New entrants, peer to peer lenders, financial technology companies etc are currently making bold claims about how they will change the banking industry. But superior technology is rarely enough to create a lasting “defensive moat” around a business. In fact, the analogy of “defensive moats” may be apt, because moats around medieval towns rarely provided protection from a determined besieging army.
Take the siege of Rouen, which was attacked by Henry V in 1418. Henry began the siege on 1st July, as he lacked enough cannon to destroy the walls, he decided that over the next five months he would starve the inhabitants into submission. In order to discourage escape, he dug a moat around the town. At some point the inhabitants decided to expel the old and infirm. But Henry refused to let them pass through his lines, so they were left to die in the ditch between the army and the walled town.
In 1981 IBM had revenues of $30bn, v $15m of Microsoft. IBM dominated the mainframe market, and had seemingly a very deep moat around its business. It had corporate relationships, and decades of research and development producing mainframes and business computers.
Back then Apple with revenues of $330m was actually 20x bigger than Microsoft. But the story has been oft told how IBM let Bill Gates write a favourable contract that insisted he would keep the ownership of the software, (IBM merely licensed it from Microsoft) and also IBM were required to sublicense the operating system to other computer makers. Microsoft was then able to overcome Apple’s initial lead, and had a market share of 80% in operating systems market, for two decades. By the mid-1990s IBM was loss making for 3 consecutive years, culminating in a $7bn loss in 1993.
Net Revenues 1981 1991 10 year 2001 10 year 2011 10 year
$m CAGR CAGR CAGR
Microsoft 15 1,843 62% 25,296 30% 69,943 11%
IBM 30,000 64,766 8% 85,866 3% 106,916 2%
Apple 334 6,308 34% 5,363 -2% 108,249 35%
Net income 1981 1991 10 year 2001 2011 Microsoft 463 7,349 32% 23,150 12%
IBM -598 7,723 145% 15,855 7%
Apple 309 -25 n/a 25,922 176%
I have gone back and looked at revenues and profits in all three companies over the last three decades, starting in 1981. Microsoft completely undermined IBM, by providing the software for IBM’s machines. The numbers show that being big does not protect you when a new entrant starts taking your business apart. Microsoft grew revenues at a Compound Annual Growth Rate (CAGR) of 62% in the 1980s, falling to CAGR of 30% in the 1990s.
Between 1986 and 2000, Microsoft averaged an after tax return on capital of 29%. This is a phenomenal return – but this understates just how high returns were in the software business. Microsoft did not pay a dividend, so tens of billions of dollars of returns accumulated on the companies balance sheet. If Bill Gates had distributed the cash, his return on capital would have been around 100% after tax.
Microsoft’s moat seemed very deep and very wide. And yet, by creating the ipod, then iphone, then ipad – they completely undermined the defensive moat around Microsoft. Apple’s revenues grew at CAGR 35% to $108bn so by 2011 had overtaken both Microsoft and IBM, in revenues and profits.
Could the same thing happen to banks? Customers will always want current accounts, but perhaps the other activities that banks do will pass to specialists – who can do them more conveniently and cheaply.
Infrastructure of retail banks is frustratingly outdated, and banks are built in a way that invites competition from financial technology companies (so called “fin tech”). But the real vulnerability is not bad technology. Tech savvy programmers have always been dismissive of Microsoft’s user experience and programming bugs.
Instead it is that banks make themselves vulnerable by how they price – offering core deposit services cheaply or free while squeezing customers on ancillary products such as overdrafts, currency exchange, branch based advice on long term savings and insurance.
It wasn’t the US or EU regulators that broke up Microsoft or IBM’s moat. Instead it was a totally new way of creating value for the customer, which the incumbent found it impossible to compete with.
My own thoughts are that financial new entrants might not make huge amounts of money for their equity owners. Instead financial services might reduce cost and complexity for customers. In the same way that new entrants in the supermarket sector have kept food prices low for customers, but been a disaster for Tescos and other supermarkets shareholders. That is, new entrants could well shrink the revenues pools in traditional banking. And when banks have high fixed costs, which have traditionally been a defensive moat, those same fixed costs are going to be very hard to manage in the new era of competition. Perhaps then, bankers are at risk of suffering the same fate as the old and infirm citizens of Rouen.
The Innovators – Walter Isaacson
Competition Demystified – Bruce Greenwald