Friday, November 13, 2009

One-off businesses

This is the opposite of recurring revenue businesses. Basically, the company sells a product to a customer and that’s the end of it. There is no need for the customer to buy anything else for the next few years and hence no contact between the customer and the product seller for the next few years.

Most products that most companies make fall under this category: cars, massage chairs, LCD TVs, home sports equipment (like treadmills and stationary bicycles), vacuum cleaners, MLM magnetic beds, well you name it.

There is a stark difference between these one-off products and necessity/staples like shampoo, soap, kitchen paper etc. That is: you don’t buy staples products once and do nothing for the next 3 years. You keep buying them. Of course, there are times that the lines can be blurred.

There are a few major shortfalls with this type of business model:

1. The resellers and distributors have no interest to provide good service and they hope to rip off as much margin as they can from the customer since they won’t see them again for some time.

2. Since repeat sales from the same person is low, the company needs to utilize extensive advertising and marketing to sell their products. (well staples may also require this in order to sell, remember the Dove and the Pantene ads?) And the worse part is, if advertising and marketing expenses are cut, revenue falls.

3. The company is forever chasing volume growth because that is what drives the whole business. Hence the company needs to keep opening new stores or to keep coming out with “differentiate” products that are essentially not so different: like massage chair, followed by leg massage machine, head massage device, eye massage eye-wear etc.

4. It also means that sustainable revenue growth is close to impossible. The revenue stream is highly cyclical, following replacement cycles, general economic trends and/or market sentiments.

The prime example in the Singapore context would be OSIM which, by the way, is quite well managed even though it has a crappy business model. But as Warren Buffett puts it, "When a management with a reputation for brilliance tackles a business with a reputation for bad economics, it is usually the reputation of the business that remains intact."

For OSIM, the Free Cash Flow track record shows quite clearly that the management is prudent, at least pertaining to generating free cash flow. The company had delivered on average close to SGD 30mn of free cash flow per year over an average equity base of SGD 260mn over the past few years. Which in my opinion is a very significant feat. You just have to give it to Ron Sim.

However the other woes of the company overwhelm this positive FCF. The major blunder was the M&A of Brookstone, which we shall not discuss as it doesn’t really prove the point here.

Stripping out Brookstone, it was still evident that the quarterly sales fluctuated wildly from roughly S$50mn to S$150mn over the past few years. As mentioned, revenue growth needs to be driven by new products, more ad spending and/or new store sales. All of which need money ie less money for shareholders. It is definitely not easy for this business to actually generate good return on capital.

Unfortunately, as the facts add up, this company had an average dividend yield of meagre 1+% over the past 10 years. Its stock price was $0.16 in 2000, went all the way up to $1.36 and fell dramatically back down to $0.04 at its low and is $0.42 today. An investor would have lost money most of the time if he bought OSIM in the past 10 years. Specifically, he would only had made money if he bought in 2000-01 when it was still below $0.20 or in 2008 near the lows.

Wednesday, November 04, 2009

Near Monopoly Part 2

To illustrate Pt 4 and 5 of the previous post, we look at a Singapore company: SMRT. As with railroads in other countries, SMRT is a kind of natural monopoly bcos the capital outlay is so intensive, no competitor can come in and build a similar infrastructure just for the sake of competition. Even our beloved Government tried that and failed when they gave the North East line to another operator only to realize it doesn’t work.

So SMRT is in a good position to basically do whatever they want to enjoy supernormal profits.

First, they raise prices like nobody’s business. Well it’s subjected to approval from the LTA but heck, LTA always approves anyways. So the Singaporean passengers comprain and comprain like there’s no tomorrow. Actually in my opinion, it helped bcos SMRT became less aggressive somewhat after seeing the social repercussions. The truth is, Singapore train fares are probably still quite low at 70c for 1 station compared to global average of roughly US$1. So prepare for MORE fare hikes to come.

And after raising fares, the quality of service actually drops. That’s probably the unforgivable action. Trains take more than 10 min to arrive at non-peak hours and they frequently break down with minimal repercussions. Talk about 1st World Service!

Nonetheless, the shareholder benefits. SMRT shareholders have seen net profits grown S$100mn to S$160mn over the past 10 years. Dividends more than doubled from 3c to 7c. If you have bought SMRT at 60c (roughly the IPO price), dividends over the past 10 yrs would have reaped 40c. Not to mention the price today is $1.6.

With increasing population and real estate potential from re-developing its stations, SMRT’s future growth may not slow down unlike some other Singapore monopolies like SPH and Singpost. There is also the wildcard of whether the other future lines (Circle, Downtown etc) will be given to SMRT to manage as well. Again since most of the capex is done by the Government, it's a free lunch for SMRT and its shareholders.

However, it is likely that the company will continue to squeeze the commuters by providing ever declining quality of service and at the same time raising fares whenever the opportunity arises. Hence it is prudent for every commuter to become an SMRT shareholder.

As a shareholder, besides the dividends and capital gain, you can go and eat free food at the AGM and screw the management by asking tough questions. Hopefully they wake up their ideas and start to look at BOTH profits and services.