In describing his and Warren Buffett's investing philosophy, Charlie Munger once said, "We have to have a business with some inherent characteristics that give it a durable competitive advantage."
In their search for winning investments, Buffett and Munger generally shy away from tech companies (although that appears to be changing), but one company that I believe possesses a competitive advantage they would like is Ubiquiti Networks (NASDAQ:UBNT). Ubiquiti sells Wi-Fi hardware to both internet service providers and enterprises -- a business typically thought of as a commodity. Here's how Ubiquiti cracks the code.
What is Ubiquiti's advantage?
On the company's recent earnings call, CEO Robert Pera gave investors a broader view of what he sees as giving the company an advantage:
... I believe up to this point in time, Ubiquiti, as a company, has been misunderstood by a lot of people. I feel we have a group of core competencies that gives us a great competitive advantage in the market.
Specifically, our ability to target markets, our vision and being in markets a lot of times before others; of course, our business model, which revolves around touchless evangelism and pull; I would say how we allocate our resources and get great investment on our resource allocation; and finally, which we don't get enough credit for, is our design capabilities. And I believe, we're one of the few companies right now in the hardware space that could execute on beautiful technology, inside and out. ... together, those core competencies have given us a really unique, I think, competitive advantage in the market ...
That's a lot to take in, and certainly a big combination. The main advantage that Ubiquiti investors should appreciate is its unique business model, which I think is the most durable of those listed. Most enterprise hardware companies rely heavily on sales teams, but Ubiquiti's model goes in the exact opposite direction -- what Pera means by "pull" rather than "push" marketing.
Death of a salesman
Munger has been quoted as saying that "extreme maximization or minimization of one or two variables" can be a building block to "extreme success." Ubiquiti Networks minimizes one particular variable to an extreme: selling, general, and administrative costs (SG&A). Those costs are for things like advertising and customer support, as well as related personnel such as sales, accounting, and HR executives.
From the outset, the company decided to essentially operate as a lean research and development organization while hiring virtually no sales force, instead letting customers discover Ubiquiti by virtue of its low prices and features via word-of-mouth, or "touchless evangelism," as Pera puts it.
Ubiquiti also spends very little on customer support, instead directing its tech-savvy customers to the Ubiquiti Networks Community, where they can confer with each other as well as members of Ubiquiti's research and development team. Last year, the community had 4 million registered users, 11 million active user sessions, and registered 173,000 new members. Those new member registrations are up almost sixfold since 2014!
That Ubiquiti has grown in an unconventional way means its financial profile looks very different than other enterprise hardware companies'. Take a look at Ubiquiti's margins and sales per employee (the middle three columns) in the chart below.
One can deduce how much the company spends on R&D and SG&A by looking at the difference between gross margin (the first column) and operating margin (the second column). Over the past three years, Ubiquiti spent only 12% of revenues on these expenses. That's significantly lower than competitors, which operate with 21%-97% operating expenses to sales.
This is due to the very low SG&A, and also the fact that Ubiquiti hires very small teams of highly talented engineers. The small number keeps R&D expenses in check, even though product engineering is at the company's core.
The unique business model allows Ubiquiti to sell its products at much lower prices than competitors -- sometimes as low as 25% of competitors' offerings -- while also making a very high operating margin of 34%. This allows Ubiquiti to earn an extremely high return on equity of 50%, while the company still maintains a solid net cash position.
|Company||Operating Margin||Return on Equity||Net Cash (Debt)/Market Cap|
|Hewlett Packard Enterprise||8.0%||7.4%||(20.9%)|
Is it durable?
I think Ubiquiti's competitive advantage is durable as long as it keeps executing on product development. It would be anathema to "premium" enterprise companies such as Cisco to suddenly dramatically cut their prices and fire sales teams that they have depended on to land large enterprise accounts. In fact, in fiscal 2016, over one-third of Cisco's total employees were in sales and marketing. It would be very hard for large enterprises like Cisco to change that high-touch model overnight to be more like Ubiquiti.
And while Ubiquiti has built its enterprise business in smaller businesses, it is now targeting higher-end markets occupied by these large tech giants with its new Unifi Elite service. Whether these enterprises will go for the new low-priced offering over the traditional high-touch stalwarts will be certainly be interesting to watch.