The Economics of Customer Businesses

Read a recently article by Michael J. Mauboussin called "The Economics of Customer Businesses"  which I highly recommend.  For those not familiar with Legg Mason, they run a bunch of world class mutual funds which subscribe to a value philosophy and have terrific long term records.  Michael is the Chief Investment Strategist for Legg Mason.

In his most recent piece, he analyzes consumer businesses such as Netflix, Sirius Satellite, DirectTV, etc. and has some non-obvious insights.  Some of them were:

1. Aggregate churn rates in these high growth consumer businesses can be misleading early on.  The more relevant information is to look at churn rates for various cohorts i.e. customers who joined during a particular time frame and then track that over time.
2. Not all customers are equal.  There can exist a whole spectrum of wildly profitable to wildly value destroying customers in your customer base.  The trick early on is finding out who is profitable and keeping them while getting rid of the "unprofitable" bunch.  For example, Amazon recently launched an online DVD rental service in England very similar to Netflix except for one crucial difference - while Netflix allows unlimited rentals in a month, Amazon only allows a limited number of rentals in a month.  Any customer who rents more than 9 "new" movies a month is a money loser for Netflix and they "eat" that loss for the value of the "unlimited rental" message.  Amazon is cleverly sucking away some of the "profitable" customers away from Netflix with their modified positioning
3. There are also some diffusion equations that can predict customer adoption well.