The competition

If the market is expanding, it is better to have smaller rivals than several large ones with the financial and marketing clout to cream off all the market’s expansion. Where possible, it is best not to try to compete against the likes of Microsoft. Conversely, if the market has reached maturity, it is better for the few remaining companies that have specialised in particular niches to have large rivals that will not take the risk of attacking them because the potential gains would be too small. Conversely, a stable market with a large number of small rivals frequently degenerates into a price war that drives some players out of business. But since a company cannot choose its rivals, it is important to understand what drives them.

Some rivals may be pursuing power or scale-related targets (e.g., biggest turnover in the industry) that are frequently far removed from profitability targets. Consequently, it is very hard for groups pursuing profitability targets to grow in such conditions. So, how can a company achieve profitability when its main rivals – e.g., farming cooperatives in the canned vegetables sector – are not profit-driven? It is very hard indeed because it will struggle to develop since it will generate weak profits and thus have few resources at its disposal.

How does competition work?

Roughly speaking, competition is driven either by prices or by products:

• where competition is price-driven, pricing is the main, if not the only factor, that clinches a purchase. Consequently, costs need to be kept under tight control so that products are manufactured as cheaply as possible, product lines need to be pared down to maximise economies of scale and the production process needs to be automated as far as possible, etc. As a result, market share is a key success factor since higher sales volumes help keep down unit costs (see BCG’s famous experience curve which showed that unit costs fall by 20% when total production volumes double in size). This is where engineers and financial controllers are most at home! It applies to markets, such as petrol, milk, phone calls, etc.;
• where competition is product-driven, customers make purchases based on after-sales service, quality, image, etc., that are not necessarily pricing-related. Therefore, companies attempt to set themselves apart from their rivals and pay close attention to their sales and customer loyalty techniques. This is where the marketing specialists are in demand! Think about Bang and Olufsen’s image, Harrod’s atmosphere or the after-sales service of Volvo. The real world is never quite as simple, and competition is rarely only price- or product-driven, but is usually dominated by one or the other or may even be a combination of both – e.g., lead-free petrol, vitamin-enhanced milk, caller display services for phone calls, etc.

Production

Value chain

A value chain comprises all the companies involved in the manufacturing process, from the raw materials to the end product. Depending on the exact circumstances, a value chain may encompass the processing of raw materials, R&D, secondary processing, trading activities, a third or fourth processing process, further trading and, lastly, the end distributor. Increasingly in our service-oriented society, grey matter is the raw material, and processing is replaced by a series of services involving some degree of added value, with distribution retaining its role.

The point of analysing a value chain is to understand the role played by the market participants, as well as their respective strengths and weaknesses. Naturally, in times of crisis, all participants in the value chain come under pressure. But some of them will fare worse than others, and some may even disappear altogether because they are structurally in a weak position within the value chain. Analysts need to determine where the structural weaknesses lie. They must be able to look beyond good performance when times are good because it may conceal such weaknesses. Analysts’ ultimate goals are to identify where not to invest or not to lend within the value chain. Let’s consider the example of the film industry. The main players are:

. the production company, which plays both an artistic and a financial role. The producer writes or adapts the screenplay and brings together a director and actors. In addition, the production company finances the film using its own funds and by arranging contributions from third parties, such as co-producers and television companies, which secure the right to broadcast the film, as well as by earning advances from film distribution companies (guaranteed minimum payment);

• the distributor, which also has a dual role assuming responsibility for logistics and financial aspects. It distributes the film reels to dozens, if not hundreds, of cinemas and promotes the film. In addition, it helps finance the film by guaranteeing the producer minimum income from cinema operators, regardless of the actual level of box office receipts generated by the film;
• lastly, the cinema operator that owns or leases its cinemas, organises the screenings and collects the box office receipts. Going beyond a review of a particular value chain, additional insight can be gained into the balance of power by modelling the effects of a crisis and assessing the impact on the different players. During the 1980s, the number of box office admissions fell right across Europe owing to the advent of new TV channels and video cassettes.

Which category of player was worst affected and has now generally lost its independence?

Cinema operators? Granted, the fall in box office admissions led to a contraction in their sales. Some had to shut down cinemas, but since their properties were located in town and city centres, cinema operators that owned the premises had no trouble in finding buyers, such as banks and shops, that were prepared to pay a decent price for these properties.

The others modernised their theatres, built up their sales of confectionery that carry very high margins and have capitalised on the renewed growth in cinema audiences across Europe over the past 10 years. What about the production companies? Obviously, lower audiences meant lower box office receipts but, at the same time, other media outlets developed for films (television channels, video cassettes), generating new sources of revenue for film producers.

All things considered, film distribution companies were the worst hit. Some went bankrupt, while others were snapped up by film producers or cinema operators. Film distribution companies had only one source of revenue: box office receipts. Unlike cinema operators, they had no bricks-and-mortar assets which could be redeveloped.

Unlike film production companies, they had no access to the alternative sources of income (royalties from pay TV or video cassettes) which caused the slump in the number of tickets sold. They had agreed to pay a guaranteed minimum to film production companies based on estimated box office receipts but, given the steady decline in admissions, these estimates systematically proved overoptimistic. As a result, distributors failed to cover the guaranteed minimum and were doomed to failure.

When studying a value chain, analysts need to identify weaknesses where a particular category of player has no or very little room for manoeuvre (scope for developing new activities, for selling operating assets with value independent of their current use, etc.).