Thursday, January 10, 2008

On Moats

Warren Buffett calls them "moats". These are strong, durable advantages which protect the company and its profits from the onslaught of competing firms. Mr. Buffett gives his executives just one goal: "expand the moat". Understanding competitive advantages (or lack thereof) is essential in any valuation of a company.

Of course, spotting a moat isn't always so easy. For a long time, people would tell you Starbucks was an excellent company with a strong moat. But it's moat mostly revolved around its brand image, and the Economist has covered how everything is not so frothy for Starbucks now.

...A tightening of purse strings has increasingly encouraged defection to fast-food chains such as Dunkin’ Donuts or Panera Bread. They sell reasonable coffee for as little as a quarter of the price of the fancy Starbucks brew.

The biggest of all fast-food chains is also about to launch a full frontal attack on Starbucks. This year McDonald’s will help customers to wash down its burgers by installing coffee bars with “baristas” dedicated to turning out the sort of Italian-style coffees that brought Starbucks its success, in nearly 14,000 American restaurants. The addition to its menu is the biggest diversification ever attempted by the burger giant. McDonald’s has already made smaller forays into providing decent coffee, and with some success. Last February Consumer Reports, a trade magazine, rated its filter coffee more highly than the same sort of beverage served up at Starbucks.

For some time, Starbucks managed to earn extraordinary returns because the Starbucks brand meant something to people. But there is often few advantages in retail- anyone can walk into your stores and copy what you are doing. Now that people have seen the great profits to be made in selling coffee, they are devising ways to steal a piece of the lucrative pie. That is bad news for Starbucks.

In contrast, here is a moat I came across while reading the WSJ- LVMH Bottles Up Champagne Market (subscription required-hat tip David Lau)
For revelers who toasted the New Year with champagne, the odds are about one in five that the bubbly was bottled by LVMH Moët Hennessy Louis Vuitton.

The conglomerate, controlled by French billionaire Bernard Arnault, has managed in recent years to lay claim to the largest share by far of the Champagne region's limited grape output. LVMH has done that by cultivating the independent growers who raise most of the grapes -- including by offering them free farming help.

The result is that LVMH, which owns six brands including Veuve Clicquot, Moët & Chandon and Dom Pérignon, dominates the $5.4 billion global champagne market. LVMH doesn't break out its champagne sales, but its wines and champagne revenue in 2006 totaled $2.2 billion. LVMH had 19% of the global market for champagne by volume in 2006, according to Impact Databank, a market-research firm. The company had more than two-thirds of U.S. champagne sales by value and about 62% by volume.

LVMH focused on the needs of independent grape growers, allowing it to secure a long-term supply.

As global demand for bubbly increases, LVMH's strategy leaves it in a unique position. Independent farmers own 90% of the vineyards in France's Champagne region -- the only source of grapes for bona fide bubbly -- and LVMH is the biggest buyer of their grapes. LVMH is also the single largest owner of vineyards in Champagne, possessing 1,650 hectares, or 5%, of the fields available. The French fashion-to-spirits company has achieved a rare agricultural feat: sewing up much of the world's supply of champagne grapes.

...By controlling brands and raw materials, the company is shielded from competition and wields greater control over prices than rivals. Fueled by champagne sales, LVMH's wines and spirits unit is expected to have grown more than 10% in 2007.


LVMH's hegemony in the region has met some resistance. By making champagne, a wine with rich tradition, part of one man's industrial portfolio, LVMH is creating a dependency that could undercut farmers' negotiating power in the future, they say.

"It's dangerous for the equilibrium of the champagne industry," vineyard farmers union leader Patrick Le Brun said in an interview during September's harvest. "The growers' hands will be tied." Yet for many in Champagne, LVMH's presence is a win-win situation...

A year ago, he began offering grape farmers a 25-year contract with the champagne house, the longest ever seen in the region until then. He is sweetening the deal with a 7% signing bonus to the grapes price, which is currently around $7.30 a kilo across the region.

Some union leaders, such as Mr. Le Brun, fear the new quarter-century contract will consolidate LVMH's supremacy in Champagne even further. Yet most growers are happy with the security it provides.

Here, we see a company which has control over the limited raw materials for its product-champagne. If LVMH is successful in securing enough 25-year contracts, that will be a very durable and enduring advantage. And if the demand for champagne continues to grow over that period, that will "expand the moat" by making those contracts more valuable. The profits will naturally follow.


uccmal said...

Hey Nick, I am not convinced of the arguments against Starbucks. There are several things going against the anti-SB:
1) McDonald's lacks atmosphere and there is no way they are going to get it in the shove the customer through environment.
2) Mcdonalds's like Tim Hortons does alot of their business through drive throughs. Starbucks is walk in and as such a different customer is attracted.
3) Ditto for Dunkin Donuts. They will have their hands full staying in the low range coffee market as Tim Hortons goes to the US.
For Starbucks:
1) Old CEO is back in charge and understands the issues.
2) Offshore. They have barely scratched the surface. I have been to SB in Madrid and Paris and both were packed. This is in a land where people grew up thinking of expresso as coffee. Macdonald's is also busy in Europe but they cater to a different customer base there than SB.
3) Canada - SB still has alot of room to grow here.

Starbucks is trading at a PE discount to Mcdonald's when Mcd has had a revenue upsurge and SB has had a disappointment. SB = 22; MDc = 37.

Disclosure, I have been buying 2010 leaps on SB. Last night my sister in law was excited because the first SB opened where she lives in Hamilton, Ont - city of 300000.


Nnejad said...

Hey Al, I wasn't making any judgment on whether its stock is a good investment or not. My point though was that I believe their business is assailable. If not from McDonalds or Dunkin Donuts, then from the several other coffee shops which provide a similar upscale and comfortable environment. Starbucks' only protection lies in its superior and familiar images in our mind; sometimes these remain powerful, sometimes they die away. I am definitely interested in seeing how things turn out in the case of Starbucks.

Anonymous said...


I appreciate your "moat warning" on Starbucks and could not help but to join in on this one. Here are my 2 cents* worth… (maybe more like 20 cents)… *I apologize in advance for using up megabytes if this is not that useful-- I am still learning this stuff.

Starbucks has more than just their image in our heads going for them. Still on Valueline's growth screen, this business seems to be a large, financially-stable retailer selling a legal, addictive substance that is quickly consumed. On the wide moat side of things, there is the large infrastructure (domestic and international footprint), costing (decent purchasing power), business systems and training already in place, informational advantage of where to put a new store – and more importantly where NOT put a new store.

Coffee-wise, most would agree that there is a strong link between the name and specialty coffee and that the brand is solid due to longevity, reputation, mindshare, and some brand loyalty. A consumer brand that has been built with little or no TV advertising, by the way – what a deal.

Their key person (superstar founder) is now back and ready to kickstart managerial innovation to build the brand again and work on widening the moat. (He was the one sharing brand-dilution bad news a while back, by the way.—“candor” for those Buffett fans out there) But moving on… forget the coffee and all the other beverages and food that they sell to a busy world, this brand means something when you need a “third place” to go to in order avoid work or avoid your annoying family for a little while. --There are moments where I’d pay $23.75 for a latte if you know what I mean. (A third place with atmosphere by the way, as your other post mentioned.)

Adding to their lollapalloza effect are two things I like to see: multigenerational and multicultural appeal. Also, unemployed people need a place to hang out and jobhunt.

No back-of-the-coffee-shop analysis is complete without the bear case. This brand now suffers from a love-hate effect (Americans turn on large companies once successful). Starbucks are even being vandalized in certain cities. Are people finally wising up that paying $4 for a beverage is nuts? Is Starbucks no longer cool?

Starbucks is also a bit weak on the “uniqueness” side of things because there are plenty of suitable alternatives. (Avoiding the family at Barnes&Noble is OK too.) There are no switching costs whatsoever, except for the caffeine headache if you go cold turkey. Part of the danger here is that Starbucks operates in a finicky, narrow moat industry. Our grandparents did not drink this stuff, but they drank cheap coffee, Coke, etc.

Another issue is that Starbucks does not have a stable of unrelated brands to support the business. Compared to Procter&Gamble or a General Dynamics with many brands, SBUX has a case of "one-brand"-itis.

Now we say hello to our little friend --creative destruction. Coffee will be around for years, and nothing stops Starbucks from adapting their offerings. I don’t think new equipment or technologies will change the picture here, but I can think of a nonstop stream of products, marketing, and scenarios that could “fill in their moat” and erode their advantages. The biggest two threats (one internal and one external) are (1) general mismanagement of the brand. Essentially, what effect will new innovations around this brand have in the next few years? (2) McDonalds could temporarily dent the sales and probably cause Starbucks to lower their prices if successful. Lower prices are not going to help pay for all that healthcare.

There is probably more bad news, but I’m ready for another venti cappuccino….

To counteract the negative, one hope is that international results will knock everyone's socks off. Also, after McDonald's gets the remaining people out there hooked on coffee, where will they hang out? Finally, they are finally starting TV advertising to fluff their brand.

Bottom line is this: is a $20 SBUX share circa Jan 2008 the kind of opportunity that you would be a fifth of your net worth on it? Or for the more hasty investors-- will it be double in a few years? Valueline seems to think so.

My conclusion is that this is indeed a wide moat business, though dangerously close to narrow moat if mismanaged. I’m officially interested in this business and give it a score of 7.5 out of 10. (10 being widest moat and I’ll consider anything over 7.)

Now, is there a buying opportunity? Well, you could say they have been stung this year for sure. The price drop has been severe this year --— looking like a classic growth stock stumbling.

So the key questions now are (1) is buying SBUX at $20 now better than holding cash? YES. (2) Is buying SBUX at $20 better than your best investment idea? better than buying Berkshire now? hmmm... grasshopper…?

Full Disclosure: I've been nibbling in the mid to low $20s and I am currently deciding about a potential 'large purchase' if things dip further.