Customers Don’t Grow on Trees

Firms, at their core, sell products and/or services to customers. Often it costs money to build awareness of the product or service you’re selling, sometimes small sums, sometimes large. It’s useful to think of this through the lens of a metric called customer acquisition cost (CAC). We will look at why this calculation is both insightful, yet often flawed.

At its simplest, firms make money by selling things to people (or to other firms and/or governments). But if you were to set up a business today selling widgets, how would people know about it, and how would they know to buy your product over other existing widget providers? You could maybe hire a sales team to go door-to-door and educate people about the widgets you sell. Perhaps you could launch a national TV advertising campaign for your product. All of these actions cost money and can be thought of as the cost necessary to acquire a customer.

Customer acquisition cost refers to the total marketing and sales expenses divided by the number of new customers acquired. In other words, how much money did you need to spend to acquire each incremental customer (i.e., to get that customer to either buy your product or service). CAC is an important metric, particularly for early stage businesses, because it can be assessed against the lifetime value (LTV) of a customer. Investors favour companies with CACs that are lower than their customer LTVs, and CACs that are getting lower over time. The opposite dynamic, where a companies CAC is higher than its customer LTV, can spell the end for a business.

We recently pored over the recently-lodged Peloton (PTON) S-1, a registration statement for firms planning an initial public offering. Peloton sells stationary exercise bikes and treadmills that are connected with software such that users can watch classes by virtual instructors as they workout. The business is in a nascent stage of building out its subscriber base of users who, after initially purchasing the bike or treadmill, pay a recurring $39/month fee (or $19.49/month for the digital-only subscription). In its S-1, PTON discloses its “net CAC”, so let’s look at what the numbers say.

In FY19, Peloton had a net CAC of just $5. For a business selling $2,000 exercise bikes and $4,000 treadmills this sounds very low. It’s worth drilling into the company’s definition of net CAC. They take adjusted sales and marketing expense and subtract the gross profit dollars from equipment sales, dividing this by the number of users acquired.

Firstly, what are the adjustments PTON is making? It just so happens that this adjusted S&M expense strips out stock-based compensation (which is absolutely a real expense, whereby employees are paid with stock options rather than cash). Stock-based compensation expense was around $90m in FY19, or almost 10% of PTON’s revenues. This is a significant expense, with its exclusion serving to understate PTON’s true CAC.

The second point to explore is why PTON is subtracting the equipment gross profits. The company is netting out the gross profit from equipment sales, with the logic here being that the gross profit dollars earned from selling a customer a bike or treadmill should be used as an offset to the cost of acquiring those subscribers. The point here is to isolate the economics of the subscription revenues from the economics of selling the equipment. However, the issue here is that selling the equipment (bikes/treadmills) is inexplicably linked to generating subscription revenues, given that users only pay the $39/month subscription fee once they buy the equipment (n.b.: it’s possible to buy digital-only subscriptions where a user can access Peloton’s content on their own non-Peloton device, but these are omitted from PTON’s CAC calculation).

It follows from this that the way PTON defines its CAC means that it is linked to its equipment sales, and more specifically the gross profit dollars earned on those equipment sales. For an investor hoping for a declining CAC (or at the very least a CAC that is stable), this quirk with PTON’s CAC definition may be cause for concern. If competition were to at some point pressure equipment prices then this would likely lead to lower gross profit dollars on equipment sales, which would have the effect of increasing the CAC.

While the above issues around the CAC are specific to PTON, there are broader shortcomings of the metric that investors should consider. For example, how long does it take for a lead to convert to a sale? For long lead-time businesses, there might be a mismatch between when the marketing expenditure was incurred, and when that sale is finally made, which can distort the CAC metric.

What about a business such as Evernote that follows a freemium model, where there is a cost to support users while they are free before they convert to paying users? The stock standard CAC definition falls short here in capturing the true economics of Evernote acquiring a customer, as it fails to account for costs to support non-paying users before they convert to paid users.

As always, it’s worth making adjustments to reported company definitions where appropriate in order to get them to properly reflect the underlying economics of that business. The CAC definition is no exception, and investors that blindly use the metrics provided by companies do so at their own peril.

George Hadjia is a Research Analyst with Montaka Global Investments. To learn more about Montaka, please call +612 7202 0100.

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