The first thing we do when analyzing a new business is to develop a thorough understanding of the industry in which it operates. The primary purpose is to understand how a company can create a durable competitive advantage (DCA) in that industry, which allows the company to achieve above average market share and results for a sustained period of time. A DCA can come in various forms, including brand awareness, barriers to entry, or a large scale effect offering economies of scale. The form the advantage takes often relies on the industry the company operates in. Regardless of form or industry, a DCA is absolutely necessary for shareholders to realize long-term above average results and a requirement for any long-term investment that we make.
Over the years we have developed a long and growing list of industries we understand and, therefore, fall into our “circle of competence.” We decided to write a series of blogs that discuss how to create DCAs in different industries. The goal is to devote each blog to a single broad sector of industries or to a particular industry. This is the inaugural post in that series.
DCA in Differentiated Manufacturing
This blog is about how a company can create a DCA in what I call differentiated manufacturing, which is a broad sector that encompasses certain manufacturing industries. In general, I separate manufacturing companies into commodity and differentiated. As it implies, each differentiated manufacturer produces a slightly unique product as opposed to a commodity product such as oil or ethylene. I wanted to start with the differentiated manufacturing sector because the vast majority of investors and even managers completely misunderstand how a true DCA is created in this sector.
When most people think of a unique product, they think that the key to success is the features of that product. However, those unique features are largely irrelevant the majority of the time. Rarely is a product so unique and ahead of the competition that its features alone give it a DCA. A Segway might be an example of such a product, but there may very well be alternatives that I simply never heard of. Cyalume (CYLUW.OB) is another company with such a unique product that there really is no viable alternative, but that is due to rare and unusual circumstances (market size has traditionally been too small for large companies to undertake the necessary R&D, and CYLU has literally 100% of the government contracts for their core products, making it impossible for a smaller company to catch up R&D-wise without substantial financial backing).
Conversely, some people believe that having strong brand awareness is key to a DCA, but those people would also be wrong most of the time. Sure, there are companies like Coca-Cola (NYSE:KO) and Apple (NASDAQ:AAPL) with incredible brand strength that can charge a premium for their product and still maintain strong market share on brand strength alone. But brand awareness is very difficult to turn into a DCA and is often overrated. A book called, "The Brand Bubble," by John Gerzema and Ed Lebar published in 2008 talks about the false perceptions regarding brand strength. The following is an excerpt from the book:
“… according to the data, consumer attitudes toward brands were in double-digit decline. And this erosion did not pertain to just a few brands, but to thousands. We saw large numbers of well-respected brands that had, on average, lower scores on these metrics – results low enough that marketers would consider them indicative of “commoditized attitudinal patterns.” These are numbers that basically say consumers know the brands well, but they are hardly inspired to buy them.”
The book goes on to state, per data accumulated from 1993-2007, the following:
- Brand trustworthy ratings dropped almost 50% over the last 9 years of that period,
- Esteem and regard for brands fell by 12% in 12 years, and very few brands were widely regarded across general population,
- Awareness of brands fell by 20% in 13 years,
- Brand quality perceptions fell by 24% over the last 13 years of that period, and
- Only 7% of prime time commercials were found to have a differentiating message.
If you are not yet convinced, consider this phenomenon. Battery companies in the United States try very hard to differentiate themselves. We have all heard of Energizer (NYSE:ENR) and Duracell. The Energizer bunny was actually originally intended to mock a Duracell commercial that featured a similar bunny running on batteries and beating a drum. In the United States, private-label batteries have never been more than 10% of the market, but in Europe private-label batteries comprise 60% of the market. The same four companies largely dominate both markets. They just sell their products more often as private-label in Europe instead of branded. If the brand was so important, it would dominate everywhere. Clearly European consumers do not see value in the brand when it comes to batteries.
My last example to highlight the decline of brand significance is Great Value. Great Value is Wal-Mart’s (NYSE:WMT) private label group of products. The products are made by the same companies that make the branded products but are simply labeled Great Value. 100% of the groceries I buy are Great Value because the cost savings is significant and the quality is the same.
So if it is not unique product features or brand awareness, what allows a company to create a DCA in differentiated manufacturing? The answer is the company’s distribution system. Specifically, what matters is how cheaply, uniquely, and diversely can the manufacturer get the product in front of the consumer. There is a reason best-in-class companies tout the size and efficiency of their distribution networks in investor presentations.
Understanding a distribution system and whether or not it creates a DCA is a nuanced undertaking. No two distribution systems are the same and what works for one industry may not work for another industry. So I will walk through a few examples and provide some high-level rules.
First off, what does the distribution network entail? It includes the company’s warehouses, distribution centers, transportation assets (e.g., trucks), and storefronts. Any of those four can be owned by the company, owned by a third party, or a mixture of both. In commodity products, the location of the warehouses and distribution centers in relation to the customers and how cheaply you can transport goods is paramount because being the low-cost provider is vital and actual distribution is a major part of cost (particularly if the commodity is especially heavy relative to its cost). However, in differentiated manufacturing, while cost still matters, efficiency is more important. Storefronts need reliable service from suppliers to ensure their own operations run smoothly. By and large, however, the biggest key is the storefront. How many stores are your products sold in, how convenient is it for the customers, and who has the true power in the relationship between the manufacturer and the retailer (obviously, the last one is irrelevant if the stores are company-owned). After all, it does not matter how great your product is if no one can find it. Conversely, you are more likely to sell a lower quality product if it is easier for the customer to obtain.
Mohawk Industries (NYSE:MHK) Case Study
Consider Mohawk Industries, the world’s largest flooring company. The company owns a number of brands, including Mohawk, Aladdin, Karastan, DalTile, Unilin, Quick-Step, and Columbia, among others. The company boasts market-leading positions in carpet and rugs, hardwood, ceramic, stone, and laminate products in the United States, the leading premium brand in laminate and hardwood flooring in Europe, and growing presences in Mexico, Russia, and China. MHK’s largest presence is in the United States, so I will focus on that market. MHK had 22% of the total flooring market in the U.S. in 2010, just ahead of Shaw’s 21% and well ahead of 3rd place finishers Armstrong and Beaulieu at 6% each. MHK makes great products, but so do Shaw, Armstrong, Beaulieu and their other competitors. Each company can boast a unique feature to their product or some unique expertise, so how does MHK stand out? Assuming all other competitive attributes are equal, MHK maintains strong market shares by simply being in more places than its competitors and doing so profitably, which is harder than it sounds. The key is having great relationships with retailers and the ability to efficiently and cheaply service the 25,000+ retailers the company does business with in the U.S. alone. MHK even states in its 2010 10-K: “In each of the markets, price competition and market coverage are particularly important because there is limited differentiation among competing product lines.” [emphasis added]
Flooring retailers are different from most retailers in that they only carry samples. It is cost and space prohibitive for retailers to keep sufficient inventory on hand, so they keep samples and the manufacturer just delivers directly to the customer’s house after purchase. Because the inventory costs are considerably lower for flooring retailers, that industry has not seen the level of consolidation experienced in the tools and hardware industry (i.e., Lowe’s, Home Depot). As a result, MHK is dealing with significantly more and smaller retailers than, say, a tool manufacturer deals with. This results in a strong shift of power towards MHK. MHK’s largest customer only represents 5% of sales. A decision by MHK to not sell its products to a mom and pop retailer hurts the retailer much more than it would hurt MHK, and both parties understand this. Regardless, MHK makes sure it maintains a strong relationship with these retailers and that they are set up to succeed. For instance, MHK offers marketing and advertising support to the retailers, which include sales and management training, in-store merchandising systems, exclusive promotions and assistance in certain administrative functions, including helping to host and maintain the retailer’s website. Further, product delivery is done predominantly on MHK’s own trucks operating from strategically positioned warehouses.
Further, MHK’s Dal-Tile segment, which dominates the ceramic tile market with five times greater market share than its nearest competitor, is believed to be the only major ceramic tile manufacturer with its own network of company-owned stores. If the company can successfully operate its own storefront (not a foregone conclusion among manufacturers) and is the only competitor doing so, that further establishes an advantage because MHK has greater control over the distribution and customer experience.
While this model may not sound difficult to replicate, it takes a large capital investment and the proper mindset. Unfortunately, most of MHK’s largest competitors are not publicly-traded, so it is difficult to compare profitability. One metric that can be calculated, however imperfect, is sales per employee. While it does not account for the capital investment required for a large distribution network, it does take into account the massive manpower required to service such a large distribution network. Below is a table showing the competitors, U.S. market share, and revenue per employee:
U.S. Flooring Market Share – 2010
Sales per Employee
Shaw has a greater emphasis on the soft flooring market (31% market share versus 25% for MHK), which is less profitable than the hard flooring market and helps explain its lower revenue per employee. Shaw is a Berkshire Hathaway company and, therefore, likely also has a DCA similar to MHK. It is perfectly ok for more than one company in an industry to have a DCA. In fact, that often creates an oligarchy type market that helps prevent a competition on prices. While Armstrong’s employee data was unavailable, it is important to note that the company emerged from bankruptcy in 2006 and is still recovering, so clearly MHK outperforms that company. Tarkett is actually a French-based company with a stronger presence abroad than in the U.S. Tarkett has made available more information than the other competitors, so we can see that, company-wide, MHK surpasses Tarkett in gross margin but has roughly the same operating margins. However, Tarkett touts itself as offering a “larger range of different flooring types in more countries than anyone.” This level of dispersion stretches the company somewhat thin and makes it very difficult to offer the same level of distribution as MHK, hence the lower overall revenue and far lower market share in the U.S.
In summary, MHK’s strong distribution network is nearly impossible to match because of the scale needed to afford it and the time it takes to build it. Currently, Shaw is the only competitor that can truly match it in the U.S., and Shaw focuses more on the less profitable soft flooring market. Regardless, the market is plenty big for the both of them, and both will continue to realize dominant market shares for years to come.
Sherwin-Williams (SHW) Case Study
Consider also Sherwin-Williams, a global leader in the development, manufacture and sale of coatings (i.e., paint) and related products. SHW owns a number of brands, including Sherwin-Williams, Dutch Boy, Krylon, Minwax, and Thompson WaterSeal. SHW is the largest coatings manufacturer in the U.S. and the third largest worldwide. Like MHK, SHW is an innovative company with high quality products known and respected throughout its markets. However, Akzo Nobel and Benjamin Moore, among other SHW competitors, boast the exact same reputation. All major competitors in the industry strive to constantly push the bar for better and better paint products. So what sets SHW apart in the U.S.? Once again, the answer is its distribution network. In this instance, what truly gives SHW the advantage is the vast network of company-owned stores SHW has compared to its peers. In fact, SHW has nearly twice as many company-owned stores as the next 9 closest competitors…combined.
As I have noted earlier, you cannot assume that a manufacturer will be able to successfully operate a retail location. Manufacturing and retailing are two entirely different sets of operations and skill sets, and many a manufacturer has tried its hand at retail and failed utterly. SHW, however, has been operating storefronts successfully for years. In the coatings industry, particularly in the U.S., having direct control of the customer experience and establishing long-term relationships with those customers is vital. Why would that be any different from, say, a clothing store, you ask? Because SHW’s target customer relies heavily on SHW for their own jobs. SHW’s target customer is the professional contractor who wants the convenience, personal care, and professionalism of a store devoted solely to paint products. While Home Depot, Lowe’s, or even Wal-Mart may have highly knowledgeable and helpful employees in their respective paint areas, those places are not nearly as convenient as a smaller, more intimate paint store where every single employee present is knowledgeable about paint and can help you. Would you rather go to Wal-Mart, deal with constantly changing paint experts, and sit through long-lines to buy your product or go to SHW, deal with the same employee/manager every time, and get in and out much more quickly? Further, the big-box retailers, by virtue of their size, generally have fewer locations per city, making SHW more convenient geographically.
SHW’s approach will become increasingly more beneficial going forward. In 1980, only 41% of sales were to professional contractors in the U.S. The other 59% were to “do-it-yourselfers” (DIY). However, as of 2010, that mix has shifted to 55% contractors and 45% DIY. It actually peaked prior to the housing crisis and has come down slightly in the last few years as people have saved money by painting themselves. As the economy recovers and this long-term shift continues, I would not be surprised to see the percentage of sales to contractors top 60%.
SHW still sells via the traditional channels (e.g., independent retailers, big-box chains previously mentioned), and those traditional channels are very important for getting in front of as many people as possible, particularly the DIY crowd. But SHW does not rely on any one retailer, thus retaining a balance of power in the relationship. In fact, SHW states in its annual report that no single customer was material. To highlight this point, SHW recently lost its contract to provide paint for Wal-Mart because SHW was fine walking away from the relationship. Akzo Nobel, who replaced SHW, accepted terms SHW was unwilling to accept and is expected to realize a 31% increase in its U.S. sales as a result. Clearly, Akzo Nobel will rely much more on Wal-Mart than SHW did, which will give Wal-Mart significant bargaining power in that relationship. Akzo Nobel is a fine company and is larger than SHW globally with its own DCAs worldwide, but this contract with Wal-Mart does not evidence that dominance. They are trying to build back up a beleaguered brand they purchased in 2008 while SHW will not lay off a single employee as a result of the loss of this contract. This turn of events demonstrates the DCAs SHW has in the U.S. coatings market as a result of its vast network of company-owned stores.
Finally, despite a practically non-existent housing market the past few years, SHW has been able to raise prices during that time and lost little volume as a result. The ability to raise prices during tough times is clear evidence of a strong and sustainable market position.
In terms of profitability, SHW is a cash cow and has realized ROE in excess of 30% annually since 2006 and ROIC in excess of 20% annually since 2005. For a multi-billion dollar company that is already #1 in its market, that performance is outstanding.
Rule One: The first metric I look for in determining whether a differentiated manufacturer has a DCA is the percentage of sales to big-box retailers, particularly Wal-Mart. It comes down to balance of power. If a company has 50% of its sales to Wal-Mart, then Wal-Mart has all of the power in that relationship in most instances. Wal-Mart can crush that company by forcing them to lower prices or cancelling the contract altogether. Wal-Mart will feel little to no pain from doing so. The ultimate question to consider is “who feels more pain if this contract is cancelled?” I often pass altogether on small companies with a high percentage of sales to Wal-Mart, Home Depot, Lowe’s, or Best Buy unless there is some other factor significantly depressing those companies’ stock prices.
Rule Two: When trying to determine if a company has a DCA, another quick and dirty metric that applies to most companies regardless of industry is free cash flow (FCF) as a percentage of revenue. Conventional wisdom states that if FCF/Revenue exceeds 5%, then the company likely has a DCA. Like any rule of thumb, this rule should be applied with great caution and only as a way to quickly size up a company for further analysis. The rationale for the rule is that companies with a DCA should be highly profitable, and a 5% FCF/Revenue margin is considered to be highly profitable. This metric should be looked at as an average of at least 5 years because it is easy to manipulate any single year via variations in capital expenditures or working capital adjustments. In our case studies above, SHW had an average FCF/Revenue of 8.55 over the last 10 years, which is phenomenal. MHK averaged 6.47 over the last 10 years, which is also impressive. Some industries obviously have lower margins, such as grocery stores, so the expectations should be shifted down (though I stay away from grocery stores in general because of those low margins). Conversely, your expectations should be shifted up for the technology and healthcare industries, which generally have higher margins.
Rule Three: This rule is kind of cheating and may not be available to us for much longer, but Berkshire Hathaway tends to only buy differentiated manufacturing companies with DCAs. Both companies discussed above have major competitors (Shaw and Benjamin Moore) that are owned by Berkshire Hathaway. Obviously, Warren Buffett will not be around for forever and there is as yet no proof that his successors can continue his success. While Buffett continues to run the company, however, I will be intrigued by any industry in which he buys a company outright, especially if it is differentiated manufacturing.
Rule Four: An asset turnover ratio in excess of 1.0 is to be desired. For every dollar of assets retained in differentiated manufacturing, a company should be able to generate at least one dollar of revenue. Obviously, during bad times, the ratio may dip below 1.0. Over time, however, the ratio should exceed 1.0. It is easier to do if a company comes by those assets organically. When a company acquires another business, however, it runs the risk of paying too much for that business, resulting in inflated asset values. SHW, which generally comes by its assets organically, has realized an average asset turnover of 1.58, which again is phenomenal. On the other hand, MHK started off the decade strong, only to see its ratio drop consistently due to the housing crisis and two large business acquisitions it paid too much for during that time period. Still, the average turnover ratio was 1.18 for the decade despite dropping below 1.0 in 2006 and staying there. MHK recently wrote off a large percentage of its intangibles after realizing it paid too much for those acquisitions, so this ratio should be back above 1.0 next year. It is important to note, however, how this ratio can be skewed by paying too much for otherwise highly performing assets or by writing down a significant percentage of assets while realizing the same level of sales. As with any metric, look carefully and proceed with caution.
I have walked through just a couple of industries in the differentiated manufacturing sector to demonstrate how to establish a DCA in that sector. There are numerous other industries in that sector that I did not cover. The DCA discussed is intended only for those industries that manufacture a final product to be sold to the end consumer. Companies that provide inputs to another company for the manufacture of a final product must look to other ways to create a DCA, which is a topic of a future blog in this series.
To sum up, put little faith in “brand strength” or “unique product features” and focus instead on the nuts and bolts of the company’s distribution system and on who has the power between the manufacturer and the retailer. An expansive and efficient distribution system is nearly impossible for a competitor to overcome. Also look for management that focuses on their distribution system in investor presentations, otherwise they might allocate capital towards projects that do not establish or sustain the company’s DCA. This is not to suggest that innovation and brand awareness are not important, but they are a necessary cost of doing business and not normally a way for a company to set itself above the competition.
Understanding DCA’s in any industry is a continuous process, so I welcome any feedback or disagreements you may have. We can improve our understanding together.