Lecture Outline: External Analysis

For Class on January 30

Topic Highlights
1. 2. 3. 4. 5. 6. How to use the S-C-P Model to understand industry structure and performance. How to use the Porters Five Forces Framework to gauge industry attractiveness. Basic ways to use external strategic analysis to formulate strategy. Limitations of S-C-P and Porters models for strategy formulation. How industry structure relates to environmental opportunities. First mover advantages and disadvantages.

Why Learn It? Industry/external analysis identifies opportunities and threats, and allows managers to evaluate the attractiveness of an industry. Empirical studies have shown that the industry impact on firm profits account for as much as 20% of the variation in returns between companies. In some sectors, such as retailing, industry effects account for 40% of the variation in profits between firms.

Utah Pie The Utah Pie Company made fresh baked pies for the Salt Lake City market in its local plant. About 10 years after its founding, the company entered the rapidly growing frozen pie segment. Despite competition from 3 much larger companies (Continental Baking, Pet Milk, and Carnation), Utah Pie steadily gained market share, due in part to its lower prices. The companys local manufacturing facility allowed it to enjoy a lower cost structure than its national competitors due to lower distribution costs. About a year after its entry into the frozen pie segment, the company was forced to cut its prices significantly in response to price cuts by the 3 large players in the market. Utah Pie sued Continental Baking for price discrimination (predatory pricing) and conspiracy under the Sherman and Robinson-Patman Acts. Pet Milk admitted that it had sent a spy into Utah Pies factory. Continental Baking sold comparable quality pies at higher prices in other markets in which it did not face rivalry. Ultimately, the US Supreme Court over turned the Court of Appeals ruling and found for Utah Pie. Procter & Gamble and the Liquid Household Bleach Market P&G acquired the assets of the Clorox Company in 1957. In 1957, P&G had sales of over $1B and spent about $80mm on advertising compared to sales of about $40mm for Clorox and advertising of about $5.5mm. P&G was by far the largest manufacturer of household cleaners, soaps, and detergent in the US market. While P&G did not change Cloroxs pricing policies after the acquisition, the FTC ruled that the acquisition was illegal and violated section 7 of the Clayton Act, and ordered P&G to divest Clorox. The US Supreme Court unanimously found in favor of the FTC, and Procter & Gamble was forced to divest 1 Clorox in 1967.

Question: What philosophy lies behind the US Supreme Court decisions in favor of Utah Pie and against P&G? In the 1800s, several huge businesses (called trusts) controlled major pieces of the US economy including the supply of products (such as steel) and prices. These so-called trusts posed a threat to economic prosperity, and even to the stability of the US government. Congress passed anti-trust laws to encourage competition, eliminate price fixing, and prevent monopolies from competing illegally. As a society, we believe more competition is better. Competition prevents companies from exploiting consumers and artificially controlling the supply of vital products and services, because it acts as a check on price increases, forces companies to become more efficient over time, and to improve product quality.

Question: What tools did the FTC use to show P&Gs acquisition of Clorox violated antitrust law? 1. The FTC argued that the relevant market was the household liquid bleach market rather than the household cleaner market. Clorox had a market share of 48.8% at the time, while its next largest competitor had about a 16% share of the market (Purex). The top 6 firms in the market held about 80% of the market with the remaining 20% of the market split between about 200 small firms. Question: Why did the FTC rely on market shares and market share distribution to argue the acquisition was anticompetitive? 2. The underlying assumption is that the more concentrated the industry, the lower the level of competitive behavior, and the higher the financial performance of the industry (and individual firms). The two most common ways to measure concentration are the concentration ratio and the HHI (Herfindahl-Hirschman Index). The Concentration Ratio is usually calculated by adding up the market shares of the top 4 or top 8 firms in an industry as in the 4 firm concentration ratio or the 8 firm concentration ratio.

Coke & Pepsi Example: Concentration of US Soft Drinks Industry Company Estimated Retail Sales Market Share Coca-Cola $31,164.0 42.0% PepsiCo 21,740.6 29.3% Dr.Pepper-Snapple Group 12,391.4 16.7% Cott 3,561.6 4.8% National Beverage 2,077.6 2.8% All Others 3,264.8 4.4% Total $74,200.0 100.0% Source: WSJ 3/18/2011 Cokes 2010 US Soda Market Share Rose; CNNMoney 4 Firm Concentration Ratio = Coca-Cola + PepsiCo+ Dr. Pepper/Snapple + Cott = 42.0%+29.3%+16.7%+4.8% = 92.8% Top 5 Producers have 95.6% market share 3. Given the assumed link between industry concentration and competitive behavior, the was developed to help understand what types of market This is a S-C-P highlymodel concentrated industry. conditions result in non-competitive behavior. We use the S-C-P to understand the industry landscape. 4. S-C-P stands for Structure-Conduct-Performance. The model says the structure of the industry determines the strategic choices of the firms in the industry especially pricing behavior-which determines the financial performance of the industry. 5. Structure = the number of firms in the industry, the concentration of the industry, homogeneity of products, and barriers to entry and exit. ** The Extremes Perfectly Competitive Markets Fragmented industry, no product differentiation, no pricing power, low barriers to entry and exit = intense price competition, no competitive advantage only parity. CR4 of 0% indicates a perfectly competitive market. Monopolies Highly concentrated industry (only one firm), costly entry, high pricing power, competitive advantage/high returns. CR4 of 100% indicates a monopoly. **In Between Monopolistic Competition Large number of small firms, low-cost entry and exit, heterogeneous products. Competitive advantage is possible, high returns for some firms and not for others. CR4 3

under 50%. Oligopoly Small number of large firms, costly entry and exit, either heterogeneous or homogenous products. Competitive advantage is possible, high returns possible. CR4 between 50%80%, above 80% tending toward a monopoly. 6. The HHI is a better indicator of industry structure than the CR4 or CR8. The HHI shows the distribution of market shares within an industry. Example: The 6 top firms hold 90% of the industry in two industries. The CR6 figure indicates a fairly to highly concentrated industry. In industry A, each firm has a 15% share of the market. In industry B, one firm has 80% of the market and the remaining 5 firms each have a 2% share. Do the two industries have identical structure? Are they equally competitive? We cant tell by looking at the CR. But, the HHI shows the distribution of market shares. HHI Example: HHI=sum of the squares of the market shares of the top 50 firms (or total number of firms in the industry) Industry A (Assume next 45 firms have 1% of the market each) Firm 1 = 15%, Firm 2 = 15%, Firm 3 = 15%, Firm 4 = 15%, Firm 5 = 15% HHI = (15)2+(15)2+(15)2+(15)2+(15)2 = 225+225+225+225+225+ 45(12) = 1,170 INDUSTRY A is an UNCONCENTRATED INDUSTRY Industry B (Assume next 45 firms have 1% of the market each) Firm 1 = 75%, Firm 2 = 2%, Firm 3 = 2%, Firm 4 = 2%, Firm 5 = 2% HHI = (75)2+(22)+(22)+(22)+(22)+45(12) = 5,625+4+4+4+4+45 = 5,686 INDUSTRY B is a HIGHLY CONCENTRATED INDUSTRY HHI Levels Figure less than 1,500 unconcentrated industry Figure between 1,500-2,500 moderately concentrated industry Figure over 2,500 highly concentrated industry Closer to 0, closer to perfectly competitive Closer to 10,000, closer to monopoly (100)2 HHI for the US Soda Market is 2,924

Conclusions: Very concentrated industries tend to be characterized by low-to-no price

competition and high returns. Very unconcentrated industries tend to be characterized by intense price competition and low returns. Porters Five Forces Michael Porter examined industry structure and the S-C-P and determined there were 5 major factors that impacted profitability for firms and industries. Those factors are called Porters Five Forces. When the five forces are strong or represent a high threat to an industry, industry profitability tends to be low. When the five forces are weak or represent a low threat to an industry, industry profitability tends to be high.

Threats 1. Buyers 2. Suppliers 3. Rivalry 4. Entry 5. Substitutes Buyer & Supplier Threats Key Factors 1. Buyer/Supplier industry is concentrated with a few large firms accounting for a significant percentage of sales or key inputs. Think: Bargaining Power Example: Gillette and Walmart Walmart accounted for 25% of Gillettes sales and 15% of Procter & Gambles sales before the merger. One widely touted benefit from the merger was the rebalancing of power between the manufacturers and Walmart. P&G still accounts for less than 10% of Walmarts sales. 2. Buyer can switch to other providers easily and get comparable products/services Think: no/low switching costs, nothing to bind the buyer to your firms products/services and increases the buyers bargaining power. Example: Apples iPod and iTunes. Encryption meant it was very difficult to make copies of songs purchased on iTunes. ITunes songs would not play on another MP3 player. The customers library of songs created huge switching costs -- iPod has 76% of the player market. 3. Supplier it is expensive or difficult to switch to another supplier forces your firm to stick with the supplier and increases the suppliers bargaining power. Example: PC manufacturers earn low margins and returns despite having enjoyed a very long product life cycle. The profits in the industry are appropriated by Microsoft and Intel. Microsofts market share is 85% and the firm has only 1 major competitor Apple with a 14% share. Intels market share is 82% of the microprocessor segment. 4. Vertical Integration buyers or suppliers can vertically integrate into the firms piece of the value chain.

Rivalry Threat Key Factors 1. industry is highly fragmented with a lot of small players 2. industry growth is slowing or demand for products/services is mature or declining 3. capacity utilization when capacity utilization is low, firms compete aggressively on price to cover fixed costs esp. true in high fixed costs businesses like paper and chemicals. 4. cost of exit is high so firms cant transfer (sell) their assets easily 5. low brand loyalty so consumers are likely to switch to other brands easily (products not differentiated to consumer). Entry Threat Key Factors 1. Barriers to entry protect high industry profits, low barriers allow new companies to enter the market and compete away high profits. 2. Barriers to entry include: experience curve (Honda), high capital investments required or large minimum efficient scale, high sunk costs such as advertising, high brand loyalty, managerial know-how, differential access to low cost inputs or distribution, retaliation by existing competitors, proprietary technology, and government policy/regulations. ** This was a key factor in the FTC vs. Procter & Gamble case. The FTC successfully argued that P&G represented a threat of entry into the liquid bleach market without Clorox, and that P&Gs substantial media buying discounts and distribution efficiencies would create high barriers to entry if allowed to acquire Clorox. Substitutes Key Factors 1. Substitutes cap pricing power in an industry. 2. Substitutes are products that meet the same customer needs as your firms product, but in different ways. Aluminum cans are substitutes for glass bottles. 3. The ease of switching (switching costs) and the perceived level of similarity determine the threat level of substitutes. Complementors-Key Factors Complementors have emerged as an important industry force since Michael Porter developed the 5 Forces model in the 1970s. A complementor makes your product more valuable to your customer when the customer purchases the item. A competitor makes your product less valuable to your customer when the customer purchases the item.

Generic Strategic Opportunities In Different Types of Markets The generic strategies discussed in the textbook arise from a combination of features of industry structure. The two big variables are industry growth rate (position in the industry life cycle) and number of firms in the industry. INSERT INDUSTRY LIFE CYCLE DIAGRAM

1. Emerging markets allow first mover or early mover advantages. These advantages include a. setting the dominant design, technology, or business model for the industry; b. closely affiliating your brand name with the product EXAMPLES: Kleenex, and Coke; c. locking up key resources before others know they are valuable SOFT SOAP Example; d. experience curve benefits; e. develop customer switching costs; f. lock up distribution or best geographic locations for manufacturing; and g. take the best market positions. 2. First Mover Disadvantages a. pioneering costs; b. make all the mistakes in design and technology; c. make the wrong technology bet; d. demand uncertainty makes gaining financial resources difficult, also makes it hard for established firms to know how much manufacturing capacity is needed. 3. Fragmented Markets consolidate the industry take out rivals, purchase positions in the market, gain market share = scale benefits 4. Mature Markets process improvements, product refinements, emphasize customer service. 5. Declining Markets demand falls usually due to new technology and new products. Can also be impacted by broad societal changes and changes in the economy. The product/service is likely to disappear over time. Strategies are to gain leadership and dominate whats left of the market and/or to harvest (maximize cash flow) to invest elsewhere or return to shareholders. EXAMPLE Earthlink The Rest of the Story

What is Procter & Gambles Share of the US Liquid Bleach Market Today? 0% P&G never entered the market. The firm determined that it was not a large enough market to justify spending the marketing dollars needed to overcome Cloroxs advantage in the market. P&G is highly unlikely to enter any market that does not lend itself to technological improvement and product differentiation. Cloroxs share? 80%