Average Economic Profits of U.S. Industry Groups, 1978-1996

1. Average Economic Profits of U.S. Industry Groups, 1978-1996 Value Line Industry Groups Source: Compustat, Value Line, Marakon Associates Analysis

2. Average Economic Profits in the Steel Industry, 1978 -1996 ROE-Ke Spread 40% Great Northern Iron 30% 20% Worthington Inds Nucor Steel Technologies 10% Oregon Mills Commercial Metals 0% Carpenter British Steel PLC Cleveland-Cliffs Birmingham Quanex Lukens (10%) USX-US Steel ACME Metals Ampco Inland Steel (20%) Armco WHX Bethlehem Average Invested Equity ($B) (30%) $0 $1 $2 $3 $4 $5 $6 $7 $8 $9 $10 $11 $12 $13 $14 $15 Source: Compustat, Value Line, Marakon Associates Analysis

3. Average Economic Profits in the Drug Industry, 1978 -1996 ROE-Ke Spread 60% SmithKline 40% Schering Plough American Amgen Watson Rhone-Poulenc Home Mylan Labs Glaxo Products Bristol Merck Warner Lambert Perrigo Myers 20% Pharmacia & Upjohn Eli Lilly Pfizer Forest Labs Alza 0% ICN Scherer Ivax (20%) Genetech Biogen Roberts Genzyme (40%) Dura Chiron Cephalon Gensia Cygnus (60%) Immunex Average Invested Equity ($B) (80%) $0 $5 $10 $15 $20 $25 $30 Source: Compustat, Value Line, Marakon Associates Analysis

4. A Three-Dimensional Business Landscape

5. Supply-Demand Analysis Monetary Units Supply Equilibrium Price Demand Equilibrium Physical Quantity Units

6. The “Five Forces” Framework for Industry Analysis Suppliers Sources of Bargaining Power: Switching costs Differentiation of inputs Supplier concentration Presence of substitute inputs Importance of volume to suppliers Impact of inputs on cost or differentiation Threat of forward/backward integration Cost relative to total purchases in industry New Entrants Entry Barriers: Economies of scale Brand identity Capital requirements Proprietary product differences Switching costs Access to distribution Proprietary learning curve Access to necessary inputs Low-cost product design Government policy Expected retaliation Industry Competitors Factors Affecting Rivalry: Industry growth Concentration and balance Fixed costs/value added Intermittent overcapacity Product differences Brand identity Switching costs Informational complexity Diversity of competitors Corporate stakes Exit barriers Substitutes Threat Determined by: Relative price performance of substitutes Switching costs Buyer propensity to substitute Buyers Bargaining Power of Buyers: Buyer concentration Buyer volume Switching costs Buyer information Buyer profits Substitute products Pull-through Price sensitivity Price/total purchases Product differences Brand identity Ability to backward integrate Impact on quality/performance Decision makers’ incentives

7. The Value Net Customers Company Competitors Complementors Suppliers Source: Adam Brandenburger and Barry Nalebuff, Co-opetition (New York: Currency Doubleday, 1996), p. 17

8. Industry studies Books Investment analysts Market research Business school cases Trade associations Business press General publications (e.g., Wall Street Journal, Fortune) Specialized industry trade journals Local newspapers Online services (e.g., Bloomberg, OneSource, Compustat) Government sources Antitrust, legal, or tax documents Census or IRS data Regulatory bodies Industry and company directories Thomas’ Register Dun & Bradstreet Company sources Annual reports SEC filings Public relations/promotional material Internet sites Company histories Public Sources of Information about the Business Landscape

9. Some Common Long-Run Dynamics Threat of New Entry • Decline in economies of scale + customer heterogeneity þ fragmentation of market into niches • Escalation of sunk costs þ concentration • Emergence of switching costs þ entry deterred Bargaining Power of Customers • Concentration or fragmentation of buyers • Backward integration • Improvement in buyer information • Surge or decline in demand • Emergence of new distribution channels • New means for coordinating with customers • Shifts in customer tastes • Bargaining Power • of Suppliers • Concentration or fragmentation of suppliers • Forward integration • Improvement in supplier information • Surge or decline in supply • Emergence of substitute inputs • New means for coordinating with suppliers Rivalry Among Existing Competitors • Shift in industry growth • Change in mix between fixed and variable costs • Emergence of dominant design or product • Consolidation • Fragmentation / new entry Availability of Complements • Emergence of new complements • Change in barriers to entry in complement market • Threat of Substitutes • Emergence of new substitute • Improvement or decline in relative price performance of substitute • Increase in buyer comfort with substitute • Change in barriers to entry in substitute market Source: Jan W. Rivkin

10. Distribution of Industry Returns Average Return on Equity in US Industries, 1982-1993 11.7% 13.8% 16.5% First Quartile Average 22.2% Fourth Quartile Average 9.3% Number of Industries Average = 14.7% Median = 13.8% Return on Equity (Percent) Note: Return on Equity = Net Income / Year End Shareholders’ Equity; Analysis based on sample of 593 industries Source: Jan W. Rivkin’s Analysis Based on Dun and Bradstreet Data

11. Profitability Differences Across Selected Industries Pharmaceuticals Prepackaged software Semiconductors Women's clothing stores Dental equipment Eating places Drug stores Petroleum / natural gas Race track operations Trucking except local Engineering services Cable TV service Motor vehicles Scheduled airlines 0 5 10 15 20 25 Operating Income / Assets, 1988-95 (%) Computer system design Source: Jan W. Rivkin based on Compustat

12. To craft an effective strategy, you must take account of the external environment (the landscape) To decide whether to put your firm in an environment (entry) To decide whether to extricate your firm from an environment (exit) To position your firm to succeed in a given environment To assess the effect of a major change (e.g., deregulation) To shape the environment But the environment is enormously complex The Managerial Problem • You need structured ways of thinking about the environment • …that capture the richness of the real business world • …but separate signal from noise

13. Some (Complementary) Solutions • Supply / demand diagrams • Industry structure analysis (Five Forces) • Value net • Ecological metaphors

14. From Supply / Demand to the Five Forces • What determines the long-run supply / demand balance? • Entry barriers and intensity of rivalry affect whether firms will add capacity in response to excess demand • Exit barriers affect whether firms will retire capacity in response to excess supply • What determines the effect of a supply / demand imbalance on profitability? • In industries with intense rivalry or powerful buyers, small amounts of excess capacity tend to lead to big price wars • In industries with powerful suppliers, the benefits of excess demand may accrue to the suppliers • Supply / demand analyses say little about what determines the position and shape of the two curves

15. Industry Analysis: Factors to Consider Threat of New Entry • Economies of scale • Proprietary product differences • Brand identity • Switching costs • Capital requirements • Access to distribution • Absolute cost advantages • Government policy • Expected retaliation Bargaining Power of Suppliers Bargaining Power of Customers • Differentiation of inputs • Switching costs • Presence of substitute inputs • Supplier concentration • Importance of volume to supplier • Cost relative to total purchases • Impact of inputs on cost or differentiation • Threat of forward integration • Buyer concentration • Buyer volume • Buyer switching costs • Buyer information • Ability to integrate backward • Substitute products • Price / total purchases • Product differences • Brand identity • Impact of quality / performance • Buyer profits Rivalry Among Existing Competitors • Industry growth • Fixed costs / value added • Overcapacity • Product differences • Brand identity • Switching costs • Concentration and balance • Informational complexity • Diversity of competitors • Corporate stakes • Exit barriers Threat of Substitutes • Relative price performance of substitutes • Switching costs • Buyer propensity to substitute Source: Michael E. Porter, Competitive Advantage (New York: Free Press, 1985)

16. Typical Uses of Industry Analysis • Understand current profitability levels • Identify forces that must be countered in order to achieve superior profitability • Test decision to enter an industry • Test decision to exit an industry • Assess effect of a major change (e.g., deregulation) • Identify ways to alter industry structure

17. Other Users • Entrepreneurs • Investment bankers • Financial analysts • Venture capitalists • Consultants • Anyone making a career choice

18. The Value Net Customers Firm Suppliers A player is your competitorwith respect to customers if customers value your productlesswhen they have the other player’s product as well A player is your complementor with respect to customers if customers value your product more when they have the other player’s product as well Competitors Complementors A player is your competitor with respect to suppliers if it is less attractive for a supplier to provide resources to you when it is also supplying the other player A player is your complementor with respect to suppliers if it is more attractive for a supplier to provide resources to you when it is also supplying the other player Source: Adam Brandenburger and Barry Nalebuff, Co-opetition (New York: Currency Doubleday, 1996)

19. What the Value Net Adds • Complementors • Symmetry

20. Expanded Industry Analysis Threat of New Entry Bargaining Power of Suppliers Rivalry Among Existing Competitors Bargaining Power of Customers Availability of Complements Threat of Substitutes

21. Degree of Rivalry • Concentration and balance • Industry growth • Fixed (or storage costs)/Value added • Product differences • Brand identity • Switching costs • Intermittent cover-capacity • Diverse stakes • Exit barriers

22. Economies of scale Product differences Brand identity Switching costs Capital requirements Access to distribution Absolute cost advantages Learning curve Access to necessary inputs Low cost product design Government policy Expected retaliation Entry Barriers

23. Intrinsic Strength Buyer concentration Buyer volume Switching costs Buyer information Ability to backward integrate Substitute products Pull through Price Sensitivity Price/Total purchase Product differences Brand identity Impact on quality/performance Buyer profits Decision maker’s incentives Power of Buyers

24. Power of Suppliers • Supplier concentration • Substitute suppliers • Supplier volume • Product differences • Brand identity • Switching costs • Low buyer information • Threat of forward integration • Pull through

25. Threat of Substitution • Product function not form • Entire value added chain • Thread depends on • Relative price/performance • Switching costs • Often an S-curve process

26. The Power of Complementors • Relative concentration • Relative buyer or supplier switching costs • Ease of unbundling • Differences in pull-through • Asymmetric integration threats • Rate of growth of the pie

27. Issues with the Five-Forces Framework • Industry definition • Completeness (e.g., import competition) • Consistency (e.g., import strategic variety) • Duplication (e.g., switching costs) • Symmetry (e.g., buyer substitution vs. supplier substitution, complements) • The role of informational conditions • The need for macroenvironmental analysis • Long-run focus vs. change • shocks • cycles • trends • Product rather than resource focus

28. Landscapes • Landscape is broader than industry • Landscape includes firms, institutions, and other players which often are not viewed as part of an industry • Landscape includes networks of firms (from different industries) whose profits may be interdependent (e.g. Microsoft-Intel)

29. Commitment Opportunities and Structure • Production scale economies set a lower bound on concentration • Many settings are more concentrated than production scale economies would imply • Opportunities to commit resources to advertising and R & D in ways that enhance willingness-to-pay to some minimal degree are what lead to “excess” concentration

30. Steps in Landscape Analysis • Define the landscape: what is in, what is out • Identify the players • e.g., who are the customers, really? Who are the competitors? • Assess the relationships among players • See Porter (1979, 1980) for some factors to consider • Sniff-test • Is assessment in line with actual profitability? • Are more profitable players better positioned vis-a-vis competitive forces? • Assess recent and future changes

31. Identify forces that must be countered in order to achieve superior profitability Test decision to enter Test decision to exit Assess effects of a major change Identify ways to alter structure Pinpoint most threatening force and seek ways to counter (e.g., build switching costs, find new sources of supply) Consider effect of entry on structure; choose relative position; select entry vehicle; compare costs of entry to benefits Identify options for improving structure or relative position; select exit vehicle; compare costs of exit to benefits Consider how change will affect each force Assess consolidation, backward integration, forward integration, investments that raise entry costs, entry into substitute market, etc. Steps in Landscape Analysis (cont.) Purpose Common steps

32. Common Pitfalls in Landscape Analysis • Failing to define the landscape clearly • A clear definition is more important that the “right” definition • Confusing transient effects with structural forces • Ignoring changes in structural forces • Assuming that competitive forces cannot be altered • Confusing evidence of a force with its underlying cause • e.g., blaming customer power on customer price sensitivity rather than exploring root causes of price sensitivity • Ignoring the full range of substitutes • Paying equal attention to all the forces

33. Lessons • Industries or landscapes are neither created equal nor stay equal • The concept of “extended competition” provides a comprehensive framework for assessing structural attractiveness • A firm’s strategy can increase or decrease its exposure to competitive forces • Other things being equal, a firm should seek to trigger actions that improve structural attractiveness • But it isn’t enough to look at just structural attractiveness: competitive position must also be considered

34. Conclusion • Envisioning the business landscape • Adapting to the business landscape • Shaping the business landscape