The Analysis of Competitive (Industry) Forces
Competitive forces have the power to change the direction and economic viability of the firm. Michael Porter published his classic model of industry structure analysis in 1980.39,40 The model focuses on five competitive forces arranged in an airport hub-and-spoke layout, that is: (1) the threat of new entrants (north terminal), (2) the intensity of competitive rivalry (hub), (3) the bargaining power of buyers (east terminal), (4) the bargaining power of suppliers (west terminal), and (5) the threat of substitutes (south terminal).
Entry barriers reduce the threat of new entrants (i.e., economies of scale, expected retaliation, high brand loyalty, etc.). If there are strategic groups within the industry, mobility barriers within the industry will inhibit or prevent movement from one strategic group to another. In an industry, firms within strategic groups follow similar strategies, whereas different strategic groups within the industry follow different strategies.
In Porter's analytical framework, the subject of the analysis (e.g., NGC) is positioned in the central box, and it is the center of the analysis. Rivalry determinants and the determinants of buyer power, supplier power, and substitution structure the nature of the industry and give the analysis depth and breadth. The five forces operate in the external environment of the firm and have the potential to create opportunities and threats for firms in the industry. The basic logic of the model argues that the more intense the competitive forces are, the lower will be the long-run return on investment and vice versa.
Analysts use the model to analyze the structure of industries and to position firms in their industries with the intention of creating sustainable competitive advantages (i.e., sustainable levels of excellence in free cash-flow generation). Free cash flow is the preferred measure because cash pays the bills; cash creates and sustains credit; and cash and credit secure assets that generate more free cash flow. Therefore, it is important to never run out of cash or credit.41 Analysts typically use free cash flow in the valuation of assets (e.g., payback, net present value, and internal rate of return criteria). Otherwise, they use some form of asset valuation (e.g., replacement cost). Sometimes analysts focus on profit as opposed to free cash flow. However, as the statement of cash flows clearly shows, profit is only a partial measure of cash flow. It is the first line on the statement of cash flows, and it excludes significant sources (uses) of cash.
Analysts want to know how the industry creates value (i.e., free cash flow) and who captures the value created. They envision the firm competing with its competitors (i.e., the intensity of competitive rivalry). In addition, Porter argues that the firm is also competing with its buyers and suppliers. Buyers typically want lower prices, higher quality, longer warranties, etc. If the switching costs are favorable, they might buy a competitor's products or play one firm against another. The greater the bargaining power of buyers is, the greater is the buyers' share of the value created by the industry, everything else being equal.
By contrast, suppliers want higher prices, lower quality requirements, less onerous warranties, etc. The greater the bargaining power of suppliers is, the greater is the suppliers' share of the value created by the industry, everything else being equal.
Porter saw substitute products as coming from outside of the firm's industry (e.g., beef, pork, and chicken are substitutes). The substitute serves the same function (e.g., nutrition), yet it is different (e.g., in appearance and/or chemical composition). Thus, it can place a ceiling on the price the firm can charge for its product, thus limiting the producers' value-creation possibilities. Last, if the threat of new entrants is high and low prices are a barrier to entry, it could further limit the producers' value-creation possibilities. An industry with strong buyers and suppliers, economically viable substitutes, and entry-barrier pricing, could be very unattractive. Unattractive industries often find it difficult to raise capital—debt or equity.
Analysts use Porter's model to understand the structure of an industry and the forces shaping the development of the industry, past and future. Typically, they want to learn how to position the firm in the industry to create a sustainable competitive advantage. Thus, using Porter's model to analyze the aerospace and defense industry might reveal the following:
Bargaining Power of Buyers—High to Moderate
The contracting activities of the DoD drive the economic activities of the aerospace and defense industry contractors. The primary buyer is the DoD (i.e., the Pentagon), which represents the various military services. Thus, contracts are usually associated with a military service (e.g., a navy contract). NGC's other buyers include civil buyers (i.e., nongovernment buyers, such as police forces and border patrols), commercial buyers, foreign governments, and scientific institutions (e.g., NASA). The DoD's purchases are significantly influenced by economic forces, military/terrorist forces, and the president's and the Congress' agendas (i.e., political forces). In June 2010, Loren Thompson, defense analyst, pointed to "trends unfolding within the Pentagon . . . migration of funding out of high-end technology and into people skills . . . move to 'in-source' tens of thousands of jobs previously contracted out to industry."42 This migration threatens NGC's ability to retain high-technology talent.
Intensity of Competitive Rivalry—High and Rising
In the aerospace and defense industry the annual revenues of the largest 25 firms range from $3 billion to $65.7 billion.43 The world's largest aerospace and defense contractors are Lockheed Martin, BAE Systems (United Kingdom), Boeing, Northrop Grumman, General Dynamics, and Raytheon. The larger firms have invested heavily in proprietary product technology and building economies of scale and brand identity (e.g., in 2009, NGC spent $610 million on research and had 6,293 patents). There are also hundreds if not thousands of smaller firms in the global supply chain. Competition at all levels of the industry is increasing, putting downward pressure on profit margins and free cash flows. The DoD clearly favors competition. Firms will likely reduce their margin requirements to protect revenue generation. Well-positioned firms will purchase firms with distinctive competencies. Firms without distinctive competencies will exit the industry.
Bargaining Power of Suppliers—Moderate
The large firms in the aerospace and defense industry (e.g., NGC) depend on a global supply chain. Given that the large firms are developing, producing, and marketing relatively similar products and services, it appears there may often be alternative buyers for suppliers' products and services, giving suppliers more bargaining power than they would have as a sole (captive) supplier. In addition, the industry depends on a continuous infusion of research—its own and the research of universities and independent research facilities. The bargaining power of these facilities depends on the quality of their research (i.e., their reputation).
Threat of New Entrants—Low
New entrants add capacity to the industry. New entrants may bring new, even "leap-frog," technology and/or productive capacity. Given the expected decline in DoD contracting and intensifying competition, significant additions to industry capacity are unlikely. However, industry leaders and analysts are discussing the likelihood of mergers and acquisitions (e.g., Boeing and NGC) and the possibility that one of the large firms might exit the industry. They seem to agree that mergers and acquisitions among the largest firms are unlikely because of the associated antitrust issues, but they are already underway among the second- and third-tier firms. The administration and the DoD are not in favor of large-scale mergers and acquisitions.44
Threat of Substitutes—Unknown
Substitutes serve the same function as the products/services they displace. Research displaces technology, and some of the research may come from industries presently or historically not engaged in producing products/services for the DoD. The likelihood of displacement largely depends on the switching costs and value-added potential.
In the aerospace and defense industry, the pending cuts in DoD spending set the context for the high and rising intensity of competitive rivalry. The high-to-moderate bargaining power of buyers, primarily the DoD and congressional representatives fighting for a share of the DoD contracts and jobs for their home districts, increase the intensity of competitive rivalry. The moderate bargaining power of suppliers is explained by the industry's global supply chain and its dependency on a continuous infusion of research. By contrast, the threat of new entrants is low. The next section explains the use of scenarios for managing a host of complex, high stakes, and relatively unpredictable forces that shape NGC's and the industry's strategic plans.