What Value Investors Need to Know: High Switching Costs

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Aug 31, 2011
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In commoditized markets, customers are indifferent to brands and demand curves are elastic. Customers frequently change products, services or suppliers due to price fluctuations. For companies in highly competitive markets without any durable competitive advantages, the laws of economics create this inelastic demand curve, making it impossible to achieve returns above the cost of capital. Every business wishes that its customers were loyal and dedicated to its products, services or brand. While this is difficult to achieve in practice, there are steps that companies can take to ensure customer loyalty. So how can enterprises ensure success in retaining customers while generating higher revenues, profits, and above-average return on capital?

The first step is to be in the right business. I don’t believe that even a trillion dollars in start-up capital given to Warren Buffett could yield a toaster manufacturing enterprise with a durable competitive advantage. There are many other sectors however, that have much more favorable underlying business economics. Successful businesses can manage to retain a high percentage of their customers by employing strategies that incur high costs for their customers who intend to switch over to their competitors. Such “high switching costs” dissuades their customers from crossing over to their competitors. High switching costs provide the organization with a “lock-in” mechanism for retaining their customers. This is also known as “Customer Lock-In” or “Vendor Lock-In.” In other words, switching costs are such costs that consumers incur when shifting from one supplier to another.

Switching costs can be of different types such as capital investment in equipment, cancellation fees, learning and training costs, psychological and social risks, searching costs, cognitive effort, installation and start-up costs or uncertainty. High switching costs created by an enterprise in a particular market segment also act as an “entry barrier” for competitors who may be considering entry into that market segment.

Here are some examples of well-known companies that have created High Switching Costs for their products:

Stryker Corporation (SYK, Financial)

It is one of the world’s leading medical technology companies having a diversified portfolio of innovative healthcare solutions such as complete Knee Replacement Systems, Hip Replacement Systems, Bone Systems, Shoulder and Elbow Systems, Sports Medicine, Soft Tissues Repair, Neurotechnology and Spine products, etc.

Stryker works closely with surgeons and healthcare professionals to provide the best patient care possible. Surgeons, who are trained on and familiar with Stryker’s products, find it difficult to switch over to their competitor’s products since that would involve high re-training costs on the competitors’ devices, longer time and effort in training, loss of income from conducting surgeries during training period etc. Hence such surgeons are loyal to Stryker and continue to enjoy the comfort and familiarity of working with their products.

Thus, Stryker benefits from the high switching costs associated with its products and can increase the cost of its products to a certain extent to gain higher revenues and profits.

Microsoft Corporation (MSFT, Financial)

Microsoft Corp. needs no introduction since its Windows Operating System (OS) and Office software is ubiquitous. It has infiltrated almost every home across the world through personal computers, PDAs and other equipment. The graphical interface, ease of use and affordability of the Windows OS has impacted computing to such a level that people cannot imagine life without it.

In addition, it has developed a number of application software such as Office (Business Application), Outlook (Email Application), and Explorer with proprietary features that are difficult to replicate, making users hooked and locked-in to these applications. There are a number of other vendors who have developed a wide variety of applications on the Microsoft Windows platform that are being used globally. All these aspects have created high switching costs around Microsoft Windows and related products making it extremely costly for users to switch to other competing Operating Systems such as Linux and Unix.

Organizations and individuals have been using Windows and related applications for a very long time, long before other operating systems and applications were developed. This makes it very difficult for the average user to switch to alternative options.

Paychex (PAYX, Financial)

Paychex is one of the leading companies in the world in the business of outsourced Human Resource (HR) Services such as Payroll Processing, HR Administration and Compliance, Group Health Insurance, Employee Benefits, Time and Labor Management, etc.

Paychex offers payroll processing services to small and medium businesses that do not have trained in-house staff to perform this function. Being a specialist in payroll processing, Paychex is able to deliver such services faster, at a lower cost and with very high accuracy. To execute this function in-house, enterprises will have to hire payroll employees, train them to use customized systems, invest in equipment such as computers and software, deal with IRS audits and address employee complaints due to frequent errors. Instead, it is easier and cheaper for such companies to outsource the payroll processing function to specialist service providers like Paychex.

Thus Paychex benefits from high switching costs that have created a lock-in mechanism for its customers resulting in maximum customer retention and consequently higher revenues and profits. It is through high switching costs that Paychex has built a wide economic moat and a durable competitive advantage.

In addition to high switching costs, these companies share other characteristics. High return on invested capital, healthy free cash flows, lots of cash and relatively little debt. This is no accident, high-switching costs generate a durable competitive advantage and should be the first step of any investment screen. Finding companies that possess this advantage is a great start in as part of an value-investor based investment strategy. The other critical pieces are ensuring that the business is understandable, well-managed, and finally that it is trading at a discount to intrinsic value. These topics, however, are for another day.

Invisible Fence Brand

Invisible Fence brand is a (not so well-known) small private company that manufactures underground electric fencing for pet containment. The Invisible Fence System involves a collar that delivers an electric shock to dogs if they try to cross the invisible fence border. I just purchased their system due to the fact that my border terrier kept escaping my house. The product and installation cost me approximately $1,200 and covers one-half acre. This company wisely imbedded a lock-in mechanism for me since its proprietary batteries that are required to power the collar only last for approximately three months and cost roughly $30. Therefore, in addition to the $1,200 for installation, this company essentially has me locked into a $120 subscription for the life of my dog… brilliant!

Value Investors should consider the power of high switching costs to provide a competitive advantage to a firm, potentially allowing them to produce returns that exceed the cost of capital.

Disclosure: Long MSFT, PAYX, SYK

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