Subscriptions, Subscriptions everywhere, nor any spot to think

“Subscriptions, Subscriptions everywhere, nor any spot to think” is NOT a line from Coleridge’s “The Rime of the Ancient Mariner”. Nevertheless, taking some time to think carefully about the subscription economy (while avoiding albatrosses and chronic thirst) is time well spent.

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Jun 19, 2019
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Wikipedia defines the subscription business model as one in which “a customer must pay a recurring price at regular intervals for access to a product or service”. This description seems a good place to start. Clearly the idea of a subscription business model isn’t just a modern phenomenon – newspapers, magazines and phone companies have operated along these lines for years.

Yet, anecdotally, it would seem that there are more and more goods and services that are offered to us on a subscription basis. For example, software tends to be sold on a “software as a service” basis rather than a perpetual licence, you can get cooking ingredients or bottles of wine delivered to your door, watch movies and play games via subscription, enjoy the benefits of unlimited next day deliveries and there are now even financial exchanges that run on a subscription model.

Why do subscriptions matter?

First, subscriptions can be great news for the businesses themselves, providing visibility over future profitability and cash flows and giving the confidence for management to invest in the future growth of their business. As well as internal confidence, external capital providers may be more willing to lend to organisations with subscriptions, encouraged by the presence of visible or recurring revenues.

However, it also throws up new challenges for those analysing businesses. If the poor sailor suffering from thirst was financially savvy and only had a myriad of annual reports for entertainment, he might have realised something quite strange—these subscription businesses can sometimes look very different, depending on whether you use your naked eyes to glance at the finances of the company as a whole, or if you take a magnifying glass and look at the economics of each transaction.

This strange effect happens because the economic value in a subscription transaction is spread out over time, whereas a single one-off purchase is all dealt with at one point in time. With subscription businesses becoming more abundant, its crucial investors have an understanding of how to analyse businesses at this micro level. This is the world of “unit economics”.

Unit economics 101 – Churn

Churn is the percentage of customers (or customer transaction value) that will leave a business in any given period. You can think of churn as the size of the leak in a bucket, while a business is trying to funnel in new customers at the top. Churn is a crucially important number, allowing investors to determine the value of each customer and even helping them to define the maximise size of a business.

As an example, let’s take a look at Business A and Business B, which are two companies that deliver cooking ingredients to their customers on subscription. Both start with 100 customers. Due to a limited customer tolerance for annoying flyers through letterboxes, they can each only attract 10 new customers per month. Let’s imagine Business A sends slightly more varied meals and enjoys a 3% monthly churn rate, whereas Business B is more like a school dinner menu, causing 5% of its customer base to flee every month.

This may look like a small difference. But poor Business B will sadly max out at 200 customers—at this point the 10 new arrivals merely cancel out the 10 leaving the business. In contrast, Business A can continue to grow for much longer, reaching the lofty heights of 333 customers before stasis finally sets in!

It’s a simple point, but a powerful demonstration of how a fairly innocuous statistic in an annual report might have a huge impact on the eventual outcome of an investment decision. The J.P. Morgan Asset Management Behavioural Finance Team believe in combining the breadth of quantitative research with the depth of fundamental insight. As a UK small-cap analyst, one tiny clue today (such as a low churn rate) might help identify the leading companies of tomorrow.


Ed Hezlet is an assistant portfolio manager in the J.P. Morgan Asset Management International Equity Group – Behavioural Finance Team. Read more about our UK capabilities >

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Ed Hezlet

Investment Assistant, UK Equity Group, J.P. Morgan Asset Management

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