The Subscription Situation with The Subscription...Box Model

Posted: Jun 04 2014

 Which company had a better year last year? 

Company A

- generated $39 million of revenue last year

- 67.5% gross profit margins

- grew its customer base from 10,000 customers/month to 120,000 customers/month throughout the course of the year

Company B

- generated $11.7 million of revenue last year

- 80% gross profit margins

- grew its customer base from 10,000 customers/month to 120,000 customers/month throughout the course of the year

 

99% of people would answer, “Company A.” 99% of people would be incorrect if provided only with the information above. Why?

Well, two reasons that can be summed up with the following phrases, both of which were invented by men far more intelligent and impressive than I'll ever be and both of which are particularly applicable in this scenario: 1) all revenue is not equal and 2) cash is king.

So, what's that mean in actual terms? I'll show you in a minute and while doing so, will also demonstrate what is so appealing about the subscription box + traditional retail business model AND prove the claim made in Part 1 of this series: Birchbox is really not a subscription box retailer.

To best illustrate all of the above, I'm going to compare and contrast three businesses: 1) a traditional online retailer 2) a pure play subscription box business and 3) a hybrid subscription box/online retail company

Also, don't worry, I will also show how Company A is not necessarily the answer to the question above.

 

Exhibits

Company A: Traditional Online Retailer

                     

Company B: Pure Play Subscription Box Business

 

 

Company C: Hybrid

Glossary

The columns titled Month, Revenue, and # of customers should be pretty self explanatory.

As for the others:

Gross profit margin simply reflects revenues minus cost of goods sold (costs directly related to the products you sold).

GP/customer reflects the gross profit divided by the number of customers.

Retention rate indicates the number of customers who bought goods in each and every one of the months prior to the month reflected in that row. In other words, the retention rate for February reflects the % of customers who bought in January. The retention rate in March reflects the number of customers, as a %, who bought in January and in February and in March, as a percent of the total of customers who bought over that period of time.

# of new customers is a calculation of the # of customers, or people who bought goods in that month, minus those customers who were “retained,” or who bought in all of the months prior and bought in that month.

Customer acq. cost (CAC) refers customer acquisition cost. In its simplest form, it can be calculated as sales and marketing expense divided by the number of new customers. In other terms, it refers to all marketing expenses, promotional efforts, etc. that go into acquiring one customer. The $35 number may seem high to you, but it really isn’t that crazy in this space.

Monthly CAC (monthly customer acquisition cost) is the (customer acquisition cost) * (number of new customers)

CAC/GP is the Monthly CAC divided by Total Monthly Gross Profits.

Gross Profit is equal to Revenue * GP margin.

% of subscribers reflects the pool of customers who are subscribers and purchase via the traditional online retail store in that month

Analysis

So what does this all mean? What can we take away from all of these numbers and terms?

Many things, but I’ll warn you, the takeaways are for this set of assumptions. There are some definite universal trends and themes reflected here that hold true in almost every scenario, but don’t get caught up with absolutes and definites. That’s a dangerous approach and one that leads many people to answer “Company A” to the question we initially posed.

And while we’re on the topic of that question, let’s examine it.

Company A in the question above can be represented in Exhibit 1. This company has a 67.5% gross profit margin, rising revenues, a growing customer base, relatively reasonable customer acquisition cost, yet, as presented, is less attractive than Company B, i.e. Figure 2. How so? Well, if you look at the Total Gross Profit minus Total Customer Acquisition for Company A, you can see that Company A’s gross profit covers what it spends on acquiring customers and leaves only $4.87 million remaining. That $4.87 million isn’t money in the bank either. There are other expenses, interest on any outstanding debt, taxes, etc. and at the end of the year, Company A may earn a pretty small amount of cash in hand.

Company B on the other hand, has less than 1/3rd of Company A’s total revenue but is able to cover the cost of acquiring its customers and have $5.16 million remaining? Why? Well, a few things:

1)    Company B, the subscription box company, has 80% gross profit margins because they often sell samples of items and these samples are supplied to them for free. Additionally, these companies don’t have to worry about returns, etc. because they have a no return policy on the subscription boxes. So the only real direct cost of selling these subscription boxes is shipping fees.

2)    But perhaps the two most important differentiating elements between Company A and Company B are: 1) Retention rate and 2) customer acquisition cost.

 

This scenario assumes a 12 month subscription and based on industry chatter, that’s about right for a successful company like Birchbox. So, this means, once a customer signs up at the beginning of a respective period, they are locked in for a year, they are going to pay you their subscription fee each month, and they are retained throughout the life of the analysis done. In other words, retention rate is 100%. This matters even more when you examine… customer acquisition cost.

 

How so?

 

Company B doesn’t lose customers from one month to the next, so from month to month, all they need to focus on, and spend on, is acquiring new customers to build their customer base.

 

Company A, on the other hand, loses customers each month so each month, they have to both restore their customer base, to make up for the numbers they lost, and build their customer base.

 

Thus, the cost of customer acquisition per month for Company A is significantly more burdensome than it is for Company B and even though gross profit per customer for Company A is +2.5x that of Company B, as the CAC/GP column illustrates, at some point, the cost of acquiring customers stops declining, as a percent of gross profit, and actually starts to rise again.

 

In the case of Company B, CAC/GP steadily declines.

 

But now let’s turn our attention to Company C, akin to the Birchbox model. Company C has a set of subscribers for their monthly subscription box business and a group of customers who buy via their traditional online retail store.

 

At the end of the year, Company C covers its cost of customer acquisition and has $15.4 million left over. Not so bad, right? Well yes, but easier said than done.

 

The keys to Company C’s success, as illustrated in this analysis, are:

 

  1. % of subscribers who purchase from the traditional retail store
  2. customer acquisition costs, albeit a function of % of subscribers who purchase from the traditional retail store

Let’s explore these two elements in greater depth, starting with % of subscribers who purchase from the traditional retail store.

So, Company C has a sweet deal in many ways. It’s got this steady stream of cash coming in from its subscription box business with all of the elements of Company B’s subscription box business. Once a customer signs up, he or she is bound for a year. However, by signing up subscribers, Company C is also doing another thing in the long term: decreasing its customer acquisition costs. And this statement requires some more explanation, so let’s get into it.

If you think about what customer acquisition costs are, in essence, they are the amount that you pay for your revenue. So, earlier I said that “not all revenue is equal” and this is what I mean. In a lot of businesses, the retail business included, retailers pay for revenue. Not bribe or anything, but they pay for revenue. Without ads, press, promotional campaigns, celebrity endorsements, etc., very, very few brands just take off without advertising. So, customer acquisition cost is all of the sales and marketing you do, or everything you pay, for your revenue. In the case of Company C, sure, it pays for its revenue, but part of that money that they spend to acquire a customer is for the subscription box business and when a subscribers receives his or her box, if he or she enjoys the sample product and wants to buy more, he or she goes to Company C’s online store and purchases it. Why won’t they go to Amazon? Because Company C, like Birchbox and other successful companies in the subscription box business, largely sell products that you can only find on their online store.

So, to recap: Company C pays to acquire subscribers, but once they have subscribers, the products themselves are the “marketing’ and “advertising” campaigns and they don’t need to pay to re-acquire those customers for their traditional, online store.

In the case of Birchbox, more than 50% of their subscription box subscribers purchase on their traditional online retail store.

For purposes of this analysis, I was super conservative and assumed that only 25% of sales from the traditional retail store come from the subscriber base.

Not having to re-acquire customers also allows Company C to save costs while building their traditional online retail store. They only need to acquire those who don’t come from their subscriber pool (in this case 25% came from the subscriber pool) and despite low retention rates from the online store, Company C still fares well at the end of the day.

Three final points:

1)    I mentioned that Birchbox is not a subscription box business. How so? Well, the beauty of Birchbox strategy is that growing the number of subscribers is important, but not the primary goal past a certain point. Instead, Birchbox has shifted its time and focus on boosting the % of subscribers who purchase via their traditional, online retail store and if they can accomplish this, they will drastically drop their customer acquisition cost, increase overall gross profit/customer, and knock it out of the park. Thus far, they’ve done a pretty damn good job of doing that. Also, that’s why they aren’t a subscription box company. They view a subscription as the beginning of their journey, not the end and subscriptions are just a way for them to cost effectively tap into the rest of your wallet.

2)    Part of the reason that Birchbox is not just a subscription box business is that it’s almost impossible to scale a business and grow it to a considerable size on subscriptions alone. While revenues relative to costs matter, while cash is king, at some point the absolute size of revenues and profits matters and getting to that size through subscriptions alone requires an enormously sized customer base or a subscription fee that is very high. Either of those long term strategies will likely up the cost of customer acquisition.

3)    Finally, this analysis is based on a number of assumptions. I’d like to think that these these assumptions are educated and I can guarantee that they are the product of research, study, and trends, norms, themes, and precedents. But they are assumptions, they are variables, and as they change and as the industry changes, dynamics can change.

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