Why This Company Is Good Now and Potentially Great In the Future

A good company stands still, while a great one strives for continuous improvement. Xerium isn’t satisfied with its current status as the top two players in its businesses and has embarked on initiatives to be a better company.

Mar 25, 2014 at 5:09PM

Source: Xerium

Every investor likes a good company, but they will love a great one. While the definition of a good company varies, characteristics like recurring revenues and high customer switching costs will definitely be qualifying criteria. Xerium Technologies (NYSE:XRM), a global provider of industrial consumables and services in machine clothing and rolls & services, will meet such criteria for a good company. In addition, it is making headway with various initiatives and potentially transforming itself into a great company in the near future.

Recurring revenue model
Businesses with recurring revenues generally fall into two categories. The first category involves long-term contracts associated with the provision of services on a recurring basis such as subscription and licensing. The second category relates to non-contractual sales of products and services with a short replacement cycle. Xerium's machine clothing business, accounting for two-thirds of revenues, belongs to the latter category.

Xerium's machine clothing products are replaced at the average frequency of 12 weeks. They range from the forming and pressing fabrics which have to be replaced within 40 to 45 days, to process belts which last for 8 to 16 months. More importantly, Xerium's products and services account for approximately 3% of its customers' paper production costs, but represent key inputs into the paper production process. Any significant defects could result in production downtime and significant losses for the paper production companies. As a result, customers are less price sensitive and less likely to defer replacement purchases for the sake of cost savings.

Another company which derives recurring revenues from the sale of products with a short replacement cycle is Libbey (NYSEMKT:LBY), one of the largest manufacturers of glass tableware products globally. It generates about 90% of its domestic foodservice glassware revenues from replacement sales. Due to the nature of the restaurant business, glassware have a high probability of being damaged or broken by staff and diners alike. Furthermore, as glassware tends to come in matching pairs or sets, customers have no choice but to replace their damaged glassware with new ones from the original vendors (Libbey in this case.)

The recurring revenue model provides both Xerium and Libbey with two key advantages. Firstly, revenue streams become more predictable. Excluding 2009 which was affected by the Global Financial Crisis, Xerium's revenues have not fallen by more than 10% in any single year in the past decade. Similarly, Libbey hasn't experienced more than any 10% drop in sales annually since 2004. Secondly, new products contribute directly to new revenue growth, instead of making up for lost revenues in the prior year.

High switching costs
On one hand, it is great for a company to possess a recurring revenue model. On the other hand, high customer switching costs need to be in place to protect these revenue streams. Xerium has two factors working in its favor, when it comes to retaining its customers.

Firstly, almost all of Xerium's products are manufactured in line with customer specifications. Therefore, customers risk significant downtime if they were to switch to another supplier apart from Xerium.

Secondly, Xerium has introduced its Value Results Program for its clients, a consulting service intended to quantify benefits of Xerium's products on its customers' bottom line. By understanding how its customers use their products and subsequently using the knowledge acquired to further assist clients, Xerium establishes "sticky" customer relationships.

Source: Xerium

Closing the gap
While Xerium is a good company, it isn't great yet because it is still trailing the market leaders in its respective businesses. Xerium is the second biggest player to Albany International (NYSE:AIN) in the machine clothing market; and Germany's Voith is the leader in the rolls market with 32% market share and Xerium is a close second with 26% market share. In addition, these two markets are relatively mature, suggesting modest growth opportunities.

Since 2013, Xerium is undergoing a process of transformation to be a better company. Firstly, Xerium plans to gain market share in its core businesses by expanding its product offerings and geographical reach in higher growth regions. Brown paper forming fabrics, new fiber cement belts and shoe press belts represent some of the gaps in Xerium's current product offerings and Xerium is looking to launch new products in these areas. In China, one of the fastest growing paper markets, Xerium has expanded its plants in the country.

It is also venturing into non-paper markets such as engineered textiles, roll covers and mechanical services where it can capitalize on its core competencies in technology. It is possible to draw comparisons with Albany's diversification into aerospace engineered composites here. Albany's vision is to become a leading Tier 2 supplier in the aerospace industry and generate revenues in the range of $300 million-$500 million by 2020.

Foolish final thoughts
Xerium is a good company with loyal customers and stable revenues. In the near future, it has a good chance of being a great company, as it gains market share in its existing markets and expands into other markets offering positive growth prospects.  

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Mark Lin has no position in any stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.

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