By Quan Hoang
A moat is really about protecting a company's profit as Warren Buffett said:
"You give me a billion dollars and tell me to go into the chewing gum business and try to make a real dent in Wrigley's. I can't do it. That is how I think about businesses. I say to myself, give me a billion dollars and how much can I hurt the guy? Give me $10 billion dollars and how much can I hurt Coca-Cola around the world? I can't do it. Those are good businesses."
A business may make less profit because of lower sales, lower margin, or both. So, there are two sides of a moat: the sales side and the margin side. The sales side can be broken down into customer retention and customer acquisition.
There are many factors that lead to high retention, including customer behavior, price insensitivity, switching cost, etc.
Customer behavior is subtle. Sometimes customers just don't think about switching. I used to wonder how small banks can compete with big banks. I realized that a bank's moat doesn't come from low funding cost or low operating cost but actually from customer habit. Customers rarely change their primary banking account. So, a small bank may have a low ROE because of its high costs but it can still have stable local market share. Despite their big scale to sell many financial products, big banks can't steal business from small banks very easily.
Similarly, car owners rarely shop for a new insurer unless there's a bad experience, there's a major event in their life (move or marriage) or there's a spike in the price of their premiums. In fact, insurers like State Farm and Allstate (NYSE:ALL) have greater retention rate than Progressive (NYSE:PGR) and Geico because they sell bundled products. So, even though Progressive and Geico have a huge cost advantage, they have only low double-digit market share after decades of gaining market share. There are simply not many people shopping for new car insurance policies each year.
Price insensitivity helps retain customers in the face of price competition. Customers may pay little attention to price when it's a tiny part of their total spending. Switching from Coca-Cola (NYSE:KO) to a private label cola simply doesn't save much.
Even better, some customers are willing to pay more for convenience, tailored solutions, product quality, or customer services. I find it interesting that Frost often pays less than one-tenth of the Federal Funds Rate for its interest-checking deposits. For example, Frost paid only 0.47% on its interest-checking deposits in 2007 while many other banks paid about 1.50%. I'm not sure why but perhaps Frost's customer service is so good that customers simply don't care about getting interest income on their deposits.
Strong customer acquisition can be achieved through distribution, mind share, product superiority, or price.
The best example of distribution power is perhaps big food companies. By owning key brands, they have the power to convince retailers to carry new brands. Similarly, journal publishers like John Wiley have distribution power by selling bundles of journals to university libraries.
Mind share also benefits customer acquisition. Mind share can be created by advertising, word of mouth or simply positive experience. If a customer decides to buy car insurance directly, he'll pick either Geico or Progressive. Price comparison is actually much less common in the direct channel than in the agency channel. Direct customers know they'll get a good price from Geico or Progressive.
Mind share is particularly strong when a purchase is infrequent. The classic example is See's Candies. People shop on only one or two occasions a year so there's no incentive to look for other brands. To a lesser extent, some furniture brands in the U.S. spend a lot in advertising so that people think of Tempur-Pedic when they want to buy a memory foam mattress, think of Select Comfort (NASDAQ:SCSS) when they want to buy an air-adjustable mattress, or think of La-Z-Boy (NYSE:LZB) when they want to buy a recliner.
Product superiority usually results from investment in R&D or service. It is strongest when there's a network effect, which makes a popular product more valuable to customers. People join Facebook (NASDAQ:FB) because many of their friends are there. People go to Amazon (NASDAQ:AMZN) or eBay (NASDAQ:EBAY) because that's where they can find the most sellers and thus the best price.
Finally, low price is always a powerful customer acquisition tool.
Margin can be protected by maintaining the gap between price and costs. To analyze the margin side of moat, the key questions are:
- Does the company have lower costs than competitors?
- Does the company have higher asset turnover than competitors?
- Does the company have higher customer willingness to pay than competitors?
- Is the power of suppliers and buyers low?
Low cost, high asset turnover, and high customer's willingness to pay provide a cushion against price competition in the industry. Low power of buyers and suppliers keeps profits from leaking out of the industry. Increasing concentration of buyers or suppliers is a big threat to future profits. Better organized buyers or suppliers may demand better pricing or they threaten to sell or source directly.
To evaluate moat, we should look at 3 things:
- Barrier to entry
- Potential damage of new entrants
- Rivalry among existing firms
Barrier to Entry
In this step, we should try to detect all advantages of a company in customer retention, customer acquisition, and margin protection. Barrier to entry is high when several factors are required at once so that entrants need not only money but also time to compete well.
Let's look at Hunter Douglas (OTC:HDUGF).
Customer retention isn't very important for Hunter Douglas because purchases are infrequent. That said, Hunter Douglas's customers are highly satisfied. Hunter Douglas's focus on product innovation and services raise a customer's willingness to pay. Customers rarely downgrade to a lower quality product unless they move to a rental home.
Hunter Douglas's greatest strength is in customer acquisition, specifically distribution. Independent dealers choose Hunter Douglas because the product quality is higher and they can sell the brand more easily. In fact, it's usually the brand that draws traffic to dealers rather than dealers getting the traffic themselves. Hunter Douglas advertises more than anyone else in the window coverings industry. It also enjoys great word of mouth.
Hunter Douglas's margin is sustainable. Thanks to its huge relative market share, Hunter Douglas benefits from economies of scale in advertising, in R&D, and in fixed investments in its integrated and highly automated manufacturing facilities. Customer's willingness to pay is higher than competitors because of product quality, advertising, and dealer service. Finally, the power of suppliers and buyers is low. Hunter Douglas is an integrated manufacturer so its inputs are mostly commodities. Dealers have little power because they're individual mom-and-pop operations.
A competitor needs brand recognition and low cost to recruit dealers. But it needs wide distribution to have low cost and to justify advertising investment. So, this is a chicken and egg problem. The best chance to compete with Hunter Douglas is through the online channel or through the big box channel. The only weakness in Hunter Douglas's moat is the possibility of a market share shift between channels.
It's worth noting that customer power is very strong in the big box channel, which Hunter Douglas avoids. Home Depot (NYSE:HD) or Lowe's (NYSE:LOW) usually demand a low price. Hunter Douglas's competitors sell through big boxes and make little profit to reinvest in marketing or product innovation. And they tend to cut product quality to meet the low-price demand from big boxes. So, end-customers can be segmented by channels.
A weak example is Weight Watchers (NYSE:WTW).
WTW's customer retention is weak because its members come and go. People don't take responsibility for their failure so they're always eager to try new weight loss programs.
WTW's customer acquisition is a bit better. It has no distribution advantage because fads can pick up easily in health and fitness. However, it has strong mindshare. Many people know what it is and know its effectiveness. In fact, its members re-enroll in the program on average three more times during their lives. All WTW needs to do is to give people a reason to join right now instead of putting off joining indefinitely.
WTW's margin is great. Customer willingness to pay is high thanks to the social value of weight loss. The power of suppliers and customers is low. So, it'll make a lot of profits as long as it gets enough customers.
So, WTW doesn't have moat but it has some strength in customer acquisition. Its former customer base, about 20 million in the U.S., grows over time. The overweight population grows over time. So, it just needs the right program news and the right marketing buzz. In the past, Weight Watchers has always made record profits after each cycle.
Potential Damage from New Entrants
Sometimes a business can be good despite a low barrier to entry. I think WTW is a good example. So, it's useful to make some attempts to judge the potential damage of new entrants.
The best tool in this step is to look at history. I unfortunately underestimated WTW's risk in the recent cycle. The problem is that I only had WTW's financial data back to 2001. I would have been more cautious if I had financial data back to 1990 to see how WTW performed in its previous crisis in early 1990s. Without financial data, we only know that WTW has always been able to reinvent its program during each crisis.
I think there's some similarity between WTW and restaurant chains. The market is huge. Each chain has a different concept and few have a big market share. But barrier to entry is low and customers are willing to try new restaurants.
New entrants actually don't do as much damage to existing chains as people think. There are not many new successful stories like Chipotle (NYSE:CMG). And it took Chipotle 20 years to seize just a 2% market share. A rate of two percent is less than the restaurant industry grows in a single year.
Moreover, new restaurants don't always open in a brand new location. Often, they open in or near a location another restaurant concept had occupied before. So, the total supply of fast food restaurants doesn't necessarily increase more than population growth despite the industry's low barrier to entry.
So, the biggest competition in fast food chains is actually among existing chains.
Recently, Value and Opportunity argued that Fossil (NASDAQ:FOSL) has no moat because "…wholesale distribution network seems to be quite open for newcomers like Daniel Wellington." It's true that department stores always have store space to test new suppliers. Retailers care about gross profit per square foot so they often switch suppliers in that area of their stores. Sometimes a new entrant may succeed.
But how much will the success of a new watch brand actually hurt Fossil?
Customer's willingness to pay is high in this category so it won't hurt margin. It may hurt volume, thus reducing gross profit per square foot of Fossil's licensed watches. But cannibalization might not be as high as most people expect. Revenue of Michael Kors (NYSE:KORS) watches went from $100 million to $900 million in 5 years but it didn't hurt Fossil's other brands. And Fossil's other brands didn't benefit from the recent fall in Michael Kors either. Perhaps not many people wear watches today so Michael Kors helped bring more consumers to the category. Or it simply induced people to buy more often.
Also, can Daniel Wellington build on its early success and keep its brand relevant? It's a big challenge for any newly successful entrant.
So, I think it's safe to bet that a (growing) diversified portfolio of strong licensed brands can help Fossil gain market share over time.
Rivalry Among Existing Firms
This step is similar to the Barrier to Entry step. However, we compare a company's strengths in customer retention, customer acquisition, and margin with its competitors. We want to see some durable competitive advantages that allow a firm to gain market share over time. And we want to make sure that the moat is widened over time.
In our bank example, every American bank has a pretty good retention rate. However, some regional banks such as Commerce Bancshares (NASDAQ:CBSH) and BOK Financial (NASDAQ:BOKF) have the scale to sell other products like wealth management or payment systems service. Selling more products to a customer creates a closer relationship and improves retention. More products also mean more touch points to acquire new customers. Finally, more products result in more fee income, reducing net operating cost and creating a cost advantage. A cost advantage may allow for more reinvestment in products and services. So, these banks will possibly gain market share from tiny local competitors over time.
There's nothing innovative in this framework. But I think it can help us connect different competitive advantages and see a clearer picture of moat. It's a simple way to think about moat. But the most important question is always the one Warren Buffett asks:
"I say to myself, give me a billion dollars and how much can I hurt the guy?"