Understanding the business model: Hard-Asset-Based Businesses

Companies in the hard-asset-based subsector depend on big investments in fixed assets to grow their businesses. Airlines, waste haulers (Waste Management, Allied Waste, Republic Services), and expedited delivery companies (FedEx, UPS) all fall into this subsector.

In general, these companies aren't as attractive as technology-based businesses, but investors can still find some wide-moat stocks and good investments in this area.

Industry Structure

Growth for hard-asset-based businesses inevitably requires large incremental outlays for fixed assets. After all, once an airline is flyinng full planes, the only way to get more passengers from point A to point B is to acquire an additional aircraft, which can cost $35 million or more.

Because the incremental fixed investment occurs before asset deployment, companies in this sector generally finance their growth with external funding. Debt can be used to finance almost all of the asset's cost, so lenders generally require the asset to provide collateral against the loan. With this model, high leverage is not necessarily a bad thing, provided that the company can make enough money deploying the asset to cover the cost of debt financing and earn a reasonable return for shareholders.

With this in mind, airlines are generally the least attractive investment of all the companies in this subsector. Airlines must bear enormous fixed costs to maintain their fleets and meet the demands of expensive labour contracts, yet they sell a commodity service that's difficult to differentiate. As a result price competition is intense, profit margins are razor-thin - and often non-existent - and operating leverage is so high that the firms can swing from being wildly profitable to nearly bankrupt in a short time. If you don't think this sounds like a recipe for good long-term investments, you're right - airlines have lost a collective $11 billion (excluding the impact of recent government handouts) between deregulation in 1987 and 2002. Over the same time period, 125 airlines had filed for Chapter 11 bankruptcy protection, and 12 of them filed for Chapter 7 liquidation.

But despite the terrible performance for airlines in general, a few carriers have fared very well. Southwest, for one, has been profitable for 30 consecutive years - an amazing achievement considering the cyclicality of its business and the dismal operating environment for the industry in 2002. Southwest's superior financial performance is largely because of its main strategic advantage: a low cost structure driven by its practice of flying one type of aircraft for all its no frills, point-to-point routes. In an industry with less-than-desirable fundamentals, Southwest has achieved superior financial results by deploying a different and dominant, business strategy.

Other characteristics of hard-asset-based businesses make this segment worth watching. The idea of limited or shrinking assets, for example, can go a long way to provide stability in the competitive landscape for these companies. Because of the NIMBY (not in my back yard) principle, it is very difficult to get approval for new landfill sites. As a result, it is highly unlikely that new competitors will enter the landfill side of the waste management business. That puts a company such as Waste Management, which owns 40 percent of the total U.S. disposal capacity via its 300 landfills, at an advantage.

The majority of hard-asset-based companies fall into the narrow- or no-moat buckets. With few, if any, competitive advantages for many of these companies, investors should look for a pretty steep discount to a fair value estimate before buying shares.

Hallmark of Success for Hard-Asset-Based Businesses

Cost leadership: Because hard-asset-based companies have large fixed costs, those that deliver their products most efficiently have a strong advantage and can achieve superior financial performance, such as Southwest in the airline industry. Firms don't usually advertise their cost structures per se, so to get an idea about how efficiently a company operatees, look at its fixed assets turnover, operating margins, and ROIC - and compare its numbers to industry peers.

Unique assets: When limited assets are required to fulfill the delivery of a particular service, ownership of those assets is key. For example, Waste Management's numerous, well-located landfill assets represent a significant competitive advantage and brrier to entry in the waste management market because it's unlikely that enough new landfill locations will get government approval to diminish its share of this business.

Prudent financing: Remember, having a load of debt is not itself a bad thing. Having a load of debt that cannot be easily financed by the cash flow of the business is a reccipe for disaster. When analyzing companies with high debt, always be sure that the debt can be serviced from free cash flow, even under a downside scenario.

(Some Malaysian companies in this hard-asset-based businesses are Air Asia, MAS, Maybulk and Transmile.)



Ref: The Five Rules for Successful Stock Investing by Pat Dorsey