Wednesday, November 12, 2014

Is industry consolidation overrated?

Recently, an investor I follow on Twitter wrote: "Most overplayed investment theme: bad industries consolidating leading to rational competition and price increases."

My sense is that he's right: industry consolidation is a precursor to oligopolistic pricing, but it's not enough by itself. In industries with minimal barriers to entry, the benefits of consolidation are usually temporary for a variety of reasons:

• If the industry is cyclical and has long lead times between capital investment and returns, it's easy for players to misjudge the cycle and overbuild regardless of how consolidated the industry is.

• Often the consolidation happens during an economic boom and merely amplifies pricing power that already existed. Once the boom ends, pricing discipline breaks down.

• If the industry consolidation is financed with debt, the newly-consolidated players may overproduce in order to generate the cash flow they need to meet their debt obligations.

• Price increases attract new entrants, and these entrants have no institutional memory of the hard times that would restrain them from overproducing.

There are also some circumstances in which consolidation actually worsens industry dynamics. In 2011, the coal-mining industry consolidated when coal prices were near their peak, and as Credit Bubble Stocks writes:

The mergers resulted in a funny kind of adverse selection where the most bullish managements with the worst historical sense and facility at market timing ended up controlling capital allocation for the whole industry.

Sometimes consolidation gives an industry greater financial resources: economies of scale, lower borrowing costs, etc. If it gains these resources but lacks pricing discipline, then consolidation really just gives the industry players more rope with which to hang themselves.

Examples of "bad oligopolies"

Iron ore is the quintessential bad oligopoly. A handful of companies dominate iron-ore mining, but it has minimal pricing and cap-ex discipline, there were a bunch of aggressive new entrants during the boom years, and the major players recently started a price war.

Several prominent hedge funds have invested in Greek bank stocks. Their belief is that the Greek banking system is poised to earn high returns on equity because it's consolidated into four players.  Vienna Capitalist has written an excellent post critiquing this assumption:

In real life it is difficult to count the “true” number of players. You could have a lot of players in one sector, some of which occupy a niche in that market allowing them to still earn high ROEs. Alternatively, you could have only one or two players but competitive prices and average profitability. How? Well, they might be so-called “Contestable Markets” where the threat of another player entering the market keeps prices down. Airline routes are a classic example for the latter. 

According to the Austrian School, a competitive market CANNOT be meaningfully defined by the number of buyers/sellers, as the classic perfect competition model suggests. What MATTERS instead is whether there is free entry/exit into a particular market. As value investors only know too well: without barriers to entry a business is poised to earn mediocre returns, no matter how many players…

The bull case for Greek bank stocks states that all the other European countries with consolidated banking systems have high ROEs. Vienna points out that those countries have all experienced large, secular increases in debt as a percentage of GDP, and this debt tailwind may be the real reason for their high returns. They're consolidated and they earn high ROEs, but the former didn't necessarily cause the latter.

Airlines and HDDs

In the past few years, the hard disk drive industry has consolidated into three players and the American airline industry has consolidated into four major players. Both industries are earning large profits right now, but I wouldn't be surprised to see either of them revert to being a bad oligopoly. (Note: I'm far from being an expert on these industries, so my opinions could be partly or totally wrong.)

My concern with airlines is that while the industry has consolidated and arguably become more rational in the United States, it seems to be much less rational elsewhere. Reuters has an article (hat tip to Jake Freifeld) describing how foreign budget airlines are ordering lots of planes they don't need so they can get into the leasing business. If these would-be lessors misjudge demand and create a glut of aircraft, that could make it cheaper for entrants in the American market to acquire new planes. It could also reduce the value of the assets the American incumbents use to secure loans.

The risk with hard disk drives is well-known: flash memory is taking share. The price difference between flash and HDDs seems to be decreasing both relatively and absolutely. I think absolute difference is the important one: if there's a $350 difference between similar-sized drives, few people will be interested in flash. But if that falls to only $30 or $40, flash may actually be the better deal considering speed and power consumption.

I switched to a flash drive a year ago and noticed a big improvement in speed. Notably, my old hard drive was 500 gigabytes but I was using very little of that, so I only needed to buy a 120-gigabyte flash drive. That narrowed the effective price difference between HDDs and flash.

Over the years I've read various articles about flash memory shortages, so I assume there are supply constraints that prevent flash from displacing HDDs quickly. I don't find that particularly reassuring, though. Aldi and Lidl are relatively small upstarts in the British supermarket industry, yet they seem to have seriously damaged the incumbents' profitability. That's a glib comparison-- there are big differences between supermarkets and HDDs-- nonetheless, disruptive competitors often have an outsized effect on pricing and margins.

1 comment:

  1. I love it when two companies merge to unlock value and then that company eventually breaks into two different companies to unlock value.

    I'm supposed to believe that it is a perpetual motion unlocking value machine, lol. Sigh.

    And on a slightly related topic...

    Almost Live - Roscoe's Rug Emporium Featuring Pat Cashman


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