Chapter 2: Literature Overview
2.2 Five forces analysis
2.2.2. Threats of substitutes
According to Michael Porter's model substitute product is a source of threat for the company's profitability, since it significantly limits the price that can be charged for the goods, unless the enterprise is successful in product differentiation. This situation takes place because the consumers reservation price depends partly on the accessibility of substitute products25. The availability of substitutes increase the cost effectiveness of an industry simultaneously decreasing profitability of its players. The substitutes can be divided into three different groups: product-for-product substitution, substitution of need by a new product or generic substitution26. The severity of the threat generated by substitutes depends on such factors as the difference between the prices of goods, switching costs or consumer's propensity to substitute.
25 Porter, Michael E. 1979. How competitive forces shape strategy. Harvard Business Review. March-April 1979,
26 Johnson, Gerry & Scholes, Kevan, 2002. Exploring Corporate Strategy. Essex: Pearson Education Limited.
31 2.2.3 Rivalry between competitors
The level of competition between incumbents determines has a significant impact on the profitability of the industry27. In extreme cases the competition is so stiff that companies are forced to sell their products below the cost of production leading to industry-wide losses.
However, in some industries, the competition may occur mainly in form of advertising or product innovation. There are five key factors that determine level of competition between the incumbents in particular industry.
Concentration
According to Michael Porter, the level of competition is strongly affected by the number of competitors in the industry and their level of competence28. The competition is stiffer when the industry consists of a large number of similar sized players. On the other hand in the market dominated by a single firm the intensity of competition is low and the company has a significant level of freedom in its pricing strategy. When there are few players
dominating the market the intensity of competition is limited and cartels that set the price level may emerge. The concentration ratio of a industry may be measured by combing the market share of 4 leading producers or by using the Herfindahl-Hirschman Index.
Diversity of Competitors
Another factor that determines the rivalry between the incumbents is the diversity of competitors including the strategies they choose pursue. For example, if the main players in the market have chosen aggressive growth strategies the competition will become more intense.
27 Porter, Michael E. 1998. Competitive Advantage: Creating and Sustaining Superior Performance. Free Press
28 Porter, Michael E. 1998. Competitive Advantage: Creating and Sustaining Superior Performance. Free Press
32 Product Differentiation
The level of product differentiation is another factor determining the intensity of rivalry within an industry. In case, when rivals tend to offer less differentiated products the more customers will be prone to switching which result in rise of price competition levels. In a sector where the products marketed by competitors are identical, the companies compete only with price. On the contrary, in the industry characterized by high differentiation of offered the price competition may be weak, despite a large number of competing entities.
Excess Capacity and Exit Barriers
According to the Porter five forces model the profitability of the industry is also influenced by relations between demand and capacity. If capacity exceeds the demand the intensity of competition in the industry will rise. If such situation persist the factor
determining the level of competition are exit barriers of a sector. For example when industry characterizes with high amount of fixed assets or strict job protection rights it may be very costly to leave the sector and as a result lower the industry capacity levels. When excess capacity leads towards price competition, the cost structure is the key factor determining the price. If fixed costs are relatively high comparing to variable costs, the firms will continue to serve customers at any price above the variable costs, resulting in significant losses among the players in the industry29. The benefits stemming from scale economy provide additional motivation for enterprises to engage in aggressive price competition with the intention of increase their sales volume.
29 Grant, R. M. 2010. Contemporary Strategy Analysis (7 Ed.). Chichester: John Wiley &
Sons Ltd.
33 2.2.4 The bargaining power of buyers
The bargaining power of customers has a significant impact on the profitability of various business sectors. In a industry where buyers bargaining power is high, they
consumers of goods can negotiate either better price or higher quality of products30.There are two key factors determining the strength of the buyers, their price sensitivity and relative bargaining power. The price sensitivity of buyers will rise if the products purchased have significantly affect their cost structure or the level of differentiation in the industry is low.
One of the main factors affecting the bargaining power of buyers is their size and
concentration in comparison to the suppliers. The bargaining power of a customer rises if there are few buyers purchasing in big quantities. Second factor having a significant impact is buyer‘s information. If buyer is well informed about cost structure of supplier it can negotiate a better price. The last key factor is the ability of buyer to engage in vertical integration. As a result buyers may threaten suppliers that might start manufacturing the product by themselves if their purchasing price is too high.
2.2.5 The bargaining power of suppliers
In case when suppliers have high bargaining power they can choose to raise the prices or reduce the quality of provided products. High bargaining power of suppliers may lead to decrease of profitability among the companies within a industry if they are unable to transfer the growing costs to the customers by increasing the price of their products. The bargaining power of suppliers will be high if the concentration among them is high, a high level of differentiation among their products exist and the the switching costs are high. In a real economy suppliers often try to increase the switching cost on their own in order to increase
30 Porter, Michael E. 2008. The Five Competitive Forces That Shape Competition.
Harvard Business Review. Jan P79-93
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their bargaining power. Unavailability of reliable substitutes and ability of forward integration among the suppliers also leads to an increase in their bargaining power.
2.2.6 Criticism and extending the five forces model by adding complements to the analysis
Porter‘s five forces is one of the most popular tools use to analyze the competition within a particular industry. However, it has also been a subject of criticism, mainly because of two reasons. Firstly, Porter‘s constructed the model under the assumption that the
competitors, buyers and suppliers are unrelated and do not engage in collusion, which is not the case in the real economy. Secondly, some economists believe that the industry
environment impact on company's profitability is insignificant31.
Michael Porter's five forces analysis correctly identifies threat of substitutes as a factor reducing the profitability of the enterprises operating in one industry. However, the model doesn't elaborate on the impact that complements have on the condition of a industry. In theory of economy complements, are those goods or services that increase the demand for the particular product, which means they have a opposite impact than substitutes. For example, the situation in the car market depends heavily on the price of gasoline and other services such as maintenance etc. Therefore, when making a decision of purchase the customers analyze the value of whole product set instead of just one of its elements.
31 Grant, R. M. 2010. Contemporary Strategy Analysis (7 Ed.). Chichester: John Wiley &
Sons Ltd.
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Figure 2 - 12 Five forces model enhanced by adding complements to analysis
2.3 Value Net Model
Value net is alternative model to five forces analysis and it was clearly was inspired by Michael Porter's predecessor. It was created in by two economists Adam Brandenburg
representing Harvard Business School and Bary Nalebuff from Yale school of management in 1995.
The model treats industry as a game in which four actors are competing for its share of created value. Those four actors are respectively: customers, substitutors, suppliers and complementors. The framework provides a platform for analysis of division of the value created within the industry as well as interdependence between the players of the game. The model is based on the concept of Co-opetition. The authors argue that nowadays relation
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between the different players of the business environment may include cooperation and competition at the same time. If companies work together, they are able to create larger and more valuable market than if they only work individually. Afterwards the companies can compete with each for their share of the market value. By analyzing the value net model of its respective industry companies can try to seek for ways of creating sustainable competitive advantages by changing the rules of the game, so that they can gain a favorable position against other players and will be able to receive the bigger share of the value created32.
According to the model the business game consists of five elements: players, added values, rules, tactics and scope, which detailed description takes place below. In order to change the rules of the game at least one of the elements have to be influenced by the participant.
32 Adam Brandenburg and Bary Nalebuff, CO-OPETITION: A Revolutionary Mindset That Combines Competition and Cooperation 1998, found online at
http://www.uni-potsdam.de/db/jpcg/Lehre/SS_04/HS_Gesch_ftskonzepte/coopet.pdf
37 2.3 Value Net Model and the role of Guanxi
The relationships between the players of the game and the basic rules of value creation are explained by the diagram below.
Figure 2 - 13 Value net model by Adam Brandenburg and Bary Nalebuff
In order to facilitate the understanding of the framework the key elements of PARTS model are explained below:
Players
Inflow or outflow of market players have a significant impact of the overall market value of the entire value net. Therefore, before an enterprise decide to enter a market it should conduct an analysis based on the question: for which of the current players my participation will provide the highest amount of added value. Subsequently determine the way to persuade that player to pay for your involvement.
38 Added Value
Added value of a value network consists of sum of the values added by all participants.
Therefore when a new enterprise joins the network the net increase of the total value of the network will be equal to the new entrant contribution. A company should focus on
maximizing its own added value.
Rules
Although many participants of the value net tend to assume that rules of the business are set and not a subject to any further negotiation, it is just not true. Enterprise should first thoroughly understand the rules determining the situation in the market and subsequently strive to change them in a way that will benefit the company. However, other participants may also try to change the rules of the game at any time. Moreover, the party with the biggest bargaining power market usually sets the rules.
Tactics
Tactics of market players are used to shape the perceptions of other participants in the value net. The game can be influenced by changing the way other players perceive it. Every action of a company sends signals, based on which other participants create their perception of the situation within the value net. The game is equal to the collective sum of those perceptions. Most industries are characterized by presence of fog of uncertainty, scraps of information and deliberate misinformation. Tactics can help an enterprise either to clear up the fog, preserve it or stir up new one.
Scope
In the world of business value nets are not isolated from each other. In fact each value net has a link with other value nets through common players or same location of business
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operations. As a result of those linkages value nets can influence each other. In other words, every value net is situated in a bigger environment, which boundaries can be changed at any time by the participants of the net. Gaining understanding of relationships between
neighboring value nets is necessary for a company to form a successful business strategy and as a result create more added value.
The concept of Guanxi in China.
The social and cultural environment in China is significantly different than the ones of the Western countries. The country possesses many cultural traditions and specific habits. It is widely known that cultural differences highly influence the business practices of a country.
As a result, it is extremely important for Western enterprises to understand those differences when investing in China. Moreover, the commercial activities in Chinese society are highly influenced by the concept of “relationship” called “guanxi” which is significantly different from the one used in the West.
The term "guanxi" can be translated as “relationship” or “connection”. To be more precise in the Chinese language word "guanxi" is a phrase which consists of two characters.
The first one "guan" is a noun that literally means - gate, barrier. The second one "xi" is a verb that means to “connect” or “link”. There are many definitions of "guanxi", according to Pye (1982), "guanxi" is considered as "friendship with implications of reciprocal exchange of favors33". Alston (1989) defines it as a "special relationship based on personal affiliations between two persons34". Finally, Yeung and Tung (1996) describe that the term refers to building up a
33 Pye, L. Chinese Commercial Negotiating Style. 1982. Cambridge: Oelgeschlager, Gunnand Hain Inc.
34 Alston, J. (1989). Wa, Guanxi, and Inwa: Managerial Principles in Japan, China, and Korea. Business Horizon, March, 26-31.
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"linkage between two individuals who could exchange mutual interests and benefits by personal or social transactions to ensure the maintenance of such a personal relationship35".
"Guanxi" is one of the main forces that shapes dynamics in the Chinese society. It does not only refer to a very special relationship between two people, but also involves continuous exchange of favors and is regarded as an interpersonal networks of reciprocal bonds. Based on those descriptions it is obvious that interpersonal relationships in China are established by cultural-rooted criteria that are very abstract especially for Westerners. It is importance is even bigger considering the fact that, "guanxi" is often the main factor that determines relationships between people or organizations, including businesses. As a result the development of "guanxi" becomes as a major competitive advantage in Chinese business environment which often helps local enterprises to overcome its resource shortage comparing to the multinational entrants. Therefore it is then very crucial for the foreign investors to consider cooperation with a local partner in case of commencing operations in China.
2.4 Benefits of entering China Market through an M&A
2.4.1 M&A trend
Since 1990's Mergers and acquisitions have significantly increased in popularity and nowadays are a common alternative for internal expansion. According to Hitt, Harrison and Ireland globalization and technological progress are one of the factors that determined growing importance M&A, including cross-border M&A36.
35 Yeung, I. Y. M. & Tung, R. L. (1996). Achieving Business Success in Confucian Societies: The Importance of Guanxi (Connections). Organisational Dynamics, 25(2): 54-65.
36 Hitt A. Michael, Harrison S. Jeffrey, & Ireland Duane R. (2001). Mergers and Acquisitions: A Guide to Creating Value for Stakeholders. New York: Oxford University Press.
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Economists believe that there were five M&A waves in the world. The first one occurred between 1893-1904, in the U.S. consisting mainly of horizontal mergers, in such industries like oil, mining, steel, telecommunications. It was enabled by spanning the country with a comprehensive railroad system that provided an impulse for integrating companies operating on a regional scale into national giants. The wave ended before the First World War resulting in monopolization of major key industries in USA 37. The second one occurred between 1919 and 1929. Besides continuing consolidation of the key industries commenced in the first wave, it is characterized by emergence of automobile industry which leaded to rising popularity of vertical integration M&A. This wave was ended by the Great Depression in 192938 During the third wave which began in 1955 and ended between 1969 and 1973 the concept of “conglomerate” has emerged and has been widely accepted by American business strategists39.The idea of conglomerate promotes growth of companies by entering new
industries and achieving more benefits from diversification. The fourth wave of M&A occurred started between 1974 and 1980 and lasted till 1989. This period is strongly marked with emergence of hostile takeovers supported by investment banks and began with the acquisition of Inco by ESB with assistance of Morgan Stanley. “This successful hostile bid opened the door for the major investment banks to make hostile takeover bids on behalf of raiders.”40
In the middle 1990s, the fifth M&A wave have begun. The period is characterized by five - fold growth in value of mergers and acquisition when comparing to the 1980's and dramatic increase in importance of cross-border M&A. During this wave, the parties involved in the M&A are usually enterprises of a significant size. As a result of mergers, many of the
37 Lipton, M. (2006, 09 14). Merger Waves in the 19th, 20th and 21st Centuries. The Davies Lecture (pp. 3.)
38 Lipton, M. (2006, 09 14). Merger Waves in the 19th, 20th and 21st Centuries. The Davies Lecture (pp. 4.)
39 Lipton, M. (2006, 09 14). Merger Waves in the 19th, 20th and 21st Centuries. The Davies Lecture (pp. 5.)
40 Lipton, M. (2006, 09 14). Merger Waves in the 19th, 20th and 21st Centuries. The Davies Lecture
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companies became the major players in their respective industries41. The fifth wave of M&A is the first one with a truly global impact. Its emergence was enabled by many factors such as rapid development of science and technology, in particular major breakthroughs in
communications solutions that facilitate managing on a global scale. Secondly, commencing of WTO which pushed government towards liberalizing their capital inflows policies created more favorable environment for cross-border M&A. Along with continuous economic growth and rising levels of globalization, more and more countries became aware of the benefits of foreign direct investments for both recipient and source of capital. As a result, governments provide various kinds of support for domestic enterprises interested in cross-border
acquisitions such as investment insurance or providing information concerning target market.
Moreover, the levels of competition on the global market are rising making M&A one of the key activities determining the performance of an enterprise on a worldwide scope. By engaging in cross-border mergers and acquisitions companies can quickly improve their competitiveness, expand scale of operations, and as a result, increase the significance of its business on the global market.
The value of cross-border M&A has experienced significant growth in the last fifteen years42 Although the majority of them still take place between entities based in developed countries, emerging economies gradually catch up and are increasing their importance as destinations for cross-border M&A, mainly due to huge growth potential of their large markets. Therefore, acquisition of a local company is becoming a popular alternative for internal growth, significantly shortening time required for market entry enabling enterprises to grasp the opportunities arising on fast growing markets.
41 Shimizu, K., Hitt, M. A., Vaidyanath, D., & Pisano, V. (2004, 07 24). Theoretical foundations of cross-border mergers and acquisitions: A review of current research and recommendations for the future. Journal of
41 Shimizu, K., Hitt, M. A., Vaidyanath, D., & Pisano, V. (2004, 07 24). Theoretical foundations of cross-border mergers and acquisitions: A review of current research and recommendations for the future. Journal of