What Is Ubiquiti Networks' Competitive Advantage?

MarketsMotley Fool

In describing his and Warren Buffett's investing philosophy, Charlie Munger once said, "We have to have a business with some inherent characteristics that give it a durable competitive advantage."

In their search for winning investments, Buffett and Munger generally shy away from tech companies (although that appears to be changing), but one company that I believe possesses a competitive advantage they would like is Ubiquiti Networks (NASDAQ: UBNT). Ubiquiti sells Wi-Fi hardware to both internet service providers and enterprises -- a business typically thought of as a commodity. Here's how Ubiquiti cracks the code.

Continue Reading Below

What is Ubiquiti's advantage?

On the company's recent earnings call, CEO Robert Pera gave investors a broader view of what he sees as giving the company an advantage:

That's a lot to take in, and certainly a big combination. The main advantage that Ubiquiti investors should appreciate is its unique business model, which I think is the most durable of those listed. Most enterprise hardware companies rely heavily on sales teams, but Ubiquiti's model goes in the exact opposite direction -- what Pera means by "pull" rather than "push" marketing.

Death of a salesman

Munger has been quoted as saying that "extreme maximization or minimization of one or two variables" can be a building block to "extreme success." Ubiquiti Networks minimizes one particular variable to an extreme: selling, general, and administrative costs (SG&A). Those costs are for things like advertising and customer support, as well as related personnel such as sales, accounting, and HR executives.

From the outset, the company decided to essentially operate as a lean research and development organization while hiring virtually no sales force, instead letting customers discover Ubiquiti by virtue of its low prices and features via word-of-mouth, or "touchless evangelism," as Pera puts it.

Ubiquiti also spends very little on customer support, instead directing its tech-savvy customers to the Ubiquiti Networks Community, where they can confer with each other as well as members of Ubiquiti's research and development team. Last year, the community had 4 million registered users, 11 million active user sessions, and registered 173,000 new members. Those new member registrations are up almost sixfold since 2014!

That Ubiquiti has grown in an unconventional way means its financial profile looks very different than other enterprise hardware companies'. Take a look at Ubiquiti's margins and sales per employee (the middle three columns) in the chart below.   

One can deduce how much the company spends on R&D and SG&A by looking at the difference between gross margin (the first column) and operating margin (the second column). Over the past three years, Ubiquiti spent only 12% of revenues on these expenses. That's significantly lower than competitors, which operate with 21%-97% operating expenses to sales.

This is due to the very low SG&A, and also the fact that Ubiquiti hires very small teams of highly talented engineers. The small number keeps R&D expenses in check, even though product engineering is at the company's core.

The unique business model allows Ubiquiti to sell its products at much lower prices than competitors -- sometimes as low as 25% of competitors' offerings -- while also making a very high operating margin of 34%. This allows Ubiquiti to earn an extremely high return on equity of 50%, while the company still maintains a solid net cash position.

Is it durable?

I think Ubiquiti's competitive advantage is durable as long as it keeps executing on product development. It would be anathema to "premium" enterprise companies such as Cisco to suddenly dramatically cut their prices and fire sales teams that they have depended on to land large enterprise accounts. In fact, in fiscal 2016, over one-third of Cisco's total employees were in sales and marketing. It would be very hard for large enterprises like Cisco to change that high-touch model overnight to be more like Ubiquiti.

And while Ubiquiti has built its enterprise business in smaller businesses, it is now targeting higher-end markets occupied by these large tech giants with its new Unifi Elite service. Whether these enterprises will go for the new low-priced offering over the traditional high-touch stalwarts will be certainly be interesting to watch.

10 stocks we like better than Ubiquiti NetworksWhen investing geniuses David and Tom Gardner have a stock tip, it can pay to listen. After all, the newsletter they have run for over a decade, Motley Fool Stock Advisor, has tripled the market.*

David and Tom just revealed what they believe are the 10 best stocks for investors to buy right now... and Ubiquiti Networks wasn't one of them! That's right -- they think these 10 stocks are even better buys.

Click here to learn about these picks!

*Stock Advisor returns as of August 1, 2017

Billy Duberstein owns shares of Ubiquiti Networks. The Motley Fool owns shares of and recommends Ubiquiti Networks. The Motley Fool recommends Cisco Systems and Netgear. The Motley Fool has a disclosure policy.