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Running the rule over the subscription economy

Companies of all shapes and sizes are pinning their hopes on subscriptions and recurring revenues. Can a tech-friendly business model work for all sectors?
Running the rule over the subscription economy

More than 400 years since the first book was published by subscription – and more than 160 years since the first edition of the Investors’ Chronicle – the business model is capturing the attention of companies and investors on a scale much greater than our forebears could ever have envisaged.

When we think of subscriptions we still instinctively think of media, albeit streaming services are as likely to come to mind as the printed word nowadays. But technological advances are not confined to the world of video-on-demand: offering products and services on a subscription basis is becoming increasingly prevalent across almost every part of the modern economy.

Subscription services aren’t new, and nor is the concept of the ‘subscription economy’: it has been touted in management consultant circles, insofar as such things exist, for at least half a decade. The idea was that an increasingly digitised world would provide opportunities for businesses of all kinds. But away from the media world, much of this growth has been happening in the background – or at least in the back office – via the increasingly ubiquitous provision of cloud services and accompanying software offers. The valuations afforded to software-as-a-service (SaaS) companies emphasise that investors have been eager to capitalise on these opportunities. But from the perspective of the individual in the street, this boom wasn’t always readily apparent.

That has all changed following a two-year period in which large swathes of society were frequently confined to their homes. Consumer goods companies have entered the fray like never before, delivering their products to customers’ doors for the first time. Over a fifth of UK retailers developed a subscription service or product during lockdown, according to analysts at Bernstein, on top of the 28 per cent who already offered such services.

From video games to luxury goods (where the promise of exclusivity and new products is particularly persuasive), the subscription model is extending its reach across all kinds of consumer markets.

Many of these companies are early-stage ventures, using cloud-based systems and subscription-based payment management tools offered by highly valued US fintechs such as Stripe and BlueSnap to set up on the cheap. In true tech sector style, they often begin operating with a loss-leader pricing strategy. But the trend also encompasses the very biggest consumer brands, from Unilever (ULVR) and Procter & Gamble (US:PG) to Hermes (FR:RMS). In these cases, the shift to selling cosmetics, or toothpaste, or handbags on a subscription basis raises the scenario of cutting out traditional distributors entirely.

“A subscription product, with steady income and guaranteed order size and demand, is allowing previously B2B companies to become B2C, potentially changing the balance of power between retailers and manufacturers permanently,” said Bernstein in a recent research note.

The change in mindset is not confined to retail markets. Companies from a wide range of sectors are either signing up to subscription models, offering such models to their own corporate customers, or both.

The emergence of cloud computing set the scene for the SaaS boom, and that same ability to access systems remotely, and/or to rent solutions rather than purchase them outright, is now making it much easier for other industries to shift from a product to a service mindset. The traditional focus on individual transactions is being superseded by a desire to stay close to the customer for as long as possible: what began as software-as-a-service is gradually becoming 'everything-as-a-service'. The acronym – XaaS – is unlikely to win any marketing awards. But product manufacturer chief executives, who have long looked enviously at the multiples on which cloud software companies trade and the higher margins they produce, are keen to join the party on whatever terms they can.

Those making such plans have typically been given a warm welcome by shareholders. The recurring revenues on which subscription models are based are highly valued by investors: reliable revenue streams are a classic sign of a quality business, prized by everyone from venture capitalists and private equity to industry figureheads and traditional asset managers. Repeat custom is a core attribute of the type of company in which Warren Buffett likes to invest; in the UK, popular domestic equity funds like Liontrust Special Situations (GB00BG0J2688) also place a particular focus on recurring business. Subscription revenue streams should, in theory, also make forecasts simpler and aid with a number of other internal business variables, from retention costs to inventory management.

But behind the hype, there are significant challenges – financial, logistical, and behavioural – for companies to overcome and for investors to monitor. Private investors must also pay close attention to these business models, and familiarise themselves with a different range of financial metrics, if they are to make hay.

 

Teething problems

For starters, not all recurring revenues are alike. Insurers have plenty of repeat business, but aren’t exactly renowned for having an engaged customer base. In the hardware world, investors who have found success with companies that lease rather than sell equipment, such as Ashtead (AHT), could be forgiven for thinking they are already on board with the subscription mindset. But as the name implies, it is the ‘service’ aspect that XaaS advocates insist sets it apart. Rather than simply renting out hardware, the idea is to provide training, maintenance and ongoing support to the client, all of which should foster engagement, increase loyalty, garner much more data on customer preferences, and create the opportunity to provide add-on or cross-sold services as part of the relationship.

The obvious precursor in the industrials space is Rolls-Royce’s (RR) power-by-the-hour jet engine maintenance programme, which began all the way back in 1962. Sixty years on, great claims are being made for equipment providers’ own role in the subscription economy. Astute Analytica forecasts a compound annual growth rate of 11.5 per cent for ‘equipment-as-a-service’ between 2021 and 2027.

Switching to this kind of approach is easier said than done. It’s not simply tardiness that causes the likes of industrials to lag behind other sectors when it comes to digital subscriptions (SEE PIE CHART). Combining elements of software and hardware businesses under one roof is no small task. High barriers to entry make it much harder for new entrants to make a stir, and transitions for existing businesses are little easier. Financial modelling must incorporate the fact that assets will stay on the books for longer – which means depreciation must also be taken into account. Salesforces must adjust their own mindsets and incentive schemes, and work more closely with other departments. And the financial costs – of buying and then holding onto equipment, and shifting to revenue streams that accrue over time – may necessitate external financing.

Faced with those kind of demands, it’s no surprise that many companies take a more iterative approach, for instance by buying a business that already has large recurring revenue streams and running it as a separate entity; or by sticking with the existing sales model and offering after-care or maintenance services on top.

Management teams are fond of calling this shift a ‘hybrid’ approach. But there can be risks here too: a better term might be ‘halfway house’. Stephan Liozu, former chief value officer at Thales (FR:HO) and author of the Industrial Subscription Economy: A Practical Guide to Designing, Pricing, and Scaling Your Industrial Subscription, says keeping a foot in both camps can prove counter-productive, not least because it can encourage a half-hearted approach when it comes to subscriptions.

“Generally speaking industrials have not been applying the best practices from the direct-to-consumer world,” he says.

“For example, many [businesses] make it very difficult to find the info on subs on their website; they do not publish transparent pricing, it’s a case of one size fits all. A fair amount also include the subscription in the price of the equipment or product in order to justify the premium, instead of creating a separate offer they could monetise.”

While the pandemic has accelerated a shift to digital services, and increased the confidence of those who insist a cloud-based future awaits almost every sector, Liozu thinks it has made some companies more wary of the financial implications of shifting business models.

“The [issue has been] the capex implications and the financial risk during the pandemic, the risk to balance sheets”.

In other sectors, the benefits of a hybrid model are more obvious. Carmakers have been investing heavily in software services, and, alongside the shift to electric vehicles, are banking on this business line as the key to their future success. Volkswagen (DE:VOW3) chief executive Herbert Diess, speaking to technology website The Verge in January, went as far as to claim that “the differentiation, the competitiveness, and the customer experience will all depend 90 per cent on software [in the future]”. That looks a bold claim but Volvo (SE:VOLCAR), for example, brought its software development in-house last year and is shifting its entire sales model online as part of its push into subscription services.

The SaaS sector, the cradle of the modern subscription business model, also offers cautionary tales. The travails of Sage (SGE) show that even a business which appears well-suited to a recurring revenue model – selling accounting services to a SME customer base - can stutter along the way.

Subscription services now make up 70 per cent of Sage’s total sales, with recurring revenues from maintenance and support programmes (which it breaks out separately) accounting for a further 22 per cent. But its shares effectively went sideways for much of its transition to this model. Tardiness was partly to blame – competitors like Intuit (US:INTU) and Zero (AU:XRO) were much quicker in recognising the benefits of a subscription, cloud-based service. But there have also been operational pains, as in its first-half results in 2018, when the company acknowledged that it had eaten into some of its existing maintenance and support revenues in a bid to shift UK customers to the broader subscription services.

Sage’s fortunes are also a reminder that recurring revenues are no panacea – even now, several years into its transition, margins are under pressure and research and development spend is still having to be ramped up. Sage is now guiding for margin growth again, but the wave of money still flooding into the cloud software sector means competition isn’t going away.

 

Subbed off

Business-to-business (B2B) subscription services do have one distinct advantage over their consumer counterparts. B2B enterprises are unlikely to suffer from the same kind of subscription fatigue that some think could increasingly dog the consumer space.

These suspicions are understandable: life is returning to something like normality for much of the Western world, and the increased spending on products as opposed to experiences is likely to mean revert to an extent. Subscription businesses’ attempt to portray their own offerings as experiences is unlikely to withstand this shift in mindset.

A survey from Barclaycard Payments last summer found UK households were spending an average of £52 a month on subscriptions, up 12 per cent from a year before. The cost of living squeeze will also put pressure on these charges. The ‘cancel any time’ flexibility offered by subscription services, a key selling point in many quarters, may prove a double-edged sword.

Others have seen a different kind of pushback. Warhammer retailer Games Workshop (GAW) made headlines last autumn with news of a boycott from a minority of its fiercely loyal customer base. The complaints centred on a crackdown on unofficial fan websites – a move that appeared to be sparked by the imminent launch of the company's subscription service Warhammer Plus. 

The episode may also speak to a broader issue with this business model. Goods and services that are increasingly being rented rather than owned help lower the upfront costs to consumers, but in some quarters this practice is seen as yet another example of younger generations being unable to take a stake in society. The rationale behind ‘web3’, which posits that everyone can acquire their own part of the internet of the future, is arguably a reaction against this – even if ownership rights in this case extend no further than intangible digital assets.

Advocates say that the rental model appeals to the modern, environmentally conscious consumer. But this too can work both ways, and there are warning signs flashing for some commercial businesses that have had success building recurring revenue streams.

Tractor maker Deere & Co (US:DE) is another industrial pioneer of subscription services, selling its software to farmers who value its data for the marginal gains it can provide to crop yields. But the burgeoning ‘right to repair’ movement, which sees mending devices and equipment as a crucial part of a sustainable, ‘circular’ economy, has set its sights on the company. Two lawsuits were filed in the US last month, claiming that the need for software updates prevents farmers from going elsewhere to fix their own equipment.

 

Valuations

These issues are far from market-moving – not when Deere is forecasting a 20-25 per cent increase in net sales from its production and precision ag (software) division in the current fiscal year. But issues like this show strains can be put on the basic principle of subscription set-ups: keeping the customer happy. That ethos is not so different from any business model, of course. Yet companies and their investors prize the stability of recurring revenues, and any sign that these are on the wane tends to be viewed dimly.

Such problems are now confronting many US recurring revenue titans: think of the questions over Netflix’s (US:NFLX) customer growth rates, or the growing suspicion that competition across the SaaS space is getting tougher.

That’s particularly the case when so many subscription companies trade on elevated multiples. In 2022, when rising interest rates are affecting the discounts applied to all businesses’ future cash flows, any sign of weakening growth simply compounds those worries.

It’s not hard to argue that this particular part of the as-a-service economy was overdue a period of reflection. Last year saw the emergence of Pipe, a US marketplace that allows SaaS start-ups and their kin to sell off future revenue streams ahead of time. The Financial Times reported last March that the company ultimately aims to securitise those revenue streams. That goal can’t help but bring to mind the overconfident bankers who did something similar with consumer mortgages back in 2007. Pipe itself was valued at $2bn in a funding round last summer.

But not all XaaS companies are priced in such delirious ways. The Natixis IM Thematics Subscription Economy fund (LU2205575967), launched at the start of 2020, claimed at the end of last year that the universe of subscription businesses “now trades at a historic relative discount [to the wider market] while still posting hefty premiums in terms of EPS and sales growth”.

Precise valuations will always be in the eye of the beholder, but there are quirks to watch for when it comes to subscription-focused businesses. Chloe Smith, an analyst on the CFP SDL UK Buffettology (GB00BF0LDZ31) and CFP SDL Free Spirit (GB00BYYQC271), funds, both of which target businesses generating recurring revenues, says a traditional discounted cash flow analysis is a sensible option.

Monitoring the health of those companies’ cash flows is a different question. Companies transitioning to repeat revenue streams like to shout loudly about the growth of their recurring revenues. But this growth, if it is cannibalising existing sales, can cause problems for the top line and indicate the “transition” may take longer than first thought, as Sage has found out.

One risk factor on which investors should try to keep an eye is customer churn. Customer retention is much cheaper than customer acquisition, and the compounding effect of retaining customers for a lengthy period means avoiding churn is effectively a form of operational leverage for a business. Other key metrics such as average revenue per customer (ARPC) feed into this: businesses with lower ARPCs are likely to have higher churn rates, because the customer base can more easily move on. And differing pricing models for different customers means revenue churn should be examined as closely as customer churn - one does not always equal the other.

The problem is that these metrics are not always disclosed by businesses, particularly now the as-a-service model is spreading out far beyond its original sectors. Smith says “it depends which area a company operates in. In the software space companies get asked about it continually. [In other areas] you can’t clearly see any reporting on churn. It [will] all come down to whether there is demand for it”.

Those who do take the plunge have plenty of options available. The UK is not known for its tech focus but the ubiquity of SaaS and related industries is such that there are a variety of different UK-listed companies in the space, from large businesses like Sage and Aveva (AVV), to a range of Aim-listed stocks like Ideagen (IDEA)Gamma Communications (GAMA), Sopheon (SPE) and Beeks Financial Cloud Group (BKS). But the investment case for the sector is not a new one, and the valuations of these types of businesses, here as in the US, reflect the fact that a lot of investor money has already poured in. The same goes for other listed companies that rely on recurring revenues, such as Smart Metering Systems (SMS), which trades on a forward PE of 56 times.

For all their flaws, finding a hybrid business model might still be the best way for a private investor to get in on the ground floor. Businesses like Bloomsbury (BMY) (‘Bloomsbury’s compelling narrative’, IC 11.02.22) spring to mind - education is another big growth sector for the subscription model – or even Weir Group (WEIR). Jefferies upgraded the engineering and services firm last month, saying that while there is “still work to be done to prove the doubters wrong”, the company has done much heavy lifting “under the radar” in recent years in a bid to improve its cash flow and margins, setting the scene for a further push into software and automation.

 

Looking ahead

Even the frankest assessment of all the risks involved in subscription businesses is unlikely to conclude that the XaaS sector as a whole faces headwinds. The ability to extract more value from customers on a multi-year basis, while ostensibly providing improved levels of service all the while, is too tantalising a prospect for company management teams. The advent of cloud-based services and more sophisticated payment processing tools have opened up that opportunity to a much wider range of businesses. And for those that are struggling to make the shift, help is on the way. Liozu notes that banks are developing new financial instruments, distinct from those used in the leasing world, to help support companies manage the initial cash flow impact of moving to a subscription-based model.

From an investor standpoint, the prospect of reliable cash flows, higher margins, and improved returns on capital afforded by such business models is just as unlikely to dim any time soon, whatever the growing pains suffered by particular businesses.

And while there is a question mark over sections of the consumer market, demand for XaaS from the business world is continuing to increase. The ability to sign off as-a-service purchases as operational expenditure rather than upfront capital expenditure, is a particular benefit from a financing perspective – as is the flexibility afforded by rental models, and the perception that the manufacturer is sharing more of the overall business risk.

Even regulatory changes are proving supportive: the introduction of IFRS 16 accounting standards at the start of 2019 meant companies were no longer able to keep leased equipment off their balance sheet. In this context, leasing carries as much financial pressure as purchasing assets outright – a consequence that will create more interest in equipment-as-a-service. Accounting reforms are a rather more mundane driver of change than the grand catalysts spurring on other types of recurring revenue. But they do emphasise that, like any economy, ultimately it is the aggregation of actions, large and small, that is pushing the subscription economy onwards.