The idea behind the blog post is to explain why our goal at Tapprs is NOT to be the biggest rental house, but to be the most profitable one. To seek the most efficient use of every rupee in our business. That needs a different approach – we are going that route.

Note: It’s not a post against being big. Being big is a factor of effective capital allocation. It’s an added benefit. However, if you’re a poor allocator of capital, you’re not better off being big.

In the last 1 year, our strategy at Tapprs has been anything but aggressive.

In fact, we have consciously slowed down & expanded lesser than planned. It’s a fun business, though it has its share of negatives.

Here are a few things that forced me to slow down and think hard:

1. my preferred rate of profitability (for doing any business)
2. capital intensiveness
3. inflation
4. scalability beyond a point is moot

1. Let us examine profitability

In this business, you make money by giving out expensive equipment at a daily rental. So you need to have a large inventory. To make 1 rupee, you need 1 rupee in investment.

So if you want to have a revenue of 1 crore, you will need a similar investment. Want 5x, then invest 5x more.

Clearly, its a capital intensive business. And it has its own risk too. So, if I were to take so much trouble, I would probably expect 25%-30% profit margins. If not, why do it at all? Lets keep this in mind.

In a capital heavy business, sales to assets is usually around 1 or lower (1 rupee of asset needed to create 1 rupee of revenue).

One way to judge the business is by looking at its return on equity.

Return on Equity = Profit after tax (net profits) / Equity

or, expressed differently

Return on Equity = (PAT / Sales) x (sales/assets) x (assets/equity)

which is

 ROE = Net profit margin x Asset turnover x Leverage

We know our business will have a low asset turnover of about 1 (can take it to 1.5 if handled well). Assume that the business is mostly funded by equity (leverage = 1) since not many will give a loan for a new company.

ROE = NPM x 1 x 1

ROE = NPM

Like I said earlier, I want my investments to return a minimum of 25% (or better,  30%). Which means the NPM of the business I invest in should be the same figure.

Now, a well run rental business could have a 30% post tax margin (running from home, not having employees, not paying yourself a salary, etc are not my way of running a business today – eventually, when you’re a full fledged business, there’s no escaping these costs).

That means you make a 43% margin post depreciation and amortization and interests, but before tax. Since depreciation rules are 15% for plant & machinery (my CA says rentals assets have to fall under this category and nowhere else – I am somewhat not sure) and since our sales to assets turnover is 1, that means a 58% margin before depreciation. (If sales to assets is 1.5, this becomes 53%). Since we assume no loans, interests dont play a role here.

That means, your operating cost structure has to be lower than 42%. (Okay, 47% if you are happy with a ROE of 25%)

So, if you could manage these

• operating cost at 42% (salaries, rentals, damages, repairs, marketing, etc)
• depreciation is 15% (if this is wrong, I have to load a bullet into the gun for my CA)
• tax is 30% on the remaining 43%
• profit margin is now 30%

Only then, the investors return on investment is 30%. And it is almost never higher than that once you hit a decent size. ( Unless you do some magic with raising revenue and reducing costs).

Notes:

1. Taking a loan could be one idea – but most new businesses will not be eligible for one. I would simply treat friends & family loans as similar to equity (they are being kind to you).
2. Amortization of assets will mean you can’t expense all your costs, only a portion.
3. Mostly, early on, you’re profitable only on paper, but cashflow negative (because of asset amortization / depreciation rules).
4. Assuming you’re a honest citizen paying service tax and income tax and not cheating upon it (many businesses are not!!)

As an example, assume your operating cost is 15 lakhs, you have to make at least 36 lakhs in revenue (post service tax) to ensure 30% ROE. The higher your cost, the worse your returns. Conversely, the higher your revenue, the better the returns (assuming cost doesn’t rise).

Typically, from here, as revenues increase, the cost doesn’t increase in same vein. But you can’t just go out and raise revenue just like that – you need upfront investments in more inventory.

Remember, since only 15% of new asset purchases can be expensed, the profit you see here is ON PAPER. Cashflow is negative at least early on. (Subsequent years, it helps you because there no actual expense, but you deduct depreciation – but still, its heavy upfront).

2. It’s a money sink!

Now, there are businesses that don’t need much money after the initial phase – meaning, every incremental rupee of revenue will come at a less than equivalent investment. 

But in a rental business, since you only can churn assets at 1x mostly, to make an additional rupee of revenue, you need an equivalent investment – regularly. Either from accruals or from equity dilution or new loans.

3. Inflation hits you

Lets take an oversimplified example.

You are a single lens rental place. Canon 100-400 that cost you 80,000 is the only lens you rent out. You make 80,000 in year 1 and also in year 2. Assume you made a 80,000 profit in these 2 years and kept it in bank.

Year 3, its time to replace the lens. (If you’re a good rental house, you probably will).

You sell it for some 40-50,000. How much does a new replacement cost now? 130,000. Oh oh! You now need to add an additional 80,000 (post your used item sale). Poof, all your profit is now gone back into the SAME ITEM. Yes, you made a profit, but its no longer yours – the business took it back. This repeats in cycles – every 3-4 years when the equipments have to be purchased at increasingly higher cost!!!

Warren Buffett has this to say about capital heavy businesses:

“Asset-heavy businesses generally earn rates that often barely provide enough capital to fund the inflationary needs of the existing business, with nothing left over for real growth, for distribution to owners, or for acquisition of new businesses.”

“In many businesses particularly those that have high asset/profit ratios—inflation causes some or all of the reported earnings to become ersatz. The ersatz portion—let’s call these earnings “restricted”—cannot, if the business is to retain its economic position, be distributed as dividends. Were these earnings to be paid out, the business would lose ground in one or more of the following areas: its ability to maintain its unit volume of sales, its long-term competitive position, its financial strength.”

4. Scalability at good margins

In Bangalore, there are 4-5 rental houses now. I have my doubts on how many can do business more than 1 cr annually at good margins. The best one(s) might do.

The rest will be smaller players. Yes, you can get big on inventory if you have money, but your profit margins would suffer.

Okay, all that gyan is fine. What is your final point?

We’re perfectly happy not chasing size. We are chasing the best & most efficient use for every rupee we put into our business. Every single rupee of incremental investment has to ensure a certain rate of return – else, there’s no point in growth.

I would like to quote Aswath Damodaran here:

“Growth is not free and is not always good for value”.

Questions are welcome!