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.

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