Business checklist

? What is the competitive landscape? Q7 ? What is the role of regulation in the business?

Objective: All the checklist questions so far were internal to the company. This is the first question external to the company. But it is arguably the most important one, as the level of competition and regulation in a sector can make or break the fortunes of players in that sector.

What to look for: What is the type of competition in the sector? e.g. perfect competition, monopoly, oligopoly Who are the company’s key competitors? Is the company’s product/service globally tradable or non-tradable? Is there a threat of new entrants? Can the company’s product or service be substituted by current or emerging substitutes? What is the bargaining power of customers and suppliers? Is the sector heavily regulated, including restrictions on product/service pricing and/or returns on investment?

Type of competition Economists refer to four major types of market/competitive structures –

Perfect Competition: Here there are large number of buyers and sellers with an absolutely homogenous product/service.

Monopoly: This is the extreme opposite of Perfect Competition, where there’s only one major seller. This is quite rare in today’s day and age e.g. Power Grid Corporation is a virtual monopoly in India’s power transmission infrastructure.

Oligopoly: Oligopoly is when a small number of firms collude, either explicitly or tacitly, to restrict output and/or fix prices, in order to achieve above normal market returns.

Monopolistic Competition: This type is the mid-path between Perfect Competition and Monopoly, and the most prevalent form. Here, a large number of sellers oer products/ services which are similar but not perfect substitutes of each other i.e. dierentiated. A company may earn above-normal return on capital for some time, but competition soon catches up to drive down returns to sector average. The above classification is based on number of sellers in the sector. However, the number of sellers alone does not determine profits and profitability in a sector. Rather, it is the intensity of competition between the players which does. Consider Paints versus Wireless Telecom in India. The Paints sector has four major players – , Berger Paints, Kansai Nerolac and Akzo Nobel – while the Wireless Telecom sector has only three – , and Reliance Jio (through ). Yet the following is the PAT and RoE trend of both the sectors.

1 THINK EQUITY THINK MOTILAL OSWAL Competition in the Paints sector is benign

Paints Sector PAT (INR bn) RoE (RHS)

50 30%

40 25%

30 20%

20 15%

10 10%

0 5% FY11 FY12 FY13 FY14 FY15 FY16 FY17 FY18 FY19 FY20 Competition in the Wireless Telecom sector is cut-throat

Wireless Telecom sector PAT (INR bn) RoE (RHS) 100 20%

0 10%

-100 0%

-200 -10%

-300 -20%

-400 -30% FY11 FY12 FY13 FY14 FY15 FY16 FY17 FY18 FY19 FY20

Competition in the Paints sector is completely benign. The sector continues to make rising profits and robust RoE in excess of 20%. In sharp contrast, competition in the Wireless Telecom sector is cut-throat. As a result, the sector is bleeding. It is reporting losses in the aggregate, and RoE is hugely negative.

A holistic way to assess the competitive landscape is oered by Michael Porter’s Five Forces model (Framework #11).

Framework #11 Porter’s Five Forces framework Threat of The Five Forces framework of Michael new entrants Porter is ideal to assess the attractiveness of industry structure. The exhibit below presents a diagrammatic representation of Rivalry the Five Forces. Bargaining among Bargaining existing power competitors power of suppliers of buyers

Threat of substitute products or services

2 Framework #11

Porter’s Five Forces – Implications

FORCE #1 – Inter-firm rivalry Implication: This lies at the core of the industry structure analysis. Higher the rivalry among incumbents, lower the industry attractiveness and vice-versa.

FORCE #2 – Threat of new entrants Implication: The threat of new entrants compels incumbents to operate at low profitability as a strategy to keep them away.

FORCE #3 – Threat of substitute products or services Implication: Like the threat of new entrants, the threat of substitutes also compels incumbents to operate at low profitability. However, this is relatively rare.

FORCE #4 – Bargaining power of customers Implication: Higher the bargaining power of customers, lower the sector attractiveness and vice versa. If the customers are large and concentrated, their bargaining power tends to be high, whereas fragmented customers tend to have lower bargaining power. High brand pull and high switching costs also imply lower bargaining power of customers.

FORCE #5 – Bargaining power of suppliers Implication: Higher the bargaining power of suppliers, lower the sector attractiveness and vice versa. If the suppliers are large and concentrated, their bargaining power tends to be high, whereas fragmented suppliers tend to have lower bargaining power. We have rated most sectors on the five forces (tabled on next page). Sectors with score of 3 or higher are attractive i.e. incumbents in these sectors will have a relatively easy time in terms of profitability. On the other hand, if sector score is 2.5 or lower, incumbents in such sectors will need to have a sharp strategy to survive and thrive. Tradable or Non-tradable Tradable businesses are those who products can be traded across geographies. Such businesses are perennially exposed to the threat of imports, and product prices will be invariably linked to landed cost e.g. metals and chemicals. In contrast, non-tradable businesses are insulated from imports. Product pricing here is just a function of domestic competitive forces e.g. FMCG, cement, and the full array of services such as banking, insurance, etc. What is the role of regulation in the business? This is the second part of Q#7. Regulation is outside the five forces framework, and can make or mar the fortunes of a sector. For instance, in the power generation and transmission business, Return on Equity is capped at 12%. Likewise, the domestic pharma sector faces the overhang of government putting quite a few of its products under price control. Investors need to keep a sharp eye on regulation, and preferably avoid over-regulated businesses.

3 Sector Structure Score for major industries based on Porter’s Five Forces

SCORING Inter-firm Threat of Bargaining Power of TOTAL METHODOLOGY: Sector Rivalry Entrants Substitutes Customers Suppliers SCORE

Each of the Five Cigarettes 1 1 1 1 1 5.0 Forces is rated 0 Paints 1 1 1 1 1 5.0 or 1 with a middle Automobiles - 2-wheelers 0.5 0.5 1 1 1 4.0 score of 0.5. Oil & Gas - Downstream 1 1 0.5 1 0.5 4.0 Ports & related 0.5 1 1 0.5 1 4.0 As an illustration, Automobiles - Tractors 0 1 1 0.5 1 3.5 for a sector, if Gas Distribution 1 1 0.5 1 0 3.5 Bargaining Power Automobiles - Cars/UVs 0 0.5 1 0.5 1 3.0 of Customers is Banks - Private Sector 0 0.5 1 0.5 1 3.0 high, that sector Banks - Public Sector 0 0.5 1 0.5 1 3.0 gets 0 for that Cement 0 0 1 1 1 3.0 Force. Fertilizers 0 1 1 1 0 3.0 Conversely, if IT - Software 1 1 0 0 1 3.0 Bargaining Power Mining/Minerals 0.5 0.5 1 0.5 0.5 3.0 of Customers is NBFC - Insurance 0 0.5 1 0.5 1 3.0 low, the sector Oil & Gas - Upstream 0.5 0.5 1 1 0 3.0 gets 1. Pharmaceuticals 0.5 0 0.5 1 1 3.0 If Bargaining Telecom 0 1 1 0.5 0.5 3.0 Power is Agri & related 0 0 0.5 1 1 2.5 balanced, the Auto Ancillaries 0.5 1 1 0 0 2.5 sector gets 0.5. Automobiles - LCVs/HCVs 0 0 1 0.5 1 2.5 Aviation 0 0.5 1 1 0 2.5 Every Force is Ceramic Products 0 0.5 1 0.5 0.5 2.5 rated this way, Automobiles - Cars/UVs 0 0 1 0.5 1 2.5 and the sum total Consumer Durables 0 0 1 0.5 0.5 2.5 of all Five Forces Hospitals/Diagnostics 0.5 0.5 1 0 1 2.5 is the Sector Hotels & Restaurants 0 0.5 1 0 1 2.5 Structure Score. NBFC - Housing 0 0 1 1 0.5 2.5 Non Ferrous Metals 0.5 0 0.5 1 0.5 2.5 Paper 0 1 1 0 0.5 2.5 Capital Goods 0 0 1 0 1 2.0 Chemicals 0 0 1 0 1 2.0 Engineering 0 0 1 0 1 2.0 Gems & Jewellery 0 0 1 0.5 0.5 2.0 Media - Print/TV 0 0.5 0.5 0 1 2.0 NBFC 0 0 1 0.5 0.5 2.0 Plastic Products 0 0.5 1 0.5 0 2.0 Realty 0 0 1 0 1 2.0 Steel 0 0 0.5 0.5 1 2.0 Travel 0 0.5 1 0 0.5 2.0 Retail 0.5 0.5 0.5 0 0.5 2.0 Tyres 0.5 0.5 1 0 0 2.0 Construction 0 0 1 0 0.5 1.5 Shipping 0 0.5 0.5 0 0.5 1.5 Packaging 0 0.5 0.5 0 0 1.0 Sugar 0 0 1 0 0 1.0 Textiles 0 0 1 0 0 1.0

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