Distribution moat — An Underappreciated Moat (But Not By Berkshire Hathaway)?

Author’s note: This post here is a re-post from the original article at MoneyWiseSmart.com, where the author mainly writes and talks/ teaches about investments there now.

When we buy into great companies with high return on capital to compound our wealth for the long term, we want to make sure that those companies have strong moats, and even better growing moats. This is so that they can fend off existing or future competitors to protect their high profit margins and returns on capital.

As an investor, what are the moats that you generally like or look out for?

The common moats that people look out for are:

1. Intangible assets (e.g. patents, branding, regulatory licenses);
2. Switching costs;
3. Network effect;
4. Cost advantage; and
5. Efficient scale.

All these moats are good and have been well explained. Today, we would like to discuss another moat that is less apprarent, and seems to be under-appreciated, or at least less discussed in the public — the Distribution moat, which can be categorised as intangible assets.

The Distribution Moat & Playbook

So what is distribution moat?

For a company to be able to sell a solution (either product or service) to its end customer, it would need at least (i) a good solution, and (ii) a strong distribution channel or network to reach its customers well. In fact, the latter (a strong distribution channel) could be even more important than the former (a good solution).

Peter Thiel, a billionaire entrepreneur and venture capitalist, puts this point well in his book Zero to One, stating that “Superior sales and distribution by itself can create a monopoly, even with no product differentiation. The converse is not true.”

If a company has a strong distribution channel or network to reach its customers effectively and efficiently, it has a huge advantage over other competitors that do not have such distribution. The distribution channel is generally broken down into two different forms:

1. Direct — Where the company distributes its solutions to the end customers directly; or
2. Indirect — Where the company distributes its solutions to the end customers indirectly, e.g. through distributors, wholesalers, or retailers.

Each of the two forms has its own pros and cons, including speed to market, resources and capital requirements, profitability, quality control, extent of risks taken up, and maybe less apparently (but importantly) the impact on the working capital cycle, and hence the free cash flow generation, of the company. (One good example is the impact of sale/ distribution model on the working capital cycle of Pax Global, a leading innovative global payments enabler in the point of sale (POS) industry, which you can watch our analysis here)

Let’s explore the direct distribution a bit more.

Think Apple — Apple sets up its own retail stores worldwide to reach the consumers directly, sinking in lots of resources and capital expenditure to do so. Why? Because it allows Apple to reach the consumers directly, controlling the whole customer experience and quality of products and services, and establishing a strong connection, relationship and trust with the end consumers. With that relationship and trust, a lot of the Apple fans are willing to pay a high premium for its products and services. Such is the power of an effective distribution and strong branding.

However, an effective distribution is not enough — the distribution network has to be efficient and wide too. Let’s look at Coca-Cola, one of Warren Buffett’s favourite investments. On top of its branding moat, one strong advantage that Coca-Cola has is its extremely wide distribution network, where it can reach even the most remote villages of the world in more than 200 countries and territories. Sugar water is no rocket science. However, even if you have a better sugar water than Coca-Cola and a strong branding, you would find it very difficult to establish the same scale in distribution network as Coca-Cola, to achieve similar level of sales (even if your products are in demand) and similar level of profitability (~30% operating profit margin) or return on equity (40%-50%) as Coca-Cola.

This wide distribution network allows Coca-Cola to deploy one very powerful playbook to grow well — acquiring good brands (e.g. in sparkling soft drinks, water, sports drinks, juice, dairy, plant-based drinks, tea, and coffee, including some of those brands owned by Coca-Cola shown in the picture below), and leveraging its stronger distribution network to distribute those products to a wider audience, more effectively and efficiently, than what the acquired companies could achieve themselves. This allows Coca-Cola to generate higher profit margins and returns on capital, and compound the value of the company and the shareholder value.

That’s what a strong distribution network can achieve for the wealth of a company. No wonder Coca-Cola has been one of Berkshire Hathaway’s main holdings for a long period, which has compounded 84x in share price from 1980–2020 at a CAGR of 12%.

The Same Distribution Moat Playbook Used by Legacy B2B Payments Players

This distribution moat playbook happens not just in the B2C space, but also in the B2B space too. Let’s see how this same playbook, of acquiring good solutions and leveraging one’s strong distribution network to distribute those solutions more effectively and efficiently, has panned out in the B2B payments industry in the past few decades. The exact same playbook.

If you are familiar with the payments industry, you would probably have heard of some of the largest independent merchant acquirers in the U.S. — First Data, Global Payments, and Worldpay/Vantiv (note: a merchant acquirer is a financial institution that processes credit and debit card transactions for a company or merchant). These large global acquirers have been taking up the majority of the market share since many years ago (as seen in the picture below) and earning tens of billions of dollars of revenues every year.

You would probably also know that, over the years, these few companies have grown significantly through merger & acquisitions, acquiring lots of companies to achieve scale advantage. The companies acquired all have different technologies and platforms that are not fully integrated with each other, so the large global legacy payments players (like First Data, Global Payment Networks, and Worldpay/Vantiv) end up with a patchwork or mish-mash of technologies and platforms that are not fully integrated back-end. This means that data do not flow seamlessly across the payments chain, and innovations are more difficult to be achieved (as even if the ideas are there, technological wise they are hard to implement). (Note: This is one of the key problems some modern payments players are trying to solve now, with one good publicly-listed one being Adyen — which you can watch our analysis here)

Despite having technology platforms that are not fully integrated (with lots of problems to be fixed back-end), they have managed to grow over the years by using that playbook we discussed — acquiring companies in various fields (in related banking/ payment softwares or services), and then using their distributions to and relationships with the wide network of merchants and banks to sell those new solutions effectively and efficiently, on top of also acquiring smaller competitors to achieve scale, allowing them to continue to grow well for many years. Global Payments (which is listed and has not been acquired by others like the rest) has seen its share price growing to 45x over 20 years (i.e. a CAGR of 21%) as the company grows bigger in size (with its revenue growing from USD 1.6b in 2010 to USD 7.5b in 2020, by around 3.7x more in 10 years).

Now The Same Distribution Moat Playbook, But Executed by A Modern B2B Player (& What A Coincidence that Berkshire Hathaway Has Invested in It)

We have talked about the power of the Distribution Moat playbook, which could be very powerful in the right circumstances.

Now what if we tell you that this year, we have discovered one modern payments company that is deploying the exact same playbook, just like the global legacy payments players discussed above. Not only that, but it actually does it much better, as unlike the legacy players, this payments company has developed its modern technology platform from scratch over the years in a seamless way to deal with various payments and banking solutions. This, in our opinion, positions it to be in a very nice spot to execute that playbook well to grow and compound the value of the business.

And what a coincidence that Berkshire Hathaway (that recognises the power of distribution moat) also has an investment stake in this company (although the investment was not made by Warren Buffett himself, but by his portfolio managers Todd Combs).

Meet this company — StoneCo. And let’s give a quick overview of the company and then discuss how it is executing this distribution moat playbook.

StoneCo is a leading provider of financial technology solutions in Brazil, which empower merchants and integrated partners to conduct electronic commerce seamlessly across in-store, online & mobile channels. It was founded in 2012 as a payments gateway provider, and undertook IPO in 2018 (when Berkshire Hathaway invested). Now, it is the largest independent merchant acquirer (based on total volume) in Brazil, serving over 580k clients as of 2020 Q3, which has grown fast together with its revenue over the past few years (as shown in the picture below).

StoneCo aims to be the partner of choice for all the small and medium businesses (SMBs) and micro-merchants in Brazil, offering as a start, the payments and acquiring services (A), and then banking (B) and credit © solutions, making up the ABC solutions. On top of that, it also offers various softwares to the clients, like customer relationship management (CRM), enterprise resource planning (ERP), retail management, e-commerce softwares etc.

StoneCo has a proprietary go-to-market approach which is called the Stone Business Model, of which one of the elements is to have a hyper-local distribution, where StoneCo sets up local operations hubs called the Stone Hubs in various localities in different cities in Brazil. This is so that it can be located close to the clients, with its personnel in those hubs serving the clients well and fast when needed to provide the best customer service (which is not common in Brazil). At the end of 2019, it had 350 of such Stone Hubs located in 2,700 cities (i.e. around half of all the cities) in Brazil. This active strategy of developing a strong distribution network, with close relationships with its clients, has resulted in StoneCo now having this massive distribution network moat, which took it many years to build up.

With this strong distribution moat, StoneCo has started executing on that playbook that we discussed earlier — on acquiring (or developing) new solutions, and leveraging on its wide and strong distribution network to sell those solutions effectively and efficiently. In particular, over the past few years, StoneCo has acquired different software companies dealing with reconcilation, CRM/ loyalty, ERP and other specialised solutions, etc (as shown in the picture below), and developed its own technology platform for the Banking (B) and Credit © solutions, which is fully integrated with its payments/acquiring (A) solutions, unlike the global legacy players.

As StoneCo has this strong distribution network and trust/relationship with ~500k clients, it is easy for it to distribue any new solutions to them effectively and efficiently, much more than the software companies themselves that have less reach. So StoneCo can just keep acquiring complementary software/services companies, distributes them and achieve a win-win situation for both itself and those software companies, while achieving all these at a high return on capital. This results can be seen in the chart below, where the number of clients adopting StoneCo’s non-payment solutions (i.e. software, banking and credit) have increased significantly recently, as StoneCo launched those new solutions over time.

With its modern technology platforms that are integrated seamlessly and strong distribution moat that it has taken years to build up, StoneCo is able to execute the playbook that the global legacy payments players have been using for years much better than those players (particularly due to its better technology and business model). This playbook has helped StoneCo to grow very well in the past few years, recording revenue and net profit growth of 63% and 164% respectively in 2019.

By having a strong distribution moat, StoneCo is also able to enter into new areas (e.g. new software or other banking services) to expand its total addressable market (TAM) (to 6x the acquiring TAM), since its competitive advantage does not just lie with a strength in a certain product, but also its ability to distribute (any other relevant products or services) effectively and efficiently with its massive 500k+ client base. This would provide it with a long industry runway to continue reinvesting and growing for many years to come, and also positions itself better from any risk of disruptions to certain of the solutions it is providing now.

The distribution moat of StoneCo is just one of the many strong moats that it has and is still developing further, which could probably be what captured Berkshire Hathaway’s eyes to invest in it too.

This article is mainly to just highlight the distribution moat, which might have been under-appreciated, or at least less discussed these days. Hopefully you have enjoyed the article and learnt something today (and if so, feel free to share it with your friends to benefit them too)!

If you are interested to learn more about StoneCo, including its many other strong moats and strong management who are great capital allocators, our short analysis video below would help, and our full analysis can be found at our Multibagger Research Series (where we cover in detail great businesses in the world that could compound your wealth for a long period)!

https://moneywisesmart.com/MultibaggerResearch/

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