PYPL - Own The Toll Booths

Summary

• Many toll roads of different shapes and sizes exist in our world today, and each of them have a toll booth.
• The major operators of these booths have enjoyed decades of prosperity and outsized returns, I investigate a few identified companies.
• I believe it is highly likely that new toll booth operators in new industries will appear in the years to come, a few possible candidates come to mind.

Background

Many toll roads of different shapes and sizes exist in our world today, and each of them have a toll booth. Of course I am not referring to just turnpikes and highways, but to metaphorical toll roads that exist within our modern society as well. When you woke up this morning and checked your email and phone notifications, that data was transported along a complex path possibly all the way around the world. How about the electricity that was used to charge those devices? You can see my point, in this article I will highlight a few major companies that act as toll booth operators who charge fees to access their networks and investigate their historical performance versus the benchmark of the S&P 500. Additionally, I will think out loud and present some possible future candidates for new operators in new industries.

Toll Booth Companies

I have compiled a quick list of enterprises that could be identified as a toll booth, however there are many more than just those contained in this list. I find the following companies to be of importance due to their positions in industries that are important now and will continue to be so in the future.

1. Cogent Communications ( CCOI ) as a toll booth for internet traffic. CCOI is an internet access provider and owner of a massive amount of fiber optic cable infrastructure. They are so large in fact, they actually own cables that direct 20% of the entire world's internet traffic. There is an excellent article written here by a fellow SA author that I recommend if you would like to have a greater understanding of the global internet architecture. In short, Cogent is collecting payments from telcos, end-user internet providers, and many more to manage the world's internet traffic.
2. American Tower ( AMT ) for mobile data. AMT is the largest operator of cell towers in the world and has operations in nearly every region on the planet. On top of this, they have also begun a vertical integration strategy with cloud data management via ownership of data centers as detailed in a previous article I have written. With mobile data usage increasing exponentially, American Tower will be the beneficiary of higher revenues with little-to-no increase in cost.
3. DTE Energy ( DTE ) for distribution of electricity. DTE recently spun-off its natural gas division to become a pure-play electric utility. Given that its headquartered in Detroit, there is a substantial dependence on this provider's network now and in the future as the Big 3 auto companies are rapidly transitioning to EVs. Many other electric utilities could also be used for this toll booth example but I find this one to be particularly compelling.
4. Watsco ( WSO ) for distribution. WSO focuses heavily on the distribution of HVAC equipment and replacement parts, building the largest and most efficient network for supplying these crucial systems and parts. As global temperatures have steadily increased and improvement in the standard of living has been significant over the past few decades, demand for HVAC systems has exploded. On top of this, green legislation has mandated improved efficiency standards that require upgrades of existing systems. The toll road operated by Watsco in this industry is unparalleled and will continue to prosper.
5. Union Pacific Railroad ( UNP ) for transportation. In the first and only example of an actual road, this railroad is an absolute giant with incredible leverage. The vast majority of goods being transported via rail do not have any options in terms of other modes of transportation. The consolidation of the industry along with the extremely high barriers to entry mean this regional railroad is the one and only rail line for many customers and you can imagine how UNP has reaped the rewards. With essentially non-negotiable rate increases and passing on costs to the customer, railroads have generated large profits for over a hundred years. The included tailwind of a focus on domestic manufacturing and mining of natural resources has only placed more importance on this toll booth.

Historical Performance

It should not come as a surprise that nearly all of these companies have generated outsized returns versus the S&P 500. To illustrate, I have compared the total return of the S&P 500 versus an equal weighted portfolio of the above companies. The comparison models the returns from 2000 to present, I chose this time period as it captures a several large events affecting the stock market such as the dot-com bubble, the great financial crisis, and the recent global pandemic. To truly know the strength of these companies it is important to understand how they perform in difficult situations as well as times of economic growth.

The outperformance of this portfolio is massive, generating a total return that is nearly 4.5x the return of the S&P 500 if you had simply invested an equal portion across the five companies and let it compound. Past performance is not an indicator of future returns, but the results are encouraging about the strength of these businesses either way.

Predicting New Toll Booths

Innovation and change are happening faster than ever as we continue to develop new technologies and make new discoveries. This naturally leads the way to new industries and new toll roads that need operators. Being able to identify and predict who these players may be could make a massive difference in your long-term returns. I will brainstorm and think out loud about a few ideas that I've quickly pondered but would like to perform more research.

• Visa ( V ) and PayPal ( PYPL ) could possibly have the opportunity to solidify this status on the rapidly growing digital payments highway. They both exhibit dominant positions in the market and are continuously innovating to stay ahead. The global adoption of digital and cashless payments still has a huge runway, in fact it's still in its early stages. I personally believe the potential as leaders in this industry is massive and extremely profitable.

• Microsoft ( MSFT ) and Amazon ( AMZN ) could become toll booths for company data transportation brought about from the relatively new cloud industry that has been booming. Between the two of them, they own more than half of the entire market and are in the best position to scale. The high margins and the quickly growing addressable market led to an undeniably attractive position.

• Spotify ( SPOT ) may have a unique opportunity as the number of options for audio/music listening are slowly consolidating. Just 15 years ago, it was normal to use 4+ devices or sources to listen to music or podcasts. A typical week for most people may have involved listening to the radio station directly at home or through a car, playing music on an mp3 player, purchasing CD's, and purchasing songs/albums on iTunes. Now all of that can be done from one device from one source, and with the added benefit of listening to any audio you want anytime you want. The far and away largest owner of the music/podcast freeway is Spotify. It seems as if the company is starting to figure out how to monetize its products and increase its capabilities and services, the potential to accelerate revenue per user and benefit from network effect can catapult the company to financial success. For most people, music is an important part of life that won't be sacrificed for a reasonable monthly fee.

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