Why Marketplaces Will Reign Supreme

Anyone running a business understands the importance of competitive forces and strategic planning. Successful implementation of a competitive strategy insulates a business from new entrants, deepens a company’s relationship with its customers, and ultimately enables sustainable economic profits, or earnings in excess of a company’s cost of capital.

Every Economics 101 course covers the concept of market equilibrium pretty well. In competitive markets, economic profits are only possible in the short run. Over time, excess profits will attract additional competitors into an industry which reduces prices and drives down profits to exactly equal the cost of capital.

However, in practice, there are companies that are able to sustain long-run excess profits due to the existence of sustainable competitive advantages. Warren Buffet famously refers to these advantages as a company’s competitive moat.

Just as a physical moat protects a castle from invaders, an economic moat protects against new entrants and insulates a business’s profitability.

Digging the Moat

In this post, we explore several sources of competitive moats and examine how the rise of platform businesses changes the landscape, using the industrial supply as a case study.

While corporate executives speak often speak about a multitude of competitive advantages, there are really only five legitimate sources for competitive moats:

Intangible Assets – Does a company possess a brand, patent protection, or favorable government regulation that enables pricing power or superior margins over its peers?
Cost Advantages – Does a company have process advantages, economies of scale or scope, or bargaining power with suppliers that enable lower per-unit costs than its competitors?
Switching costs – Are there expenses in time, hassle, or money that a customer would incur when changing from one producer to another?
Network effects – Does the value of a particular good or service increase for both new and existing users as more customers use that good or service?
Efficient Scale – Is the size of the market such that additional entrants would cause returns to fall dramatically below the cost of capital for all participants?

The industrial distribution industry is notoriously characterized by fragmentation and rather thin margins. Nonetheless, one could argue that, historically, some of the big players have benefited from competitive moats.

A New Paradigm

A prime example, Grainger has grown EBITDA at a near double-digit compound annual growth rate (CAGR) over the last ten years rising to become a more than $14 billion company.

However, with the emergence of a platform threat in the shape of Amazon Business, these historical advantages are no longer sufficient and the distributor profit pool looks quite ripe for disruption.

Despite what a company executive might argue, intangible assets are not a competitive advantage for industrial distributors. Customers are extremely price-sensitive and would not be willing to pay more for goods from a specific distributor.

In a traditional sense, network effects are also nonexistent for industrial distributors. Customers do not benefit from Grainger adding additional customers; if anything, they stand to lose due to competition for Grainger’s inventory.

As for efficiencies of scale, industrial supply is massive and highly fragmented, so that idea can be discarded.

That leaves cost advantages and switching costs. Traditionally, size matters in distribution. By establishing economies of scale, a company can spread fixed costs over more units which either allows for increased profitability or lower prices.

Companies like Grainger have used this advantage to expand its sales force and distribution channels, and to expand into new geographies, which worked well against local mom-and-pop competitors.

Due to its size, Grainger was able to move into new product categories and regions and compete fiercely on price to gain market share.

However, this advantage is flipped on its head against a competitor like Amazon, which sells 480 million SKUs in the United States alone, yielding unmatched economies of scale.

As a result, Amazon can charge significantly lower prices than even the largest of the established distributors. Incumbent players are stuck with a bloated cost structure in the face of Amazon’s lean e-commerce approach and no longer benefit from any of the relative scale advantages.

Is That A Moat?

One could potentially make an argument that industrial distributors benefit from switching costs. The products they sell are often mission critical for customers – not having the correct items, on the correct day, with all the correct components can mean costly downtime.

For instance, consider the construction of a new building. All of the electrical components need to be there on the day the electrician is on site or else or else the developer pays the electrician to do nothing. And electricians are expensive.

Theoretically switching to a brand-new supplier introduces this risk. However, these types of logistical challenges fall right into Amazon’s sweet spot.

Over the years, Amazon has excelled at delivering small pack-and-ship type items. Recent reports suggest Amazon is building out its logistical capabilities to further optimize shipping expenses and ensure the company can fulfill its delivery promises for its full suite of products at very low prices. For industrial distributors, switching costs look more like a puddle than a moat.

The rise of Amazon Business is an unequivocal threat to B2B distributors. Incumbents have two choices: rely on what has worked in the past and watch from the sidelines as Amazon eats their lunch, or embrace the platform business model, pursue digital transformation, and re-establish sustainable competitive advantages.

Incumbents interested in option one should consult such well-off companies like Circuit City, Blockbuster, and Borders.

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