India Economy

Of entry barriers, high and low

Shyam Pattabhiraman | Updated on March 16, 2013 Published on March 16, 2013

Sectors with low entry barriers make happy hunting ground for foreign companies.

Barriers make it difficult for new firms to enter the market. This protects the incumbents’ revenues and profits.

As global players are increasingly looking to enter India, it is essential to identify the sectors and participants that are more likely to become easy prey to foreign entrants.

This insight would help in shaping better strategies both from a business and investment standpoint.

Construction players

Back in 2007, when India was at the peak of the infrastructure boom, the construction equipment sector seemed to offer huge growth opportunities never imagined before.

Soon a profitable sector with a few players turned into a melee of new entrants trying to grab market share.

Almost every major player entered India either directly or through a joint venture. When the sector was subsequently hit by a slowdown, the players realised that the pie was not large enough for everyone and may not be for a long time to come.

The threat of survival has increased competitive intensity (for example, through price reduction and other offers despite cost increase) to such an extent that today the margins in the sector have reduced to low single-digits against average margins of nearly 10 per cent that players reported back in 2007.

The erosion of profitability can be observed in the financials of listed construction equipment players such as Action Construction Equipment and TIL India. One of the factors behind the current state of affairs is low barriers to entry.

Farm equipment

Compare this to another sector — agricultural equipment — which also holds equal promise owing to increasing farm mechanisation.

However, this sector has not seen the extant of new entrants and level of competition as the construction sector has.

One possible reason for this is higher barriers to entry. If there are barriers, it is difficult for new firms to enter the market and, as a consequence, the incumbents are more protected both in terms of top-line as well as bottom-line.

In India, with farmlands being much smaller in size compared to global standards and farmers having unique requirements for their equipment, there is need for a high degree of indigenisation of products in addition to strong customer support and trust factor for breaking into the market.

These require years of experience, where incumbent Indian players have an advantage over foreign entrants. As a result, even the John Deere’s of the world are taking it slowly. Is it just a question of time before the floodgates open in the agri sector too and what happened in construction equipment gets re-enacted?

Well, its hard to predict, but my guess is that it is more likely to happen through acquisition of incumbents. So, in some sense, incumbents may continue to hold the trump card.

Consumer durables

Another sector that has been the victim of too many new entrants is the consumer durables sector — air conditioning to be more specific. This has impacted even a brand as Voltas, which has had to accept significant shrinkage in margins to protect volumes.

Strangely, despite the erosion in profitability for the entire sector, there seems to be no respite in the growth ambitions of market participants, because no one is willing to let go. Clearly, this trend is not sustainable in the long run.

Gas pipelines

Examples of sectors with high barriers to entry are gas pipelines, banking and FMCGs. In the case of the former, pipelines take years to lay and even more to break-even, but they are the most efficient way to transport gas — an increasingly popular fuel of choice.

Incumbents which already have a well-established infrastructure have a huge advantage over new entrants (for example, pre-established last mile connects with customers) and are also likely to translate this to pricing power.

There’s a catch though — pricing is regulated. Despite this, existing players like GAIL, Indraprastha Gas and Gujarat Gas record above average profitability.

Banking and brand loyalty

Banking is also a regulated industry, but regulation actually works in favour of incumbents due to licences required to open new branches and the general bias against foreign banks.

Moreover, banks also have sticky customers — I mean how many times have you considered changing your bank account? These provide them with good prospects for durable profits as long as they don’t do something outrageously irrational such as the US sub-prime episode.

FMCG also provides advantages for incumbents, thanks to established brand loyalty. Global players aspiring to enter would be better off acquiring existing brands in the segment rather than launching new ones.

Godrej Consumer — an aspiring Indian multinational in this space — is following a similar inorganic strategy for entry in Africa.

In addition to providing high barriers to entry, the same brand loyalty also translates to pricing power in this sector — a vital factor to protect profits given the rate at which inflation is inching up in the country.

Forces of competition

Michael Porter originally defined five forces — substitutes, suppliers, potential entrants, buyers and competitors within the Industry — that can affect the competitive environment.

Bruce Greenwald, a professor of finance at the Columbia Business School, in his breakthrough book Competition Demystified talks about how ‘barriers to entry’ — the force that underlies “potential entrants” — is the most important of all.

In his book he states: “Essentially there are only two possibilities. Either the existing firms within the market are protected by barriers to entry (or to expansion), or they are not. No other feature of the competitive landscape has as much influence on a company’s success as where it stands in regard to these barriers.”

The world isn’t entirely flat in that sense as painted by Thomas Friedman in his famous book World is Flat. Sectors with steep gradients do exist, and will continue to do so for a long time to come.

The challenge is that they require a keen eye to spot. But investors and businesses that identify and stick to such sectors are likely to be better off, thanks to the rewards of unfair competitive advantages.

‘Barriers to entry’ is what Warren Buffett refers to when he says that he prefers to acquire companies with wide moats and he advises the management teams in his existing companies to keep widening the moat and throw crocodiles in them.

His view: It is much better to have a small market with high barriers to entry rather a large market with none.

(The author is a business consultant. Feedback can be sent to > The views are personal.)

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Published on March 16, 2013
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