rent vs. buy: why rent a product instead of selling it?

Adobe (ADBE) used to sell physical copies of a given edition of its Creative Suite of products to individuals or small businesses for $2600 apiece.  Now it rents the same thing as Creative Cloud for $50 a month.  In 2012, selling physical copies (let’s ignore the other cloud-based tools ADBE sells–the big change is in its media tools), ADBE made $1.66 a share in profit and had $2.24 in cash flow.  This year, having gone totally digital the company says it will have earnings of around $.30 a share and will generate, I think, $1 or so in cash flow.

How can this be a good deal?  It takes over four years of rental income to generate the same revenue that a sale would do all at once.  In addition, in a world where interest rates were back to normal, present value considerations make the rental stream worth less than cash in hand today.

So why switch?

I can think of four reasons:

pricing umbrella   $2600 for Creative Suite, or $700 for Photoshop alone, leaves the door wide open for a competitor to enter the market with a lower-priced product–even a shareware entry–that does more or less the same thing as an ADBE product.

piracy  I’ve seen bootleg copies of Creative Suite on Craigslist for $100.  Yes, they’re illegal and, yes, maybe they won’t all work forever, but still the price difference is enormous!  Back when I was following Microsoft carefully–which is over a decade ago–that company thought that almost half of the copies of its Office suite being used by small- or mid-sized companies were stolen.  Because the rental model matches the cost of the software more closely with the potential buyer’s cash flow, stealing the software becomes much harder to justify.  If it’s all on the cloud, it’s impossible for most people to do.

upgrades (or lack thereof)  Before I signed up for the cloud version of Photoshop, I was using a version (CS5) that was several years old.  I’m sure there are individuals and businesses using much older versions.  Same general argument as for piracy–using outdated tools become much less worthwhile.

selling direct  Delivering Creative Cloud products through downloads eliminates the commissions paid to distributors of physical copies.  It also eliminates the expense of making the physical copies, but I think that’s a minor expense (the box and shrink-wrap are probably the largest cost elements).


ADBE thinks it will make $2 a share in 2015 and $3 a share in 2016 because of switching to the cloud for its media tools.  I’m not sure these number make the stock cheap at today’s price (I have a small position and would be a buyer at lower levels), assuming they come in as ADBE anticipates.  But I’m convinced that the piracy thing is real and that the incremental cost of selling an extra copy is as close to zero as you can get.  Also, once you start using the better tools it’s highly unlikely you’re going to go back.  You’ve probably thrown out the disks anyway.

Therefore, there’s at least a shot that number s are better than that.

But in this post, my main point is that the rental model is an extremely powerful one.

Examples tomorrow–Anixter, Olympus and EA.

the inventory problem: holding costs vs. stockout risks

The domestic auto industry reported November vehicle sales yesterday.  The numbers were very good.  But most of the (negative) media attention centered on the elevated level of inventories–about three months worth of sales–on dealer lots. Yes, that may eventually be a worry, but I don’t think it’s the right way to look at the current situation.

The auto news also gives me the occasion to write about the balancing act every manufacturer and retailer faces in deciding how much inventory to have.

the simplified story

There’s an often convoluted dance between supplier and distributor/end user about return policy, payment terms, co-op advertising…in negotiating over how much of a product to buy and at what price.  Nevertheless, the decision about how much inventory to hold ultimately comes down to weighing two opposing risks:

stockout costs.  This is when your brilliant national advertising campaign, your sterling reputation for high quality and service–or sometimes just random factors–prompt a potential customer to either go online or enter a physical store with the intention of buying an item.

You’re out of stock.  You try to interest him in a substitute, or promise to have the item tomorrow.  He says thanks, leaves and buys the item somewhere else.

You’ve lost a sale.  And the person you’ve disappointed is at least marginally less likely to have you first on his list next time he’s shopping.

That’s stockout costs.

inventory holding costs are much more straightforwardly quantifiable.

There are three main factors:

-financing costs, which in today’s world are negligible;

-liquidity risk of having your capital tied up in inventory rather than in cash during the time it tales you to make a sale; and

-the possibility that the items either become obsolete, go out of style, or–like fresh food–exceed their shelf life before they can be sold.  Then your asset has become a wirtedown.


(In the stock market, there are always complications.)

In good times, companies want to hold more inventory (because they see stockout as a greater risk than holding costs); in bad times sentiment reverses and everyone wants to hold as little as possible.

If prices are rising, procurement managers see the chance to make windfall profits and order more than they need; if prices are falling–as is chronically the case in industries like consumer electronics–inventories are kept trimmed to the bone (except in really good times, when everyone throws caution to the winds).

In industries with low fixed, high variable costs, manufacturers see no percentage in upping production volumes.  In industries like autos, with high fixed costs and therefore tons of potential operating leverage, there’s a tremendous incentive to make extra units once a firm reaches breakeven.

The competitive structure of an industry doesn’t change the nature of inventory risk, but it can change who it is who’s assuming them.  This may not always be obvious from even a detailed study of the working capital sections of the balance sheet.  If a manufacturer were to have a policy of unlimited returns (that would be crazy, but let’s just suppose), then it–not anyone farther down the distribution chain–would ultimately be responsible for any unsold goods.


More tomorrow.






using days sales to measure inventory: a dangerous method

an example

I started out on Wall Street as a securities analyst covering the oil industry during the oil and gas boom caused by the second OPEC “oil shock” of 1978-80.  The sharp rise in prices (which today looks a bit ludicrous) from $7 a barrel to $14–implying a spike in gasoline prices above $.50 a gallon!!!–caused a huge increase in drilling for new deposits.

One key shortage element was the steel pipe used to line the well hole already dug, to prevent the hole from collapsing in on itself.  Without steel pipe to line the well you couldn’t drill.  So one of my standard questions during the interviews I did with company managements as I was preparing to write evaluations of their stock prospects was how much steel pipe they had on hand.  It was usually only two or three months’ worth.  It was never enough.  And the makers of the pipe were never able to ramp up capacity fast enough to meet demand, no matter how fast they put up new plants.

Anyway, one day I was talking to the CFO of a small exploration company in Texas.  When I had last talked with him, a couple of months before, he had said his company had about two months’ worth of pipe on hand.  I asked the question again.  He said, “We have a year’s worth of pipe on hand.”

I said, “You must have finally gotten a big shipment in.  How did you do it?”  He replied. “No.  Our drilling plans have changed.”

This was my first concrete indication that the commodity bust, which often follows a big boom, had arrived in the oilpatch.  What the CFO in my story meant to say was that prices had already fallen to a level where the wells his firm had been planning to drill were no longer economical and he could no longer get financing to carry out the projects.

the cash conversion cycle

This is a measurement of how much cash a company needs under current conditions to turn a dollar invested in working capital to make a new product back into cash.  It’s the sum of three parts:  the time it takes from purchasing raw materials until the sale of a final product is made + days credit extended to purchasers – days credit extended by suppliers.

In most cases, the key time element is the first element, the time in inventory.  Hence, the focus on inventory days.

supply and demand is much more important

…as my oil company example shows.


Just as the situation of extremely constrained inventories can prompt one to draw the misleading conclusion that conditions will always be tight, the situation where inventories are massive can also be deceptive.  Housing in the US may well be a current case in point.

Despite the evidence that the housing market has been picking up in the Us for the past year, until just the past two or three weeks media reports have been strongly biased to the negative side.  One of the key figures being cited is the large inventory of unsold homes available for sale.

Two elements are wrong with this analysis, in my view:

–after many years of languishing on the market, and presumably not being maintained, I think it’s questionable whether all the dwellings counted in that inventory number are actually salable.  Maybe a quarter aren’t.

–even small changes in demand can make large differences in the days- sales measure.  For example, the latest Department of Commerce figures show that the inventory of new homes available for sale in the US has shrunk by 29% in the past year to 4.7 months.  Half of that decline is from builders creating fewer new homes.  The other half is from an increase in demand.  It wouldn’t take much more demand to push that figure into shortage territory.

I’m not saying that demand will increase (although I suspect it will).  I just want o point out that relying on days-sales figures for conclusions is potentially dangerous.