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Hot Stock Economic Moats in Hardware
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Given the hype that often surrounds them, evaluating the economic moats of technology companies can be especially tricky. During the tech-spending boom of the late 1990s, the rising tide was lifting all boats, and it was easy to mistakenly assume that some companies had a sustainable economic moat when in fact they "were merely at the right place at the right time.

Technology hardware companies often face periods of inventory imbalances. Either they accumulate too much inventory, or customers suddenly demand more than they can readily supply. The risk is that products or components that sit on the shelf for a long time may have to be heavily discounted, or worse, not sold at all. We saw the fallout of this soon afterthe Internet bubble burst in 2000, with Cisco and a host of others writing down billions in excess inventories.

A warning sign for investors is when a company's inventories grow faster than sales over several quarters. But even this trend is obscured by the complexity of the supply chain. Component suppliers, distributors, and contract manufacturers all hold inventories above and beyond the levels of the end product producer, even though the end producer often bears the economic risk for these inventories. Look in the "risk factors" section of the 10-K for these kinds of situations. If they exist, the inventory number shown on the balance sheet may not reflect true inventory. Although most hardware companies differentiate themselves based on technological advantages, technology itself does not constitute an economic moat. Companies with superior technology can easily fail, just as com­panies selling commonplace technology can dominate an industry Companies such as Intel and IBM have built moats not with superior technology, but by focusing on distribution channels, dominant scale, and broad product lines. What's more, technological leads in the hardware industry rarely last long. For example, Palm pioneered the personal digital assistant (PDA), but it wasn't long before Sony, Microsoft, Handspring, and others all eroded the firm's early lead.

Economic moats in hardware are rare, but let's look at some real-world examples of the four key economic moats we covered in Chapter 3.

High Customer Switching Costs

Telecom equipment manufacturers such as Nortel, Alcatel, and Lucent each benefit from high switching costs. Their bread-and-butter customers, former telephone monopolies such as AT&T and the Baby Bells, are extremely con­servative in their buying habits. They run extremely large, complicated networks, and they have to be 100 percent sure that any new equipment they purchase will work seamlessly within their existing networks and that their suppliers are actually going to be around IO years from now. When buying habits are that entrenched, it is unlikely that buyers will risk their jobs by changing vendors.

Low-Cost Producer

Dell Computer is a textbook example of a company that benefits from being the low-cost producer. Part of the reason Dell has been able to achieve this status is the scale it enjoys as one of the world's largest PC vendors. Because the company purchases chips and disk drives in large volumes, it has leverage with ks suppliers and can, therefore, negotiate lower component costs than its rivals. Dell is also the low-cost producer because its direct sales method is far more efficient than those used by rivals such as Hewlett-Packard. Dell not only avoids paying commissions to a third-party reseller when it sells products via the Web, but also can keep close reins on its inventories and receivables. This means Dell can pass on lower component costs to its customers more quickly than its competitors can.

A more obscure advantage that Dell gets from being the largest PC vendor is that its suppliers are more "willing to wait longer for payment and are more flexible about getting Dell the components it needs exactly when it "wants them. This allows Dell to keep its inventories low. Combined with Dell's direct sales business model, this creates a big competitive advantage because Dell receives payment for its products before it has to pay suppliers. With little money being tied up in Inventories, Dell has low working capital requirements, thus allowing it to generate enormous returns on invested capital.

Intangible Assets

Companies often use intangible assets, such as patents and brand names, to help sustain excess returns on investment over an extended period of time. Chip companies Linear Technology and Maxim Integrated Products don't often get recognition for their performance, but both of these chipmakers have outstanding fundamental track records because of their intangible assets. Over the 10 years ending in 2OO2, for example, Linear posted an average sales growth of 16 percent, average gross margins of more than 70 percent, and average returns on invested capital of 90 percent—all far better than the industry average. Maxim posted similar results.

What is it that has allowed both firms to sustain such great results over an extended period of time? A key part of these companies' success is due to their niche as suppliers of high-performance analog semiconductors. Analog chips are highly proprietary, so they lack direct substitutes, and the engineers who design these products face a set of unique design challenges. Digital circuits process information in binary fashion—that is, is and o's—whereas analog chips primarily process real-world signals—that is, temperature, pressure, weight, and sound. Firms like Linear, which have years of R&D and manufacturing experience, have a strong competitive edge over newer rivals. A scarcity of analog engineers also widens these companies' economic moats be­cause it would take a long time for a potential rival to hire an experienced staff to compete with Linear and Maxim. The knowledge and experience of these firms' engineers is an intangible asset that allows both of them to earn significant excess profits.

The Network Effect

In the hardware industry, network effects can arise because hardware often needs (1) to operate with other hardware and (2) to be maintained by people. The more a certain product becomes prevalent, the more other hardware needs to take heed of the product's characteristics and the more people (and time) are invested in learning to operate the product.

Cisco Systems' routers are a great example. Routers are basically advanced computers that decide the best route for a piece of data to follow in a network. No matter "who manufactures them, routers have to know how to "talk" to each other. A router that cannot communicate with the rest of a net­work is useless. This means that router manufacturers have to use a common set of standards when developing new products. Therefore, the vendor with the largest market share is in the driver's seat when it comes to development and evolution of standards.

Cisco was the first company to make a wide market in routers in the 1980s and gradually built code and protocols to function with more and more generations of its equipment. When others tried to enter the market, they began to realize how difficult it was to get routers to consistently operate with one another. Cisco's only other major rival in the market for high-end routers, Juniper Networks, was eventually successful, but it took over a year's time and an expensive effort to hire Cisco programmers who knew where the proverbial bodies were buried.

By becoming the de facto standard for routers, Cisco also created a secondary network effect. It takes time and extensive training to become familiar with the language and instructions for maintaining Cisco routers. The engineers who maintain networks take courses and often earn certifications to aid in their work. By being first, Cisco was able to become the first certification that most network engineers obtain—and often that's good enough, because these are the folks who also decide which equipment to buy. Cisco certification and training essentially helped to sustain the pervasiveness of Cisco's hardware.

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