Equity Research Analyst
500 miles north of San Francisco, stands one of the last holdouts from the rise of Silicon Valley. Bend, Oregon, is home to the world’s last Blockbuster, the sole survivor of what was once an 8,000 strong empire in the US, with thousands more across the world.
Blockbuster’s decline is a modern day parable about a failure to move with the times, specifically, the rise of the internet. Beginning in the mid-2000s, internet speeds gradually became fast enough to stream video on demand. Netflix, Blockbuster’s nemesis, was quick to realise the implications, particularly after seeing how people reacted to early stage video streaming sites like YouTube. As one executive of Netflix said, ‘YouTube clearly demonstrated that people were willing to trade fidelity for convenience and speed.’ They had to be able to offer what YouTube offered, video on demand, wherever you were.
While people always understood that the internet would become faster and more ubiquitous, few appreciated how fundamentally it would reshape television. There are now around 2.5bn smartphones in the world, each offering the ability to stream video on demand. Internet television is replacing traditional television, and television on mobile is accelerating this trend.
The internet has done much more than just move television online though; it has fundamentally reshaped our relationship with many of the things we used to buy or consume. Want to listen to music? Get a Spotify subscription. Thinking about trying something nice for dinner? Sign up to Hello Fresh, a meal delivery kit. And need to get from A to B? Check your route home on Citymapper, where you’ll soon be able to subscribe to a monthly service covering London’s tube, bus, train and cycle services. Subscriptions are now big business, and they’re coming to a smartphone near you.
The idea of the subscription is not new – their use in print media can be dated to the seventeenth century – but subscriptions are increasingly big business. Companies running on subscription models grow their revenues eight times faster than listed US companies as a whole, and Royal Mail is predicting the UK subscription box market to be worth more than £1bn by 2022, a 78% increase on current levels.
There are two broad types of subscription companies. Digital subscription businesses are perhaps what most people are familiar with; internet streaming companies like Netflix and Spotify, now count more than 235 million paying members between them. The second are those that deliver physical products to your door. Graze, for example, delivers selections of healthy snacks, with people able to choose their own products, or be surprised by what an algorithm recommends for them. Subscriptions boxes also promise convenience and low cost. Brands like Dollar Shave Club, for example, have built up a loyal following (and billion dollar valuations) by delivering affordable, quality razors for men fed up on shelling out on the best a man can get.
The success of Netflix in particular lies in its ability to deliver exactly what people want. Netflix is expected to spend $15bn on content in 2019, approximately the annual budget of the BBC and Sky Broadcasting combined. The more content Netflix can offer, the lower its rate of churn, or the number of people cancelling their subscriptions. Netflix also invests heavily in monitoring the behaviour of people on its site and working out what they like, tying them in ever more closely into its service.
The ability to recommend something you might like or tailor a service is part of the reason why subscriptions have become increasingly prominent in recent years. Netflix and Spotify don’t just offer access to a vast library of programmes, films and music, they recommend what you might like based on your viewing or listening habits. In doing so, they offer much more than the traditional experience of owning music.
For younger consumers, another attraction is not having so many physical possessions. You can save up to 10,000 songs in your personal Library in Spotify. On conservative assumptions, that would be the equivalent of a collection of 250 CD cases.
The catch for subscription businesses, is the need for a relentless focus on convenience. In its quest for global streaming dominance, Netflix has put its own button on remote controls, worked with manufacturers to build televisions recommended for its service, and even developed a way to adapt the quality of your video depending on the speed of your internet. That last development has allowed Netflix to expand into countries with poorer internet infrastructure, and is why you rarely see Netflix video buffering like you would on other internet sites.
All these attributes add up to give Netflix a formidable advantage versus other media companies, allowing the company to attract new customers, and giving it pricing power – the ability to raise prices over time.
While the internet has enabled the rapid growth of streaming services, the ability to order online has also helped to deliver the growth of another subscription industry – subscription boxes like those of Graze mentioned above. Generally speaking, subscription box companies have tried to capture two types of customers – those wanting to make repeat purchases of something, and those looking to treat themselves or try something new on a regular basis.
Perhaps the most successful of repeat purchases businesses has been Dollar Shave. Between 2010 and 2016, Gilette’s share of the male shaving market in the US fell from 70% to 54%. Dollar Shave Club, attracting customers through a smart marketing message, went from a standing start in 2012 to $200m of sales in 2016, when it was bought by Unilever for £1bn.
The growing ability to capture the subscriber data and analyse this potentially hands subscription businesses some large advantages. This is particularly the case compared to incumbent consumer facing businesses, whose success has been based partly on having the infrastructure and channels to distribute products to consumers. When Graze launched its healthy snacking boxes in the US, for example, it didn’t bother to test the market on what would work. Instead, it let the US public loose on what it offered, with the online ordering system gradually reflecting back to the company what people did and didn’t want.
For the meantime, the permanency of subscriptions boxes remains to be seen. Paradoxically, the key to many being successful is to make sure that people can cancel the service easily, offering people the temptation to try the service knowing they can cancel if they don’t like it. Some subscription companies have also adopted a more traditional approach, Graze, a healthy snacking business, and Hello Fresh, a meal kit service, are now selling their products through supermarkets.
It’s also become clear that the rise of subscriptions might not just be about a shift in business models. As far back as 2002, David Bowie predicted that music was going to become ‘like running water or electricity’ and that within a few years, the music industry wasn’t going to ‘work by labels and by distribution systems in the same way.’ Given Spotify’s dominance today – it accounts for more than 20% of global music industry revenues – Bowie was remarkably prescient.
While the music industry has broadly welcomed Spotify as part of the fightback against illegal music downloads, some in Hollywood have started to voice disquiet over the growing power of Netflix. Studios have complained about a lack of transparency as to whether their material will be commissioned, and have grown fearful about a loss of power in future.
But Netflix has not become known for being the gold standard of internet television for nothing. Big hits such as House of Cards have been commissioned based on Netflix user tastes, with Netflix knowing that a complex, multi-series drama like House of Cards would have failed a one hour pilot programme. For writers and directors, referred to as storytellers by Netflix, this brings a welcome degree of freedom, and the company has dramatically boosted the social media profiles of some of the actors that have featured in its hit shows.
The rise of subscription businesses coincides with another trend we see across sectors, the growing importance of data. Whoever owns the relationship with the customer owns the value in the relationship. The point of a subscription is that you can have a relationship with someone, constantly refining what you offer them and tailoring your service to make it more appealing.
From a financial perspective, there are a few important measures when it comes to understanding how investable a subscription business might be. The first of these is how much it costs to acquire a customer, technically the Customer Acquisition Cost (CAC). The second is how long a subscriber can be expected to stay with you, also known as their lifetime value (LTV). Combining these two metrics effectively tells you how much a customer is worth to the company, helping to then give a value for the business depending on how many customers it has and how quickly it is growing.
This is why the standard of a subscription’s business matters so much. If a business like Netflix can become the standard for internet television globally, its Customer Acquisition Cost should fall, as people naturally want to watch its content because everyone else does. Those same customers should then stay subscribed for longer, effectively increasing their worth to Netflix.
The rise of the subscription is not just about consumer products. Businesses like Adobe have pioneered ideas like software as a service, where you buy a subscription to continuously upgraded software, rather than iterative products updated once a year. While subscriptions have become a lot more popular in recent years, there are few signs of their popularity fading for now.