External Analysis: Industry Structure, Competitive Forces, & Strategic Groups

Part 1 Strategy Analysis3*

2013 by The McGraw-Hill Companies, Inc. All rights reserved.

LO 3-1 Apply the PESTEL model to organize and assess the impact of external forces on the firm.LO 3-2 Apply the structure-conduct-performance (SCP) model to explain the effect of industry structure on firm profitability.LO 3-3Apply the five forces model to understand the profit potential of the firms industry.LO 3-4Describe the strategic role of complements in creating positive-sum co-opetition.LO 3-5Understand the role of industry dynamics and industry convergence in shaping the firms external environment.LO 3-6Apply the strategic group model to reveal performance differences between clusters of firms in the same industry.3*


Chapter Case 3 Build Your Dreams (BYD) to Sidestep Entry BarriersChanging U.S. car marketMore competition from outside the U.S.However, NO new entry firms in the last 2 decadesHigh barriers to entry

BYD led by founder, Wang Chuanfu in China is entering the car market

Batteries to carsbypassing many hurdlesElectric cars have fewer partsBYD has the battery technologySelling in China, Africa, & South AmericaHybrid Car Video3*


BYD Electric VehiclesWhat are their chances of success?Warren Buffet invested for 10% equity.-- Sticker price half that of a Chevy Volt.-- Many obstacles are aheadWhich PESTEL factors will be most important for electric vehicles in the 21st century?BYD was Chinas fastest-growing carmaker Sold more than 500,000 cars in 2010 Shanghai government subsidy for EVs

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PESTEL FrameworkPoliticalGovernment pressuresSubsidies and incentivesDifferences in countries, states, and regions

EconomicGrowth ratesInterest ratesEmployment levelsCurrency exchange

SocioculturalNorms, culture, valuesDemographicsLifestyle changes

TechnologicalInnovationDiffusionResearch & development

EnvironmentalGlobal warmingSustainabilityPollution

LegalCourt systemLegislationHiring laws

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EXHIBIT 3.1 The Firm Embedded in Its External Environment3*


1*STRATEGY HIGHLIGHT 3.1UBS Relents to Pressureby U.S. GovernmentLarge Swiss bank in troubleU.S. government accused UBS of aiding in tax evasionBillions of dollars moved offshoreNames of 52,000 U.S. citizens soughtEventually over 4,450 names were releasedImperils Swiss Bank secrecyHistorically, a competitive advantage


EXHIBIT 3.2 Industry Structures along the ContinuumBank Oligopolies Video


Efficient MarketsThe efficient market hypothesis, in financial markets, is one in which prices reflect information instantaneously and one in which extra-ordinary profit opportunities are thus rapidly dissipated by the action of profit-seeking individuals in the market.

How well does the efficient market hypothesis for capital markets apply to product markets?

If the efficient market hypothesis applied fully to product markets then we should see over time equalization in risk-adjusted rates of return across industries.

What do the data support?3*


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Average Return on Equity in US Industries, 1982-1993

NumberofIndustries

First QuartileAverage22.2%

Fourth QuartileAverage9.3%

Note:Return on Equity = Net Income / Year End Shareholders Equity; Analysis based on sample of 593 industriesSource:Silverman 2000

Average = 14.7%Median = 13.8%

11.7%

13.8%

16.5%

Return on Equity (Percent)

Differences in Profitability Across Industries

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Industries differ in how much profit they typically provide. In this chart, we take each industry in the U.S. over a long period of time and for each, calculate ROE. Then plot a histogram. A big range. Top quartile roughly 2.5x as profitable as bottom quartilePossible (but possibly dangerous) discussion: So what?If youre trying to maximize shareholder returns, doesnt it just matter whether you can surprise the capital markets? Investment analysts know what industry youre in, so can industry membership possibly be the source of any pleasant surprise?

*Some Industries Are More Profitable Than Others ROE & ROA - Selected Industries, 19890%5%10%15%20%25%30%PharmaceuticalsTires / RubberHome AppliancesROEROA


Differences in Profitability Across Selected Industries

Source: Pankaj Ghemawat and Jan W. Rivkin, Creating Competitive Advantage

Looking within that distribution, a few selected industries. Pharmaceuticals far more profitable than scheduled air transportWhat patterns do you see?Goal of next module is to allow you to see the patterns across a much broader set of industries well

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Within Industries, Some Competitors Perform Better than Others.

ROE - Pharmaceutical Industry 19890%10%20%30%40%50%60%AmgenAMPEli LillyMerckMylanPfizer


Differences in Profitability Within Selected Industries

Source: Pankaj Ghemawat and Jan W. Rivkin, Creating Competitive Advantage

Those industry averages mask a lot of variation. Lets take semiconductors and airlines from the top and bottom respectivelyPoint out IntelUnderstanding difference between Intel and TWA requires understanding both the industry and intra-industry differencesCompanies make decent money even in poor industries. Companies do poorly even in attractive businesses. So we need to understand intra-industry competitive advantageWould you rather be at a disadvantage in a good industry or at an advantage in a poor one?

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Copyright 2005 by The McGraw-Hill Companies, Inc. All rights reserved.

The U.S. Auto Industrys Profit Pool

Exhibit 5.7 The U.S. Auto Industrys Profit PoolSource: Adapted by permission of Harvard Business Review. Exhibit from A Fresh Look at Strategy by O. Gadiesh and J. L. Gilbert, Harvard Business Review 76, no. 3 (1998), pp. 139-48. Copyright 1998 by the Harvard Business School Publishing Corporation, all rights reserved.

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Decomposition of Variance in Profitability

Source: Anita M. McGahan and Michael E. Porter, How Much Does Industry Matter Really? Strategic Management Journal, 1997

Tendency to ask, which matters more. Lots of conventional wisdom and research on thisWarren Buffets line on this: When an industry with a reputation for tough economics meets a manger with a reputation for excellent performance, its usually the industry that keeps its reputation intactResearch in this line: takes the full distribution of returns across not just firms, but across business segments within firms. So Disney split into film & TV, theme parks, consumer products. By regression techniques, tease out how much of the variation is due to differences across industry vs. differences in the advantage enjoyed by a segment within its industry. Other effects also considered: corporate parent, year, transient effectsResearch indicates that, despite a fair amount of year-to-year noise, business segment effects are very large and industry effects are also large. [Industry effects perhaps overstated]Large business segment effects => need some systematic way to think through differences in success within industries. Start doing that in the competitive positioning module

*Three Factors Determining Company PerformanceIndustry Contexte.g., during the last two decades, companies in the airlines industry have been persistently less profitable than those in the pharmaceutical industry

National Contexte.g., worlds most successful consumer electronics firms are in Japan

Company Capabilities and Strategiese.g., Wal-mart and Southwest Airlines


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Structure-Conduct-Performance

Industry Structure Number of buyers and sellers Degree of product differentiation Barriers to entry Cost structures Vertical integration Alliances

Firm Conduct Pricing Advertising R&D Investment in plant and equipment

Performance Econ profits Accounting profits (ratios)

NPV/DCF

MVA/EVA Tobins Q

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The Structure-Conduct-Performance Paradigm

The Feedback CritiqueNo one-way causal link.Conduct can affect market structure.Market performance can affect conduct as well as market structure.

The Causal View

Market Structure

Conduct

Performance

Clarke Modifications of Baye Chapter 7

Competitive Forces and Firm StrategyThe Five Forces ModelThe classic industry analysis model

Threat of Entry/Barriers to EntryNote: High barriers to entry means threat of entry is lowPower of SuppliersPower of BuyersThreat of SubstitutesRivalry Among Existing Competitors

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EXHIBIT 3.3Porters Five Forces ModelSource: Porter, M. E. (2008), The five competitive forces that shape strategy, Harvard Business Review5 forces video- M. Porter3*


Barriers To EntryThe free entry and free exit assumption that works reasonably well for describing financial markets seems to be a premise that strays so far from our world of experience that the assumption impedes our understanding of real-world product competition. Thus, empirical evidence suggests that (risk-adjusted) ROE does NOT equalize in the long run.3*


A Taxonomy of Barriers to Entry (1) Economies of Scale

Product-specific economies of scale

Lower setup costs as a percentage of total costsMore specialized machinery and tooling (e.g., Honda)

Plant-specific economies of scale

Engineers 2/3 rule: Since the area of a sphere or cylinder varies as two-thirds power of volume, the cost of constructing process industry plants can be expected to rise as two thirds power of their output capacity. (This rule applies to petroleum refining, cement making, iron ore reduction and steel conversion).Also economies of massed reserves3*


A Taxonomy of Barriers to EntryEconomies of Scale

Multi-product economies of scale (economies of scope)Example: Cost (Iron, Steel) < Cost (Iron) + Cost (Steel)Key idea: Shareable input (In this case, thermal economies in the production of iron and steel)Modern examples: Aircraft, Automobiles, Consumer electronics, Household Appliances; Personal Computers, Software, Power Tools

Multi-plant economies of scaleEconomies of multi-plant production, investment, and physical distribution.3*


*Examples of Economies of ScopeAircraft: Common wing, nose, and tail components allow several models to be leveraged using different numbers of fuselage modules to create aircraft of different lengths and passenger capacities by Boeing and Airbus Industries.

Automobiles: The Taurus platform was leveraged to provide the basis for Taurus sedans and minivans.

Consumer Electronics: Over 160 variations of the Sony Walkman were leveraged by mixing and matching modular components in a few basic system designs. (Legos)


A Taxonomy of Barriers to Entry (2) Experience Curve Advantages

Marvin Lieberman, a management professor at UCLA, found that in the chemical industry, on average, each doubling of plant scale over time was accomplished by an 11% reduction in unit costs. Thus, there is an 89% learning curve.

(Note: The mere presence of an experience curve does not insure an entry barrier. Another critical prerequisite is that the experience be kept proprietary, and not be made available to competitors and potential entrants.)3*


A Taxonomy of Barriers to Entry(3) Intended Excess Capacity

Building extra capacity for the intended purpose of deterring entrants from entering the industry. (Note: potential free-rider problems)

Excess capacity deters entry by increasing the credibility of price cutting as an entry response by incumbents (ex: Dupont in the production of Titanium Dioxide for paint)

Innocent excess capacity: Demand is cyclical; Demand falls short of expectations; Demand is expected to grow.3*


A Taxonomy of Barriers to Entry(4) Reputation

A history of incumbent firms reacting aggressively to entrants may play a role in current market interactions.

(5) Product Differentiation

Brand identification and customer loyalty to incumbent products may be a barrier to potential entrants (e.g., Coca-Cola). Product differentiation appears to be an important entry barrier in the market for over-the counter drugs and in the brewing industry.

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A Taxonomy of Barriers to Entry(6) Capital Requirements

(7) High Switching Costs of Buyers

E.g., changing may require employee retraining (e.g., IV solutions, and computer software).

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A Taxonomy of Barriers To Entry(8) Access to Distribution ChannelsThe manufacturer of a new food product, for example, must persuade the retailer to give it space on the fiercely competitive supermarket shelf via promises of promotion, and intense selling efforts to retailers.

(9) Favorable Access to Raw Materialsand to MarketsAlcoa --> bauxiteExclusive dealing arrangementsFavorable geographic locations

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A Taxonomy of Barriers To Entry(10) Proprietary Technology

Product know howLow cost product designPatents (and other government restrictions)

(11) Exit barriers (of incumbents) can be entry barriers (to potential entrants)

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A Taxonomy of Barriers To EntryHigh exit costs:

High exogenous and endogenous sunk costs (not just high fixed costs!)High asset specificityHighly illiquid assetsLow salvage value if exit occursHigh switching costsLow mobility of assetsCredible commitmentsIrreversible investmente.g., Alaskan pipeline built in 1977 at a cost of $10 billion3*


Power of Suppliers HIGH IF: Dominated by a few companiesNo substitutes for supplier productsSuppliers products are differentiatedIncumbents face high switching costsProduct is important input to buyerForward Integration is a credible threat

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Power of Buyers HIGH IF: A few large buyers (potential collusion)Large buyers relative to a seller (e.g., HMO power buying pharmaceuticals)Products are standardized and undifferentiatedBuyers face few switching costsHigh switching costs for sellersBackward Integration is credible (buyer has full information)

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Threat of Substitutes HIGH IF: Substitute is good price-performance trade-off

Buyers switching costs to substitute is low


Incumbent Rivalry HIGH IF: Many competitors in the industry (industry concentration is low)

Firms are of equal size

Industry growth is slow or shrinking (over-capacity is high)

Exit barriers are highContractual obligationsGeographic or historical attachments

Products and services are direct substitutes (product differentiation is low)3*


Degree of Rivalry

Advertising battles, on the other hand, may well expand or enhance the level of product differentiation in the industry for the benefit of all firms.

In other words, advertising is not necessarily a zero-sum game.

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The Uses of Industry AnalysisStatic Analysis -How do we explain current rivalry and profitability?

Dynamic Analysis -Where is the industry Headed In likely to be in the future?3*


Industries Evolve over Time as the Relationships Between the Five Forces ChangeDynamic 5-Forces Analysis3*


LO 3-1 Apply the PESTEL model to organize and assess the impact of external forces on the firm.LO 3-2 Apply the structure-conduct-performance (SCP) model to explain the effect of industry structure on firm profitability.LO 3-3Apply the five forces model to understand the profit potential of the firms industry.LO 3-4Describe the strategic role of complements in creating positive-sum co-opetition.LO 3-5Understand the role of industry dynamics and industry convergence in shaping the firms external environment.LO 3-6Apply the strategic group model to reveal performance differences between clusters of firms in the same industry.

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SUPPLIERS

POTENTIALENTRANTS

SUBSTITUTES

BUYERS

INDUSTRYCOMPETITORS

Rivalry amongexisting firms

Bargaining power of suppliers

Bargaining power of buyers

Threat of

new entrants

Threat of

substitutes

COMPLEMENTS

The suppliers of complements create value for the industry and can exercise bargaining power

Five Forces or Six? Introducing Complements

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Substitutes and ComplementsSubstitute: An alternative from outside the given industry for its product or service. When its performance increases or its price falls, industry demand decreases.Plastic vs. aluminium containersVideo conference vs. business travelComplement: A product or service or competency that adds value to original product. When its performance increases or its price falls, industry demand increases.Paper for Xerox copiersiTunes for iPod music players

Complementor: If customers value your product more when combined with another firms product or service.Michelin tires for Ford & GM

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A Sixth Force -- ComplementorsThe biggest benefit of considering complementors is that they add a cooperative dimension to Porters (1980) competitive forces model.

Thinking [about] complements is a different way of thinking about business. Its about finding ways to make the pie bigger rather than fighting with competitors over a fixed pie. To benefit from this insight, think about how to expand the pie by developing new complements or making existing complements more affordable.Brandenburger & Nalebuff3*


EXHIBIT 3.5Determining Industry Attractiveness3*


Strategic GroupsMobility Barrier Dimensions To Consider:SpecializationWidth of product lineTarget customer segmentsGeographic markets served

Brand IdentificationAdvertisingSales Force

Technological LeadershipFirst Mover vs. Imitation Strategy

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Strategic GroupsMobility Barrier Dimensions To Consider:Product QualityRaw materialsSpecificationsFeaturesDurability

Cost PositionEconomies of scale and scope

Vertical IntegrationBackward and/or forwardExclusive contracts and in-house service networks

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Strategic GroupsMapping GroupsAuto industry exampleGM, Ford, Toyota gasBYD, Tesla electricID best dimensionsChoose two for mapLocate firms on mapBubble size = market shareRivalry is strongest in the same groupSome groups are more profitable than others

Mobility BarriersFirms would try to move to the profit spots BUT

Specific factors that separate groups

Airlines International routesRegulations: airport slots

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EXHIBIT 3.7Strategic Groups and Mobility Barrier U.S. Airlines3*


Empirical Testing of Structure-Conduct (Strategy)- PerformanceROE(j) = 14.7 + .050 CR4(j) + .119 [CAP/S](j) + (2.08) (1.98)

1.30 [A/S](j) +1.40 [R&D/S](j) +0.26 [GROW](j) (7.20) (2.95) (2.90)

t-statistics in parenthesesR-squared = .43

CR4 = 4-firm concentrationROE = return on equityR&D/S = R&D/SalesA/S = advertising/salesCAP/S = capital expenditures/SalesGROW = demand growth3*


Empirical Testing of Structure-Conduct (Strategy)- Performance Model Specification

In practice, researchers estimate a statistical model of the following form where data are aggregated to the industry level:

Industry Profit Rates = f (Concentration, Barriers to Entry, Demand )

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Multiple regression analysis seeks to evaluate the degrees to which deviations of the dependent variable (and in this course our focus has been on profit rates as the dependent variable) from its mean are explained by or associated with variations in each of a set of independent or explanatory variables (e.g., concentration, barriers to entry, demand, etc.)3*



The nature of this association is captured by regression coefficients relating the profit rates in the industry of each independent variable, allowing us to determine the effect, for example, of a 10% increase in seller concentration on profit rates, holding all other explanatory variables constant (i.e., ceteris paribus)

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Variable Predicted Sign ReasonCR4+Higher concentration enables higher pricesCAP/S+Capital-cost barrier to entryA/S+Advertising intensity as a product differentiation barrier to entryR&D/S+Technological know-howGROW+Demand growth leads toless likely price wars3*


Structure-Conduct-Performance

Industry Structure Number of buyers and sellers Degree of product differentiation Barriers to entry Cost structures Vertical integration Alliances

Firm Conduct Pricing Advertising R&D Investment in plant and equipment

Performance Econ profits Accounting profits (ratios)

NPV/DCF

MVA/EVA Tobins Q


Note that the multiple regression results are consistent with (but do not prove!) the structure-conduct-performance model.

As you probably are aware from your statistics classes, there are many potential problems that can interfere with the reliable estimation of regression models, leading to incorrect inference about the statistical significance and economic importance of explanatory variables.


Empirical Testing of Structure-Conduct (Strategy)- Performance Three Potential Problems:

(1)Mis-specification problems;

(2)Measurement problems; and

(3)Identification problems

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Empirical Testing of Structure-Conduct (Strategy)- Performance(1) Mis-specification Problems:

Important Variables Omitted. In our regression, the impact of substitute products, and the power of buyers and suppliers have not been included in the model specification.

Irrelevant Variables Included. If you believe in perfect capital markets then you may question the idea of capital cost entry barriers and therefore you would question the inclusion of the independent variable [CAP/S] in the model.


Empirical Testing of Structure-Conduct (Strategy)- Performance(1) Mis-specification Problems:

Model assumes a linear relationship. Since the regression assumes a linear relationship, this may turn out to be a poor approximation if some of the explanatory variables (e.g., ADV/S) influence the dependent variable (i.e., ROE) in a non-linear way.

Independent variable may not be truly independent. For example, not only can increased concentration affect profit rates but profit rates may affect industry concentration.

Multicollinearity. If independent variables such as (ADV/S) and {R&D/S) are highly correlated, then the validity of the t-statistics come into question.


Empirical Testing of Structure-Conduct (Strategy)- Performance (2) Measurement Problems:For example, CR4 may not be the best measure of industry concentration, where the HHI is a better measure. Perhaps some performance measure other than ROE would also be better for testing the theory.Note: If the evidence is not consistent with the theory it is not necessarily the case that we abandon the theory. One of the many possibilities is that we do not have good measures of the theoretical concepts.


Empirical Testing of Structure-Conduct (Strategy)- Performance Identification Problems:

- These problems are related to the idea that correlation does not imply causality.

For example, you might maintain that high advertising/sales is a barrier to entry (product differentiation) strategy that causes high profit rates. The regression is consistent with Porters (1980) theory.

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Empirical Testing of Structure-Conduct (Strategy)- Performance(3) Identification Problems

However, you might argue instead that high profit rates allow more discretionary spending in marketing and thus, high profit rates cause high advertising/sales. The empirical evidence is also consistent with this theory. Thus, we have an identification problem. The data are consistent with multiple theories and we must find more refined tests and better econometric methods in order to advance our scientific knowledge in strategic management.


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INSTRUCTOR: The embedded video (click on Hybrid Car Video while in slideshow mode) is 3 minutes on some thoughts on the future of cars in the U.S. URL link is below also.

http://bigthink.com/felixkramer#!video_idea_id=18790

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INSTRUCTOR: An Interactive activity is available online through McGraw-Hill Connect on this section of the text. *

*INSTRUCTOR: A 3-minute embedded video from CNBC is found at the bottom of this slide (click on Bank Oligoplolies Video while in slideshow mode). It discusses banking in Australia as an oligopolistic industry.

http://www.cnbc.com/id/15840232?play=1&video=1614100860

*INSTRUCTOR: An Interactive activity is available online through McGraw-Hill Connect on this section of the text.

*INSTRUCTOR: The embedded video at the bottom of this slide is a 13-minute-long interview with Michael Porter. He uses the airline vs. soft drinks industries as examples of applying the five forces model. The URL is also posted below. It was taped in summer 2008 and is referenced in the text (endnote 37).

THIS LINK IS REPEATED IN SLIDE 27 IF YOU PREFER TO WAIT TO USE IT UNTIL THE APPLICATION OF THE 5 FORCES TOOL THERE.

http://www.youtube.com/watch?v=mYF2_FBCvXw

**INSTRUCTOR: An Interactive activity is available online through McGraw-Hill Connect on this section of the text.





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External Analysis: Industry Structure, Competitive Forces, & Strategic Groups

Documents

firms industry

mcgrawhill companies

forces model

pestel model

industry convergence

effect of industry structure

role of industry dynamics

strategic group model