Business Analysis Series – Part II – Competitive Landscape and Industry Structure

Imagine doing a case study pedagogy-based MBA, only that we consider real time business  examples rather than studying what happened 25 years ago.

That is what investors deal with on an ongoing basis. 

If you get your understanding and the subsequent thesis wrong, you don’t just flunk the exam  but you also lose a respectable amount of your own money. No wonder people fresh out of  business schools get things wrong more often than not in investing, their degree and the MBA  culture pushes them to sound as confident as possible without their bravado being backed by  any meaningful insights. This is the perfect recipe for disaster when one gets down to investing,  but then I digress.

One cannot understand the competitive position of a business without having the context of  how the industry evolved into the current shape it is in, neither can one derive meaningful  insights without being financially and economically numerate.

Things are the way there are for good reasons. The road less travelled is also less travelled for  a reason.

Entrepreneurs with good business acumen manage to stay away from industry  segments that are plagued by poor unit economics. 

Before you get down to reading this note, please send some time on the “Assessing unit  economics” note under the same Business Analysis series.

For a start it is good to understand how things are and hypothesize why things are the way  they are before one becomes forward looking. What completes this analysis is to go through  corporate actions within the particular industry – who has entered the entered the industry  and when, who has exited the industry and for what possible reasons, how has the product  portfolio of the incumbents changed over the past 10 years, is the industry seeing convergence  or divergence among the players.

It is much easier to understand things sequentially and systematically with real examples.

What follows next is not an all-encompassing exercise but the framework should provide a  good enough start to think about businesses in a structured manner.

Arrive at numerate answers to these simple questions

1. How do I want to define the market and the peer set? 
   • If you are trying to build a view about the innerwear market, are you considering  only innerwear or are you considering lounge wear too?
   • If you are looking a cooling solutions market, do you consider both commercial  and home cooling? Do you consider just Air Conditioners or do you want to  include Air Coolers too?
2. Once this definition is set, what are the homogeneous categories once can define  within this market? 
   • Men’s wear, women’s wear and kids wear are logical categories. So is the  categorization of unorganized, economy, semi premium and premium.  b. Commercial cooling and Home cooling are logical categories. So is the  categorization based on technology like window AC, split AC, inverter AC and  so on
   • The ground rule here is that any categorization you choose to work with should  be consistent with some form of customer segmentation. If the businesses are  using a particular way of defining market segments, that should do the job for  investors too
3. What is a good estimate of the size of each of these categories and the market?
   • How big are each of these categories – men’s wear, women’s wear, kids wear?  What is the approximate growth for each of these categories?
   • Within the commercial and home cooling segments, what is the addressable  market size in today’s terms for each of the categories you have already  defined? What are each of these categories growing at?
   • You can either do this top down or bottom up. If you start with the overall  market size number and use guesstimates to size each category it is top down.  If you are able to get reasonably good estimates of each category and then  sum them up to arrive at the overall market size, this is bottom up. In general  bottom up should be the preferred method for investors, wherever feasible
4. Who are the Top 5/10 leading players in the market and in each category?
   • Who are the Top 5 players in each of the segments? Who are the top 10 players  in the market?
   • What have each of these players been growing at? For listed companies this is  readily available, for private players one will have to mine this information out  from management interviews or industry publications

Referring back to the table we built, one can start pondering over some questions

• Why isn’t Player 3 focusing on Segment 3 which has the largest addressable size and  also the highest growth rate?
• Has Player 4 consciously chosen to focus only on Segment 3 or is it that they started  with that segment and haven’t been proactive enough to get into the other segments?

To cite a few real-world examples, consider the Indian innerwear market –

The men’s category has a size of around INR 11,000 Cr and grows at 7-9% p.a. in value terms.  The women’s category has a size of around INR 20,000 Cr and grows at around 12% p.a. in  value terms. Men’s category has more than 7 players who make annual revenue > 500 Cr each  while the women’s category has just 1 player who makes annual revenue > 500 Cr revenue  from the category.

• Why is it that the larger and the faster growing innerwear segment has fewer large  players?
• If the players see this and are still not focusing on that segment – is this because  they cannot? Or is it that they do not want to?
• If leading players other than Page Industries have stayed away from focusing on  the women’s inner wear segment, what chance does a new age player like Zivame  have of succeeding there?
• What makes the large players reluctant to address this larger market segment?

Next consider the plastic pipes market in the country. Finolex Industries and Supreme  Industries were large players before Astral Poly became a large player.

• Why did these incumbents allow Astral Poly and Ashirwad Pipes to focus on and to  dominate the cPVC market which offers higher margins than PVC pipes? • Did they err in their assessment of how big the cPVC segment would grow or did they  consciously choose not to focus on that market?
• Now that they have finally chosen to participate in the cPVC market, how has this been  changing the industry dynamics?

We are already starting to ask some pertinent questions. Answers to questions like these is  what causes an investor to have a “view” on a business and hence the stock.

What valuation the business trades at will only make sense once the context of the  market size, industry dynamics, growth rates and profit pools are studied. 

Price to Earnings, Price to Book, Enterprise Value to EBITDA – these are meaningful only within  the right context. Ratio analysis can misguide if this point is not appreciated.

As stated earlier, this is not an exhaustive or an all-encompassing exercise, this is just a basic  framework that can help avoid some elementary errors. There are multiple other perspectives  that good investors consider before they make up their mind about the quality of a business  or of a sector.

This analysis takes up almost 60% of the time I spend on the research process, especially when  I look at an industry for the first time. Without this context, one cannot understand the  strengths of a business, nor does one have the right context to be able to place and assess  why the unit economics of the business are what they are.

Would like to conclude this note by encouraging you to think about these questions –

1. Why does the pharma sector have so many companies that have been able to scale to  annual revenue > INR 2,500 Cr, most of them being profitable?
2. When was the last time you came across an IT Services company that makes losses? 3. How many paints companies do we have in India? Why are they so few in number? 4. What other industries can you think of where the industry structure is consolidated  with just 3-4 years capturing 75%+ of the market?
3. Under what conditions do the big get bigger? Under what conditions do incumbents  get disrupted?

The more one thinks, the better one can recognize patterns and come to the right conclusions. The best investors take one look at a balance sheet and can accurately guess which sector the  business operates in.

Now that is wisdom and pattern recognition, not intelligence.