Each quarter, public companies report on financial and operational progress made over the last few months. Among the various metrics disclosed, a company's revenue is second to none in terms of attention received from analysts and investors.
How can we judge the quality of a company's revenue growth and if it can be maintained? Here we will answer that question using Salesforce.com (CRM -0.18%) and Zoom Video Communications (ZM 0.05%) as our two popular examples.
Is the growth organic?
An important revenue growth consideration is whether a company is generating that growth organically. This means an organization is creating incrementally more revenue from its existing base of assets and without leaning on mergers and acquisitions (M&A) to do so.
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In our examples, Zoom is generating the vast majority of its growth organically, but what about Salesforce? For CEO Marc Benioff, sales growth has gradually slowed from 30% to 40% to sub-30% more recently. This is normal for maturing companies carving out more and more of their addressable markets.
To combat this modest showing, Salesforce has made 29 total acquisitions over the last several years. When digging into the size trend of these moves, one of its most recent completed purchases, Tableau Software for $15.7 billion, was bigger than all previous 28 acquisitions combined.Additionally, this week, the company announced plans to buy Slack Technologies at a $27.7 billion valuation -- the deal is expected to close in 2021.
This reliance on purchases to broaden Salesforce's business is not necessarily a red flag. Still, it does hint at the company somewhat needing M&A to generate increased sales rather than doing so organically.
The M&A path is less sustainable than using existing assets to grow, as it is the more expensive and chaotic expansion method.
What does the market opportunity look like?
The size and growth of a company's industry is also an important consideration for gauging growth sustainability. An organization can be operated flawlessly, with zero hiccups, and still not be able to realize outsized, long-term growth. Why?
Some industries simply are not expanding as fast as others. For example, when looking at the global energy sector, the space has a compounded annual growth rate (CAGR) of just 1% to 1.5%. For our example companies, the picture is much brighter.
Over the long term, video conferencing is set to enjoy 8.6% growth, while Salesforce's cloud computing category is expected to see long-term growth of 14.2%. This brisker pace of expansion is a good sign for both companies' ability to maintain increasing demand.
Generally speaking, the more growth a sector is enjoying, the more growth a company within that sector can pursue.
Any special circumstances?
If a company is enjoying any unique and temporary boosts to revenue growth, that should be contemplated. Zoom, for example, saw historic 367% revenue growth in its most recent quarter; its cash provided by operations spiked by 562% to $411.5 million. While this is truly admirable, it is not sustainable.
Zoom has been aided by COVID-19's forced social distancing. People simply aren't able to engage like they can in a normal environment, and Zoom is there to fill the void for both business and social interactions. More companies enabling remote living -- such as Peloton Interactive -- have seen similar spikes to growth rates in correlation with COVID-19.
PTON Revenue (Quarterly YoY Growth) data by YCharts
What about Salesforce? The company has a wide array of products supporting remote work but it also relies somewhat on strong corporate technology budgets made less certain by COVID-19. Considering this, the temporary tailwind of COVID-19 is likely there for Salesforce as well, albeit slightly less pronounced than for Zoom.
While the pandemic has been immensely powerful for some companies' expansion, it is not permanent. As the world normalizes and social distancing fades, it makes sense to expect companies boosted by the pandemic to see growth revert back to more normal levels.
Zoom's and Salesforce's expansion will not halt, but could very well slow when COVID-19 finally fades.
Understanding the fuller picture
Sustainability of revenue growth can be difficult to judge. Consistently maintaining expansion is no easy task and becomes even more difficult as a company matures. Evaluating where growth is coming from, how a company's sector prospects look, and if any temporary tailwinds exist should all be used to help us to evaluate how steady a stock's revenue growth can be.
