by Michael Zheng, 2020.05.01

The core purpose of a commercial enterprise is to provide products and services and make profits. This article is mainly about how to roughly analyze service companies from different perspectives.

Among the four most important points for analyzing characteristics of industry  (details can also see value investing paper)

• Industry cyclicality (less cyclicality, the better)
• capital intensity (ROIC), measured by return on tangible fixed assets (less capital intensive, the better)
• Purchase cycle (one-time purchase/repeat purchase, the more repeated purchases, the better).
• “product” cycle life (life). (the longer the life of the product or service, the better)

Each industry has its inherent advantages and disadvantages. The above four points are determined by the characteristics of different industries. It is not determined by its location/region / even its competitive advantage.

Despite the different brands, auto companies all have similar factories around the world. The automobile industry all has the characteristics of high cyclicality, large inventory, and low ROIC, Margins are not much different.

The raw materials of chocolate all over the world are similar, Most tobacco/liquor/ energy drinks companies no matter the regions, are not cyclical, inventories conversion is fast, and the ROIC is generally very good.

Of course, a better brand, a good technology, will be icing on the cake. For example, cosmetics giant Estee Lauder or l’oreal sa. Because of its brand advantages, channel advantages, and ROIC can be better than its peers.

This article mainly talks about how to roughly analyze companies producing or selling goods, from different angles. Among them, those companies mainly include goods producers (physical goods, intangible goods including software ) and retail & wholesale.

The Paper Contains six major parts/a few major points highlighted.

• Advantages and disadvantages of “goods” type business.

1. Advantages
2. Disadvantages

• Classification by industry (GICS industry) 8 industry TYPES Cross sectors.
• four major industry characteristics (CYC, Capital intensity, customer purchase cycle, own product cycle)

• three major types of goods companies by revenue type

1. Consumables (non-durable goods)
2. Durable goods + consumables goods /POS
3. durable goods

• Business logics
• Examples of goods companies

1: Advantages and disadvantages of good business.

A: Advantages vs service type (3 points)

1. Higher barriers to entry. Easier to differentiate

Goods manufacturers due to product technology gaps, brands, channels, and even outsourcing costs advantage, and other reasons, it is easy to form high barriers, such as loyal brand, technical advantages, and channel advantages.

1. Larger sales radius.

Other than the retail industry and public utilities, where the sales are very local, and the goods manufacturing by in large has a larger sales radius, goods produced in the same factory can be sold to different regions as long as they have local channels.

• More non-cyclical business

Due to the characteristics of goods, many products are disposable consumables, such as medical products and daily necessities, so there are many non-cyclical industries in the “goods” type business.

B: Disadvantages vs service type (4 points)

1. Carry larger inventories/ receivable, reducing the cash flow conversion rate

From the perspective of cash flow, compared with the service industry, goods companies have much more inventory, and some industries, such as the jewelry industry, residential real estate, and so on require a lot of inventory and require a lot of working capital, inventory will reduce the cash flow conversion rate.

1. Require factories, larger upfront CAPEX, reduced ROIC

In addition to some intangible commodities, such as software, music, games, sports team broadcast rights, etc., most goods companies need factories to produce their products, and require a larger upfront CAPEX, larger CAPEX means larger fixed asset, which affects the ROIC  to a certain extent.

• More fixed overheads, like the cost of goods, are difficult to adjust.

the biggest cost of the goods industry is (cost of goods sold) / production cost, the gross margin is to a particular industry normally fixed in a certain range.  The service type business can cut costs by substantial layoffs, and the goods type is less flexible.

1. Have product life, difficult to turnaround.

products themselves have a lifespan. For example, technological products and pharmaceutical products are changing faster. Once the products are replaced, the troubled enterprises will find it difficult to reverse the difficulties.

2: Classification by industry (GICS industry) 8 TYPES Cross sectors.

Goods type business lies within 8 GICS industry groups below.

• Energy: includes oil equipment and upstream and downstream oil and gas/coal companies

• Materials: Chemicals include basic chemicals / fine chemicals / agricultural chemicals / industrial gases, construction materials include cement, mining, paper, and forest products, and containers & packaging

• Industrials: manufacturing of capital goods including aerospace and defense industry / industrial machinery/building products / electrical equipment / heavy trucks and trading and distribution companies and so

• Consumer Discretionary: Consumer goods include clothing/luxury goods/footwear, automobile manufacturing/parts, household durable goods including furniture/home appliances/kitchen supplies, leisure products like toys/bikes, etc. / Retailing (retailing): including durable goods retail, discount stores/department stores, special retail including cosmetics retail, etc., online retail (including online advertising companies such as Alibaba, Pinduoduo, eBay, Ctrip, etc.)

• Consumer staple: consumer goods, including food (agricultural products / packaged food), drinks (beer / other wine / soft drinks, daily household products (including laundry detergent, dishwashing liquid, soap household tissues, etc.)) , Personal items (perfume/toothpaste, etc.), tobacco/ Retail and wholesale  food and drug

• Health (health care): medical equipment health care equipment & supply, including hospital supply products such as needles/syringes, medical products include testing equipment, drug delivery equipment, and cardiovascular/orthopedic equipment. Pharmaceuticals & biotechnology life and science tools etc

• information technology: software, Hardware & equipment, including communication  equipment / electronic equipment and parts (electronic testing equipment, etc.) /  (semiconductors) Technology Hardware, Storage & Peripherals

• Utilities, including (water, gas, and electricity)

3: four major industry characteristics (CYC, Capital intensity, customer purchase cycle, own product cycle)

There are four major characteristics of every industry.

1. Cyclicality (CYC)

cyclicality is essentially the change of volume and price.

In terms of prices, primary products(materials/energy) prices fluctuate greatly. While other types of products are cyclical, the main change in sales volume/ quantity. (For example, due to cost reasons, the price of the car is rarely reduced by 40%, and the sales volume may fall a lot)

1. Capital intensity

Capital intensity is determined by the characteristics of the industry, such as the automobile manufacturing industry, metal & mining or oil extraction industry, basic chemical industry, those rare examples of capital intensive industries, due to a large amount of capital required to maintain operations, regardless of whether the automotive industry is booming or in a downturn, its ROIC not high.

While the consumer staples industry, like cosmetics, pet food companies, and tobacco companies require little capital, the ROIC  is high.

1. Purchase cycle(3 types)

Consumables (non-durable goods) are generally purchased repeatedly.

Durable goods (non-durable goods) + after-sales service (POS contract) or related consumables

Durable goods (durable goods), one-time purchase.

1. The product cycle(life)

Unlike the service industry, products themselves have their own lifespan.

The most typical would be technology and pharmaceutical goods companies have a short product life. On the contrary, the raw material and consumer product life are relatively long.

Generally speaking, the greater the progress of science and technology can be made or the greater the increase in productivity, the shorter the product life. For example, semiconductors are getting faster and faster, screen displays are better , computers are fasters, and medicine effectiveness is getting better and better.

Although many pharmaceutical and technological products have the advantages of high gross margin and high return on capital, the short product cycle(life) is a fatal disadvantage.

On the contrary, Such as paint, cement, elevators, and snacks/drinks require little R&d expense, and have longer product cycles.

4: three major types of goods companies

Three major types of goods

According to the type of revenue recognition, I divide goods companies into 3 categories

1. Consumables (non-durable goods)

Most of the products are single-use products, companies/consumers will repeat their purchase, The raw materials of these products are generally food/chemicals, such as packaged foods(snacks) and  clean daily necessities (laundry liquid, bath, etc.) Medical products are also consumables due to hygienic reasons such as injection needles/catheters/gloves/masks, and intangible product software / TV series copyrights/sports team broadcasting rights. Some metal parts, such as replacement parts for aircraft and car maintenance, are also consumables

1. Non-consumable goods (durable goods) + after-sales service (POS contract) or supporting consumables

General sales are non-consumables, but accompanied by after-sales service or consumables

Non-consumable goods (durable goods) + after-sales service (POS contract) after-sales service examples include

Elevators, telecommunications equipment, software + services (Software AS service), mainly one-time software licenses, accompanied by software maintenance services, game consoles/game downloads)

example:

When Elevator manufacturers like Schindler Holding, KONE Oyj, and Otis Elevator Company (spin-off from UNITED TECHNOLOGIES), sell durable goods elevators, almost half of Finland’s elevator giant Kone’s revenue is coming from service and updated elevators

1. Durable goods (durable goods),

one-time consumption, general raw materials metal/fiber/plastic, such as jewelry, houses, automobiles, home appliances, most machinery, clothing, etc.

Notice: although they are all durable goods, the number of product purchases (Purchase cycle) will be different. Mobile phone/telecom network equipment or a pair of sports shoes generally have a life span of 3-5 years, while aircraft, tractors, and other products can be purchased for 10-15 years. The house can reach decades.

The higher the prices of the products they sell, the less stable they become.

For example, although they are all home appliances, those that sell small home appliances are more stable than companies that sell large items like washing machines and refrigerators. As luxury goods, luxury designer handbags are better than jewelry/watches.

5: Business logic

All businesses run within a certain logic

Of important three parts of Business logic are Revenue recognition/or business model (how they make their money), cost (largest 2-3 items, in goods, cost of goods/ R&D/AD, Labor cost in case of service type companies) ), tangible assets( largest 2-3 tangible assets)

A.      Revenue recognition (business model) The business model is how they make money. Repeated again, There are three types for goods type business. a.       Sales of consumables, including subscription model (subscription-based model like software)b.       Sales of goods + after-sales service (POS contract) or supporting consumables.  Sales of non-consumables (durable goods)

1. Cost side

Cost of goods sold (cost of goods sold) includes (raw material cost / retail wholesale industry purchase cost/manufacturing cost etc)

1. Gross margin divided in range of   < “30%   “30-40%”   “ 40-50%”   >”50%”

Gross margin is one of the important indicators to measure a good type of enterprise. Gross profit margin is determined by industry characteristics.

For example,

software products are intangible products, high-end cosmetics, cigarettes, and alcohol, carbonated beverages, luxury goods, chips (outsourcing), medical equipment, medicine, and all high-margin industries. Gross margin > 50%.

40-50 percent range including consumer goods like clothing and accessory, leisure products, household products/ some tech products.

The gross profit margin of capital goods/retail/household goods is generally 30-40%.

And commodities / cars etc. < 30%

1. Other costs include

Advertising costs (consumer goods advertising can account for 10% of revenue), R & D (technical products, and pharmaceuticals can be as high as 20%),

1. Operating margin (in normal times exclude recession)

Operating margin in the range  <5%   “5-10%”  “ 10-15%”  “ 15-20%”   > 20%

Some examples in each category

<5%  examples include  Food & stable retailers./food & healthcare distributors.

5-10% examples majority of consumer discretionary (retailers.), consumers goods like auto

10-15%, examples, like the majority of capital goods/ consumer goods(discretionary)

15-20%, or >20% examples, consumer goods (soft drinks, liquors, luxury goods) , health care products (equipment & biotech), technology products( semiconductors), and so on.

1. Type by channels

Direct sales and third parties.

In addition to the retail industry /capital goods, directly facing consumers. Most goods manufacturing reaches consumers through third parties. Like we can buy “jack daniels” whiskey through retailers or restaurants and bars.

Interesting example

Luxury goods, the most high-end luxury goods like to control their own channels. Third-party channels like department stores generally account for less than 20% of revenue. In fact, they artificially reduce their sales radius and increase capital expenditure. However, the luxurious store maintains a high-end image and maintains a high price.

1. Types by end market

Enterprise / consumer

1. competitiveness (below are competitive advantages a good type company can have )
2. Brands: Consumer goods brands, such as some whiskey or vodka brands can last for decades or even centuries. Toothpaste, cosmetics, etc.
3. Sales channels: such as bars, and carbonated drinks in fast food restaurants. For example, the only liquor wholesaler in this area.

• Patent: The patent has a term. Patent for medicines and technological products.

1. a large number of equipment/software + services have been installed.

for example, the earliest elevator company oits has a history of 100 years. Many of these offices/hotels have already installed their elevators, and also has a service contract with them,

1. Monopoly franchise: water and electricity

6: examples of goods company

three examples of good type companies.

A: Software:

Revenue model: sale of “consumables” goods,  mainly due to the subscription model, which is accompanied by value-added services. Or a one-time software license (software license) + maintenance.

From CYC perspective: subscription model. No/little CYC.

From the perspective of ROIC: light assets, software development does require early investment. But the overall software requires a few fixed assets.

Product cycle: the characteristics of technology products, the product life is short. It is easy to be replaced.

Consumer purchase cycle: Many software has changed from a one-time software license (software license) to a monthly paid subscription, shortening the consumer purchase cycle.

In summary: Disadvantages: The product life cycle is short and easy to replace. Advantages: asset-light, no cycle, repeated consumption.

B:  Capital goods: elevator

In Capital goods, the elevators industry is a special case

Revenue model: Elevator sales + after-sales service / replacement update.

Cyclical: Medium and economic cycles will affect new buildings and elevator sales. However, it has less impact on service/update. A lot of times required by laws.

Return on capital: Elevators manufacturers are the asset-light business. Return on capital is basically the best in the capital goods industry.

Product cycle: There is not much high technology advanced, and the product life is long. In fact, the gross profit of selling new elevators is very low. Elevator companies mainly rely on services/updates to make money. Beneficial for companies with a long history.

Purchase cycle: New elevators are not purchased repeatedly, and services must be purchased continuously.

In Summary: There is CYC. The new equipment is a one-time purchase, the ROIC is high, the product cycle is long, and after-sales service must be purchased continuously.

C: semiconductor

Revenue: sales semiconductor/ sales of non-consumables

CYC: high. End markets are the capital goods/ technology products industry.

Return on capital: high, fabless enterprises (US companies). Lower: General Asian chip companies, generally outsourcing manufacturing companies having their own factory.

Purchase cycle: Do not repeat purchases.

Product cycle: The product itself has a short life.

Summary: Advantages: Some companies have higher returns on capital. Disadvantages: high cyc, short production cycle.