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Grahamites
Grahamites
Articles (201) 

Distribution: A Potentially Under-appreciated Moat

June 08, 2015 | About:

During the Daily Journal meeting held earlier this year, a shareholder from Houston asked Charlie Munger (Trades, Portfolio) what in his opinion was the most underappreciated moat. Mr. Munger did not answer the question, but I thought this was a question worth spending some time on.

It would be presumptuous for me to give a definitive answer to the question. So instead, I would like to talk about a moat that is less talked about by investors – a well-established distribution system.

First of all, for some businesses such as Coca Cola (NYSE:KO), Walmart (NYSE:WMT) and Amazon (NASDAQ:AMZN), this moat is widely understood by investors. I won’t waste readers' time on those businesses.

In some cases though, especially in the small cap and micro cap world, the power of distribution network is often either misunderstood or underappreciated. A good distribution system can give a business enormous power in terms of reaching a larger consumer population, whereas the lack of an extended distribution system can put some serious constrains on a business’s ability to grow. This means having a great relationship with the distributors is extremely important because they know the customers and can direct sales to the customers at their will.

Let me use IDEXX Lab (NASDAQ:IDXX) as an example to illustrate this point. A big part of IDEXX’s business is the point-of-care veterinary diagnostic products. The vets use IDEXX’s product to perform diagnosis on your pets’ health information.

IDEXX used to have a significant competitive advantage over its competitors because of its exclusive distribution relationships with Henry Schein and MWI. Both Henry Schein (HSIC) and MWI are among the largest distributors of veterinary diagnostic products. When a vet needs to shop for a testing equipment such as an analyzer, he or she is likely to go to Henry Schein and MWI for references. Since IDEXX had exclusive contracts with both of them, IDEXX’s products are the only one that can be seen on the shelves by the vets. When we tie this into the availability bias from Charlie Munger (Trades, Portfolio)’s human psychological framework, we can see that IDEXX unique distribution relationship with Henry Schein and MWI gives IDEXX an enormous advantage over its competitors such as Abaxis (NASDAQ:ABAX), who has to basically go door-by-door to market its products. Not only does it cost more for IDEXX’s competitors to promote their products, but also it’s less efficient. This makes IDEXX’s competitors' lives pretty damn hard.

Then all of a sudden, IDEXX disclosed in its latest 10K that it has ended its relationship with the distributors and went to an all-direct sale system. This is truly astounding and befuddling. By doing this, IDEXX is giving up a really important competitive advantage it has built over time. It removes a significant barrier for its competitors in terms of getting their names out there in the market in a much easier way. Now if you go to MWI’s website, you can see IDEXX’s competitors’ names listed as manufacturer partners and IDEXX’s name is not there anymore.

I suppose this is the result of disagreement or unpleasantries between IDEXX and its largest two distributors. But whatever the reason is, I think the moat of IDEXX has narrowed significant and it would not surprise me if IDEXX loses its market share gradually down the road.

I used IDEXX as an example because I think what happened there is a good illustration of both how a distribution system can give a business great moat and how losing it can narrow the moat significant. In many niche markets, you can find businesses with wide moat because of their distribution network.


Rating: 4.4/5 (9 votes)

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Comments

Thomas Macpherson
Thomas Macpherson premium member - 1 year ago

Hi Grahamites. I think the issue for IDXX was an FTC ruling related to their exclusivity pricing arrangements. I remember discussing this with the Schein executive team in 2013 but will follow up on this and post any further data I find. Thanks for posting this. It's an area that rarely gets discussed but in some industries (such as biopharma) can play a huge role in maintaining or affecting their competitive moat. Best. - Tom

Grahamites
Grahamites premium member - 1 year ago

Tom - You obviously know more about IDXX than I do. Thanks for the information. Either way, IDXX's management is lying about why they ended their relationship with Schein, right? I don't remember them mentioning the FTC ruling in any of the calls.

batbeer2
Batbeer2 premium member - 1 year ago

Thanks for an interesting piece.

It has been a few years since I had a look at Henry Schein so take it for what it's worth.

About 3-4 years ago, I think HSIC boldly came out and said they wanted to produce (in house) a greater fraction of what they were distributing (thereby getting in direct competition with IDXX). They were going to transform themselves from a pure-play distributor to a producer/distributor.

If they executed well on this idea, then it is not surprising that IDXX is cutting the ties. At the end of the day, I think HSIC (not IDXX) is the one that "owns" the customer simply because it is HSIC that delivers the goods (literally).

Again, that's just off the top of my head so take it for what it is worth.

Thomas Macpherson
Thomas Macpherson premium member - 1 year ago

Hi Grahamites. I certainly wouldn't say they are lying. I have just enough knowledge to be dangerous so don't use my data to pass judgment! Far more research is needed to get a full understanding of the situation. Just my $.02 worth FWIW.

Thomas Macpherson
Thomas Macpherson premium member - 1 year ago

Hi Bat. I haven't heard of a healthcare (human or animal) wholesale distributor announce they were getting in to the manufacturing of products. I know Schein and others have tried to follow UPS as a technology based outsourced logistics player (Schein's purchase of McAllister/Impromed was part of that strategy), but hadn't heard of the manufacturing angle. I would be surprised if that was the reason for IDXX and Schein to go seperate ways. Do you know if there was an announcement of such an initiative? Please note my not having heard of it doesn't say much! Thanks. - Tom

batbeer2
Batbeer2 premium member - 1 year ago

I'll dust off my old files.

If I find anything to that end, I'll let you know either by PM or on this thread.

May take a few weeks though. Bit busy.

I know for a fact Geoff Gannon did some excellent work on HSIC. If you're in contact with him you could ask him for his thoughts on this.

Thomas Macpherson
Thomas Macpherson premium member - 1 year ago

Thanks Batbeer. I hope my note didn't come across as egotistical or attacking. Just alway interested in learning more about this market. Best. - Tom

cpsava
Cpsava - 1 year ago    Report SPAM

I think your article missed an element of the distribution moat. And while I am not familiar with IDXX and the medical device space, I think you would find that exclusivity agreements like the one you described come at a cost, such as more favorable pricing to the distributor in exchange for that exclusivity. As opposed to a distribution system or network, where the company (OEM) offers the value (instead of the distributer / reseller), or it is primarily internal, a moat which is essentially paid for would have a lower value. A partnership to resell can create scale, recognition, awareness, and so forth, but distribution, whether a reseller or retail agreement will come with lower profitability or a fixed cost of establishing the exclusivity. It is a trade-off, but one that is clearly more valuable and resiliant if internal rather than paid for.

Carlos Sava

@ClarendonCapMgt

Thomas Macpherson
Thomas Macpherson premium member - 1 year ago

Great comment Carlos. The distinction between the two is vital. A great example is exclusivity marketing rights for a pharmaceutical (say between two larger pharmaceuticals) versus a co-development/distribution agreement between a pharmaceutical and smaller biotech/solo molecule biopharma. The difference in the moat (from a logistical, legal, and perceived value/strength) is enormous. Thanks again for the great insight. Best - Tom

Grahamites
Grahamites premium member - 1 year ago

Carlos - Great point. IDXX may not be a good example of the point I was trying to make. Thanks for pointing that out.

Tom - great example for the point Carlos raised.

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