By: Gage Burchall & Roy Liu
The castles of medieval times have a powerful hold on people’s imaginations. The grand castles evoke images of chivalric stories and the legacy of epic battles. During such intense sieges and stand-offs, competing kingdoms would come to claim the land held by these castles’ for themselves - creating the necessity for wide moats to be dug out in the name of protecting the kingdom.
Similar to medieval castles, businesses also require wide moats to prevent competitors from entering the market and eroding away their market share and excess returns. First coined by the famous investor Warren Buffet, the term economic moat can be simply defined as a company’s unique advantages that enable it to sustain excess returns and protect it from competitors.
Economic moats may stem from a variety of sources but one of the most important is switching costs. It’s a powerful yet subtle business model that emerges when customers are unable or unwilling to switch to competing products or services. The reason is that there’s usually an additional fee, extensive inconvenience, or a reduction in benefits associated with changing the products or services. The magnitude of switching costs are determined by how immersed the customer is with the products or services or the amount of training required to use them (or the training required to switch to a competitor's system for that matter).
The software sector is a prime example and full of companies that benefit from extremely high switching costs. Due to the industry’s fast paced nature, disruption and innovation are constantly creating opportunities for new entrants to step in and compete in various sub-markets. Thus, it is incredibly important to assess the condition of a company’s switching costs by closely monitoring its’ customer retention rate. If the number of new users increases but more valuable users move to other products, this might indicate a deteriorating moat.
To illustrate the protective capabilities of switching costs we can look at Thomson Reuter (TRI) as a case study. TRI is a high-end provider of business information through its data management platforms. TRI has three major segments: legal, corporate and tax. At first glance, TRI may appear to be just another plug-and-play SaaS solution that clients can easily switch to cheaper alternatives. However, TRI has a different dynamic in place to protect their high value clients of top 100 global law firms, fortune 100 companies, and U.S. top 100 CPA firms. While simple at first glance, TRI’s SaaS solutions are highly customizable and purpose built for transaction support with each client's specialized business operations and transactions. Knowing this we see little reason for any firm to want to drop TRI for a competitor. The products among the top players are actually quite similar but they do have slightly different structures or are built differently. TRI has embedded its services with clients through training, so it does not make sense for the clients to invest extra time and effort to learn another product. TRI also has different ways of formatting and including citations, and once the clients have become accustomed to a certain type of model, switching to another product will inevitably result in errors. By and large, these firms certainly don’t want to run the operational risk of going with a lesser known provider. This customer stickiness leads to high switching costs, reflected in its duopoly status across all three segments as well as its high customer retention rates (~90%).
Therefore, we can see that firms which are able to deeply ingrain clients in their service or otherwise offer unique solutions have a relatively easy time maintaining market share. Overall, TRI is fundamentally a good business because of its superior switching costs that protects it from competitors thus clearly displaying the efficacy of switching costs as a competitive moat.