How recurring revenue impacts the bottom line
Not long ago, about the only companies that sold products by subscription were utilities, gyms, and media.
But over the last two decades or so, the subscription model has spread. The great majority of the software industry has gone SaaS. Blue Apron delivers meals to doorsteps for a monthly fee. Dollar Shave Club took on industry giant Gillette by shipping razors at regular intervals. Amazon users can subscribe and save when buying batteries, teas, toiletries, snacks, and more.
Why are so many firms switching to subscription-based sales? Enterprise software provider Zuora thinks it has the answer: In its September 2018 Subscription Economy Index report, Zuora calculated that subscription businesses grew revenue 5 times faster than U.S. retailers and about 5.5 times faster than S&P 500 companies.
Unlike one-time sales, subscriptions deliver recurring revenue because they promote customer retention. According to research by Retention Science, subscription services see an average of 7.68 orders per customer per year, while retail establishments average 2.36 orders and flash sellers post just 1.41 orders over the same span. All told, 28 percent of subscribers make a repeat purchase within six months of their first order; just 8.5 and 6.2 percent of traditional retail and flash sale customers, respectively, do the same.
The True Value of Recurring Revenue
Every company can see the value in loyal customers. But how, exactly, do recurring revenues benefit the bottom line?
1. Create cash flow now — and into the future.
What’s more valuable: five customers who each spend $50 now, or five who pay $10 for an undefined number of months into the future? While it might be tempting to take the money and run, retaining those customers just 5 percent more effectively — which subscription models do and then some — can boost profits by 25 to 95 percent.
Companies like Blackbaud may finally be convincing the business world to choose recurring revenue over short-term gains. When the nonprofit software provider announced its financial results for the second quarter, it credited recurring revenue for its 16 percent growth that represented 90 percent of total revenue. By implementing customer success software Gainsight back in 2014, Blackbaud has steadily reduced its customer churn. Using Gainsight to proactively communicate with customers at scale and monitor them for churn risk, Blackbaud increased the efficiency of its customer success management team by tenfold.
2. Open up other income streams.
One of the most popular recurring revenue models for big-ticket items is leasing. Leasing rates are rising in the auto industry, for example, where lease originations grew from barely 1 million to 4.3 million in 2016. In 2017, leases accounted for about 31 percent of all new vehicle sales.
When a consumer leases a car, they pay the leasing provider a monthly rent for its use. But they also agree to fees for wear and tear, excess miles, and the lease itself. Depending on the miles driven and scratches acquired, those auxiliary costs can number into the thousands of dollars. Of course, the dealer also gets the car back at the end of the lease. None of those ancillary revenues are generated when a consumer simply buys the car.
3. Reduce marketing expenses.
One of the greatest reasons that recurring revenues boost profits? Customers who reliably come back don’t require additional attention from the marketing and sales team. Consider the percentage of their total budget that various industries spend on marketing: Consumer packaged goods, which heavily relies on off-the-shelf sales, spends 24 percent, the most of any sector; energy companies, which sell a product consumers use every day, spend just 4 percent.
A hidden factor behind subscription services’ marketing savings? Their young, digital-first user base. Dollar Shave Club, one of the darlings of the industry, gained more than 12,000 new customers with its breakout YouTube video in 2012. Compare the costs of posting a video to YouTube — free — to those associated with marketing to older demographics via direct mail or television advertisements.
4. Make budgeting more effective.
One-and-done sales models have highs and lows. Consider the fact that holiday shopping was up 4.9 percent last year from 2016, posting a new record for dollars spent, while retail sales unexpectedly declined for the first three months of 2018. A retail CFO trying to predict the company’s 2018 revenues or provide budget outlays would have had quite a tough time.
Subscription companies, however, have more certainty in their budgets. They can better predict metrics like total transactions and customer lifetime value because sales volumes fluctuate less and customer churn is lower. That also makes them appealing to potential investors, who want to see prospects “5 C’s of Finance”: committed monthly recurring revenue, cash flow, customer acquisition cost, customer lifetime value, and churn rates.
5. Reduce investment risk.
Speaking of investments, subscription companies’ bottom lines benefit from reduced re-investment risks. When a company makes money, its executive team must decide whether to put the funds back into the company or distribute them to stakeholders. A company that acquires a big chunk of cash after a dry spell is tempted to take it as a profit rather than risk it on tech upgrades or team training.
The revenue predictability of a subscription business, however, means that it can spend a greater portion of a quarter’s profits on the business without worrying about whether it can cover next month’s expenses. What’s more, a company that knows it has some guarantee of future revenues can afford to sink a larger share of its assets into a large-scale upgrade rather than take financing, which comes with interest and other costs.
Sure, subscription companies’ individual transactions are often less valuable than those of firms that focus on one-time sales. But think about all that subscription companies buy for themselves with recurring revenue: certainty around future cash flow, new business opportunities, lower expenses, VC attention, and more. Recurring revenue may be harder to come by than single sales, but companies and consumers alike agree that subscriptions are worth their while.