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The Business of Subscriptions

Past performance does not predict future returns. You may get back less than you originally invested. Reference to specific securities is not intended as a recommendation to purchase or sell any investment.

In this episode of Global Infusions, Tom and Tom explore the business of subscriptions. From cable TV to coffee and Photoshop to food deliveries, everything seems to be a subscription now. What is driving this, and what could be next? They also discuss using fish skin to treat burns, the issues around AI music, the UK government’s efforts to ban encryption, and a celebrity sake brand.

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TR – Hello, I’m Tom Record and I’m here with Tom Morris. Welcome to Global Infusions, an investment podcast from the Liontrust Global Fundamental team that takes a long term view of today's stories.


Last episode we chatted about the business of collectables from scrap paper stamps worth millions to cellophane wrapped trainers and everything in between. This episode we’re tackling subscriptions – from Netflix to coffee beans. If your taste buds are tickled or you have any questions for our next episode, please do collect them up and send them in via your client contact or through the contact us link on the Liontrust website.


So sit back, grab a cup of tea, and remember that when we talk about individual companies we are not making a recommendation to buy or sell shares and that some of these companies may not be held across Liontrust’s global fund range.


So Tom, let’s start with the obvious question, why does everything seem to be a subscription nowadays?


TM – OK well we need to answer that from both sides of the transaction – businesses and consumers. For businesses it’s about maximising the lifetime revenues from a customer by getting them to commit to a regular payment which they are likely to maintain, maybe even forget about, for several years.


TR – Most management teams call this stickiness – they want sticky customers.


TM – It can also help businesses to better match revenues with costs. For instance with software, most people now expect updates. That means that development costs are ongoing, and don’t match well with a product sold once, for a single up front payment. They match much better with a subscription.


TR – Yes for software specifically, that also helps with version control and compatibility. If every user is paying regularly to receive the latest version of the software, it means they’re all using the same one, rather than being split between loads of historically purchased versions that might have different features, and may not even be compatible with each other.


TM – Yes it makes collaboration a lot easier.


TR – Salesforce was a pioneer on this.


TM – Yes, and Adobe followed in 2011, launching a cloud-based subscription service for its widely used creative suit of software, something that’s now normally referred to as software as a service.


TR – Things like Photoshop.


TM – Exactly. It proved to be so successful that in 2013 they announced they would be a cloud subscription only business, stopping development of boxed software entirely.


TR – And then pretty much all productivity software businesses followed, including Microsoft.


TM – Yes, and there’s a bit of a financial hit for the first few years, as they stop selling high priced one-off software packages, and instead move to these comparatively low priced monthly subscriptions, but in the long-run it makes complete sense.


TR – And the other side of the transaction is the customer. They’ve generally been happy to move towards subscriptions because the costs are spread out over time.

TM – That’s a big deal for both household consumers and other businesses trying to manage their cashflows. generally speaking people have been pleased to see a big one off payment turn into a series of smaller more manageable payments.

TR – OK, so when most people think about subscriptions, they tend to think about media, and things like Netflix and Spotify.

TM – Yes, TV has been a fascinating industry in terms of its business model over the last few decades, and in particular the channel bundles pioneered by the cable and satellite operators.

TR – So cable TV presumably started in the US.

TM – Indeed – an engineer called Robert Tarlton built the first cable TV system in his hometown of Lansford, Pennsylvania, in 1950, to get around the problem of a mountain range blocking the broadcast signal from the nearest TV antenna tower.

TR – So it was an accident of geography.

TM – Yes, basically. The cable service proved to be extremely popular with residents who were sick of bad TV reception, and soon he took his idea to a Jerrold Electronics, who helped to commercialise it and roll it out to other cities.

TR – And I would guess it became a bit of a money printing machine.

TM – Indeed. Other people started to notice, and eventually one of them, Ralph Roberts, bought one of the city networks built by Jerrold in Tupelo Mississippi. He started buying others too, rolling them up into a giant cable operator that would become Comcast.

TR – Fascinating.

TM – And so basically from the 1970s onwards, the dominant TV business model in the US became the subscription channel bundle, provided either by cable or eventually satellite companies.

TR – And those channel bundles became more and more expensive, eventually getting to $80 or $100/month, providing an opportunity for someone to come in priced at a huge discount and disrupt the industry.

TM – Netflix.

TR – Exactly. The internet had broken the cable companies’ monopoly on distribution. You no longer needed to be part of their channel bundle in order to reach viewers. You could go directly to a viewer over the internet instead.

TM – And so that’s what they did. I think I got my Netflix subscription in 2012, shortly after in launched in the UK, and at the time it was about £6/month or so, a massive discount to services like Sky.

TR – So there’s a famous quote, attributed to Jim Barksdale, the former CEO of Netscape, that there are ‘only two ways to make money, bundling and unbundling’.

TM – That’s a great quote.

TR – It is, and we’ve been seeing it in action in TV, with bundling up until the 2010s, then unbundling driven by Netflix and all the other streaming services that followed.

TM – And now perhaps some evidence of bundling again, as people like Amazon and Apple try to become intermediaries for your media subscriptions, packing them up for you into a bundle that may supposedly offer better value.

TR – And the cycle continues. Now one facet of this is thinking about who owns the relationship with the customer. Intuitively, they are the ones who know the customer best and should be able to suggest new shows and importantly decide what to advertise.

TM – Yes! We should definitely talk about advertising, which tends to go hand in hand with media subscriptions.

TR – Indeed, so cable TV obviously always had ads as well as those chunky subscription fees, with the notable exception of HBO, but until recently most subscription streaming services were ad free.

TM – Which is nice, but it does mean that prices have to be higher, making the services less affordable, and potentially out of reach of a lot of people.

TR – Exactly, and that’s why in the last couple of years we’ve seen an effort from media companies to introduce lower priced tiers that come with some ads. Hulu and Paramount+ did it in the US, and then Disney and Netflix followed, and now it feels like everyone offers an ad-supported tier.

TM – And the amazing thing about those tiers is that they can actually be even more profitable for the streaming company than the higher priced ad-free ones

TR – Yes I know that Paramount have talked about making more revenue per month from people on the basic tier with ads than from people on the standard package, and I think Netflix said the same thing in their recent Q1 results?

TM – They did. Specifically, they said average revenue per user for people on the basic ad-supported tier in the US, which costs $6.99/month, was higher than for people on the standard no-ads tier, which costs $15.49/month.

TR – So that implies that they’re making at least $8.50 in ad revenue per user per month, which is pretty good going. It means that they don’t need to worry about losing revenue if people choose to downgrade from the more expensive plan to the cheapest ad-supported one, because they actually make more money at that level rather than less!

TM – It’s great isn’t it? It also provides Netflix with a path to stop users sharing their passwords – instead of being locked out, customers can be downgraded to an ad-supported tier.

TR – It is very impressive. So before we move on from Netflix, it’s time for a quick quiz.

TM – OK I’m keen.

TR – So Netflix announced in April that it is going to close down its legacy DVD-by-mail service, to focus exclusively on streaming. Netflix shipped its first DVD, the Michael Keaton horror-comedy Beetlejuice, in March 1998. Since then it has mailed over 5.2 billion discs, but what has its most popular DVD rental title been?

TM – Oooo that is a good question. Well let’s think. It started the service in 1998, and I would guess that usage had dwindled to a very low level by 2020, so we need a film that was very popular in the noughties and early 2010s – so I’m going to go with… Pirates of the Caribbean?

TR – Well you’re in the right kind of timeframe, but you’re way out on the film – Netfix’s most popular DVD actually was the 2009 Sandra Bullock sports drama The Blind Side.

TM – Ah, the American football film? I think Sandra Bullock won an Oscar her role, but I would never have guessed it for this. Great trivia!

TR – Right so I think one of the biggest benefits of subscriptions is that stickiness we were talking about earlier and the way it interacts with the costs of finding new customers.

TM – So these are the costs of advertising to find a new customer – so paying for keywords on Google, or running marketing campaigns.

TR – Exactly. And companies know that if they can convert a first time customer into a repeat customer with a subscription, then the lifetime value of that customer could be very high, and so they can afford to spend a lot on reaching them. This is the customer acquisition cost or CAC, which companies talk a lot about.

TM – And the CAC doesn’t all have to go to Google. It can also be in the form of a discount for new customers to get them to try a service.

TR – Yes, and that’s why very high priced subscriptions generally have the biggest initial discounts, because the high lifetime value enables the business to justify very high customer acquisition costs.

TM – Which is why things like meal subscription services are able to offer such cheap first months, before the price springs up to the normal, often pretty high, level.

TR – Yes and the other big benefit to the business is the ongoing relationship they get with customers, allowing them to respond to feedback and behaviour to evolve their product offering. You mentioned meal subscription services, and indeed loads have appeared over the last few years from HelloFresh to Mindful Chef through Gousto or SimplyCook.

TM – So many, and we’ve tried a few in our house, a few of them are pretty good, but the big downside is that all of them result in a quite a lot of washing up.

TR – Yes, that was the thing that eventually put my parents off. But it is also a great example of how the recipe boxes can track how consumer tastes are evolving and adjust the recipes and contents of their boxes to remain relevant to the people who are eating them.

TM – Sticking to the food and drink theme, it’s been interesting as we came out of lockdown to see Pret offer coffee subscriptions in the UK at a what looks like a pretty attractive price.

TR – Yes, you can get up to 5 coffees a day for just £25 / month

TM – And a lot of caffeine buzz!!!  That £25 seems really good value when you compare it to the cost of a flat white at over £3.

TR – Which is why our colleague Tom Smith is often spotted in the office with his Pret coffee, first thing. But the real story here is that coffee has a very low marginal cost – so the main costs are the overheads and the milk, and the big benefit is that sometimes subscribers will come in either with a friend or to buy something to go with their coffee – say a cake or pastry.

TM – Hmmm cake! So the subscription can act as marketing campaign that brings in footfall, and occasional extra sales, which makes it all worthwhile.

TR – Exactly.

TM – This is quite similar to Costco’s business model, where they pioneered subscription membership for physical retail.

TR – Yes, we’ve talked before about the Costco hotdog and fizzy drink deal that inflation forgot and is still $1.50 – the same price as in 1985. But we should talk about Costco’s overall business model too

TM – OK, so it charges customers $60/yr to be able to shop there, and calls them members. Now this subscription plays two roles – firstly it’s a nice revenue stream, but more importantly, it’s an incentive for people to shop at Costco rather than somewhere else, because they feel like they have a sunk cost already. It creates loyalty.

TR – And this is exactly the same model that Amazon have used to build up Prime. You pay for it, and then you default to using it rather than other retailers because you’ve already paid for it.  A great retention tool.

TM – Perhaps the next subscription frontier is household maintenance? After all, it’s pretty closely related to insurance, which most people are fairly happy with. Why not pay a set amount each month to a company that promises to send in a trusted tradesperson every time one of your pipes burst or your boiler or air-conditioning stops working?

TR – You can see that market developing in the UK with Homeserve and British Gas, and in the US with companies like Frontdoor.

TM – Indeed, and I can tell you from bitter experience how difficult, expensive and time consuming getting a good plumber or electrician can be, so having someone take care of it for me does hold some appeal. I mean it goes without saying that I am not handy myself – I have visions of my house literally exploding like the death star if I tried to fix a pipe or a plug.

TR – I see the benefits of a maintenance subscription!  OK, let’s move on to the news – Tom, what has caught your eye this month?

TM – So first up from me is a follow up on last episode’s discussion about sake

TR – And its growing popularity outside of Japan?

TM – Yes, and you might remember that we said one sign it is reaching a cultural tipping point would be when a celebrity launches their own branded sake, like they’ve been doing with gins and tequilas for the last decade.

TR – And I’m guessing it’s happened?

TM – It has indeed – in fact I saw that Brooklyn Beckham is launching his own sake, called WeSake

TR – David Beckham’s son?

TM – Yes, who is now married into the wealthy Peltz family, so I doubt raising the VC money was difficult. Anyway, he’s put Sake in a can with a nice label, and I’ve not tried it yet, but to be honest I’m a sucker for this sort of thing so I probably will.

TR – Well there we are – Sake’s journey into the mainstream continues.

TM – Exactly. He gave an interview to rolling stone where he spoke about his love of Japan, and so they asked him what Japanese artists he listened to, and he couldn’t name any and so started talking about k-pop instead.

TR – A bit awkward.

TM – Yes not ideal. Now I love k-pop too, I’m a big blackpink fan, but if you’re talking to a music magazine about a japanese product launch, it might be wise to do a bit more homework.

TR – Indeed. So the first thing from me is a paper I came across that looks at a novel way of improving treatments for burns victims. This technology is at an early stage, but appears to be cheap, effective and viable in a wide range of developing markets.

TM – OK, that sounds interesting. What’s so novel about it?

TR – Well, the treatment involves using fish skin, actually Nile Tilapia skin, as a dressing instead of a skin graft. So apparently Tilapia skin has non-infectious bacteria, high amounts of type I collagen, and a similar structure to human skin and the treatment worked well enough that the burn victims skin recovered in 17 days without needing to change the dressing.

TM – Interesting. And as you say, potentially a cheap and effective way of treating burn patients, particularly in developing countries. OK, next up from me is the rise of AI-generated music, that has really exploded in the past month.

TR – Ah yes I’ve seen quite a few songs that use AI to sound like they’re by a certain artist – and some people are getting rather annoyed about it.

TM – Yes and the record labels have predictably reached for the legal button, threatening action against people who train AIs based on existing songs, which they say is infringement of their IP rights.

TR – So this a bit like those image generation AIs we’ve talked about a few times, where you can instruct them to make a painting of a swan in a spaceship, by Monet, and it will generate something that looks very realistic.

TM – Realistic within the context of a swan in space.

TR – Well yes, but dead on how you’d expect a Monet to look.

TM – So conceptually, a similar thing is happening now with music. You can ask AIs to generate beats, write lyrics, and then sing or rap the words in the voice of a famous musician. Pretty soon they’ll be able to generate realistic videos as well.

TR – Someone has made a track with the voices of Drake and the Weeknd I think, which has done really well.

TM – Yes it’s called Heart on My Sleeve, and it was posted to TikTok and youtube by someone called Ghostwriter, where it ended up getting millions of views. It sounds like a plausible collaboration between those artists – if I heard it out of context I would believe it was really them.

TR – It’s not really my thing, though Blinding Lights is a great song… but I must admit, this track does sound very realistic.

TM – And that’s a problem for the music industry. Now that anyone can sound like Kanye or Drake or whoever, the internet is going to be flooded with AI-driven music content. Initially it seems to be mostly songs written by humans, where the AI element is just the altered vocals, but the direction of travel is clear.

TR – And I suppose the problem with this, rather than the image generation stuff we just spoke about, is that people are mostly pretending to be living artists, rather than long-dead ones.

TM – Yes, Drake is very much alive, with various forms of IP protection on his work, and he’s not happy to see people pretending to be him.

TR – I can understand that. The focus of the current legal complaints seems to be the training of the AIs, where they listen to millions of existing tracks in order to learn what music, and artists, sound like. The record companies are trying to argue that that training is breaking their IP rights over their content, which they licensed to streaming services for human rather than AI consumption.

TM – But in principle how is it really any different from a human listening to all of the Beatles’ back catalogue and then writing a song in their style?

TR – I suppose it’s just the industrial scale of the consumption, with the primary purpose of enabling further works to be created that could be deepfakes of existing artists, with what sounds like their own voices. But clearly this a bit of a legal grey area, and we’re likely to see a lot of action in courts, and perhaps ultimately though regulation as well.

TM – Agreed.

TR – So the next thing from me is also on regulation, specifically the debate that is going on here in the UK surrounding the new online safety law.

TM – Oh that’s been very controversial. It seems like a mass surveillance bill.

TR – I think it’s really interesting, especially the new requirement for providers of end to end encrypted messaging platforms to be able to scan messages.

TM – So this would be platforms like WhatsApp and Signal, scanning everyone’s messages before they are sent.

TR – Exactly! Now, both of those services use end to end encryption which means that they technically can’t scan message contents at all – only the sender and receiver can see what’s in the message. It might be possible to scan attachments before they are sent, but this creates loopholes that can be exploited by malicious actors or requests from the state to monitor all communications.

TM – So the UK government wants to break encryption on personal messaging, allowing all our messages to be scanned and monitored, supposedly just by the government itself, but in practice the removal of end-to-end encryption would leave us vulnerable to anyone reading our messages, from criminals to rogue states.

TR – Yes, and the truth of it is that the UK represents only 2% of WhatsApp’s userbase, so would they weaken the privacy standards for the other 98% of users worldwide? Well, Tom, I can tell you that they have already said that they won’t.

TM – Yes I saw comments from both Whatsapp and Signal saying they would leave the UK if the gov tries to force them to break encryption. You introduce a backdoor for monitoring in one country, and soon every country will demand one, including more authoritarian ones who will almost certainly use it for identifying and oppressing journalists, opposition politicians, that sort of thing.

TR – Another  example of poorly thought through regulation.

TM – Agreed. I want to see an end to this government’s attempts to end end-to-end encryption.

TR – Ha! That’s a lot of ends!

TM – I can see the motivation, but the implementation is bonkers, and would just make us all less safe. So the last thing from me this episode is another piece on AI, this time an implementation called miniGPT-4, developed by researchers at the King Abdullah University of Science and Technology in Saudi Arabia.

TR – So what does it do?

TM – It’s an AI trained to recognise and interpret images. So not just identify them, but build upon what it has recognised with helpful suggestions. So for instance in the demo they’ve published they show it photos of food and ask it how to cook those dishes. It recognises them and provides instructions.

TR – That’s pretty cool.

TM – Yes I thought so too. You can also show it a photo of a product – in the demo they use mugs and a lamp, and ask it to make ads for them.

TR – So this kind of tech could be very useful for Meta and Google, the online ad giants.

TM – Absolutely – useful for any online advertiser or retailer. You can also show it photos of problems around your house, and ask it for instructions on how to fix them, like an overflowing washing machine.

TR – Sounds like it could be the basis for a proper visual assistant.

TM – Yes that’s what I thought too. It must only be a matter of time before Google integrates something like this into its core app. Think of the ad opportunities – it could recognise what is broken and offer to send you the parts you need, or recommend a local engineer, perhaps as part of one of the subscription services we mentioned earlier.

TR – Absolutely. Well, Thank you for listening to Global infusions - a podcast that believes that the best discussions are had over tea and cake. We hope you've enjoyed your cuppa and our thoughts on the business of subscriptions. Please do just that and subscribe through Apple or Spotify and with that we wish you goodbye!

TM – Goodbye!

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