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.
