Not intended to be intended advice. I do own shares in Apple and Mastercard.
In business, controlling the customer relationship is key. If your company is able to earn the role of customer gatekeeper, then your company has leverage over all the other businesses that want to access those customers. One example is the way that Apple inserted itself between wireless providers and their customers. Before the iPhone, people selected a carrier first (back then, there were material differences in signal strength and coverage depending on where you lived) and the phone, often a nondescript handset, was generally an afterthought. Cellphone hardware providers begged carriers to carry their phones. So the carriers held significant power over their suppliers.
Once Apple inserted itself into the equation, customers clamoring for the iPhone no longer cared about who the carrier was or even that much about network quality, they only cared about whether the carrier offered the iPhone or not. For the first four years of its life, the iPhone was only available to Cingular Wireless (now AT&T Mobility) subscribers — this was a huge advantage for them at the time.
Apple now controlled the customer relationship. In essence, Apple had basically set up a giant tollbooth between the wireless carriers and their customers. And Apple being Apple, it was determined to extract a heavy price from the wireless carriers (who had little choice but to pay up). That’s why Apple was able to have the carriers subsidize the cost of buying a $700 smartphone for so many years where Apple got paid upfront for the phone and carriers took on all the financing risk (and slowly got paid back by wireless customers over the course of a two year plan). Apple basically got a free ride for years on the balance sheets and marketing spend of the carriers.
Today, thanks in large part to the carriers’ efforts to sell as many wireless plans as possible (which also resulted in as many iPhones sold as possible), Apple has been able to set up many tollbooths around their most prized asset, iOS users:
- Apple takes a 30% cut from any app purchase because it sits between iOS app vendors and their customers.
- Apple takes a cut for every song, movie, show, book, etc. purchased on its platform.
- When an iPhone owner pays with Apple pay, Apple gets a small cut of the transaction from the bank that issued the underlying credit card.
- By acting as a gatekeeper between iOS users and other companies, Apple collects licensing fees from companies like Google that want their software to be integrated into iOS. For example, over the years Google has paid Apple billions of dollars in licensing fees to be the default search engine in Safari.
So from Apple’s example, we can conclude that it pays greatly to own a chokepoint in front of customer demand or a toll booth on a bridge connecting numerous buyers and sellers.
Some Other Examples Of Tollbooth Businesses
There are many other examples. Let’s go over some of them:
Two Sided Marketplaces (Platforms)
These are by far the most well-known and powerful tollbooth businesses. A two sided marketplace (a.k.a. platform) sits between buyers and sellers. Some examples are eBay, Mastercard, LinkedIn, Apple’s app store, Airbnb, and Uber. Let’s use Uber as an example.
Uber sits between drivers and riders. Uber’s job is to connect drivers and riders, and it takes a small cut for each ride that it facilitates. So if Uber wants to make as much money as possible, it needs to maximize the amount of transactions that take place on its platform. It can do so by scaling both sides of its platform until the network effect takes over.
Here is what I mean by network effect. The more drivers there are on Uber, the easier it is to get a ride (and the more competitively priced the ride will be due to higher supply). Thus, more drivers attracts more riders.
When the number of riders goes up, it attracts more drivers because there are now more potential customers on the platform. And once again, more drivers attracts even more riders. And the cycle keeps going creating a nice feedback loop.
That’s why objective numero uno for platforms is to scale faster than all competitors. Platforms tend to be winner-take-all or at least winner-take-most because the bigger you are, the more of a network effect you enjoy, which means both more money and more growth. Moreover, the added money allows you to reinvest in your platform and make it better or subsidize one (or both) sides of the platform to grow it even faster.
My previous post arguing that Airnbnb’s platform is superior to Uber’s is worth a read if you want to learn more about these types of companies:
Less Obvious Examples Of Tollbooth Businesses
The easiest way to identify a tollbooth business is to imagine the business landscape that the company operates in and figure out whether there exists a bridge that separates vendors from customers. Tollbooth businesses are the ones that either own the bridge or operate a tollbooth on the bridge (and therefore they get to charge everyone that needs to cross).
A less glamorous example of a tollbooth business is Moody’s (or its competitor Standard and Poor’s). Moody’s rates bonds in terms of credit risk. If you want to borrow money in the bond market (by issuing bonds), you will need to pay one of the big three rating agencies for a credit rating (there are a few others but Moody’s, S&P, and Fitch own most of the market). So Moody’s owns one of the main tollbooths on the bridge that connects bond issuers (companies that want to borrow) with bond buyers (investors willing to lend).
Sticking with the finance sector, banks own and operate a few tollbooths as well. The most lucrative one is the investment banking department. Besides direct listings and SPACs, which are the minority, if your company wants to go public, raise money via an equity or debt offering, acquire another company, or get acquired, then you will need to pay up (millions if not tens of millions in fees) for some investment bankers. Investment banks have set up tollbooths all over financial markets and charge dearly.
Realtors are another tollbooth business that I am surprised has not been disrupted yet. It amazes me that despite everything, when I want to buy or sell a house, I have little choice but to pay a realtor 3%.
A few other examples:
- Stock exchanges.
- Western Union.
- Auction houses like Christie’s and Sotheby’s.
Tollbooth businesses at the right price make for intriguing investments because they generally own what Warren Buffett calls an economic moat, which protects them from competition. The evidence of this moat is in the fact that people and companies that desire to transact (a.k.a. cross the bridge) have no choice but to pay the toll.
That said, as an analyst of businesses, we should do our best to understand why the toll booth exists and what key factors protect it from excessive competition and allow it to keep making money. Only by thoroughly understanding this can we avoid investing in businesses whose toll booths are about to be disrupted away.
Lastly, and this is something I plan to explore further in the future, it’s worth giving some thought to how a company can go about building a tollbooth. Off the top of my head, I can think of the following:
- Emerging the victor through years of bitter competition, bankruptcies, and finally consolidation like the railroads did.
- Providing improved transparency into and a much better user experience for what was previously an opaque and inconvenient process like LinkedIn did for job hunters or Uber did for taxis.
- Granted by government regulators like the credit rating agencies.
- Tradition. And by resisting innovation and change via lobbying, politics, relationships, and deliberate opaqueness like the investment banks.