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Covid-19 business transformations: The subscription revolution

  • The impact of Covid-19 on the shape of business will be immense

  • The pandemic will both accelerate the shift to subscription models in developed markets and catalyse the shift in EM

  • Investors should favour firms that deepen their customer relationships and implement recurring revenue business models

Covid-19 business transformations: The subscription revolution
Paul Domjan
Paul Domjan

Senior Contributing Analyst

Tellimer Research
23 May 2020
Published byTellimer Research

There is widespread agreement among observers and commentators that Covid-19 will fundamentally change business and commerce. Some of those changes will simply mean extending the working practices, like tech-enabled remote working for the masses, that began during Covid-19. Other changes will build on trends that the Covid-19 response has accelerated, like shifting away from cash to digital money, with positive knock-on effects for the growth of e-commerce in the developing world. In other cases, changes will be focused on business by geopolitics, for example as geopolitical competition increases the risk of tariffs and other trade disruption. The impetus for economic recovery also risks rolling back positive progress in ESG and climate, as governments and investors cast a blind eye on long-term damage incurred in the course of short-term growth.

Let’s get recurring

All of these are examples of projecting current developments into the future, but changes will also result from the lessons that companies learn during the lockdown and the impact of those lessons on their business models. While these lessons are many and varied, ranging from questioning just-in-time supply chains to reassessing how to market to and engage customers, the biggest of these lessons is likely to be around the value of committed customer relationships and recurring revenue. Covid-19 will both accelerate the shift to subscription, recurring revenue, business models in developed markets and catalyse such a shift in developing markets.

Commitment issues

Markets have long recognised that not all revenue is created equal, and the 20+ EBITDA multiples on many subscription businesses prior to Covid-19 already reflected the value of beginning your financial year with committed customer relationships, client contracts and revenue already in place. Covid-19 has highlighted just how valuable recurring revenue is and will cause more consumers to prefer to engage through a subscription model. Successful businesses will use this crisis as an opportunity to make the transition to recurring-revenue business models.

Discussion of business models is easily dominated by the business’s own perspective – after all, the business model is all about how the business organises itself and goes to market, but a business model only works if it meets the needs of the market, so let’s begin with the customer’s perspective. Covid-19 has taken a tremendous toll on household incomes, especially in developed countries that failed to effectively implement policies to maintain employment, like the US, and emerging markets without the resources to do so. It is unsurprising that hire-purchase, arguably the first transformation of a traditional business into a recurring revenue business, first came into common use in Britain during the Great Depression, leading parliament to pass the Hire-Purchase Act of 1938 to protect buyers from overly aggressive tactics by sellers.

Today, businesses, like households, are stressed and uncertain – concerned about both future prospects and short-term cashflow. In such circumstances, customers, whether they are end consumers or businesses themselves, are more likely to prefer to commit to an ongoing service at a manageable cost rather than expose themselves to the potentially higher, less predictable cost of working with a traditional vendor. Importantly, they are also more likely to prefer a bundle of services that are good enough rather than pay more to get the best possible service in each category, and, as we shall see shortly, bundles are a natural extension of recurring revenue business models.

Revenue security

Covid-19 has shown just how quickly a dislocation can cause revenue to vanish, even from established customers. More worryingly, when a firm is no longer engaged with its customer, that historical relationship may count for little when that customer returns to the market, looking for a new solution to their problems. Firms with large cash balances have had resources to buffer the impact of Covid-19 and give them time to reorient, but firms with subscription business models have another powerful buffer: commitment revenue and committed customers. Indeed recent data indicates that only c30% of subscription businesses have experienced revenue contraction during Covid-19.

Deeper customer engagement

Recurring revenue relationships can encourage businesses to engage more closely with their customers and think more deeply about their customer needs. Rather than selling a product or a one-off service, a subscription creates an ongoing relationship. This encourages firms to take the time to understand how their customers’ needs are changing and what they can do to deepen relationships and increase the value that they offer customers. This means the subscription businesses are better positioned to respond to downward pricing pressure by increasing value, by offering bundles of complementary services for example, rather than discounting prices or losing customers. This will help them to respond to Covid-19 with greater agility than traditional businesses.

Deeper customer relationships also give recurring revenue businesses more options to work with customers through difficult circumstances. Recent research has found that businesses offering the flexibility to suspend and resume subscriptions are more likely to retain customers. By keeping the customer relationship intact through the period of lockdown and recession, these businesses will be able to restart existing relationships as Covid-19 abates rather than needing to rebuild from scratch.

Making it work in emerging markets: The Theory

The shift to recurring revenue business models has been underway for some time in developed markets, but it has proven more challenging in emerging markets. Covid-19 might change that. Recurring revenue relationships typically rely on both the buyer and the seller accepting one another’s creditworthiness. If the buyer pays in advance, they need to be confident that the seller will be around to provide the service when they need it. Similarly, where the buyer pays in contracted installments, the contract is an asset of the seller, the value of which depends on the buyer meeting their contractual obligations.

Furthermore, many such models require regular recurring payments, which are more complicated, especially in B2C, in many emerging markets than in developed markets, which benefit from widely distributed credit card networks and direct debit arrangements. By accelerating the adoption of digital payments and electronic money, Covid-19 is helping emerging markets to build a payments ecosystem that will enable subscription business models in the same way that cards and direct debits do in developed markets. Not only will Covid-19 accelerate the development of the infrastructure to support recurring revenue, it will also lead firms in emerging markets to welcome new business models. Necessity, in the form of financially strained, risk-averse customers, will help to overcome the inertia of existing business models.

Making it work in emerging markets: The Practice

Having helped businesses in both developed and developing countries to make this business model transformation, I appreciate the complexity it entails, including reengineering business processes, changing the approach to sales and marketing, reprofiling revenue and engaging differently with customers. At the end of that process, the impact can be greater in emerging markets than in developed ones because a recurring revenue business model allows the firm to lower barriers to entry by reducing initial cost and increasing flexibility.

In developed markets, new subscription services are often displacing existing traditional businesses, whether in enterprise software, video rental or business services. In emerging markets, however, subscription models can allow a customer, whether a business or a household, to procure a service for the first time, both by lowering the entry cost and by allowing customers, especially business customers, to experiment with a new type of solution on a small scale. This can mean, for example, implementing new services or software in a small number of sites or in a single city before rolling it out across the business. As such, the subscription transition often enables emerging market businesses to access new customer segments as well as serve existing customers differently.

Roof-top solar is one example. High upfront cost combined with the risk of breakages and obsolescence have limited the roll-out of these systems, especially to households. A subscription model would be ideal, as it would spread the cost of power as a service, incorporating maintenance and equipment upgrades into a single monthly payment. Historically such a model would have been constrained by the complexity of collecting monthly payments and difficulty assessing the credit quality of the customers. Digital payments are addressing the first problem, as well as providing data that can help to measure credit quality. New tech products are now using a range of alternative data to help to better assess credit, helping to solve the second problem. Finally the Covid-19 recession is likely to shrink the pool of customers who can afford these systems up front, forcing solar companies to find new ways to access customers. Technology is reducing the risk of moving to a subscription business model, while Covid-19 is leading firms to increase their risk appetite. This creates a new area of acceptable risk, where new subscription business models will emerge.

What it means for investors

New entrants often arise as dominant players after recessions because recessions both are caused by and cause major changes in the structure of the economy. Not only did Salesforce, Facebook, Airbnb and Google famously grow into dominant positions during recent recessions, but GE, GM, Disney and many others are children of more distant recessions. New entrants don’t need to transform their businesses to thrive in the new environment – the new environment is the only environment they’ve known. For established firms to match their agility, they need to recognise the need to transform early, rather than merely seek to wait for good times to return, and they need to be willing to abandon aspects of their historical business model to achieve a new one.

Investors should be looking at the private company universe, especially in rapidly changing areas like fintech, to try to find the new entrants that understand the new environment and will thrive. Some of these companies are young and well-placed for the future, as GM and Google were. Others will be founded during the recession itself, as Disney and Airbnb were.

When assessing established, listed firms, investors will need, as many already are, to shift their focus to emphasise the robustness and resilience of a firm’s strategy in multiple future scenarios. Business models are a key driver of robustness and resilience, and investors should watch closely for firms that implement subscription and recurring revenue business models to deepen their relationships with customers and improve the robustness of their revenues.

This is the first in a series of reports that seek to pull together many strands of Tellimer research to understand better how business, globally and especially in developing markets, could change after Covid-19.