With stock markets around the world near record highs, trustees are pondering whether and how to de-risk portfolios. This situation poses a quandary, as traditionally safer asset classes, such as high quality bonds, offer little prospective return. Yet, some traditional options at the higher end of the risk spectrum—high yield bonds or dividend stocks—are unusually expensive at current levels. Because it can be difficult to predict the direction of markets and make judgments about the macroeconomic environment, one approach is to invest in companies that can march along, regardless of the economy or whether the market is up or down.
More than a century ago, K.C. Gillette came up with a plan: Have customers buy one razor, but sell them an ongoing supply of blades for life. Of course, Gillette didn’t exactly give away his safety razors. They retailed for the relatively substantial sum of $5 in 1903, the equivalent of about $140 in 2014. Still, the real money was in the blade—that thin, inexpensive, disposable piece of stamped steel that men around the world have bought in various forms ever since.
This built-in demand creates an ongoing stream of what’s called “recurring revenue,” and it’s become the Holy Grail for many companies operating in industries ranging from technology to consumer products. The “razor blade” model Gillette perfected applies in some unexpected ways, and it’s something to pay close attention to when evaluating potential investments.
Companies that adhere to a recurring revenue model can remain relatively stable in challenging economic environments, riding out portfolio volatility during periods of stock market turbulence. They often have deep moats of protection around their business models, as well as defensive characteristics, given that demand rarely ceases.
Aircraft Equipment Suppliers
Growing demand is spurring airlines to buy new planes. Aircraft ﬂeets are expected to more than double over the next two decades, driven in part by the “new middle class” in the emerging markets. Typically, demand for new planes tracks gross domestic product growth. But, demand for new aircraft is expected to become far more robust, as an additional 14,940 aircraft in today’s ﬂeet will likely be replaced over that period. New jets are more technologically advanced and constructed with much lighter weight components that make them 20 percent more fuel efficient. Because fuel prices account for about 40 percent of airline operating costs, this upgrade makes a real difference.
It also creates investment opportunities. One could consider investing in commercial airlines, which will benefit from growing passenger traffic. Or, one might invest in airplane manufacturers, which now have substantial order backlogs. But, perhaps the most interesting investment opportunities are in the parts and components suppliers. These companies develop and manufacture equipment that makes air travel safer and design upgrades to make it more enjoyable. Better still, they’re not aligned with predicting the success of any single airline company or any speciﬁc aircraft manufacturer.
The engine business is a good example of the recurring revenue model in action. A handful of companies supply the vast majority of engines for commercial jets, fighter planes, helicopters, ocean liners and power plants. But, selling the engine is just the beginning, and it’s not necessarily how manufacturers make their money. Instead, these companies sell the engines for a relatively modest profit, knowing that maintenance, repairs and engine overhauls will keep them busy and ringing up revenue for decades. By the end of an engine’s life, every part may have been replaced, some numerous times.
Jet engine maintenance can be worth seven times the initial cost of the engine, providing decades of recurring revenue. (See “Economic Life Cycle of an Aircraft Engine,” this page.)
Technology as a Service
The technology sector, once associated mostly with high flying growth companies that disdained paying dividends, may be headed for its third straight year as the top dividend-paying sector in the S&P 500. That’s partly attributable to the decision by Apple to begin paying a dividend after more than 30 years as a public company. Companies like Apple have put something of a twist on the razor blade model by tapping into a variety of recurring revenue streams by creating mobile devices that use a variety of applications and content. Once consumers have the device or platform for recurring revenue, they buy applications and content through the company’s app store.
More broadly, the sector’s rise in the dividend column is partly due to the transition of some companies away from a sales model to a subscription and service model able to generate significant recurring revenue. Because technology can rapidly become commoditized, some companies have moved away from a reliance on the one-time sale of a product—often hardware—in favor of ongoing revenue from software and services. Some software companies now generate what’s called “sequential revenue” by encouraging customers to consistently upgrade to the latest versions of their programs.
Mobile devices create recurring revenues for data providers. Amazingly, only about one-third of the world’s population has ever been on the Internet. For many, their first trip will be on a smartphone. By the end of 2018, there will be an estimated 8.2 billion wireless subscribers in the world. Those subscriptions are expected to generate an estimated $1.2 trillion in total mobile service revenue over that period.
Phone companies may be one of the classic examples of recurring revenue, with many telecoms providing plans that combine voice, text and data services into a single price point on a monthly recurring basis. That’s probably not going to change, but what people do with phones is undergoing a dramatic shift, one that’s driving revenue for companies.
When it comes to phones, it’s not all about talking anymore. Voice revenue is expected to fall from 63 percent of revenue in 2012 to 40 percent in 2018. That shift is being driven by the seemingly insatiable demand for data, relatively fast and reliable data networks and soaring sales of smartphones and tablets that can access that information. About 65 percent of the subscribers at major carriers owned a smartphone at the end of the first quarter of 2013.
By 2018, there will be more mobile devices than people globally. (See “Staying Connected,” p. 54.)
Because the barriers to entry are so high, biotechnology drugs (or biologics) represent an unusually secure revenue stream for certain companies. Biologics are incredibly complex and used to treat maladies ranging from rheumatoid arthritis to breast cancer. They can be composed of sugars, proteins, nucleic acids or a combination of those substances. Others are living entities, cells and tissues that can come from humans, animals or microorganisms.
For those afflicted with certain ailments, biologics, when taken regularly, can slow the progression of a disease or, in some cases, cure a condition outright. A higher survival rate means patients take the drug for a longer period of time. This outcome has resulted in a remarkable track record for biologics, which are expected to represent the majority of sales among the top 100 drugs by 2018. (See “Take Your Meds,” this page.)
Research is crucial for investors in any industry, but biotechnology is among the most complex. Biologics have a long, risky and expensive development cycle, sometimes taking a decade or more from discovery to approval. Once approved, some of these drugs can command premium pricing. This complexity also means that it’s difficult for generic manufacturers to copy the drug when it comes off patent, extending the potential life of the revenue stream.
Given the favorable characteristics of certain companies with recurring revenues, trustees can take more comfort when these companies are held in beneficiary portfolios. These investments tend to march along regardless of the general economic environment or overall direction of the stock market. These durable franchises have the potential to thrive in many different business environments, playing an important role in protecting beneficiaries’ capital and generating long-term income.
—The views expressed herein are those of the author and do not necessarily reflect the views of Capital Group Private Client Services and should not be construed as advice. The thoughts expressed herein are current as of the publication date, are based upon sources believed to be reliable and are subject to change at any time. There is no guarantee that any projection, forecast or opinion in this paper will be realized. Past results are no guarantee of future results. This material is provided for informational purposes only and does not take into account your particular investment objectives, financial situation or needs. You should discuss your individual circumstances with a licensed investment professional.