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“Swallowing the Fish”: A short-term reality for subscription businesses

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We’re in the midst of a global economic shift where businesses and consumers alike prefer access to services over the ownership of products: the Subscription Economy.

As a result, companies around the world are rethinking their business models to implement a SaaS approach in order to meet new customer demands and scale in an increasingly competitive landscape. Look no further than HPE's strategic shift to a subscription business model, or the fact that Apple’s services revenue reached an all-time high of $12.5 billion (nearly 20 per cent of its business) by the end of its FY’19.

The benefits of subscription business models are unparalleled in this new economy. Recent research found that subscription businesses are achieving 5x faster revenue growth than the S&P 500 (18.2 per cent vs. 3.6 per cent).

However, while moving towards subscription services helps companies grow in the long term, the shift is not without short-term headwinds, which can include:

  • Go-to-market challenges, resulting from transitioning your direct sales or channel to a subscription approach from an up-front sales approach. This involves a change in compensation models, as well as training and education (how to sell the value prop of subscription).
  • Transitioning traditional SKU-based product catalogue to subscriptions. Some companies will try to make every SKU a subscription, but that’s the wrong approach. You must think from the customer need inward, not from the product design outward.
  • Customer success. The notion of customer success usually does not exist in traditionally product-focused companies. You have to think through how you are helping your customers along on the journey and focus on growing relationships, not transactions.

Subsequently, companies switching from a product-based solution to services-focused model frequently have to “swallow the fish.” The fish is what happens when a traditional company starts to shift its revenue mix from an asset purchase model to a subscription model. During this period, the company experiences a string of quarters where top-line revenues shrink as revenues from large, pay-up-front deals are replaced by recurring subscriptions without the big up-front payment.

At the same time as revenues dip, the company must make investments in many of the new capabilities and structures that are required for a profitable subscription-based model. The traditionally profitable and stable mix of more revenue than costs is replaced with a tumultuous period of costs exceeding revenue. The end result, however, is that this period of investment and restructuring results in greater efficiencies and higher revenue growth, thus completing a fish-like curve.

This has happened to a number of notable enterprises like Adobe, Nutanix and Microsoft, and is a reality for any business undergoing a major transformation into a services provider. Let’s take a look at some examples.

Adobe:

Adobe was a trailblazer for the industry, moving Creative Suite to monthly subscriptions in 2012 to align with evolving content creation requirements and to avoid flat growth under perpetual licensing. In doing so, Adobe had to “swallow the fish.” Net income plummeted nearly 35 per cent the following year, as its upfront expenses grew.

However, in three years, Adobe Creative Cloud went from almost no subscription revenue to a virtually 100 per cent subscription model. When Adobe announced its transition, it’s stock was trading around $25. Today, it’s trading around ~$328.

Additionally, the company grew its total Digital Experience subscription bookings in FY’19 by more than 20 per cent YoY.

Microsoft:

Roughly five years ago, Satya Nadella made some very smart (but also very unpopular!) decisions and investments that set Microsoft up for success in a cloud-based world. In shifting his company away from static hardware and on-premise sales towards a subscription-based cloud model, Microsoft, like Adobe, experienced short-term challenges.

From mid-2014 to mid-2015, Microsoft’s stock appeared to stall out for a few years prior to starting a steady ascent. Operating expenses during this time period increased, as Satya likely made a few upfront investments, spending a bit of money and R&D on building out his server infrastructure and service-oriented field team. In the same period revenue dipped as the company transitioned its revenue mix from products to services, forming a fish-like visual. 

Microsoft’s stock price wavered around $50 during this transition period, where as today it’s around $150 and climbing. Satya Nadella set his company up for a long, steady ascent.

PTC:

PTC is one of the 50 largest software companies in the world. Five years ago, PTC went all-in on subscriptions, and as a result its earnings took a dip. In the second quarter of 2015, PTC recorded $303M in revenue. A little over a year later, that number dropped to $288M. In the same period, earnings swung from $17.4M profit to a loss of $28.5M.

PTC has now reported that it’s ARR grew 12 per cent in fiscal 2019 and announced that it will acquire SaaS product development platform, Onshape.

There are countless opportunities for enterprise organisations who shift their business to provide valuable ongoing services via subscriptions - faster revenue growth, deeper relationships with customers, access to critical data, and more.

But the truth is, transitioning to a subscription business model is no easy feat and requires time and investment. However, this shift in business model is a necessary one for any company to compete with a new generation of born-in-the-cloud, SaaS-based companies, and to truly connect with their customers.

Amy Konary, VP of Customer Business, Zuora