Subscription economy part 2
Case studies
Understanding the power game companies play
Equipped with the analytical grid developed in our previous article , we can issue an opinion on various subscription cases. In summary, a subscription offer to win customers in a viral way must meet the following criteria:
create abundance with a scarce resource,
identify a utility function that is as differentiating as possible from the abundance created, since the exclusivity of the resource has been destroyed
guarantee this utility function at a reasonable cost: a subscription is a guarantee
More precisely, the degree of attractiveness of a subscription offer depends on:
the gap between the scarcity of the good/service produced and the abundance proposed. The larger this gap is, the more value is created by the company that manages to achieve this alchemy.
the art of transforming abundance into utility. As the initially exclusive production becomes abundant, the company must find its differentiation elsewhere, ideally in a function provided by the object. The more effectively this task is accomplished, the more value the company will create. Clay Christensen developed in his book Competing against luck this theory of the job to be done: for him, people do not buy a good or service, they hire it to perform a function.
Finally, the ability to guarantee a low rate for the performance of this task. This will be possible when the marginal cost of creating abundance is as low as possible. Pooling then has a very significant effect on the average cost and therefore the price of the subscription. Digital goods are very suitable for subscription, unlike goods with high variable costs.
A few practical examples will allow us to see how companies measure themselves against these three criteria. We will provide a note on their business model (not on their price, management, etc.). We start with two companies that rely on an exclusive resource par excellence: their real estate portfolio:
AWS is excellent on all three criteria.
AWS is based on a unique real estate positioning composed of 50,000 to 80,000 servers located in 70 countries, covering an area of 1,300 ha, all connected by a high-speed cable network. Only Google and Microsoft can compete. From this fleet, AWS creates an abundance of computing power that is second to none. A company no longer needs to own its servers, AWS' offer is superior in every respect. The gap between the scarcity of the constituted park and the abundance provided is enormous.
AWS offers a simple service: meet all your IT needs (from storage to programming, databases, ERP, CRM, etc.). AWS' competitive advantage is its ability to constantly create new features to meet the needs of its business customers. The functionality may not be perfect but it exists before competitors have reacted. The abundance is thus transformed into a differentiated service, placing AWS far ahead of Microsoft with $30B in annual revenue.
Here again, one thing is clear: computers can be easily shared. The marginal cost of a new user is low on hardware (because its capacity use is spread over the entire fleet) and zero on software. AWS can take advantage of its position as first mover in the cloud to have a clear advantage on the average cost of its offer, with more users per number of servers.
Note 10/10
WeWork: interesting to look at, because the company like AWS monetizes its real estate stock. The recent S1 details the business model:
We offer our members flexible access to beautiful spaces, a culture of inclusion and the energy of an inspired community, all linked by our extensive technological infrastructure. We believe that our company has the power to improve the way people work, live and grow. In early 2010, we opened our doors to our first community of members at 154 Grand Street in New York City. At first, our members were mainly freelancers, start-ups and small businesses. Over the past nine years, we have rapidly expanded our activities while fulfilling our mission. Today, our global platform integrates space, community, services and technology in more than 528 sites in 111 cities in 29 countries. Our 527,000 members represent global companies in a variety of industries, including 38% of the Global Fortune 500. We are committed to providing our members around the world with a better working day for less.
WeWork's real estate portfolio has a unique location in major cities. The company then seeks to create abundance from this park, which is not an easy task. AWS achieves this thanks in particular to the power of its cables, which eliminates distances and commoditize space. WeWork standardizes the workspace so that it is interchangeable. Cloud advances in particular allow plug & play. A company can accommodate its employees in any space and return to work where it left off. By being located in the heart of large cities, the company also tries to trivialize the location, but it is more difficult because of the uniqueness of each location. A company choose the place it want to work according to distance from its employees homes, suppliers, customers, etc. Abundance is easier to create with a computer park than with space. First difficulty for WeWork.
From this (relative) abundance, WeWork offers a simple solution to companies: manage all their real estate needs as they evolve. This is its utility function: to provide the company with the exact number of workstations at the place it wants at the time it wants. No need for costly infrastructure investments, no need for real estate management! The company has more locations than its competitors, so it offers a more attractive offer.
Whete the bottom hurts is mutualization. It is limited to each building that should be filled to the best of its ability (like any rental building). You can't send a group of employees anywhere to fill the workspace, as you can with an IT workload. The AWS model is again much superior. However, the WeWork business model makes it possible to reduce the average cost per employee, as shown in the following graph from S1:
Standardization of the workspace and precise adjustment to the number of employees reduces the overall cost to the company
Note 6/10
Netflix: the company transforms a digital asset, which is easily reproducible unlike real estate. Exclusivity is based on copyright and the creator's desire to restrict the offer.
The company started from a potentially abundant offer, that its suppliers could duplicate, to make it even more accessible by streaming. Indeed, at the start of its streaming offer, Netflix had entered into an agreement with Disney to use its catalogue. This agreement was necessarily limited in time, weakening Netflix's position. Not having control over the exclusivity of its offer, Netflix had a real weakness, risking seeing competitors with the same films or losing its catalogue. Creating abundance with abundance is not a real winning strategy and Netflix quickly understood this, taking the plunge into exclusive productions. They now represent about half of the company's $15 B in annual film expenditures.
Netflix excels at providing its subscribers with all their TV needs. The recommendation algorithm presents the films and series most likely to appeal with attractive personalized posters. Netflix's streaming technology outperforms all its competitors. The objective, like the traditional TV of yesteryear, is to maximize the hours spent watching Netflix programs. Netflix increasingly represents, for 150 million subscribers, THE TV.
The accumulation of subscribers means that a film costs less per viewer than any competing platform: the marginal cost per subscriber is low, which has the effect of reducing the average cost of subscription for each new subscriber. Netflix gives back some of this advantage to subscribers by offering low prices, which attracts new subscribers, etc. This snowball effect is now almost impossible to counter, even by Disney forced to merge with Fox to compete.
Note 8/10
Spotify: tries to do with music, what Netflix does with TV. The problem is that the labels hold the historical catalogue, which is impossible to do without.
Unfortunately, Spotify has no exclusivity on its offer, which belongs to Sony, Universal and Warner. The company creates abundance for the benefit of labels. Its transformation work is nil, because the initial offer is undifferentiated (also proposed by Amazon Music, Apple Music, etc.) Spotify tries to diversify its offer by launching new artists or buying podcast companies, but these resources are too marginal compared to the abundance of its non-exclusive musical offer.
Spotify tries to counter this lack of initial advantage by winning as many subscribers as possible through a very user-friendly application, a leading playlist algorithm, etc., the idea being for Spotify to become Radio like Netflix is TV. Indeed, Spotify already has 235 million monthly average users, up 30% year-on-year. The company hopes that by accumulating subscribers, it will eventually have power over the labels. Nothing is less certain, because Apple and Amazon, if not Tencent, had the same idea.
Again, Spotify is at a disadvantage compared to Netflix. The marginal cost of a subscriber is significant since the company must pay 70% of what it receives to the labels. This variable billing literally kills Spotify. Netflix buys the films/series for a fixed amount, which reduces the marginal cost of a new subscriber to almost zero. The advantage of the scale effect is then much clearer.
Note: 4/10
Apple: having a hybrid business model, the company is very interesting to study. The company sells hardware differentiated by IOS and subscription services. Why does Apple sell hardware and rent services ?
Apple's business model is not to provide abundance but exclusivity. The model is therefore orthogonal to that of Internet companies seeking to provide abundance. Apple will play on the rarity, the time of availability of equipment, etc., and create voluntary frictions. However, according to the law seen in our previous article, the rarer a property is, the more interesting it is to own it in order to receive an annuity rather than to sell it:
When IBM was the only tech company in town producing computers, it had adopted a subscription model for example. It was competition that made IBM change. Apple's way to reconcile this law with its business model is to offer frictionless services from Apple devices. Abundance is reserved for holders of Iphones, Apple Watch, airpods through Apple's services. Thus exclusivity is transformed into abundance in the Apple universe
The utility function created by Apple is fluidity: thanks to the integration of IOS and services such as ApplePay, Apple Music, cloud to the various products offered by Apple (IPhone, Watch, AirPods, IPad), the Apple experience is much better than that of Android and people are willing to pay a high price. Subscription strengthens brand loyalty (99% loyalty to the iPhone)
Most Apple services have a low marginal cost because they are digital goods. The few figures available show an increase in margins to 64%. Apple already has 420 million subscribers and aims for 500 million in 2020. Apple as a good aggregator takes advantage of its installed base (1.4 billion devices) to charge suppliers (ex 30% of revenue on the App Store).
Note 9/10
Peloton: Similar to Apple in that it sells products (home bicycles and connected treads) as well as subscriptions to online training. But Peloton business model is the opposite of Apple: it sells subscriptions differentiated by hardware. At Apple, IOS is used to sell the Iphone, at Peloton, the connected bike is used to sell the subscription.
Peloton transforms a complicated service to obtain (team sports requires a room, a teacher, a date and space) into an abundant service: through the screens equipping the bicycles/carpets and the proprietary software installed there, the subscriber can access a multitude of courses offline or live, in a network with his friends. Peloton is trying to abolish time and space to provide abundance (like WeWork and AWS). This is a real value creation.
This abundance is transformed according to utility: Peloton is the solution to fight against procrastination and stay healthy. The integration of software (allowing to be networked, therefore motivated), programs (facilitating access to the type of sport you love) and equipment (which occupies a good place in the apartment, which will not be changed for a long time), differentiates Peloton from modular solutions.
The marginal cost of a subscriber is very low, with the subscription service provided being digital (video) and the equipment having gross margins of 43%, 13% higher than Apple's products division. The cost of acquiring a new subscriber is zero because the marketing costs are covered by the margin on the products. As a result, Peloton has every possibility to charge a low price for the subscription and make it viral. This is how Peloton has achieved 100% growth!
Note: 9/10
disclosure: CAP WEST EQUITIES is long on Amazon, Netflix and Apple
My next article will explore the relevance of a subscription model through other case studies such as Uber, AirBnb, MongoDB, Google, etc.