Saturday, March 10, 2012

Competition Demystified: Chapter 7

The author of the excellent book for beginners, Value Investing: From Graham to Buffett..., is back, this time with a book about how to understand and analyze competitive advantages. Investors interested in better understanding what gives a company a competitive advantage must give this book a read.

The authors compare and contrast two companies in different eras in different industries but faced with strategic choices that illustrate how they should think about competitive advantages. The two companies are Philips NV and Cisco.

In the early 1980s, Philips was was an innovative firm in (among other things) audio hardware technology. It had recently developed laser technology which would eventually be used to put music in digital format on compact discs instead of records and tapes.

To benefit from its leading position in this new technology, however, Philips would have to get the large record companies (the only segment in this industry where there appeared to be barriers to entry) to standardize on its format. But this would mean allowing other entrants to offer competing hardware. Philips partnered with Sony, got the CD standardized, but enjoyed only small gains as the first mover before declining costs allowed other companies to drive profitability to zero.

Cisco, on the other hand, has benefited from continued profitability due to a few differences that illustrate how its competitive advantage came to be. Cisco started by making routers allowing computers to talk to each other. Cisco grew by selling this hardware to businesses who wanted to network their computers. However, Cisco routers could not communicate with routers of different networks, making its first mover advantage a lasting advantage. Furthermore, fast-changing technology required constant upgrading on the part of customers. Since Cisco had the scale, it was able to spend more (both on R&D and on acquisitions) than competitors while still not hurting margins. Finally, Cisco also provided the support and service that IT departments required, making switching to a different provider a large and risky investment for firms.

In the late 1990s and early 2000s, another opportunity opened up for Cisco: selling to the Bells and their competitors who had large networking requirements and were moving from analog to digital. Here, however, Cisco did not have the same advantages. The telecom companies had suppliers already, and these suppliers were anxious to offer digital products. Cisco did not have the scale either, as a new entrant into this segment. Cisco tried to compete on terms, offering generous financing to secure customers. This blew up in Cisco's face during the bursting of the dot-com bubble; Cisco subsequently learnt its lesson and went back to the segment where it has an advantage.

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