Making sense of RPO, ARR and deferred revenues
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:
RPO represents the multi-year contracted revenue pipeline
ARR is a 1-year revenue projection and does not include non-recurring revenue such as consulting fees
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.
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