Show Me the Money: Analyzing Porter’s Five Forces

Imagine you had $1,000 to invest any way you wanted to. What part of the economy would you investigate to find a good bet? Would you go with the airline industry and gamble on the popularity of air travel? Would you choose the cell phone market because, hey, everyone’s gotta have one? Would you go with snack food? Sneakers?

How would you choose the best industry in which to invest your money?

How the Money Is Made

Economist Michael Porter has already asked that question – and come up with an answer. In 1980, he wrote a book, Competitive Strategy, in which he came up with five economic forces to explain why certain industries persistently outperform others. Those five forces are: rivalry; the threat of substitutes; buyer power; the threat of new entrants; and supplier power. These five forces have been successful for 30 years at evaluating why some industries consistently do better than others, says Joe Mahoney, professor of strategic management at the University of Illinois.

“It’s a fundamental way to analyze an industry,” Mahoney says of Porter’s five forces. “Warren Buffett is a very old-school investor and always says he will not invest in any business unless he understands how it makes its money. Porter’s five forces model is one tool to understand how the money is being made.”

Assume you were thinking of buying stock in an online pet product retailer, like Chewy, Inc., which went public and started trading its shares on the stock market in June 14, 2019. Everyone loves dogs — so, why not? Using the Porter’s Five Forces framework, you might hold off before plunking your money down in the industry — or maybe you would see it as a prudent investment. Here’s how it works:

Rivalry: An important piece of history is that Chewy was acquired by PetSmart, a bricks-and-mortar pet retailer, in 2017 in one of the largest-ever acquisitions of an e-commerce business. The industry in which Chewy operates includes pet food and treats, pet supplies and pet medications, other pet-health products, and pet services; Chewy operates entirely online. Competition in the pet products and services industry is strong, particularly within the online e-commerce channel as the industry shifts from in-store to online shopping. While Chewy is a leader in the online pet product industry, it has many competitors, including BarkBox, Petco and PetEdge. Giant online retailer Amazon.com is the leader in pet-product e-commerce.

Threat of substitutes: What is the threat of customers shifting to a different product that achieves a similar result? In the case of Chewy that threat is low, because few, if any, products can be substituted for pet food and related products.

Buyer power: When it comes to Chewy, this is a bit of a mixed bag. Since it is easy to hop from one online pet-product retailer to another, buyers can choose to switch fairly easily if they have a bad experience or find a better deal (or if they happen to be on Amazon). That said, automation is starting to influence their e-tailer choices. An increasing number of consumers are turning to subscription-based purchasing in the online pet-product industry. For instance, Chewy has seen growth in its autoship subscription program, which provides customers with automatic product ordering, payment and delivery.

Barriers to entry: There are not many. It takes some computing power, a sales team, product suppliers, and funding to get a pet e-commerce site in motion, and all can be accomplished fairly cheaply. In the ongoing shift to e-commerce, some pet-product distributors are even helping independent retailers in the industry to establish their online presence. Consumer demand is certainly there. According to the American Pet Products Association 2018 Packaged Facts report, spending on the overall pet market grew from $73 billion in 2014 to more than $95 billion in 2019. Packaged Facts, which does market research, also reported that online pet product revenue hit $11.4 billion in 2019, a 40% increase in sales from 2018 and a 256% increase from 2015. Chewy reported in its 2019 annual report that so-called “pet humanization,” in which people increasingly see their pets as part of the family, is helping to drive the trend.

Supplier power: Suppliers may have some bargaining power because of their size and quality, but in general, supplier power is low for e-commerce. Costs are pretty low for e-commerce companies to switch from one supplier to another. The COVID-19 pandemic has raised supply-chain issues, particularly for companies that buy from distributors outside the U.S. in countries like China. According to a post-IPO report on Chewy in TheStreet, which ran in April 2020, most of the firm’s products are sourced in the U.S.

Don’t Forget Cooperation

So does the online pet-product industry pass muster for a potential investor? That’s up to the investor, Mahoney says. Chewy’s stock price could offer a clue. Since it went public in June 2019 at $22 a share, the stock has fluctuated, but not dipped below $22. It has gone as high as $46.18.

Ultimately, Porter’s five forces analysis can’t answer all the questions you might have about making an investment, Mahoney adds. The model only works at an industry level, so even if you decide to invest in a pet-product e-commerce business, you will have to do more research to find the right company.

And the model focuses entirely on competition and ignores another force, which some consider to be the sixth part of the Five Forces model: cooperation. “For some companies, there are complementary companies to consider,” Mahoney says. “How valuable a computer company’s hardware is depends on the amount and quality of the software available. Joint ventures, alliances, networks — all kinds of companies are working together in various ways to create more areas of cooperation, and that affects the industry’s investment chances.”

Conversation Starters

Why is Porter’s Five Forces model considered an important tool in evaluating an industry? What are its limitations?

Would you invest in Chewy or another online pet product site? Why or why not?

How might corporate “cooperation” affect an industry’s financial well-being?

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