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What Makes a Competitive Advantage Durable?

- By Geoff Gannon

Someone emailed me this question:

"How do you think about sustainability of a company's competitive advantage?"

This discussion is going to get pretty theoretical. I'll try to use examples where possible to keep it grounded. The simple answer is that competitive advantage tends to dissipate over time to the extent other companies - rivals of the company you are looking at - pursue the same strategy. For that reason, you want to find situations where rivals either can't or won't pursue the same strategy as the company you're looking at. Let's start with something like Coca-Cola (KO).

Richard Branson had a smart thing to say about Coke's advantage on a podcast ("How I Built It" on NPR). He said that while Virgin Cola might be able to have a narrow taste advantage and a narrow brand advantage (in the U.K., at least), it could never have a big advantage in either taste or brand because generally people like the taste of Coke and people think well of the brand.

It was much easier for Virgin to target entry into the airline business where generally people didn't like the quality of British Airways' service, and they didn't like British Airways' brand. The current offerings in the airline industry were inadequate. Coke is adequate. Honestly, this is usually one of the most durable competitive advantages. If you produce a commodity type product - and essentially cola is a commodity that anyone can copy the flavor of - then the incumbent just needs to be adequate.

I often use the example of Google. Google is the default search engine that most people use. Most people don't try different search engines and compare them. Google's search engine doesn't need to be the best to keep people searching anymore. It just needs to be adequate. It's difficult for search engine users - unless they are directly comparing searches on different engines - to be aware of the inadequacy of a particular search engine. Google has a lasting competitive advantage in search even if it doesn't have a particularly good search engine. By the way, I'm not saying Google's search engine is bad. I'm just saying that a slightly better search engine wouldn't be more popular.

The inability to compete away the incumbent's customers is a strong form of competitive advantage. People overlook this with Coca-Cola. I've heard many investors say that you can't raise the price of Coke in a vending machine from $2 to $3 a bottle and sell the same amount. No, of course you can't. That's not the point. The point is that there are only two companies - Coke and Pepsi (PEP) - who would ever be allowed by the management of a hotel, apartment building, dorm, etc., to put a vending machine in there regardless of what the price was. Even if I have a portfolio of brands and say I want to charge $1 a bottle, the management company won't put my vending machine in there. A restaurant won't sell my fountain drinks for 50% off Coke or Pepsi products.

That's not true in a lot of industries. In a lot of industries, you can compete away some customers with even slight - like 5% - price discounts. It's hard to get placement for any soda that isn't owned by Pepsi or Coke at even 50% discounts. No one wants to give you floor space for your vending machines, no one wants your soda fountain, and no one wants to give you shelf space. Without availability, it doesn't matter if you had $1 billion a year to spend on TV ads. People don't order soda over the internet. They drink it in movie theaters and restaurants and buy it from vending machines and get it by the case in grocery stores. If your product isn't able to get in those places, it's not going to get into customer hands.

So you can't compete on price in soda. What do you do? Compete on taste. That's impossible. The flavor profiles of the main brands in the portfolio of drinks these two companies distribute is really commoditized and really mass appeal. You can choose between orange soda from Minute Maid or Fanta. You can choose a lemon lime drink from 7UP or Sprite. You can choose a cola from between Coke and Pepsi. There isn't much difference. If a customer isn't indifferent to the two products at the same price, it's because of their own past history with the drink or with the way the brand is positioned. It's not with the taste of the product.

This is very different from when I go and order a beer. Some of the same beers carried at a bar, restaurant, etc., have aggressively different flavors. There are some flavors - not the ones I happen to drink - that will appeal to a very large audience. Those products scale really well. But I don't like the taste of those beers. I don't have a problem with the brands. I have nothing at all negative to say about the Corona brand or the Dos Equis brand. I enjoy some of the ads those companies have run in the past. Their brands are probably pretty well positioned to sell to me. They are offered at the right price. They are available wherever I drink beer. And yet I never drink them because they just lack the kind of flavor I look for in a beer.

This isn't true in cola. It's easier to segment the market in beer by what the drinker is looking for than it is in cola. This means that - despite their tremendous distribution advantages - some major beer companies are exposed to competition from rivals like Boston Beer (SAM) and smaller craft brewers. Over time, they may just buy these rivals up the way soda companies tend to do. Big beer brands are very durable, but they aren't as durable as big soda brands. Let's stay with the alcohol example and compare wine to vodka. Which product - if it has the leading brand - will have the more durable position? It's clearly vodka. The difference in taste between vodka of similar cost is not great compared to the huge differences in taste between wines of the same cost. It's possible to compete aggressively on taste in wine. It's hard to compete on taste in vodka. You need to compete on brand, availability and price.

Competitive advantages usually have historical roots. There's nothing special about Coke or Pepsi really. It's just too late to compete with them now. Maybe there was something special about Google as a search engine. Maybe there wasn't. I remember searches before Google. And, yes, I eventually switched to using Google because I found their search results more helpful. It did matter once. I found it pretty hard to imagine that, if there was Bing and no Google now, Google would win me over with its searches.

This is why all banks and all ad agencies have competitive advantages. Every bank and every ad agency has a competitive advantage with regard to existing customers. It is hard to compete away a bank customer by offering higher interest rates. It is hard to win over a satisfied client of another ad agency. In both cases, a switch is usually the result of something the company with the customer messes up. Very few people leave one bank for another unless they were unhappy with their first bank. You can run a ton of ads saying you have lower fees, better customer service, etc., than the bank across the street. You're not going to take happy customers away from them.

The durable competitive advantages I've discussed above are the most common ones you'll see. From time to time, you'll come across some weirder ones. I own a stock called BWX Technologies (BWXT). It has durable competitive advantages. However, those advantages are unusual. They are the result of the projects Babcock & Wilcox (BW) works on being tied to nuclear, which is essentially a once hot and now long-ignored tech, and tied to work for a huge, single customer. That customer is the U.S. federal government generally and especially the U.S. Navy.

The U.S. Navy has some important projects - aircraft carriers, intercontinental ballistic missile subs and attack subs - that run on nuclear power. They don't build versions of these ships that don't run on nuclear, and, generally, no one builds other kinds of ships that run on nuclear. Very few countries have aircraft carriers, missile subs or attack subs that run on nuclear. Many of these countries aren't especially friendly with the U.S. To ensure you can have a continuous and economical program for these projects you need to provide continuous work to at least one manufacturer. No one wants a lot of these things. The U.S. wants more of them than anyone else. This naturally leads to a situation where you are going to have one seller (Babcock) and one buyer (the U.S. Navy).

Also - because this benefits the economics of both the buyer and the seller - you're going to have a steadier build rate for these things than you otherwise would. I consider BWX Technologies and the U.S. Navy to be mutually dependent. Yes, essentially BWX's entire business depends on the U.S. Navy continuing to order these ships. Essentially the U.S. Navy's entire advantage over other navies depends on BWX Technologies being able to provide the nuclear-related components for these ships. There's obviously a growth limitation here. BWX won't be able to do work for smaller and emerging naval powers who want a nuclear navy. On the other hand, there haven't historically been other customers who provide enough demand to keep a naval nuclear components manufacturer in business if that company doesn't have the U.S. Navy's orders. There's a barrier to entry here in the sense that you don't have a survivable niche to start from.

What new entrants in any market need is a safe, secure beachhead to start from. They need a way to get into the industry, learn how to do things, etc., while not bleeding cash. This is what I call a "survivable niche." You need a customer, a market segment, etc., that will try you out over a competitor and provide you enough profit to let you stick around. Not all industries have that. There's no survivable niche in building shipboard nuclear reactors. It's basically winner takes all.

There aren't really very good survivable niches right now for businesses in direct competition with Google, Facebook (FB), etc. The problem there is that those industries attract firms that have the will but not the way. Even if there is no way to make money in search engines because Google has the entire profit pool, there are big corporations willing to try. It's generally best to find industries where there is neither a will nor a way to compete. Even a hopeless attacker can do some damage to an incumbent firm.

I don't think many companies could replicate the expertise that BWX Technologies has in shipboard nuclear reactors. But, beyond that, I don't think there are many firms that want to try. About 50 years ago, nuclear was an exciting technology. It's a dull, antiquated technology today. It only makes headlines when those headlines are negative. A nuclear business isn't going to attract a lot of new competition.

A lot of firms that eventually do damage to the market leader start out in a small part of the market. Their best attack site depends on the structure of the industry. By far the easiest is geographical segmentation. This is how Boston Beer survived in competition with the major U.S. brewers. It didn't go national for a really long time. It got local distribution in one city and then one region of the country.

If Boston Beer had tried to get into supermarkets nationally, it would have failed instantly. But it launched a concentrated attack on a very, very small geographic segment of the market. That's usually what works. Even Virgin Cola was successful in that respect at first. Virgin Cola was only really destroyed once Branson caused enough commotion that Coke used its market power to tell the retailers it was selling to that they had to pull Virgin from their shelves or else. Firms with tremendous market power sometimes use those threats to eliminate all new entries.

A good example of this , according to a lawsuit, is Plantronics (PLT). Plantronics is the preferred supplier of headsets to call centers. Plantronics has long been the best headset maker in the U.S. Companies that supply call centers with equipment want to supply them with Plantronics products. However, they would, if given the choice, probably like to sell Plantronics products alongside competing products. A competitor of Plantronics alleges that Plantronics has robbed its customers of that choice. It's insisted on exclusive distribution. Because of Plantronics' market position an exclusive distribution agreement is effectively a death sentence to a rival because the hurdle that rival now has to clear is being preferred as the exclusive source of equipment over Plantronics. I'd say the Plantronics example is not durable for legal reasons.

Swatch (UHRN) also has an enormous competitive advantage in Swiss watches. Swatch has economies of scale that almost all of its competitors lack. There are only about three companies in Switzerland that can be at all independent producers of large quantities of watches. The vast majority of watchmakers depend on companies like Swatch - actually, it almost always is Swatch itself - to supply them with critical components. Swatch has - in the past - agreed not to make the fairly rational if ruthless decision of simply cutting supplies to any competitor that annoys it and thus putting that competitor out of business for good.

If Swatch cut off the supply of critical components, Swatch's rivals would need to invest in significant capex. Many of them would be unwilling or unable to come up with the cash needed to do this. They'd go out of business. I'm not saying no one would survive, but I am saying you'd need to have a lot of mergers and a lot of additional capex just to have a supply of what Swatch had been providing externally.

As I said, Swatch has agreed not to use this market power. It would be extremely harmful to the Swiss watch industry as a whole if Swatch ever freely exercised the clout it has as a supplier. This situation sometimes happens when a company's competitors use that company as a supplier.

In the U.S., Tandy (TLF) is in a similar position in leathercrafting retail. Many of Tandy's smaller rivals actually depend on Tandy for supplies of some of the things it sells. Again, this is an economies of scale issue. Tandy can often order 20 times what the rival would order of the same stock-keeping unit. You just can't do that economically. There will be a dominant design for a given product and that design will be whatever Tandy orders.

It makes sense for a small rival of Tandy to simply buy the product from Tandy and sell it on to its own customers than to try to get its own separate supply of the product or simply not carry it. Retailers often have to carry products where they are in a bad bargaining position. It doesn't matter if your supplier of batteries, razor blades, etc., can really demand a high price from you or not. General retailers can't afford not to carry batteries and razor blades, and it's very hard for them to find any sort of private label solutions. It's not impossible, but it's not good. Retailers who have gone the private label route have often found that they simply became dependent on the private label provider. Walmart (WMT) learned this with Cott (COT). Walmart terminated a 10-year exclusive distribution deal with the company. Many years later, it continues to buy from Cott.

Are economies of scale always a durable competitive advantage? No. They may not be in very fast-growing industries. A company like Western Union (WU) has a scale advantage over a company like MoneyGram (MGI). Basically, Western Union signed up more agents than MoneyGram. The economics on a per agent basis need to be the same for agents to be indifferent to who they sign up with, but it's possible for the network operator to get better and better results - basically, lower and lower costs per transaction - simply by signing up more agents.

This presents a real problem. It puts pressure on all companies that aren't the largest to grow as quickly as possible. They need to do this because failure to grow as quickly as the market leader will just make your relative cost position worse every year. Sometimes this makes the smaller rival sacrifice profitability to increase growth. MoneyGram may offer a higher signing bonus to agents than Western Union would, MoneyGram may offer agents a little higher share of the commission, and MoneyGram may even try pricing its services below Western Union to stimulate additional transaction activity. Any of those three actions can become permanent handicaps. Agents may expect bigger signing bonuses, agents may expect higher commissions, and customers may assume that MoneyGram should always offer the same service as Western Union at a lower fee. These can become permanent positioning decisions even though that's not how they were intended.

Brands tend to be pretty durable. Economies of scale tend to be pretty durable. But what we are talking about in these examples are basically "consumer commodities." Coke and Western Union are brands that are trying to influence the decisions of large numbers of individuals. Those individuals don't - because they aren't an organized group - have the power to bargain with these companies over things like price. But they also - because of what these products are - tend to still buy as a group.

It would be odd for some people to strongly prefer Western Union over MoneyGram or to strongly prefer the taste of Pepsi over Coke. This is why the economies of scale are possible in the first place. It's a mass popular product. It doesn't have appeal to a specific group. It can appeal to everyone. This is probably what Warren Buffett (Trades, Portfolio) sees in Apple (AAPL). The iPhone can have a similar durable competitive advantage to something like Coke or Google. Apple now has huge economies of scale, network effects, a well-known brand, etc. It is in a position where as long as it is adequate it should be able to keep a huge part of the market. It doesn't need to differentiate itself from competitors. It just needs to not annoy the masses.

In the future, people probably won't consider buying phones from anyone but Apple unless they are dissatisfied in some way with their existing iPhone. The mission at Apple no longer has to be about winning converts to the brand. The mission is now just being adequate enough to keep existing customers satisfied enough not to roll the dice on an alternative. The way phones work - where someone wants to have only one - makes switching very unlikely. Switching is a lot more likely in cases where you can give a little of your business on a temporary basis to a competitor.

I might switch which beer I drink because I have nothing to lose by trying any competing beer just once. I'm not going to try competing phones just once. The truth is that I - like most people - will never really know how most phones "taste." I'll never give another phone a chance. That's the most durable competitive advantage of all. When your customer doesn't want to try a competitor's product - that's a durable competitive advantage.

Disclosure: Long BWX Technologies.

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