Research Analyzing Industries

By John Del Vecchio (TMF Fuz)
March 9, 2000

Structural analysis of an industry is a valuable tool that can be used as a primary determinant of a firm's long-term profitability. Understanding the dynamics of competitive forces can provide insight into the attractiveness of an industry and the potential for returns on capital. Michael Porter, a Harvard Business School professor, has developed a framework for understanding an industry's structure. Porter's analysis is widely taught in business schools and commonly used by analysts. Porter's book, Competitive Strategy, provides an excellent, readable resource for understanding the impact of competitive forces on an industry. According to Porter, the five competitive forces affecting an industry are: threat of entry, competitive rivalry, bargaining power of suppliers, threat of substitutes, and the bargaining power of buyers. Let's use the airline industry as an example of how an analyst may interpret the competitive forces that affect an industry.

Threat of Entry
The threat of new entrants presents the possibility that new firms will enter the industry and diminish industry returns by passing along value to buyers in the form of lower prices and raising the cost of competition. Factors that determine the threat of entry include capital requirements, economies of scale, switching costs, and brand value. In the airline industry, access to capital is plentiful. Banks extend credit to airline carriers, and the debt and equity markets provide alternatives for raising funds. Because it's relatively easy for weaker airlines to obtain credit, the industry has become saturated.

Brand identity is important in the airline industry, and benefits larger airlines. Major carriers allocate considerable resources to marketing efforts. Frequent flier programs and other incentives have been successful in enticing travelers to fly with certain carriers. The frequent flyer incentive can often be strong enough to cause a customer to choose one carrier over another -- even when the other carrier offers a lower fare.

Barriers to entry are also heightened by the hub system in the airline industry. Carriers can offer travelers more choices while tying up less capital through their hubs. As a result, the hub system creates market power for large carriers.

Bargaining Power of Suppliers
Factors relating to the bargaining power of suppliers include the threat of forward integration and the concentration of suppliers in the industry. Suppliers are concentrated within the airline industry. Boeing and Airbus supply most commercial fixed-wing air carriers. Supplier concentration makes it difficult for competitors to exercise leverage over the supplier and obtain lower prices or play one supplier against another. The threat of forward integration is low. It is unlikely that Boeing, for instance, would staff flight attendants, commercial pilots, and a maintenance crew, and operate flights all across the country. Supplier power further diminishes the ability of competitors to earn high profits.

Bargaining Power of Buyers
The third competitive force is the bargaining power of buyers. If significant buyer power exists, industry returns can accrue to buyers in the form of lower prices. Buyer power is determined by switching costs, the relative volume of purchases, the standardization of the product, elasticity of demand, brand identity, and quality of service. Buyers are presented many choices when choosing an airline carrier. Because of the Internet, pricing information is less fragmented and easier to compare. Often, a traveler can find price discrepancies for the same exact flight. One seat is hardly any better than the next since everyone arrives at his or her destination at the same time. Vacation travelers will also search out the best deals. Airline travel is not cheap, and can be the most expensive part of a family vacation. Hence, for some buyers, demand is very elastic (as the price drops, demand increases). However, airlines may move their prices in tandem with other carriers and force buyers to pay the market price until a price war breaks out.

Availability of Substitutes
The fourth factor affecting industry competition is the availability of substitutes. The relative price of substitutes and the buyer propensity to substitute have effects on the industry. Likely substitutes for airline travel include automobiles and trains. Driving from Washington, D.C., to Philadelphia may provide a cheap mode of transportation, and buyers may be more inclined to use automobile travel for such a trip. A less hurried traveler may hop aboard a train and enjoy the relaxation and scenery that train travel affords. However, airline travel can save time and money for longer distance adventures. Flying from Washington, D.C., to San Francisco is often cheaper -- and far more time-efficient -- than chugging along in a train or automobile. As a result, buyers may be more inclined to choose air travel to reach their destination. The threat of substitutes has to do with time, money, personal preference, and convenience in the air travel industry.

Competitive Rivalry
The final factor is competitive rivalry. Intensely competitive industries generally earn low returns because the cost of competition is high or buyers are receiving the benefits of lower prices. Factors that affect competitive rivalry include industry growth, fixed costs, brand identity, and barriers to exit. The airline industry is fiercely competitive. Industry growth is moderate, and carriers are struggling to take away share from each other. Barriers to exit are substantial in the airline industry. Grounded planes do not earn any returns and disposing of these assets is difficult. Often, because of bankruptcy laws, companies in financial distress such as Pan AM or TWA can remain competitors for a very long time.

Not all of these factors are equally important when assessing the overall attractiveness of an industry. In the airline industry, it's easy to gain entry, but very difficult to get out. This is often the worst possible scenario for a competitor. Not surprisingly, airlines have been mediocre investments in recent years.

It is important to note that a full-fledged industry analysis would require talking with customers, suppliers, competitors, industry experts, and a variety of other sources. However, as a general overview, using Porter's five forces is an excellent way to get a feel for whether or not you would like to invest in a particular industry.