Beyond barriers to entry: the advantage of barriers to capacity expansion
A recent conversation with my colleague Christian Deckart, portfolio manager of our global small cap and global equity strategies, around the utility sector had me reconsidering what it means for a company to have a strong competitive advantage. While the industry does have fairly established barriers to entry (it would be quite a substantial undertaking to recreate an electricity distributor’s power grid from scratch) we are generally underexposed to utilities and tend not to own very many. Why are barriers to entry—a competitive advantage investors often prize—seemingly not enough in this case?
There is, as Christian pointed out, arguably another, more robust means of competitive advantage: that of barriers to capacity expansion. And this factors into one of the two main reasons behind limiting our exposure to the utility space.
First, regulatory risk is high and completely outside of investors’ control. Even when regulators are benign, they still tend to regulate the profitability of utility companies. This means that the distribution of returns is asymmetric: equity investors are fully exposed to the downside of ‘stroke of the pen’ risk while the regulator tends to cap the upside. A good example of this playing out, as my colleague Jorg wrote about a few months ago, would be Germany’s decision back in 2011 to permanently shut eight of its 17 reactors after the Fukushima Daiichi disaster, with plans to close the rest by 2022.
Second, the product is usually commoditized. Which is where barriers to capacity expansion comes in. At the end of the day, the customer doesn’t care what brand of electricity or natural gas he’s getting, or who it comes from—just that it is reliably available and reasonably priced. Utility companies are businesses that only operate at scale, and therefore may have, or face, strong barriers to entry. As alluded to earlier, recreating an entire distribution network is certainly a large barrier. But this advantage, perhaps, isn’t as robust as it usually seems at the outset. While in many cases, competition between a small number of players can be rational and effective—as in a cozy oligopoly—all it takes is one first mover to create a price war.
Just think of satellite imaging providers. Over ten years ago, two companies used to dominate this industry with around 50% market share, each in navigable satellite maps: Tele Atlas and NAVTEQ. Before 2009, Google Maps used these suppliers for its satellite imaging. (One might say barriers to entry could not have been higher—just two players had 50% oligopolistic market share each. In order to compete on equal footing, a new entrant would have needed to provide satellite maps of the whole world!) The two, however, were gearing up for a price war. Google didn’t care whether it used Tele Atlas or NAVTEQ as a supplier—it just wanted accurate imaging. And an accurate image of the world, by definition, is undifferentiated—it is simply “accurate.” What may have appeared at first as a strong barrier to entry turned out to be a rather weak competitive advantage on the part of Tele Atlas and NAVTEQ. There was no barrier to capacity expansion—or, in other words—barrier to selling to one additional customer. Once a satellite image is taken and the map is produced, the “capacity” of a digital map is limitless and comes at zero marginal cost.
Of course, in 2009, Google discontinued using Tele Atlas, opting instead to use their own consumer feedback and providing turn-by-turn navigation technology for free on Android—proving the point that their end customers did not care where the maps came from in the first place. Even if Google hadn’t developed their own technology and another company had chosen the difficult route of entering the competition, that new company would have had just as good a chance of winning Google’s business—so long as the service was priced attractively and reliable.
The sobering tale of the attractiveness of these businesses is best encapsulated in the EU’s antitrust report and competitive findings on their acquisitions:
“The limited switching costs and the competition with the other navigable digital map supplier all tended to limit the price increase that could be imposed by either Tele Atlas or NAVTEQ on their downstream competitors and eventually on consumers.”
And we all know today where these “limited price increases” ended. The maps on our smartphones today are effectively free.
So what, then, does the advantage of barriers to capacity expansion look like?
Constellation Software (CSU), a diversified software company, provides a useful counter-comparison. Constellation owns a variety of vertically integrated software companies whose products are mission-critical to their customers. As an example, they provide billing software to fitness clubs. Customers tend to be pretty sticky given the enormity of the task of switching billing software providers and given how important the software is to running their business. The barriers to entry themselves aren’t terribly high as creating software doesn’t require a massive investment, but the barriers to capacity expansion are very high: Constellation’s customers don’t want another type of, or more, billing software—they just want the software they already have, and possibly with some enhanced features. Having built their business around these niche markets, it is very difficult for Constellation’s competitors to break in, not because the barriers to entry are high but because the barriers to capacity expansion are very difficult to surmount.
It is, in short, worthwhile for investors to expand their competitive advantage framework beyond the usual, familiar barriers.
 There was only one single other supplier!