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Investing in the subscription economy – 3 companies with strong recurring revenues

Subscriptions are part of daily life for businesses and consumers these days. But why should investors pay attention to companies that rely on this type of revenue?
Hand holding smartphone and shows a digital screen of subscribe - Gettyimages

Important information - This article isn’t personal advice. If you’re not sure whether an investment is right for you please seek advice. If you choose to invest the value of your investment will rise and fall, so you could get back less than you put in.

Subscriptions are part of daily life for businesses and consumers these days. But why should investors pay attention to companies that rely on this type of revenue?

The subscription economy is an economic model in which businesses provide customers with goods and services on a subscription basis. This could be anything from an £50 gym membership to a £500k HR system.

Subscription models are attractive because they reduce risk. Predictable, sticky revenues mean you can better-anticipate future cash flows. That helps decision making and can provide confidence to invest for growth. Ongoing interactions create a rich data set for strengthening customer relationships, cross selling and developing service or product offerings.

And the beauty of subscription models is both parties can benefit. As a customer, you can get convenient access, spread costs and enjoy an offering that keeps improving.

What are the challenges?

Obviously succeeding with this model isn’t without its challenges. Switching to recurring revenues can require significant changes to the way a business markets and delivers its offering. This isn’t cheap and unlike traditional one-off sales, recuperating expenses isn’t always as quick, as companies are reliant on clients adopting their subscriptions long term.

Plus, if the product offering or proposition doesn’t hit the right spot, then no one will sign up.

Not all subscription companies are created equal though. Here's a closer look at three companies with strong recurring revenues.

This article isn’t personal advice. If you’re not sure an investment is right for you, seek advice. Investments rise and fall in value, so you could get back less than you invest. Past performance isn’t a guide to the future. Ratios shouldn’t be looked at on their own.

Investing in an individual company isn’t right for everyone because if that company fails, you could lose your whole investment. If you cannot afford this, investing in a single company might not be right for you. You should make sure you understand the companies you’re investing in and their specific risks. You should also make sure any shares you own are part of a diversified portfolio.

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The technology company best known for software like photoshop offers a variety of tools for creative professionals, communicators and other consumers.

Adobe did away with physical, shrink-wrapped products back in 2013 and is now an established Software-as-a-Service (SaaS) provider. Though the transition wasn’t easy, 94% of revenues now come from subscriptions. Helping it to attain industry-leading operating margins and more predictable cash flows.

The future looks promising in Adobe’s main growth niches, with its Creative, Marketing and Document offering all set to benefit from enterprises shifting to cloud-based operations.

However, where we get excited is the artificial intelligence (AI) opportunity and the group is well positioned to benefit.

It’s already had success integrating AI into in its products, but its new Adobe Firefly software sees it enter into the latest trend of generative AI with Microsoft and Google.

But this opportunity also poses a threat. Adobe aren’t alone in the creative AI space. Content generation tools like OpenAI Sora are mature, widely used and give Adobe’s offering a run for its money.

However, this is where Adobe benefits from its catalogue of products and market dominance. The software provider is woven into the creative and content business and unlike some competitors can be used throughout the creative cycle, from idea generation and editing through to distribution. Still, competition is something to monitor.

Adobe’s SaaS model also generates good levels of cash. In 2023, it generated close to $7bn in free cash flow. And with its balance sheet in good shape, Adobe has the firepower to invest in growth and stomach ups and downs.

Trading at a discount to its long-term average, the valuation is more compelling than it has been. But the market still has high expectations and will be sensitive to earnings disappointments.

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On the face of it, Costco might look like any other wholesaler, selling a selection of electronic, apparel and food items. But it’s the membership side of the business that’s helped propel it to become the 12th largest company in the Fortune 500.

Aimed at small to medium-sized businesses and families shopping for personal needs, Costco offers great price savings.

As a volume player, its operating efficiencies and no-frills approach enables it to run profitably at significantly lower margins than traditional retailers. Operating margins of 3.3% are nothing to get too excited about, but its trading volumes and memberships are.

You have to be a member to buy from anyone of Costco’s 874 stores. And they’ve found the sweet spot which people are willing to pay.

Almost 74 million households have been convinced to subscribe to one of Costco’s annual $60-$120 packages. This has helped membership fees to climb 8.4%, to $4.6bn in 2023, representing almost three quarters of the company’s profits. With global renewal rates at ticking up to 90.5%, Costco is proving it’s a subscription that people aren’t willing to give up.

There are psychological implications to paying membership too. Knowing you’ve paid to shop somewhere can help encourage repeat trips and a sense of loyalty.

Costco’s differentiated customer offering, and the stability of their club card revenues help set them apart. It’s also got an ace up its sleeve the form of its own-brand Kirkland Signature range. Not only does this provide control over operations and inventory, but also provides customers with products found nowhere else.

But Costco isn’t unique in what it does. The retail business is highly competitive, with other established warehouse-club operators like Walmart and new entrants like Target. Amazon also can’t be ignored. The group’s lower margins mean it has less ability to stomach a severe increase in competition, which is something to keep an eye on.

Compared to peers, it has one of the highest valuations, reflecting opportunities ahead, but this also increases risk. Any missteps will be punished.

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Since debuting Microsoft Office 365 11 years ago, Microsoft has gone from a desktop software company to a SaaS juggernaut. Its array of fast-growing offerings, from Azure and LinkedIn, through to Microsoft 365 are helping to generate sticky recurring revenues.

We’re particularly excited by Azure, which boasts 72% gross margins. Closing the gap to AWS, second-quarter Azure revenues rose 30%, with AI services helping to provide a 6% boost. This comes after a period of delayed deployments pointed to cloud spend slowing amidst a tougher economic backdrop. But recent data seems to suggest a reacceleration, which could be a big benefit to Microsoft.

Azure’s key to Microsoft’s future, but let’s not forget its bread and butter.

The company’s now far more than Excel or Word, but they’re still core to its subscription revenues. In 2023 Office 365 Commercial revenue grew 13%, thanks to 11% more users and an increase in revenue per user.

Microsoft is a great innovator and with that comes new ways to increase customer fees. The group stated early demand for its latest innovation, Copilot is unparalleled, but hasn’t yet shared sign-up numbers. The share price has risen on AI hopes, so there could be heightened volatility in the near term.

These catalysts mean Microsoft valuation has continued to march well above its long-term average. And this growth comes at a cost. Underpinning advancements in generative AI is a huge amount of spending. Microsoft's balance sheet is in good health, but investing ahead of future revenues can be a risky business and we’ll have to wait to see if it pays off.

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This article is original Hargreaves Lansdown content, published by Hargreaves Lansdown. It was correct as at the date of publication, and our views might have changed since then. Yields are variable and not guaranteed. Investments rise and fall in value so investors could make a loss.

This article is not advice or a recommendation to buy, sell or hold any investment. No view is given on the present or future value or price of any investment, and investors should form their own view on any proposed investment. This article has not been prepared in accordance with legal requirements designed to promote the independence of investment research and is considered a marketing communication. Non-independent research is not subject to FCA rules prohibiting dealing ahead of research, however HL has put controls in place (including dealing restrictions, physical and information barriers) to manage potential conflicts of interest presented by such dealing. Please see our full non-independent research disclosure for more information.

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Written by
Guy Lawson-Johns
Equity Analyst

Guy works as an Equity Analyst within the share research team, delivering current research and analysis on individual companies as well as broader sectors.

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Article history
Published: 4th April 2024