Someone emailed me this question:
“If there are two companies in good industries that previously have good records of profitability, but currently their revenue is declining due to slowing down/temporary oversupply condition in their business sector/industry, how do you determine which company will survive once the sector recover vs. the company that will not survive. What parameters do you usually look at?”
This kind of analysis is going to be more useful in situations where competition is very direct. Warren Buffett (Trades, Portfolio) has talked about the test of asking how much damage could you do to another company if you were given billions of dollars to do so? In other words, if you gave me $10 billion, could I put a big dent in the number of units of Coca-Cola (KO, Financial) sold this year? Or, could anything I do make Coca-Cola lower the price it charges for its products? In that case, the answer is I could do very, very little damage to Coke, and it would be hard for me to influence the amount Coca-Cola charges for its products.
Competition is indirect in situations where the customer retention rate is very high or the price charged for the product is not frequently changed for competitive reasons. Competition is direct in situations where we are essentially talking about a commodity. Two gas stations on opposite corners of the same intersection are in direct competition. Meanwhile, two ad agencies are not in direct competition. Competition between ad agencies isn’t very direct because clients usually make two separate decisions. One, they decide to put an account “in review” and then two, they choose – if they fire their existing agency – with whom to replace that agency. Price is often not a major factor. Here we are going to be talking about those industries where an overzealous competitor can do a lot of harm to a more rational competitor. We are going to be talking more about things like auto insurance and less about things like advertising.
In insurance, GEICO and Progressive (PGR, Financial) have big advantages over many of their competitors. Nonetheless, a competitor like State Farm or Allstate (ALL, Financial) can take actions that would result in a much worse combined ratio for GEICO and Progressive for as long as the company is underpricing its policies. In the long run, neither State Farm nor Allstate can price policies profitably at a level that can do harm to GEICO or Progressive. Provided Allstate or State Farm are willing to have underwriting losses year after year – they can certainly reduce the profits of both GEICO and Progressive a lot. You can see this in the past record of these companies.
Let’s talk about general signs you can look at that will tell you the difference between a marginal player in an industry and the leader in terms of competitive factors like unit cost, name recognition, etc. Probably the most general – though somewhat technical – measure you can use in all industries is the variation in operating margin. A company’s operating margin is earnings before interest and taxes (EBIT) divided by sales.
The variation I am talking about here is called either the coefficient of variation or the relative standard deviation. It’s a dimensionless number. It has no unit. Basically, you can compute – or rather, you can have Excel compute for you – the standard deviation in a series of past operating margin results. The standard deviation itself is uninteresting. If a company had an average (arithmetic mean) operating margin of 30% over the last 10 years and if the standard deviation in that series was 10%, this is interesting for our purposes only in the sense that 10% divided by 30% is 0.33. In other words, the variation in this company’s operating margin is one-third. That’s low.
But we aren’t looking at the absolute level here. What we care about is the order – when ranked from lowest variation to highest variation – that the firms in the industry are arranged in. If we are looking at producers of copper wiring in the U.S., and one firm has a coefficient of variation (standard deviation divided by arithmetic mean) of 0.4 while another firm has a coefficient of variation of 0.9 in its operating margin – we can be relatively sure the first firm is in a more stable competitive position. It’s more likely to have the inside track.
Why? Well, that’s a little complicated to answer. Basically, firms tend to keep prices more stable than a constant re-evaluation of their pricing power would suggest. In other words, a monopolist may not be raising prices as quickly as theory says it could. However, you would be able to see that when a monopolist does raise its prices, it sees little resistance to the price increase.
The rule of thumb is that firms don’t like to experience contractions in their operating margins. They like to increase unit sales over time, and they like to do that at the same or possibly higher profit in the future. This is a rule of thumb. It’s not perfect. But if you have five different firms in the same commodity industry and you order them from the firm with the lowest variation in its operating margin to the firm with the highest variation in its operating margin, I’d be shocked if the firm with the lowest variation in its operating margin is in a weak competitive position. Variation in the operating margin is really a measure of profit wobble. In a capitalist economy, some firms tend to act as shock absorbers – they take a hit – and other firms tend to pass the shock on to customers, suppliers and employees without themselves showing much sign of the shock rippling through their industry, the economy, etc.
High variation in operating margins is like a seismic reading showing a shock at various points in the firm’s history, the industry’s cycle and the overall macro-economy. The rule of thumb is that the firm with the lower variation in its operating profit is the firm with the less marginal competitive position.
There are plenty of other signs. Let’s stick to ones you can see at the corporate level. Try to find as long a history as possible for all the companies in the same industry. If possible, even in 2016, you want data from different firms in the same industry as far back as 1994. Why? Because this will give you the best chance of having boom and bust figures for each company.
If most of the companies in a given industry were losing money in 2003, but the company you are looking at was turning a profit – the company you’re looking at is more likely to be the industry leader. A counter-intuitive sign you can often rely on is which company gets talked about the most in the press, by analysts, etc. during a recovery. That company is probably in a weak competitive position. A company in a strong competitive position will show less earnings growth from the bottom of a cycle to the top of a cycle. In fact, in the midst of a boom period, analysts and journalists and investors will often focus on the company with the weaker competitive position and talk about how quickly that company is growing earnings relative to the industry leader. They may not talk a lot about the speculative and cyclical nature of this growth. Obviously, a supermarket that had a 1% margin in bad economic times and a 2% margin in good economic times will show higher earnings growth than a supermarket that had a 2% margin in bad times and a 3% margin in good times.
Note that the relative profitability of the firms here didn’t change. In fact, the leader always kept a 1% profit advantage – which may be the result of a constant advantage in expenses – throughout the recovery. If two companies have similar business models, you can also gauge competitive position by comparisons of returns on capital, margins, turns and credit ratings. Especially in an industry with economies of scale that can continue to be captured even at really big size, the leading firm will be able to match the growth rates of weaker firms even while having a higher credit rating. There could be noncompetitive reasons – purely financial decisions made by a private equity owner, etc. – that explain financial strength differences. And this is definitely a backwards-looking measure. But if you take something like the airline industry in the U.S., it’s clear that Southwest (LUV, Financial) must have had a much stronger competitive position than the other major carriers at some point. Southwest has much greater financial strength than its peers. It owns a lot of its planes, it has a better credit rating, etc.
Now, let’s talking about industry-specific data. Some industries provide competitive information below the corporate level. Airlines may tell you their cost per seat mile. A producer of copper wiring may tell you its price per pound. GEICO and Progressive give you their combined ratios. They also break the combined ratio down into the loss ratio and the expense ratio.
In some cases, it is easy to do direct comparisons. For example, in the airline industry costs are well known. The same is true in the cruise industry. Carnival (CCL, Financial) and Royal Caribbean (RCL, Financial) are comparable. You can always check which company has the lower costs per passenger. In the cruise industry, ships always sail full. That’s an oversimplification, but it’s not much of one. Price is relatively unimportant. A computer will determine what price will result in maximum revenue without sacrificing any occupancy for a specific cruise. What you need to know is the cost per passenger for the cruise line. The only tricky part here – as with airlines – is that these firms don’t control their fuel costs. Oil is a commodity. Jet fuel and bunker fuel is going to cost the same for everyone. I would suggest that you segregate fuel costs from nonfuel costs. The lasting competitive advantage of one firm over another has to be something internal. It can’t be driven by fuel costs.
Sometimes firms in direct competition have advantages other than price. Two examples are batteries and money transfers. Duracell and Energizer and companies like Rayovac do compete on price. But, no one buys Rayovac batteries when they are priced at the same level as Duracell and Energizer. Basically, Duracell and Energizer (ENR) are full-price batteries and other competitors are value competitors. They are unable to compete unless they charge less.
The same is true in money transfer. MoneyGram (MGI, Financial) competes with Western Union (WU, Financial). We know that MoneyGram is – in many corridors – at a competitive disadvantage to Western Union because of three figures it discloses or which it’s possible (with a little digging) to turn up. Western Union is sometimes able to offer the same services as MoneyGram at a higher price. MoneyGram may charge $9 for a certain money transfer whereas Western Union will charge $10 for that exact same service. This wouldn’t happen unless customers were not indifferent to the two brands at the same price. It turns out customers aren’t indifferent. If you offer customers the choice of using MoneyGram or Western Union at the same fee level, most customers choose Western Union.
The same is true of agents. If you look at what we know about signing bonuses paid to agents and at the commission split between the payment processors and the agent, we can see that MoneyGram has offered more lucrative terms to its agents than Western Union has. I’m talking in the aggregate here. I’m sure there are some corridors where MoneyGram has offered the same or even less attractive terms than Western Union. Overall we know that MoneyGram tends to charge less for the same service as Western Union, it tends to offer a bigger signing bonus to its new agents, and it tends to offer a slightly more favorable commission split to its agents. You don’t charge customers less or pay suppliers (which are essentially what agents are here) more unless you have a reason to do so. Western Union has greater market power than MoneyGram. You can test this by digging up the kind of more basic competitive data like price, signing bonuses and commission splits – or you can look at things like operating margin data. You can also look at scale.
As a rule, you’d expect a company in a stronger competitive position to have higher transaction volume per agent and a bigger agent network. In some industries, it’s complicated. Credit cards are a good example of an industry with direct competition but where it’s complicated by the different business models of the competitors. American Express (AXP, Financial), Visa (V, Financial) and MasterCard (MA, Financial) all compete with each other and with Discover (DFS, Financial). Who is in the best competitive position? By some measures, it’s clearly Visa and MasterCard. By other measures, it’s American Express. By no measure is it Discover. Discover is clearly in the worst competitive position. MasterCard and Visa have some huge scale advantages. But American Express has scale advantages in terms of transaction value per customer (that is, per card) and brand preference.
There are signs that American Express had been – at least in the past – able to offer less to both its cardholders and merchants than MasterCard and Visa did. On the other hand, Visa and MasterCard grew faster. The problem all these companies have – which you can find in industry data – is that they have all tended to raise their rewards rates in recent years. That is a sign of shifting power away from payment processors and toward credit card holders. It’s a bad sign for the industry. Basically, it’s as if Duracell and Energizer were both flooding the market with more coupons to sell the same number of batteries.
I don’t think it’s usually difficult to figure out which firm in a shrinking industry is in the strongest positon. I mentioned before how both Barnes & Noble (BKS, Financial) and Staples (SPLS) were clearly the strongest off-line players in their respective industries. Likewise, if driverless cars eventually spell the doom of the auto insurance industry, it’s clear that GEICO and Progressive will turn a profit for longer than other insurers. GEICO and Progressive have a better business model than their competitors.
By almost all the signs I discussed here, GEICO and Progressive have the inside track in auto insurance. If they pursued a suicidal strategy, they could inflict underwriting losses on other auto insurers year after year. The reverse isn’t really true. Other auto insurers don’t have the financial strength and the low costs needed to force GEICO and Progressive to continually lose money. They can force GEICO and Progressive to have a bad year – but not a bad decade. They’d be out of business long before GEICO or Progressive was out of business. The industry cost data is really clear on that point. But even the corporate level financial statements are clear indicators that GEICO and Progressive are the strongest competitors and will outlast the other players in their industry if there is a multiyear price war.
Disclosure: None.
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