#78 - Customer Lifetime Value

There Is No Average Customer

Hi 👋 - To readers in the US, happy Memorial Day 🌭. Customer lifetime value isn’t the stuff of beach reads, but it is the primary driver of corporate value. This post looks at customer acquisition costs, monetization, and retention dynamics. Thanks for reading. Don’t forget your sunscreen.


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Unhappy Families

Customers are like Tolstoy’s unhappy families, all different in their own way. To value a consumer business, you need to understand customer lifetime value (CLV), which is driven by acquisition, monetization, and retention.

Because these variables are dynamic and interactive - and there’s no average customer - calculating CLV is difficult, as Michael Mauboussin, Head of Research at Counterpoint Global, writes in a recent report. Mauboussin is the finance equivalent of Daniel Kahneman, who wrote Thinking Fast and Slow. His report illuminates the tradeoffs and complexities of forecasting consumer businesses. 

Customer Lifetime Value (CLV)

CLV is composed of customer acquisition cost, monetization, and retention: 

  • Customer Acquisition Cost (CAC): How much does it cost to acquire a customer? This is mostly marketing like online advertising and promotions (15% off your first order), but also includes content and product spending. For example, one rationale for Spotify giving Joe Rogan a $100M contract was that exclusive content would attract new users. Some portion of this expense should be included in Spotify’s CAC.

  • Monetization: How much does each customer spend? This boils down to average order value and purchase frequency. Larger basket sizes and more frequent purchases mean more revenue. 

  • Retention: How long do customers stick around for? Are transactions one-off or recurring? CAC is paid upfront, so more longevity translates into higher profits. 

Additionally, business models matter. Because economics are well defined, subscription businesses are more predictable. For example, every month Spotify Premium costs $9.99. As long as a customer stays active (and their credit card hasn’t expired), you can bank $9.99 in monthly revenue. This is one reason why subscription businesses get higher multiples.  

Stage of maturity matters as well. For a mature company like eBay most value comes from existing customers. In contrast, for a less mature company like ThreadUp, which is bringing the thrift store online, most value comes from future customers. eBay’s value skews heavily towards the left side of the chart below, while ThreadUp’s skews to the right. Strategically, both eBay and ThredUp focus on improving monetization and retention. However, ThreadUp will focus a relatively larger share of its resources on growing its customer base.

Customer Acquisition Cost

Sales growth is the primary driver of business value, and customers drive sales growth. CAC is a key metric for consumer businesses, but as Mauboussin points out, one that’s often misused.  To start, CAC isn’t static. Further, it’s not a single number. CAC varies over time based on product penetration and competitive intensity.  

Sociologist Everett Rogers, who studied how ideas and technologies spread, created a framework for product adoption in his book The Diffusion of Innovations. Adoption follows a bell curve, with innovators and early adopters on one end and laggards on the other. Most customers are somewhere in the middle: 

Customers aren’t homogenous. Your most enthusiastic customers find you, but you need to find your marginal customers. For example, someone sleeping outside an Apple Store the night before a new iPhone drops is an innovator or early adopter. Apple doesn’t need to spend anything to coax them to show up with their sleeping bag and folding chair. In contrast, reaching the late majority and laggards requires marketing investment1.  Due to diminishing returns, CAC increases moving from innovators to laggards. Because the price of a given iPhone is fixed, early adopters are more profitable and generate more cash flow than laggards. 

Monetization

Again, there’s no average customer. Spending patterns follow power laws: a disproportionate amount of revenue comes a few customers. Researchers have found that the top 20% of customers generate nearly 70% of revenue. The person sleeping outside the Apple Store waiting for the new iPhone also buys AirPods and a Mac. 

Another reason for this dynamic is that top customers are finite. For example, at the end of March 2021, Alibaba, China’s e-commerce giant, had 811 million active customers2 versus China’s population of 1.4 billion. Alibaba’s early customers were affluent customers living in big cities like Beijing and Shanghai. As the company grew, new customers came from smaller and less affluent cities. Alibaba is currently investing heavily in Taobao Deals, a direct-sourcing product geared towards price sensitive consumers in small cities and rural areas. Relative to tier one cities, these customers have less discretionary income, meaning lower purchase frequency and basket size. Future customers may not look like your current customers. 

Retention

Averages are problematic with retention too. Retention rates vary cohort to cohort and change over time. Like CAC, there’s no one retention rate. For example, cohort retention rates generally improve over time. That’s because unhappy customers are quick to leave, while happy campers stick around. As you move from early adopters to laggards, retention curves likely start at a lower level (though still improve over time). Early users are the people sleeping outside the Apple store. They’ll keep spending. Grandma, bless her, is less enthusiastic.  

Another factor impacting customer longevity is that the speed of technological adoption is accelerating. It took the telephone 60 years to penetrate 70% of American homes. Cell phones accomplished this feat in a decade. One interpretation is that there’s never been a better time to be selling a new product. You can get big, quick. But nature abhors a free lunch. Another interpretation is that your competition can displace you faster. Mauboussin notes that it took Facebook eight years to reach one billion monthly active users (MAU) compared to two and a half years for TikTok. CLV is determined by acquisition costs, customer volume, revenue per customer, and longevity. Faster adoption means that while customer volume is increasing, longevity may be decreasing. CLV variables are all interconnected.  

All Models Are Wrong, Some Models Are Useful

Customers are all different in their own ways. They’re not homogenous. The variables driving CLV are dynamic and interconnected. Models that treat CAC or retention rates as static are likely to miss the mark. By highlighting common mistakes - CAC goes up, not down over time - and tradeoffs, Mauboussin gives analysts tools to make their models more useful. That’s something to be happy about. 


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More Good Reads

If you’re interested in business analysis, modeling, or valuation, Mauboussin’s full report is a good read. Benchmark’s Bill Gurley on the dangerous seduction of the LTV formula3. Below the Line on how to build a revenue model. 

Disclosure: The author owns shares in Alibaba, Apple, and Facebook. When it comes to iPhone adoption, he is in the early majority.

1

Apple spent $20 billion on selling, general and administrative expenses in the fiscal year ending September 2020. Marketing is a big part of this, though the company doesn’t disclose specifics.  

2

Per Alibaba’s 1Q 2021 earnings report

3

I’ve referenced this post a few times, but that’s because it’s a great reminder of the shortcomings of formulaic approaches, the (often missed) tradeoffs between variables, and the gulf between models and reality.