2021 was the year of the recurring revenue model. For evidence, look no further than three of the largest companies in the world: Microsoft, Amazon, and Netflix. Despite a pullback toward the end of the year, these three companies added a combined $308 billion to their market caps in 2021 and each stock significantly outperformed the S&P 500, in part because of the power of recurring revenue.
Before we look at Microsoft, Amazon, and Netflix, let’s answer a few basic questions about recurring revenue.
It is revenue from a specific source that is received in consistent, periodic payments and is highly likely to continue in the future.
Recurring revenue comes from memberships, contracts, and subscriptions. Your monthly gym membership is a source of recurring revenue for Anytime Fitness, your monthly cell phone bill provides recurring revenue to AT&T, and the $10.99 you send to Netflix each month provides the streaming company with a steady flow of recurring revenue.
1) It leads to stronger margins in the long-term. Businesses that have built a large recurring revenue base spend less on retaining customers. Entering into longer-term relationships with customers allows businesses to escape the endless cycle of constantly having to resell to the same customer over and over. Recurring revenue also allows businesses to more accurately forecast demand and therefore operate more efficiently.
2) It provides certainty to future income, decreasing risk. For example, unpredictability in the number of iPhones that will be sold in the future – the iPhone is not a recurring revenue product– adds volatility to Apple’s revenue. If the iPhone sneezes, Apple catches a cold. Whereas Microsoft can rely on a steady stream of revenue from companies that pay hundreds of dollars per employee per year to obtain access to the Microsoft Office software suite. Microsoft never catches a cold because Office gives it immunity.
3) Humans constantly underestimate the pace of time, so the ideal revenue model is one that is tied to the clock. That’s recurring revenue. Payments that occur automatically every month serve as a sort of inertia that prevents customers from considering alternatives or deciding they no longer want or need a subscription or membership. As a result, businesses with recurring revenue naturally have higher renewal rates (or lower churn), which puts them one step closer to monopoly.
Now, let’s take a look at Microsoft, Amazon, and Netflix.
I mentioned above how Microsoft Office gives Microsoft continuous cash inflows. Office is just one of a host of software and cloud services that provide Microsoft with recurring revenue. Microsoft has undergone a transformation to a recurring revenue model under CEO Satya Nadella, who took the helm in 2014. Microsoft’s share price has reflected investors’ affection for the new model, increasing more than 80% since the start of 2016.
Amazon has a few different recurring revenue streams:
1) Amazon Prime: Prime is Amazon’s $12.99/month membership program which also gives customers access to Amazon’s video and music streaming platform. Prime generates little income for Amazon on its own, but it generates billions of dollars of additional online retail sales by building customer loyalty, in part by providing free 2-day shipping, which comes with a Prime membership. The free shipping is funded by monthly inflows from the Prime membership fee.
2) Subscription-Based Retail: Recurring revenue is not just for software. Through Amazon’s Subscribe & Save program, customers can set up automatic shipments of a certain product – for example, toilet paper – every month or as often as they’d like. The result is recurring revenue and greater customer loyalty for Amazon.
3) Amazon Web Services (AWS): AWS provided approximately 10% of Amazon’s revenue and virtually all of its operating profit in 2017 (Amazon’s online retail business was not yet profitable that year). AWS offers cloud computing services to organizations, often in the form of a subscription, which generates recurring revenue.
Netflix is the poster child of recurring revenue. All of its $11.7 billion in 2017 revenue was recurring, coming from its streaming and DVD subscription services. Netflix dominates the streaming video on demand (SVOD) market and rarely loses customers due to its subscription model. In an October 2018 survey of 500 SVOD customers, 89% of those surveyed had Netflix and Netflix demonstrated an impressive renewal rate of 93%.
While all is currently bright and rosy for these three companies, the recurring revenue model is not perfect. For starters, it’s not always the best option. Some products and services simply don’t fit in this model. More importantly, transitioning to a recurring revenue model often requires significant capital investment and can compress profits in the short-term. Convincing customers to commit to a long-term monogamous relationship with a business requires investment in an excellent product or service, development of a strong brand, and heavy initial marketing and advertising spend. Meanwhile, revenue can fall significantly in the first stage of the transition. For example, Adobe, known for its PDF and Creative Cloud software, went from selling its software outright for $1000+ to selling a $50/month subscription in 2012, resulting in a painful hit to both its top and bottom line. However, the transition eventually led to incredible growth. From 2012 to 2018, Adobe’s revenue grew 105% while Net Income grew 211%.
Recurring revenue helps businesses fend off competition through the development of long-term relationships with customers, often leading to stronger growth and healthier margins.
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