Following last week’s article describing the concept of economic moat, we now look at switching costs and the network effect. Both are competitive advantages that protect a company, in other words, that contribute to that company’s economic moat.
Switching cost
High switching costs make it difficult, costly, or both for customers to switch from one supplier to another. A company enjoying this type of protection is said to have a sticky business model because the switching costs make its customers stick with it as its supplier.
For example, half of my home is connected to an Apple product (air pod, iPhone, MacBook, Apple TV, etc.). It would be difficult to change my smartphone to an Android model. I love the convenience and connectivity of Apple’s product ecosystem. But that creates a product prison that I can’t escape without going through a steep learning curve and lots of costs.
Some industries that enjoy high switching costs
Microsoft’s product suite, including Windows and Office software, is deeply embedded in both individual and corporate workflows, creating high switching costs. A company moving away from Microsoft products would have to deal with downtime for employees during the migration and software installation, training costs, etc…
Many software and service-related companies benefit from high switching costs; Automatic Data Processing is enmeshed in companies’ payroll systems, and Thompson Reuters offers subscription services to legal and accounting departments.
Other industries also benefit; automakers who get their custom parts, made to their specifications, from Magna International would incur a lot of set-up costs to switch to another vendor, and the initial adjustment period with the new vendor could affect productivity.
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Switching cost types
There are three types of switching costs:
- Financial switching costs: Pipelines like Enbridge and TC Energy benefit from long-term contracts that ensure they get paid regardless of the economic environment. Financial switching costs are usually enforced by contracts or fees.
- Procedural switching costs: The time, set-up cost, and learning curve I described in the Apple, Microsoft, and Magna examples.
- Relational switching costs: Losses due to ending long-term business relationships can be quite high. Think of how much companies using Fastenal’s on-site vending machines or on-site hydrogen connections to Air Products & Chemicals would have to pay to change suppliers. Relational switching costs also include losses in loyalty perks, specialization (Magna), product compatibility (Apple again), and data migration (such as the convenience of Equinix offering co-location services to clients that do business together).
Some industries don’t benefit from high switching costs or a high degree of customer loyalty. This includes industries with many competitors and those whose products are commodities that don’t differ much from one company to another. For example, I have a loyalty card for IGA, a grocery store owned by Empire, but it doesn’t stop me from shopping at my local butcher shop, Metro, or Loblaws.
Adding a loyalty program is a good attempt at increasing switching costs, but it’s a small ditch, not a wide moat protecting the castle. As much as I love Alimentation Couche-Tard, it has little to no switching costs.
Network effect
Have you ever looked at a business and thought “Wow, it’s so easy for this company to make money, everybody uses their product!” This is the network effect.
As the company offers more value to customers by improving its product, making it feature-rich or easier to use, by adding complementary products, its customer base grows. As the customer base grows, the company adds more and more value, creating a snowball effect.
Network effect examples
For example, Dividend Stocks Rock members benefit from that network effect; as we get more members, we have financial means to improve the platform. As the platform improves, more investors want to become members, and so on.
The best example is probably Visa and Mastercard which have built a duopoly. In the beginning, not all merchants accepted credit cards or not all credit cards. As more people used Visa and Mastercard, more merchants accepted them. Fast forward: V and MA are now processing billions of transactions per year. The best part? They earn a fee for each transaction. Try to create your own credit card company today and get merchants to accept it…
Other examples include Google and Facebook. The more people use Google to search the internet, the more data Google gets from those searches enabling it to improve search results—debatable at times—and sell more ads. As search results get better, more people use it. Facebook also benefits from the network effect; who would go there to share their stories or reach out to others if most of their friends and family weren’t on the platform?
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Network effect types
There are three types of network effects:
- One-sided network effects: This relates to a single group of customers. As the customer base increases, the company growth gets stronger; it adds more value to its offerings which brings in more and more new customers. Meta and Google would fall into this category.
- Two-sided network effects: This relates to two groups of customers. For example, the more sellers you have on a platform, the more choices you have, and the more buyers come, attracting even more sellers. There’s a close relationship between the number of people looking for a place to rent and the number of people renting on Airbnb. Visa and Mastercard also fall into this category.
Complementary network effects: This relates to separate companies mutually benefitting from each other’s growth. For example, the more Apple grows its iPhone sales, the more Broadcom sells RF filters, and the more Qualcomm sells 4G and 5G wireless chips.
Companies in commodity sectors or those offering undifferentiated products, such as basic materials, some traditional manufacturing, and some energy companies, don’t benefit much from network effects. If everybody wants to buy gold, gold miners will just sell more of it, but they don’t benefit from a moat protecting their business. These businesses compete on price and operational efficiency, not on increasing value from additional users or participants.
That, in a nutshell, was switching costs and the network effect. Next week, we’ll cover the other competitive advantages that contribute to companies’ economic moat: intangible assets, cost advantages, and scale efficiency.
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