Thursday, December 23, 2010

Porter’s Five Forces Series Part 2 – Intensity of Rivalry

In this second part of the Porter’s Five-Forces series, I take a look at intensity of rivalry. This is an important factor as the more in-fighting there is amongst companies within the same industry for market share and profits, the more rates of return will be depressed and suffer. If companies practice cutthroat pricing and start under-cutting one another, it will result in a lot of happiness only for the consumer and a lot of pain for all players involved as it can become a vicious cycle. If rivalry is intense, players may also have to spend a lot on marketing, advertising and promotion to regularly promote superior product features or for brand awareness, so as to stay one step ahead. This can, in the long-run, erode margins further and prove very costly.

In some industries where there are several dominant players, some of them may eventually recognize the hazards of price competition and destructive rivalry and may voluntarily restrain their rivalry. Some of the factors below will intensify rivalry and make it harder for firms to compete with one another:-

1) Many equally balanced competitors – If an industry has no clear dominant player then it becomes a “free-for-all” and will result in fierce fighting for a share of the profits. Even if there are only a few players, assuming they are evenly balanced in resources, then they may end up innovating and fighting constantly to stay ahead and drag down one another’s rate of return. This will ultimately benefit the consumer most; and firms would do better if they are able to employ some degree of co-operation, or if there is one dominant firm in the industry.

2) Slow industry growth – In industries where growth is rapid, all players within the industry are able to increase sales (and profits) without taking sales away from one another. This is evident in an industry such as MICE which is expanding rapidly in South-East Asia, including China; and will mean that all players (Pico FE, Kingsmen and Cityneon) will be able to enjoy higher revenues and profits. For slow growth industries, there is hardly any growth prospect for any one player so they tend to start attacking one another for market share, which increases the intensity of rivalry.

3) High fixed costs – Firms which have a high fixed cost structure will slash prices to maintain turnover as they have a high breakeven point. Some examples quoted are steelmaking and paper making. Industries which produce perishable goods also have to cut prices rapidly as they have to achieve rapid throughput.

4) Products are not differentiated – This point is pretty simple. If the products are commoditized then firms will compete purely on price, which means there will be higher intensity of rivalry between competitors to undercut one another.

5) Extra capacity added in large increments – This relates to adding of extra capacity in a sudden, large increment such as building a new plant. This occurs when there is a huge demand shift in the industry which causes all players to simultaneously increase production and build facilities to increase manufacturing; resulting in a future over-supply situation. We have seen how this happened for the textile and shipping industries.

6) When rivals have different strategies, origins, personalities and relationships – This refers to rivals within the industry adopting tactics which destroy shareholder value for all players, rather than engaging in “tacit collusion” to try to boost revenues and profits for all players. The rules do not allow any player to gain an upper hand and to establish a high rate of return. In the end, all players engage in actions or corporate strategies which affect all players negatively, and result in a sub-par return for all firms within the industry.

7) High exit barriers – If an industry has low returns, theoretically, this should spur the weaker firms to exit the industry in order to free up resources to deploy to higher value-added activities or businesses. The reduced supply will ensure that the firms that remain can capture a greater market share and thus generate a higher rate of return on capital employed. In reality, however, it may not be easy for firms to exit an industry due to the following factors:-

a. Specialized Assets – If assets within the industry are highly specialized and cannot be deployed for any other purpose, this would make it very tough for players to exit unless they suffer a drastic write-off, or decide to switch business altogether. One example I can think of is the OSV business, in which companies such as Ezra and Swiber have highly specialized assets catered to the O&G industry which cannot be used for any other industry.

b. Fixed Costs of Exit – There may be fixed costs involved in exiting an industry. Examples given include amounts paid under labour agreements, divestment process needing lawyers and accountants, as well as compensation for any broken (frustrated) contracts.

c. Strategic Loss – The business or division may form an integral part of an organization’s overall strategic goals or alignment, and divesting it may be undesirable because of this. It may hold some reputation or may be kept within the organization for other reasons.

d. Emotional Barriers – This has to deal with emotional circumstances which make the manager or CEO unable to divest or discontinue an operation or business division. The person may have spent so much time and effort to build up the business, and is therefore unwilling to let it go. The managers may also be ill-suited for any other trade other than the one he was assigned to do. It is possible for a division to be retained for purely emotional reasons rather than rational ones, and is pretty common as we are all humans.

e. Government and Social Barriers – Governments often step in to prevent closure of businesses in order to save jobs and promote social cohesion. As a result, companies within the industry grimly battle it out and endure the low returns which are endemic to the entire industry.

Part 3 to be released next year will talk about the threat from substitutes and also buyer power, and I have combined these 2 as threat from substitutes is just a very small section.

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