Is high-flying Apple Computer losing its cache? At a Wednesday presentation discussing business moats at the Morningstar ETF Conference in Chicago, the computer company with its once? dominating strong network effect with the iPhone, and long appreciated for its product innovation, was questioned on a going forward basis as a panel considered the impact of the unique competitive advantages “moats” offer investors.
Five fundamental moat factors include intangible assets, cost advantage, strong network effect, efficient scale, switching cost
Andrew Lane, Chairman of Morningstar’s Moat Committee, looks at Apple Computer the way one might look at 5 day old flowers in a vase.
When Apple first launched its iPhone, for instance, the product was clearly unique among peers – in fact, some early adopters considered that it didn’t have peers. But as technology has increasingly leveled the playing field, Apple’s “moat” has gone from wide to now narrow, Lane says. Moats matter because they provide a company pricing power and the ability to generate strong revenues.
“When the iPhone was first launched, the feature differences were significant,” Lane said, with a strong network effect providing a moat along with switching costs also providing the firm loyal customers willing to pay a high price for the product. “Look at the product features today. They really are not that much different in meaningful ways.” The camera might be margionally better, for instance, but the overwhelming gap with the competition on features is closing, he said. With a moat closing, competition could increasingly be based on price, which could influence profit margins.
A strong network effect that gets customers hooked into a product family in part based on the widespread adoption, one of five primary moat factors Lane considers. Examples of a network can be found in Facebook, which has a wide moat due to the size of those who use the network. A competitor would be required to not only create the same technology, which can be replicated, but the key to competing with Facebook would be obtaining mass user adoption. If friends don’t see posts, the point of social media is lost. Visa and MasterCard also have wide moats for different reasons. In this case, it is due to the networking effect of their credit processing system being widely accepted by retailers.
Switching costs were the issue Lane mentioned most as a moat factor. He cited manufacturers who provide mission critical parts to airplanes as having a high switching cost because if a failure occurred the costs would be significantly higher than any potential savings achieved by switching.
Use strong network effect, efficient scale as well as ROIC, a quantitative measure, to define moat
Efficient scale is another factor driving moat success. Erin Lash, Morningstar’s defensive analyst, notes that Kroger, a beaten up grocery store retailer, has achieved efficient scale and may be a value in part due to the extensive data it has on its consumer. Further, the company, which was hard hit when Amazon announced its acquisition of Whole Foods, has a strong brand, part of an intangible asset value that helps create a strong moat.
The fact the stores also have gas stations, much like Costco, also can provide a cost advantage by selling gas as a lost leader to obtain store traffic.
Lane notes that not only are their five fundamental factors that determine a company’s moat, but also quantitative factors come into play. He likes to look at Return on Investment Capital as a metric to determine a firm’s moat. While considering this number is helpful, it is further meaningful when modeling is extended into the future.
This is how Erin Lash, Morningstar’s consumer defensive analyst, justifies Amazon’s moat which certainly has a strong network effect with its addictive products like Amazon Prime. While the current ROIC analysis is poor, as the company solidifies its grip on the retail market its moat will be better represented in financial numbers such as ROIC, Lash noted, looking forward with the quantitative indicator.
While most corporations with significant moats are large cap stocks, Lane says a company’s size does not necessarily infer it has a moat. Likewise, just because a stock does not have a wide moat doesn’t mean it will not deliver performance.
Chris Higgins, Morningstar’s Industrials analyst, points to the 12 large steel companies, which are cyclical in nature and have generated significant returns in the past, as “having zero moat” and certainly no strong network effect but still providing investors value.