Do software companies have moats?
In this post I want to explore the idea of software companies having moats. For our terms I’m going to define an economic moat as an advantage one company has over competitors. A moat can take many forms including
- product differentiation
- perceived product differentiation
- driving costs down
- locking in customers
- locking out competitors.
An investor could argue that some software company somewhere qualifies as having a moat under one of those qualities. What I want to consider is do software companies have a moat in general, and if they do what are common aspects of that moat.
I believe that tech companies in general all inherit common characteristics of the industry, and three of those characteristics are, driving costs down, locking in customers, and locking out competitors. Many software companies have perceived product differentiation (Apple and Oracle come to mind), but I don’t believe that’s a widespread trait. I also don’t believe that real product differentiation exists much in the software realm.
So what are the aspects of software companies that give them a moat? I want to discuss each below.
Low Costs: A software firm has fixed assets of possibly an office, and computer equipment, but outside of that, most of the companies assets is stored in the minds of it’s designers, engineers and programmers. People react much better to cost cutting than machines do. An employee is willing to take a pay cut if they believe that at some point in the future their hard work might pay off with stock options. Whereas a company that has fixed machinery can’t decide to only use half the electricity without damaging it’s production pace.
Locking in Customers: For most non-technical users learning a new software package is a big ordeal. Consider that Apple OS X is easier to use, but Microsoft Windows has a much bigger market share. Most users who learned Windows at the office purchased a PC to use Windows at home, even though there were superior choices available.
A second example of this is word processors. Microsoft Office is the word processing package of choice worldwide. There are not many people using WordPerfect, or OpenOffice, even though they provide the same user experience, often at a much lower cost (OpenOffice is free). Office has locked in users with training, and with file formats. To open a Word document a user must be running Office.
Software companies lock in customers much like a bank. They create a switching cost which is the hassle of installing and learning new package so high that users are content to use a product that might not be the best choice available.
Locking out Competitors: This is an area that I feel is opening up, but is still very real. Most software companies create products that conflict with competing products. Try running Oracle on Windows, it doesn’t work well because Microsoft has it’s own database engine SQL Server. The same can be applied almost across the board, Apple locks out competitors unless they use the Apple guidelines for software, Microsoft does the same thing with Windows.
With all the great things going for software companies what could stop them? I have a few value destroyers listed below.
- Open Source Software - This is a movement where programmers build software components for free for the good of humanity. The software is often equal to the commercial version, and the price most of the time is free. You can’t compete with free.
- Revenue Recognition - This is a dicey subject not talked about often, but it’s a grey area in the GAAP on how to recognize software revenue if software is a service. This issue is what led NEC from being delisted recently. Improper recognition could make a company seem much more profitable than it is.
- Unfair expectations - Most investors have not forgotten the DotCom bubble in the 90s, and there are still some of the same expectations floating around. This leads to unfairly high P/E ratios, and share prices that are often high flyers for companies that don’t have much of a profit.
Does the implied economic moat around most software companies create a good investment opportunity? I think this needs to be evaluated on a case by case, as there are definitely great opportunities amongst the industry. What is known is that software companies have a great competitive advantage that is not available in many other industries, and investors should take advantage of good bargins on solid software firms.