Monday, July 09, 2007

Research Series Part 3 - Porter's 5-Forces Analysis

In this part of the research series, we will be looking at analyzing a company and its industry using the classic Porter's 5-Forces model. This model was developed by Michael E. Porter in 1979 and I find it to be very useful in analyzing a company, its stakeholders and its immediate competitive environment. Strategy consultants at large firms such as Boston Consulting Group and McKinsey and Company also use his model as a guide to formulating strategies for their clients in order to restructure or turn-around their businesses.

The model's 5 forces consist of the following:-
  • Bargaining Power of Customers
  • Bargaining Power of Suppliers
  • Threat of New Entrants
  • Threat of Substitute Products
  • Intensity of Competitive Rivalry

Each will be explained in turn and we shall see how these forces affect our analysis of a company, in order to determine if it will have a strong enough competitive advantage and a durable value proposition to offer such that it can continue to grow revenue and earnings, as well as retain market share.

Bargaining Power of Customers

Each company has to have customers in order to do business, and customers are of utmost importance to a company in order for it to sustain its revenue stream and find avenues for growth. Some companies have a few major customers (e.g. Karin Tech's main customer is Sun Microsystems and chip companies like UTAC and Chartered supply to the major component manufacturers), while others have a myriad of smaller customers. When we say bargaining power of customers, we refer to how easily the customers are able to switch suppliers, and the extent to which customers can influence pricing from the supplier. For example, in a commodities industry (e.g. biscuits), customers can easily get their supplies from multiple suppliers and do not have to rely on just one. Thus, bargaining power of customers is high in the biscuit industry. Customers who are large and influential may also be able to force their suppliers to agree to certain conditions governing their business which is not always favourable to the supplier. Thus, we must evaluate each company to see the extent of influence their customers have on them.

Bargaining Power of Suppliers

This is the reverse of the previously discussed situation, whereby a company is subject to the higher bargaining power of suppliers. Some industries are well-consolidated in Singapore such as banks (only 3 major ones UOB, DBS and OCBC) as well as telecoms (also 3 major ones Starhub, M1 and SingTel); thus they have more power to determine prices to customers and customers may not have the power to refuse such prices. A clear example was when Starhub opted to increase its fees for its TV packages; customers cuold not resist much because they are the only Cable TV provider currently. The same applies to companies as well, as some companies may buy their supplies from only a few suppliers. This puts them in the position to get "squeezed" by their suppliers who may increase selling prices at their whim or with-hold certain new products till they can sell them to other customers as well. A company should not be unduly affected y its suppliers, otherwise it will face a severe gross margin problem when suppliers increase their cost of goods sold.

Threat of New Entrants

This relates to the ease with which new players can enter an industry ans is also called "barriers to entry" for new competitors. Some industries are highly capital-intensive (e.g. oil rigs) and require a significant amount of capex in order to even start-up. This is why Keppel and SembMarine are in such a strong position and see their share prices soaring. This is due to their unique competitive position and the fact that competitors will find it almost impossible to compete effectively against them. Some industries are commoditized (e.g. PCB Boards and IT Services) and almost any company can be set up with the appropriate human resource to begin operations. This means that eventually, price wars will break out and margins will be eroded for all players, thus benefitting no one. Thus, it is important to assess if a company's industry is resistant to competitive entry, and also the role the company plays in the industry (e.g. market leader like Keppel or a normal market player like CH Offshore in the marine sector). I shall touch on durable competitive advantages for the companies I own in a future post.

Threat of Substitutes

This ties in very closely with the previous point, but is more geared towards the company's products and services and how well customers can find substitutes for them. If a company can offer a unique product (patented) or service which no one else can provide, that gives them a strong competitive edge and higher pricing power as well. For example, in the alternative fuels industry, ethanol can replace palm oil which in turn can easily be replaced by other sustainable fuel sources which have yet to be discovered. Thus, the threat of substitutes looms in the industry and companies may find their competitive edge eroded very quickly once a substitute product is found. When that happens, demand for the company's product falls drastically (assuming elastic demand curve) and margins are likely to suffer greatly as well. Therefore, watch for a company's products and services to see if they are easily replicable. If so, then the risks of investing in such a company are proportionately higher.

Intensity of Competitive Rivalry

This factor talks about the intensity with which competitors slug it out to gain market share, and whether the industry is growing, expanding or evolving such that the dynamics of the industry are changing. This will affect all firms within the industry and may change the competitive landscape drastically, or leave once dominant firms by the wayside as they struggle to adjust to new conditions. A good example is the airline industry, which saw a shake-up a few years back with the introduction of budget carriers. By introducing a whole new concept of affordable and no-frills air travel, it created never-before encountered competition for existing players like SIA. SIA had to devise strategies to counter this new competitive threat which operated in a totally different way from other full-service airline competitors. Thus, the ability of the airline to adapt to changes will ensure its survival, or its downfall into oblivion. This applies to other companies in other industries as well whose landscape changes frequently, such as the IT industry.

By combining Porter's 5-Forces analysis into your research, it can enhance your understanding of the industry and also help to analyze if the company can deal with competition, and if it has a durable competitive advantage. The company's strategies and expansion plans will also show if suppliers and/or customers have more bargaining power and this can also be inferred from reading the Annual Report. For more questions on this, you can always leave a comment and I will reply ASAP.

For Part 4 of the series, we will look at key aspects of the Annual Report, which is neglected by so many people. By reading and analyzing the Report, we can glean valuable insights into a company and its financial standing.


hannahzgg said...

Very nice...

easy for understanding and very good example...

Thanks for the effort...

Anonymous said...

Hi Musicwhiz, Can you give comments on pacandes (know that you're vested) based on the five points? In this way I know is against the priciple of analysis before investing, but since we can still accumalate if it is of good value, I guess it is still not wrong.

musicwhiz said...

Hi there,

OK I will find time to do it and post in some time in future, as it requires some analysis and fact-finding on my part. But it's good to have requests from readers so I know what people wish to see !

I will also be doing a competitive advantage analysis soon for all my investments, which is related to the 5-Forces as well.

Thanks for the support, and cheers !

Anonymous said...

very good 5 forces write up. i have almost returned it all to my lecturer. important consideration for FA too. thank u for ur article.. :)