Switching Costs Boost Firms' Competitive Advantage

Time to money; there are significant barriers to customers switching providers or suppliers which give firms such as Pearson and WPP an advantage over their rivals

Morningstar Equity Analysts 13 October, 2017 | 3:29PM
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Switching Costs Chart

Switching costs are one-time inconveniences a customer incurs to change from one product or service to another. Customers typically will not change providers unless the value proposition of doing so more than offsets the implicit costs. Price is not the only determinant of switching costs, as risk, hassle, distraction, psychology, and inertia can also come into play.

These costs occur in a variety of industries, where customers have invested time and money to adopt products or services that are important to their purpose, a dynamic we see in fields such as banking and application software. When switching costs are present, the cost, duration, and inherent risks of switching to a different vendor for a product or service with which the customer is familiar and has invested significant resources are too great to motivate the customer to change. This enables the incumbent vendor to enjoy high customer retention rates and/or pricing power that yield substantial returns on invested capital.

Switching costs are the third most prevalent source of competitive advantage - or economic moat - in our coverage universe, applying to 21% of the companies we cover. Although we occasionally observe switching costs in isolation, they pair with other moat sources far more frequently. Most commonly, they are accompanied by intangible assets and cost advantage.

Great Friction Lessens Chance of Switching

One of the core tenets of switching costs involves friction. The more potential friction if a business or consumer moves away from a product or service, the less likely they are to switch. For investors, however, quantifying the true cost of switching can be challenging, as customer lock-in can manifest itself in several ways.

The customer bears some inherent cost of switching to a different product or service, as they must invest some finite resources to use or consume said product or service. However, the new supplier also bears responsibility. It is not enough to merely offer a comparable product or service to the customer in a switching cost industry, as the customer's inertia with its existing solution will be too great to overcome. 

The new supplier or vendor must provide a solution that places the customer in a clearly superior position versus the incumbent solution, while retaining pricing power to overcome the incumbent's inertia and mitigate the customer's friction when switching products, a tall order for any market where customers incur significant switching costs. For this reason, using price cuts to incentivise switching can often prove ineffective, as the new supplier would need to offer incredibly attractive terms to incentivise a locked-in customer to switch, ultimately leaving the supplier exposed to dilutive returns on invested capital.

8 Reasons Not to Switch

We believe there are several switching cost characteristics that can ultimately support an economic moat or competitive advantage:

Significant Monetary Investment: As the capital required to research, vet, and consume a product or service increases, customers become less likely to purchase an alternative product or service from a different vendor. 

Significant Time Investment: Time is a precious, finite resource for both individuals and companies. The more time an entity invests in a product or service, be it via testing, implementation, user training, or merely enhancing familiarity via use over time, the less likely a customer will be to switch

Risk Aversion/High Cost of Failure: In many cases, customers will fall back on the adage of "if it ain't broke, don't fix it." Solutions that are familiar and reliable are likely to keep a customer from running the potentially costly risk of adopting a new solution. This is particularly true when it involves functions with a high cost of failure, a risk that often occurs in the creation or production of a product or service.

Industry Standardisation/Lack of Viable Market Alternatives: It is not uncommon for certain products or services to achieve "industry standard" status, and in some cases, this leads to a vendor creating a product or ecosystem that is difficult for a customer to leave. Industry standardisation can occur based on broad customer familiarity with a product or service, or if the product or service continually proves itself superior to market alternatives, resulting in "best-of-breed" status.

Razor/Razor Blade Dynamic: Companies that can create complementary recurring revenue streams after selling a related product stand a strong chance of retaining those customers. We see this dynamic with products that require maintenance contracts or very specific replacement parts.

Multiple Customer Touchpoints: Firms that can successfully cross-sell, upsell, or deliver a bundle of services into their customer base stand a stronger chance of retaining that customer, particularly if those products are interrelated in some way. These bundles could ultimately tip the scales to incentivise the customer to both adopt a product or service and commit to it for a longer period of time.

Mission Criticality of a Product or Service: Product or service criticality is generally found in enterprise settings. Enterprises that consume or rely on products that sit near or support core functions of the business are difficult for a rival to replace. 

Long Product Upgrade Cycles: Products that require long periods to go through redesigns and upgrade cycles can prevent customers from switching, while the components that go into that product are unlikely to change in the interim, creating a beneficial position for the suppliers of those components. For example, an auto manufacturer is unlikely to make sweeping changes to the design and input components of a vehicle year to year; it is more likely they will utilise a fairly uniform design with known components over a multiyear period, making only moderate changes during the life of a vehicle programme.

Our industry-specific analysis highlights the unique industry dynamics at play and how that helps the companies within each sector:

Automotive Parts

Economic moats of automotive part suppliers such as GKN (GKN) are usually based on a combination of cost advantages, intangible assets, and switching costs. Their switching costs tend to be based on their close ties with original equipment manufacturers, and suppliers are usually involved at an early stage of the Original Equipment Manufacturer (OEM) product development. From the beginning of development through production life, vehicle programmes generally last between seven and 14 years, during which established suppliers face low risk of being replaced by a competitor. 

Auto parts customers would incur prohibitively high switching costs should they decide to withdraw business in the middle of a vehicle programme, especially when a complex, highly engineered, critical vehicular system is being supplied.

Costs for switching to another supplier include, but are not limited to, the substantial lead time and investment to develop and validate a new system; the potential for production disruptions during transition; the cost of moving large, expensive heavy equipment and tooling in instances where the customer is the owner; lengthy time to develop the competing supplier's product to customer specifications; and preproduction validation to ensure process and product integrity.

The whole course of changing a critical supplier might cost an OEM as little as a few million dollars to as much as $1 billion, because of engineering investment; a potentially immense amount of capital for tooling as well as facilities; and long lead time, including preproduction validation.

There is also a switching cost element to an automotive supplier's integral engineering relationships with its OEM customers. Having long-standing engineering relationships supports faster, more responsive development, as supplier and customer engineering teams already have a degree of cohesiveness from working together on past and current projects. Whenever a vehicle launch is delayed, OEMs risk underutilising highly capital-intensive manufacturing facilities, resulting in higher costs and lower returns. In certain circumstances, launch delays for new models could also result in fines from governing bodies around the world. The strong relationships between suppliers and OEMs create incumbency and lead to a high probability that the supplier will win contracts for subsequent products.      

Hotel Operators

Switching costs and intangible brand assets are the primary sources of hotel companies' narrow economic moats. Companies such as London-listed International Hotels Group (IHG) that manage and franchise their brand and business model have sticky long-term management and franchise agreements, typically 10-to-30 years in duration, which have high switching costs for the franchisees.

Termination of these contracts requires significant expenditures to renovate and rebrand a property to meet new brand specifications, results in a disruption to business operations for the franchisee, and leads to termination fees that must be paid by the franchisee, typically around two to three years’ worth of average monthly management fees, plus the previous year’s incentive fee.

The long duration of contracts, as well as low attrition among franchisees, has historically enabled the large hotel operator/franchisors to generate excess returns. Additionally, hotel operator/franchisors benefit from brand intangible assets. Business and personal travellers typically seek out brands they already know when staying in a location they have not stayed in before.

As a result, branded chain hotel companies are typically able to capture reduction in search costs and reputation for a reliable and consistent experience through higher room rates than boutique hotels of similar quality. Additionally, private operators looking to franchise and outsource management capabilities aim to join established brands that can drive strong revenue and profitability.

We believe alternative lodging options, such as apartment and home rentals, will continue to grow. Other key determinants of deciding the duration of a lodging company's economic moat are the average length of the company's contracts, loyalty programme engagement, and room mix. Hotel contracts can range from 10 to 30 years, with most shorter than 20 years; thus, it is difficult to have confidence that returns will persist beyond 10 years.

In addition, asset-light hotels tend to have sizeable reward networks, but only a fourth of members are active, which highlights the intense industry competition and the weak switching costs associated with reward schemes. Finally, while exposure to updated design in select-service and lifestyle brands can position a company well with the increasing mix of millennial travellers, this demographic is a heavier user of alternative lodging options.

Advertising Industry

The global advertising industry is dominated by the "Big Five" advertising agencies - WPP (WPP), Omnicom (OMC), Publicis (PUB), Interpublic (IPG), and Dentsu (4324) - which collectively comprise around 30% of the global advertising agency market. The primary source of competitive advantage for these companies is intangible assets based on brand equity, reputation, and consumer data - which is accumulated by managing and tracking the performance of campaigns. We believe this data, along with data provided by third parties, helps these firms analyse campaigns' returns on investment very quickly and provides a competitive advantage over smaller advertising agencies.

In addition to intangible assets, we believe the large advertising agencies also benefit from switching costs based on strong client relationships and integration with client marketing departments and business processes. The large agencies have global footprints that enable multinational clients to develop globally coherent advertising strategies, which small advertising agencies are unable to provide. The large agencies also provide a wide range of services that can meet all of their clients' advertising requirements, whereas small agencies typically fulfil only part of clients' total advertising needs.

The large agencies are also sufficiently large enough to dedicate employees directly to meeting their large clients' advertising needs, which often means becoming embedded in product life cycles. Integration of advertising processes with enterprise software applications - such as customer relationship management and marketing systems - and product research also creates switching costs. However, the traditional advertising agencies are facing competition from technology and consulting companies that are expanding beyond their original digital remit.

Publishing Companies

Economic moats in the publishing industry have similarities to the advertising industry in that both industries depend on intangible assets and switching cost moat sources. However, the technological disruption of the publishing industry means it has developed particularly strong switching costs based around proprietary information platforms. 

Switching costs in the publishing industry exist because of four key factors. First, clients often need to be trained on a particular system, and the subsequent familiarisation with that system means users are reluctant to switch to an alternative provider without good reason to do so. In addition, services often have few - if any - comparable services, meaning users may have few or no real direct comparison system with the same features, functionality, and content.

Customers of companies like Pearson (PSON) may also sign multiyear agreements locking them into a particular provider. In addition, services usually comprise a small proportion of customers' total costs, and clients have a low propensity to switch away from systems that work when there is little to be gained financially. Publishers' information platforms often do not have proprietary intellectual property, but the accessibility and the familiarity of clients with the platforms create switching costs. 

From a return on capital invested (ROIC) perspective, the publishing industry generates relatively high ROICs because it is a capital-light industry in general, with assets often comprising internally generated software. However, ROIC including goodwill is much lower, which reflects the consolidation of the industry to acquire strategic assets and achieve economies of scale as incumbent publishers repositioned their businesses to defend against technological disruption. 

10 and 20 Year Timescales

Switching costs are the third most prevalent source of competitive advantages in our coverage universe of 1,500 companies, and in many industries, they represent the strongest, clearest source of competitive advantage. However, switching costs rarely exist in isolation; 88% of switching cost companies boast a secondary moat source, most frequently intangible assets. To ascribe a specific moat source to a company, we require that it be able to hold up on its own merits if any other moat source were to erode.  Morningstar analysts assign economic moats based on the sustainability of economic profit generation rather than the magnitude of economic profits. Around 850 of the 1,500 companies we cover have such a competitive advantage.

More specifically, Morningstar's narrow-moat designation – which signifies a small competitive advantage - reflects an analyst's high degree of certainty that a firm will generate economic profit 10 years from now but not 20 years from now. A wide-moat designation – or significant competitive advantage - requires near certainty that excess normalised returns will be positive 10 years from now and that excess normalised returns will more likely than not be positive 20 years from now.

 

 

 

The information contained within is for educational and informational purposes ONLY. It is not intended nor should it be considered an invitation or inducement to buy or sell a security or securities noted within nor should it be viewed as a communication intended to persuade or incite you to buy or sell security or securities noted within. Any commentary provided is the opinion of the author and should not be considered a personalised recommendation. The information contained within should not be a person's sole basis for making an investment decision. Please contact your financial professional before making an investment decision.

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Morningstar Equity Analysts  Morningstar stock and fund analysts cover 2,000 mutual funds, 2,100 equities, and 300 exchange-traded funds.