After a 100% rise over the last 18 months, Target
The stuff moats are made of
Warren Buffett coined the term "economic moat" to describe the strength of a company's competitive advantages. Many factors confer short-term competitive advantages, but in his excellent The Little Book That Builds Wealth, Morningstar's Pat Dorsey convincingly argues that only four factors create an enduring economic moat. Let's use Dorsey's criteria to see what Target's moat is made of, and just how sustainable it is.
1. Intellectual property rights
Moat-building intellectual property includes intangible assets like patents, licenses, and brands. Any company can have a brand, but truly moat-widening brands must increase a consumer's willingness to pay for a product.
Moat source: Yes
Target has carved out a profitable niche in the competitive retail landscape. The company's products are cheap, but still chic, and its aesthetically pleasing stores attract a more affluent clientele than competitors like Wal-Mart
2. Customer switching costs
Products that are tightly integrated with a customer's business or lifestyle make it difficult for that customer to switch to a competitor's product.
Moat source: No
While consumers may enjoy shopping at Target, they're only a coupon away from switching to Wal-Mart's everyday values.
3. The network effect
The value of some services increases in direct proportion to the number of people using them. For example, Facebook offers a much richer experience with 500 million users than it did with a handful of undergraduate dorm-mates.
Moat source: No
Additional Target shoppers only make the store more crowded for the other shoppers.
4. Cost advantages
Finally, lower costs can create lasting competitive advantages. The benefits of operational efficiencies and smart processes inevitably erode over time. A truly sustainable cost advantage, like economies of scale or a superior geographic location, simply can't be copied.
Moat Source: Yes
With a $38 billion market cap, Target enjoys an edge over its suppliers. However, its scale advantages are dwarfed by those of Wal-Mart.
Numbers don't lie
To determine whether a company enjoys a sustainable competitive advantage, examine its return on invested capital over time. Returns consistently exceeding a company's cost of capital suggest that it possesses a nice moat. Here's how Target's ROIC stacks up next to its competitors:
|
Company |
FY2008 |
FY2009 |
FY2010 |
|---|---|---|---|
|
Target |
11.3% |
8.5% |
9% |
|
Kohl's |
15.2% |
11.3% |
11.4% |
|
Sears Holdings |
6% |
2.9% |
4.6% |
|
Wal-Mart |
12.9% |
13% |
13.7% |
Source: Capital IQ, a division of Standard & Poor's.
Survey says: Narrow moat!
Target's brand may be strong, but it simply can't match Wal-Mart in terms of efficiency. However, even though Target is clearly a second banana to the big W, the company still enjoys a nice niche. Thanks to the strong and steady free cash flow it generates, Target has recently popped up in the portfolios of top investors like Wally Weitz and Ken Heebner.
Ready to buy?
Not so fast, my Foolish friends! Even if you believe that Target can widen its narrow moat and fend off the competition, that doesn't automatically make it a smart buy. While competitive advantage is critical, it's also essential for investors to have a strong understanding of a company's management, finances, and valuation -- and to always buy at a significant margin of safety.
That's the strategy our team at Motley Fool Inside Value employs. You can read all of the team's research reports, and see their best buys for new money now, with a 30-day free trial.
