Stretching subscriptions

Subscription-driven cash flows have been the gold standard for many industries for decades now. Senior multi-asset investment specialist Craig Brown takes pause at coffee-as-a-service.

Coffee machine with coffee cups

By Craig Brown 

It was walking past the fourth coffee shop offering all-you-can-drink coffee deals for a flat monthly fee that I started pondering the limits of the subscription business model.

You’ve no doubt seen or heard of a few of these new memberships and clubs that were cooked up by baristas when commuters were as rare as badgers in London. This sort of strategy is old hat for investors, as we discussed on the latest episode of our podcast, The Sharpe End. The shift of business models from one-off sales to recurring revenues is probably the most fundamental driver of value for companies over the past 10 to 20 years – especially when tied in with digital technology. Software-as-a-service is a glib term that underpins how companies like Apple and Amazon can lock people into monthly payments embedded in commercial ecosystems that drive ever more business their way. Of course, being able to rely on a stream of income arriving each quarter makes companies more valuable, pushing price-earnings multiples higher.

But it’s important that the business offers something unique that hooks the customer in. Amazon’s unrivalled delivery network, Microsoft offering a complete suite of programs that make up the spines of offices big and small, or Adobe’s cutting-edge tools for the creative minded, both amateur and professional. That’s why we hold these companies. Coffee-as-a-service seems too commoditised for this sort of benefit, in my opinion. When times get tough, or if people do the math after a couple of months and realise they aren’t getting value, what’s stopping them simply cancelling?

Take Peloton, which we don’t own – although David does use one of its exercise bikes to hang out his washing. This business was a darling of the early pandemic as people trapped in lockdowns snapped up its machines and signed up to the subscription classes. Peloton’s share price soared as its users and sales ballooned; however, recently it has fallen sharply as costs mount and revenue expansion decelerates. It has now slashed the price of its bikes by 20% (to David’s chagrin) as usage of its machines slips. It’s still growing sales strongly, mind, and it doubled its users over the past year. Yet there are a lot of other exercycle manufacturers and online fitness classes too. And we can’t help but dwell on David getting tangled in his lockdown good intentions – “I’ll use it more in the wintertime,” he argues, weakly – and we wonder how many other people are in the same position. To me, Peloton seems a bit like the gym membership you buy and don’t use enough to justify. The only difference is that you have to look at the Peloton every day, so it’s harder to put it out of your mind.

The dangers of far-flung forecasts

Because subscription-model businesses are valued more highly by investors, there are huge incentives for company managers to make the change. Or talk a good game about the move at least.

We believe it pays to be careful when looking at companies that boast recurring revenues. Are those cash flows really as persistent as managers would like them to be? Also, in recent years some businesses have been bid up by excited investors because of subscription models that were actually terribly loss-making. As an example, google the fate of MoviePass, which offered free daily cinema tickets for just $9.95 a month …

There’s another leg to this strategic shift in modern business to recurring cash flows. When everyone and his dog has made the change from one-off revenue to subscription services – which with the arrival of coffee-as-a-service seems to be firmly the case – management’s focus shifts to arguing just how far into the future those cashflows can be modelled and relied upon.

Cash flow forecasts should always be taken with a pinch of salt. No one knows what will happen in the next five years. Just think back to everything that went down in the last five. Yet lately we’ve started seeing some external analysts justifying sky-high valuations by using 2025 earnings as a denominator for the price-earnings multiple. With rates so low, many investors risk attributing too much value to far-flung profits when calculating how much shares should be worth. Again, I would be scrutinising exactly how much value subscription services are offering their customers. Because, as obvious as it sounds, customers are much less likely to dispense with a service they find very useful or, better yet, critical.

So have I signed up for one of these coffee subscriptions? No, I’ll stick to my jar of instant and the odd frothy coffee when the mood takes me. I don’t need to add a wasted coffee subscription to the gym membership card gathering dust in my wallet …

Tune in to The Sharpe End — a multi-asset investing podcast from Rathbones. You can listen here or wherever you get your podcasts. New episodes monthly.