Which firms can survive a storm?
By
Deputy Editor
Tim Bennett Nov 27, 2007
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More and more pundits are fretting about the prospect of a US recession – but the outlook is glum on this side of the Atlantic too.
The housing boom is well and truly over, and both consumers and business are finding that lending is drying up.
So which firms are most vulnerable, and which can ride out the hard times? One useful guide is Harvard professor Michael Porter’s five forces, which examines the competitiveness of different industries.
When most or all of these five forces are favourable, an industry can sustain several competing firms, which can all earn attractive returns. Where there is intense pressure from one or more of the forces, only the best firms will earn decent returns, or even – in the case of a downturn – survive. So what are these “forces”?
1. Barriers to entry
The higher the barriers to entry, the harder it is for new firms to get a foothold in an industry, and the less competition there is for those that are already established.
Barriers come in a range of guises. First, there’s Government regulation – up until the “Big Bang” and the deregulation of financial markets in 1986, for example, building societies could not compete directly with retail banks as they do today.
Then there’s capital intensity. Some products – for example, the aircraft conveyor belts made by Smiths Industries – require expensive, specialist equipment to build. Obviously, this limits the opportunities for smaller players to break into the market.
Branding is another barrier. Even the mighty Virgin discovered it’s tough breaking into a cola market dominated by Coke and Pepsi, which spend a fortune on brand awareness and command brand loyalty.
Lastly, there’s proprietary knowledge. Outsourcing group Capita’s business can only be taken away by a handful of firms that can match its knowledge of local and national government infrastructure.
2. Supplier power
Industries that depend heavily on specific supplies of labour, components and raw materials tend to be less profitable because suppliers can charge high prices, knowing their customers have few alternatives. Suppliers get powerful if there are few of them, if there are few substitutes for what they offer, and if the cost of switching from one supplier to another is high.
PC makers such as Hewlett Packard and Sony are dependent on Microsoft for operating systems and Intel for processors – which makes these two companies highly profitable.
3. Buyer power
It stands to reason, therefore, that the ideal position for any firm is to be a big buyer in a field of many, smaller competing suppliers, who can be beaten down on price or face the threat of losing valuable contracts. Classic examples of such firms include the big supermarkets, such as Tesco and Sainsbury, as well as Japanese carmakers Toyota and Nissan.
4. Rivalry
In a competitive market, every firm wants to be top dog, but the intensity of this rivalry can vary significantly. One way to measure this is “industry concentration” – the share of a market controlled by the top four firms. The higher it is, the lower the rivalry and the more profits are concentrated in a handful of firms. There is also greater scope for collusion (manifested in price fixing), hence the UK’s competition commission’s recent investigation into the UK’s “Big Four” food retailers.
Rivalry is increased, and profits are threatened, when there is a larger number of firms fighting for market share, which leads to slower growth overall. This problem is made worse when there are low levels of product differentiation and customers can easily switch from one firm to another.
The estate-agency business is a good example. As long as the housing market is buoyant, a large number of rival firms can be sustained – but as sales dry up, many will go to the wall. Restaurant groups also suffer from this problem – coffee chain Starbucks has seen its shares fall more than 30% since the start of the year, partly down to customers deserting it for cheaper rivals.
5. Substitution
Porter’s final force is the ease with which a firm’s product can be substituted for something else – not the same product from another firm, but something else altogether. The entertainment industry is full of examples – records losing out to CDs and then to downloadable music – which has had a disastrous impact on music retailers such as HMV.
More subtly, substitutes are not always complete replacements. For example, if aluminium becomes too expensive, then drinks companies will use substitutes, such as glass or plastic bottles, instead.
However, the mere existence of a substitute is not in itself a threat until it can be produced at similar volumes and at a similar cost. For example, it seems unlikely that a biofuels revolution will hit the profits of oil giants BP and Shell anytime soon.
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