"Sticky" Business Equals Enormous Profit
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Barriers to entry, durable competitive advantage, wide economic moat, Porter's five forces . . . call it what you want. Basic economics suggest that above average profits will not last unless something protects them from envious competition. There are plenty of ways in which businesses can keep their moats deep and wide, but one method stands out, tried and true: customer stickiness.
What is customer stickiness?
Customer stickiness: A highly adhesive "substance" that, for one reason or another, compels customers to stick around and repeatedly open up their wallets.
Businesses with customer stickiness make it difficult for customers to switch to competitors' products or services (commonly referred to as high switching costs). Definitely a rare trait for any business, customer stickiness is hard to come by. But one company, in particular, has mastered customer stickiness and profited handsomely: IBM (NYSE: IBM).
What Makes IBM "Sticky"?
IBM has created itself a unique and defendable economic moat by providing integrated IT solutions in a 3-prong fashion: Software, services, and hardware. Its scale, experience, and breadth allow IBM to offer solutions with much greater depth than its competitors. This depth is greatly enhanced by IBM's stickiness, particularly:
- Software for mission-essential, complex applications - Not only is IBM an IT service provider itself, but it provides software for other IT organizations which run complex, mission-critical applications.
- Relationships - Since its turnaround in 1990, IBM has dramatically diversified its offerings as it has transformed itself into a services organization. More importantly, its services come in the form of a relationship. Relationships, of course result in reoccurring revenue. But even more importantly, relationships increase switching costs and make the customer relationship even stickier (and reoccurring revenue more dependable!).
Customer stickiness creates value
Since 2002, IBM's operating profit has compounded at about 12% annually. IBM has earned the trust of shareholders by decreasing risk while simultaneously strengthening its competitive position. Much of this success is a result of IBM's transformation into an organization that offers a stickier value proposition. This success has not gone unnoticed.
Even Dell (NASDAQ: DELL) has been reducing its hardware sales as a percentage of total sales as it seeks to offer IT solution services, a "stickier" offering with greater promise of reoccurring revenue and higher profit margins:
By the end of the year, enterprise solutions and services accounted for roughly 50 percent of gross margins—a record result, and great validation that we’re on the right road and delivering the technology solutions our customers need.
-- Michael Dell (Dell fiscal 2012 annual report).
HP (NYSE: HPQ) is following in the footsteps of IBM as well. As competition gets tougher and tougher in the PC business, HP and Dell are counting on the stickiness of IT solutions to help them make a turnaround. In fiscal 2011, HP acquired Autonomy in an effort to "help position HP as a leader in the future of information management" (HP fiscal 2011 annual report). In the process of the acquisition, HP created a new Information Management business unit.
And don't forget about Berkshire Hathaway (NYSE: BRK-B) (NYSE: BRK-A). Berkshire Hathaway, of course, is full of sticky businesses. Consider Berkshire's insurance subsidiary, General Re, a reinsurer. Reinsurers insure insurance businesses. They are counted on for disastrous situations. Sticky relationships are key to the reinsurance business. And don't forget: Warren Buffett put about $11 billion dollars to work in IBM, and IBM now makes up Berkshire's second largest stock holding. So buying Berkshire Hathaway will get you shares of IBM, too.
The Bottom Line
Keep an eye out for customer stickiness. But don't count on businesses with customer stickiness to trade at bargain levels. Customer stickiness is highly valued (for good reasons!). If you haggle over price too much on businesses with customer stickiness, you might miss the boat.
DanielSparks has no positions in the stocks mentioned above. The Motley Fool owns shares of Berkshire Hathaway and International Business Machines. Motley Fool newsletter services recommend Berkshire Hathaway. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.If you have questions about this post or the Fool’s blog network, click here for information.