Efficient Scale: Moats with Natural Monopoly

The term “economic moat” describes a company’s ability to maintain its competitive advantages and defend its long-term profitability. This moat investing education series explores the five primary sources of moat, according to Morningstar: 1) switching costs; 2) intangible assets; 3) network effect; 4) cost advantage; 5) efficient scale. Here we explore the concept of efficient scale.

Moats with efficient scale boast few competitors

Virtually every company dreams of a market with few competitors. An environment with only a handful of business rivals can become one where “efficient scale” is possible, according to Morningstar.

Efficient Scale: When a company serves a market limited in size, new competitors may not have an incentive to enter. Incumbents generate economic profits, but new entrants would cause returns for all players to fall to a level in line with or below the cost of capital.

Companies that benefit from this dynamic typically operate in a market that may only support one or a few competitors, which limits competitive pressures. Additionally, for efficient scale markets, market entry often requires very high capital costs, which are not justified by the limited profit potential a new competitor might achieve.

Efficient scale commonly applies to companies involved in telecommunications, utilities, railroads, pipelines, and airports. For example, while the U.S. does not have publicly traded airports, they are common in other areas of the world. Few cities can support more than one major airport. The financial incentive may not exist to compete with an existing airport because, due to limited demand, reduced market returns may not justify the initial capital necessary to build another airport.

Often a "Narrow" moat

Though it can be powerful, efficient scale is one of the least common sources of moat among companies with a “wide moat” rating, or companies with sustainable competitive advantages expected to last 20 years or more, according to Morningstar.

Across the five sources of moat, efficient scale is the most likely to drive a "narrow moat" rating from Morningstar, meaning that economic profits are more likely than not to persist ten years into the future but are highly uncertain thereafter. Returns on invested capital for efficient scale companies tend to be only modestly above capital costs, which makes it difficult to have a high degree of conviction that a company will continually generate economic profit 20 years from now.

Efficient scale in action

Union Pacific Corp (UNP US) is the largest public railroad in North America. In addition to cost advantages, perhaps not surprisingly Union Pacific’s wide economic moat is also based on efficient scale. According to Morningstar, “UP's rights of way and installed track form a nearly impenetrable barrier to entry.” The company’s system stretches across the Western U.S., from the Pacific to the Mississippi, and captures about half of the rail volume in the region.

Dominion Energy Inc (D US) is an integrated energy company. Its activities include electric generation, natural gas transmission, storage, distribution and gathering pipelines, and electric transmission and distribution lines. Morningstar states that Dominion’s Atlantic Coast Pipeline “is an excellent example of the dynamics of the efficient scale moat source” because “once a pipeline is constructed, there is little incentive for competitors to enter a market.”

DISCLOSURE

Company-specific information based on Morningstar analyst notes last updated as follows: Union Pacific Corp.: 10/25/2018; Dominion Energy Inc.: 12/20/2018.

This commentary is not intended as a recommendation to buy or sell any of the named securities. Holdings will vary for MOAT and MOAT Index.

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