I’ve been wanting to write about companies that rent products or services. Some are very new, like (the highly speculative) Solarcity (SCTY). Others are older and are switching to this earnings model, like Adobe (ADBE).
To do that, though, I thought it best to start with the profit model. The business involves high up-front costs to set up and/or to find customers, with only gradual revenue generation. So it means negative cash flow on each new customer st first, followed hopefully by a waterfall of incoming cash eventually.
Most analysts, me included, use some variation on Discounted Cash Flow (DCF),to value on this kind of activity. But, unlike using DCF to calculate the value of a bond, this process is inherently risky when figuring the value of having a given customer base. That’s because the future cash flows aren’t guaranteed. The customer can often switch to another service provider, for example. Or he may, for one reason or another, stop using the service altogether.
The model itself isn’t new. Companies using it include:
–insurance companies issuing policies
–load investment management companies selling mutual funds
–companies that rent or lease equipment or services.
the main variables
The main variables to consider are:
–general costs of subscriber acquisition, like necessary capital equipment, R&D…
–the specific costs of acquiring a customer, like providing free trial periods or paying sales commissions, and
–the length of time a customer typically keeps the service.
For example, in a traditional mutual fund management company, a service provider:
–maintains a staff of analysts and portfolio managers and does brand advertising
–it pays a commission of, say, 5% of the principal invested to the salespeople who sign up the customer,
–it collects, in the simplest payment structure, an annual management fee of about 1% of the money under management, and
–it keeps a client in a given product (or at least it did when I was more intimately familiar with the numbers) for about eight years.
So it pays 5% of the beginning assets up front and collects 8% of the assets in fees before the client leaves. …a reasonable, but not great, deal for the management company in a rising market, not such a hot one in a falling market. Something also depends on how the client leaves–that is, whether he exits the fund group entirely or merely shifts to another product within the fund family.
That’s it for today.