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Analysing and assessing a company or an industry is always tricky. It takes hours of analysis to decide whether an industry or a company is attractive and doesn't have any weaknesses. But what if there are set parameters for you to compare and determine the attractiveness? One such model is Michael Porter's five forces. From strategic managers to investors, everyone uses this model to determine what position the company is in. It covers all kinds of industries and waters down various factors into five simple categories.
- The threat of new entrants: Can a new player easily enter an industry and get market share? That's what the threat of new entrants discusses. A company or an industry's profitability is generally higher if new firms cannot easily enter. Some classic indicators of whether an industry has this threat are to see whether there are any entry barriers, regulatory barriers, higher capital requirements, switching costs, or very well-established players. If an industry has these characteristics, then it is difficult for a new player to enter and if an industry doesn't have these, then it is relatively easy. The IT industry is one such example. It does not have high capital requirements or entry barriers and thus new players can gain market share in their niche easily.
- Competition in the industry: The intensity of competition in the industry determines how attractive an industry is and how well the companies can grow. While competition, in general, is not bad, a cut-throat competition can affect profitability. Some characteristics of a highly competitive industry are a high number of competitors, slow growth, homogeneous products, and no clear industry leaders or industry leaders by just a margin are some indicators of a highly competitive industry. A great example of this is the paper industry. There are many listed and unlisted competitors all around the country and since the industry has a homogeneous product, it is difficult for any kind of product differentiation.
- Bargaining power of suppliers: When suppliers of an industry or a particular company have significant power and they can influence the prices, we can conclude that they have bargaining power. When a company or an industry has less number of suppliers, when switching cost of changing suppliers is high or if one supplier contributes majorly to a company, then that industry or company is prone to this risk. A great example of this, which we are witnessing right now, is the demand for semiconductors. It is a critical raw material for many industries but has a limited number of suppliers. TSMC (Taiwan Semiconductor Manufacturing Company) is the market leader with more than 50 per cent market share, resulting in higher pricing power.
- Bargaining power of buyers: This is when customers have the power to drive the selling prices lower. When the customers are big buyers or when the product is not critical for a buyer, this situation arises. B2B (business to business) segments usually have this issue as it constitutes big buyers. It also happens when a company sells to a niche market where there is less number of buyers or when the company has government as its customer. A great example is Sona BLW where 45 per cent of the company's revenue comes from just three customers. Another example is VA Tech Wabag, the water treatment company which depends on government projects for its revenues. In 2015, the company faced a major blow when the new Andhra Pradesh government decided to put water treatment projects on hold causing financial distress to the company.
- The threat of substitute products: Sometimes competition need not necessarily be from the same industry. A product from a different industry too can replace the company or industry's product. A great example of a substitute product is classic tea and coffee. While coffee drinkers won't switch easily, if there is a massive jump in price and the price of tea stays constant then many coffee drinkers may switch to tea. Other examples are theatre and OTT (over-the-top) media services, physical books and e-books, etc. How Netflix dethroned Blockbuster is the best example as Netflix disrupted Blockbuster's brick-and-mortar model which resulted in its imminent downfall.
So, the next time you are looking at an industry or a company, apply these factors first. Any company or industry that is weak in all the areas must be avoided as it is too vulnerable. I'm sure readers will have realised something, all these factors deal with external and not internal forces. So even if a company is strong with respect to all these external forces, poor management or capital allocation internally might still ruin it.
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