Monday, 6 August 2012

Why moats matter for tech investors

Think different

Microsoft is a company which arouses awe and anger in equal measure.

For the financial analyst awe at its 40% margins. At the unending cashflows which gush from its Windows and Office monopolies. At its $51bn net cash pile (plus the $80bn-odd in buybacks its made over the years).

For the tech lover anger at how it has repeatedly dropped the ball over the last few years. How they had a monopoly on browsers and blew it. How they were doing smartphones while the iPhone was still in sketchup. How they could have bought Google and blew it.

Warren Buffet thought about MSFT differently. For him it was a company which had a royalty on communication. Back in 1997 he wrote

"In effect the company has a royalty on a communication stream that can do nothing but grow.It's as if you were betting paid for every gallon of water starting in a small stream but wiht added amounts received as tributaries turning the stream into an Amazon. The toughest question is how hard to push prices.... Coke is now getting a royalty on swallows; probably 7.2 billion a day if these average gulp is one ounce. I feel 100% sure (perhaps mistakenly) that I know the odds of this continuing-again 100% as long as cola doesn't cause cancer. Bill has an even better royalty"

Put bluntly Microsoft had (and still has, fifteen years later) an enduring position which enables it to charge a tax (let's call it, the Windows/Office licence fee) every time a business wants to use a computing device.

The reason why this royalty has endured so long is because Microsoft has a very big moat.

Why Moats are a feather in your CAP

Moat's are an obsession for Warren Buffet. It's one of the key characteristics he looks for in a business - an enduring competitive advantage which keeps competitors out and allows you to therefore retain pricing power, margins and high returns. As he wrote in his 2007 Letter to Shareholders:

"A truly great business must have an enduring “moat” that protects excellent returns on invested capital.  The dynamics of capitalism guarantee that competitors will repeatedly assault any business “castle” that is earning high returns.  Therefore a formidable barrier such as a company’s being the lowcost producer (GEICO, Costco) or possessing a powerful world-wide brand (Coca-Cola, Gillette, American Express) is essential for sustained success.  Business history is filled with “Roman Candles,” companies whose moats proved illusory and were soon crossed."

Restating this in more coldly financial terms, a business creates value if it generates returns above its cost of capital (the heart of the EVA valuation approach). Over time you would expect returns to be eroded down to the cost of capital, a period known as the competitive advantage period (CAP). A moat is simply a set of circumstances (be it patent protection, an ecosystem or a lower cost structure) which is hard for competitors to replicate and therefore extends your competitive advantage period.

Moats and technology

For technology companies owning a platform and the associated eco-system is the surest way to built a moat around your business. For all of Microsoft's failings over the last fifteen years (and they are many) it has retained an iron grip on the Windows computing platform, particularly in the world of enterprise computing where a combination of complexity, vested interests and sheer institutional inertia makes it very hard to displace.

True with the advent of cloud computing, remote systems and bring your own device, the days of a Microsoft free office may one day come, but that is still a very very long way off (and in the meantime MSFT has enjoyed a spectacular run, as least in terms of cash generation).

Moats are particularly important in technology for reasons which I highlighted in a previous post. Firstly technology companies often generate unusually high returns on their capital because they are asset light, and high growth. This means only a few years extra competitive advantage period can yield significant cash returns. Secondly the competitive landscape in technology can change much more rapidly in other industries as Moore's Law drives faster silicon and new product categories - therefore anything which can give you a material competitive advantage is worth its weight in gold.

A few technology moats

To round this post off, here's an entirely non-comprehensive list of moats in the technology world. Simply ones that occur to me as I write:

  • Oracle & SAP: Massive installed bases for their enterprise applications, where customers pay an annual royalty (let's call it tribute) on their initial licence, and will only ever switch in the direst of circumstances.
  • ASML: The biggest tech company you've never heard of. Near-monopoly position in next-generation EUV manufacturing processes. Bottom line - if you want to build a chip on a next generation process these are the ONLY people who produce the machines you need.
  • Apple: App ecosystem around iOS, particularly on the iPad (warning - it will be interesting to see though how quickly Android catches up. They are already getting there for smartphone apps :-x).
  • Facebook: Network effect of having everybody and their mum (or "and unfortunately their mum"!!) signed up on their platform (along with a vast amount of personal data, pictures and social connections). Also the eco-system of third party apps building on the Facebook platform.
  • ARM: Ecosystem of chip providers (Qualcomm, Samsung, Mediatek, Apple, TI &tc) who go to them for low-power chip designs because a) they are the de-facto standard and b) they are happy to sell neutrally to all comers.
  • eBay: Network effect of being the biggest online auction site - sellers and buyers will both go to where they can find liquidity.

However what's even more interesting (for an investor) than technology moats is when the markets thinks a company has a moat, but it doesn't at all. But that's a story for another day...


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