Competition and Economic Moats

If you have been keeping up with the past few articles from investBETA, you now know how to research, pick apart and ultimately model a business in Excel. That is all well and good, but what really brings all of this together is a proper understanding of what makes a good business. You may recall an earlier article on identifying the drivers of a good business for comparison and modelling, though it should come as no surprise that real analysis involves more than just dividing a couple numbers and slapping a multiple on them. To be clear, looking at and comparing key ratios is important, but certainly not the be-all and end-all of analyzing a business. That’s where competition and economic moats come in.

DISCLAIMER: This article references an opinion and is for information purposes only. It is not intended to be investment advice. Seek a duly licensed professional for investment advice.

What Is It?

Competition is the driving force behind capitalism. Resource are limited whilst our wants are unlimited, creating scarcity. This is good for consumers because it means companies are competing to create better and better products for cheaper and cheaper prices. The reason that companies do this is to satisfy as much demand as they can to maximize profits. Looking at it from the companies’ — and shareholders’ — point of view, less competition is better because they can sell products for higher prices and spend less money innovating.

There are two main methodologies of analysing competition that we’ll be going over today, enduring profitability and Porter’s Five Forces. They are both related and should be used in conjunction to understand a business. The most important information that you can extract from them is to what extent a company is a price-setter, as opposed a price-taker. This is called pricing power. A price-setter is a company who has a very large influence over the price of a product in some industry. A price-setter within a monopolistic market is referred to as a price-maker and has virtually exclusive-say as to the price of the product. Price-takers on the other hand have very little to no say as to the price of a product and can only sell as high as the market price. This is characteristic of commodity markets like oil. These are both extreme examples, whereas most companies fall somewhere in the middle.

Enduring Profitability

The average phone price in 2007 was about $200, but in 2008, Apple came out with the first iPhone with a starting price of a whopping $500. It’s been over a decade since then, and today, most iPhones are sold for over $1000, whereas most android phones of the same calibre sell for much less. How does Apple sell for so much yet somehow maintain such high sales numbers? The answer lies in enduring profitability, and more specifically, economic moats.

The term “economic moat” was popularized by Warren Buffett and refers to a business’s ability to sustain competitive advantages over competitors in the long run. This acts as a protection for long-term profits and market share, much like a real moat acts as a protection against intruders from a castle. But just as a moat needs to be managed appropriately to make sure that it doesn’t dry up, so does an economic moat. Managing an economic moat involves reinforcing competitive advantages through steady investment, identifying areas of growth that may undermine advantages, realizing the strategies to capitalize on the business circumstances to the fullest extent, and prevent threats likely to create competitive inroads.

We can group the types of economic moats into a few broad categories, as listed:

1. Supply

Competitive advantages in supply are all about cost advantages that allow a company to produce and/or distribute their goods or services at a cheaper rate than competitors. This may include exclusive/privileged access to materials or, more commonly, proprietary technology or patents. Exceptionally experienced employees or management can also fall into this category. An example of this can be seen with many pharmaceutical companies with huge supply side economic moats for the first several years after developing a drug because of patents. This allows them to have complete discretion over pricing decisions in the market for that drug, making them price-makers.

2. Demand

Competitive advantages from demand come from access to a share of the market that other companies cannot match. This encompasses everything from brand loyalty to customer habit and cost of switching. In the real world, Apple acts as a great case study to exemplify this. There is no denying that they have strong brand loyalty from a large portion of their users, though getting the newest iPhone each year has become something of a habit for its more affluent customer base. On top of all of this, the company has a number of things that add to the cost of switching brands for customers. The first being the proprietary ecosystem of products and services that work together seamlessly such as iMessage, Apple Watch, Apple TV, AirPods, so on and so forth. The second is the implicit cost of losing resale value; the average iPhone retains 70% of its value resold nine months later, whereas the average Samsung phone comes in at less than 40%. Realizing this, many customers resell their current iPhone and use that money to subsidize the cost of their next iPhone, in effect reducing the real cost by more than half in some cases.

3. Economies of Scale

Competitive advantages from economies of scale are fairly self-explanatory. As production volumes increase, fixed costs per unit decline, resulting in the same production process becoming cheaper at a larger scale. Costco greatly benefits from this economic moat. Since they buy products at such a large scale, they reduce the per-unit cost for the manufacturer and can thus transfer the savings to consumers resulting in lower prices. Another added benefit of this is massive pricing power when dealing with suppliers.

Pricing Power in Action

Pricing power exists in not only between b2c (business-to-consumer) relationships but also in b2b (business-to-business) relationships. Going back to the example of Costco, its scale allows it to be in a price-setter position when making large stock purchasing orders, leveraging its position to demand lower prices from suppliers. In an opposing example, we can look at Del Monte Foods, which is a large fruits and canned vegetables producer. They have very little say in the selling price of their bananas because if they sell above the market price, the banana wholesalers will simply buy from another, cheaper producer. Del Monte Foods does not have a differentiated product, nor does it have an economic moat.

That is not to say that you cannot have a good business without a differentiated product, a common misconception. All types of barriers to entry are good for current market players, as it lowers the risk of new entrants. Oil is a commodity product, but that doesn’t mean anybody can get up and start producing oil and drive the industry profit to zero. It is a very capital-intensive business and requires experience and much expertise.

Up until this point, we have largely been talking about economic moats for specific companies within a sector, though many of these same concepts can be applied to entire sectors to analyze their attractiveness for investors. Generally speaking, industries with tall barriers to entry and large economic moats are indications of areas to look for strong businesses. Still, it is important to remember that it possible for there to be growing assets in shrinking industries. A good place to find good research for sector competition and growth is www.ibisworld.com. You should be able to login with a post-secondary institution’s login credentials if you have access to them.

Porter’s Five Forces

Porter’s Five Forces is the most prevalent model for identifying competitive forces in an industry. It comprises…

1. Competitive Rivalry
2. Threat of New Entry
3. Supplier power
4. Buyer power
5. Threat of substitution

1. Competitive Rivalry

This force deals with the number and strength of competitors in the industry, where strength is based upon the rivals’ product quality. Strong rivalry means aggressive under-cutting in price and a large risk of suppliers and buyers leaving to seek lower price and better quality. Such industries generally have smaller profit margins with a larger threat to business profitability.

2. Threat of New Entry

The ability of new players to enter the market can threaten a company’s position. The quicker and easier it is for a new player to enter an industry and gain a foothold (significant market share or consumer awareness), the more susceptible an established competitor is to being weakened. Barriers to entry are what protect against this force.

3. Supplier Power

Suppliers directly affect the bottom-line of a business, so it is important to look at the number of suppliers and cost of switching suppliers for each unique input. The fewer the suppliers and higher the cost of switching, the more each supplier is depended upon, giving them more pricing power. In contrast, a supplier industry with many players and a low cost of switching gives the business being supplied more pricing power.

4. Buyer Power

Customers directly affect the top-line of a business, which is why pricing power can be lost to buyers. Similar to the previous force, a larger number of customers and a low cost of acquiring new ones is the optimal scenario where buyers have little choice. This would mean the company is a price-setter, and can adjust prices with less change in demand. A fewer number of customers with a high cost to acquire each additional one gives buyers the pricing power and makes the company a price-taker.

5. Threat of Substitutes

The final force is based upon the ability of some other goods or services to be used in place of the one being offered. Industries built upon products with no clear substitutes are in a better position to be in charge of pricing decisions and vice versa.

An Investor’s POV

When looking to generate new investing ideas, it may seem a daunting task to conduct large-scale research on industries and eventually pick out a specific player to analyze on a deeper level. The Porter’s Five Forces model offers an outline with which to simplify the process. After picking out a select industry or sector, backing up the large-scale research with a specific analysis on the enduring profitability of the business is great next step. This method can also serve as good guide to reanalyzing current investments and ensuring long-term value.

Exemplar: Pollard Banknote (PBL:TSE)

For some context, you may want to look over the previous article where we built out an operating model and forecast for the company here. Let’s start by looking at Porter’s Five Forces for the overall instant lottery ticket manufacturing sector.

Porter’s Five Forces

Looking at the competitive landscape, we find only a handful of businesses operating in the space, with Pollard Banknote being the largest in Canada and the second largest in the world. This can be attributed to the nature of the industry. These businesses are selling to lotteries, most often government-run lotteries with whom they have built long-term relationships and contracts. The larger printing industry has seen long-term decline, though the specialized segment of lottery manufacturing continues to see long-term growth.

As you might expect, the barriers to entry don’t end there, as specialized industrial printing at such a large scale is very capital intensive and requires a lot of expertise. This is why the risk of new entrants in the space is very low. It would be very difficult and require a large up-front investment to even make a dent in the space even after a number of years, due to the formal RFP process (request for proposal) used in most of the world.

The major raw materials purchased regularly are paper card stock, industrial printing ink, and aluminium which is used in the ticket scratching adhesive. After doing research in these areas, it becomes evident that all three of these materials are sold much like commodities with little volatility or pricing power. On top of this, Pollard Banknote expresses in its previous annual filing that it has decade-long forward contracts with these suppliers, lowering any such risk further.

The contracts that are made with government lotteries tend to leave room for fluctuating consumer demand, though this is less of a problem than one might suspect at first glance. Looking at larger trends from ibisworld tells us that instant ticket lottery demand is actually fairly resistant to economic downturn, but reacts well to increases in disposable income. Fortunately, Canadian disposable income is forecasted to grow at an annualized rate of 2.7% per year. The bad news is that the number of buyers in the entire global market is in the low hundreds due to the majority government involvement. The cost of acquiring more market share is also high because of this.

The threat of substitutes is modest in the space considering the gaining in popularity of online gambling platforms and mobile apps. Many players are developing subsidiaries and methods of capitalizing on these opportunities with things like iLottery. Though, these plans may be in jeopardy from the DOJ’s new interpretation of The Wire Act which may deem all online betting illegal in the United States by lotteries. In any case, this is the most significant downside of the industry from a competitive POV.

Specific Competitive Advantages

The major supply advantages Pollard Banknote posses are in their product mix. Unlike other competitors in the instant ticket production market, they have a lineup of complementary displays, dispensers, and connected website interactivity offerings. All their products become more valuable when they work together seamlessly. Another added benefit is the licensed trademarks it has exclusive rights to for the time-being, including video games, television shows as well as other brand names.

The only real competitive advantage on the demand-side, besides the long-term contracts with lotteries, is the law prohibiting the importing of lottery tickets into the United States from anywhere outside of North America. This is definitely a barrier to entry, though there aren’t any important players operating outside North America regardless.

A recent competitive advantage Pollard Banknote has gained is their new “Tresu” 22-station in line press, allowing tickets to be manufactured at a lower operating cost. The previous modular press has been retooled to be used for smaller test runs where flexibility is important.

Thesis

After looking at all aspects of the lottery manufacturing sector, we find it to be a space with very high barriers to entry and low supplier power. The threat of substitutes exists but overall growth has been steady and indicated high resistance under economic downturn. The main concern in the space is the limited number of buyers. With a handful of major players, the market is saturated though competitors aren’t aggressively undercutting, leaving fair margins for all players. Pollard Banknote, specifically reserves majority market share in Canada and comes in second globally. Competitive advantages are being used effectively but I forecast growth in-line with the rest of the sector, at about 6% per year, slowly declining over the next decade. In the bullish case, if the DOJ stands down and iLottery grows significantly, this may revitalize growth in the longer-term.

Hopefully, this article helped you learn the importance of analyzing competition in adding conviction to your investment decisions. If so, be sure to look over some key takeaways and at some next steps you can take to support us and further your learning!

Key Takeaways

1. For shareholders, less competition is better because the company can sell products for higher prices and spend less money innovating
2. Specific competitive advantages for a company can be understood through an analysis of enduring profitability. These advantages can fall under supply, demand, or economies of scale.
3. Larger sector or industry trends can be analyzed through Porter’s Five Forces, consisting of 1)Competitive Rivalry, 2)Threat of New Entry, 3) Supplier power, 4)Buyer power, and 5) Threat of substitution.

Next Steps

1. Share this article with anyone you think might be interested 🧐
2. Follow me and the InvestBETA publication on Medium for more content like this 😃
3. Go follow @InvestBETA on Instagram for youth-driven investment events and opportunities 📈
4. Connect with me on LinkedIn to hear about my future projects and what I’m up to 🎓