Monday, September 10, 2007

The Razor-and-Blade Model

In this post, I would like to introduce a familiar business model (for most value investors) that can help most investors in their analysis of companies. It is also a model that entrepreneurs should seriously adopt when they want to start their own businesses. It is a very basic model that can help generate good recurring income and is probably a sign that the company will be in the business for a long, long time and not those fly-by-night bubble tea shops where you see them today but not tomorrow.

This business model is known as the razor-and-blade model. Well for the uninitiated, this is the model where you sell the low profit margin razor at a cheap price and then earn back the money by selling the blades at a high margin.

Though mundane as it may sound, this model has proven itself time and again that it can generate stable cashflow and earn a good margin. Unfortunately, as the guru used to say, it’s hard to teach a new dog old tricks. So a lot of businesses don’t employ this model.

This model plays on the human mindset by enticing people to buy something, usually having the impression that it should be expensive at a low price. Then after “locking-in” the customer, the co. sells him consumable products at a higher margin. However, our ape-evolved minds cannot relate that instantly and we still think we are getting a good deal.

For example, we buy a mobile phone at S$199 thinking that it’s quite value-for-money given a lot of sophisticated stuff goes inside this cool piece of plastic and electronics (So the phone is the razor here). However, we then need to buy the blades (talk-time) that cost us $30-50 a month! And worse still, we are lock-in for 2 years! So is it really value-for-money if you think of the whole package? Hmmm…

Sounds like it’s a bit unscrupulous? Feel like you are being treated unfairly? But hey, that’s life, folks. Become a shareholder of the company then and screw the management during AGM! That’s why I own Singtel! Haha!

Anyways, besides the telcos, today we see various businesses employing this simple model, including our favourite Ipod (selling you the Ipod/razor, then the songs/blades), Canon printers, Playstation and Nintendo games, anti-virus softwares etc. But at the macro level, not a hell lot of businesses are doing this. Well of course, sometimes the nature of the business does not allow the adoption of the model, like the retail business. Which also implies that maybe that’s why retail businesses cannot earn a hell lot of money. Sadly when Singaporeans say they want to be entrepreneurs, most people think of retail businesses like restaurants, bubble tea (*gosh*) and clothings etc. My guess is only 1 in 20 retail shops will actually "succeed" ie earn as much as a full-time job after adjusting for time and effort put in.

The razor-and-blade model also manifests itself in different versions but the crux remains at its ability to generate recurring income stream. This is best exemplify by Dell, which recently announced that it wants to provide IT services to its clients instead of simply selling them the box (ie the PC lah). So in this case, the PC is the razor and the servicing contract is the blade. So Michael Dell really got some Liao one ok? Don’t pray pray!

Maintenance contract is actually a very good razor because it usually last for 2-3 yrs and hence securing the stable cashflow from the client for that time period, like the telcos (btw telcos is short-form for telecommunications companies like Singtel, Starhub hor). And with minimum extra capex or cash outflow, you actually get this money rolling in.

So next time when you see a business with a razor-and-blade model, remember to give it some credit bcos chances are it will still be earning money even when the crunch comes, unlike a lot of other businesses which will probably go into red. Especially those hot sectors nowadays, like RE related construction where majority of co.s involved don’t really have a business moat and are rising simply bcos it’s high tide now.
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