I recently finished Creating Shareholder Value By Alfred Rappaport and although I found it a little overly complex, I do think it has a host of very good and very usable information. I won't be reviewing the book, but I do want to focus on his section on competitive analysis, as I felt it was one of the most valuable areas of the book.
Rappaport breaks down his competitive analysis into three parts:
Industry attractiveness
Competitive position
Competitive advantage
In this post, I will focus on number 1. At some point, I might delve more into 2 and 3.
Industry Attractiveness
When looking at industry attractiveness, he uses Porters Five Forces as his guidelines:
Demand variability: how stable/unstable is the demand for the industry's product? More stability = less risk.
Sales price variability: how volatile are the sales prices of an industry's products? Less volatile = less risk.
Pricing Power: does a firm in a specific industry have the ability to easily increase the sale price if the price of inputs increases? Greater pricing power = less risk.
Input Price variability: are input prices stable/unstable? More stability = less risk.
Operating leverage: does the business have a high percentage of costs that are fixed? The higher the fixed costs, the less more risk a firm is exposed to if demand declines.
Going forward I will be using this industry attractiveness analysis as part of my checklist. But let's use this framework on one of my holdings that has a bright future currently, and over the next few years (at least), Micron! I'll be focusing on the DRAM segment of Micron's business.
Demand Variability
The demand of the entire DRAM industry has a long history of being unstable. This is what created the opportunity for getting cheap Micron shares in the first place. Due to the industry being less disciplined about controlling supply, the prices of DRAM varied widely. But this was also during a time that DRAM was almost exclusively used in PCs. With the quick advancements of technology, there are more and more products using DRAM semiconductors, meaning the cyclicality of the demand is diminishing.
A good analogy is if a company has one client buying all its products. If that client no longer needs/wants the product, the demand will decrease, and the price will go down (or you're stuck with a bunch of inventory). But if you have a number of different clients buying your product, and one of those clients might have a lower demand for a time, the remaining diversification will lessen the blow. Now that DRAM is used more and more in Mobile devices (due to 5g), Servers, IoT, EUV's, it's pretty hard to see the demand decreasing significantly any time soon.
Sales Price Variability
This goes hand in hand with the demand variability above, however, this is more focussed on the supply side of things. As I mentioned above, more disciplined CAPEX spending by all three members of the DRAM oligopoly as well as some consolidation in the industry has made it so no one is flooding the market with supply. As long as all parties involved are able to keep demand at or above supply, the DRAM spot and contract prices won't go down.
I have no idea if this will last forever, but it seems like right now, even though demand is high, CAPEX doesn't seem to be getting out of control like it once did. This disciplined CAPEX allows the DRAM pricing to stay at a somewhat stable level, and as demand increases, as it is now, results in increased ASP's (average selling prices) and massively increased margins.
Pricing Power
When it comes to pricing power, the nature of an oligopoly means good things. As long as the supply from all three players doesn't get too out of whack with demand, all three players can reap the benefits of increased demand. I'm not saying these players are working together to screw over their buyers, but they realize at this point, that keeping CAPEX under control, allows for all parties involved to maintain high margins, and stay profitable.
If you were to compare this to say a franchise like Coca-Cola, then I'd say no, the pricing power isn't the same. The product differentiation isn't much different between Micron, SK Hynix, and Samsung in DRAM. So one company probably won't be able to increase prices much, without a buyer looking at one of the competitors for a better price. But the industry as a whole can increase prices based on advancements in technology, but these technological advantages usually only last a few quarters at best before their competitors catch up.
So, on the topic of pricing power, the industry as a whole has pretty good pricing power, but individuals in the industry don't have much pricing power.
Input Price Variability
Input prices tend to be pretty steady for the industry and individual players in the DRAM market. If you look at Micron's cost of goods sold over the last decade, it has essentially gone up linearly. The reason revenue growth doesn't go up linearly, is because of the legacy cyclicality of the industry.
Management has said they are experiencing some supply chain issues along with everyone else in the world due to COVID, but that these are likely to subside into the second half of 2022. It also doesn't seem like these supply chain issues are actually affecting the input price of their materials.
Operating Leverage
The DRAM players all tend to have high fixed costs, here are Microns TTM
COGS: $17.318B
OPEX: $3.71 B
CAPEX: $8.879 B
This industry doesn't have a tonne of cost-cutting opportunities like other industries might. The cost of goods sold won't be going down anytime soon unless they want to take a huge hit in market share and revenues. OPEX will need to stay high so they can continue their market-leading R&D and attract talent to their workplace. CAPEX spending will always go up due to the new fabs being built to build smaller and more advanced semis and to keep up with competitors.
The good thing about Micron is that it showed during a massive downturn in ASP's, that it can stay profitable. At one point in its history, this was not possible, but now that there has been industry consolidation, and more disciplined CAPEX spending, the black cloud of unprofitability has become a much lower probability event than in the past.
Micron's long-term debt is currently sitting at $6.9B. Their FCF could pay this off in about 4.5 turns. Not the greatest coverage I've seen, but given the increased stability in operations, I don't think that debt is much of a problem for them.
To finish this section up, I want to go over some valuable industry insights to really cement my understanding. These are questions that should be answerable after a thorough industry analysis, as outlined by Rappaport.
How attractive is the industry as a whole?
At this point, I think it's quite an attractive industry:
- 5G will continue mobile growth
- EVs will continue to get smarter and smarter and require greater computing power
- IoT in both residential and industrial will continue to proliferate increasing the efficiency and performance of human employees
- Servers will continue to get larger and larger as more and more businesses around the world move to the cloud
- PC's will continue to become more powerful requiring more powerful parts
What critical factors create the most value in the industry?
The number one factor is keeping supply at or below demands. This ensures the ASP stays elevated and that margins will remain high
How sensitive is the value of companies in the industry to a change in key factors?
Industry participants are quite sensitive to changes in ASP. If supply exceeds demand, there isn't much that can be done other than wait for a 180. In the case of this happening all participants will see income, and margins contract. The silver lining for Micron is that they actually survived the last down cycle of semis and were still able to eke out a profit despite the ASP's dropping significantly.
A prolonged DRAM glut would have severe consequences on all players. If ASP's were to stay depressed over a multi-year period, you could see some of these producers, would have issues paying back debts, and keeping the lights on. However, since semis are now intertwined with governments and the functioning of our future, it's unlikely that governments wouldn't bail these companies out. So I give the probability of a prolonged supply glut over the next 5 years a pretty low number, say 2-5%.
If ASP's go down, earnings shrink, so you usually see share prices decrease due to earnings and multiple contractions.
How might individual entities and the industry as a whole, be affected by changes in industry structure, by competitive and general economic environmental by other pressures?
As discussed above, the key factor is keeping ASP from being in a prolonged trough. Since the industry isn't making products with too much differentiation, it will be hard for one company to take up too much market share. A general economic downturn would have less of an effect on ASP's than you might think. You can see there wasn't a drop-off during the beginning of the Coronavirus.
With the explosion of 5g, EV, AI, Cloud, Big Data, IoT, I don't see much stopping the increases over the next decade, but I don't have a crystal ball. I'm willing to bet money that Micron will continue to go up in price, so I think you can see what side I'm on here.
One note of importance is China. The Chinese have been attempting to crack into the semis industry for years now unsuccessfully. They've spent billions on fabs, that hasn't produced anything that would be in direct competition with Micron, yet. The day could come, where Chinese versions of DRAM are produced cheaper than Micron can produce it, which could result in a supply glut. I deem this a likely probability but is still a few years/decades into coming to fruition.