Luxury Purchases Masquerading As Recurring Revenue: Is No Price Too High For Subscription Businesses?

Venture capitalists have added a new dimension to that well known Sherwin Williams slogan by covering the earth in subscription businesses. Having a ‘subscription’-based revenue stream today makes a business worthy of investor affection, even adoration. Even established businesses are contorting themselves into subscription services. Subscription revenue (and its cousin recurring revenue) is the elixir that makes fund raising and rising valuations possible. Startups and established businesses want you to buy mobility, ‘subscription boxes’, clothing boxes, shaving razors subscriptions, meal kits, computing power, online storage solutions, etc. all on a subscription basis; or better yet, ‘as a service’. In the view of this, let’s consider two thought experiments.

If you sell a widget, is your business worth more if you sell it as a subscription than if you sell it on a traditional ‘as needed’ basis? I believe the answer is no. All told, the consumer sees the same value in the product. Take meal kits. A consumer might be willing to value a meal at $10. That won’t change just because they ‘subscribed’ to a weekly delivery. Further, food consumers, in aggregate, will not rapidly increase their consumption (they can only eat so much, subscription or not) by more than say, 1-2% a year. That is just the nature of food consumption growth. One meal-kit company might divert a little business from a restaurant to grow faster using promotions. The same could be said of clothing boxes, etc. But when the whole industry doesn’t grow, the value proposition has to be undisputable. It’s true that where a subscription is priced lower than the traditional delivery mechanism (e.g. dollar shave club), there’ll be large consumer uptake (by drawing business away from incumbents even in a low-growth market like razors). But that is not a new paradigm; it’s simply proving an old paradigm that consumers gravitate to lower prices for equivalent value. So if every business in the country/world became a subscription business would they all be worth more? Certainly not. For one, most of these industries aren’t growing as a whole (food consumption example noted above). Second, aggregate revenues (based on what the consumer is willing to pay) don’t change and aggregate expenses probably go up because of the logistics involved, which means margins are lower. Third, there exists a mass of well-funded venture-backed competitors willing to lose money. Can this set the stage for increased valuations? In my view, no.

Yet, today companies are twisting themselves to fit a subscription model. Why? Because a sound idea (this time taken from software businesses) has come to dominate thinking in spaces where it just doesn’t apply. Subscriptions are used to tout customer “LTV”. Then LTVs are used to justify the need to invest NOW (before competitors invest) with venture raised funds rather than reinvesting capital generated by the business. But why the hurry? Why not prove the concept and then re-invest profits to grow the business? The thinking goes, “We cannot wait. E-commerce is a winner take all market. We better dominate before our competitor does”. In reality, there are very few winner-take-all markets. Internet Search is one of them. The credit card networks are another example. Meal kits are certainly not winner-take-all markets, though that didn’t stop HelloFresh from claiming that it was. There is no need for all consumers to order from the same provider. Same can be said for the growing list of clothing boxes, online storage companies, and market places. But consider how easy it is to sound like you have a network business… “Well, we will lose money to acquire a mass of customers. When we have a lot of customers, we can afford to have a lot more widgets (whether clothing options, meal recipes, data storage, or any other item), which means we can have yet more customers attracted to the growing choices now available. And no one will be able to steal customers from us, due to our scale. This means customers will not leave us…which means our LTV is large, which means we better lose money now to acquire customers.” This type of a sales pitch is happening daily in the VC/incubator/angel world. What are essentially luxury purchases afforded by the few are marketed to many in the upper reaches of an economic boom by the use of promotion subsidies (funded by VCs). The reality of Blue Apron, BirchBox, Chef’d, etc. would make one think the backyards of VC firms seem should be knee deep in dead subscription/network businesses. That reality has not been reflected in investment decision making.

The second thought experiment is comparing subscriptions to leases. When calling something a subscription business, it’s helpful to compare it to a lease. Leasing companies do not generally trade at the kinds of generous valuations afforded to ‘subscription’, ‘marketplace’, or ‘recurring revenue’ companies. Why? Because they are financing companies, subject to the vicissitudes of the economy, credit quality, unemployment, defaults, etc.

One thing a lease shares in common with a subscription is recurring payments. But there’s a big difference. While a lease is a legal contract requiring payments, a subscription is ‘at-will’ and cancellable with little notice. Leases also generally finance ‘expensive objects’ which are sold once and paid-for over time. But in services (meal kits, delivery, or mobility), there is no object; the service is continuously provided. This seems like a big difference and is the reason why financing components of, say, John Deere are easily separated for analysis. However, I believe the second difference is only cosmetic. The company is agreeing to keep providing the service (which means they must keep incurring related expenses) and the subscriber is agreeing to buy it, until they stop buying it. What makes some subscription businesses better than others is that the nature of the product keeps the customer from cancelling. For e.g., ERP software. This makes is kind of like a lease (but even better), an almost-certain stream of payments from the consumer that is unlikely to get cancelled baring the unthinkable. This is why the concept of LTVs made a lot of sense is some types of software. However, that is certainly not the case with a meal kit, a Netflix subscription, or even in-app purchases. At the first hint of trouble to the consumer, the meal kit, the clothing box, and other ‘subscriptions’ are as likely to be shown the door as a meal out at a restaurant and a shopping trip to Nordstrom. Leases will fare much better as they did during the GFC because of their contractual nature. And if we value lease companies with the fear of credit quality, economic fluctuations, and default, then these should be considerations for ‘subscription’ businesses also, which are already structurally weaker as noted above.

This extends even to established platforms like Apple. While services revenue is growing at a nice clip, will it be too difficult for end users to switch to free Google Photos (or other storage) from iCloud in the event of a little belt tightening? This line of thinking applies to even phone sales which, having stagnated, are now reliant on price increases. Many customers finance their phones (a true lease, not ‘communications subscription’) as you would a big ticket appliance (the phone almost replaces the ‘home computer’ of yesteryear). As a result, in a less forgiving economic environment we should expect the sales of high-end phones to show the similar (though less severe) character as sales of homes or cars, i.e. consumers make the old ones last longer are loathe to take on (and do not qualify for) new financing. I’m simply using Apple as an example. I don’t think this factor should have a big bearing on Apple’s valuation because Apple’s valuation is quite reasonable and some of this appears priced in unlike in the subscription unicorns of the world.

The latest example of the luxury good masquerading as a subscription service is, of course, Peloton. The company raised $550 million just a few days ago at a valuation of $4.15 billion. Just 16 months ago, this valuation was $1.25 billion. According to Fortune, “Peloton will use the money to expand internationally, bring a treadmill to market and establish itself as the premier source of fitness-related content. The company will open in Canada and launch five retail locations in the U.K. this fall, its first moves beyond the U.S.”

The proposition goes like this: you buy a $2000 stationary bike. This can be financed in a ‘true lease’. Then you pay an additional $39 per month ‘subscription’ to access their library of training videos. “The Peloton Monitor only shows Peloton content. Without the subscription, the bike will have 3 pre-selected classes and will show the metrics while riding, but will not track them to your profile”, according to the company. In other words, the Peloton bike is useless without the subscription. Even at a 0% APR, the cheapest package costs $58 per month for the bike (for 3 years!) and another $39 for the subscription, for a total of $97 a month before taxes. (The newly coming treadmills will sell for $4000, so the cost will be almost double for runners). Now this total of $97 is more than the monthly cost of many gym memberships, which come with live classes. If gym memberships didn’t have great persistence when consumers suffered last time, what gives confidence that Peloton costing many times as much will? The company wishes to establish a ‘platform’ by signing up fitness content (like Netflix) to be transmitted through the Peloton monitor. Needless to say, with normal stationary bikes retailing on Amazon for $200 and free availability of YouTube classes, the value proposition is seriously in question.

Also not to be ignored by investors are the omni-present competitors in a capitalist economy such as Flywheel, NordicTrack, and Echelon. Part of the recent capital raise will be used to fight these competitors, which is generally not a positive-return activity. However, this is a season where no price is too high. Accordingly, the company is looking to go public in 2019, notwithstanding the fate of Soul Cycle whose IPO was cancelled last May due to ‘market conditions’.

The CEO has said the company is profitable, though it’s not known on what basis…GAAP, non-GAAP, EBITDA, Adj. EBITDA, or EBITDA before customer/marketing expenses (seriously, this exists). Certainly, Peloton isn’t profitable enough to fund $400 mm on its own or in the debt market. But, when a $4.15 billion valuation is placed on a company with $700mm in revenues, unreliable profitability, a small target market that solely resides in large cities with high incomes and small dwelling, it seems ‘subscription’ based ‘platforms’ are a better sales pitch to investors than $4000 treadmills might be to consumers. Investor enthusiasm at this price, which has already tripled in 16 months was best captured in a NY Times article,

Jay Hoag, general partner of TCV, compared the business model to Apple’s iPhone and App Store. And he said Peloton’s repeat revenue from subscriptions reminded him of Netflix, where he’s a board director, and of Spotify, a TCV portfolio company. “They have a similar-sized opportunity to reshape fitness,” he said.