Competitive Niche: A Good Source Of The Moat For Small- And Mid-Sized Businesses

Oct. 28, 2019 3:57 PM ETACN, AMZN, EGOV, GGG, HD, IBM, INFY, LOW, MSFT, TSCO, WDFC, DOV, ITW8 Comments
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Summary

  • A competitive niche is sometimes a good source of moat for smaller businesses.
  • To assess niche-market moat, investor may want to examine the company's ROIC as well as why larger-scale players cannot steal market shares.
  • We list four of our interesting niche-market picks with analysis.

Written by Steven Chen, MBA.

Source: quickanddirtytips.com.

Overview

A competitive niche can sometimes build the economic moat for a business, especially small- or mid-sized ones. This happens because the narrower the target group is, the more effectively the company can compete with focused effort and resources.

However, there is also a potential issue with the competitive niche if the niche is so small or so specialized that it does not give an adequate return to the owners. Therefore, a check on the historical returns on capital is quite useful.

If the above is not the case, as value/quality investors, we would often need to examine why potential competitors, especially those larger-scale players, do not enter the niche space to fight for shares.

Below, we can see some of our interesting picks, where companies have successfully transformed their competitive niches into sustainable moats.

NIC Inc. (EGOV)

Source: Govloop.com

Kansas-based NIC Inc. builds digital solutions for governments to provide a higher level of service (e.g., renewing vehicle registration, purchasing national park tickets) to businesses and citizens and increase efficiencies. It typically absorbs upfront development costs but charges transaction commissions whenever users enjoy the online government services it builds (e.g., renewing vehicle registration, purchasing national park tickets).

The niche-market focus on B2G (business-to-government) IT services adds to the durable competitive edge of the business. The company possesses its deep and unique understanding of the government's digital needs, reflected by the proven fit of its cost-effective transaction-based model.

NIC is now a market leader in the eGovernment services space. As displayed below, the company has a broad portfolio of partnerships across over 50% of the states. Some states with the most profound enterprise relationships include Kansas, Nebraska, Indiana, all of which have used NIC's services for over 20 years now.

Source: Investor Presentation, August 2019.

Also, the small-scale niche of eGovernment, although being lucrative, would not be economically appealing enough for technology conglomerates, like IBM (IBM), Microsoft (MSFT), or large consulting firms, such as Accenture (ACN), Infosys (INFY), specialize in the space. Without too much competition, NIC generated consistently high ROICs over the past ten years (see below).

Source: GuruFocus; data as of 10/27/2019.

Thanks to the transaction-based toll-bridge model, above 90% of the company's total sales are recurring (see below). The long-term visibility, predictability, and high margin of these revenue streams lay the groundwork for the management to better plan its growth strategy and investments in platform expansions and acquisitions to widen the gap against peers in the eGovernment space. For example, the company launched RxGov to address the national prescription opioid epidemic through transparent, predictive, actionable data. On the inorganic front, the company acquired Complia to capture growth concerning the cannabis licensing and registration domain.

Source: Investor Presentation, August 2019.

WD-40 (WDFC)

California-based WD-40 Company is dedicated to creating positive lasting memories by developing and selling products that solve problems in workshops, factories, and homes around the world. For more than four decades, the company sold only one product, WD-40 Multi-Use Product, a maintenance product that acts as a lubricant, rust preventative, penetrant, cleaner, and moisture displacer. For the latest two decades, the company has evolved and expanded its product offerings through both research and development activities and the acquisition of several brands worldwide.

WD-40 currently markets and sells its products in more than 176 countries and territories worldwide primarily through mass retail and home center stores, warehouse club stores, grocery stores, and hardware stores. During FY2018, WD-40 brands, including Multi-Use (i.e., Strategic Initiative #1 below) and Specialist (i.e., Strategic Initiative #2 below) Products, contributed to 87% of the company's total sales.

Source: Corporate Presentation, May 2019.

Looking at the competitor list on Owler below, we find little reluctance among larger-sized businesses to compete with WD-40. All the most relevant competitors have annual sales of below $50 million, compared with WD-40's $423 million.

Source: owler.com.

WD-40 demonstrates its competitive niche of creating multiple successful products based on one single formula. The economies of scale here result in a cost advantage that potential market entrants would struggle to match.

Protected by this low-cost moat in a moderately-competitive space, WD-40 should surprise no one by delivering consistently superior returns on tangible assets (above 18% every year), as demonstrated below for the last decade.

Source: GuruFocus; data as of 10/27/2019.

WD-40 branded products are expected to drive future growth with support from geographic expansion, increased market penetration, new products, and digital channels. The management estimates that the sales from Strategic Initiatives #1 and #2 will total $630 million by FY2025 - that is an 83% increase from the FY2018 level.

Tractor Supply (TSCO)

Source: agreerealty.com.

Tennessee-based Tractor Supply is the largest rural-lifestyle retailer in the United States. For more than 80 years, the company has been focused on serving its unique niche, as a one-stop shop selling products for home improvement, agriculture, lawn/garden maintenance, and livestock, equine and pet care.

According to Owler below, three out of the top five competitors of Tractor Supply are not so comparable in terms of scale (i.e., annual revenue). The remaining two, namely Home Depot (HD) and Lowe's (LOW), have yet to pose any material threat to the company. Why? Tractor Supply focuses on the rural regions as it builds its stores in locations that are far away from city centers. At the same time, it does not make economic sense for large retailers with a more comprehensive range of SKUs.

Source: owler.com.

Additionally, the rural-lifestyle retail niche is shielded from digital disruption. This is because it does not take the strategic priority for e-tailers, such as Amazon (AMZN), to ship bulky items like a 50-pound bag of hog feed sold only for a dozen bucks with the infrastructure mostly serving more densely-populated areas.

The competitive niche helps Tractor Supply build and widen its economic moat. As a result, it earns high returns on tangible assets over the past decade (i.e., always above 10% except during the financial crisis).

Source: GuruFocus; data as of 10/27/2019.

The company is seeing a nation-wide 2,500 store opportunity in the niche space, assuming that at least one store is needed across every 1,800 communities (see below). Compared to almost 1,800 Tractor Supply stores at the end of FY2018, we see some (although not massive) room for the company's further geographic expansion.

Source: 2019 Investment Community Day.

Between 2014 and 2018, the total sales grew every year (see below). In the meantime, the same-store sales grew on average at an annual rate of 3.26%, which exceeds the management's long-term target of 3%. It appears to us that the current growth momentum is healthy and could sustain for the foreseeable future, even in this niche retail space.

Source: 2018 Annual Report.

Graco (GGG)

Image result for graco fluid handling

Source: graco.com.

Minnesota-based Graco is the leading manufacturer of fluid handling systems and products for painting, anti-corrosion, fluid transfer, gluing, and sanitary applications for markets like automotive, aeronautic, body refinish, wood, building, and construction.

The company operates mostly in niche categories, such as premium equipment solving the difficulties of handling a wide variety of materials with viscous, abrasive, and corrosive properties that may require precise ratio control. There is not so much competition as approximately 50% of Graco's revenue (or 93% of all SKUs) comes from products sold either one or zero per day, as indicated below.

Source: Investor Presentation, Q2 2019.

Few businesses want to go after those products, and Graco dominates the niche categories through reputation earned for decades and scale of outlets, facilities, installed base across 100 countries (see below).

Source: Investor Presentation, Q1 2019.

Leveraging its competitive niche, Graco has consistently delivered high returns on tangible assets for the past ten years (see below).

Source: GuruFocus; data as of 10/27/2019.

Moving forward, management set a CAGR target of 12% with a clear plan (see below), mainly supported by new products and geographic expansion.

Source: Investor Presentation, Q2 2019.

It is worth pointing out that Graco typically invests more than 2.5x its broader-market peers like Illinois Tool Works (ITW), Dover (DOV) when it comes to R&D (i.e., 4.3% as a percentage of sales at Graco vs. 1.6% at the peer group between 2014 and 2018). In this sense, it is reasonable to expect Graco's leading positions in its niche market to last.

Summary

Overall, we see the competitive niche as a good source of an economic moat, especially for small- and mid-sized companies, as long as the niche-market business model is viable from an ROIC perspective. By laser-focusing on the niche space, businesses could gain sustainable advantages in terms of specialization, cost, reputation/brand, or a combination of these. In this regard, diversification (or "diworsification") is the last management action that shareholders hope to see.

What is your favorite niche-market stock? Feel free to comment below.

This article was written by

Urbem Capital profile picture
3.72K Followers
Urbem Capital is the research arm of Urbem Partnership. Unlike most other equity research institutes, we purely focus on the rare species of wonderful businesses for the long run - that is less than 0.1% of all public companies worldwide.For more, check out founder Steven Chen's GuruFocus publications - https://www.gurufocus.com/ic/space.php?uid=451967&do=article

Disclosure: I am/we are long EGOV. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Additional disclosure: Mentioning of any stock in the article does not constitute investment recommendations. Investors should always conduct careful analysis themselves and/or consult with their investment advisors before acting in the stock market.

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