2 Key Sources of Moat

This week Morningstar.com is presenting excerpts from Morningstar's new book, Why Moats Matter: The Morningstar Approach to Stock Investing, which details what makes a moat and how to identify the five sources of moat. Below is Part 2 of the excerpts. You can find Part 1 here. 

Cost Advantage
Companies can dig economic moats around their businesses by having sustainably lower costs than their competitors. A favorable cost position can stem from process advantages, a superior location, scale, or access to a unique asset. Process advantages are interesting, but we award economic moat ratings to companies with this edge only if the process can't or won't be easily replicated by competitors. An advantageous location can also give a company a cost edge, and this leg up can be sustainable given the difficulty of duplication. Meanwhile, companies that enjoy economies of scale have lower average costs than their competitors with smaller capacities.

Managed care organizations, or MCOs, provide a good illustration of the economies-of-scale version of the cost advantage source. These firms provide health insurance services to their members (individuals, groups, or the government). One of the most valuable effects of having a large membership base is that the MCO can significantly scale its selling, general, and administrative, or SG&A, costs. Expenses such as corporate costs, IT infrastructure investments, depreciation of fixed assets, certain selling expenses, payment processing, and customer service expenses are largely fixed, and therefore having more members lowers the average cost per member. The major MCOs that we believe possess economic moats-- UnitedHealth (UNH), WellPoint (WLP), and Aetna --are able to operate at a lower level of SG&A per member than smaller MCOs that don't have moats.

Furthermore, an MCO with a large membership base also has a better ability to control overall medical costs by negotiating advantageous pricing with its providers (hospitals and doctors). To obtain profitable pricing, companies need to either have a large geographic reach to provide demand at multiple nationwide sites or have the local density to control a large portion of demand in a specific geography. Basically, a provider will give better pricing to payers that control more demand. This dynamic is a product of a few factors. First, a procedure usually becomes cheaper to execute for a provider each additional time it is done. Therefore, a provider can cut pricing for a payer with a large membership base and still preserve its gross margins. Second, since a payer that controls a large portion of demand also potentially controls a large portion of a provider's gross profits, the provider will be more apt to provide discounted pricing.

North American Class I Railroads-- CSX (CSX), Norfolk Southern (NSC), BNSF, Union Pacific (UNP), Canadian National (CNI), Canadian Pacific (CP), and Kansas City Southern --earn wide economic moats in part from sustainable low-cost advantages. Barges, ships, aircraft, and trucks also haul freight, but railroads are the low-cost option by far where no waterway connects the origin and destination, especially for freight with a low value/weight ratio. Moreover, railroads claim quadruple the fuel efficiency of trucking per ton-mile of freight and make more effective use of manpower despite the need for train-yard personnel, in part because of greater railcar capacity and longer trains. Even for goods that can be shipped by truck, we estimate that railroads charge 10%–30% less than trucking containers on the same lane. And we have confidence in the sustainability of these railroads' economic profits because they've been investing heavily in their cost advantages. They're making increasingly effective use of two of their most expensive inputs: labor and fuel. 

Regarding the former, railroads are producing more tonmiles per employee than in the past. This is due in part to larger cars, combined with increased speed, reduced downtime at terminals, and more effective work rules and practices. Concerning the latter, the Association of American Railroads reports that in 2012 U.S. railroads moved a ton of freight on average 476 miles per gallon of fuel, up from 414 ton-miles per gallon in 2005 and double the 235 level of 1980. This was accomplished via larger cars, more-fuel-efficient locomotives, idle-reduction technology, throttle position selection guidance software that learns a route to optimize fuel and safety, distributed power to reduce required horsepower, rail lubrication, and locomotive engineer training and incentives.

Key Questions: Cost Advantage

1. Does the company benefit from economies of scale? Specifically, which costs are fixed and can therefore be leveraged? What quantitative evidence do we have that this company benefits from lower per-unit costs than a competitor with smaller volumes? Many companies claim that they benefit from economies of scale, but it's important to look for proof that a company with larger volumes indeed has lower per-unit costs than a smaller competitor.
2. Does the company benefit from economies of scope? Which costs are spread over a variety of products? What quantitative evidence demonstrates how this company benefits from lower per-unit costs than a competitor that produces a smaller variety of products? Some companies can leverage significant R&D expenses and process knowledge over a variety of products meeting diverse client needs. Once again, it's crucial to focus on finding actual quantitative support that this results in lower per-unit costs.
3. Does this company benefit from low transportation costs? What is the cost of transportation relative to total costs or the price of the product? What is the transportation cost for relevant competitors? Transportation costs can really alter a company's competitive positioning, especially for goods that have a low value/weight ratio. To illustrate, transportation costs matter very little when shipping gold, where an immense amount of value can sit comfortably in the palm of your hand. In contrast, an entire ton of construction aggregates costs only $10. In situations like that, producers located closest to potential customers have a great cost advantage over far-flung competitors.
4. Does this company own or control geological deposits with advantageous characteristics? How rare or prevalent are deposits of high quality? In the energy and basic materials sectors, owning an advantaged geological deposit can be a formidable competitive advantage, because humans—even with substantial capital and time—can't replicate what Mother Nature took millions of years to form.
5. Does this company have a unique production process that results in a cost advantage? Quantify the cost advantage that comes from this process. Can this process be replicated? A process-based cost advantage is ultimately replicable, but we do find that some companies can operate for decades with a cost advantage due to a superior production process. Keep an eye out for potential new entrants. While incumbent competitors may be stuck with the inferior production process that they've already built, it's easier for new industry entrants to use a superior production process because they're starting from scratch.
6. Does this company have bargaining power with suppliers that results in a cost advantage? What percentage of the company's total costs benefits from this bargaining power? What type of discount does this bargaining power result in? Many companies claim that they're big and powerful enough to extract discounts from their suppliers, but we need to see quantitative proof that this results in a material cost advantage before awarding a narrow or wide economic moat rating on this basis alone. For bargaining power to result in a sustainable competitive advantage, we wouldn't want to see any looming threat of supplier consolidation.
7. Does this company have advantaged access to raw materials? What percentage of total costs does the raw material amount to? What does the cost advantage amount to, relative to industry competitors that don't have advantaged access to raw materials? Why can't other industry players get access to these low-cost raw materials? What is the outlook for supply, demand, and prices for the raw material? For example, some companies benefit from having access to lowcost energy. Before considering a narrow or wide moat rating on this basis, though, we need to make sure that the cost advantage is sustainable. Regional changes in supply and demand, or substitution, can cause raw-materials-based advantages to be fleeting. ​

Switching Costs
Switching costs are the expenses--whether in time, hassle, money, or risk--a customer would incur to change from one producer or provider to another. Customers facing high switching costs won't necessarily make a switch even if a competitor is offering a lower price or a better-performing product or service. The improvement in performance or price must be large enough to offset the cost of switching. High switching costs are especially prevalent and powerful when there is a high cost of failure, or the cost of the specific product or service in question is fairly insignificant relative to the customer's total operating costs.

Apple (AAPL) is a good example of a company whose customers would suffer switching costs if they changed products. There are a variety of switching costs around the iOS platform that should allow the company to retain a good portion of its current user base without having to compete on price alone. Apple iOS users who purchase movies, TV shows, and applications from the iTunes store are unable to transmit these media to Android or other portable devices (while music is transferrable). iCloud adds another layer of switching costs by synchronizing media, photos, notes, and other items across all Apple devices. We believe an owner of an iOS device--say, an iPad--is less likely to switch from an iPhone to an Android phone if it means that the individual will be unable to sync or access a portion of his or her content. Additional Apple devices, such as the Mac and potentially an iWatch, could raise these switching costs even further.

Asset managers such as BlackRock (BLK) also benefit from switching costs. While the costs for investors might not be explicitly large, the perceived benefits of switching from one money manager to another are at times so uncertain that many investors take the path of least resistance and stay where they are. As a result, money that flows into asset-management firms tends to stay there--borne out by an average net annual redemption rate of only 30% for long-term mutual funds, which excludes the impact of money market funds, during the past 5-, 10-, 15-, 20-, and 25-year time frames. "Asset stickiness," or the degree to which money stays with an asset manager over time, plays a vital role in determining which companies in the asset management industry have the widest economic moats.

Looking more closely at BlackRock, which we feel has the widest moat in the asset management industry, we find that the company benefits from a diverse product portfolio, which is equally split among active and passive investment strategies. This effectively makes the firm agnostic to shifts among asset classes and investment strategies, limiting the impact that market swings can have on its overall level of managed assets. With much of BlackRock's assets under management sourced from institutional clients, which tend to be more long-term-oriented than retail investors, the company has also been able to tap into a far stickier set of assets than many of its peers. While BlackRock may not be a household name, it is well known and well respected in the institutional channel, especially in fixed income, where it effectively forms an oligopoly with PIMCO and Legg Mason . BlackRock's ownership of iShares, the leading provider of exchange-traded funds, or ETFs, on a global basis, has endeared it to institutional investors, and should provide the firm with strong brand recognition in the retail advisor channel--in our view, the stickiest part of the retail channel. These attributes have all combined to build a wide economic moat around BlackRock's operations.

Rockwell Automation (ROK) has a wide economic moat thanks to a high degree of customer switching costs for its Logix automation control platform. Changing automation vendors is a decision not made lightly by a manufacturer; the organizational disruption caused by the change creates a number of potential costs for the customer, making sticking with the status quo the lowerfriction choice. Think of the controller as the brains of the manufacturing floor. Any surgery involving it is delicate and approached with extreme care by the manufacturer. As a result, an automation firm such as Rockwell has a heavy incumbency advantage, building meaningful barriers to successful entry.

Key Questions: Switching Costs

1. What are the costs and benefits of switching? Comparing the costs of switching with the price differences among available alternatives is the best way to prove that a company benefits from switching costs.
2. Are customers' existing assets and processes linked to a particular provider's offering? How material would training needs be if a customer switched providers? How much lead time is necessary for a customer to switch? How significant would the business disruption be if a customer switched providers? Answers to these questions help paint the picture of what switching entails. Sometimes it's hard to quantify switching costs, but high degrees of asset specificity, significant training needs, long lead times, and high potential for business disruption all help create customer switching costs.
3. What are renewal rates for this company? High customer switching costs typically manifest themselves in high renewal rates for existing clients.

Excerpted with permission of the publisher John Wiley & Sons, Inc. from Why Moats Matter: The Morningstar Approach to Stock Investing. Copyright (c) 2014 by Morningstar. This book and ebook is available at all bookstores, online booksellers, and from the Wiley website at www.wiley.com, or call 800-225-5945.