Are Subscription Businesses at Risk in a High Inflation Environment?
People are worried about inflation. You can go on CNBC, Bloomberg, or the WSJ and every day there are articles with headlines like this one:
“As long-term Treasury yields rise, investor Peter Boockvar warns inflation would spark the ‘market’s worst nightmare’“
The headline is clickbait (and just a tad bit of fear-mongering), but it is telling the truth: investors are worried about inflation. Sure, some have been worried and wrong about it since 2009, but this time it might be different. Well, actually, I have no f-‘ing clue whether this economy is different, and neither does almost anyone else.
What I am worried about is if high inflation comes, how it will impact the business performance of the stocks I own. A clear distinction I want to make is that I’m not worried about what any inflation does to short-term stock prices. I’m concerned that inflation may negatively impact certain business models, and therefore long-term earnings power. That is what matters to long-term stock performance, and what any buy-and-hold investor should be trying to analyze. Everything else is noise.
Specifically, I’m worried that the hottest current business model, subscriptions, will face headwinds if inflation creeps up to the mid-single-digits. Why? Because these businesses are built on low-cost, recurring revenue streams that can easily be inflated away without pricing power. And, if history is any indication, subscription businesses struggle to raise prices.
I’ll go into further detail of why I think this below, but first, let’s talk about companies that will do well in an inflationary environment.
Companies That are Natural Inflation Hedges
An inflation “hedge,” at least how I think about it, is a company or security who’s earnings power or payout can counteract high inflation. The best example of this is the credit card companies Visa and Mastercard. These companies make all their money from processing payments and get a small “take-rate” (usually 0.1% of the transaction) every time someone uses a card.
Why does this counteract inflation? Since Visa and Mastercard are paid on a percentage-basis, any aggregate pricing increases will flow in tandem to the companies’ top lines.
PayPal, Square, and Shopify are other businesses that come to mind as natural inflation hedges. Basically, anyone who’s model revolves around growing the number of dollars flowing through its platforms will naturally fight a rise in overall prices.
Companies that can Pass on Inflationary Pressure to Consumers
There are quite a few companies in this segment of the market. Businesses that will have to make an active decision to raise prices but will have little effort in doing so (unlike Visa, who’s revenue will grow with no effort).
An easy example is retailers. Costco, Home Depot, and Kroger will have to choose to raise prices if they want to counter any inflation (and honestly, this is where a lot of inflation “starts” in the first place), but won’t see much pushback because of how the consumer interacts with the business. A customer at Costco won’t blame the company for raising prices on individual items. They take note when their total bill is higher, but usually put blame on the individual items on the list, not Costco itself.
It also doesn’t change Costco’s or any other retailers’ value proposition. Just because consumer prices rise in aggregate doesn’t mean Costco can’t still be the low-cost bulk solution, even if they have to raise prices on an absolute basis. Whole Foods can still be the premium brand for organic products and high-quality food. The value proposition still stands vs. other retailers if they have to raise prices too.
Subscription Companies may Have Trouble with High Inflation
I think recurring revenue businesses will struggle to counteract inflation. That doesn’t mean every subscription business will underperform, just that on average they will face headwinds trying to raise prices if faced with 4%+ inflation.
You might be skeptical reading this. We’ve all been taught the narrative that recurring revenue models are superior because of how reliable the cash flows are. Well, as Charlie Munger teaches us, let’s invert the situation and see what happens.
If the economy faced deflationary pressures, I’m confident subscription businesses would do well. The lock-in of customers into certain price points would increase cash flow margins as the overall cost to run the business went down. Eventually, if faced with enough deflation subscription prices would have to drop. But there would be a lag in the timing of CPI declines and then future dropping of subscription prices, which would benefit companies with recurring revenue contracts.
Going through that example, it makes sense that subscriptions become a worse business the more inflation we get. That cost lag, a benefit with deflation, would work in reverse with inflation. Think of Netflix as an example. If wages, materials, and other expenses started going up while the price of the service stayed the same, cash flow margins would have to go down. Raising the price of a subscription service is tough because it creates a step-change for the customer, and historically it has been tough to pull-off vs. an a la carte model.
In the end, what becomes important is the value the subscription is providing. If the consumer or business benefits enough from the product offering, churn won’t increase and financials will stabilize over time. But even if it is a valuable service like Amazon Prime, price increases will still likely lag any inflationary pressures, putting profit growth on a lag with expenses growth.
To conclude, I’m not certain inflation is coming (remember, everyone is usually wrong about their inflation predictions). But if it does, I want to make sure my portfolio is ready to succeed no matter what.
Disclosure: The author is not a financial advisor, and may have an interest in the companies talked about.