Foreign exchange provider Ozforex Group Ltd (ASX: OFX) has some of the qualities that I look for in an investment. The online company has little in the way of capital tied up in fixed assets and the incremental cost to serve each new customer through its proprietary platform is minimal. Therefore, it is unsurprising that the business generated an impressive return on starting equity (ROE) of 45.8% in 2016.
However, there are other aspects to the business that I find less appealing. My main issue is that I believe competition for online foreign exchange services will intensify as it is quite easy for companies to enter the market.
There are some regulatory hurdles for would be competitors to overcome such as acquiring licenses and abiding by money laundering rules. Also, perhaps they would be initially unable to offer such a broad range of currencies or have such a slick online platform as the likes of OFX. However, it is not very hard to satisfy any of these requirements with the right team and sufficient capital.
I generally like technology companies with customers that are reluctant to leave because of high switching costs but this is not the case with OFX. There is nothing to stop its customers from shopping around for the best exchange rates whenever they need to send money overseas.
And whilst I accept that OFX delivers a high level of customer service due to its streamlined platform and 24 hours a day, seven days per week customer service offering, I think that for most customers the most important consideration is price.
What do the numbers say?
OFX's active client numbers grew by just 5.9% in 2016 to 150,900, the lowest rate for at least five years and I thought it was telling that for the first time the company did not disclose new customers. If 2016 new customer numbers were anywhere close to the 60,700 recorded in 2015, then customer churn was high for the year.
Declining profit margins are another tell-tale sign of a weak business model. Back in 2011, earnings before interest, tax, depreciation and amortisation as a percentage of revenue (EBITDA%) were 52.4%, whereas in 2016 they had fallen to 33.2%.
Admittedly, 33.2% is still a pretty healthy margin but is based on underlying results rather than statutory figures. In this case I'm slightly dubious of the one-off costs omitted in the underlying results related to rebranding as to me this should be treated the same as any other marketing expense.
2016 also saw a big increase in the amount of intangibles and property, plant and equipment that were capitalised and therefore did not flow through the profit and loss statement. The combined spend was $9.4 million, dwarfing the annual depreciation and amortisation charge of $1.4 million as well as the total cost of all similar assets previously held on the balance sheet of $4.3 million.
It's not all bad
By no means do I think that OFX is a bad company, but I don't think it is a particularly strong one either. The recent ramp up in costs and capital spend might prove to be prudent investments in future growth, rather than a rising cost of doing business. Indeed, net income grew by 180.8% to $103.9 million in the five years to 2016 and a similar performance over the next five is likely to deliver excellent returns to shareholders.
