Category Archives: Competitive Analysis

Chapter 8 in Competition Demystified, Games Companies Play, Discussion Part 2

Posted on March 7, 2012 | Leave a comment

Most people are prisoners, thinking only about the future or living in the past. They are not in the   present, and the present is where everything begins.–Carlos Santana

Part 1: http://wp.me/p1PgpH-xz

This chapter should teach the importance of analyzing companies’ competitive behavior within an industry.

Part 2: When a competitor wants to be “deviant,” how can others in the market control the deviant behavior?

It is possible to change the environment by making adjustments that support cooperation and control non cooperative behavior. These adjustments work by making deviant behavior less rewarding and cooperation less costly into two categories: structural and tactical.

Structural adjustments are prior arrangements that directly limit the consequences of deviant behavior.

The most elegant structural adjustment is for competitors to arrange their businesses to stay out of each other’s way by occupying separate and distinct niches in the market. These niches can be defined by geography, by field specialization, even by times of the day.

The first structural adjustment to make, then to escape the prisoner’s dilemma is to avoid direct product competition. The adjustment can actually increase the consumer choice, as in the Pan Am decision to fly on the half hour. It can also cure duplicative overhead, and in the case of the expertise needed in the auction houses, and enhance economies of scale, as in the examples of Wal-Mart and Coors, where the advantages diminished as they moved further afield.

Customer loyalty programs, if properly designed, are a second structural adjustment to limit the consequences of competitive price reduction. For example, frequent-flier programs offer customers benefits like free flights or upgrades as they accumulate miles flown on a particular airline. Two critical aspects in the design of these programs are generally absent: first: rewards must be tied to cumulative, not merely current, purchase so that they build customer loyalty over time; second and the rate at which rewards accumulate should increase with increasing volume. This last point is important, because if each mile flown earns the same unit of rewards, the program is simply a general price discount. Customer captivity is strengthened with that airline if greater awards are given.

A third way of adjusting the structure is to limit output capacity in the market, If firms agree to restrict the amount of product that can be offered for sale, and they abide by that agreement, the benefits of price cutting by many of them will be sharply reduced or eliminated entirely. The price-cutting firm gains nothing if it cannot supply the additional customers it tries to capture by lowering its prices. Indeed, in many industries, the major problem arising from the installation of more capacity than the market can support is not the direct costs of creating and serving the capacity. Rather, it is that with additional capacity available, a firm is tempted to lower prices in the hope that by winning more customers, it can make use of the new factories equipment, space, time or other assets. The price war that is likely to result undermines profitability not only on the new business attracted, but on the pre-existing business as well. Restriction of air time by media companies is an example.

A fourth kind of structural adjustment that also requires universal compliance by incumbents is the adoption of pricing practices that raise the cost to any firm that lowers its price. One typical arrangement is a so-called most-favored-nation (MFN) provision in industry pricing contracts. Under the MFN provision, if a firm offers a lower price or better terms to one customer, it must offer the same price or terms to all its customers. This policy keeps a company from poaching selective customers by offering lower prices because any price reduction applies automatically to all of its customers. Firms are discouraged from cutting prices to gain new business.

Another structural adjustment that restricts price competition is an agreement to limit purchasing and pricing decisions to a specific and narrow window in time. The television networks and other medial have used preseason advertising purchase markets that operate for two to three weeks before the beginning of the annual season. During this period, advertising is implicitly sold for less than it will cost later on the spot market. By keeping the buying period short, the suppliers make it difficult for customers to play suppliers off against one another. The resulting “orderly” markets are less vulnerable to the threat of successive price reductions to which anxious medial sellers might resort to fill slots if the purchasing period went on indefinitely.

Social interactions within an industry may serve as an informal but still powerful restraint on competitive behavior that undermines collective price discipline. Where there are industry norms that involve “fair” pricing among the firms, they may be strengthened by the added social stigma that attach to a deviating company. Thus, industries like ladies’ undergarments, which have been characterized by remarkable discipline over many decades, tend to be industries in which the owners and managers come from similar backgrounds or geographic areas.

A final structural adjustment that restrains the degree of price and feature competition within an industry is the basic reward system, both formal and informal, within the competing firms. If a firm’s bonus, promotion, and recognition systems, values sales growth over profitability, then controls on price cuts that boost volume at the expense of profits are likely to be weak. Price competition within the industry is likely to be intense, and it will be impossible to maintain relatively high prices.

Tactical Responses

Tactical adjustments are prior commitments to respond to deviations by a single firm. Their purpose is to reduce the benefits of deviation and lead the transgressor back to cooperation.

As complements or alternatives to structural adjustments, they can help inhibit direct competition. Any successful tactical response in a prisoner’s dilemma/price competitive situation requires two components: an immediate–even automatic–reaction to a competitors’ price reduction, and a simultaneous signal of a willingness to return jointly to higher prices. The first component makes certain that a firm that cuts prices never benefits from any reductions it has initiated. A firm under attack counters immediately and even automatically by matching the new, lower prices.

The second component, the signal of a willingness to raise price jointly, is necessary to make sure that the firms not remain mired in the low-price environment created by the initial price cuts and the immediate and often automatic matching responses.

“Best industry price contracts: are examples of an automatic price response strategy. Such contracts provide reimbursement to customers if the price the customers pay is higher than one veritable offered by an industry competitor. “Meet or release” contracts are another automatic response, with the added benefit of not requiring the firm to match a rival’s price if it things it is too low for anyone to make a profit.

Firms must respond aggressively and automatically to a competitor’s price war.

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Chapter 8 in Competition Demystified, Games Companies Play, Discussion Part 1

Posted on March 7, 2012 | 1 comment

Only free men can negotiate; prisoners cannot enter into contracts. Your freedom and mine cannot be separated. –Nelson Mandela
Chapter Eight’s questions was first discussed: http://wp.me/p1PgpH-uG

More on Prisoner’s Dilemma: http://perspicuity.net/sd/pd-brf.html

Chapter 8: Games Companies Play: A Structured Approach to Competitive Strategy, Part 1: The Prisoner’s Dilemma Game

QUESTION: Describe in a few sentences the dynamics of a prisoner’s dilemma game with two competitors of a similar size and the likely equilibrium in the real world of Lowes and Home Depot.

The essence of price competition among a restricted number of companies is that although there are large joint benefits to cooperation in setting high prices, there are strong individual incentives for firms to undermine this cooperation by offering lower prices and taking business away from the other competitors.

Competitive situations of this sort take the name of prisoner’s dilemma because they imitate the choices faced by two or more accused felons. If those, who participate in a criminal activity, are caught, and are then interrogated separately–if they all cooperate with one another and refuse to confess–there is a strong probability that they will bear the charge, and they can expect a light sentence.  But each of them can negotiate a deal with the police for even less jail time if he confesses and testifies against his confederates. The worst case is for an accused to maintain his innocence but have one of his confederates confess. Given these alternatives, there is a powerful temptation to abandon the group interest and confess.

Regarding Lowes and Home Depot, who face a prisoner-like dilemma in how they interact and respond to each other, for every issue, the outcome of any action by Lowes depends upon how Home Depot chooses to respond and vice versa.

Assume that the offerings of these competing firms are basically equivalent, then, so long as they charge the same for their product, the competitors divide the market equally. If they all charge a high price, relative to their costs, then they all earn high profits. If they all charge a high price, relative to their costs, then they all earn high profits. If they all charge a low price, they will divide the market, but now each of them earns less. However, if one firm decides to charge a low price while others charge more, we can assume that the firm with the low price captures a disproportionately large share of the market. If the additional volume more than compensates for the smaller profit per unit due to the lower price, then the firm that dropped its price will see its total profits increase. At the same time, the firms that continue to charge a high price should see their volume drop so much that their profits will be less than if they also charge the low price.

So it is no wonder that to maintain their cooperative position is difficult, both for the accused felons and for competitive firms. The usual outcome is what referred to in game theory as a “non cooperative equilibrium.”

Equilibrium

Equilibriums are outcomes that are stable because no competitor has an obvious incentive to change its action. These equilibriums depend on two conditions:

Stability of expectation

Each competitor believes that the other competitors will continue to adhere to their present choices among the possible sources of action

Stability of behavior

Given the stability of expectations, no competitor can improve its outcome by choosing an alternative course of action. These two conditions work together; if no competitor has a motive to change its current course of action (stability of behavior), than no change will occur, confirming the stability of expectations. The most common form of competitive interactions is where there are large joint benefits from cooperation but strong individual incentives to deviate.

—

The reply to the second question on Chapter 8 will be posted next in Part 2

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Investing in Banks

Posted on February 27, 2012 | 3 comments

A Lesson in Punctuation

An English professor wrote the words, “a woman without her man is nothing” on the blackboard and directed the students to punctuate it correctly.

The men wrote: “A woman, without her man, is nothing.”

The women wrote: “A woman: without her, man is nothing.”

A reader has asked me a question about investing in banks. Unfortunately I avoid banks because I believe banks are a speculation on a bank management’s ability to make prudent, rational lending decisions combined with the whims of Federal Reserve policy. You have the risks of “bank runs” due to fractional reserve banking. (I can’t value the bank or normalize earnings or ROIC so I do what a pretty girl at a bar would do–just say, NO!) However, understanding how the banking system works is critical to understanding economic booms and busts.  My suggestion is to begin reading the books mentioned below as a starting point before venturing to banks’ financial statements.

Excellent Blog: http://variantperceptions.wordpress.com/

To learn more about banks you can read American Banker: http://www.americanbanker.com/ and S&P industry reports on banking. Also, the Wall Street Transcript has articles on banks and the banking industry here: http://www.twst.com/

The History of Banking: www.mises.org/books/historyofmoney.pdf

How banking Works: www.mises.org/books/mysteryofbanking.pdf

Money, Banking and Credit Cycles: www.mises.org/books/desoto.pdf

Warren Buffett plugs Jamie Dimon, The CEO of JP Morgan as a good banker and suggests reading his shareholder letters.

Jamie Dimon’s 2010 Letter to Shareholders: http://files.shareholder.com/downloads/ONE/1713791083x0x458384/6832cb35-0cdb-47fe-8ae4-1183aeceb7fa/2010_JPMC_AR_letter_.pdf

2009 Letter: http://files.shareholder.com/downloads/ONE/1713793272x0x362440/1ce6e503-25c6-4b7b-8c2e-8cb1df167411/2009AR_Letter_to_shareholders.pdf

A reader, generously contributed this: http://www.scribd.com/doc/83007803/Banking-101-for-Large-Cap-Banks-May-2011

A Handbook on Analyzing Banks: http://www.amazon.com/Bank-Analysts-Handbook-Conjuring-Tricks/dp/0470091185/ref=cm_cr_pr_product_top

Review of the above book:

Great introduction, some conceptual/structural flaws,October 27, 2009

By Brad Barlow (Cave City, KY) – See all my reviews
(REAL NAME)

This review is from: The Bank Analyst’s Handbook: Money, Risk and Conjuring Tricks (Hardcover)

Frost’s book gets 4 stars based on its strength and accessibility as an introduction, it’s clarity (for the most part), and the breadth of topics that he covers related to banks and the banking industry.

Unfortunately, Frost’s understanding of economics is poor, leading to a relatively shallow (but certainly textbook these days) discussion of central banking and the regulatory framework in general. He, like so many other modern writers in finance and economics, would benefit greatly from actually reading a sound economic theorist, like Henry Hazlitt or Ludwig von Mises, rather than sporadically quoting JK Galbraith and Adam Smith. This lack of understanding on his part at times undermines the conceptual framework of the book, detracting from its clarity.

A few final praises and quibbles: His use of clear examples to illustrate important points is very welcome, but there are a few cases where he could give a fuller explanation (e.g., the 20-yr mortgage example). I like the diagrams showing flows of funds and parties to common transactions, but he could have picked a better font, as the small cursive script is not always easy to read. Finally, what’s with the front cover art, seriously?

Overall, I’m quite satisfied and thankful for the book. Definitely buy it if you are in the industry.

Avoid banks and seek other ideas.

You can look here: http://www.crossingwallstreet.com/buylist

http://www.crossingwallstreet.com/my-favorite-links

The key to doing well on Wall Street is actually very simple: Buy and hold shares of outstanding companies. But too many investors never learn this valuable lesson. Or if they do learn it, they learn it the hard way. That’s where I come in. I want to help investors avoid the mistakes that separate successful investors from those who always find themselves spinning their wheels.

Without a Central Bank

A reader, Taylor, mentioned the distortions caused by central banks. What would happen if we did not have central banks?

Life without a central bank (Panama) http://mises.org/daily/2533

In this modern, post-–Bretton Woods world of “monetary order” and coordinated central-bank inflation, many who are otherwise sympathetic to the arguments against central banks believe that the elimination of central banking is an unattainable, utopian dream.

For a real-world example of how a system of market-chosen monetary policy would work in the absence of a central bank, one need not look to the past; the example exists in present-day Central America, in the Republic of Panama, a country that has lived without a central bank since its independence, with a very successful and stable macroeconomic environment.

The absence of a central bank in Panama has created a completely market-driven money supply. Panama’s market has also chosen the US dollar as its de facto currency. The country must buy or obtain their dollars by producing or exporting real goods or services; it cannot create money out of thin air. In this way, at least, the system is similar to the old gold standard. Annual inflation in the past 20 years has averaged 1% and there have been years with price deflation, as well: 1986, 1989, and 2003.

Panamanian inflation is usually between 1 and 3 points lower than US inflation; it is caused mostly by the Federal Reserve’s effect on world prices. This market-driven system has created an extremely stable macroeconomic environment. Panama is the only country in Latin America that has not experienced a financial collapse or a currency crisis since its independence.

As with most countries in the Americas, Panama’s currency in the 19th century was based on gold and silver, with a variety of silver coins and gold-based currencies in circulation. The Silver Peso was the currency of choice; however, the US greenback had also been partially in circulation, because of the isthmian railroad — the first railroad to connect the Atlantic to the Pacific — that was built by a US company in 1855. Panama originally became independent from Spain in 1826, but integrated with Colombia; however, being a small state, it was not able to immediately secede from Colombia, as Venezuela and Ecuador had done. In 1886 the Colombian government introduced several decrees forcing the acceptance of government fiat paper notes. Panama’s open economy, being based on transport and trade, plainly could not benefit from this; an 1886 editorial of its main newspaper read:

“there is no country on the globe, certainly no commercial center, in which the disastrous consequences of the introduction of an irredeemable currency would be felt as in Panama. Everything we consume here is imported. We have no products and can only send money in exchange for what is imported.”

In 1903, the country became independent, supported by the United States because of its interest in building a Canal through Panama. The citizens of the new country, in distrust of the 1886 experiment of forced fiat Colombian paper notes, decided to include article 114 in the 1904 constitution, which reads,

“There will be no forced fiat paper currency in the Republic. Thus, any individual can reject any note that he may deem untrustworthy.”

With this article, any currency in circulation would be de facto and market driven. In 1904 the Government of Panama signed a monetary agreement to allow the US dollar to become legal tender. At first, Panamanians did not accept the greenback; they viewed it with mistrust, preferring to utilize the silver peso. Gresham’s Law, however, drove the silver coins out of circulation.[1]

In 1971 the government passed a banking law that allowed for a very liberal and open banking system, without any government agency of consolidated banking supervision, and confirmed that no taxes could be exacted from interest or transactions generated in the financial system. The number of banks jumped from 23 in 1970 to 125 in 1983, most of them being international banks. The banking law promoted international lending, and because Panama has a territorial tax system, profits from loans or transactions made offshore are tax free.

This, and the presence of numerous foreign banks, allows for international integration of the system. Unlike other Latin American countries, Panama has no capital controls. Therefore, when international capital floods the system, the banks lend the excess capital offshore, avoiding the common ills, imbalances, and high inflation that other countries face when receiving huge influxes of capital.

Fiscal policy has little room to maneuver since the treasury cannot monetize its deficit. Plus, fiscal policy does not influence the money supply; if the government tries to raise the money supply during a contraction period by obtaining debt in international markets and pumping it into the system, the banks compensate and take the excess money out of circulation by sending it offshore.

Banks cannot coordinate inflation due to ample competition and the fact that (unlike even the United States banking system prior to the Federal Reserve) they do not issue bank notes. The panics and general bank runs that were so common in the US banking system in the 19th century have not occurred in Panama, and bank failures do not spread to other banks. Several banks in trouble have been bought — before any runs ensue — by larger banks, attracted by the profits that can be made from obtaining assets at a discount.

There is no deposit insurance and no lender of last resort, so banks have to act in a responsible manner. Any bad loans will be paid by the stockholders; no one will bail these banks out if they get into trouble.

After several years of accumulation of malinvestments during the booms, banks begin the necessary liquidation of bad credit. Since there is no central bank that can step in to provide cheap credit, the recession begins without any hampering by monetary policy. Banks thus create the necessary contraction by obeying market forces. Panama’s recessions commonly create deflation, which mollifies consumers and also facilitates the recovery process by reducing business costs.

Only the fact that the law does not allow for the downward flexibility of wages makes recessions longer than they would otherwise be.

Deflation happens without the terrible consequences that Keynesian economists predict; and the country, now under democratic rule, is experiencing its 4th year of market economic growth well above 7%. So the policy makers who have said that abolition of the central bank is unfeasible need only look to Panama’s macroeconomic environment, which has been favorable for over 100 years, to realize that it is, in fact, not only possible, but very beneficial. Clearly no government-forced fiat currency, no central bank, and the absence of high inflation are working quite well in this small country. Who can argue that these policies would not work in larger economies?

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A Reader’s Question: How to Build a Competitive Advantage?

Posted on February 27, 2012 | 11 comments

What To Wear For An IRS Audit

A man was called in for an audit by the IRS. So, he asked his accountant for advice on what to wear. “Wear your worst clothing and an old pair of shoes. Let them think you are a pauper,” the accountant replied.

Then he asked his lawyer the same question, but got the opposite advice:”Don’t let them intimidate you. Wear your best suit and an expensive tie.”

Confused, the man went to his Minister, told him of the conflicting advice, and asked him what he should do.

“Let me tell you a story,” replied the Minister. “A woman, about to be married, asked her mother what to wear on her wedding night. ‘Wear a heavy, long, flannel nightgown that goes right up to your neck and wool socks.’ But when she asked her best friend, she got conflicting advice: ‘ Wear your most sexy negligee, with a V neck right down to your navel.'”

The man protested: “But Reverend, what does all this have to do with my problem with the IRS?”

“It doesn’t matter what you wear; you’re going to get screwed.

A Reader’S Question: How to start a business that will develop a moat?

From Arden—his question:

Regarding “real life” businesses- a lot of time when I drive by a vacant shop, I think a lot about what kind of business I would start there, usually the results I reach seem too risky for me. What are some businesses can a guy start, that will have even the most basic moat? Is it even possible? As a businessman, I would love to know your view.

Dear Arden:

Most likely, you would need to start a low-capital-intensive service business, so your chances of creating a competitive advantage would come through either regional economies of scale or niche product economies of scale with customer captivity. The odds are against you, but you must at least operate in a focused and operationally efficient way. Also, don’t confuse an arbitrage profit with a competitive advantage like I did when I started a tariff-switching business in Brazil. Fast growth with high profits don’t indicate a competitive advantage.

I would read all about competitive advantages by reading:

Competition Demystified: http://www.amazon.com/Competition-Demystified-Radically-Simplified-Approach/dp/1591841801/ref=sr_1_1?ie=UTF8&qid=1330361257&sr=8-1

Strategic Logic: http://www.amazon.com/Strategic-Logic-J-Carlos-Jarillo/dp/1403912599/ref=sr_1_1?s=books&ie=UTF8&qid=1330362742&sr=1-1

Then review this post and the video (link in the post) here: http://wp.me/p1PgpH-1N

Economics of Strategy: http://www.amazon.com/Economics-Strategy-David-Besanko/dp/0470373601/ref=sr_1_1?s=books&ie=UTF8&qid=1330361290&sr=1-1

Good Strategy, Bad Strategy: http://www.amazon.com/Good-Strategy-Bad-Difference-Matters/dp/0307886239/ref=sr_1_5?s=books&ie=UTF8&qid=1330362844&sr=1-5

I humbly suggest reading about the Pampered Chef by Doris Christopher. The company, The Pampered Chef, was purchased in 2004 for about $900 million by Buffett. Mrs. Christopher at the age of 35 started the company with a $3,000 loan—the only money ever put into the company! The company uses a multi-level sales organization to put on kitchen shows with proprietary cooking utensils (similar to a Tupperware Party). She built a business from scratch into a world-class organization. (Warren Buffett in the preface).

Additional readings:  

Billion dollar Lessons: http://www.amazon.com/Billion-Dollar-Lessons-Inexcusable-Business/dp/B003156BE0/ref=sr_1_1?s=books&ie=UTF8&qid=1330362800&sr=1-1

Competitive Strategy (Porter): http://www.amazon.com/Competitive-Strategy-Techniques-Industries-Competitors/dp/0684841487/ref=sr_1_1?s=books&ie=UTF8&qid=1330361326&sr=1-1

Co-Opetition:  http://www.amazon.com/Co-Opetition-Revolution-Combines-Competition-Cooperation/dp/0385479506/ref=sr_1_4?s=books&ie=UTF8&qid=1330361407&sr=1-4

Modern Competitive Analysis: http://www.amazon.com/Modern-Competitive-Analysis-Sharon-Oster/dp/019511941X/ref=sr_1_1?s=books&ie=UTF8&qid=1330361426&sr=1-1

Little Book that Builds Wealth (on Moats):http://www.amazon.com/Little-Book-That-Builds-Wealth/dp/047022651X/ref=sr_1_1?s=books&ie=UTF8&qid=1330361453&sr=1-1

Morningstar’s Five Rules for Successful Stock Picking: http://www.amazon.com/Five-Rules-Successful-Stock-Investing/dp/0471686174/ref=pd_sim_b_1

Essays of Warren Buffett    http://www.amazon.com/Essays-Warren-Buffett-Lessons-Corporate/dp/0966446127/ref=sr_1_1?s=books&ie=UTF8&qid=1330365582&sr=1-1

Joe Mansueto of Morningstar Discusses Moats

Here is what Joe Mansueto, the founder of Morningstar, said about building a business with a moat: “When I started Morningstar in 1984, my goal was to help individuals invest in mutual funds. Back then a few financial publications carried performance data, and that was about it. By providing institutional-quality information at affordable prices, I thought we could meet a growing need.

But I also had another goal. I wanted to build a business with an “economic moat.” Warren Buffett coined this term, which refers to the sustainable advantages that protect a company against competitors—the way a moat protects a castle. I discovered Buffett in the early 1980s and studied Berkshire Hathaway’s annual reports. There Buffett explains the moat concept, and I thought I could this insight to help build a business. Economic moats made so much sense to me that the concept is the foundation for our company and for our stock analysis.

…Why spend time, money and energy only to watch competitors take away our customers?

I wanted Morningstar’s economic moat to include a trusted brand, large financial database, proprietary analytics, a sizable and knowledgeable analyst staff, and a large and loyal customer vase.

—

Let me know if you start a business.  You will, at least, have a head start on building an advantage.

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Chapter 8 in Competition Demystified: Games Companies Play–Questions

Posted on February 24, 2012 | 9 comments

The Prisoner’s Dilemma is a short parable about two prisoners who are individually offered a chance to rat on each other for which the “ratter” would receive a lighter sentence and the “rattee” would receive a harsher sentence. The problem results from the fact that both can play this game — that is, defect — and if both do, then both do worse than they would had they both kept silent. This peculiar parable serves as a model of cooperation between two or more individuals (or corporations or countries) in ordinary life in that in many cases each individual would be personally better off not cooperating (defecting) on the other.

Chapter 8:  A Structured Approach to Competitive Strategy, Part 1: The Prisoner’s Dilemma Game

This chapter has no HBR Case Study but it is important to understand. A great supplement to this chapter and to understanding Game Theory is the book, The Art of Strategy (A Game Theorist’s Guide to Success in Business and Life) by Avinash K. Dixit and Barry J. Nalebuff, the authors of Thinking Strategically.

Questions

  1. Describe in a few sentences the dynamics of a prisoner’s dilemma game with two competitors of a similar size and the likely equilibrium in the real world of Lowes and Home Depot.
  2. When a competitor wants to be “deviant,” how can others in the market control the deviant’s behavior?

I will post the discussion next week.

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Chapter 7: Production Advantages Lost, Part 3

Posted on February 23, 2012 | Leave a comment

All products become toasters in the end

Part 2: http://wp.me/p1PgpH-tC

Part 3: Explain the statement, “No matter how complex and unique products seem at the start, in the long run they are all toasters.”

Though they differ from one to another in functional and design features, one toaster is pretty much like another. But with no barriers to entry here, it is unreasonable to assume that any manufacturer is earning an exceptional return on its toaster assets.

How different is a complicated and expensive piece of network equipment—a router, smart hub, or Lan switch—from a toaster? Initially very different, but ultimately, not so different at all. The success of Cisco in its original business attracted new entrants, most of whom could not put a dent in Cisco’s performance without extensive technical and maintenance support. They were not sophisticated enough to mix and match communication equipment the way families do with household appliances.  Also, the need to develop successive new generations of software and hardware makes fixed costs a permanently large part of total costs, and they are a source of economies of scale. (In contrast, in CD manufacturing, plant, and equipment were a once-and-for-all expense. Economies of scale topped at a two million discs per year plant.) All these factors created competitive advantages for Cisco, and put up barriers to entry in its enterprise-class business.

But it seems clear that those advantages diminish over time. Equipment becomes more reliable and easier to use. Support and service costs decline. Compatibility across company product lines increases as equipment functions become standardized. Research and development costs decline as product lines mature. Customers become more confident in their use of equipment and more willing to try new, lower cost suppliers. Some of these changes have already affected Cisco. The trends identified above will ultimately eliminate Cisco’s competitive advantages entirely.

Technological change can be the enemy of the investor.

Our next study will be Chapter 8 in Competition Demystified.

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Chapter 7: Production Advantages Lost Part 2

Posted on February 21, 2012 | Leave a comment

Part 1: http://wp.me/p1PgpH-ta and the original post on the case study is here: http://wp.me/p1PgpH-r2

Logan James, a huge contributor to this blog, continues his analysis….

Question 2: Why was Cisco able to dominate the router market in the 1980s and 1990s in a way that Philips was not in the compact disc market?

Answer: Cisco’s router and switch products were much more complex than Philips’s compact discs. Cisco’s customers, in the beginning, were businesses, government agencies and universities. These institutions required initial setup of router and switch networks as well as continual service to make sure that the networks were up and functioning properly. If you’re a business that runs a network, imagine what it would be like if your network went down and business essentially stopped? Who would you call? Probably Cisco first. You would also view Cisco as the expert in the router/switch markets and would rely on their advice in regards to servicing the network. If you want to upgrade your network equipment, they’re probably getting the first call. So you have captive customers combined with some economies of scale (maybe in R&D, advertising, manufacturing). Note: Would need to check to see if these advantages show up in the numbers.

Philips sold compact discs, which are not complex. The company was the first mover, like Cisco, but did not benefit from any competitive advantages. Why would a recording studio be captive to one maker of compact discs unless that company had patents protecting its products for a period of time? The purchaser of the CD does not care which company makes the CD, they just want the music. Note that Philips initially targeted a niche part of the music market but planned to take share away from vinyl records in the future.

Note that growth can harm companies that benefit from EOS + CC because it is easier for competitors to enter the market, take demand and achieve minimum efficient scale. Two examples where this did not occur are MSFT and CSCO.

My comments below are repetitive to Logan James but may reinforce concepts pertinent to this case.

Cisco managed to create competitive advantages for itself, which became stronger as its business grew. The advantages of economies of scale never became important for Philips because the CD market was large relevant to the efficient plant size of two million discs per year. Cisco, by contrast, because of the high software content and attendant high fixed costs for its routers, enjoyed economies of scale advantages. It managed this advantage brilliantly.

Cisco prospered by solving a problem that was widely shared. By removing the language barriers between computer systems, Cisco made networking throughout the enterprise a reality. A company that makes life much better for its customers gets handsomely rewarded, provided it can separate itself from competitors offering similar benefits.

Cisco’s market had two elements missing from the CD market–substantial customer captivity and economies of scale. Routers are sophisticated pieces of equipment, a complex fusion of hardware and software. A high level of technological expertise was required to install and maintain the systems, an expertise not widely available except for those customers with large and skilled IT departments. The others relied on Cisco or its competitors (3Com and Wellfeet). As they expanded their own internal networks, they naturally turned first to the vendor whose equipment they already owned, not wanting to incur the risks and costs of developing a relationship with a new supplier. This asymmetry of familiarity was abetted by another feature of routers that made it difficult for customers to switch: the routers themselves were not compatible. Customers were made captive by complexity.

Cisco’s pre-tax return on invested capital during 1990-2000 was 142%!

Cisco moved into the new market of telecommunications service providers. As an entrant into this market, Cisco was without the critical competitive advantages it enjoyed in the enterprise market. It has no captive customers; so far as established customer relationships are concerned, it was the outsider looking in. Without this kind of customer base, Cisco had no economies of scale in distribution or service support. Because Cisco was working on new products for new customers, it had no economies of scale advantages in research and development either.
Part 3: Next Post.

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Analysis of Ch. 7 on Production Advantages Lost Part 1

Posted on February 20, 2012 | 5 comments
 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

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Questions on Chapter 7: Production Advantages Lost: Compact Discs, Data Switches and Toasters

Posted on February 12, 2012 | 2 comments

If it’s a penny for your thoughts and you put in your two cents worth, then someone, somewhere is making a penny.” –Steven Wright

Chapter 7: Philips and Cisco in Competition Demysitified

The questions are on Chapter 7 (pages 137 to 159) from Competition Demystified. Also, read: An Open Letter to Warren Buffett Re: Cisco Systems http://www.capatcolumbia.com/Articles/Reports/Buffett.pdf and Philips Case Study: http://www.scribd.com/doc/81400135/pcd

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.

Question 2: Why was Cisco able to dominate the router market in the 1980s and 1990s in a way that Philips was not in the compact disc market?

Question 3: Explain the statment, “No matter how complex and unique products seem at the start, in the long run they are all toasters.”

We will follow up by the end of the week.

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Answers to Chapter 6 Questions

Posted on February 12, 2012 | Leave a comment

“I just got out of the hospital. I was in a speed reading accident. I hit a book mark and flew across the room.” –Steven Wright

Q: What competitive advantages does Microsoft enjoy in the operating system industry?

The only segments within the PC world with features suggesting that there are barriers to entry protecting incumbent firms from new entrants are operating systems and CPUs. In both there are a small number of competitors and stable market share. Microsoft enjoys both customer captitivy and economies of scale in the operating systems business. Customers prefer to stick with what they know, especially regarding software. Swithching costs can be prohibitive when many users have to be taught to use unfamiliar programs. Search costs also inhibit change because the buyer has to have confidence in the reliability of the new system and the survivability of its creators.

The most important advantage is economies of scale. Writing complicated software keeps expensive engineers at their terminals and benches for hundreds of thousands of work hours. On the other hand, the marginal costs of the next unit of the operating system can be low as zero, and seldom more than a few dollars, even when burned on a CD and boxed with a manual.

Network effects enhance both customer captivity and economies of scale.

Q2: Why have “box makers” not been able to establishy a competitive advqtage over other competitors? Why was the enormous growth in the market for PCs such a problem for Compaq specifically? Did it have any alternatives that might have worked out better than its chosen strategy? Did Apple?

The Compaq story is so interwined with the hsitory of the PC that it is easy to miss the more general significance. It lost its competitive advantage and the resulting high levels of profitability as the markets grew and allowed competitors to develop equivalent economies of scale. Rosen, the venture capitalist, was astute to recognize that the quality and economies of scale advantages of Compaq benefited from in the 1980s were now history, and that unless Compaq changed its business plan, it was going to be fighting against lower-cost but qualitatively equal competitors. He and his team pursued the operational efficiency in the absence of competitive advantage.

Apple confronted a grim situation. In the two market segments–microprocessors and operating systems–there were powerful competitive advantages, enjoyed by Intel and Microsoft, based on economies of scale, supplemented by captive customers and some proprietary production technologies. The other segments were highly competitive.

Apple operated, either by itself or in partnership with Motorola, in five market segments within the PC universe. Apple did not possess a competitive advantage. Tying those segments together in the name of “synergy” did not help. Also, the evolution of the industry toward separate maor players in each segment argued strongly against the existence of significant advant5ages from vertical integration. Apple held only 10% of the PC market so it had no bargaining power in alliances.

Apple should have specialized and focused on operational efficiency at least to where it could have earned its cost of capital.

END

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