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This story provides the context for the financial forecast. This story should be based on a thoughtful strategic analysis of the company and its industry. There is an extensive strategy literature to help you develop these stories; in this chapter, we will describe some of the analytical frameworks that you could use.
Keep in mind that what ultimately drives the value of the company is your assessment of whether and for how long a company can earn returns in excess of its opportunity cost of capital. To do this, companies must develop and exploit a competitive advantage. Without a competitive advantage, competition would force all the companies in the industry to earn only their cost of capital (or even less).
Competitive advantages that translate into a positive ROIC versus WACC spread can be categorized as:
1. Providing superior value to the customer through a combination of price and product attributes that cannot be replicated by competitors. These attributes can be tangible (the fastest computer) or intangible (brands, copyrights, patents).
2. Achieving lower costs than competitors.
3. Using capital more productively than competitors.
A competitive advantage must ultimately be expressed in terms of one or more of these characteristics. Describing competitive advantages this way also helps to begin to shape the financial forecast.
The four analytical frameworks that we will touch on are the classical industry structure analysis based on work by Michael Porter; customer segmentation analysis; competitive business system analysis, and a more recent analytical framework by two colleagues, Kevin Coyne and Somu Subramaniam.
Industry Structure Analysis (Porter Model)
Industry structure analysis looks at the forces that will shape an industry's profitability. Michael Porter of Harvard is best known for having formalized
Exhibit 11.1 Porter Industry Structure Model
industry structure models.1 An approach to industry structure analysis is shown on Exhibit 11.1. In this model, four forces drive an industry's profit potential: substitute products, supplier bargaining power, customer bargaining power, and entry/exit barriers.
The existence of substitute products can place significant limits on an industry. For example, railroads and trucks compete for the movement of freight. Rail movement is relatively cheap for large, long hauls but is not as flexible and inexpensive as truck movement for small, short hauls. For some shipments between the very long and very short, a shipper could use either rail or truck transportation and could try to create bidding competitions between them.
Entry and exit barriers determine the likelihood of competitors entering and leaving the industry. Entry barriers arise when there are skills or assets that only a few competitors can obtain. Access to capital is rarely an entry barrier because it is easy to obtain. On the other hand, access to new technology and patents can shut out new competitors. Exit barriers exist when competitors are better off staying in the industry, even though they are not earning their cost of capital. Exit barriers often arise in capital intensive industries where companies may be earning more than their marginal cost so they do not wish to exit, but the returns on capital are low. Furthermore, management may continue to invest capital in low-return industries for long periods because they do not wish to dismantle their organization or they are hoping other competitors will leave first.
The bargaining power of suppliers determines what share of the total pool of customer revenues can be retained by the industry. If a company can increase its bargaining power, its share of the revenue will increase. Wal-Mart, the discount retailer, has successfully exploited its purchasing power and information technology about customer wants to obtain from vendors
1 M. Porter, Competitive Strategy: Techniques for Analyzing Industries and Competitors (New York: Free Press, 1980).
lower prices and better service than its competitors. But attempts to extract value from suppliers do not always work. Many department stores have attempted to cut out the manufacturers altogether by developing their own house brands for which they design the products and contract out the manufacturing. Some of these retailers have found that costs for design and manufacturing are not low enough to make up for the lower prices they generally have to charge for their non-name-brand goods.
The bargaining power of customers also affects the industry's share of revenues. In carpet manufacturing, for example, the major competitors have found ways to skip the wholesalers—who traditionally distributed their products to retailers—and deal directly with the retail stores. They have thus been able to take a significant share of the total revenue pool away from the wholesalers.
The Porter model is static. The Structure-Conduct-Performance model, developed by McKinsey consultants in the 1980s, adds a dynamic element to industry structure analysis as illustrated in Exhibit 11.2. The S-C-P model adds external shocks to the system to analyze how they will affect the structure, how competitors are likely to respond, and how the performance of the industry and competitors will be affected.