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.