Transcript Strategy Analysis - TWISTED ILLUSION

Chapter Two:
Strategy Analysis
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Strategy Analysis
Definition: It is a qualitative analysis that identifies the firm’s profit
drivers and key risks. It makes the subsequent accounting and
financial analysis mare practicable. This, in turn, enables the analyst
to assess the sustainability of the firm’s current performance and
make realistic forecast of future performances. A firm’s value is
determined by its ability to earn a return on its capital in excess of its
cost of capital (NPV). While a firm’s cost of capital is largely
determined by the capital markets, its profit potential is determined
by its own strategic choice.
n
NCFt
NPV  
t


1

k
t 0
where, k  R f  ( Rm  R f )  j
NCF  Net profit  Depreciation;
Net profit  TR  TC
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Strategic choice depends on:
• A. Industry choice: The choice of industry or a set of
industries in which the firm operates.
• B. Competitive positioning: The manner in which the firm
intends to compete with other firms in its chosen industry
or industries.
• C. Corporate strategy: The way in which the firm expects
to create and exploit synergies across the range of
businesses in which it operates.
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A. Industry Analysis
• Average profit of the market varies considerably based
on different industries. The differences imply the
associated risk factor as well. The risk and return
preference of each firm is best demonstrated by the
choice of its industry. Profit of each industry depends on
“five forces”.
1. Rivalry among existing firms
2. Threat of new entrants.
3. Threat of substitute products
4. Bargaining power of buyers
5. Bargaining power of suppliers
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A. Industry Structure and Profitability
DEGREE OF ACTUAL AND POTENTIAL COMPETITION
1. Rivalry Among
Existing Firms
2. Threat of New
Entrants
Industry growth
Scale economies
Concentration
First mover advantage
Differentiation
Distribution access
Switching costs
Relationships
Scale/learning economies
Legal barriers
3. Threat of
Substitute Products
Relative price and
performance
Buyers willingness to
switch
Fixed variable costs
Excess capacity
Exit barriers
Industry
Profitability
BARGAINING POWER OF INPUT AND OUTPUT MARKETS
4. Bargaining Power of Buyers
5. Bargaining Power of Suppliers
Switching costs
Switching costs
Differentiation
Differentiation
Importance of product for cost and
quality
Importance of product for cost and
quality
Number of buyers
Number of suppliers
Volume per buyers
Volume of suppliers
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1. Rivalry among existing firms
depends on:
•
•
•
•
•
i. Industry Growth rate: The competitive behavior of a firm with high growth
industry and stagnant industry is different.
ii. Concentration and balance of competitors: Concentration of the number
of firms in the industry shapes the competitive behavior of the firm.
(Example: IBM in mainframe computer formulates the rules of industry,
Coke-Pepsi restrict price cut)
iii. Degree of Differentiation and switching costs: If the products are very
similar the switching cost of customers is low and price competition is
common. If the products are differentiated switching cost is high and rivalry
is less acute.
iv. Scale or Learning Economies and Ratio of Fixed Cost to Variable Cost:
For steep learning curve and large economies of scale there are incentives
for aggressive competition. Similarly, for high fixed cost to variable cost ratio
there is incentive to reduce price to utilize the installed capacity. (example:
airline industry)
v. Excess Capacity and exit barriers: Specialized assets with excess
capacity makes a firm aggressive in price cut. Exit becomes then difficult.
There may be regulations restricting the exit.
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2. Threat of New Entrants
depends on:
• i. Economies of Scale: Large scale economies is a constraint for new
entrants. The existing firm is motivated to handle this risk by a large
investment in research and development (pharmaceutical or jet engines),
in brand advertising (soft-drink), or in physical plant and equipment
(telecommunication)
• ii. First Mover Advantage: The first mover might be able to set industry
standard, to enter into exclusive arrangements with suppliers of cheap
raw materials, or to acquire scarce government licenses. He may
capitalize learning economies or significant switching costs. This makes
new entrance difficult. (example: switching cost of Microsoft’s DOS
operating system is quite high)
• iii. Access to channels of Distribution and Relationship: Limited capacity
of distribution channels and high costs of developing new channels can
act as powerful barriers to new entry. Existing relationship between firms
and customers in an industry also make it difficult for new firms to enter
an industry.
• iv. Legal Barriers: Patents, copyrights limit new entries. Similarly,
licensing regulations limit entry into taxi services, medical services,
broadcasting, telecommunications industries, etc.
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3. Threat of substitute products
• Substitute products are not necessarily similar products
rather the products that perform the same function. For
example, car rental and air lines may be substitutes, Jute
and synthetics are substitutes. Technological innovation
may introduce substitute like computer for type writers. It
depends on:
• i. Relative price and performance
• Ii. Customers’ willingness to switch
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Relative Bargaining Power in Input and
Output Markets
• While degree on competition in an industry determines
whether or not there is potential to earn abnormal profits,
the actual profits are influenced by the industry's
bargaining power with its suppliers and customers. On
the input side there is labor, raw materials and
components, and finances. On the output side firm may
either sell directly to the final customers, or enter into
contract with intermediaries in the distribution chain.
There is a competition among all these factors called
relative bargaining
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4. Bargaining Power of buyers
Depends on:
• 1. Price sensitivity: Buyers are more price sensitive when
the products are undifferentiated and switching cost is
low.
• 2. Relative bargaining power: In a monopoly market
there is low bargaining power of the buyers and in a
perfect market there is high bargaining power of the
buyers. This in turn, depends on number of buyers
relative to number of sellers, as well as the volume per
buyer.
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5. Bargaining Power of Suppliers
• Suppliers’ bargaining power is the opposite to the
bargaining power of the buyers. In a monopolistic and
oligopolistic market the supplier or suppliers have strong
bargaining power. (Example: Power of Coke-Pepsi on
bottlers) On the other hand, in a perfect market they do
not have a bargaining power as they have to accept the
market price. (Example: can producers lack power).
Market of intermediate goods also determines the
bargaining power when they are the exclusive suppliers
for the next sequence of producers. (IBM’s unique
position as mainframe suppliers dominates computer
leasing business)
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Industry Analysis: Case Study
Personal Computer Industry
• Introduction: Computer industry introduced in 1981 when IBM
announced its PC with Intel’s microprocessor and Microsoft’s DOS
operating system. With tremendous growth, in 1997 there was 100
million PC installed capacity, 30 million PC overseas sales with 21%
annual growth rate. Since then the profitability went down. Despite
the spectacular growth in 1998 the industry experienced low
profitability. Why?
• Concentrated market: Top 5 firms sharing 60% so price cut was
common. The industry began in 1981 by the IBM with Intel microprocessor
and Microsoft’s DOS operating system.
• Undifferentiated products: Many firms producing identical products
and acute competition experienced price cut.
• Large scale economies: Components share 60% of the price, so large
procurement needed.
• Low switching cost as different brands use same Intel microprocessor
and Microsoft Windows operating system
• Easy access to distribution channel
• Easy entry due to easy availability of spare parts. (Michael Dell
started Dell computers with mare assembling at his dormitory room)12
Industry Analysis: Case Study (Contd.)
Personal Computer Industry
• Substitute products like Apple’s Macintosh computers offered competition
• Power of suppliers and buyers: Intel (microprocessor) and Microsoft
(DOS) hold strong bargaining power as suppliers. From 1983 to 1993
corporate buyers became price sensitive as computer procurement cost
was very significant for successes, and once being aware of the
technology brand names mattered little to them.
• Tremendous pressure on firms to spend large sums of money to
introduce new products rapidly, maintain high quality, and provide
excellent customer support contributed to low profit potentials.
• Prospective issue: Dominance of Intel and Microsoft in input market is
going to continue which indicates little change of the structure of the
industry in future as well
• Limitation of the analysis: Industry may not have clear boundaries
(Shadow zones: workstation, manufacturers abroad, for Dell’s industry
analysis IBM compatible PCs vs. all PCs)
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B. Competitive Strategy Analysis
• This is the strategy of positioning a firm in the industry. It
refers to the strategy of the competitive advantage of the
firm over other firms of the same industry. Commonly it is
either (i) Cost Leadership or (ii) Product Differentiation.
• (i) Cost Leadership refers to the firm’s advantage in the
cost of production. This depends on the production
system.
• (ii) Product Differentiation refers to the advantage of the
firm regarding the specification of the product. This
depends on the acceptability of customers on the
marketing point.
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Strategies
for Creating
Competitive
Advantage
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Competitive Strategy 1:Cost Leadership
• Cost Leadership means to create sustainable cost advantage
over rivals with regard to same product or service. It arises
from:
– Economies of scale: To explore the optimum scale
– Economies of learning: Complication of technology of production.
Both short run and long run
– Efficient production: constrained optimization
– Simpler product design: Alter value chain to bypass costproducing activities.
– Lower input cost: procure or produce?
– Low cost distribution: owning or hiring?
– Little research and development or brand advertisement. Industry
standard? Cost-benefit of low R&D?
– Tight Cost Control system: To ascertain the cost centre,
standardize costs and identify the agent responsible for variation
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Cost Leadership in case of identical commodity
Firm
Price
Si
(MC)
Price
Industry
Sf1
Sf2
AC1
Tk.50
AC2
D=AR=
MR
D
(MU)
Qi
Quantity in million
Q f 1 Qf 2
Quantity in thousands
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Competitive Strategy 2:
Product Differentiation
• Product differentiation strategy seeks to be unique
in industry along some lines highly valued by
customers. It implies to identify such attributes, and
meet that in a unique and cost-efficient way. It
involves:
–
–
–
–
–
–
Superior product quality
Superior product variety
Superior customer service
More flexible delivery
Investment in brand image
Investment in R&D, engineering skills and marketing
capabilities
– More focus on creativity and innovation.
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Advantage of product differentiation
Without differentiation:
Elastic demand curve
With differentiation:
Relatively Inelastic demand curve
MC
MC
AC
Price
AC
D=AR
AR=MR
MR
Quantity
Quantity
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Competitive Strategy Analysis (Contd.)
• Competitive Advantages involves the identification of
either cost leadership or product differentiation. It
requires:
– 1. Match between firm’s competence and key success factors to
execute strategy.
– 2. Match between firm’s value chain and activities required to
execute the strategy
– 3. Sustainability of competitive strategy.
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Case Analysis: Personal Computer Industry (Contd.)
Success of Dell Computers
•
1.
2.
3.
4.
5.
Despite the constraints Dell was quite successful. Why?
Direct selling (through internet web site). Utility of retailer went down
as computer became standardized on the Windows-Intel platform.
Dell was pioneer in direct selling. It saves the markup of retailers.
Made-to-order manufacturing. This allowed to concentrate more on
quick assembling and shipping. It saved the cost of inventory pileup,
working capital and obsolete inventories.
Expertise third party after sale services & very effective telephone
based servicing.
Lowest accounts receivable days of the industry by encouraging the
customers to pay on credit card.
Dynamic R&D investment: Dell recognized that Intel and Microsoft
are key suppliers and they invested huge amounts in developing new
generation processors and software. So Dell R&D concentrated in the
organizational aspect that respond quickly to these changes.
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C. Corporate Strategy Analysis
• This refers to the corporate decision whether to
concentrate on single line of business or to diversify the
business among different lines. It relates to the goal of
wealth-maximization of shareholders. Conflicting views
have been observed. The portfolio theory says that
diversification is more economic on the part of the
investors rather than the firm. Unlike 1970s, recent trend
of US companies is to reduce diversity. On the other
hand, the global trend of group of companies or
multibusiness organization still continues with some
successes. Example: General Electric is successful in
creating significant values by managing highly diversified
business ranging from aircraft engines to light bulb.
Sears has not been successful in retailing together with
financial services.
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Effectiveness of Diversification
Probability
Return of
Umbrella
Return
Ice-cream
Portfolio
Return
Rainy
0.25
25
-5
10
Moderate
0.5
14
10
12
Dry
0.25
0
15
7.5
13.3%
7.5%
10%
8.9%
7.5%
1.8%
67%
100%
13.5%
Climate
Return E(R) =
Risk

 R * P 
i
i
2
(
R

R
)
 i Pi 
Risk (Coeff. of variance)
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U.S. Industry Profitability, 1971-90
Pharmaceuticals
Printing and publishing
Food products
Chemicals and allied products
Petroleum and coal products
Instruments and related products
Industrial chemicals and synthetics
Paper and allied products
Aircraft, guided missiles, and parts
Fabricated metal products
Motor vehicles and equipment
Rubber and misc. plastic products
Electric and electronic equipment
Machinery, except electrical
Stone, clay, and glass products
Textile mill products
Nonferrous metals
Iron and steel
ROE
21.4%
15.5
15.2
15.1
13.1
12.9
12.9
12.5
12.4
12.3
11.6
11.6
11.5
11.1
10.4
9.3
8.3
3.9
ROA
11.8%
7.1
6.6
7.5
6.5
7.2
6.2
6.0
4.1
5.7
5.6
5.1
5.4
5.8
4.8
4.3
3.9
1.5
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Value creation at corporate level
• This depends on the transaction cost of performing a set of
activities inside the firm versus using the market
mechanism. Transaction cost economics implies that the
multiproduct firm is an efficient choice of organizational
form when coordination among independent, focused firms
is costly due to market transaction cost.
• Transaction cost increases if the production process needs
specialized assets, such as human capital skills, proprietary
technology or other organizational know-how that is not
easily available in the market place.
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Corporate Strategy Analysis (Contd.)
Advantage of value creation at corporate level (disadvantages of
introducing a new business)
1. Significant information gap between investors and entrepreneurs.
(lemon’s problem)
2. Significant information gap between buyers and producers.
Besides, due to poor legal infrastructure buyers may not enforce
warranties
3. Unavailability of quality people. When employer fails to assess the
quality of applicant for new position, he would like to stick to the
old people and give them promotion.
4. Communication cost within the organization goes down regarding
confidentiality of customers.
5. Head office can significantly reduce cost of enforcing agreements
between organizational subunits.
6. Organizational subunits can share valuable nontradable assets
such as organizational skills, systems and processes.
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Corporate Strategy Analysis (Contd.)
• Disadvantages of value creation at corporate level:
• When transaction cost increases?
1. Lack of specialization. Top management may lack information, skills
and expertise related to different industries.
2. Lack of economies of scale.
3. Diversification is motivated more by higher investment rather than
higher profit.
4. Creates agency problem.
5. Becomes difficult to assess the performances of each unit of the
firm. Sometimes even poorly performing units are subsidized by the
organizational head office that fails to ensure the justice expected by
the investors.
• Remedies:
1. Decentralization of organization
2. Hiring specialist managers for each business unit
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For corporate strategy analysis:
An analyst should ask..
• Are there significant imperfection in product, labor or
financial market? Market imperfection increases
transaction cost.
• Does the organization have special resources such as
brand names, proprietary know-how, access to scarce
distribution channels to create economies?
• Is there a good fit between the company’s specialized
resources and the portfolio of businesses?
• Does the company make appropriate distribution of
decision making across the different units?
• How does the company handle the agency cost and
coordination problem?
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Applying corporate strategy analysis
Amazon.com
• Amazon.com, a pioneer in electronic commerce sector, started
operation as online bookseller in 1995 and went public 1997.
Successes led an increase in share price. Market capitalization
was $36 billion in 1999. Expansion strategy included acquisition of
other online businesses, and selling online CD, videos, gift,
pharmaceutical drugs, pet supplies, and groceries.
•
Advantages:
1. valuable brand name on the internet. Since electronic commerce is a
new phenomena, customers valued it quite high.
2. Amazon acquired critical expertise in flawless execution of electronic
retailing that can be exploited in many areas.
3. Amazon has been able to create a tremendous amount of loyalty
among its customers through superior marketing and execution.
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Applying corporate strategy analysis
Amazon.com (Contd.)
• Constraints:
• Amazon was expanding too rapidly. Expansion beyond
book retailing must fail.
• Competitors like Wal-Mart, Barnes & Noble are also
having valuable brand names execution capabilities, and
customer loyalty. Which must offer formidable competition
in retail business.
• Expanding rapidly in so many areas may confuse
customers, dilute Amazon’s brand value, and increase
chance of poor execution.
• Effect:
• Sales increases but profitability goes down and more
importantly share price goes down from $221 in April 1999
to $118 in May 1999.
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