rent vs. buy: examples

Olympus Optical of Japan (yes, the huge-derivative-speculation-losses, put-out-a-hit-on-the-new-chairman Olympus) was the first company to open my eyes to the value of the rental model vs. selling an item.  The company makes endoscopes, the computer plus coated fiber optic cable devices used in colonoscopies and endoscopies.  Olympus initially used a razor/razor blade model to sell these devices around the world.  It sold the computer devices at slightly above cost.  The fiber optic cables were supposed to be the razor blades, being replaced at regular intervals with new ones, generating high profits.

Olympus didn’t make much money from endoscopes, however.  Physicians generally refused to buy replacement fiber optic cables, even when Olympus salesmen told them they risked having the cables break apart in patients’ bodies.

So Olympus tried an experiment in the US.  It switched to a rental model.

Let’s say an endoscope kit sold for $60,000 (a number I made up).  If so, the new idea was to rent the units, throwing replacement cables to avoid safety problems, for $1,000 a month.  Because $1,000 a month was easier for a doctor to stomach than $60,000 upfront, more doctors signed up for the machines.  In addition, because Olympus was collecting rent for each machine over something like a ten-year useful life, reported profits skyrocketed.  Yes, this is partly a question of accounting technique (more about this tomorrow), but the amount of money Olympus ultimately collected for each machine was double what it had before.

Anixter, the wire and cable company.  This was one of the first companies I covered in my career as an analyst.  Back then, Anixter’s main business was industrial wires and cables.  It ran a national system of warehouses.

The Anixter salesman would call on a customer, ask how much wire and cable inventory a company had–usually a lot more than anyone realized– and offer to buy it all on the spot.  Anixter would guarantee to meet all the company’s wire and cable needs from Anixter warehouses.  Outsourcing to Anixter would mean the customer could repurpose its warehouse space, lay off or reassign the three guys who dealt with the inventory, and free up, say, $10 million the firm had lying around in wire and cable stock.

The manager who shifted the company from owning its own inventory to working with Anixter would be a hero in the eyes of top management.  People couldn’t sign on the dotted line fast enough.

At the same time, although apparently not many clients realized this initially, there’s no going back from a decision like this.  If you’ve taken a victory lap for creating $10 million in cash out of thin air, as well as saving $300,000 in annual expense, you can’t subsequently return to the board to say you need money to build a new warehouse, hire new employees–and, by the way, you need another $10 million (or more) to fund inventory.

As well, in the case of Adobe, there’s no place to go back to.  As the company put it, ADBE has burned the boats.  It no longer sells its media products.  It only rents them.

Electronic Arts  In the early days of MMOGs, I was at an analyst meeting for ERTS.  Someone asked how many users the company had for its MMOG.  The then-CFO, long since retired, said he didn’t know.  All he knew was that the company collected $10 a month from 180,000 credit cards.

I took this to mean that the company had a significant number of people who were renting the game but never using it.  This isn’t necessarily a good situation.  You’d prefer that people love your service so much that they’re heavily engaged every day.  On the other hand, the no-show users are pure profit.

Tomorrow:  the Achilles heal of rental, the upfront capital needed to get going.

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