When the term “financial due diligence” is used in the market, what typically comes to mind is a “quality of earnings analysis.” While quality of earnings analysis is important to understand recurring or operational earnings, there are a number of other meaningful analyses that should be considered.
The technology, media, and telecommunications (TMT) space are filled with competition and technological advancement, which requires a higher level of investor education in a fast-paced environment, especially during pandemic conditions.
The following are key analyses and considerations that can give any investor an in-depth look into the key drivers of a business in the TMT industry, providing unique vantage points into the potential upsides and pitfalls of a transaction.
Revenue analyses: Is the company appropriately reviewing and analyzing its financial statements in order to maximize the value of its service offerings?
1. Revenue recognition: While it is important to understand a company’s cash flow, it can be meaningful to review earnings under U.S. generally accepted accounting principles (GAAP) and Accounting Standards Codification (ASC) 606 (the new revenue recognition standard effective fiscal year 2019), especially in a transaction environment.
2. Customer retention: Customer retention analyses assess customer revenue trends over a period of time. The metrics used to calculate customer retention can be but are not limited to: recurring revenue, annual recurring revenue (ARR), total contract value (TCV), customer billings, customer count, subscriber count, user count, and logo count. Customer retention is considered a benchmark analysis for a company with a recurring revenue or subscription model.
3. Contracted backlog and estimated pipeline: Backlog and pipeline analyses can provide meaningful insights into expected revenue and, with the combination of customer retention, the analyses can provide meaningful insight into a company’s revenue forecasting and financial modeling.
4. Customer concentration: The tracking of how earnings are derived, and from whom can provide meaningful insights into a company’s customers, including: (a) understanding customer concentration risks and the potential impact from customer departures, (b) understanding commonalities in sales between the larger customers for upsell potential and marketing efforts, and (c) understanding opportunities for customer revenue diversification.
5. Lifetime value (LTV): An LTV analysis presents the total estimated revenue expected from a customer based on historical reported customer revenue and the estimated customer life span. A customer’s LTV can be a key metric for a growing TMT company and can assist management in making strategic business decisions.
Cost analyses: Is the company maximizing its profit potential and managing costs effectively and efficiently?
6. Gross profit analyses: Gross profit equals revenue minus costs to service the revenue. While the definition sounds simple, in practice, companies tend to define gross profit differently and, at times, incorrectly.
7. Utilization rates: Utilization rate is defined as the number of time employees spend on client-facing or billable assignments as a percentage of their total available time at work or employee plan hours. Utilization rates can provide meaningful insights into the company’s operational efficiencies and management of employee costs (including overtime).
8. Customer acquisition costs (CAC): CACs are costs associated with acquiring and monetizing a customer. CACs can help determine optimal pricing of a product or service and the scalability of a company. At a minimum, the potential earnings from a customer should be covering the CAC and the expected cost to service the customer.
9. Software development costs: When a TMT company has internal-use software (software-as-a-service (SaaS)) or external-use software (on-premise software) offerings, they face the challenge of determining which costs should be expensed versus capitalized. While the capitalization rules differ between internal-use and external-use software, tracking the supporting information is critical in either case.
10. SaaS Rule of 40: The Rule of 40 is an index to measure efficiency and growth for SaaS companies. The formula behind the Rule of 40 calculates the revenue growth rate plus EBITDA percentage, with the sum of these two ideally being equal to or greater than 40%.
While the importance and value of each of these analyses will be dependent on the target’s profile, each of these analyses should be contemplated in any proposed TMT transaction. Further, they can assist with calculating the company’s return on investment (ROI), or the net benefit or gain over the related cost. However, each company and transaction varies and consideration should be given to unique analyses, including cash flow management through the COVID-19 crisis that can be performed during diligence to better understand ROI.
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