We see it all the time. Companies say they possess a competitive advantage because of (fill in the blank). If it were only that easy, I could just read through a handful of annual reports, plunk down my money, and call it a day. Alas, it's not so simple. Much like waking my daughters up for school in the morning, sussing out a real competitive advantage will require some work, some finesse, and most of all, some time.
That's OK, though. I'm here to shed some light on one of the best tools I know for getting down to the nitty-gritty of assessing a company's competitive advantage: Porter's Five Forces.
Use the force(s)
OK, maybe Porter's Five isn't quite as cool as the Force. But since I don't have a Wookiee around, it'll have to do. The actual model is pretty straightforward. We examine a company through five lenses: barriers to entry, threat of substitutes, power of buyers, power of suppliers, and industry jockeying (also known as rivalry).
These five areas can help us begin to get an idea of a company's competitive advantage. While it's far from foolproof (note the little "f") and somewhat subjective, this test is also fluid and can change with time. Most of all, it allows us to look at a company from a variety of perspectives in order to get a more holistic picture.
Let's examine a Foolish favorite: Netflix (Nasdaq: NFLX).
Barriers to entry
On the one hand, renting movies is not tremendously difficult. Just navigate the red tape, gather enough capital to start a business, and go to town. However, we need to consider the formidable strength of Netflix's brand, which is strong enough to keep new competitors at bay. The lack of real barriers to entry might have been a threat 15 years ago, but I don't think that still applies now.
Threat of substitutes
Here, Netflix could run into some potential trouble. Netflix rents movies. So does Coinstar's (Nasdaq: CSTR) Redbox. But consider how many other forms of entertainment there are out there today. Video games are a great example of an industry competing for that entertainment share. Companies like Activision Blizzard (Nasdaq: ATVI) are constantly developing cutting-edge content, against which Netflix must continue to compete for consumers' entertainment bucks.
Power of buyers
Netflix doesn't have to deal with retail middlemen. It runs everything from its site, from mail rentals to instant streaming, selling directly to the consumer. Consumers always have a choice, but Netflix has done a great job managing its brand. I bet that when most people think movies, they think Netflix. As long as consumers want movies, Netflix ought to do well. But the market is a competitive place, and buyers do have the power to take their business elsewhere.
Power of suppliers
What would Netflix be without its content? From this perspective, suppliers' power looks considerable. Netflix gets its content through direct purchases, revenue-sharing, and licensing agreements with the studios and other distributors. In other words, the suppliers have a good amount of say-so when it comes to time frames for release, and how much it will cost. Take into consideration other well-known platforms for obtaining content, such as Apple's (Nasdaq: AAPL) iTunes and sites such as Hulu.com, and you can see that suppliers definitely exert influence over Netflix's fortunes.
Industry jockeying (rivalry)
I remember 15 years ago, when your choice for a weeknight movie at home was between the local rental shop and Blockbuster. Today, there are all sorts of ways to get whatever content your heart desires, and that mix of options will only get more competitive over time. Netflix's advantage lies partly in the proprietary recommendation technology it uses to find new movies that its users might enjoy. While this feature is easy to overlook, it offers tremendous value and increases the likelihood that consumers will stick with Netflix.
Tell me the answer you will
When I look at Netflix through Porter's Five Forces, I see a market leader that has made its way into houses and computers all over the country. While there may be some areas where the company could be somewhat vulnerable, I don't know that there is anything that can necessarily stop Netflix anytime soon. And with visions of international expansion on the horizon, Netflix could just be getting ready to start a whole new movie -- one that investors ought to plan on watching.
