Durable Competitive Advantage Series_Differentiated Manufacturing

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Durable Competitive Advantage Series:

Differentiated Manufacturing

The first thing we do when analyzing a new business is to develop a thorough understanding ofthe industry in which it operates. The primary purpose is to understand how a company cancreate a durable competitive advantage (DCA) in that industry, which allows the company toachieve above average market share and results for a sustained period of time. A DCA can comein various forms, including brand awareness, barriers to entry, or a large scale effect offeringeconomies of scale. The form the advantage takes often relies on the industry the companyoperates in. Regardless of form or industry, a DCA is absolutely necessary for shareholders torealize long-term above average results and a requirement for any long-term investment that wemake.

Over the years we have developed a long and growing list of industries we understand and,

therefore, fall into our circle of competence. We decided to write a series of blogs that discusshow to create DCAs in different industries. The goal is to devote each blog to a single broadsector of industries or to a particular industry. This is the inaugural post in that series.

DCA in Differentiated Manufacturing

This blog is about how a company can create a DCA in what I call differentiated manufacturing,which is a broad sector that encompasses certain manufacturing industries. In general, I separatemanufacturing companies into commodity and differentiated. As it implies, each differentiatedmanufacturer produces a slightly unique product as opposed to a commodity product such as oilor ethylene. I wanted to start with the differentiated manufacturing sector because the vast

majority of investors and even managers completely misunderstand how a true DCA is created inthis sector.

When most people think of a unique product, they think that the key to success is the features ofthat product. However, those unique features are largely irrelevant the majority of the time.Rarely is a product so unique and ahead of the competition that its features alone give it a DCA.A Segway might be an example of such a product, but there may very well be alternatives that Isimply never heard of. Cyalume (CYLUW.OB) is another company with such a unique productthat there really is no viable alternative, but that is due to rare and unusual circumstances (marketsize has traditionally been too small for large companies to undertake the necessary R&D, andCYLU has literally 100% of the government contracts for their core products, making itimpossible for a smaller company to catch up R&D-wise without substantial financial backing).

Conversely, some people believe that having strong brand awareness is key to a DCA, but thosepeople would also be wrong most of the time. Sure, there are companies like Coca-Cola (KO)and Apple (AAPL) with incredible brand strength that can charge a premium for their productand still maintain strong market share on brand strength alone. But brand awareness is verydifficult to turn into a DCA and is often overrated. A book called, "The Brand Bubble," by John
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Gerzema and Ed Lebar published in 2008 talks about the false perceptions regarding brandstrength. The following is an excerpt from the book:

according to the data, consumer attitudes toward brands were in double -digit decline. Andthis erosion did not pertain to just a few brands, but to thousands. We saw large numbers of well-

respected brands that had, on average, lower scores on these metricsresults low enough thatmarketers would consider them indicative of commoditized attitudinal patterns. These arenumbers that basically say consumers know the brands well, but they are hardly inspired to buythem.

The book goes on to state, per data accumulated from 1993-2007, the following:

Brand trustworthy ratings dropped almost 50% over the last 9 years of that period, Esteem and regard for brands fell by 12% in 12 years, and very few brands were widely

regarded across general population, Awareness of brands fell by 20% in 13 years,

Brand quality perceptions fell by 24% over the last 13 years of that period, and Only 7% of prime time commercials were found to have a differentiating message.

If you are not yet convinced, consider this phenomenon. Battery companies in the United Statestry very hard to differentiate themselves. We have all heard of Energizer(ENR) and Duracell.The Energizer bunny was actually originally intended to mock a Duracell commercial thatfeatured a similar bunny running on batteries and beating a drum. In the United States, private-label batteries have never been more than 10% of the market, but in Europe private-labelbatteries comprise 60% of the market. The same four companies largely dominate both markets.They just sell their products more often as private-label in Europe instead of branded. If thebrand was so important, it would dominate everywhere. Clearly European consumers do not see

value in the brand when it comes to batteries.

My last example to highlight the decline of brand significance is Great Value. Great Value isWal-Marts (WMT) private label group of products. The products are made by the samecompanies that make the branded products but are simply labeled Great Value. 100% of thegroceries I buy are Great Value because the cost savings is significant and the quality is thesame.

So if it is not unique product features or brand awareness, what allows a company to create aDCA in differentiated manufacturing? The answer is the companys distribution system.

Specifically, what matters is how cheaply, uniquely, and diversely can the manufacturer get theproduct in front of the consumer. There is a reason best-in-class companies tout the size andefficiency of their distribution networks in investor presentations.

Understanding a distribution system and whether or not it creates a DCA is a nuancedundertaking. No two distribution systems are the same and what works for one industry may notwork for another industry. So I will walk through a few examples and provide some high-levelrules.
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First off, what does the distribution network entail? It includes the companys warehouses,

distribution centers, transportation assets (e.g., trucks), and storefronts. Any of those four can beowned by the company, owned by a third party, or a mixture of both. In commodity products, thelocation of the warehouses and distribution centers in relation to the customers and how cheaplyyou can transport goods is paramount because being the low-cost provider is vital and actual

distribution is a major part of cost (particularly if the commodity is especially heavy relative toits cost). However, in differentiated manufacturing, while cost still matters, efficiency is moreimportant. Storefronts need reliable service from suppliers to ensure their own operations runsmoothly. By and large, however, the biggest key is the storefront. How many stores are yourproducts sold in, how convenient is it for the customers, and who has the true power in therelationship between the manufacturer and the retailer (obviously, the last one is irrelevant if thestores are company-owned). After all, it does not matter how great your product is if no one canfind it. Conversely, you are more likely to sell a lower quality product if it is easier for thecustomer to obtain.

Mohawk Industries (MHK) Case Study

Consider Mohawk Industries, the worlds largest flooring company. The company owns a

number of brands, including Mohawk, Aladdin, Karastan, DalTile, Unilin, Quick-Step, andColumbia, among others. The company boasts market-leading positions in carpet and rugs,hardwood, ceramic, stone, and laminate products in the United States, the leading premiumbrand in laminate and hardwood flooring in Europe, and growing presences in Mexico, Russia,and China. MHKs largest presence is in the United States, so I will focus on that market. MHKhad 22% of the total flooring market in the U.S. in 2010, just ahead of Shaws 21% and well

ahead of 3rd place finishers Armstrong and Beaulieu at 6% each. MHK makes great products,but so do Shaw, Armstrong, Beaulieu and their other competitors. Each company can boast aunique feature to their product or some unique expertise, so how does MHK stand out?Assuming all other competitive attributes are equal, MHK maintains strong market shares bysimply being in more places than its competitors and doing so profitably, which is harder than itsounds. The key is having great relationships with retailers and the ability to efficiently andcheaply service the 25,000+ retailers the company does business with in the U.S. alone. MHKeven states in its 2010 10-K: In each of the markets, price competition and market coverageareparticularly important because there is limited differentiationamong competing product lines.[emphasis added]

Flooring retailers are different from most retailers in that they only carry samples. It is cost andspace prohibitive for retailers to keep sufficient inventory on hand, so they keep samples and themanufacturer just delivers directly to the customers house after purchase. Because the inventory

costs are considerably lower for flooring retailers, that industry has not seen the level ofconsolidation experienced in the tools and hardware industry (i.e., Lowes, Home Depot). As aresult, MHK is dealing with significantly more and smaller retailers than, say, a toolmanufacturer deals with. This results in a strong shift of power towards MHK. MHKs largest

customer only represents 5% of sales. A decision by MHK to not sell its products to a mom andpop retailer hurts the retailer much more than it would hurt MHK, and both parties understandthis. Regardless, MHK makes sure it maintains a strong relationship with these retailers and thatthey are set up to succeed. For instance, MHK offers marketing and advertising support to the
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retailers, which include sales and management training, in-store merchandising systems,exclusive promotions and assistance in certain administrative functions, including helping to hostand maintain the retailers website. Further, product delivery is done predominantly on MHKsown trucks operating from strategically positioned warehouses.

Further, MHKs Dal-Tile segment, which dominates the ceramic tile market with five timesgreater market share than its nearest competitor, is believed to be the only major ceramic tilemanufacturer with its own network of company-owned stores. If the company can successfullyoperate its own storefront (not a foregone conclusion among manufacturers) and is the onlycompetitor doing so, that further establishes an advantage because MHK has greater control overthe distribution and customer experience.

While this model may not sound difficult to replicate, it takes a large capital investment and theproper mindset. Unfortunately, most of MHKs largest competitors are not publicly-traded, so itis difficult to compare profitability. One metric that can be calculated, however imperfect, issales per employee. While it does not account for the capital investment required for a large

distribution network, it does take into account the massive manpower required to service such alarge distribution network. Below is a table showing the competitors, U.S. market share, andrevenue per employee:

CompanyU.S. Flooring Market Share

2010Sales per Employee

Mohawk 22% $198K

Shaw (SHW) 21% $160K

Armstrong (AMSRF.PK) 6% N/A

Beaulieu 6% $161K

Tarkett 4% $218K

Shaw has a greater emphasis on the soft flooring market (31% market share versus 25% forMHK), which is less profitable than the hard flooring market and helps explain its lower revenueper employee. Shaw is a Berkshire Hathaway company and, therefore, likely also has a DCAsimilar to MHK. It is perfectly ok for more than one company in an industry to have a DCA. Infact, that often creates an oligarchy type market that helps prevent a competition on prices. WhileArmstrongs employee data was unavailable, it is important to note that the company emerged

from bankruptcy in 2006 and is still recovering, so clearly MHK outperforms that company.Tarkett is actually a French-based company with a stronger presence abroad than in the U.S.Tarkett has made available more information than the other competitors, so we can see that,company-wide, MHK surpasses Tarkett in gross margin but has roughly the same operating

margins. However, Tarkett touts itself as offering a larger range of different flooring types inmore countries than anyone. This level of dispersion stretches the company somewhat thin and

makes it very difficult to offer the same level of distribution as MHK, hence the lower overallrevenue and far lower market share in the U.S.

In summary, MHKs strong distribution network is nearly impossible to match because of the

scale needed to afford it and the time it takes to build it. Currently, Shaw is the only competitorthat can truly match it in the U.S., and Shaw focuses more on the less profitable soft flooring
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market. Regardless, the market is plenty big for the both of them, and both will continue torealize dominant market shares for years to come.

Sherwin-Williams (SHW) Case Study

Consider also Sherwin-Williams, a global leader in the development, manufacture and sale ofcoatings (i.e., paint) and related products. SHW owns a number of brands, including Sherwin-Williams, Dutch Boy, Krylon, Minwax, and Thompson WaterSeal. SHW is the largest coatingsmanufacturer in the U.S. and the third largest worldwide. Like MHK, SHW is an innovativecompany with high quality products known and respected throughout its markets. However,Akzo Nobel and Benjamin Moore, among other SHW competitors, boast the exact samereputation. All major competitors in the industry strive to constantly push the bar for better andbetter paint products. So what sets SHW apart in the U.S.? Once again, the answer is itsdistribution network. In this instance, what truly gives SHW the advantage is the vast network ofcompany-owned stores SHW has compared to its peers. In fact, SHW has nearly twice as manycompany-owned stores as the next 9 closest competitorscombined.

As I have noted earlier, you cannot assume that a manufacturer will be able to successfullyoperate a retail location. Manufacturing and retailing are two entirely different sets of operationsand skill sets, and many a manufacturer has tried its hand at retail and failed utterly. SHW,however, has been operating storefronts successfully for years. In the coatings industry,particularly in the U.S., having direct control of the customer experience and establishing long-term relationships with those customers is vital. Why would that be any different from, say, aclothing store, you ask? Because SHWs target customer relies heavily on SHW for their own

jobs. SHWs target customer is the professional contractor who wants the convenience, personalcare, and professionalism of a store devoted solely to paint products. While Home Depot,Lowes, or even Wal-Mart may have highly knowledgeable and helpful employees in their

respective paint areas, those places are not nearly as convenient as a smaller, more intimate paintstore where every single employee present is knowledgeable about paint and can help you.Would you rather go to Wal-Mart, deal with constantly changing paint experts, and sit throughlong-lines to buy your product or go to SHW, deal with the same employee/manager every time,and get in and out much more quickly? Further, the big-box retailers, by virtue of their size,generally have fewer locations per city, making SHW more convenient geographically.

SHWs approach will become increasingly more beneficial going forward. In 1980, only 41% ofsales were to professional contractors in the U.S. The other 59% were to do-it-yourselfers(DIY). However, as of 2010, that mix has shifted to 55% contractors and 45% DIY. It actuallypeaked prior to the housing crisis and has come down slightly in the last few years as peoplehave saved money by painting themselves. As the economy recovers and this long-term shiftcontinues, I would not be surprised to see the percentage of sales to contractors top 60%.

SHW still sells via the traditional channels (e.g., independent retailers, big-box chains previouslymentioned), and those traditional channels are very important for getting in front of as manypeople as possible, particularly the DIY crowd. But SHW does not rely on any one retailer, thusretaining a balance of power in the relationship. In fact, SHW states in its annual report that nosingle customer was material. To highlight this point, SHW recently lost its contract to provide
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paint for Wal-Mart because SHW was fine walking away from the relationship. Akzo Nobel,who replaced SHW, accepted terms SHW was unwilling to accept and is expected to realize a31% increase in its U.S. sales as a result. Clearly, Akzo Nobel will rely much more on Wal-Martthan SHW did, which will give Wal-Mart significant bargaining power in that relationship. AkzoNobel is a fine company and is larger than SHW globally with its own DCAs worldwide, but this

contract with Wal-Mart does not evidence that dominance. They are trying to build back up abeleaguered brand they purchased in 2008 while SHW will not lay off a single employee as aresult of the loss of this contract. This turn of events demonstrates the DCAs SHW has in theU.S. coatings market as a result of its vast network of company-owned stores.

Finally, despite a practically non-existent housing market the past few years, SHW has been ableto raise prices during that time and lost little volume as a result. The ability to raise prices duringtough times is clear evidence of a strong and sustainable market position.

In terms of profitability, SHW is a cash cow and has realized ROE in excess of 30% annuallysince 2006 and ROIC in excess of 20% annually since 2005. For a multi-billion dollar company

that is already #1 in its market, that performance is outstanding.

High-Level Rules

Rule One: The first metric I look for in determining whether a differentiated manufacturer has aDCA is the percentage of sales to big-box retailers, particularly Wal-Mart. It comes down tobalance of power. If a company has 50% of its sales to Wal-Mart, then Wal-Mart has all of thepower in that relationship in most instances. Wal-Mart can crush that company by forcing themto lower prices or cancelling the contract altogether. Wal-Mart will feel little to no pain fromdoing so. The ultimate question to consider is who feels more pain if this contract is cancelled?

I often pass altogether on small companies with a high percentage of sales to Wal-Mart, Home

Depot, Lowes, or Best Buy unless there is some other factor significantly depressing thosecompanies stock prices.

Rule Two: When trying to determine if a company has a DCA, another quick and dirty metricthat applies to most companies regardless of industry is free cash flow (FCF) as a percentage ofrevenue. Conventional wisdom states that if FCF/Revenue exceeds 5%, then the company likelyhas a DCA. Like any rule of thumb, this rule should be applied with great caution and only as away to quickly size up a company for further analysis. The rationale for the rule is thatcompanies with a DCA should be highly profitable, and a 5% FCF/Revenue margin isconsidered to be highly profitable. This metric should be looked at as an average of at least 5years because it is easy to manipulate any single year via variations in capital expenditures orworking capital adjustments. In our case studies above, SHW had an average FCF/Revenue of8.55 over the last 10 years, which is phenomenal. MHK averaged 6.47 over the last 10 years,which is also impressive. Some industries obviously have lower margins, such as grocery stores,so the expectations should be shifted down (though I stay away from grocery stores in generalbecause of those low margins). Conversely, your expectations should be shifted up for thetechnology and healthcare industries, which generally have higher margins.


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Rule Three: This rule is kind of cheating and may not be available to us for much longer, butBerkshire Hathaway tends to only buy differentiated manufacturing companies with DCAs. Bothcompanies discussed above have major competitors (Shaw and Benjamin Moore) that are ownedby Berkshire Hathaway. Obviously, Warren Buffett will not be around for forever and there is asyet no proof that his successors can continue his success. While Buffett continues to run the

company, however, I will be intrigued by any industry in which he buys a company outright,especially if it is differentiated manufacturing.

Rule Four: An asset turnover ratio in excess of 1.0 is to be desired. For every dollar of assetsretained in differentiated manufacturing, a company should be able to generate at least one dollarof revenue. Obviously, during bad times, the ratio may dip below 1.0. Over time, however, theratio should exceed 1.0. It is easier to do if a company comes by those assets organically. When acompany acquires another business, however, it runs the risk of paying too much for thatbusiness, resulting in inflated asset values. SHW, which generally comes by its assetsorganically, has realized an average asset turnover of 1.58, which again is phenomenal. On theother hand, MHK started off the decade strong, only to see its ratio drop consistently due to the

housing crisis and two large business acquisitions it paid too much for during that time period.Still, the average turnover ratio was 1.18 for the decade despite dropping below 1.0 in 2006 andstaying there. MHK recently wrote off a large percentage of its intangibles after realizing it paidtoo much for those acquisitions, so this ratio should be back above 1.0 next year. It is importantto note, however, how this ratio can be skewed by paying too much for otherwise highlyperforming assets or by writing down a significant percentage of assets while realizing the samelevel of sales. As with any metric, look carefully and proceed with caution.

Conclusion

I have walked through just a couple of industries in the differentiated manufacturing sector to

demonstrate how to establish a DCA in that sector. There are numerous other industries in thatsector that I did not cover. The DCA discussed is intended only for those industries thatmanufacture a final product to be sold to the end consumer. Companies that provide inputs toanother company for the manufacture of a final product must look to other ways to create aDCA, which is a topic of a future blog in this series.

To sum up, put little faith in brand strength or unique product features and focus instead on

the nuts and bolts of the companys distribution system and on who has the power between themanufacturer and the retailer. An expansive and efficient distribution system is nearly impossiblefor a competitor to overcome. Also look for management that focuses on their distributionsystem in investor presentations, otherwise they might allocate capital towards projects that donot establish or sustain the companys DCA. This is not to suggest that innovation and brandawareness are not important, but they are a necessary cost of doing business and not normally away for a company to set itself above the competition.

Understanding DCAs in any industry is a continuous process, so I welcome any feedback or

disagreements you may have. We can improve our understanding together.

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Durable Competitive Advantage Series_Differentiated Manufacturing