Shaping a portfolio for 2015: elaboratng on yesterday’s post

A reader had two questions about yesterday’s post, which I figured it would be easier to answer here than simply in a comment.

emerging markets

The big attractions of emerging economies to an equity investor are the possibility of very rapid economic growth for the country and of finding future titans of world industry as infants.  The two standard paths of gaining exposure to these markets are: to invest directly or to buy a developed-world multinational with significant presence in the economy in question.

Some emerging markets aren’t open to foreigners.  For those that are, the most important thing to realize, I think, is that there is typically little local support for stocks.  There are usually no pension funds or other local institutional investors (because there are no pensions and residents aren’t wealthy enough to afford financial products like insurance).  Local citizens don’t have enough money to be able to own stocks.  As a result, emerging market performance ends up being heavily dependent on foreign inflows and outflows.

Foreign flows can be very cyclical.  When developed market investors are feeling confident, inflows to emerging markets are typically very large.  When they’re scared, outflows are the order of the day.  Because there’s little local buying power, these outflows invariably cause sharp price declines.

Right now, oil-exporting emerging markets are being hurt very badly by the declining price of crude.  investors are also worried that emerging markets-based companies may have borrowed excessively, in US$, during the past few years of easy credit.  Such debts were a big factor in the crisis in emerging Asian markets that started in 1997.  In fact, today’s developments in Russia sound a lot like what happened in Malaysia in the late 1990s.

Yes, emerging market will eventually settle out.  I don’t think we’re anywhere close to that point, though.

rent vs. buy

Take Adobe.   Say you’re a web designer who wants to start a business on your own and that you want to use Adobe tools.

Buying a Creative Suite package to get started used to cost $2,500 – $3,000.  That’s a lot.

Many people would do one of two things:

–bite the bullet and buy, but never, ever upgrade; or

–find a bootleg copy on Craigslist for $200 or so.  Yes, it would probably stop working after six months, but it was cheaper than getting an “official” copy.

How many people took the second route?   I don’t know  …but probably a lot. I once heard Bill Gates estimate that 40% of the small business users of Office in the US were using counterfeit copies

Adobe has now gone over to a rental model.  $50 a month gets you access to the Creative Cloud version of all the Adobe tools.  The same sort of thing for photographers–$10 a month for Photoshop + Lightroom, vs. $600 to buy  (Amazon is selling the last disk version of Photoshop for $1500).

The plusses:

–the move from buy to rent changes a big one-time capital expenditure by a small business customer into an affordable monthly operating expense.  If users stay subscribers for at least five years, Adobe gets more money from rental than from a sale.

–Just as important, matching the tool expense more closely with customer cash flows is bringing a whole bunch of former illegals into the fold

–the company may also be attracting casual photography users who would never before have contemplated using Photoshop, but for whom $10 a month isn’t a big deal

–subscriber growth has continually exceeded consensus expectations.

The rental model isn’t exactly new.  It has been used for all sorts of equipment for years, from copiers to burglar alarms to colonoscopes.

What surprises me is that Wall Street has been so slow to figure out that the rental model works for software, too.  Yes, in the early days, the accounting looks ugly.  In fact, the faster the transition to rental goes, the uglier the income statement looks.  Development expenses remain the same, but instead of chunky sales revenue, the company only shows subscription payments for that month.  But professional analysts should be able to see past that.  My guess is that they miss completely the bootleg copy phenomenon.






rent vs. buy: financing and Solarcity (SCTY)

My California son, Brendan, got me interested in SCTY a while ago.  SCTY rents solar panels that generate electricity to individuals and to companies.

From an analytic point of view, it’s a complex and interesting firm.  It may also eventually turn out to be an important component of the nation’s power generation.  But it’s by at least a mile the riskiest stock I own (both Brendan and I hold small positions).  For instance, SCTY is a JOBS Act company , so the financials it has published to date aren’t ready for prime time.  Its business is heavily dependent on government subsidies of one type or another–and they’re shrinking.  It’s part of–but not at the heart of–the Elon Musk empire.  So holding it runs counter to the time-honored rule that you have your money as close as possible to where the entrepreneur has his–in this case, that would be Tesla, I think.

In this post, I want to use SCTY to  illustrate that in the rental model, a company can have an immense call for capital in advance of the business generating much revenue.  This can pose a significant risk.

Here goes:

First, note that I’m making the numbers simple (read:  pretty much making them up) and that there are many, many more moving parts to what SCTY does than I’m going to write about here.  But I think what I do say gets to the essence of the matter.

the business basics

1.  Look at a typical rooftop solar panel array that SCTY installs on a single family house.

–the panels cost $10,000 to build and install

–they have a 30-year life

–the homeowner signs a 20-year contract to pay $50 a month to rent them.

2.  In this industry, there’s some urgency to get panels installed on rooftops, at the very least because once someone has signed a 20-year contract, he’s not going to switch to another provider.  So the first mover has a key advantage.

financing new customers

Suppose SCTY installed panel arrays on 50,000 rooftops last year and wants to install another 100,000 this year.  What do the money flows look like?

Well, $30 million is coming in in rental income from last year’s installs.  But this year’s installation program will require $1 billion!! in capital to complete.  Where is this money going to come from?

In many senses, SCTY is a startup.  It doesn’t have deep pockets or an existing cash-generating business to use to fund the panels.  So raising $1 billion, and presumably more than that next year, is a formidable obstacle.

my point

That’s the point of this post–that the upfront capital committment in a rental business–especially involving physical stuff–can be very large.  From a financial point of view, some rental/service companies aren’t that much different from owning, say, an oil tanker, a steel blast furnace or a cement plant.  Not so glamorous if you look at them this way.

what SCTY does

The SCTY solution?  …the installed solar arrays are each sort of like a bond, that is, they pay a fixed amount of money each month for twenty years.  At the end of that period, the array still has ten years of useful life and therefore hopefully a substantial residual value.  If you package up a big bunch of them, the result doesn’t look that different from a collection of car loans or home mortgages.  In other words, the bundle is a security that you can sell to institutional investors who are looking for fixed income investments.  That’s a bare-bones version of what SCTY does.  Of course, it doesn’t hurt that SCTY is run by a financial entrepreneur.  Not every solar panel company is going to have the size or credibility to do this.






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.

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.

music: download vs. streaming

The Wall Street Journal had a short article on Christmas Eve about the music business.  I can’t see any way to use its contents to buy or sell a particular stock today.  But I thought it was interesting, anyway–and it has some bearing on the issue of owning vs. renting, which I think it a key way in which the internet is changing the world.

Here are the facts, obtained by the WSJ from a “major record company”:


The firm in question can identify how many individuals access its content, both by downloading albums/individual tracks from services like iTunes, and by listening on services like Pandora or Spotify.  In the latter case, the music company gets a miniscule payment from the service–much less than a penny–whenever a subscriber listens to a track.

For this music company, a downloader/CD buyer in the US generates $14 in yearly revenue.  A premium streaming service subscriber (still a very small number in the US) is worth about $16.

In Sweden, where over 60% of the population uses streaming services (3x the proportion in the US), a streamer is worth $17.75 a year; a downloader generated under $4.  Although it doesn’t explicitly say so, the Journal seems to me to be clearly suggesting that this is where the world is headed.


As you’d expect, downloading is very strong during the initial release of an album, when marketing spending is highest.  Streaming, on the other hand, usually builds slowly.

“Many” albums “eventually”–no quantification of number or time-frame–make more money from streaming than from downloads.

The sense I get is that albums fall into three groups:

–blockbusters, where initial download sales are very high and where streaming begins to contribute more than half of total revenue within a few months

–successes, where download sales are acceptable and where cumulative streaming revenue ultimately surpasses download sales–but only after a number of years.

–duds, where download sales are mostly a function of marketing hype and where both revenue streams dry up as soon as marketing spending ceases.


There’s really not enough data to be sure, but…

…as usually is the case in the physical world, renting looks like its ultimately more profitable for the owner of the property than selling, even when the transactions are done in bits and bytes

…the current mad rush to create new streaming services seems to validate the Pandora/Spotify model

…the value of the music company backlist has been severely underestimated

…the fact that the Journal many albums achieve streaming success, not “must” suggests there are lots of duds that can be the focus of cost-cutting.