November 2019 – Understanding a “Switching Cost” Moat
An economic “Moat” is defined as something intrinsic, embedded in a business that allows it to charge higher than normal rates over a sustained period which somehow protect it from competitive forces.
There are several different types of moats, but some moats get a lot more attention than others. For example, a Brand moat like Coca-Cola gets far more attention than one that is less visible like a Network moat like Facebook.
A good place to start learning about these Moats is by reading Pat Dorsey’s book called “The Little Book that Builds Wealth” where the author categorizes them into 5 groups:
- Intangible Assets (Patents and Licenses)
- Switching Costs
- Network Effects
- Cost Advantages
In this memo I am briefly going to talk about the “Switching Cost” moat which allows companies like Grainger (NYSE: GWW) to earn higher than normal margins over a long period of time without facing disruption threats from competitors and new entrants to their industry.
Grainger operates in what is classified as the Maintenance Repair and Operating (MRO) supply industry. Companies in this industry supply various products, parts and tools to businesses that are not direct inputs into their customers primary products or services. Rather the MRO suppliers focus on selling things that are meant to support the maintenance and operation of the facilities that manufacture their customers primary products.
It would be a very common mistake to think that this industry is be very susceptible to competition with the likes of companies such as Amazon, or any other online retailer that can manage to mobilize some unskilled labor, set up some warehouse space and fill it with inventory.
MRO companies generally support customers who employ a department of a skilled trades people whose main responsibility is to diagnose and carry out repair work and fulfill work orders. The process of completing work orders can involve diagnosing issues being experienced in mobile equipment, buildings, industrial plants or any other company asset. Often the work that needs to be carried out is directly related to a producing asset where managements primary goal is to achieve as high as a utilization and production as possible.
In these facilities you have a workforce of contractors/employees who work 10-12 hours shifts who execute work orders throughout the day as efficiently as possible. Often these workers must diagnose a problem before they even know what tools or supplies they will necessarily they will need to repair it. This is where an MRO supplier that is embedded on their customers worksites (or at a minimum within close vicinity) comes in handy. Grainger will often set up their own branch on the industrial site to help support it more effectively.
Here are three things that can be attributed to an MRO companies’ moat:
- Minimizing Customers Unit Cost of Goods – A manager of a fleet of haul trucks at a mine wants high utilization of their fleet so that they can move as much of their resource to market as possible. High utilization helps reduce their unit cost to the lowest amount possible by spreading their overhead costs across more units. Having the right tools and supplies on hand is imperative to make this happen. An MRO contractor will own and manage the inventory on behalf of its customers on site often without any direct competition once they have been awarded a contract. Once the company is set up, the MRO supplier has a monopoly on their customers business.
- ERP Integration – Once an MRO company is set up with a customer, it becomes increasingly difficult to get rid of them quickly because quite often the MRO’s inventory is set up in their customers Enterprise Resource Planning system (ex. SAP, IBM Maximo etc.). It takes a lot of effort, time and money, to transition away from one vendor to another once the two parties have been fully integrated through these systems.
- Cost/Benefit Relationship – The products that MRO suppliers sell are low priced in relation to the assets that they are supporting. The price changes of these products generally do not garner much attention from management in terms of cost sensitivity. Of course, the size of the overall contract with an MRO supplier can be quite large, it is hard for a customer to to implement an effective negotiation strategy with a company that has a price list of thousands of items. This strategy makes it fairly easy for the MRO suppliers to pass through inflationary price increases without much resistance from their customers.
The value loss for a business for having an unfilled work order is much higher than the alternative option of shopping around for a less expensive screw where the price savings would be minimal in the grand scheme. So, the incentives that are aligned with the labor that is responsible for diagnosing and fulfilling work orders is not necessarily aligned with saving money or finding the cheapest product available. Their incentives are aligned with closing work orders as quick as possible.
All these things translate to very high switching costs. This is the same type of moat that can be used to explain (for different reasons) how banks manage to keep their customers for a long time. It is important when considering an investment that you think about the decision-making process of the typical customer. This is just one example of a moat that can been found in an “under the radar” company. I will touch on some more of the moats in future memos, so stay tuned.
If you have any suggestions, comments or feedback that you would like to share feel free to email me at alex@StockWriteUps.com.
Enjoy the Journey,