RPMGlobal's marshmallow test

Your five-year-old self has one of two choices: one marshmallow immediately or two after 15 minutes. Which would you pick?

Of the 600 kids tested by Stanford psychologist Walter Mischel only one third could wait for the second marshmallow. This patient minority were better fed and also more successful later in life, if higher SAT scores are anything to go by.

Many established software companies face a similar test. They currently eat ‘immediate marshmallows' in the form of one-off licence sales, but changing to a subscription model offers a bigger meal, that's ultimately well worth the wait.

RPMGlobal is one such company, with 47% of total software revenue coming from one-off licence sales. That's a lot of immediate marshmallows. Trouble is, a large portion (42% to be exact) are sold in the final month of the financial year. So, a bad June for RPMGlobal would be like a retailer mucking up Christmas.

That's a big risk, and it's part of the reason why RPMGlobal, and other licence-based software companies, trade at much lower multiples than software-as-a-service (SAAS) companies.

Subscriptions

The solution? Introduce a subscription option – and that's what RPMGlobal is now doing.

Instead of having to buy the software outright, miners can now rent it from RPMGlobal as they use it. This transforms large capital expenditure into lower operating expenditure.

This isn't SAAS. The software will still be stored and accessed from the miner's computer,  because poor connectivity at mine sites prevents reliable access via the internet. So, the only change is to the payment terms.

But as we'll see, this will make a big difference to RPMGlobal's near-term financial results.

Revenue cliffs

If the market values SAAS businesses so highly then why don't all businesses make the switch? The answer is that it isn't easy.

Shifting to a subscription model creates what industry folks call a ‘revenue cliff'. Upfront revenue is now spread over time, causing total revenue to step down at the start of the journey (even though annual sales are unchanged), as the Table 1 shows.

Companies need strong balance sheets to withstand the temporarily lower earnings (or higher losses) it brings. They also need patient investors.

Revenue cliffs challenge investors whose idea of valuation is slapping a multiple on one year's worth of earnings. The business could be striding ahead but that won't reflected in the financial results, and that can befuddle casual observers.

Voluntarily reducing near-term earnings is a no-go zone for many management teams. They've raised capital on the promise of higher earnings and they're often incentivised on that basis, so like the five-year-olds in Mischel's test, holding out for two marshmallows could be a painful wait.

But greater value awaits the companies able to make the transition.

Awaiting two marshmallows

Market acceptance for RPMGlobal's subscription pivot was initially unclear. It's normally customer feedback that drives product innovation, but it was RPMGlobal's shareholders (including us) that suggested it.

But as RPMGlobal announced at its AGM, customers have responded very positively with prospective sales converting to subscriptions 'overnight'. So, it's likely that 2018 will be RPMGlobal's first step off the revenue cliff.

If we assume the company sells the same amount of software in 2018, but with 50% of licence sales converting to subscriptions, total revenue will fall by 16%. But the decline could be much larger if adoption is higher.

Point is, revenue growth is no longer a useful proxy for RPMGlobal's progress, so deeper thinking is required. As the first mover, subscription pricing could give RPMGlobal a competitive edge and could also expand the market by making its software more affordable to smaller resource companies. A big decline in revenue this year (due to high adoption of subscriptions) would be fantastic news for long-term shareholders.

But it could also discourage short-sighted investors. We've noticed heightened volatility recently and it's possible that more will follow.

This could be a source of opportunity, with wealth transferring from the impatient to the patient. But we're not there yet. So at current prices, up to a maximum of 3%, we suggest you continue to HOLD.

Note: The InvestSMART Australian Small Companies Fund owns shares in RPMGlobal. You can find out about investing directly in Intelligent Investor portfolios by clicking here.

Disclosure: The author holds RPMGlobal directly and also indirectly via units in the InvestSMART Australian Small Companies Fund.