Checklist: Efficient Scale

“A competitive advantage is something a firm can do that rivals cannot match. It either generates higher demand or leads to lower costs.”
—Bruce Greenwald & Judd Kahn, All Strategy Is Local

Why Moats Matter: Efficient Scale

I’m currently reading the new book Why Moats Matter: The Morningstar Approach to Stock Investing, written by Heather Brilliant and Elizabeth Collins.

WMM1In chapter two What Makes a Moat? the authors discuss the different sources of a moat.

The different kinds of moat sources discussed are:

  • Intangible assets
  • Cost Advantage
  • Switching costs
  • Network effect
  • Efficient scale

Efficient Scale

This post is about the last category of sources of competitive advantages, efficient scale.

The authors describe efficient scale as “…a dynamic in which a market of limited size is effectively served by one company or a small handful of companies. The incumbents generate profits, but a potential competitor is discouraged from entering because doing so would cause returns in the market to fall well below the cost of capital.”

Further, the authors state that “This phenomenon especially makes sense when a new entrant would have to sink a lot of capital. To cover its entry costs, it would want a sufficient share of the market, but if the market opportunity is limited, a fight for market share would cause prices to fall and hurt returns for all players in the industry. This barrier to entry relies on new entrants being rational. Knowing this, existing players often set prices that are high enough to generate sufficient returns on invested capital, but low enough to disincentivize prospective entrants.”

So, how does efficient scale differ from cost advantage? The difference is in that “…the incumbent firm’s cost advantage isn’t necessarily difficult for a potential rival to replicate. It’s just that the other potential players have no incentive to enter the market, even if they could ultimately achieve the same cost profile that incumbents have. Further, it doesn’t make sense to say that the company has a low-cost advantage, because there’s no basis for comparison.”

About pricing, “Often, an efficient-scale business has a high degree of short- or medium-term pricing power. However, the company frequently chooses not to exercise this power to the fullest extent, even though doing so would maximize its current profitability. The business exercises restraint because it does not want to invent a rival to enter the market, which could destroy the economic rents for both players. The ability to exercise pricing power intelligently to influence the size of the “economic pie” in a way to both make sufficient profits and deter rivals is a distinguishing characteristic of efficient-scale businesses.”

Key Questions: Efficient Scale (Why Moats Matter, p. 31-32)
  1. Define the limits of the market. Is the addressable market finite or are boundaries blurry? What is the size of the market, and what is the capacity of existing industry players? How many companies serve the industry? Markets that lend themselves to the efficient-scale phenomenon are clearly defined and served by only a handful of players or fewer.
  1. What is the cost of entering the market? How much market share would the new entrant have to grab in order to recoup the cost of entry? These questions help assess the economics facing potential entrants
  1. Have potential competitors tried to enter the market and ultimately failed? Evidence of failed entries can solidify and efficient-scale-based argument for a narrow or wide economic moat.

Examples in the book of companies with moats based on efficient scale:

  • Pipelines
    • Magellan Midstream Partners*
    • Mid-American Pipeline* (privately held ownership by Mid-American Energy Holdings Company, Berkshire Hathaway Energy, i.e., a Berkshire Hathaway subsidiary)
    • Plains All-American Pipeline*
  • Mexican Airports
    • Grupo Aeroportuario del Pacifico
    • Grupo Aeroportuario del Sureste
    • Grupo Aeroportuario del Contre Notre

*No companies mentioned in the book by the authors. Searched and found this list, and picked the top three companies.

Pipelines

Using Greenblat’s formula for calculating return on capital we get the return below.

Amounts in millions.
Fiscal year 2013.
Magellan Midstream Partners Mid-
American Pipeline
Plains All-
American Pipeline
Return on Capital 19,2% 24,2% 16,7%
EBIT 705 2 256 1 728
Net Fixed Assets 3 916 9 328 10 819
Net Working Capital -242 -3 -447
Current Assets 397 991 4 964
Current Liabilities 638 970 5 411
Excess Cash (>5%) 0 24 0
Drivers of Return on Capital
EBIT-margin, % 37,2% 66,3% 4,0%
× Invested Capital, turns 0,52 0,36 4,12
= Return on Capital 19,2% 24,2% 16,7%
Earnings Yield 3,3% N/A 5,9%
EBIT 705 2 256 1 728
Enterprise Value 21 665 N/A 29 408
   Market Capitalization 18 980 N/A 21 580
   Debt 2 685 3 552 7 828
   Excess Cash 0 24 0

Mexican Airports

Using Greenblat’s formula for calculating return on capital we get the return below.

Amounts in Mexican Pesos, millions. Fiscal year 2013. Grupo Aeroport-
uario del Pacifico
Grupo Aeroport-
uario del Sureste
Grupo Aeroport-
uario del Contre Notre
Return on Capital 45,5% 258,2% 104,1%
EBIT 2 373 2 871 2 209
Net Fixed Assets 5 876 322 2 166
Net Working Capital -657 790 -43
Current Assets 2 872 2 445 2 277
Current Liabilities 1 212 668 957
Excess Cash (>5%) 2 317 987 1 363
Drivers of Return on Capital
EBIT-margin, % 45,4% 52,7% 64,6%
× Invested Capital, turns 1,00 4,90 1,61
= Return on Capital 45,5% 258,2% 104,1%
Earnings Yield 4,6% 5,4% 10,4%
EBIT 2 373 2 871 2 209
Enterprise Value 51 430 52 827 21 150
   Market Capitalization 51 893 50 973 19 443
   Debt 1 854 2 841 3 070
   Excess Cash 2 317 987 1 363

Disclosure: I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company or individual mentioned in this article. I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. This article is informational and is in my own personal opinion. Always do your own due diligence and contact a financial professional before executing any trades or investments.

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