In the context of the analysis in Chapter 1, a number of struc-tural factors take on a particular importance in determining the na-ture of competition in the decline phase of an industry. Shrinking in-dustry sales make this phase potentially volatile. However, the ex-tent to which the incipient competitive pressure erodes profitability depends on some key conditions, which influence how easily capaci–ty will leave the industry and how bitterly the remaining firms will try to stem the tide of their own shrinking sales.
1. CONDITIONS OF DEMAND
The process by which demand declines and the characteristics of the market segments that remain have a major influence on competi-tion in the decline phase.
UNCERTAINTY
The degree of uncertainty perceived by competitors (whether ra-tionally or not) about whether demand will continue to decline is one of the most potent factors affecting end-game competition. If firms believe that demand might revitalize or level off, they will probably try to hold onto their positions and remain in the industry. Their ef-forts to maintain position despite shrinking sales will have a high probability of leading to bitter warfare. This situation has been oc-curring in the rayon industry, where there have been continued and probably justified hopes that rayon’s losses to nylon and steel in the tire cord market, and losses to other fibers in the textile market, could be reversed. On the other hand, if all firms are certain that in-dustry demand will continue to decline, it will facilitate the process of withdrawing capacity from the market in an orderly fashion. In acetylene, for example, it became quickly clear that the skyrocketing cost of natural gas would make ethylene a lower-cost substitute for many of the chemical processes using acetylene. Here the least effi-cient firms began early to develop strategies for withdrawal.
Firms may well differ in their perceptions of future demand; some firms may foresee a higher probability of revitalization, and these firms will be prone to hang on. Furthermore, there is some evi-dence in case histories of declining industries that a firm‘s perception of the likelihood of future decline is influenced by its position in the industry and its exit barriers. The stronger the firm‘s position or the higher the exit barriers it faces in leaving, the more optimism seems to exist in its projections of the future.
RATE AND PATTERN OF DECLINE
The more slowly decline is proceeding, the more it may be masked by short-run factors in firms’ analyses of their positions, and the more uncertainty there usually is about future decline. Un-certainty greatly increases the volatility of this phase. If demand is declining precipitously, on the other hand, firms have a hard time in justifying optimistic future projections. In addition, large declines in sales make abandonments of whole plants or divestiture of whole di-visions more likely, which can rapidly adjust industry capacity downward. The smoothness of decline also plays a part in uncertain-ty. If the industry’s sales are inherently erratic such as in rayon and acetate, it may be difficult to separate the downward trend in sales from the confusion caused by period-to-period fluctuations.
The rate of decline is partly a function of the pattern in which firms actually decide to withdraw capacity from the business. In industrial businesses whose product is an important input to cus-tomers, demand can decline precipitously if one or two major pro-ducers decide to withdraw. Customers fear for the continued avail-ability of a key input, and they are prone to shift to a substitute more quickly than otherwise. So firms that announce exit early can strong-ly influence the rate of decline. The rate also has a tendency to accel-erate as decline proceeds because shrinking volume raises costs and perhaps prices.
STRUCTURE OF REMAINING DEMAND POCKETS
As demand declines, the nature of the pockets of demand that remain plays a major role in determining the profitability of the re-maining competitors. These may offer more or less favorable pros-pects for profitability, based on a complete structural analysis like that outlined in Chapter 1. For example, one of the major remaining pockets of demand in the cigar industry is the premium segment. This segment is quite immune to substitution, has price-insensitive buyers, and is amenable to the creation of high levels of product dif-ferentiation. The firms that can maintain a position in this segment are well placed to earn above-average returns, even as the industry declines, because they can defend their positions from competitive forces. In the leather industry, upholstery leathers have been a sur-viving pocket in which technology and differentiation have the same effect. In acetylene, on the other hand, the market segments where acetylene has not been displaced by ethylene are threatened by still other substitutes, and in those markets acetylene is a commodity product subject to price warfare because of its high fixed manufac-turing costs. Thus profit potential in the remaining pockets is pretty dismal.
In general, an end game can be profitable for the survivors if the remaining pockets of demand involve price-insensitive buyers or those who have little bargaining power, because they have high switching costs or other traits like those discussed in Chapter 6. Commonly, remaining demand is price-insensitive when it is replace-ment demand and when demand from the manufacturers of the orig-inal equipment has disappeared. The profitability of the end game will also depend on the vulnerability of remaining pockets of de-mand to substitutes and to powerful suppliers, as well as the pres-ence of mobility barriers, which protect firms serving the remaining segments from attack by firms seeking to replace sales lost in disap-pearing segments.
CAUSES OF DECLINE
Industry demand declines for a number of different reasons, which have implications for competition during the decline phase:
Technological Substitution. One source of decline is substitute products created through technological innovation (electronic calcu-lators for sliderules) or made prominent by shifts in relative costs and quality (synthetics for leather). This source can be threatening to industry profits because increasing substitution usually depresses profits at the same time it cuts into sales. This negative effect on profits is mitigated if there are pockets of demand in the industry that are immune or resistant to the substitute and have favorable characteristics in the sense previously described. Substitution may or may not be accompanied by uncertainty over future demand, de-pending on the industry.
Demographics. Another source of decline is shrinkage in the size of the customer group that purchases the product. In industrial businesses, demographics cause decline by reducing demand in downstream industries. Demographics as a source of decline is not accompanied by the competitive pressure of a substitute product. Thus if capacity can leave the industry affected by demographics in an orderly way, surviving firms may have profit prospects compar-able to those before decline. However, demographic shifts are often subject to great uncertainty, which is destabilizing for competition in decline as has been discussed.
Shifts in Needs. Demand can fall because of sociological or other reasons which change buyers’ needs or tastes. For example, cigar consumption has fallen in large part because of cigars’ plum-meting social acceptability. Like demographics, shifts in needs do not necessarily lead to increased pressure of substitutes for remain-ing sales. However, shifts in needs can also be subject to great uncer-tainties, like those in cigars, which have led many firms to continue to forecast a resurgence of demand. This situation is very threaten-ing to profitability in decline.
The cause of decline, then, gives clues about the probable de-gree of uncertainty firms perceive about future demand as well as some indications about the profitability of serving the remaining segments.
2. EXIT BARRIERS
Crucial to competition in declining industries is the manner in which capacity leaves the market. Just as there are barriers to entry, however, there are exit barriers which keep firms competing in de-clining industries even though they are earning subnormal returns on investment. The higher the exit barriers, then, the less hospitable the industry will be to the firms that remain during decline.
Exit barriers stem from a number of fundamental sources:
DURABLE AND SPECIALIZED ASSETS
If the assets of a business, either fixed or working capital or both, are highly specialized to the particular business, company, or location in which they are being used, this creates exit barriers by di-minishing the liquidation value of the firm‘s investment in the busi-ness. Specialized assets either must be sold to someone who intends to use them in the same business (and if they are specialized enough, to use them in the same location) or their value is greatly diminished and they must often be scrapped. The number of buyers wishing to use the assets in the same business is usually few, because the same reasons that make the firm want to sell its assets in a declining mar-ket will probably discourage potential buyers. For example, an acet-ylene manufacturing complex or a rayon plant has such specialized equipment that it must be sold to another owner for the same use or scrapped. An acetylene plant, futhermore, is so difficult to disman-tie and transport that the costs of doing so may equal or exceed the scrap value. Once the acetylene and rayon industries began to de-cline, the potential buyers willing to continue to operate the plants up for sale were close to nonexistent; those plants that were sold were sold at enormous discounts to book value and often to specula-tors or desperate employee groups. Inventory in a declining industry may also be worth very little, particularly if it normally turns over very slowly.
If the liquidation value of the assets of a business is low, it is economically optimal for the firm to remain in the business even if the expected discounted future cash flows are low. If the assets are durable, the book value may greatly exceed the liquidation value. Thus it is possible for a firm to earn a book loss but it be economi–cally appropriate to remain in the business because the discounted cash flows exceeded the opportunity cost of capital on the invest-ment that could be released if the business were divested. Divesting the business in any situation in which the book value exceeds the li-quidation value also leads to a write-off, which has some deterring effects on exit that will be discussed later.
In assessing the exit barriers caused by asset specialization in a particular business, the question is whether or not there are any mar-kets for the assets as, or as part of, a going concern. Sometimes as-sets can be sold to overseas markets at a different stage of economic development, even though they have little value in the home country. This move raises the liquidation value and lowers exit barriers. Whether there are overseas markets or not, however, the value of specialized assets will usually diminish as it becomes increasingly clear that the industry is declining. For example, Raytheon, which sold its vacuum tube–making assets in the early 1960s when tube de-mand was strong for color TV sets, recovered a much higher liquida–tion value than the firms that tried to unload their vacuum tube facil-ities in the early 1970s, after the industry was clearly in its twilight years. Few, if any, U.S. producers were interested in purchasing by this later time, and foreign firms supplying vacuum tubes to less ad-vanced economies either had already purchased tube–making equip-ment or were in a much stronger bargaining position once U.S. de–cline was obvious.
FIXED COSTS OF EXIT
Often substantial fixed costs of exiting elevate exit barriers by reducing the effective liquidation value of a business. A firm often must face the substantial costs of labor settlements; in fact in some countries, like Italy, fixed costs of exit are effectively huge because government does not sanction a loss of jobs. The costly full-time ef-forts of a number of skilled managers, attorneys, and accountants will usually be consumed for a significant period when a company is divesting. Provision must sometimes be made for maintaining avail-ability of spare parts to past customers after exit; this requirement involves incurring a loss which, discounted, becomes a fixed cost of exiting. Management or employees may need to be resettled and/or retrained. Breaking long-term contracts to purchase inputs or sell products may involve substantial cancellation penalties, if they can be abrogated at all. In many cases the firm must pay the cost of hav-ing another firm fulfill such contracts.
There are often also hidden costs of exit. Once the decision to divest becomes known, employee productivity may be prone to sag and financial results to deteriorate. Customers quickly pull out their business, and suppliers lose interest in meeting promises. These sorts of problems, also problems in executing a harvest strategy as will be discussed later, may accelerate losses in the waning months of own-ership and may prove to be significant costs of exit.
On the other hand, sometimes exit can allow the firm to avoid fixed investments it would otherwise have had to make. For exam-ple, requirements to invest in order to comply with environmental regulations may be avoided, as may other requirements to reinvest capital just to stay in the industry. Requirements to make such in-vestments promote exit, unless making them yields an equivalent or greater increase in the discounted liquidation value of the firm, be-cause they raise investment in the business without raising profits.
STRATEGIC EXIT BARRIERS
Even if a diversified firm faces no exit barriers from economic considerations relating solely to the particular business, it may face barriers because the business is important to the company from an overall strategic point of view:
Interrelatedness: The business may be part of a total strategy involving a group of businesses, and leaving it would diminish the impact of the strategy. The business may be central to the corpora-tion’s identity or image. Exiting may hurt the company’s relation-ships with key distribution channels or may lower overall clout in purchasing. Exit may idle shared facilities or other assets, depending on whether or not they have alternative uses by the firm or can be rented on the open market. A firm terminating a sole supply rela-tionship to a customer may not only foreclose sales of other products to that customer but also hurt its chances in other businesses in which it is relied on to supply key raw materials or components. Vi-tal to the height of interrelatedness barriers is the corporation’s abili-ty to transfer resources freed up from the declining business to new markets.
Access to Financial Markets: Exiting may reduce the confi-dence of the capital markets in the firm or worsen the firm‘s ability to attract acquisition candidates (or buyers). If the divested business is large relative to the total, its divestment may strongly reduce the financial credibility of the firm. Even though a write-off is justified economically from the point of view of the business itself, it may negatively affect earnings growth or otherwise act to raise the cost of capital.3 Small losses over a period of years through operating the business may be preferable to a single large loss from this stand-point. The size of write-offs will obviously depend on how depre-ciated the assets in the business are relative to their liquidation value, as well as the ability of the firm to divest the business incrementally as opposed to having to make a once and for all decision.
Vertical Integration. If the business is vertically related to an-other in the company, the effect on barriers to exit depends on whether the cause of decline affects the entire vertical chain or just one link. In the case of acetylene, its obsolescence made downstream chemical synthesis businesses using acetylene as a feed stock obso-lete. If the firm was in acetylene as well as in one or more of these downstream processes, closing the acetylene plant either closed the downstream facilities or forced the firm to find an outside supplier. Although it might negotiate a favorable price from an outside sup-plier because acetylene demand was falling, ultimately the firm would have to exit from the downstream operations as well. Here the exit decision would have to encompass the whole chain.
In contrast if an upstream unit sold to a downstream unit an in-put that had been made obsolete by a substitute, the downstream unit would be strongly motivated to find an outside supplier to sell it the substitute input, to avoid worsening its competitive position. Thus the fact that the firm was integrated forward might hasten the decision to exit because the business’ strategic value had been elimi-nated and it had become a strategic liability to the company as a whole.
INFORMATION BARRIERS
The more related a business is to others in the company, partic-ularly in terms of sharing assets or having a buyer-seller relation-ship, the more difficult it can be to develop clear information about the true performance of the business. Businesses performing poorly can be hidden by the success of interrelated ones, and the firm might consequently fail even to consider economically justified exit deci-sions.
MANAGERIAL OR EMOTIONAL BARRIERS
Although the exit barriers described above are based on rational economic calculations (or the inability to make them because of fail-ures in information), the difficulty of exiting from a business seems to go well beyond the purely economic.” A consideration that turns up in case study after case study is management‘s emotional attach-ments and commitment to a business, coupled with pride in their abilities and accomplishments and fears about their own future.
In a single business company, exit costs managers their jobs, and thus may be perceived as having some very unpleasant conse-quences from a personal standpoint:
- A blow to pride, and the stigma of “giving up”
- Severance of an identification with the business that may be longstanding
- An external sign of failure which reduces job mobility
The longer the history and tradition of the firm and the lower the likely mobility of senior management to other companies and careers, the more serious these considerations are likely to be in de-terring exit.
Ample evidence suggests that personal and emotional barriers also extend to top managements of diversified companies. Managers of the sick division are in much the same position as those of a single business firm. It is difficult for them to propose divestment, so the burden of deciding when to exit usually falls on top management. Identifications with particular businesses can still be strong at the top management level, however, particularly if they are long-stand-ing or early businesses for the firm, are part of the historical core of the firm, or were started or acquired with the incumbents’ direct par-ticipation. The decision of General Mills to divest its original busi-ness (commodity flour) was surely an agonizing choice, for example, and one that actually took many years to make.
Just as identification can extend to top management of the di-versified firm, so can pride and concern for external image. This is particularly true, once again, when top management of the diver-sified company played some personal role in the business that is a candidate for divestment. Moreover, diversified companies have the luxury, in comparison to single business firms, of funding poor per-formers with profitable businesses, and sometimes of being able to avoid disclosing poor results in a sick division. This ability perhaps allows emotional factors to creep into decisions to divest in diver-sified companies, even though ironically one of the benefits of diver-sification is supposed to be a more detached, dispassionate review of investments.
Managerial exit barriers can be so strong that, as illustrated in a number of studies of divestment case histories, divestments did not occur until a change in top management took place even though the unsatisfactory performance had been chronic.5 Although this may be the extreme situation, nearly everyone seems to agree that divest–ments are probably the most unpalatable decision managements have to make.6
Managerial barriers can be reduced by experience with exit. For example, they appear to be less prevalent in firms in the broad area of chemicals, where technological failure and product substitution are common; in firms in sectors where product lives are historically short; or high-technology firms, who are more liable to perceive pos-sibilities for new businesses to replace declining ones.
GOVERNMENT AND SOCIAL BARRIERS
In some situations, especially in foreign countries, closing down a business is next to impossible because of government concern for jobs and impact on the local community. The price of divestment may be concessions from other businesses in the company or other terms that are prohibitive. Even where government does not become involved formally, community pressure and informal political pres-sure not to exit can be very high, depending on the situation in which the company finds itself.
Closely akin is the social concern that many managements feel for their employees and local communities, which may not translate into dollars and cents but is nonetheless real. Divestment often means putting people out of work, and it can mean crippling a local economy. Such concerns often interplay with emotional barriers to exit. In Quebec, for example, there has been tremendous social con-cern about closing down pulp mills in the depressed Canadian dis-solving pulp industry, many of which are in one-company towns. Executives are torn with concern for communities, and formal and informal government pressure has been brought to bear as well.7
Because of any or all of these types of exit barriers, a firm may continue to compete in an industry even though its financial per-formance is subnormal. Capacity does not leave the industry as it shrinks, and competitors grimly battle it out to survive. In a declin-ing industry with high exit barriers, it is difficult even for the strongest and healthiest firms to avoid being hurt in the process of decline.
MECHANISM FOR ASSET DISPOSITION
The manner in which the assets of firms are disposed of can strongly influence the potential profitability of a declining industry. In the Canadian dissolving pulp industry, for example, a major plant was not retired but sold to a group of entrepreneurs at a signif-icant discount to book value. With a lower investment base, man-agers of the new entity could make decisions on pricing and other aspects of strategy that were rational for them but which severely crippled the remaining firms. Selling the assets to the employees at a discount can have the same effect. Thus if assets in a declining indus-try are disposed of within the industry and not then retired, it is even worse for subsequent competition than if the original owners of the firms stayed in business.
The situation in which government subsidies keep ailing firms alive in declining industries is nearly as bad. Not only does capacity not leave the market, but also the subsidized firm can depress profit potential even further because it is basing its decisions on different economics.
3. VOLATILITY OF RIVALRY
Because of falling sales, the decline phase of an industry will be particularly susceptible to fierce price warfare among competitors. Thus the conditions that determine the volatility of rivalry outlined in Chapter 1 become particularly acute in influencing industry prof–itability in decline. Warfare among the firms that remain will be most intense in the decline phase in the following situations:
- the product is perceived as a commodity;
- fixed costs are high;
- many firms are locked by exit barriers into the industry;
- a number of firms perceive a high strategic importance in maintaining their position in the industry;
- the relative strengths of remaining firms are relatively balanced so that one or a few firms cannot easily win the competitive battle;
- firms are uncertain about their relative competitive strengths and many attempt ill-fated efforts at changing position.
The volatility of rivalry in decline can be accentuated by sup-pliers and distribution channels. The industry becomes a less impor–tant customer to suppliers as it declines, which may affect prices and service.8 Similarly, the power of channels will increase as the indus-try declines if distribution channels handle multiple firms, control shelf space and shelf positioning, or can influence the ultimate cus-tomer’s purchase decision. In cigars, for example, shelf positioning is crucial to success since cigars are an impulse item. The power of distribution channels for cigars has increased markedly during the industry’s decline, and sellers’ margins have correspondingly fallen.
Perhaps the worst situation from the standpoint of industry ri-valry during decline is the situation in which one or two firms are rel-atively weak in terms of their strategic position in the industry, but they possess significant overall corporate resources and a strong strategic commitment to stay in the business. Their weaknesses force them to attempt to improve position by desperate action, like price cuts, that threatens the entire industry. Their staying power forces other firms to respond.
Source: Porter Michael E. (1998), Competitive Strategy_ Techniques for Analyzing Industries and Competitors, Free Press; Illustrated edition.