Hey there. My apologies that this one arrived a little late in the week. I'm building my product and coding all week. Coding can literally exhaust 100% of my brain juice and patience that approaching the end of the day/week, I just can’t do anything else. So I specifically set aside a few days just to read and write. I’ve planned ahead so the rest of this series should arrive regularly (Mon 8 AM). Let me know how you find the content so far. If you know React, help appreciated. 🙏
Chain Owner
Defining an industry is not straightforward. The real estate industry is big. Vanke (Note: SZSE: 000002, a residential real estate developer) certainly is in the real estate industry. What about Lianjia (Note: "Homelink", an offline & online real-estate brokerage)? Yes. Construction companies? Design companies? Yes, them too.
When we describe an industry as big, we have to consider that there may be many participants in the industry, and we also have to consider the structure of the industry chain.
An industry can be big, but every link in the industry can be very different. Every industry chain has a Chain Owner (“the apex predator”), who lives most comfortably in the industry and has the most initiative during an industrial change. In contrast, if you are not a strong player in your industry chain, you may be more passive when the industry changes.
For example, in the PC industry, the Chain Owner is Microsoft. Now they're moving into Cloud Computing, which means that their software and operating systems may not be sold directly, but through the cloud. (Note:i.e. Azure Marketplace)
Smiling Curve
One of the theories that describe the industry chain is the Smiling Curve coined by a Taiwanese entrepreneur, Stan Shih, the founder of Acer Inc.
The smiling curve is a graphical depiction of the value-adding potentials of different stages of the value chain in an IT-related manufacturing industry…According to Shih’s observation, in the personal computer industry, both ends of the value chain command higher values added to the product than the middle part of the value chain. If this phenomenon is presented in a graph with a Y-axis for value-added and an X-axis for value chain (stage of production), the resulting curve appears like a “smile“. - Wikipedia
Smiling Curve (Image: created by Rico Shen for Wikipedia)
The best place to be in an industry chain is either upstream - close to core inputs or downstream - close to the end consumers.
This theory usually applies to industries with a long chain. However, some industries may be more complex and it’s not as clear-cut. Of particular interest is the Ecosystem Model which is prevalent for Internet businesses.
Internet Ecosystems
Unity in Gaming
Unity (NYSE: U) recently IPO-ed at a ~$20B market cap. Their main product is the game engine. However, if they only sell the game engine, they’re just a technology vendor, and there’s no way they can command such a high market cap.
Unity is building an ecosystem for the gaming industry (and more). For example, when you’re developing a game, you usually need some assets. So Unity has an Asset Store for gaming assets. Unity also has other ecosystem offerings such as Distribution Portal (downstream) and educational programs (upstream).
Let's look at what Amazon did to the book publishing industry in the U.S. Books isn’t a big industry per se. Amazon started their “Everything Store” with books. To sell more books, Amazon incorporated book reviews. In China, bookselling (JD.com, DangDang) and reviews (Douban) are separated.
Next, Amazon did e-books with Kindle. After purchasing the copyrights, Amazon digitalized all these books and distributed them via Kindle. Now, when both your paper books and e-books, as well as book reviews, are all on Amazon, publishing seems a natural thing for Amazon to do.
When authors write their books paper-first, there is an extra step of converting them into Kindle e-books. So Amazon offered the option to let the authors write directly in the Kindle format, then Amazon helps them to publish back in the traditional paper form.
This reversed the traditional publishing process and like so, Amazon accelerated the digitization of the publishing industry and improved industry efficiency, and established the industrial ecosystem.
Conversely, if establishing an industrial ecosystem can improve industry efficiency, then you must either become an ecosystem builder or join as a productive member, otherwise, you will be eliminated from the ecosystem. (as shown below)
Food Delivery
The food delivery industry doesn’t have too many links in the chain, but there is a small ecosystem going on.
When Meituan Delivery started, there are already 30+ food delivery companies in the market. To make food delivery websites, there must be engineers. These companies i) started earlier than Meituan and ii) have experienced engineers. I approached some of them about acquisitions, so Meituan can straightaway pick up these industrial experiences and put them to use, rather than starting from scratch. Cash, stock, valuation, whatever can be discussed.
However, none of them accepted our offer. They said, “We’ve raised money. We have product, tech, customer service teams. We’re a fully functioning company. Your offer price is too low.”
I told them at the time, “You know, at the end of the day, there will only be 2 or 3 companies that remain. The way you guys operate won’t survive till the end.” (Note: Why so covered in #005 Market Concentration.)
I was just stating the rule of the industry in a matter-of-fact way. But they felt I was too arrogant and unfriendly, so they refused to deal.
Alright, so no acquisition, we started to build the product ourselves. Later, these guys came back saying, “Now we’re willing to be acquired.”
I replied, “Sorry, we already have these things because we’ve built them. There are very strong Scale / Network Effects in the industry. If you’re not top 3, you don’t have much chance. Go see if Alibaba (Ele.me) wants to buy you. If they won’t buy, then pivot as soon as possible.”
They asked, “What should we pivot to?”
I said, “Delivery requires a lot of delivery drivers, and managing the delivery drivers has anti-network effects. So Meituan and Ele.me will definitely do two things:
Contract out the smaller cities to agents.
Develop a lot of franchisees for the delivery operation.
You have two options:
Choose a few smaller cities (hundreds of thousands of population) and work as agents to Meituan or Ele.me. You guys already have the experience. That’s better for both you and Meituan / Ele.me.
Work as delivery franchisees. (Note: White-labelled 3rd party logistic provider I presume)
Both businesses can be profitable. Pivot early to become ecosystem players in the delivery industry. Both options don’t need R&D, so you have to cut your R&D team.”
That is a tough choice. Some companies did make the tough choice and pivoted to become ecosystem players and survived, and even survived pretty well. Others hesitated and never made the pivot, then got eliminated from the ecosystem.
Porter’s Five Forces Framework is a method for analysing competition of a business…five forces that determine the competitive intensity and, therefore, the attractiveness (or lack thereof) of an industry in terms of its profitability. - Wikipedia
Porter’s Five Forces Framework (Image: created by Denis Fadeev for Wikipedia)
Not every one of the five forces has to do with the industry chain, but the theory did describe the relationship between upstream and downstream. Downstream is your customers, and upstream is your suppliers.
Looking at a business from a simplified POV, usually, it has both upstream and downstream. There are few businesses whose upstream or downstream are at the end of the chain. Weibo is one such exception - the people who produce content are the end upstream, and the people who consume content are the end downstream.
What affects the relationship between upstream and downstream?
A core factor is market concentration. For a company, the best situation is that the concentration of both your upstream and downstream are very scattered, and only your concentration is high. This kind of luck is hard to come by.
But if
your upstream or downstream concentration is higher than yours, or
because of your high concentration, your upstream and downstream have to game with you to change your concentration,
the game will persist for a long time.
Consider what happens when you are in an industry where your upstream has a high concentration (the extreme case would be you only have one viable supplier) - you want to reduce your reliance. Qualcomm is the leading mobile phone chips manufacturer, but Apple and Huawei also have their own chips.
The Game between Airlines and OTAs
Let’s look at an example related to Meituan. Meituan sells air tickets, and the concentration in the airline industry has slowly increased in the past. The largest OTA selling air tickets in China is Ctrip (now Trip.com), followed by Tongcheng-Elong (0780.HK), Fliggy (by Alibaba), and Meituan.
In all, there are 5 or 6 meaningful OTAs. And there are 4 big airlines in China - China Eastern Airlines, China Southern Airlines, Air China, and Hainan Airlines, and many non-competitive smaller ones. The industry has similar numbers of upstream and downstream companies. When the numbers of upstream and downstream companies are almost the same, and the numbers are small, fierce games will occur.
Game between upstream and downstream
We’ve noted earlier the importance of market concentration. The reason for the emphasis is that you should not let your business objectives go against the laws of the market -in this case, your upstream or downstream can interfere with your market concentration. Airlines don’t want the concentration of OTA to be too high, because it results in OTAs having too much bargaining power. But there are always companies that don’t respect the laws of the industry. In this case, Ctrip.
Ctrip acquired Qunar in 2015, and Qunar should be the second-largest OTA, only behind Ctrip. Informed eyes knew exactly what Ctrip was up to - it wants to expand its presence and market share in the OTA industry and ultimately gain stronger bargaining power over its suppliers. (and buyers perhaps.)
If there are fewer OTAs and more airlines, then the airlines would have to compete for tickets sold through OTAs. The airlines saw that coming so they strategized a countermeasure.
They did two things. Firstly, the airlines gathered together to lobby government agencies and industry associations to pass government-sanctioned industry standards, which include reducing the agent commission rate.
In the past, there’s no stipulation on OTA’s commission rate. Once a flight is scheduled, the marginal cost to serve another passenger is close to zero, which results in high flexibility in pricing. If a ticket is priced at $800, the airline can continuously lower the price to match with demand, despite higher and higher commission rates charged by the OTAs. If there are many OTAs, at least there is some room for the airline to game between them.
But when OTAs merge, that room is gone. Since the number of airlines is small, they can collude to reset industry rules. If I’m not wrong, now OTAs cannot raise commission rates over 0.8%, which led to a sharp reduction in profits in the OTA industry. You might have merged with your competitor and you have a larger combined market share, but the increase in market concentration led to vehement reactions downstream, and your market space got compressed.
The second thing was that airlines became motivated to groom other OTAs, which lead to the growth of smaller OTAs. This caused the market share that Ctrip gained through the merger to fall back. Data shows it’s still declining.
This is a typical upstream-downstream game. When you go against the market concentration that a link in the chain should have, and to pursue supernormal profits, you will definitely be pushed back by market forces. The consequence of the pushback is that Ctrip’s stock price has been stagnating over the past ten years, despite the tremendous growth overall in China. (Note: 4-5X market cap over 10 years, 2-3X from 2015 onwards, “stagnating” by Internet / China measures)
Trip Group Market Cap 2010 - 2021 (Source: Macrotrends)
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This is pure goldmine.