Business Moat: Essential for the Consumer Goods Industry in a Price War

With the emergence of Amazon as the dominant eCommerce retailer, the companies in the consumer goods industry have never needed a business moat more than before. A business’s brand power is essential for setting up a minimum advertised price (MAP), in order to sustain a long term competitive moat and allow it to survive fierce continual price wars between retailers.

The price wars between Amazon, Walmart, and the small retailers gasping for survival have illustrated some of the most important lessons for the consumer goods industry and the investors who buy their stocks.

These lessons are timeless, and the reality of doing business in the non-stop competitive world of capitalism. But the lessons of economic moats have never been made more clear than during Amazon’s rise in retail during the first two decades of the 21st century.

A few definitions before we talk about consumer goods companies who have lived and died in the fierce Amazon and Walmart environments.

Business moat: A business moat, or economic moat, is a competitive advantage for a company that allows it to maintain its profitability over the long term due to its inherent features (a superior product, superior business model, and/or advantage from scale).

Minimum advertised price (MAP): A minimum advertised price (or MAP) is an agreement between a manufacturer/ goods producer and a retailer which states that a retailer can’t advertise a company’s product below this MAP price. This protects a product’s reputation and pricing power.

Price wars: A price war is an environment wherein two competing companies in the same market will aggressively price products in order to increase market share, oftentimes pricing these products with no profit margins or even at a loss.

A strong moat for a business stuck in the middle of a price war can help it from becoming “collateral damage” when titans like Walmart and Amazon duke it out for dominance in a market.

This business or economic moat is essential for the long term survival of a consumer goods producer, as it allows them to maintain profit margins by avoiding these detrimental pricing schemes on their products through setting a minimum advertising price (MAP).

There are more realities between the dynamics of goods producer/ manufacturer and retailer that we need to understand, but first let’s provide context with a historical example of how it works.

Amazon’s Ruthless Price War in Diapers, In Order to Swallow Up a Small Competitor

As told in the great book about Jeff Bezos called The Everything Store: Jeff Bezos and the Age of Amazon, Amazon rose from a tiny website into a retail behemoth by 2010. Once Amazon had set up an impenetrable moat in books and ebooks, the company set their sights for a lucrative consumer goods/ durables category—more specifically, in diapers.

At the time, Amazon had grown to a size where they could afford to start a business segment whose sole purpose was to watch competitor’s prices both offline and online.

Once the company found a fast growing competitor which seemed to have a moat in a niche, Amazon would go squash it to claim that business as theirs.

A company called Quidsi with the website had found their niche by focusing on just one category of consumer durables, and building extremely efficient and localized distribution in order to provide rock bottom prices for customers.

Once Amazon got a whiff of Quidsi’s rapid growth, they decided to enter the space and take it for themselves.

Long story short, Amazon engaged in a ferocious price war with Quidsi, launching a special subscription including Prime for moms and eventually dropping the price of diapers so low that at one point Amazon was losing hundreds of millions of dollars per month.

It took many months of fighting between the two companies before it reached that extreme crescendo, at which point Amazon engaged in intense acquisition talks with Quidsi.

Quidsi was in quite the quandary at the time.

Knowing that Amazon had the superior economic resources (its scale and aggressive pricing schemes being its biggest business moat), it knew that Amazon could be the last man standing in a price war like this, so they eventually folded.

What I mean by that is, the company agreed to a favorable acquisition price for Amazon out of the (rational) fear that the price war would eventually put Quidsi out of business.

In the race to scale for the ultra price competitive retail business, Amazon was first, and ruthlessly aggressive—and that competitive moat allowed it to steal market share in many similar industries as well.

How Price Wars Can Cripple Margins for the Consumer Goods and Durables Industries

Consumer goods companies caught in the middle of a fierce price war can become collateral damage in the process, which can permanently damage the brand and its profitability.

A simple way to describe this is with an example.

Say that you had a small diapers brand during the Amazon battle with Quidsi. Say that you sold a pack of diapers for $50. Then, during the price war, both Quidsi and Amazon cut the price of your diapers to $35.

This lower $35 price point has conditioned customers to expect to only pay $35 for your brand, and so they’re likely to balk at paying $50 when they’ve considered you a $35 quality diaper.

While big retailers eventually end their price war and prices go back to profitable margins, the perception of your brand has become permanently crippled with customers, and will likely take them to your competitor’s diaper products which are viewed as superior, or a better deal now than before.

The Relationship Between Retailer and Consumer Goods Producer

Unfortunately, that’s what can (and does) happen if you’re a producer without a strong business moat.

You see, retailers will often agree on a wholesale price with a manufacturer, but that’s where the relationship ends. By law, the retailer is allowed to re-sell your products at whatever price they want, either much higher to swallow up profits, or much lower (even at a loss) to attract higher sales volumes.

Once the retailer has purchased the products from the producer, it’s now their product to do with it what they please.

Now of course a producer isn’t bound by law to sell to the retailer either. If you don’t like that Amazon is damaging your brand by selling it at a loss, you can choose to take your business elsewhere.

But if a retailer has so much negotiating power where the price of not being available for sale in the retailer is higher than the potential erosion of margins, a producer is usually stuck with little negotiating power.

That’s why for a large retailer, scale is one of the most important moats it can have.

Once a retailer becomes THE place to go by many consumers, pretty much every company in the consumer goods industry has to play by their rules or lose out on significant business.

How A Business Moat Shields the Consumer Goods Producer

The negotiating battle works the other way too, though. If a brand gains enough power to be basically essential, where the retailer would lose business by not carrying that specific brand, then the consumer goods producer can draft contracts to limit exposure to a price war.

For example, say that you have a very strong brand in the mind of consumers—like Doritos chips or Coca Cola. Any grocery store (or retailer-grocery hybrid like Walmart) would be a fool not to carry your products, because people sometimes go to stores to buy just those products. In other words, the brand power of Doritos and Coca Cola are so strong that the customer HAS to have it, and so, the retailers generally HAVE to have it too.

That’s not to say that consumer goods producers with the strongest moats can wield their power like a tyrant.

The number of customers a retailer might lose from absurd demands might not be worth the trouble, and vice versa, and so you can see that there’s a healthy balance of power, with give-and-take, that occurs between large companies with moats which do business with each other.

A consumer goods producer could take the “nuclear” option and cease to do business with a retailer which too heavily discounts their products, but oftentimes they use a technique called the minimum advertised price (or MAP).

What the MAP does for a consumer goods company is limit how much a retailer can advertise any promotional prices at.

Note that this only works for advertising—a retailer can still choose the price once a customer is in the store (at which time a version of the nuclear option might be a producer’s only choice).

But, by having a shield that is bound, by law, to prevent a retailer from heavily discounting your consumer goods, your brand can keep its premier spot in the customer’s mind and that price point anchor.

The MAP is something that the retailer and consumer brands company will write into their sales contracts, and so that’s why it’s bound by law.

But, and this is key, a consumer brands company has to have the negotiating power (competitive moat) in order for a retailer like Amazon to want to agree to these terms in the first place.

If a consumer goods product has no moat, to the point where it is essentially a commodity and easily replaced, then a retailer has no reason to agree to the MAP, since the product is so easily replaceable.

Investor Takeaway

And so that’s why when investors are analyzing companies in the consumer goods industry, the true business moat is one of the most critical things to examine.

A company could have great profit margins, like we saw with diapers, but unless the diaper brands themselves have a moat which shields them from a price war, their margins could go down the drain and become awful investments.

It’s why some of the best investors like Warren Buffett have talked about the supreme importance of a company moat, a competitive advantage that allows a company to sustain its great financial performance.

Looking at stocks solely by their historical results (earnings, growth, etc) misses the point because without the moat, those great margins are unlikely to become sustainable.

That’s because the price wars aren’t limited just to retailers and consumer goods, but to all sorts of businesses and industries.

A company without a competitive advantage but great results is just asking for other businesses to come in and steal share and/or get caught up in a bigger price battle between titans.

A quote I really love by Buffett is:

“In the business world, unfortunately, the rear-view mirror is always clearer than the windshield.”

Knowing the numbers behind an investment is great, and we have lots of resources to help investors with that task.

But arguably more important is the business moat (or lack of a moat) that needs to be examined and analyzed with an investment. It’s why I really urge investors to read the 10-k thoroughly and analyze the business, its products, and its moat rather than just the financial metrics.

Capitalism can be great for consumers, but it can also be a death knell for companies and investors—especially those with no moat.

Not only must a company have a moat, but so must an industry, as the ebook destroyed the physical book store industry quickly careened the industry into a decline stage.

As an investor, you don’t have to micromanage every possible price war and sales negotiation. Let the people in the business you’ve invested in worry about that.

Instead, figure out the companies that seem to have the strongest moats, and hang on to them. As long as their financials don’t deteriorate (which I show how to analyze with the Value Trap Indicator), then they should make for fine investments over the very long term.

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