2 More Key Moat Sources

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 3, the final installment of the excerpts. You can find Part 1 here and Part 2 here. 

Network Effect
The network effect occurs when the value of a particular good or service increases for both new and existing users as more customers use that good or service. The network effect is a virtuous cycle that allows strong companies to become even stronger.

Major online travel agents, or OTAs, such as  Expedia (EXPE) and  Priceline (PCLN) are examples of companies whose economic profits are protected by the network effect. Both travel suppliers and consumers gravitate toward the big OTA platforms that consistently consolidate the largest collection of travel inventories and distribute them efficiently. Huge transaction volumes measured in billions of dollars each year run through the Expedia and Priceline families of booking sites. That’s made these platforms a highly coveted distribution channel from the perspective of travel suppliers that are eager to list their services. In turn, this increases the appeal of the booking sites to travelers, thus setting off the virtuous cycle.

 Tencent (00700) is among the most influential and profitable Internet firms in China, with a dominant position in instant messaging, online gaming, and social networking. By providing a high-quality online experience that has helped Chinese Internet users stay connected, informed, and entertained for more than a decade, Tencent has won the loyalty of several hundred million subscribers. Tracing its roots to an instant messaging service, Tencent has expanded into a massive and sticky online platform for 500 million Chinese Internet users during the past decade. Adding to its hugely popular QQ instant messaging service, which has more than 80% of share in terms of IM user time according to third-party researcher iResearch, Tencent has built its social networking and social media platforms to an impressive scale during the past few years. Tencent boasts more than 500 million accounts (though it’s possible to have multiple accounts per user) both on the Qzone platform and on its Twitter-like microblog site, and it signed up more than 400 million users on mobile app WeChat, launched only two years ago. There are likely overlaps among the subscriber groups, but the numbers still serve to illustrate a network effect that Tencent’s peers would be hard-pressed to match. Although Internet users can easily set up accounts on competing platforms, we think none of the rivals is close to the scale of Tencent. Leveraging its massive user base and site traffic, Tencent has been able to grab top shares in both online gaming and brand advertising despite being a latecomer to these markets.

 Core Labs (CLB) provides the analytical firepower and tools needed to deeply study the geological structure and fluid dynamics of an oilfield reservoir. Core’s efforts revolve around analyzing well cores and how hydrocarbons move through the reservoir, so it can suggest ways to improve recovery rates in a mature oilfield by a few hundred basis points. As compensation for its work, Core extracts just a fraction of its value to the operator through its fees, and the customer may be able to realize billions of dollars in incremental profits. 

Core Labs is unique among its oil services peers thanks to its reservoir studies program. Companies pay a nominal fee to participate in an industry consortium—where more than 100 companies may participate—focused on how to best produce a certain reservoir. These studies are an important way for Core to strengthen relationships with a key group of customers while generating a significant network effect. By joining the studies, companies gain valuable knowledge relatively quickly and cheaply, while Core receives important data that the oil and gas firms have paid hundreds of millions, if not billions of dollars, to obtain. The network effect occurs because the more companies join the consortium, the more information Core can offer everyone, and the more value the offering has. Core’s data analysis then provides the consortium with the needed information to properly allocate drilling capital. As reservoir dynamics change, the consortium studies naturally support further analysis of the reservoir and additional purchases of the associated services and equipment from Core. Oil and gas companies seeking the best techniques to exploit a given reservoir and thus generate the highest possible returns are compelled to take advantage of Core’s position as a knowledge leader, by joining Core’s studies and becoming regular users of Core’s services.

 Dassault Systèmes (DASTY) is a market-leading provider of 3-D computer-aided design, or CAD, and product lifecycle management, or PLM, software. Dassault’s solutions allow its clients to design, collaborate, manufacture, and maintain products in a timely and cost-efficient manner. The company’s flagship CAD product, SolidWorks, and leading PLM product, CATIA, are the driving forces behind the company’s success (roughly 60% of group revenue), and a current roster of clients such as Boeing, BMW, Nokia, Nestle, and General Electric highlights the quality of the company’s solutions. Dassault has an extensive education program that trains users from an early stage, high school and college, to be proficient in the company’s tools, which creates a growing network of employees and employers that prefer Dassault products. This growing network of users provides the firm with a positive network effect, as students want to be trained on the software that most potential employers use, and employers want to use the software that most students know.

Key Questions: Network Effect

1. Explain how the value of the good or service increases as more customers and suppliers join the network. Try to provide quantitative proof that value (in real terms) increases faster than the rate of customer or supplier additions (with metrics like sales per user or sales per branch). With companies that truly benefit from the network effect, there’s usually a clear, logical story for how value increases with additional customers and suppliers. Quantitative proof helps solidify the argument
2. How does the company monetize its network? Many Internet companies have powerful network effects in the sense that the value of the service increases with additional users. Unfortunately, companies aren’t always able to charge enough for the services they provide. Ability to sufficiently monetize the network through subscriptions, advertising, or charges provides a return to investors and ensures the company has money to reinvest in its network. Sufficient monetization of the network is a requirement for a narrow or wide moat.
3. Given that the offering’s value increases as the network grows, do the company’s suppliers and customers have strong bargaining power? How much value does the company have to share with its suppliers and customers? Sometimes suppliers or customers have bargaining power because the company needs them to increase the value of the network. If the company is in a weak bargaining position, it may be unable to sufficiently monetize its network. ​

Efficient Scale
Efficient scale describes a dynamic in which a market of limited size is effectively served by one company or a small handful of companies. The incumbents generate economic profits, but a potential competitor is discouraged from entering because doing so would cause returns in the market to fall well below the cost of capital.

This phenomenon especially makes sense when a new entrant would have to sink a lot of capital. To cover its entry costs, it would want a sufficient share of the market, but if the market opportunity is limited, a fight for market share would cause prices to fall and hurt returns for all players in the industry. This barrier to entry relies on new entrants being rational. Knowing this, existing players often set prices that are high enough to generate sufficient returns on invested capital, but low enough to disincentivize prospective entrants. 

Efficient scale differs from cost advantage, because the incumbent firm’s cost advantage isn’t necessarily difficult for a potential rival to replicate. It’s just that the other potential players have no incentive to enter the market, even if they could ultimately achieve the same cost profile that incumbents have. Further, in cases where a specific or niche market is being served by a single firm, it doesn’t make sense to say that the company has a low-cost advantage, because there’s no basis for comparison. 

Often, an efficient-scale business has a high degree of short- or medium-term pricing power. However, the company frequently chooses not to exercise this power to the fullest extent, even though doing so would maximize its current profitability. The business exercises restraint because it does not want to incent a rival to enter its market, which could destroy the economic rents for both players. The ability to exercise pricing power intelligently to influence the size of the “economic pie” in a way to both make sufficient profits and deter rivals is a distinguishing characteristic of efficient-scale businesses.

Pipelines Pipelines are arguably the best illustration of the efficient-scale classification, because these wide-moat companies don’t benefit much from other sources of economic moat, yet they frequently demonstrate an ability to earn economic profits year after year. Suppose there’s a need to move 250,000 barrels per day, or bpd, of crude oil from producing basin A to refining center B, and a pipeline exists that has the capacity to move 275,000 bpd along this route. There is no incentive for competitors to enter; the pipeline is efficiently scaled to the market. Pipelines have the added benefit of not needing to rely on potential entrants to be rational. The pipeline industry is heavily regulated because of environmental and safety concerns and eminent-domain considerations. In addition, regulators prevent the building of new pipelines unless there is a demonstrated economic need to do so. Because of the monopoly status of many pipelines, regulators also control rates but generally allow pipeline companies to earn an adequate return on their capital. This reflects the capital intensity of the business, as well as the regulated rates. However, remember that in our economic moat framework, it’s the sustainability of excess economic profits that matters, not the size of the spread between ROIC and WACC. Because pipeline companies generally secure long-term contracts from their customers, and because there is little risk of technological disruption, these economic profits are very likely sustainable.

Mexican Airports Mexican airports provide another good example of companies that benefit from the efficient-scale phenomenon. These companies own the rights to operate geographic monopolies of airports in Mexico, allowing them to extract high economic profits from their customers. These monopolies resulted from the Mexican government’s decision to privatize the country’s main airports in 1998. As a result, Grupo Aeroportuario del Pacifico, Grupo Aeroportuario del Sureste, Grupo Aeroportuario del Centro Norte, and a privately owned firm were granted concessions to operate the airports for 50 years, significantly limiting competition. In return, the companies comply with the regulation of fees charged to airlines and passengers and make necessary infrastructure investments. To comply with the granted concessions, the private airport operators must submit a master development program, or MDP, every five years to the Ministry of Communication and Transportation for review and approval. The MDP contains proposed capital spending on each airport for the next five-year and subsequent 10-year periods. The Ministry then uses the MDP and other factors to arrive at the maximum rate that operators will be allowed to charge departing passengers. Beyond the intangible asset of the government concession, Mexican airports benefit from the efficient-scale phenomenon because many cities can support only one major airport.

Key Questions: Efficient Scale

1. Define the limits of the market. Is the addressable market finite or are the boundaries blurry? What is the size of the market, and what is the capacity of existing industry players? How many companies serve the industry? Markets that lend themselves to the efficient-scale phenomenon are clearly defined and served by only a handful of players or fewer.
2. What is the cost of entering the market? How much market share would a new entrant have to grab in order to recoup the cost of entry? These questions help assess the economics facing potential entrants.
3. Have potential competitors tried to enter the market and ultimately failed? Evidence of failed entries can solidify an efficient-scale-based argument for a narrow or wide economic moat.

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.