How to Analyze Ecosystem for an Industry?
A good starting point is Profit Pool Analysis and Michael Porter’s 5 Forces Framework. Profit Pool Analysis is a technique for analyzing the total profits earned at all points along the value chain or network of an industry providing a meaningful product or service for a customer. This is useful for analyzing the overall industry but also the categories and individual firms within an industry.
Growth and Decline of the PC Era
In this PC era example (below), the Wintel monopoly of CPUs and OS had the highest margen and were scalable businesses. Most other players such Memory Chips, Mother Boards, Software and Services experienced fast growth but were eventually commoditized and could easily be substituted. As PC adoptions have plateaued, both Intel and Microsoft were joined by the successful PC builder Dell, and branched into Business Servers. All in turn, have been disrupted by the cloud. Currently “niche” player Apple owns 50% of the PC hardware profits.
How to Build a Profit Pool Analysis?
The concept of Profit Pool is repeated across many industries. For example, if we look at US Telco market we need to include Wireless, Cable+Broadband, Device, Content + Aggregators, E-commerce, Streaming & Infrastructure. To build the profit pool analysis for US Telco we usually take the top 5 companies and sum the rest (the long tail for each category) into a 6th player. We simplified this model to include all company revenue. Then we look for momentum changes, YOY Growth in Revenue, EBIT and Enterprise Value (the size of the circle).
Delving further into US Telco allows us evaluate the ultimate category killer the mobile phone. Recently, Clay Christensen concluded “Android devices are killing Apple now [with] about 80 percent of the market.” But Fortune says the iPhone “took home 93 percent plus of mobile-phone profits” in 2014 and Forbes says Apple earned “about 60 percent of all smartphone profits” globally in 2013. Since an Ecosystem can have only one Alpha male known as “the Gorilla”, it is all important to understand which brand owns the customer; in this case Verizon or Apple, and which has greater “stickiness” for generating EBIT going forward.
As part of our Strategy Science Toolkit, we start by looking at Enterprise Value and Competitive Advantage Period to see who has greater momentum for driving the Ecosystem moving forward.
Competitive Advantage Period is a measure of how long returns above the cost of capital will be earned. CAP is also known as “value growth duration” or “T” in the economic literature and is also similar in concept to Credit Suisse “fade rate” or CFROI. http://biq.com.mx/credit-swiss-holt-fade/ Apple has higher ROIC, increasing investment levels and improving NOPAT. In a highly leveraged deal, Verizon bought out Vodaphone’s share of the US business, lowering WACC, but tripling profits. However Apple’s CAP has increased to 21.55 years while Verizon’s has been reduced to 3.77 years, mainly due to competitive pricing pressure.
Tying It All Together
What ties Ecosystem, Profit Pool and CAP together, are the network effects of technology for increasing market potential; Moore’s concept of crossing the chasm and attacking adjacent markets, or Christensen’s Innovation Dilemma reducing an incumbent competitive advantage and disrupting an existing ecosystem with a lower cost structure. Both change the underlying CAP premise. Finally if we go back to our mobile example, after a brief sharing of power, cerca Jan 2013, the street says there is more upside to growing Apple’s Device base vs. Verizon’s mobile customers.
So what is this important for you?
- Generally speaking, higher ROIC businesses within an industry are the best positioned competitively (reflecting scale economies, entry barriers and management execution). As a result, it is often costlier and/or more time consuming for competitors to wrest competitive advantage away from high-return companies. In Telco, Apple bests all and clearly drives the ecosystem ahead of Verizon.
- Second is the rate of industry change; Innovation + Deregulation + Regulation. High returns in a rapidly changing sector (e.g., Software) are unlikely to be valued as generously as high returns in a more prosaic industry (e.g., Beverages). Regulation such as Net Neutrality (USA) , breaking up encumbant Telco Monopolies (Mex) and directed taxation such as IEPS (Mex), all effect NOPAT and CAP.
- The final driver is barriers to entry. High barriers to entry— or in some businesses, “lock-in” and increasing return— are central to increasing the CAP and the sustainability of high returns on invested capital. Think Intel in PC CPUs.
Since I covered the future of Financial Services in our Christmas Edition http://biq.com.mx/cuento-de-navidad/, so lets take the example of the Automotive Industry, recently baptised by a GM Exec I met at the San Fran, Digital Innovation Summit, as “Personal Transportation”. Watch this space.