Building Sustainable Competitive Advantage

Intangible Assets, Switching Costs, Network Economies, and Cost Advantage Provide a Critical Edge

Ron Stacey contends the answer is not a dominant market share, efficiency, or even a talented management team. Companies with lasting advantage tend to be strengthened by intangible assets, switching costs, network economies, and cost advantage. Find out why. 

Capitalism is about competition and free markets. Accordingly, it behooves any business to have a good understanding of the factors that drive competition in its industry in order to strategically position the business for success. In this article, we review the origins of competitive strategy, its evolution into more easily understandable manifestations from an investment perspective (the moat), and then address each of four primary competitive advantages: intangible assets, switching costs, network economies, and cost advantage. Lastly, we provide some tips on how any business can build competitive advantage by applying an understanding of the basic principles of competitive strategy.

Three decades ago, Harvard business school professor Michael Porter established a framework for analyzing industries and competitors in his seminal work Competitive Strategy. Porter’s industry analysis captured the complexity of competition in four forces: the threat of new entrants, the threat of substitutes, the bargaining power of customers, and the bargaining power of suppliers. Porter identified three generic strategies: differentiation, low-cost producer, and focus. While over the years the names have changed, the underlying concepts remain the same.

In a more modern take on the Porter framework, Pat Dorsey, Chief of Research at Morningstar, recently published The Little Book that Builds Wealth as a guide for stock pickers. In this highly readable publication, Dorsey points out how to identify great investments by finding companies with long-term sustainable competitive advantage. The key, identify companies with a high return on invested capital, then determine if that return is temporary short term (false advantage) or permanent long term (sustainable advantage). If the value of a business is equal to the discounted cash flow of all the cash it generates into the future, then it stands to reason that a business that generates cash for a longer time is more valuable than one that generates cash for a shorter time.

Return on invested capital is a fairly straight forward, but highly important notion. Invested capital includes the firm’s interest bearing debt and equity. A firm that can generate 50 cents in free cash flow for every $1 invested is more valuable than one that generates 25 cents in free cash flow for every dollar invested. Free cash flow to the equity is cash available for distribution to shareholders, dividends if you will, after all of the firm’s obligations, including capital reinvestment, have been satisfied. Firms with a high return on invested capital for extended periods are those that posses a significant competitive advantage, or to put in more in the vernacular, a “moat.”

That famous investing duo, Warren Buffet and Charlie Munger of Berkshire Hathaway, that’s right, the old shirt company, ground their investment thinking in the concept of the moat. To quote Buffet, “So we think in terms of that moat and the ability to keep its width and its impossibility of being crossed as the primary criterion of a great business.” Moats, as it were, are a structural circumstance particular to a business. But before we address each of these moat types, let’s discuss what moats are not.

What “Moats” Are Not
While this revelation might come as a real shocker, great products rarely make a moat simply because, well, it’s capitalism. Great products attract great competition which eventually hammers down the return on invested capital. Take Chrysler, (RIP), for example. When Chrysler introduced the minivan in the 1980s, profit margins were fat, and the other automakers soon took note since no structural characteristic of the auto industry prevented other firms from producing minivans. About that same time, Gentex introduced the patent-protected automatic dimming rear view mirror and profit margins were fat for Gentex and remain so even today as the company is constantly improving, innovating, and updating its product lines and patent portfolio.

High or dominant market share does not create an economic moat per se. In competitive industries, market share and dominance can be fleeting. Kodak, IBM, Netscape, and General Motors are examples of companies that at one time dominated their industries before succumbing to competition. Size can help a company create competitive advantage, but size in and by itself is not usually an economic moat unless it creates a cost advantage (See below.).

Running mean and lean, more efficiently than the competitors is not a sustainable source of competitive advantage. Without some form of proprietary advantage, a business cannot execute flawlessly indefinitely. If nothing else, the competitors will get sharper in order to survive. Stop going to the gym for a week and see how fast those lost brand advantage Krispy Kreme doughnuts catch up with you.

And lastly, competitive advantage is not a talented management team or super star CEO. Granted, better to have a business run by geniuses than morons, but given the competition for those CEO jobs and the huge paychecks, there are a few morons, although some might disagree with me on that. How much influence can a single manager have in a large organization anyway? Most super star CEOs get that tag post ante, after the results are posted. And being political animals, they know how to take credit. For example, is Jeff Imelt at GE grossly inferior to the famous Jack Welch? Based on the share performance at GE under Imelt versus Welch, it appears to be the case. More likely, the stars have yet to align for Imelt, but they will if he hangs on long enough because, well, it’s GE. Lastly on superstar CEOs, here is a Warren Buffet quote: “When a management with a reputation for brilliance tackles a business with a reputation for bad economics, it is the reputation of the business that remains intact.”

Intangible Assets
Brands can represent a formidable competitive advantage if, and only if, the brand enables the business to charge more for the branded product. Familiarity in and of itself may not confer pricing power (Kraft Cheese). Coca-Cola is a good example of brand extracting value. Aswath Damadoran, the famous “valuator” from NYU Stern School of Business, estimates the value of the Coca-Cola brand at between $50 and $64 billion measured by the “excess return” earned by Coca-Cola over other non-branded competitors. Other powerful brands are names like Tiffany, Oreo, Bayer, and Cadbury.

Patents allow for a business to sell its patented products, without competition. Nice. Patents, however, are subject to expiry, challenge, and reverse engineering. A company with a formidable patent moat is one with two things: (1) multiple patents and (2) a history of innovation to keep those patents coming and keep out the competition. Some notable examples are 3M, Merck, and Eli Lilly.

Regulatory “anomalies” can generate competitive advantage provided the regulated business can actually price like a monopoly. Utilities, for example, while requiring regulatory approval to operate, are limited as to their return on capital. One the other hand, bond rating agencies (Moody’s, S&P), slot machine manufacturers and “accredited” institutions of higher learning enjoy great returns since entry is limited through “accreditation,” while pricing is unregulated. For years, credentialing by the “professions” (law, medicine, and accounting) kept supply tight and margins high.

Switching Costs
Of course, the poster child for switching costs is banks. On average, bank deposits turnover about every seven or eight years and banks used to earn 15 percent on average on equity (before the Great Recession). Everyone can identify with the hassle involved in switching bank accounts. The banks build in switching cost products, like direct deposit payroll and bill pay services.

Software products with large installed bases are another good example of switching costs. Intuit, the maker for Quick Books, has a dominate market share because of the cost, not to mention the headache, of switching to another software, specifically migrating all of the data, reformatting, and the learning curve associated with the switch. Quick Books becomes so entangled in the day-to-day business operations of small and midsize companies that it is impossible to easily change. The same is true for software company Oracle that has made a fortune on data base management. Of course, Oracle has coded the database management software such that it’s nearly impossible to easily migrate the data to another program, not to mention reprogramming all the application software to work with a different database manager. The power of these switching costs is evident in the annual licensing and maintenance fees that command margins upward of 70 percent. Customer retention for Oracle is better than 95 percent, a virtual annuity.

Networks
Networks for a business have to do with casting a very wide net and leveraging the “main frame,” in dot com parlance. More simply, a company with a network advantage controls more territory than competitors and the cost to displace it, should any be so foolish, is prohibitive. It’s a geographic franchise of sorts only in today’s modern world it’s virtual. And, in fact, businesses based on information transfer are much more likely to use the network effect to their advantage.

How important is it to grab that territory and become the standard for millions of users? Very. Recall the case studies from business schools on the browser wars with Netscape and Internet Explorer. Even though both companies spent hundreds of millions on development, both knew that the first to become the standard would prevail. Both gave the product away while constantly improving and updating. In the end, Internet Explorer captured the flag and Netscape has gone by the wayside. Of course, Microsoft did the same thing, albeit not in quite the same way, with Word and Excel, the universal language of the knowledge worker.

More recently, eBay has come to dominate the online auction market in U.S., with a better than 85 percent share, and is so entrenched (much like switching) as to be nearly impenetrable. The reason is that eBay captured that critical mass first and was able to keep it, unlike Netscape. In Japan, however, Yahoo dominates the online auction business simply because Yahoo got there first, and gave the product away. Some refer to this phenomenon as “first mover advantage.”

Other good examples are the credit card companies that control the networks over which, with the advent of the debit card, conceivably every commercial transaction must flow. The big four networks, Visa, Discover, Amex, and MasterCard handle 85 percent of all credit card transactions nationwide. In a $15 trillion dollar economy, that’s a lot of revenue and it’s not going anywhere anytime soon. The continuously evolving technology has given rise to these new industries with powerful competitive advantage.

Cost Advantages
Cost advantages must be sustainable, immune to lower cost substitutes, and reside in industries where the customer is price sensitive. An example of unsustainable competitive advantage is shifting production to a low labor cost country. Since most of these countries have an enormous supply of labor (and the minute the supply gets tight, it isn’t cheap anymore), the competition simply moves to the low cost labor. In these situations, typically the consumer benefits as the industry competition drives margins down to pre-low cost labor levels. It is amazing how many industries have gone down this ruinous road, like apparel manufacturers, for example, of which there are none left in the U.S.

The first of four generic sustainable cost advantages is a cheaper process or more efficient business model. A good example success story is the Southwest Airlines business model of only one airplane type, point–to-point (no hubs) routes, fast turnaround, an employee culture of “thrift,” and one class of service. Moreover, Southwest Airlines’ strategy included locking up gates and secondary airports and lining up a continuous supply of new airplanes that are much cheaper to run than used ones. The major airlines were unable to copy the model, even if they wanted to, without destroying their own business model, featuring unions, hubs, and discriminating classes of service. One other advantage for Southwest Airlines, the company was able to achieve scale to the point it became too big to kill, before the majors took note. Every now and then, a baby sea turtle makes it to the ocean.

A second type of cost advantage is geography or location, call it the geographic franchise. Generally it takes the form of a freight advantage for “commodity priced” products or services. Take, for example, the waste hauling or garbage pick-up business on which we all heavily depend. Waste Management, in addition to mastering the regulatory hurdles, is also very smart about locking up landfills. The shorter the truck has to haul the garbage, the more cost effective the service. The same concepts hold true for quarries and cement companies. Or a manufactured product that takes up a lot of space but little weight, in other words, shipping a lot of “air,” also creates a location advantage. For example, sheet metal ducting that goes into the HVAC systems in new homes and commercial buildings.

Another great location advantage example is Billy Bishop Toronto City Airport, located on Ontario Island, a one-minute water taxi ride from downtown Toronto. The competing Toronto Pearson International airport is a $50 up to 50-minute cab ride. Airline entrepreneur Robert Deluce bought the run down terminal, entered into a long term lease with the Toronto Port Authority, bought 20 brand new Canadian built turboprop aircraft and started Porter Airlines running regional commuter service to places like Newark (Continental’s major hub) and Montreal. The airline is a huge success. Now the big boys, Air Canada, and Continental, for example, want back in. So in typical sore-loser fashion, they sued for access to gates at City Airport. Eventually they’ll get there, but right now, Mr. Deluce is holding his own in fine Southwest Airlines style. With any luck, he, too, can become too big to kill.

Command and control of unique assets is third on the list. This type of cost advantage is usually evident in the extraction industries like mining or oil and gas. For example, if an exploration and production company has an asset where oil and gas is near the surface in great quantity, it can extract those assets for a much lower cost than those plunging the depths of the Gulf of Mexico. Of course, both companies are still subject to the vagaries of market prices, but the low-cost producer will always have better margins, or at best go broke last.

The fourth and final type of cost advantage is that venerable favorite, size. Scale based cost advantage is found in three categories, distribution, manufacturing and nice markets.

Cost advantage in distribution is typically related to a physical network like UPS in package delivery, and Sysco in food service distribution. Once achieved, critical mass in a distribution system is virtually impossible to displace. An unusual example is Darden Restaurants, operator of the Red Lobster chain. The ability to keep 650 locations stocked with fresh seafood on a daily basis is feasible only because of the highly efficient Darden supply distribution system; provided, however, it’s the restaurant business, an industry with relatively poor fundamental economics.

Competitive advantage from scale typically applies to manufacturing operations as taught in Economics 101. More specifically, the cost advantage is derived as a function of the interrelation between fixed costs, and variable costs as depicted in the classic breakeven chart. The ability to spread fixed costs and mechanize production tasks lowers total costs. Toyota has less than 1.2 direct labor hours in its manufacturing of an automobile engine, perhaps less in the throttle control systems. Exxon Mobil in its refining operations, for example, has far better margins and, hence, return on invested capital simply as a matter of throughput and volume. Moreover, companies with large market shares, in media content costs, for example, can spread costs over a much larger sales base and hence enjoy better margins.

The ability to dominate a niche market can yield significant cost advantage; put more colloquially, the big fish in a little pond. Usually, the niche is only large enough to support one entrant profitability, so it makes little sense for competitors to spend the capital necessary to displace the incumbent. Examples here include second tier markets for cable/broadcasting, TV stations in Boise, ID, for example. Other examples of niche domination might be product oriented where a particular product line dominates its niche end use markets effectively enough to fend off competition. Graco is a prime example dominating the market for high-end paint sprayers and high-end food service equipment while earning 40 percent returns on invested capital. Or lastly, the go-to software for a particular application, think Turbo Tax.

As a final mention on cost advantage, we throw in “too big to fail” financial institutions. These entities have the implicit backing of the U.S. government which allows them to borrow money at rates significantly lower than competitors, and take risks beyond what conventional competitors might consider prudent. Talk about competitive advantage! Of course, the long-standing poster children for these entities are Freddie Mac and Fannie Mae, and. more recently. most of the really big banks.

Parting Thoughts
For most small to mid-size business, it may appear that none of these options for building competitive advantage are viable strategies. Not so. Take for example a small commercial/residential lawn care business. The ability to capture all of the buildings/houses within a specific area creates a cost advantage since the crews spend less time traveling and more time generating revenues, sort of a labor productivity advantage. Take that some company, and create a custom lawn care program using proprietary products and, voila switching costs.

As another example, one of our clients in the packaging industry built a great competitive advantage by recognizing an opportunity within its niche to capture all the packaging business from a major customer. The company acquired some specialized and somewhat rare used equipment and set up shop right next to the key customer. Although the amount of business is significant, it’s not enough to induce a competitor to source and install the capacity necessary to compete for that customer; as long as no one gets greedy. This brings to mind the great John D. Rockefeller Sr. whose Standard Oil dominated the lighting oil market by keeping the price of kerosene low. Mr. Rockefeller had a good understanding of capitalism and competition, as evidenced by his famous quote, “Competition is bad for business.”

Hopefully, this brief article has provided some useful insight into sustainable competitive advantage. In order to put this information into use, it is necessary to begin thinking about your business in terms of real competitive advantage. By understanding the underlying principles of competitive advantage, even a small business can build meaningful advantage by recognizing promising opportunities to do so.

By Ron Stacey, Managing Director, Legacy Advisors

Ron Stacey is the Founder and a Managing Director at Legacy Advisors, a Dallas-based boutique investment bank. Mr. Stacey has owned and operated three privately held businesses nesses and has successfully completed over a billion dollars in senior debt, mezzanine and equity financings. He has been involved as an advisor in over 350 M&A transactions, including leveraged acquisitions, and management buy outs. Please contact him at rstacey@legacyadvisors.org or call (214) 705-1112 with comments.