• US Equity

    Moats with efficient scale boast few competitors

    Brett Liddell, CFA
    11 October 2017
     

    "How Moats Translate into Sustainable Competitive Advantages" is a five-part moat investing education series that explores the primary sources of economic moats. The idea of an economic moat refers to how likely a company is to keep competitors at bay for an extended period. According to Morningstar Equity Research, there are five key attributes that can give companies economic moats, and which are viewed as sources of sustainable competitive advantages: 1) Network effect ; 2)  Intangible assets ; 3)  Cost advantage ; 4)  Switching Costs ; and 5) Efficient Scale.  Here we explore the concept of "Efficient Scale."

    Efficient scale: Think natural monopoly

    Virtually every company dreams of a market with few competitors. An environment with only a handful of business rivals can become one where efficient scale is possible. An example is an airport.  This is because few cities can support more than one major airport as the financial incentive to compete with an existing airport does not exist because, due to limited demand, reduced market returns may not justify the initial capital necessary to build another airport.

    Efficient scale commonly applies to companies involved in telecommunications, utilities, railroads, pipelines, and airports. Here is how Morningstar defines it:

    Efficient scale
    Efficient scale is a dynamic whereby a market of limited size is effectively served by one or a small handful of companies. In many of these situations, the existing players earn economic profits, and a potential competitor is discouraged from entering because market entry would cause returns in the market to fall below the cost of capital. Companies that benefit from this dynamic are efficiently scaled to supply a market that is only "juicy" enough to support one or a few competitors, which limits competitive pressures. Additionally, for efficient scale markets, market entry often requires very high capital costs, which are not justified by the limited profit potential a new competitor might achieve.

    Efficient scale often means a "narrow" moat

    Across the five moat sources (network effect, intangible assets, cost advantage, switching costs, and efficient scale), efficient scale is the most likely to drive a "narrow moat" rating from Morningstar. This rating is driven primarily by utilities companies, many of which warrant a moat rating due to efficient scale but may be limited by government regulation. Returns on invested capital for efficient scale companies tend to be only modestly above capital costs, which makes it difficult to have a high degree of conviction that a company will continually generate economic profit 20 years from now. Efficient scale is, therefore, the least common moat source among "wide moat" rated companies and only slightly more common among all wide and narrow moat-rated companies. But, efficient scale can be powerful.

    Economic Moat
    Five Sources of Sustainable Competitive Advantage

    Five Sources of Sustainable Competitive Advantage

    Source: The Morningstar® Economic Moat Rating System.

    Efficient scale in action: Two case studies of moat companies

    To demonstrate the power of efficient scale in creating ‘wide economic moats’, we highlight two companies: CSX Corporation and UPS.

    CSX Corporation (CSX US) has a ‘wide economic moat’ rating from Morningstar based on cost advantages and efficient scale. CSX is based in Jacksonville, Florida and is a premier rail transportation company with a market cap of nearly US$50 billion. CSX operates in the Eastern United States and controls 20,800 miles of track, hauling coal products, chemicals, intermodal/shipping containers and other merchandise (such as forest products). Writes Morningstar, "The network of track and assets Class I rails have in place is impossible to replicate. CSX spans the densely populated Eastern US, capturing about half of the rail volume in the region. Its rights of way and installed track form a nearly impenetrable barrier to entry."

    United Parcel Services (UPS US) earns a ‘wide economic moat’ rating from Morningstar from efficient scale, cost advantage, and the network effect. Morningstar writes, "The company crafted its moat by assembling an integrated international shipping network unlikely to be matched by any but a few global players. Extensive express, ground, and freight networks demand a huge quantity of trucks, trailers, terminals, sorting equipment, drop boxes, IT systems, and skilled labour. Replicating these assets in the absence of ample package flow would be costly, and few entities would endure the financial losses during the necessary density-building phase." UPS is the world's largest parcel delivery company and delivers on average 19 million packages per day around the world.


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