Analysis of Ch. 7 on Production Advantages Lost Part 1

 A reader, Logan, provided a thorough, intelligent analysis of the case study of Philips and Cisco (first mentioned here: http://wp.me/p1PgpH-sL) from Chapter Seven in Competition Demystified below. My comments are in Italics. Please do not hesitate to add your comments if you have additional insights.Question 1: Discuss first mover conditions that Philips might have considered in entering the compact disc and compact disc player markets. Consider: market growth, establishment of standards specs, patents, customer captivity, economies of scale.

Answer:

First mover conditions:

Will Philips be able to have any sustainable/structural competitive advantages in this industry? Will we be able to develop and maintain any structural competitive advantages? If so, which ones? Proprietary technology? Patents/trademarks? Learning/experience? Demand? Economies of scale + Customer captivity? How sustainable will these advantages be? What will we be able to do in the long run that competitors cannot do?

The market for compact discs could be very large in the future. How large? In several years, perhaps 200 million units will be sold. Will growth in the market be good or bad for Philips? That depends on whether the company will have any structural competitive advantages and how sustainable those advantages are.

Supply: Philips will have no long-term supply based competitive advantages. There are NO patents protecting the CD technology (since it was developed at MIT in the 1950s). We are to assume that any competitors with available funds will enter the market and replicate the technology if they choose. One potential advantage Philips might have is an experience based advantage from being the first mover. We should try to quantify this.

Where was Philips going to make its money in the CD market? None of the record companies like CBS/Sony paid a royalty to Philips for its technology. Quite the opposite, Philips and Sony had to persuade them to take up the new product; they were not about to reduce their returns for the favor. No patents protected the technology. And the large record companies were the only players in the whole industry who were concentrated enough to wield some bargaining power. Philips was NOT in a position to coerce them. 

Perhaps it could prosper as a manufacturers of CDs. As the first mover into the field, might Philips been able to take advantage of its earlier start down the learning curve, producing the discs at a much lower variable cost than companies just beginning to learn the intricacies of achieving high yields by keeping contamination to a minimum. Although experience did help in raising yields and lowered variable costs, it was offset by the disadvantage of being the first to invest in a production line. Here, costs were lower for the latecomer, who did not have to pay the penalty for taking the lead.

The balance between these two forces would depend on how rapidly the market for CDs developed. On balance, then, Philips could expect to benefit from an initial learning curve advantage over new entrants. However, as an entrant gained experience and moved down the learning curve, this advantage would start to shrink and would disappear entirely once the entrant had procured a cumulative volume of 50 million discs. Because it was using later-generation equipment, its capital costs would be lower than Philips’s.

Demand: Demand for the new CD technology is dependent on the acceptance of the new format by the 5 major recording studios. In order for the technology to be a success, a few studios will need to adopt the format and cause the others to follow suit. Will the recording studios be captive to one supplier of CD technology? Habit? No. Switching/Search costs? No. The recording studios are essentially purchasing a commodity product and are not captive to one particular manufacturer of CDs. If Philips is the only game in town, the studios will be forced to use them. Since we know that there are no patents protecting the CD technology, entrants will flood the market (if they can) and at best they will compete based on price and “product differentiation.”

It will cost $25 million and take 18 months to build the first manufacturing line with a capacity of 2 million units. Internal projections show that the costs of equipment and time to manufacture new facilities will decline in the future. Therefore, entrants will have an advantage over the incumbents with older manufacturing facilities. Will higher volume offset the disadvantage of using older technology? In 3 years’ time, it is projected that Philips could be selling 10 million units. Variable cost per CD will be roughly $1.77 vs. $3.00 for an entrant in the 0-5 million unit output range. This is an advantage of $1.23. Using the older equipment, Philips fixed costs per unit at 20% cost of capital and 10 year depreciation will be $2.50 vs. $1.12 for a spread disadvantage of $1.38 per CD. Therefore, higher unit volume will be more than offset by the more efficient and productive new facilities.

Questions: What are the fixed costs relative to the size of the market? Can Philips focus on a niche? If so, which niche? What is the minimum efficient scale? Will competitors take customers and market share away from our company? Why would a recording studio use our products and not potential entrants?

Plants can be efficiently operated at a scale of 2 million units. Given that demand is projected to reach 200 million in the next several years, companies will enter the market since customer captivity is very limited. In order to reach minimum variable costs per unit, a competitor would need to reach 50 million units per year. If Philips could enter the market and CREATE customer captivity, it could potentially control a large enough share of the market to make entrance by competitors prohibitive. But we have observed that customer captivity is going to be VERY limited.

How will the establishment of standards specs impact the industry? If you develop the standard that everyone decides to use AND you have some structural competitive advantage (supply, demand, or EOS+CC) then you can benefit from being the company that manufactures the standard (think MSFT). If competitors can copy the standard and you do not have captive customers or patents, you will be competing on a semi-level playing field (you might have some advantages in terms of know how). Since you are first mover and create a new product, you can benefit in the short-term potentially from learning and experience. Over time, competitors will gain the knowledge and experience (do it themselves or hire your people away) so as to make this advantage dissipate. Question: Apple has created several product categories. In the long-run, how do you assess whether Apple can continue to create new products and that competitors will not catch up?

If the CD market exploded to 200 million or more units per year, then at least some new entrants could rapidly reach a cumulative output of 50 million. It is unlikely that Philips would benefit from customer captivity, since its important customers were the large, sophisticated and powerful major record companies. Thus, Philips ‘s cost advantage would last for less than two years. Paradoxically, the only condition that might sustain Philips’s learning curve would be a SLOWLY growing CD market, so that it would take years before competitors could reach the 50 million cumulative milestones and complete their passage down the learning curve.

From this perspective, the problem with the market for discs was not that it would be too small; it would be TOO LARGE. Even if it had a head start, Philips was not going to sustain an advantage based on being first mover for more than a few years. Unless it achieved some measure of customer captivity, there was no reason to think that Philips could keep current customers from taking their business elsewhere. And since plants could be efficiently operated at a scale of only 2 million discs per year, economies of scale in production would both be a deterrent to entry. Without captive customers., durable production advantages, or relative economies of scale, Philips would benefit from no competitive advantages as a producer of CDs.

It might have been better off if CDs had been restricted to a niche market in which it would have had the field to itself for perhaps five to seven years. During this interim period, it might have been able to earn above average returns, maybe enough to compensate it for its initial development expense.

In the CD market, Philips never had the kind of honeymoon that Cisco enjoyed. It never established customer captivity; its customers were large and sophisticated, and its product did not require significant support. It also never benefited from economies of scale. Distribution and service support for raw, unrecorded CDs accounted for a tiny share of the costs, and while the original development costs may have been high, continuing R&D expenditures were negligible. Learning curve related advantages, Philips’s only remaining hope of competitive advantage, were undermined by the rapid growth CD market, which allowed its competitors also to move quickly down the experience curve. Philips confronted a world without competitive advantage–a “toaster” world.

WHAT MATTERS IN A MARKET ARE DEFENSIBLE COMPETITIVE ADVANTAGES, WHICH SIZE AND GROWTH MAY ACTUALLY UNDERMINE.

Part 2 Tomorrow

5 responses to “Analysis of Ch. 7 on Production Advantages Lost Part 1

  1. For the record…Longleaf Partners Fund has Philips in its portfolio : http://www.longleafpartners.com/downloads/llpfx-123112.pdf. If you go back to earlier letters, they mention the healthcare division and the shareholder friendly attitude of management. Healthcare is one of three divisions – the other being Lighting and Consumer Electronics – and should be the so-called sweet spot (at least compared to the other two). Also notice how it seems Longleaf Partners has a ‘total payout yield’ screen running somewhere. DirectTV and Dell are two other companies which are allocating a lot of cashflow towards share buybacks and dividends.

  2. Thanks for the comments and link PT. Why do you think they own it?

  3. Reading their comments I believe it is a combination of:
    (1) The healthcare division – which Longleaf believes is forgotten among the other two divisions (lighting and consumer electronics). In my opinion, they do not own it for the lighting and consumer electronics division since these two division have in my opinion no competitive advantage.
    (2) The cash-flow allocation attitude of management: they are buying back stock and shareholders are also receiving a dividend.

    Other elements at stake:
    – 4Q 2011 results showed a surprise on the consumer electronics division and a lower than expected margin at the healthcare division. See slide 13 on the recent quarterly presentation http://www.newscenter.philips.com/main/corpcomms/resources/corporate/Q4_2011/presentation_4Q11.pdf

    – If I’m not mistaken, Philips recently installed a new CEO. They had some profit warnings, which also makes the new management team now has lowered the hurdle to jump over. Profit warnings often come in three or fourfold (just saying they are seldom on a one time event)….and automatically lower the hurdle for future EPS beats. Although this is not relevant for long term value creation, EPS beats often have positive stock reaction. (Btw, for a nice example, look at Diageo : I believe they didn’t beat EPS one time after 2008, still they are always growing earnings and allocating cash flow in a smart way. Look at the stockprice to see the result of this –> there was a fund that posted a nice analysis of these type of CF allocating companies, I will post the link later today or tomorrow). Regarding profit warnings, compare to Cisco, where the CEO also lowered guidance in order to allow him some time to put the business on order and to have a lower hurdle to jump over.

    – I did not perform a full valuation of Philips, it might be that Longleaf did a sum-of-the-parts analysis where they say for example they get the healthcare division for free (or the other way around). The company stated however they don’t want to split up, so closing a ‘holding discount’ here will be difficult given that lighting and consumer electronics will not become the star divisions.

    – Don’t know about the competitive advantage in the healthcare equipment industry…other giant players like GE and Siemens are also active in the bigger healthcare equipment sector.

    – No leverage risk: I believe the balance sheet shows a net-cash position.

    Just my two cents of course…comments always welcome!

  4. When we return to Apple, this might make for an interesting case study as well:

    BlackBerry Maker in Turmoil

    http://online.wsj.com/article/SB10001424052702303404704577312010085459278.html

    “The overhaul comes just two months after Thorsten Heins took the reins at RIM and confidently proclaimed there was no need for “seismic” change.

    In the past, Mr. Heins has signaled he wasn’t interested in selling the company. But after two months on the job, Mr. Heins said he realized the challenges facing the company are much more significant than he initially thought.

    RIM said Thursday it would no longer provide earnings guidance “due to a desire to focus on long term value creation.”

    Prem Watsa’s Fairfax ups RIM stake:

    http://uk.reuters.com/article/2012/01/27/oukin-uk-rim-watsa-idUKTRE80Q1C420120127

  5. Pingback: movers web » Disadvantage of Being a First Mover experiences opinions

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