In the first two sections of 101 Equity Analysis we've looked at the details of the company and the industry it operates in. We've gathered a lot of information, but we haven't yet really understood the dynamics of the industry. http://boards.fool.com/Message.asp?mid=21423336http://boards.fool.com/Message.asp?mid=21391915Now we'll use the knowledge gathered in the Company and Industry profiles to analyze the long term profit potential of the industry based on its dynamics. The best book I've read on this is Harvard Business School Prof. Michael Porter's Competitive Strategy: Techniques for Analyzing Industries and Competitors (Free Press, 1980). It expands on his classic Harvard Business Review article - How competitive forces shape strategy : Harvard Business Review, March 1, 1979. Here's another source where you can read about Porter's model:http://www.quickmba.com/strategy/porter.shtmlPorter's contention is that the ultimate profit potential of an industry (long term R.O.I.C.) is the collective result of 5 key forces :1. Threat of new entrants2. Bargaining power of customers 3. Bargaining power of suppliers 4. Rivalry among existing firms5. Threat of substitute products or serviceshttp://harvardbusinessonline.hbsp.harvard.edu/b01/en/common/item_detail.jhtml?id=79208Since these forces define the basic structure and dynamics of the industry, the interplay among these forces and their relative dominance is almost an industry characteristic key to understanding how it works. A new entrant has to either make the rules of the game work in his favor, or figure out how to change the rules of the game.If these 5 forces are collectively rated 'low' for an industry, chances are it offers high potential for sustainable profitability. Porter's examples were oil services, soft drinks, cosmetics, toiletries. Conversely, a collective rating of 'high' would not be very conducive to long term profitability e.g. in the tire, metal can and steel industries.Porter's 5 forces analysis can be valuable for both startups and established companies. In fact one of the key things to look for in an IPO prospectus would be how the NKOB is addressing existing industry structure. However, since the 101 project is focused on relatively more established players, our focus will be more on the defender than on the attacker in any industry, in terms of its Sustainable Competitive Advantage or 'moat'.As Buffett puts it : “"We like to own castles with large moats filled with sharks and crocodiles that can fend off marauders -- the millions of people with capital that want to take our capital." I'm sure there are many other variations out there, but the gist is - without long term Sustainable Competitive Advantage, a competitor doesn't stand a chance of survival.http://aol.fool.co.uk/stockfoolery/2000/sf000502a.htmIn this post we'll only look at #1:Threat of new entrants, since each of the forces needs some amount of detailed explanation. Depending on how much discussion this generates, I'll come back and address the other forces sequentially.Threat of new entrants:In an industry with a dominant monopoly, the monopolist corners long term profits. Hence, the more difficult it is for new competitors to enter the industry, the more profitable it will be for existing players. Some questions that help assess the threat of new entrants are:- What economies of scale are available to industry participants?- Is there significant customer perceived product/service differentiation?- How capital intensive is the industry?- How high are the switching costs for customers?- How difficult is it to secure distribution access?- Does Government policy limit or regulate competition?Economies of scale relate to all aspects of the business – not just production volume. Established Consumer products companies like Coke have huge distribution networks which lower the incremental distribution cost of new products. WalMart's humongous scale makes it very difficult for a new competitor to get comparable prices and service levels from vendors. But most restaurants don't enjoy economies of scale – making it relatively easy for a new entrant to set up and get going. Generally, the more customized/localized the product/service, the less economies of scale it enjoys.Customer perceived differentiation drives the ability to charge a premium – hence be more profitable. Bare metal Cardiac stents were becoming commoditized until J&J came up with the Cypher Drug eluting stent – the value of the stent market doubled as a result, and both J&J and Boston Scientific raked in the shekels. Starbucks basically sells coffee – but it does so wrapped in its 'third place' mystique that empowers it to charge a hefty premium. OTOH, purchasing of toilet paper or cement generally tends to be rather price conscious due to the lack of customer perceived differentiation.Almost by definition, capital intensive industries tend to produce lower ROIC – and hence are less attractive for new entrants. Here are some examples of ROIC (Return on Invested Capital) – WACC (Weighted Average Cost of Capital). Software, Services, and Consumer products are less capital intensive than Utilities, Telecom and Hardware – so they make a lot more in ROIC.http://www.fool.com/School/roic/roic.htm?source=EDSTRMSector ROIC-WACC Software 13.5% Business Services 7.8% Consumer Goods 5.4% Utilities -3.1%Telecom -3.6%Hardware -6.3% http://news.morningstar.com/doc/article/0,,116556,00.html?phsection=Comm3Switching costs for customers are a powerful deterrent to new entrants. Microsoft is a classic example (used to be IBM) where 'you can't get fired for buying Microsoft products'. Airline loyalty points are a way of keeping switching costs high for serial travelers. Any change of vendor which requires extensive re-training of users and/or a major overhaul of existing processes and systems will have high switching costs. Conversely, the more standardized (undifferentiated) the offering is, the easier it is for customers to switch e.g. the switching cost from one brand of gasoline to another is very low, as is the effort required to choose between one cab company and another. Coke's recent EU settlement to 'allow rivals to occupy 20 percent of the space inside its coolers and to allow outlets to serve a "guest" beverage from some Coke-branded soda fountains' is an excellent example of how distribution access can be restricted in an industry. Exclusive auto dealers are another example of how difficult it is for a new entrant to compete on either distribution or after-sales serviceGovernment policy affects industries in many ways. In utilities and public services, government agencies like the FCC and EPA play a major role in determining how companies are allowed to operate. In health care, the FDA pretty much makes or breaks a company's future viability with its protracted approval process. Meeting - and keeping up with - government regulations is very expensive and time consuming – not too many wannabes have the wherewithal for it. Boeing would probably disappear if not for the DOD's gold plated projects – the only way Airbus could compete was with the help of EU subsidies.
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