Switching Costs Build Moats and Retain Customers

"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 "Switching costs."

Customers get locked-in by switching costs

Many successful companies build customer loyalty by offering high quality products and/or services. Some also have the unique advantage of integrating their products or services into a customer's daily activities and operations, therefore making it tough and costly to switch providers. Powerful moats can be built on "switching costs" which are often embedded in strong business models. Switching costs lock customers into a company's unique ecosystem and make it expensive to move. Not just monetary in nature, switching costs can also be measured by the effort, time and psychological toll it takes to switch to a competitor.

Switching costs have the potential to put a company in a position to increase prices and deliver hefty profits over time. They are a key competitive advantage and are evident in a range of industries, from camera equipment to computer software/hardware to telecoms, among other things: Nikon or Canon? Apple or PC? AT&T or Verizon? Morningstar Research explains them as:

Switching Costs. When it would be too expensive or troublesome to stop using a company's products, the company often has pricing power. Architects, engineers, and designers spend entire careers mastering Autodesk's ADSK software packages, creating very high switching costs.

An early example: Gillette razor blades – designed to create brand attachment

King Camp Gillette, the inventor of the first mass produced safety razor, was one of the first entrepreneurs to optimise the switching cost approach to lock in customers. In 1902, Gillette developed and began selling inexpensive razors with disposable blades that he had patented. This ensured Gillette a constant high demand for blades, as customers who considered other blades quickly realised that they would incur the cost of a new razor as well.

Economic Moat
Five Sources of Sustainable Competitive Advantage

Source: The Morningstar^® Economic Moat^™ Rating System.

Switching costs in action: Two case studies of moat companies

To demonstrate the power of switching costs in creating economic moats, we highlight two moat companies: Microsoft and TransDigm Group.

Microsoft Corp.'s (MSFT US) Office software is used by more than one billion people around the world. Morningstar has assigned Microsoft a "wide economic moat" rating given its strong network effect and switching costs: "Microsoft's office tools are robust, as the suite is widely used and easily understood by enterprise employees around the world, leading to increased compatibility and efficiency when collaborating". The Windows Operating System has created a virtual monopoly for Microsoft, while the Microsoft Office suite offers one of the most complete feature sets on the market. Microsoft has also become one of the world's leading cloud computing firms.

TransDigm Group Inc. (TDG US) is a leading designer and manufacturer of engineered aircraft components for commercial and military aircraft. TransDigm's "wide economic moat" rating is based on both switching costs and intangible assets. The company's intangible assets are derived from the intellectual property underlying its products, and switching costs are associated with TransDigm parts, their inclusion in plane design, and the need for FAA certification of these parts. Morningstar writes, "…the low overall dollar value of the company's parts, versus the high cost of failure for aircraft, reinforces these switching costs".

VanEck Vectors^® Morningstar Wide Moat ETF (MOAT^®) provides access to moat-rated companies by seeking to replicate the Morningstar^® Wide Moat Focus Index^TM. Each Index tracks the overall performance of attractively priced companies with sustainable competitive advantages in their respective markets according to Morningstar's equity research team.

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Important Disclosures

Company-specific information based on Morningstar analyst notes last updated as follows: Microsoft Corp.: 21/7/2017; TransDigm Group Inc.: 8/8/2017.

This commentary is not intended as a recommendation to buy or sell any of the named securities. Holdings will vary for the MOAT & MOAT Index.

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