external analysis

Introduction Competition Entry Suppliers Customers Substitutes Comments

External Analysis

Itai Ater

School of ManagementTel Aviv University

November 3, 2015


When an industrys underlying economics arecrumbling, talented management may slow therate of decline. Eventually, though, erodingfundamentals will overwhelm managerialbrilliance.

Warren Buffet

If you want to get a reputation of a goodbusinessman, be sure to get into a goodbusiness.

Warren Buffet


The Goal

Recall, our ultimate goal is to identify the firmsstrategic positioning and its competitive advantage.The first step is to get acquainted with theenvironment in which the firm acts - External Analysis.


Market/Industry Definition

The first step in the external analysis is identifying therelevant markets that the firm operates in:

Products/servicesGeography

A market is the set of close substitutes products andgeographic regions at which these products are soldOften it is difficult to have a clear market definition (+technology and regulatory changes tend to changemarket boundaries).Nevertheless, identifying which markets are central tothe firm and which arent is important


Approaches to Identify Rivals

Correct classification is important because:Too narrow: ignores threats by potential rivalsToo broad: distracted by perceived threats

Estimation of demand elasticityPrice correlation between competitors over timeSurveysComparison of product characteristics, occasions ofuse, geographic market


The Tool

Porters five forces.Michael porter introduced this organizing scheme atthe end of the 1970s. Became one of the most,applied frameworks in strategy.Most ideas are based on the economics literature onindustrial organization. Therefore, we will mainlyemphasize economic principles.The scheme is taken from the Newtonian world:various forces work on the firm and determine itsposition.Pedagogical note: every topic includes a check list.In class we will focus on a small subset and passquickly through others.


Porters Five Forces


General

We say that a force has a strong effect on the firm if itreduces the firms current or future earnings.Later we claim that the strategic positioning of the firmshould be characterized by low pressure from thevarious forces.We will discuss these forces sequentially.The framework is supposed to address two mainquestions:

1 What characteristics of my market context areimportant determinants of profitability?

2 Given the market context, what strategic actions can Itake to improve performance?


Competition

Probably the most important driver of firms profits.Competition determines the level of profit that a firmearns and therefore:

1 It is important to understand the determinants ofcompetition.

2 Firms will take actions to reduce the competition thatthey face.


The Communication Products Price Index


The Israeli Cellular Market

Oct. 2009: Launching the search for a fifth operator.Sep. 2010: Rami Levi communications is established.Apr. 2011: An auction for frequencies takes place.July 2011: Golan Telecom is the fifth operator.Dec. 2011: Rami Levi begins its operation.May 2012: Golan Telecom begins its operation.


Average Revenue Per Subscriber


Retail Food Market2013 - 2014


Market Structure

The nature of competition is mainly driven by thenumber and size of firms in the market.It is common to use the number and the size of firmsto classify the market structure. These include:

Monopoly - little or no competition (In Israel, more than50 percent market share).Oligopoly - few large firms operate in the market.Fragmented industry - no market leader, many smallfirms.Competitive environment.


Competition

Usually, competition is bad for firms as it reducesprofits.The magnitude of the decrease depends on

Competition intensity.The dimension on which firms compete.


Competition Intensity

Competition is intense ifMany competitors or similar competitors.Similar products and low switching costs.Slow growth (cellular).Price/product information is available.High barriers to exit:

Different long-term goal (Ideology, commitment toworkers).Liquidation problems (e.g. problematic re-renting,obligations).Biased view of the future.

Competitors wish to lead because of other reasons(e.g. ego competition, Israel Hayom)


Competition Dimension

Possible dimensionsPrice.

Price transparency, easy to imitate.The strongest effect is when the firms are involved in aprice competition.

Quality.Technology.Service, availability (e.g. flights to Europe)Advertising.

Naturally, firms can compete on multiple dimensions.Generally, the smaller the number of dimensions, thestronger is the effect of competition on profits.


Price Competition

Price competition happens frequently when:Low differentiation, low switching costs, weak loyalty(cellular, airlines).Large fixed costs and small variable costs (freightrailroads, but not hotels).Perishable goods (vegetables, one-shot events).

The solution is creating loyalty and switching costs:Consumer club (e.g. frequent flier).Long term contracts.

The solution is differentiation:Within a firm (e.g. various versions).Between firms (e.g. low-cost airlines, private label).


Differentiation

Consumers often have different preferences overproducts (e.g. beer, cereal, movies)Competition is more intense when products are similarDifferentiation has two effects:

Getting away from from competing products (less pricecompetition)Getting closer to customers that prefer thedifferentiated product (better value proposition)


Strategic Group Map

A technique for looking at your position in your marketDrawing the map: identify two competitive factors inthe market. For instance:

Brand image and dist. channelsMarket penetration and price per quality

Rank the factors from high to lowPlot the results in a graph with each factor on oneaxis, where each firm is a pointDraw a circle around each firm, making the circlesproportional to its market share


Strategic Group Map - Example


It is not about the entry

Potential entrants include new firms, firms from nearbymarkets and conglomerates:Entry hurts the incumbents in two different ways:

Entry cuts into the incumbents market shareEntry intensifies competition and lowers prices.

It is not about the entry - it is about the threat.The strength of the threat depends on the barriers toentry and on the expected reaction of the incumbents.Firms which are threatened by entry may decreaseprices and increase investment. Both bad forbusiness.The analysis of entry models relies heavily ongame-theoretical models.


Barriers to Entry

Barriers to Entry - the difficulties a firm expects toencounter upon entering a new market.Coffee shops:

Relatively low costs of entrylow-tech technology

Cellular operators in Israel:Highly expensive and risky (infrastructure, service,advertising).The regulator has taken aggressive steps to enablenew carriers to enter (interconnection charges, numberportability).Incumbents enjoyed strong brand names and gooddistribution channels.

But also needs to take into account market size.


Barriers to Entry - Returns to scale

Will be discussed in detail as part of the InternalAnalysis.Bottom line: if there are returns to scale in the market,it means that big firms produce at low cost per product.Possible explanations:

Fixed costs.Large scale technology.Bargaining power.

The entrant should either be big or accept highproduction costs.More significant returns to scale imply lower threat ofentry.


Barriers to Entry - Other Examples

Network effectReputation - Ill have what she is having (infantformula, Remedia).Compatibility - in particular in computer applications.

Customers switching costs.Capital requirements

Capital is needed for facilities, equipment, credit,inventory, low initial prices.In some cases the capital is non-refundable(advertising, R&D, low prices).

Incumbency advantagesExample: connections, reputation (repeated game).Example: unequal access to distribution channels (firstmover advantage).

Regulation


Incumbents Reaction

New entrants fear that the incumbents reaction willmake their entry unprofitable.Such fear may be based on:

Past experience.Multi-market contact.The incumbents do not exhaust their resources.Prices are high.Slow growing sector.

Predatory pricing.Generally defined as sales below cost by a dominantfirm over a long enough period of time for the purposeof driving a competitor off the market.Good for consumers?


Is Entry Certain?

Often, outsiders have not yet decided about entryIncumbents pre-entry behavior may affect entrydecisions.If incumbents reduce they prices then potentialentrants may be deterred. Hence, we can expect tosee pre-entry price reductions.However, if entry is surely going to take place - thenshould the incumbent set lower prices?


Incumbents Respond to the Threat of Entry -ExampleEvidence from the US Airline Industry


Further IssuesThe Role of Commitment

Assuming entry takes place - can the incumbentmaintain the low prices?If not, then the low-prices are not effective in deterringentry...How can the incumbent commit to setting low pricesfor a long-time period?

Long term contracts with low pricesExcess capacity or inventory - creates incentives tosustain low prices


Securing Suppliers or Customers

Yet, committing to low prices is potentially very costlyfor the firmInstead, a firm can sign long-term contracts with largeenough consumers or suppliers...Consequently, making it less attractive for a rival toenter a market

Google purchased Waze presumably to preventFacebook/Apple from entering the real-time mappingapplicationMicrosoft added free explorer to Windows to drive outNetscapeElevators firms set high prices from rivals for elevatorsspare parts and thus control the downstream marketLarge retail chains (e.g. McDonalds, SuperPharm,Aminach) limit the competition they face by signingexclusivity contracts with shopping malls


Market Size and Entry DeterrenceIntermediate Size Markets Exhibit Most Action


Summary

For external analysis we focus on the incumbentspoint of view.If Barriers to entry are high, incumbents are lessthreatened by new entries.If past experience is of aggressive reaction,incumbents are less threatened by new entries.


It is all about the Bargaining Power

The firm and the supplier have a cake to share.The size of the cake is not always clear: what is theshare of the suppliers product in the selling price of thefirm?Do firms always understand their bargaining power?Do firms always use their bargaining power?

Generally, suppliers with bargaining power keep aslarge a part as possible of the cake to themselves.


The Practice of Using Bargaining Power

High Prices.Limited service (as part of transferring expenses to thefirm).Limited products or quality (exclusivity, premium).Intervention in the firms policy (especially pricingpolicy).


The Israeli Food industry

Large suppliers (Osem, Tnuva, Strauss, Unilever,Central Company)Large retailers (Sufersol, Mega)Who has the upper hand?


Monopolies in the Food Industry


More Monopolies in the Food Industry


Operational profitability in the Food Industry


Prices in the Food Industry


How to maintain or enhance your bargainingpower

Suppliers often Use smaller chains (e.g Rami-Levy) toreduce the dominance of strong retailersSuppliers strengthen their brand nameRetailers develop private label to reduce thedominance of large suppliers


When do Suppliers have Bargaining Power

The firms market is more competitive than thesuppliers market.No substitutes (e.g. suppliers are differentiated,experts).The firms market provides a small fraction of thesuppliers profits and activity.High switching costs (e.g. software).The suppliers can become players in the market.


Again, it is all about the Bargaining Power

The customers can be consumers (final customers \users) or other firms.The analysis of the case where the customers arefirms bears a lot of resemblance to the suppliersanalysis.Naturally, customers with more bargaining power getbetter prices, better service and better products.


When do Customers have Bargaining Power

The firms market is more competitive than thecustomers market.

Few customers (or very big customers)The products in the firms market are not differentiated.There are low switching costs

The customers are price-sensitive.The expenditure on the product is significant(mortgage).The product does not affect the quality of thecustomers product or other expenditures (fuel).However, customers can act irrationally.

The firm has large fixed costs and therefore must sell(soccer tickets). However,

Repeated game.Part of strategy (upgraded economy seats).

The customers can become players in the market(software outsourcing).


Social Media as a Coordinating Device

The rise of Social Online Media (e.g. Facebook) couldhelp consumers act collectively.The Cottage Cheese Boycott is a famous exampleWhat constitutes a potential target for a consumerboycott?


Intermediate Customers

Example 1: Publisher, book store, readers.Example 2: Seed company, farmers, wholesalechains.Example 3: Politician, votes supplier (e.g. head ofunion), voters.Complicated scenario:

The intermediate customers can affect the decisions ofthe end customers.Therefore, they have bargaining power with the initialsuppliers.Therefore, the initial suppliers may try to bypass theintermediate customers in marketing.


Definition

Two products are substitutes if they serve similarpurpose with different means.Economics: Two products are substitutes if anincrease in the price of one leads to an increase in thedemand for the other.It is sometimes hard to distinguish betweensubstitutes and direct competition.


Examples

Video conference vs. flight to meetings.Ketchup vs. mayonnaise. Pulp Fiction

Coca cola vs. water.New vs. old housing (zero VAT law)Swimming pools vs. sea.Electric cars vs. cars (suppose you are a fuelsupplier).


Significant Threat of Substitute

The substitute exhibits a good quality-pricecombination.

Skype vs. international calls providers.SMS/Whatapp vs. phone calls.VOD vs. video stores. But, Haozen Hashlishit orcinemas.

Low switching costs (Teva).Technology (Digital cameras).The threat of substitutes in the consumers market alsomatters.


Complements

Definition:Two products are complements if they servecomplementing purposes.Economics: Two products are complements if anincrease in the price of one leads to a decrease in thedemand for the other.

Example: Fuel and cars.Example: Applications and operating system.Example: Gaming consuls and Video games.Standardization.


Summary - Porter

porter


Various regulatory authoritiesMarket-specific regulatory bodies (e.g. ministries ofcommunication, finance, energy).Quality supervision (Ministry of health, MachonHatkanim).

These agencies usually set the rules of the game.The role of the antitrust/competition authority is toenhance market competition. Often, the objectives ofthe antitrust authority and the specific regulators clash.Do regulators advance the public interest or specificinterests (regulatory capture)?


PEST - Macro Level Analysis

PEST is used to analyze political, economic,sociological and technological factors

Political - elections, government spending, minimumwage laws, legal issues.Economic - Inflation, unemployment, exchange rates,business cycles.Sociological - cultural attitudes, lifestyle changes,ethical beliefs.Technological - changes in process and managerialinnovation.


Value Net

The five forces framework views other firms - entrants,competitors, suppliers or buyers - as threats toprofitabilityThe Value Net model introduce the concept ofcoopetition and emphasize potentialcomplementarities across players:

Firms cooperate in setting industry standards thatfacilitate industry growth.Firms cooperate in lobbying for favorable regulation orlegislation.Firms cooperate with buyers/suppliers to improveinventory management.


The Uses of External Analysis

External analysis improves the prediction of reactionto shocks (e.g. digitization of music).External analysis allows for a more accurate definitionof the market (e.g. car oil and truck oil, local markets).Mainly, external analysis provides the necessary toolsto identify strategic positioning

IntroductionThe GoalThe ToolThe Forces

CompetitionThe Israeli Cellular MarketThe Communication Products Price IndexCompetition: Good or Bad ?Competition IntensityCompetition DimensionDifferentiationStrategic Group Map

EntryIt is not about the entryBarriers to EntryBarriers to Entry - Returns to scaleBarriers to Entry - Other ExamplesIncumbents ReactionSummary

SuppliersIt is all about the Bargaining PowerThe Practice of Using Bargaining PowerWhen do Suppliers have Bargaining Power

CustomersAgain, it is all about the Bargaining PowerWhen do Customers have Bargaining PowerIntermediate Customers

SubstitutesDefinitionExamplesSignificant Threat of SubstituteComplements

CommentsSummaryRegulationPESTValue NetThe Uses of External Analysis

external analysis

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