A VALUATION ANALYSIS OF. As of November 1, 2007

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1 A VALUATION ANALYSIS OF As of November 1, 2007 Will Armistead Rebel Blackwell Blake Ramsey Mackenzie Scott Jennifer Stout 1 P age

2 Table of Contents Executive Summary... 4 Industry Analysis... 5 Financial Analysis, Forecast Financials, and Cost of Capital Estimation... 6 Accounting Analysis... 7 Valuations... 8 Industry and Company Overview Five Forces Model Rivalry Among Existing Firms Threat of New Entrants Threat of Substitute Products Bargaining Power of Buyers Bargaining Power of Suppliers Value Chain Analysis Competitive Advantage Analysis Accounting Analysis Identify the Key Accounting Policies Assess Degree of Potential Accounting Flexibility Evaluate Actual Accounting Strategy Evaluate the Quality of Disclosure Sales Manipulation Diagnostics Core Expense Manipulation Diagnostics Identify Potential Red Flags Undo Accounting Distortions Financial Analysis Liquidity Analysis Current Ratio Quick Asset Ratio Inventory Turnover Days Supply of Inventory Receivables Turnover Days Sales Outstanding Profitability Analysis P age

3 Operating Expense Ratio Operating Profit Margin Net Profit Margin Asset Productivity Return on Assets Return on Equity Capital Structure Ratios Debt to Equity Times Interest Earned Debt Service Margin Credit Analysis Internal and Sustainable Growth Rate Financial Statement Forecasting Valuation Analysis Methods of Comparables Intrinsic Valuation Discounted Dividends Valuation Free Cash Flows Valuation Residual Income Valuation Long Run Return on Equity Residual Income Valuation Abnormal Earnings Growth Valuation Appendix References P age

4 Executive Summary Investment Recommendation: Overvalued, Sell (11/1/07) MASNYSE(Nov. 1, 2007) $23.27 Cost of Capital Estimates R 2 Beta K e 52 week range $23.37$ month % Revenue $ 12,778,000,000 2 year % Market Capitalization $ 8,993,000,000 5 year % Shares Outstanding 383,890,000 7 year % Percent Institution Ownership 94% 10 year % Book Value/ Share $11.64 ROE 10.07% ROA 3.89% Altman Zscore Intrinsic Values Discounted Dividend $ FCF $ RI $ AEG $ LRROE $15.93 Financial Based Valuations Valuation Estimates Actual Price (11/1/2007) $23.27 Trailing P/E $16.93 Forward P/E $15.61 P.E.G. $16.23 P/B $38.17 Published Beta 1.04 P/EBITDA $38.19 K d (BT) 5.81% P/FCF WACC(BT) 8.86% EV/EBITDA $18.88 K e (BT) 10.97% 4 P age

5 Industry Analysis The beginning of Masco Corporation was first started in The firm integrated from the automotive parts industry into one of the top general building materials industry leaders. Today Masco has solidified their dominance within the building materials industry and remains extremely competitive and profitable. They produce and distribute their products in five segments; Cabinets and Related Products, Plumbing Products, Installation and Other Services, Decorative Architectural Products, and Other Specialty Products. In order to manufacture and produce these products Masco controls 75 manufacturing plants and 64 warehouse and distribution facilities in North America alone. Additionally, Masco operates over 280 local installation facilities, and 60 distribution centers focusing strictly on the Installation and Other services segment. Masco is among the largest manufacturers in North America of brandname consumer products designed for the home improvement and new home construction markets. (Masco 10k) The main competitors within the industry are American Standard (TT), American Woodmark (AMWD), and Sherwin Williams (SHW). Existing firms are capable of remaining in the industry due to a highly concentrated and slow growth industry, with the benefits of economies of scale. This forces high competition and limits the opportunity for new entrants into the industry very unlikely. Within the industry there is a high threat of substitute products, causing the switching costs for customers to be very low. Firms are forced to compete on price while maintaining a high level of quality and variety. Firms within the industry are forced to compete on product differentiation, while maintaining a competitive internal cost structure. The key success factor within the industry is what allows firms to gain a competitive advantage over their competitors. Within the building materials industry, these factors include; maintaining economies of scale, superior product quality, reasonable investment in brand image, and loyal relationships with key customers. The success of companies within this industry is 5 P age

6 dependent on their ability to control these key success factors that add value to the industry Financial Analysis, Forecast Financials, and Cost of Capital Estimation Financial Analysis When valuing a company, it is very useful to perform ratio analysis from given numbers in a company s financials. These calculated ratios enable analysts to compare a firm to a set benchmark, compare the firm with other firms in the industry, or compare the firm with itself over time. The three key areas analysts look at to determine the health of a firm revolve around liquidity, profitability, and capital structure. Liquidity The current ratio, quick ratio, and inventory turnover all suggest that Masco is adequately liquid both from a benchmark perspective as well as relative to its competition. Not only is Masco above or in line with its competitors, it also follows the quick test 2:1 for current ratio and greater than 1 for the quick ratio. Although at 2006 the company still appears be adequately liquid, the downward trend over the past few years needs to be watched carefully. Profitability The six profitability ratios Masco was valued on were: gross profit margin, operating expense ratio, net profit margin, asset productivity, return on assets, and return on equity. The majority of these ratios indicated that Masco was below average in terms of profitability relative to its competitors. These below average measures can mostly be attributed to declining sales. However, the increased rates of decline for Masco relative to its competitors need to be watched carefully over the next few years as they will have the impact of severely affecting firm value. Capital Structure The three capital structure ratios that Masco was evaluated on were leverage, times interest earned, and debt service margin. Masco demonstrated acceptable 6 P age

7 leverage and an ability to service principal and interest payments in line with all of its competitors. Forecast Financials/Cost of Capital Estimation Masco s cost of equity was found using the CAPM model. The Beta for this model was obtained through regression analysis. Masco s cost of debt was found by allocating differing weights and rates to liabilities and finding a weighted total rate at which their debt was financed. Both the cost of equity and cost of debt were then used to find the weighted average cost of capital for the firm. Masco s cost of equity, cost of debt before taxes and weighted average cost of capital before taxes are, 10.97%, 5.81%, and 8.89% respectively. Forecasting the various financial statements of a firm is a good indicator on how the firm will perform in upcoming years. It is important to forecast the balance sheet, the income statement, and the cash flow statement to properly see how the firm will fair in all aspects of the business. Masco s financial statements were forecasted out for the next ten years based on several financial ratios. These forecasts were based on various sustainable growth rates. For example net sales were based off a past give year growth trend. The internal and sustainable growth rate was also considered for this forecast. It was found that Masco will be able to grow at a rate of 3.25% for the next ten years. All other forecasts were based on the project net sales. Accounting Analysis The purpose of doing an accounting analysis is to help decipher whether the accounting activity done is really reflecting the business reality to stakeholders. Since GAAP provides for significant wiggle room when stating financials, a company can choose to take a more conservative or a more aggressive approach when accounting for certain business expenses. Especially in the post Enron and WorldCom era, accounting analysis has become a very important step in valuing a firm. The major areas that were identified to potentially have a material impact on the firm were how they report goodwill, warranty expenses, and research and development expenditures. Although Masco discloses how often and by what method they choose to 7 P age

8 write off goodwill, it was found that they are not impairing it at a big enough rate. For the past 5 years, Masco has never impaired more than 8% a year. Because this impairment should be more like 20% per year, the balance sheet of Masco is radically different when these changes are made. (Revised balance sheet has been included in the undoing distortions section of the accounting analysis. The second area where Masco has the ability to materially alter its accounting is how it accounts for warranty expenses. Accounting for warranty expenses is one area where Masco does a good job of disclosing as they tell us that expenses/liabilities are based on historical figures and they provide a supplementary table so outsiders can see what percentage of sales are being charged as a liability. Research and development is the final area where Masco has the ability to radically alter its financials. Although Masco s research and development expenses are briefly stated in the management discussion, relative to its competitors, Masco discloses almost nothing about its R&D expenses. Furthermore, its R&D expenses are lumped into SGA expenses, so exactly how much they spend is unclear. Although there do not appear to be any red flags, this low disclosure approach much be factored in when valuing the firm. Valuations After fully reviewing every aspect of Masco, from the accounting aspect of the company to the expected growth of the company, it was time to fully value Masco. To do this several methods were consulted. The methods of comparables valuation approach takes several ratios, forward P/E, trailing P/E, P/B, dividend yield, P.E.G., P/EBITDA, and EV/EBITDA, into consideration to find a stock price for Masco. The industry average was found of each ratio, and this average was used to compute Masco s stock price. Methods of comparables are not an accurate valuation measure. There can be outliers in the industry which severely affect the industry average and an inaccurate stock price results. Stock prices ranged from $13.44 to $ The only ratios used that found Masco to be underpriced were the P/B ratio and the P/EBITDA ratio. After consulting these ratios, Masco was found to be overvalued. 8 P age

9 Since the methods of comparables are not very accurate, the intrinsic valuation models were used. Intrinsic valuation models look at a business from every aspect. Various intrinsic models look at future earnings, future dividend payouts, and future cash flows. The intrinsic valuation models used were the discounted dividends, free cash flows, residual income, abnormal earnings growth, and long run return on equity residual income. The discounted dividends and free cash flow approaches are not very accurate. The discounted dividend only relies on dividend payout which is hard to forecast, and this model is highly sensitive to changes in cost of equity and perpetuity growth rates. The stock price was overvalued at $ The free cash flow model is also highly sensitive to any changes in the weighted average cost of capital and the perpetuity growth rate. The stock price was found to be overvalued at $ The accurate and reliable intrinsic valuation models are the residual income, abnormal earnings growth, and the long run return on equity residual income model. All of these models have little sensitivity to changes in cost of equity, perpetuity growth rate, and long run return on equity. The stock price found using the residual income model was overvalued at $15.47, using the abnormal earnings growth model Masco was overvalued at $16.15, and using the long run return on equity residual income model Masco was overvalued at $ Overall, Masco is an extremely overvalued company. It would be a strong recommendation to sell shares of the firm. 9 P age

10 Industry and Company Overview Masco is one of the largest competitors within the general building materials industry that manufactures and supplies home construction and improvement products. The firm was established in 1936 and became a major competitor within the market with sales exceeding $1 million within their first decade of operation. Masco s corporate strategy is to acquire companies in order to expand their growth within the industry. With this goal in mind Masco has been able to hold over 260 productive manufacturing and distribution plants worldwide. Centrally located in Detroit, Michigan, Masco believes they are only growing stronger within the industry while competing against companies including American Standard, American Woodmark, and Sherwin Williams. There are countless factors that Masco must maintain in order to preserve their position at the top of such an established industry. Their products must be continuously innovated in order to appease the desires of customers and distributors within the industry. Slow levels of growth, and a fluctuating housing market force Masco and competitors alike to produce varieties of products within their product mix. Masco has segmented its operations in order to pin point key markets successfully. Further research and development is required within these five product platforms that include Cabinets and Related Products, Plumbing Products, Installation and Other Services, Decorative and Architectural Products, and Other Specialty Products. Within these segments Masco produces over 40 brand name products that can be seen at large distributors including Home Depot, Lowes and WalMart and even smaller private distribution companies. Masco continues to expand their growth within the competitive industry. Its increased inventory and production efficiency has allowed their market capitalization of $9.1 Billion to stay competitive with rivalry firms American Standard, American Woodmark, and Sherwin Williams who report market capitalizations of; $7.3 Billion, Million, and $7.64 Billion. 10 P age

11 Masco s sales have remained somewhat steady over the last five years. Recent developments within the housing market have had a somewhat trivial effect on the company, but still influenced them slightly. Masco continues to dominate market share and improve their products in order to have better customer satisfaction and improved product quality. 11 P age

12 Five Forces Model The Five Forces Model is used to analyze a specific market by concentrating on five forces that are known to affect the profitability and structure of an industry. The model will interpret specific information and developments concerning rivalry among existing firms, the threat of new entrants into the market, the threat of substitute products, and the bargaining power of both buyers and suppliers. The analysis of these five competitive forces allows an inside look into the potential longterm profitability and competition of an industry. Even though forces can vary between each industry, the total effects of these forces define an industry s structure which provides a vision into the success of a specific company. General Building Materials Industry Materials Industry Rivalry Among Existing Firms High Threat of New Entrants Low Threat of Substitute Products High Bargaining Power of Buyers High Bargaining Power of Suppliers Low Rivalry Among Existing Firms The general building materials industry is composed of roughly four main competitors. The predominant competitors within the industry include; Masco, American Woodmark, American Standard, and Sherwin Williams. These companies all vary on their business structure and main products produced, but given their organization there is obvious competition within the companies. Each of these firms are participating in a highly fragmented industry that is composed of thousands of national, regional, and even local manufacturers. (American Woodmark 10k) Given this previous statement it is easy to see that the industry remains highly competitive. According to Masco s K, their main vision is to manufacture, distribute, and install home improvement 12 P age

13 and building products. This is similar to the vision of companies like American Standard and American Woodmark. In order to remain a competitive force within the industry all of these major companies must compete with low cost suppliers while still providing a quality product. With the housing market fluctuating the way it is, the average level of productivity and profitability has been declining in some situations but remained somewhat profitable in others. This causes the rivalry among the existing firms in the industry to be very significant to the success of individual firms. Companies within this industry must be innovative, concentrate on product differentiation, maintaining key customers, and remain cost conscious when it comes to production. Industry Growth The considerable amount of large and small companies providing products within the general building materials market is very significant to the level of growth within the industry. With the housing market being greatly affected by rising mortgage rates and loan problems, the market for home construction products is unstable. The housing industry has dropped to its lowest level in 16 years, so there is a decreased need for home improvement products. (WSJ.com) This means that within the general building materials industry it is experiencing relatively low levels of growth, so the firms are forced to steal market share from others and compete in price wars across the industry. However, according to major competitors, American Standard and Sherwin Williams, the fluctuations in the new construction industry did not hurt sales, but increased them quite significantly. According to American Woodmark and Masco the reason for the decline in recent growth was due to the weaker new construction sales volume. To investigate more into the inconsistency of growth within the industry analyzing the main distributors is crucial. Home Depot reported a significant loss in sales volume (10%), and Lowes reported a relatively small percent in growth compared with past years (9%). These results would support the reporting of a decrease in growth within the industry. 13 P age

14 Companies within this stagnant industry are focusing on more organic internal growth rather than using a strategy of acquisitions in order to increase market share. (Masco 10K) Sales of existing homes have a huge impact on the growth of the home improvement industry. Over the past two years the sales of these homes have fallen by at least 2% and continue to decline. With sales falling it causes consumers to lose confidence in putting more money into their homes when its value is continuously diminishing. There are still many distributors of general building materials but the growth of the industry as a whole remains almost inactive. The sluggish industry growth rate causes more rivalry among firms already established firms within the industry, and forces them to wrestle with price levels rather than create more market share. To conclude, construction of new homes during 2007 will start at a 12% decline from years prior which means the industry decline will more than likely continue in the future. (WSJ.com) 14 P age

15 Concentration The concentration and balance of firms within a market is very important to their success because it directly affects the amount of competition. An industry that is comprised of a limited number of controlling firms has high concentration. On the other hand, industry s with a large number of firms has low concentration. When an industry has high concentration, it shows that market share is divided between a limited numbers of firms so; they are able to easily control the price and movement of the market. When an industry has a low concentration of firms, it signals that there are many firms competing for market share. This forces price competitions and a strategy to keep prices down and costs low. The HerfindahlHirschman Index is a commonly accepted form of measuring market concentration. (investopedia.com) The index can range from a number close to zero all the way 10,000, which would indicate a monopoly where one firm controlled 100% of the market share. Decreases in the Herfindahl index generally indicate a loss of pricing power and an increase in competition, whereas increases imply the opposite. (Wikipedia.com) The general building materials industry has an average HHI of 2627, and according to the index, the markets with results higher than 1,800 would be considered a highly concentrated market. HerfindahlHirschman Index Average HHI Masco American Standard American Woodmark Sherwin Williams Total **Numbers collected from companies 10k s and compared to the Market Share Analysis results reported previously According the U.S. Census Bureau s most recent tabulations of statistics regarding U.S. industries, they classify companies like Masco, American Standard, American Woodmark, and Sherwin Williams as building material dealers reporting over 29,000 firms inside the U.S. industry. ( These firms control 15 P age

16 approximately 38,502 establishments nationwide. Given the number of local, regional, and national manufacturers however, there are very large companies that control a large majority of production and market share. Because the industry is stagnant, as one firm is gaining market share, another firm is simultaneously losing market share. This is illustrated by the graph below. **information on market share was derived from the 10k s of companies; Masco, American Standard, American Woodmark, and Sherwin Williams Differentiation and Switching Costs Within the general building materials industry product differentiation is critical, since the majority of potential profits depends on the ability of firms to introduce new and improved product lines to satisfy changing customer preferences. Differentiation techniques are used in order to make a product more attractive to customers, and display its unique qualities compared to similar competing products. With such high levels of competition with the industry of building materials, customers have little distinction between multiple products, so choosing products is based on price. Competition within the markets for the services provided by companies like Masco, 16 P age

17 American Standard, and others are focused on price, customer service, scope of capabilities, and quality of the underlying product. All firms within the industry are striving to produce a quality product but since the competition is so tight, price is often the primary factor. (Masco 10k) Looking into the price wars amongst firms in the industry, the idea of switching costs in introduced. When there are similar products being offered by firms within an industry, the customers have the ability to switch from one competitor to another just based on the price. The general building materials industry is comprised of thousands of companies providing almost the exact same products. Masco and American Woodmark both produce semicustom, assembled and readytoassemble cabinetry for the home under the names KRAFTMAID, and American Woodmark, and both state that there are several large and hundreds of smaller competitors. (Masco 10k) American Standard and Masco compete within the bath and kitchen segment of the home construction industry and produce faucets, sinks, and other accessories. The DELTA and Champion brands are very similar in appearance and purpose so price competition and differentiation is important. To provide more specific facts based on the idea of switching costs, the graph below provides information concerning one specific sector of business within the industry; kitchen and bath home improvement products. Masco and American Standard are the main competitors overall and they are compared to smaller competitors, Fortune Brands producing Moen products and Black & Decker producing Price Pfister. Within the specific section you see that sales are relatively level so one can conclude that the firms are selling the same amount of products and selling them at very close and competitive prices. 17 P age

18 **Information collected from Masco, American Standard, Fortune Brands, and Black & Decker 10k s Most companies within this industry are differentiating their products by providing more innovative products including and not limited to; more water conservative products, easier use and installation products, more color and finish options, and easier ways to obtain products; internet options and more central locations. (Masco, American Standard, Sherwin Williams, and American Woodmark 10 ks) In this given industry there are not very high switching costs. Since the switching costs are relatively low, it is up to the firm to compete with other companies on price and differentiation of products. Even though having a differentiated product is important when looking at the rivalry firms, having the lowest price available is what entices customers and distributors in such a competitive market. Economies of Scale and Fixed/Variable Costs Economies of scale are very important to the general building materials industry. Companies try to utilize size as an advantage to reduce the cost of production per unit. It is most beneficial when a company is able to reduce the cost per unit, while the overall output of the industry is increasing. In order for a firm to take full advantage of economies of scale, they must be able to best utilize their manufacturing capabilities. It is easier for a large firm, with quality equipment to produce more for less than a smaller 18 P age

19 firm. These large companies have more resources and are able to produce in bulk while not operating at maximum capacity. This can really help increase a large firms market share because they can get their products to wherever demand is highest at a lower cost because it is does not cost them as much to produce. In the home improvement sector of the building materials industry, the companies have distinct differences in production capabilities. In today s highly competitive markets, controlling variable costs is one of the best ways to gain an advantage on competitors. The ability of a firm to find and utilize large amounts of resources can determine whether or not it can compete in today s markets driven by cost control. Below is a graph of the total assets reported by each competitor within the general building materials industry. As it should be, Masco and American Standard reported a much larger asset base than its competitors since they are the largest and most dominating firms within the industry. Total Assets Masco $12,050 $12,149 $12,541 $12,559 $12,325 American Standard $5,143 $5,878 $6,841 $6,867 $7,413 Sherwin Williams $1,505 $3,682 $1,781 $1,894 $2,450 American Woodmark $234 $262 $307 $361 $378 **in millions Economies of scale are essential for these companies so they can maximize their profit margins. Not all products these companies make have the highest profit margins, so producing more at lower costs help combat the fixed costs they incur. Another important aspect of economy of scale is cost distribution for the various firms in the industry. In the building materials and fixtures industry, it is very important to have a low cost distribution. It is helpful if the firms are large enough to own smaller companies that actually manufacture and produce the raw materials needed to construct the goods. This way, the firms can then distribute the finished products to their buyers without having to worry about any intermediary costs. By having low distribution costs, it allows the firms to have the flexibility to decide who to ship finished 19 P age

20 goods to. The companies can decide to ship to major chain home improvement places like Home Depot and Lowe s, or smaller contractor companies focusing on higher end distribution. Excess Capacity Excess capacity within an industry occurs when the level of production within a firm is less than what is considered a firms optimal production capacity, in other words it is when supply exceeds demand. Under these circumstances a competitive industry would need to cut costs or provide discounts in order to extinguish inventory. Since the market of home improvement and new construction markets fluctuates constantly, the likelihood of an excess of capacity is also very likely. When firms in an industry incur significant excess capacity, in order to avoid a major loss, must meet the high fixed costs that are associated with production. (investopedia.com) The graph below shows the inventory turnover of the competitive firms within the industry and the average turnover of the industry. You can see from the graph that given the average, the level of excess capacity stays relatively close to the average so the status of excess capacity is still apparent within the industry, but has maintained consistent with the large competitive firms. 20 P age

21 Exit Barriers Exit barriers are those obstacles a firm would face when leaving a particular industry. The industry of general building materials is not highly regulated and it does not produce highly specialized products so the exit barriers are not extremely high. However, manufacturing companies like the Masco, American Standard, American Woodmark, and Sherwin Williams invest in capital equipment that is dedicated to one segmented task of production. Therefore, leaving an industry like general building materials would in effect, leave a company with an excess of nontransferable fixed assets. Other costs that would be significant in exiting the general building materials would be redundancy costs and contractual obligations. Overall, the exit barriers of this industry are moderate, so firms are somewhat forced to stay in the industry in order to avoid incurring a loss. Because the firm is retaining a steady level of firms within the industry overall competition will remain significant. Conclusion Overall, the industry of general building materials is highly competitive. The rivalry amongst these firms is established due to a slow level of growth within the industry, a high concentration of large firms, difficulty in producing extremely differentiated products, a seemingly low level of switching costs, economies of scale, and moderate exit barriers. The details of the industry are what force it to maintain its intense level of competition with the wellknown leaders of the industry. Threat of New Entrants The general building materials industry is comprised of a few large competitive firms and thousands of moderate and smaller, less competitive companies. Therefore, this industry is very concentrated and highly competitive. With the given competition, the ability to obtain abnormal profits is not very likely so new firms are not enticed to enter into the industry. American Standard and Masco have been operating since the early 1930 s; therefore they have acquired the knowledge and established strategies in 21 P age

22 order to sustain themselves within the fluctuating industry. Since there are a number of very large and reputable firms within the industry the ideas of economies of scale, distribution access, and customer relationships create a situation where the profitability of new firms entry into the industry is very unlikely. Economies of Scale Larger companies within an industry tend to dominate a considerable amount of market share due to the fact that they have the ability and resources to control higher levels of production. Established and larger companies that lead an industry tend to obtain and acquire a significant asset base causing the success of new and smaller firms to struggle in order to maintain a profitable bottom line. In the manufacturing industry of general building materials new entrants would have to invest heavily in capital to be competitive with large producers. However, this is very risky since the high amount invested may not be employed right away. The general building materials industry has locked in large producers like Masco, American Standard, and American Woodmark who annually report a significant asset base and have very strategic cost strategies. Given these facts, new entrants are very unlikely since they would be entering a highly concentrated industry will smaller assets with a definite cost disadvantage. Smaller firms like American Woodmark and Sherwin Williams are comparatively smaller yet they are still a competitive within the general building materials industry. This is due to their segmentation of products and their success in regards to other industries. Again, the chart below shows that the largest companies within the industry tend to be the most successful. Total Assets Masco $12,050 $12,149 $12,541 $12,559 $12,325 American Standard $5,143 $5,878 $6,841 $6,867 $7,413 Sherwin Williams $1,505 $3,682 $1,781 $1,894 $2,450 American Woodmark $234 $262 $307 $361 $378 **in millions 22 P age

23 Distribution Access Probably the most significant draw backs for new firms to enter this industry would be the inability for them to create close relationships with big suppliers. Home Depot and Lowe s are the larger suppliers, while private distribution stores and new construction companies are also key customers. Large firms within this industry have established firm relationships with these suppliers, so the ability of a new entrant to disband the loyalty created would be extremely difficult. Home Depot stocks 35,000 to 40,000 products during the year and states that in order to complement and enhance our product selection, we have formed strategic alliances and exclusive relationships with selected suppliers to market products under a variety of wellrecognized brand names. (Home Depot 10k) Since these major distributors are limiting the access to their stores to wellrecognized brand names, new entrants into the market will struggle with getting their new brand recognized. Conclusion Overall, the threat of new entrants into the general building materials industry is very unlikely. Firms can try and enter the industry but it would be extremely risky. This is due to the powerful economies that are so beneficial to the larger firms within the industry, and the access to distribution. Entering this industry and trying to network your product onto the shelves of large distributors like Home Depot and Lowe s would be difficult and costly for new entrants. Overall, the competition of new entrants into this industry is very low, allowing the concentration of large firms to remain competitive within their established industry. 23 P age

24 Threat of Substitute Products The general building materials industry is highly competitive, but has the ability to offer customers an array of choices when purchasing products. All competitors within the industry divide their focus on high end products supplying to private distributors and also offer cost sensitive products provided for the price conscious customers. Since distributors like Home Depot and Lowe s are providing relatively the same products with the label as the only distinction, the products are performing the same function for a very similar price. Customers have low switching costs; therefore their ability to distinguish one product from another is based on price. Within this specific industry there are so many brand options; Masco has eight separate cabinet brands and Sherwin Williams controls ten different paint brands. (Masco and Sherwin Williams 10k) A customer will only pay more for a product if there is a definite difference in quality that exceeds the difference in price. Companies within the industry have to make sure their products are noticeably better if they want to charge premium prices otherwise they will not stay in business long because of the obvious threat of substitutes. Buyers Willingness to Switch The wide variety of substitute products available in the general building materials industry is constant, and is the largest threat that firms within the industry face. In order to maintain a profitable customer base, firms must provide them with the quality products they seek. If customers are unsatisfied it is not costly for them to change brands. The willingness of buyers to switch products at any given time creates the driving force behind competition in the industry. Considerable research and development is put into products to provide the cutting edge quality that consumers rely on. Customers are willing to substitute the products provided by companies like Masco, American Standard, and American Woodmark because they provide the same function to customers. 24 P age

25 Therefore, the competition within the industry to innovate and provide new channels of unique products is intense. The ability of companies to maintain a competitive force in the general building materials industry is dependent on their ability to retain relationships with key customers, uphold a profitable cost structure, and introduce new products that appeal to consumers. Relative Price and Performance A person s perception of quality is derived from the price of a product. The fact that products produced in the general building materials industry are installed and visible in a home or office will cause customers to link price and quality together. A customer will be willing to pay a certain price for a quality product, so when the stated price exceeds what they deem appropriate consumers will be paying a price premium based strictly on the brand image a firm has created. Since there are low switching costs and a high willingness of customers to switch products, they will do just that. Given the industry, firms must provide a quality product at a reasonable price to customers. Since most firms rely on a majority of their sales to come from large distributors like Home Depot, Lowes, and WalMart, the products must be reasonably priced for their level of performance or they will not be considered by customers. Most customers contemplating purchasing home improvement products are not really focused on image, but quality. To retain the customers and remain competitive within the industry, the price and performance must be directly linked. Conclusion The threat of substitute products is a crucial factor that determines the overall success of a firm within an industry. Since there are so many substitute products provided in the general building materials industry, firms must compete with competitors on price and quality linked to performance. Since there are low switching costs between similar products, firms must employ strategies to keep their customers and steal new customers from competitors. This strategy would include providing easier 25 P age

26 access to products, innovating new products, or creating better customer service pertaining to installation and warranty of products. Bargaining Power of Buyers The two main factors that determine the power of buyers are price sensitivity and relative bargaining power (Palepu, 25). Price sensitivity is essentially the degree to which buyers care about an increase in price. Relative bargaining power on the other hand is a measure to which firms will actually succeed in lowering the price. Firms that have influence and a high ability to lower prices are said to have a high relative bargaining power. Price Sensitivity Because buyers are more price sensitive when products are undifferentiated, there is moderate price sensitivity within the general building materials industry (Palepu). The paradox within our industry is that it is full of undifferentiated products trying to be different. Firms such as Masco, American Standard, and American Woodmark all try to differentiate themselves by making a better faucet, or have better quality paints. However, the reality is that these products are very hard to make unique. Although there are little differences which warrant a small price premium for such products, the big buyers like Lowes and Home Depot will never pay a big price premium. Hence, there is moderate price sensitivity. Relative Bargaining Power In the building materials industry, big name buyers like Lowes, Home Depot, and Ace Hardware wield lots of power over their suppliers. Lowes, Home Depot and Ace Hardware alone account for over 59% of the general building materials industry (finance.yahoo.com). Because these stores are major players on a global level, companies within our industry will do almost anything to secure shelf space with them; even squeeze their margins. Because the big distributors such as Lowes and Home 26 P age

27 Depot have been so successful in lowering these costs, they have high bargaining power over the firms in our industry. This subordinate status to the big name distributors is one of the factors that companies in the general building materials industry must overcome if they are expected to compete. Conclusion To sum up, the bargaining power of buyers is high in our industry making it harder for new firms to enter and continued relationships key for existing companies in the general building materials industry. Firms within the industry, such as Masco, will have to learn to cater to these big distributors if they want to be successful. Not only will these companies face challenges in justifying a price premium for their products, but they will also face challenges lowering their price enough to secure shelf space with these coveted sellers. Bargaining Power of Suppliers In the home improvement sector of the building materials industry the suppliers have relatively high bargaining power. The firms in this industry are experiencing a lot of downward pressure from their buyers, and have to make up the costs on their own suppliers. The same principles dealing with industry concentration applies to the first level suppliers bargaining power. Since there are so many raw materials producers make available, these companies are forced to compete in fierce price battles to win supplier contracts. For example there are over 1200 steel plants in the US alone 16,000 lumber mills and 9500 chemical companies ( In this industry, firms use so many dollars of raw materials every year that these companies will compete for the opportunity to seal a contract, even if they cannot dictate any of the conditions. 27 P age

28 Price Sensitivity Since there is very little differentiation among supplier products, and the switching costs are so low for the industry firms, the price sensitivity is very high. The suppliers to the industry have to compete based almost exclusively on cost because the switching costs are so low. This decreases the overall bargaining power for the suppliers and gives the industry companies the ability to dictate almost all the conditions without repercussion because the suppliers still benefit from the large scale sales of their materials. The suppliers to the home improvement building materials industry have very low bargaining power, but cannot afford to lose the business, so both firms benefit. Relative Bargaining power of Suppliers The only way for suppliers to the building supplies industry can gain any leverage is by having a clearly better product with a low choice of substitutes. In this industry the quality can be a separating factor, but the mass number of suppliers forces even the highest quality product to give into the demands of those they are supplying to. This is still a beneficial situation for those suppliers that are offered a contract, although they may not realize as high a return per product, the sheer bulk of the transactions help these suppliers in need of buyers. Conclusion Not only does the strong bargaining position for the large retailers adversely affect their suppliers in the home improvement building materials industry, but also force down further pressure on the first level suppliers. There are so many possible suppliers to choose from for the industry firms that the first level suppliers have very little bargaining power with which to dictate contract conditions. Low switching costs, high availability of substitutes, and therefore high price sensitivity give all the leverage to their buyers. 28 P age

29 Value Chain Analysis Overall Classification of the Industry To recap, the general building materials industry is classified as having: high rivalry among existing firms, a low threat of new entrants, a high threat of substitute products, high bargaining power of buyers and a low bargaining power of suppliers. The factors which lead to this conclusion is that this industry is defined by slow growth, high competition firms, buyers willingness to switch, high economies of scale, and established buyer relationships. Because of this, firms must focus their efforts on not just one, but a few areas to be successful. When determining key success factors of firms in the general building materials industry, an emphasis is put on product differentiation over cost leadership. Because this industry is classified by high rivalry, high threat of substitutes, and high bargaining power of buyers, firms do not have a choice but to provide differentiated products at a competitive price. Since the threat of new entrants is low, firms within the industry have established key relationships with customers that are rarely threatened. Elements of cost leadership are needed in order to add value to a firm within the industry, but differentiation will set one firm above the rest. The building materials industry is not defined by clear cost leadership or clear product differentiation, unlike some other industries. In order to maximize profits in such an industry, firms must try and master both differentiation and cost leadership to remain competitive. Analyzing the value chain of an industry will lead into the key success factors that will drive an industry competition. There are many activities and strategies that firms within the industry will implement in order to Competitive Strategy In order to be successful in the general building materials industry, firms must display strategies that align with the key success factors mentioned above. While some industries are pure cost leadership or pure product differentiation, the building materials industry is a hybrid. This industry in particular utilizes a cost leadership strategy of; 29 P age

30 economies of scale, and product differentiation strategies of; superior product quality and variety, and investment in brand image, and relationships with customers. Economies of Scale Because the industry is classified as having high competition among existing firms, economies of scale are critical if companies are to keep costs down to be successful. Economies of scale deal with the ability to lower costs by purchasing in bulk and selling in mass quantities. Over the longrun this will not only lower costs for firms to make them more profitable, but will also make it more difficult for new firms to enter the industry because they must compete with these mega firms that are able to utilize economies of scale. Per American Standard, Masco, and American Woodmark annual reports, they all express buying raw materials in bulk quantities from suppliers that they have used before to obtain significant cost savings. Superior Product Quality Because all firms offer similar products at competitive prices, there has to be a level of differentiation that is apparent to customers. The high degree of competition in the industry keeps prices relatively stable so the only way customers distinguish between products would be superior product quality. Since prices between similar products are kept under control by the high competition and there is a low level of switching costs between different brands, customers are willing to switch based on superior quality. Investment in Brand Image Because product differentiation is key within the building materials industry, firms strive to create a positive brand image for each of their products. Wholesale distributors like Home Depot and Lowes stock their shelves with over 30,000 name brand products. (Home Depot 10k) Their focus for the future is to expand their brand name products available to the home construction market. Distribution channels within the industry are starting to expand to private distributors focused on concentrating 30 P age

31 sales in the high end renovation market. Customers in these high end channels are more focused on the brand image relative to the price. Therefore, there must be an increase in the investment in brand image of products. Expanding the investment in brand image will create a wider customer base. Relationships With Customers Mastering distribution channels and maintaining positive relationships with customers is vital for the success of firms within the industry. Since the big name suppliers like Lowes and Home Depot buy in bulk from firms in our industry, losing either of these relationships could be detrimental to companies trying to compete. For instance, sales to Home Depot represent 20% of Masco s total sales and over 26% of American Woodmark sales. As stated in Masco s 10K, Although builders, dealers and other retailers represent other channels of distribution for the Company s (Masco) products, the loss of a substantial portion of our sales to Home Depot would have a material adverse impact on the company. All competitors within our industry also stated similar opinions about the unfavorable results of losing relationships with big suppliers. Conclusion Because the general building materials industry implements traits of both cost leadership and differentiation, firms must focus their efforts on not just one, but a few areas to be successful. Due to high rivalry among existing firms, a low threat of new entrants, a high threat of substitute products, high bargaining power of buyers and a low bargaining power of suppliers, the key success factors for our industry include: Economies of scale, superior product quality, investment in brand image and continued relationships with customers. 31 P age

32 Competitive Advantage Analysis Masco seems to be stuck in the middle as it implements traits of both cost leadership and differentiation. While most of Masco s products are high end, they utilize economies of scale and efficient production methods to keep the price as low as possible. Masco is in a constant battle to keep the image of their brand name products, yet still provide these products at a low enough cost where consumers will not switch in such a competitive industry. Economies of Scale One aspect Masco utilizes similar to a pure cost leadership strategy is its sheer size to take advantage of economies of scale. Not only does Masco buy in bulk to obtain significant input cost savings, but it also dedicates entire factories to the production of a single item. These mass production methods produce so many units that the cost per unit is decreased to a minimum. Efficient Production Due to Masco s existing relationships with suppliers, they have a general idea of the number of units that will be demanded in a given year. This allows Masco to plan ahead and prevent a shortage or overage of product input. Also, with over 70 years in the building materials industry, the company is familiar with production techniques and strategies. Efficient production is reached when companies produce the same amount of product with fewer resources. Masco is able to accomplish this by outsourcing labor and having manufacturing plants all over the world where costs are lower. The number of outsourcing plants per segment is relatively smaller than the plants located in North America, but they still are producing more products at a cheaper cost to Masco. 32 P age

33 North American Properties Business Segment Manufacturing Warehouse Distribution Cabinets and Related Products Plumbing Products Decorative Architectural Products Other Specialty Products 16 8 Total Properties Outside North America Business Segment Manufacturing Warehouse Distribution Cabinets and Related Products 4 25 Plumbing Products Decorative Architectural Products 3 3 Other Specialty Products 15 8 Total In its most recent 10K Masco stated that, The company is significantly increasing the manufacturing capacity of North American assembled cabinet operations, but otherwise, generally, the Company s facilities have sufficient capacity and are adequate for its production and distribution requirements. Given this previous statement there is a stable level of economies of scale since the capacity is able to maintain efficient production within the properties held. In the past few years, Masco began to acquire many smaller companies which make it easier to produce products at a lower cost. According to Masco s 10K report, Masco is able to remain a dominant competitor in the general building materials industry by effectively managing all of their cost structure and the availability of materials and labor. However, Masco has decided to maintain a more balanced level of growth in the industry by limiting their acquisitions and focusing on more organic growth. (Masco K) Masco will continue to follow this same strategy in the future to maintain higher standards and a large market share. 33 P age

34 Superior Product Variety and Quality As mentioned before, Masco is in five different business segments. While they all revolve to some degree around the housing industry, these five segments provide Masco with a hedge against the others. For instance, Masco s plumbing sales might decline one year while their decorative architectural product sales might sky rocket. Furthermore, Masco offers substantial product variety within each of its five business segments. For example, within the cabinets and related products line, Masco produces the following brand names: Kraftmaid, Mill s Pride and Bluestone. While Kraftmaid is the higherend, specialty cabinetry, Bluestone is more generic. By giving customers such a wide variety of choices, Masco can appeal to a diverse customer base and increase revenues. The graph above shows the different segments of products that Masco offers to customers. Obviously some segments have a higher level in sales, but there is a positive movement of sales over the past five years. The availability of product variety is directly related to the product quality produced. The sales of the different segments of Masco s business would not be profitable without customers recognizing that Masco products are of quality. However, Masco does not provide much insight into their research and development structure pertaining to their goals of innovation. Although a 34 P age