, subscription revenue growth didn’t fall at all sequentially this quarter, but we can’t count on that to last, even with a company as successful as Crowdstrike. Let’s assume the rate of growth falls 2% per quarter going ahead and is 90% a year from now. For a fall of equal proportions we’ll say service revenue only grows at 21%. What happens? Let’s start again with \$100.

\$91 of this year’s revenue was subscription revenue and only 9% was service revenue.

So \$91 of this year’s revenue will grow by 90% in our little thought experiment, and \$91 x 1.90 = \$172.90. This means that the subscription revenue growth alone will account for \$172.90 of revenue next year.

\$9 of this year’s revenue will grow by 21% so \$9 x 1.21 = \$10.89. This means that the service revenue growth will account for another \$10.89 of revenue next year.

Putting them together we have \$183.79 next year, or 83.8% growth of total revenue, and revenue growth would decelerate by 4.2 points, or just over half of the 8% subscription revenue growth rate drop), but that 84% remaining growth rate is still a very high growth rate number.

We can see how the reduced service revenue cushioned the 8-point drop in subscription revenue growth. Also, by this time next year, subscription revenue has become 94% of revenue, and service revenue has dropped to only 6%. This will go on to cushion the next year’s decrease in subscription revenue growth rate. It has a huge effect on gross margin as well, as subscription revenue has high margins (and which are rising year to year) and service revenue usually has margins that are just above breakeven.

Question 4 - So why are some people assuming just an 80% growth rate next quarter, down 8% in a single quarter?

Darned if I know. Perhaps they didn’t do the kind of figuring that we just did? Perhaps they believe that after growing subscription revenue at 98% two quarters in a row, and after growing annual recurring revenue by 97%, and by 32% sequentially, that by some magic their growth rate will miraculously drop 8 points overnight? Maybe they actually believe management’s ridiculous low ball estimates? I don’t know.

I hope that you enjoyed playing with these numbers with me.

Best to you all,

Saul

A link to the Knowledgebase for this board is in the Announcements panel that is on the right side of every page on this board.

For some additions to the Knowledgebase, bringing it up to date, I’d advise reading several other posts linked to on the panel, especially “How I Pick a Company to Invest In,” and “Why My Investing Criteria Have Changed,” and “Why It Really is Different.”

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As the company matures and subscription revenue growth
becomes the biggest contributor to earnings and fewer
new customers are added is this the scenario we are
looking for in the long-run for a soft-ware company with
little overhead cost? I keep thinking the more contracts