Equity Analysis and Valuation Analysis Team Oscar Aguilar Bayle Butler Bryan Fetterman Reece Macdonald Jonathan Warren Joshua Yueng

Transcription

1 Equity Analysis and Valuation Analysis Team Oscar Aguilar Bayle Butler Bryan Fetterman Reece Macdonald Jonathan Warren Joshua Yueng 1

2 Contents Executive Summary... 6 Industry Analysis... 7 Firm Overview FIVE FORCES MODEL Rivalry among existing firms Threat of New Entrants Threat of Substitute Products Bargaining Power of Customers Bargaining Power of Suppliers Accounting Analysis Key Accounting Policies Research and Development Currency Risk Operating and Capital Leases Goodwill Warranties Accounting Flexibility Research and Development Operating Leases Goodwill Warranties

3 Evaluate Accounting Strategy Research and Development Currency Risk Operating Leases Goodwill Warranties Quality of Disclosure Research and Development Operating Leases Goodwill Warranties Quantitative Analysis Sales Manipulation Diagnostics Net Sales/Cash from Sales Net Sales/Net Accounts Receivable Net Sales/Warranty Liabilities Net Sales/Deferred Revenue Net Sales/Inventory Sales Diagnostics Conclusion Expense Manipulation Diagnostics CFFO/OI CFFO/NOA Total Accruals/Sales Expense Diagnostics Conclusion Potential Red Flags

4 Operating Leases Goodwill Sales and Expense Manipulation Ratios Undo Distortions Goodwill Appendices Sales Manipulation Diagnostics Expense Manipulation Diagnostics Liquidity Ratios Profitability Ratios Capital Structure Ratios Weighted Average Cost of Debt Weighted Average Cost of Capital Forecasted Income Statement Common Size Income Statement Forecasted Income Statement Common Size Income Statement Forecasted Balance Sheet Common Size Balance Sheet Forecasted Balance Sheet Common Size Balance Sheet Statements of Cash Flows Statements of Cash Flows Weighted Average Cost of Equity Month Rates

5 2 Year Rates Year Rates Year Rates Year Rates Business and Industry Analysis Five Forces Model Industry Growth Concentration of Competitors Economies of Scale Excess Capacity Price Sensitivity & Relative Bargaining Power Research and Development Quality and Brand Image Goodwill Warranties: Operating Leases: Undo Distortions: Operating Leases Method of Comparables Discounted Dividends Approach Discounted Free Cash Flows Approach Residual Income Approach AEG Approach Long Run Residual Income Approach Long Run Residual Income Approach (restated) References

6 Executive Summary Investment Recommendation: Overvalued Sell as of November 1, 2008 Method of Comparables AVG Ind RAW Adj P/Et P/Ef P/B DPS/P PEG P/FCF P/EBITBDA EV/EBITDA Altman Z scores As-stated Re-stated BC: NYSE(11/01/08):$ Week Range: $20.39-$ (f) As-stated Restated 2008(f) Revenue: BV Per Share: Market Capitalization: 3, Return on Equity: 4.25% % Shares Outstanding: Return on Assets: 1.79% % Dividend Yield: 1.90% - - Intrinsic Value Cost of Capital As-stated Re-stated Asstated Restated Discounted Dividends: Back Door Ke 15% 14% Free Cash Flows: - - Published Residual Income: Cost of Debt 6.2% 6.3% Long Run Residual Income: WACC(bt) 10.67% 10.58% Abnormal Earnings Growth: Period Month beta Ke R2 Upper Ke Lower Ke 3 months years years years years

7 Industry Analysis Brunswick was founded in 1845 solely as a billiards manufacturer. In the 160+ years since then, Brunswick has vastly expanded its operations across industries and now is one of the largest companies in the world, dealing mainly in the fitness and marine industries. While still a leader in the billiards and bowling industry, the company s focus and financial resources have been shifted to marine and fitness. It is a global company with operations based in the U.S.A, Europe, South America, Canada, Africa, and the Middle East. Many of Brunswick s products can be found through online dealers as well, further increasing its distribution network. The main competitors Brunswick faces in the fitness industry are ICON Health, Cybex, and Nautilus. In the marine industry the main competitors are foreign companies: Honda Motor Corp. and Yamaha Motor Corp. Since these two companies are foreign they do not follow the same disclosure policies as U.S companies. This made comparing their positions in the marine industry quite difficult. Other competitors based in the U.S are Marine Products and Fountain Powerboat Industries. Most of the products in the fitness industry are very similar so the switching costs are low for the customer. In attempt to lower the threat of substitute products in this industry, firms must compete on a cost leadership strategy. Differentiation exists in the fitness industry. However, this is not the focus, but rather a strategy implemented after cost leadership in order to maintain its market share acquired through its cost leadership strategies. In the marine industry, it is also common to compete on cost, however; the smaller companies must focus on differentiation or target a market niche to be competitive with the larger companies since they cannot compete on cost due to economies of scale. For example, Fountain Powerboats hold a very small portion of the overall marine market, but dominate the high performance boat market by using superior molds and plugs to create the highest quality hulls. More capital is invested into research and development in the marine industry than the fitness. This is because it is necessary to keep up with the latest technology to avoid becoming obsolete and to deal with changing industry regulations. To gain a competitive advantage companies in the fitness industry, a firm must 7

8 focus on cost leadership, utilizing economies of scale. Since fitness products perform the same function, little differentiation exists between products. In the marine industry, a cost leadership strategy is effective as well, with economies of scale and low distribution costs as the focus. Differentiation is also effective in this fragmented industry with the focus on quality and research and development. Brunswick benefits greatly from its large size. It is able to achieve economies of scale because they are able to produce products from different industries together, at a single manufacturing plant. This allows them to spread their large fixed costs across many different units of production, decreasing the total cost of the products to customers. Also, Brunswick benefits from its many distribution channels. With so many large facilities all over the world, transportation costs are lowered significantly compared to companies only based in the U.S.A. Furthermore, Brunswick differentiates it products by coming out with lines to target market niches. For example, they have a line of luxury super yachts to appeal to the high end market and lead the industry in recreational products such as fitness equipment. In the fitness and marine industries, most companies try to focus on one strategy; however, Brunswick uses a mix of cost leaderships and differentiation. Accounting Analysis It is important to understand that a firm s accounting methods have the ability to distort the perceived value of the company. Generally Accepted Accounting Principles (GAAP) enables firms with a cushion to manipulate numbers to appear favorable. The average shareholder may look at the balance sheet and income statement without giving any thought to the firms accounting policies. When valuing any firm it is essential to do a full accounting analysis, on both its policies and its quality and level of disclosure. An area that appears to be lacking quality disclosure could indicate management trying to sweep the issue under the rug by not drawing attention to it. Certain areas exist that are common places to look for accounting distortions. For example, research and development is recorded as an expense, therefore none of the future benefits are recorded. This could lead to assets and net income being understated if the firm relies heavily on R&D. Brunswick spends more capital than any 8

9 of its competitors on R&D, so it is reasonable to conclude that their net income may be higher if R&D could be capitalized. Brunswick did not have any significant distortions as a result of this area, but it did in operating leases and goodwill. Brunswick has no capital leases, only operating leases which are an off-balance sheet transaction. This means that no asset or liability is recorded, just an operating expense in the income statement. This can be used to appear in a more favorable position to creditors and investors because retained earnings will appear higher. While it is common practice in both industries to rely heavily on operating leases, Brunswick has a considerably larger amount. Their operating leases are equal about 13% of total long term liabilities. This is a suspiciously high number, and a serious lack of disclosure relating to operating leases, which together raise a red flag. No information is given regarding their length of leases or their interest rates paid. In order to account for this manipulation, operating leases were converted to capital leases, and the adjusted statements are used for valuation purposes. Goodwill that is not impaired properly can cause assets, owner s equity, and net income to be overstated. Brunswick has a large amount of goodwill as a result of their aggressive growth strategy of buying out other firms. Brunswick s goodwill makes up over 15% of its total assets, which is a very high amount. Goodwill is impaired by 20% to get a more accurate valuation. The two red flags, operating leases and goodwill, have been adjusted and the new statements are used get a more accurate valuation of the firm. Financial Analysis, Forecast Financials, and Cost of Capital Estimation In order to accurately value a firm, a variety of financial ratios are used and compared with competitors in the same industry. The ratios will be a measure of one of the following categories: liquidity, profitability, and capital structure and growth. Liquidity ratios are a measure of the ability of a firm to meet its short term debt obligations. These are ratios that lenders pay close attention to, since they want to 9

10 know that the company they are lending to is going to be able to pay it back in a full and timely manner. Profitability ratios measure how well a firm is able to make a profit, and how well their revenues can cover their costs. Also, capital structure and growth ratios are often used by creditors. It is important to understand the capital structure (the amount financed by debt and equity) because it indicates the ability of a firm to generate revenues to cover its short term obligations. Growth ratios give an estimate of future profitability, and capital structure ratios show a firm s financing choices. LIQUIDITY 5 yr Avg. Adj. 5yr Avg. Trend Industry 5 yr avg. Industry trend Current Ratio 1.64 N/A Stabilizing 2.03 Decreasing Quick Ratio 1.34 N/A Stabilizing 1.06 Decreasing Working Capital TO 6.69 N/A Stabilizing 6.1 Decreasing Accts Receivable TO N/A Increasing 19.4 Decreasing Days Sales Outstanding N/A Decreasing Decreasing Inventory TO 5.06 N/A Stabilizing 7.21 Decreasing Days Supply Inventory N/A Stabilizing Stabilizing Cash to Cash Cycle 106 N/A Stabilizing Stabilizing The liquidity ratios show that overall Brunswick appears to be in a better financial position to lenders than most of its competitors. Brunswick has a current ratio below the industry average but a quick asset ratio of 1.34, which is higher than the industry average. This lets lenders know that Brunswick will be able to pay off its debts, even if it can t sell off its inventory in time. Also, Brunswick appears to be the leader in its industries when it comes to collecting on accounts receivable, which further improves the firms liquidity. However, Brunswick appears to have trouble clearing out inventory. They take an average of 25 days longer to turnover inventory than competitors. It is important to note that all of Brunswick s ratios are either stabilizing or actually improving, which show it is less volatile than the industry as a whole. 10

11 PROFITABILITY 5 yr Avg. Adj. 5yr Avg. Trend Industry 5 yr avg. Industry trend Gross Profit Margin 0.25 N/A Decreasing 0.28 Decreasing Operating Expense Ratio 0.16 N/A Stabilizing 0.21 Stabilizing Operating Profit Margin Decreasing 0.06 Decreasing Net Profit Margin Decreasing 0.03 Decreasing Asset Turnover Decreasing 2.13 Stabilizing Return on Assets Decreasing 0.07 Decreasing Return on Equity Decreasing 0.18 Decreasing Looking at these profitability measures, we can draw a couple of conclusions. First, the entire industry appears to have decreasing trends. This is likely because of the poor state of the economy, which started the decreasing trend around 2006 and has lasted until present day. When comparing the data, we can see that Brunswick is close to the industry average in most categories and follows the same trends. The asset turnover for the industry is much higher than for Brunswick. This could be due to the large amount of inventory that they hold, which affected the days supply inventory and the inventory turnover measures. Notice, the operating profit margin jumped up considerably in the adjusted measure. This is due to the capitalization of operating leases. Prior to capitalization, operating leases are recorded completely as operating expenses. After capitalization, capital leases principal, not the interest, is recorded as an operating expense. Overall, we see that after undoing Brunswick s accounting distortions we get less favorable measures of profitability. CAPITAL STRUCTURE 5 yr Avg. Adj. 5yr Avg. Trend Industry 5 yr avg. Industry trend Debt to Equity Stabilizing 2.96 Stabilizing Times Interest Earned Decreasing Decreasing Debt Service Margin 0.29 N/A Stabilizing 4.13 Increasing It s important to note that perhaps the median, rather than the mean, would have been appropriate for these measures. The industry average is skewed due to large differences among firms. The debt-to-equity ratio is fairly low among all firms, which indicate they finance assets mainly through equity funds. The firms in the 11

12 industry appear to maintain a stable capital structure and Brunswick appears to be performing about as adequately as its competitors. GROWTH 5 yr Avg. Adj. 5yr Avg. Trend Industry 5 yr avg. Industry trend Internal Growth Rate 6% 4% Decreasing 5.75% Decreasing Sustainable Growth Rate 15% 11% Decreasing 14.75% Decreasing Due to the current state of the economy, one should not be surprised by the decreasing trends in growth rates. Brunswick is very close to the industry average, which leads us to conclude that the decline in growth rates is due to systematic risk, not Brunswick specifically. Once again, we see that the restated financials lead to less favorable results. The next step was to forecast the financial statements of the company using the liquidity, profitability, capital structure, and growth rate measure previously discussed. We also had to take into account the poor state of our economy. In order to do this, recession data from 2001 was used to get an estimate on the effect and length of time of this current state. First, the income statement is forecasted since it reflects revenues and expenses, therefore, future expectations should be reasonably estimated based on educated assumptions. Forecasting sales is one of the most important things to start with. We used the average sales growth rate for the first three quarters of 2008 to forecast the last quarter. Brunswick came out of the last recession fairly quickly posting a 10.67% increase in sales growth the following year in A similar percentage is used to forecast sales during the initial recovery of the economy in In 2010 through 2017, we will use a constant 10.7% increase in net sales growth, which represents the net sales growth in 2002 following the recession. With the asset turnover ratio discussed earlier, we are able to forecast assets. According to our forecasts, net sales are going to roughly double over the next ten years. It is important for investors to analyze this because it gives an idea of where the firm is in terms of profitability. Operating income was forecasted based on the forced common size percentage of 6%. After that, net income was forecasted based on forced common 12

13 size percentages. In 2008, we used the common size percentage for the previous recession. For 2009 to 2017, we used the common size percentage of the average of the 2002 and 2003 net income as a percentage of sales, which is 2.69%. Also, ratios such as asset turnover, current ratio, and PP&E turnover were used to forecast and link financial statements together. Also, we forecasted the restated financial statements. It is important to note that these forecasts are subject estimation error. The statement of cash flows is particularly difficult to forecast due to the inability to locate trends and an inability to form accurate estimates. VALUATIONS After analyzing the industry, accounting policies, and forecasting financials, the last step is to value the firm. This is done by calculating a fair market share price using models that fall into two categories: method of comparables and intrinsic valuations. When analyzing the models, we incorporate a margin of safety of 15% to the stated share price of $3.59. This gives us a range of $3.05 to $4.13 for fairly valued price per share. Therefore, if the calculated price per share is under $3.05, then the stock would be overvalued. If it is over $4.13, then it is undervalued. We used a 15% margin of error because of the difficulty in accurately forecasting. First, the method of comparables is used to value Brunswick. The key idea of these models is to compare the firm being analyzed to the industry in which it operates. For Brunswick, this can be more challenging as they operate in three different industries. Also, many of the competing firms have negative cash flows, which leads to skewed industry averages (outliers) and unusable models. We use competitor s ratios to find an industry average and any firm with drastically different numbers is called an outlier, and is thrown out. This industry average is used to find the implied price per share by multiplying it by Brunswick s own factors. This method does have serious flaws since it is not supported by theory and leaves little room for interpretation. Further, the fact that Brunswick encompasses more than one industry decreases the reliability of the method of comparables. We see the volatility of these methods in the vast differences of the computed price to the stated price. 13

14 The second and more accurate method used is the intrinsic valuation models. The intrinsic models contain more theory based assumptions, while the method of comparables focuses on historical data. Intrinsic valuations take into account the potential profitability of the specific firm that is being valued. We use the forecasted financial statements to predict Brunswick s future performance and calculate their present day value. Then, we went through sensitivity analysis, which manipulates the discount and perpetuity growth rates to see how different estimates would provide different valuations. While close attention was paid to all the intrinsic valuations, the residual income showed the most explanatory power, therefore, it is the most heavily weighted. These valuations lead to the conclusion that Brunswick is an overvalued company. It appears that its long term stability makes it a wise investment in these shaky economic times. Business and Industry Analysis Firm Overview Brunswick Corporation is a global manufacturer of recreational products including marine boats, marine engines, fitness equipment, and bowling and billiards equipment. The firm was founded in 1845 by John Moses Brunswick. Today Brunswick is a publicly held corporation that is based out of Delaware. It currently has locations in The United States, Europe, Canada, Pacific Rim, Latin America, Africa, and the Middle East. The company is divided into three different operating segments: Marine products industry (i.e. boat and engines), fitness industry, and bowling & billiard industry ( The tables below show the five year history of net sales and operating earnings of the different industries. Net Sales of Brunswick Industries

15 (in millions) Fitness Marine products 4, , , , , Bowling and Billiards Total 5, , , , ,671.4 Operating Earnings for BC Industries (in millions) Fitness Marine Products Bowling and Billiards Total As the charts show, Brunswick s overall net sales has staggered between an average growth-rate of 2.5% in the past three years. The company experienced a sharp decline in 2004 which may have been caused by a lack of consumer demand for expensive recreational products. The same concept holds true as to why operating earnings have shown a decline over the past two years. This may have been an early sign to the current economic conditions that are plaguing the global market today. Competitors The main competitors in the marine industry are Fountain Powerboats, Marine Products, Yamaha, and Honda Motor Co. The competitors in the fitness industry are Nautilus, Cybex International, and ICON Health. In the bowling & billiards industry, the competitors are Bowl American Incorporated, Dave & Buster s, and AMF Bowling (Brunswick 10K). Due to the unique operating characteristics of both foreign companies Yamaha and Honda it is quite difficult to use them as a benchmark of comparison because they operate in so many different industries. They both manufacture automobiles, motorcycles, and various other recreational vehicles and motors. Moreover, the lack of disclosure among foreign firms is quite poor which we will discuss later. The following tables indicate the total assets and net sales for Brunswick and its competitors in their respective industries. By understanding what each industry has 15

16 done over the past few years it can help guide investor decisions and identify potential red flags when analyzing a specific firm. Marine Industry: Total Asset (millions) Honda Power Products Brunswick Marine 1, , , , ,474.7 Yamaha Marine Products Fountain Power Boat Marine Products Total Sales (in thousands) HMC Power Products N/A Brunswick Marine 3,525, ,624, ,592, ,613, ,570,800.0 Yamaha Marine Products Fountain Power Boat 52, , , , , Marine Products 193, , , , ,273.0 The graph above tells us that the marine industry has seen volatility in the total amount of sales over the past five years. For the most part however it stays relatively consistent with a growing percent of sales that is declining to a zero growth rate. One may assume the reason for this, is that it may be slowing down as a result of the economy starting to slip into a recession. Therefore, because marine products are a very expensive luxury item for consumers people are starting to buy less of these items. The chart on the following page will show how well the fitness industry has performed over the past five years Fitness Industry: 16

17 Net Sales (in millions) Brunswick Corporation Cybex International ICON Health N/A Nautilus Industry Net Sales 1, , , , % change Total Assets (in millions) Brunswick Corporation Cybex International ICON Health N/A Nautilus The chart above has shown that the fitness industry has experienced much of the same volatility the marine industry has too. The fitness industry has tittered between a positive and negative growth rate over the past five years ending in 2007 with an industry growth rate of roughly -54%. A possible explanation for this may be because the economy is starting to fall into a severe recession in From both of theses charts a very similar picture can be painted. It s understood that both of theses industries fall into the same category in the sense they are both luxury items. When people have an increased amount of disposable income they are more inclined to spend money on these types of products. However, when the economy started to show signs of a recession over the past year sales declined radically as a result. 17

18 FIVE FORCES MODEL The amount of profitability a firm can achieve can directly be related to the price a firm charges for a product relative to the cost to produce it. However, there are many factors that play a role in determining the price of a product other than the cost to produce it such as the degree of competition they face within the industry. Michael Porter s five forces model enables analysts to begin the initial stages of valuing a company. The five forces model consists of different components that measure the degree of competition in a specific industry. This competition model directly ties to the industry and competitor profitability. Firm value is based on a company s ability to generate excess returns on investments that exceed the cost of capital. The other side of the model addresses bargaining power of customers and suppliers. These five components together produce a model that enables analysts to gain clear understanding of the degree of competition within an industry. Brunswick Corporation degree of competition is as followed: Competitive Force Fitness Marine Rivalry among existing firms High Moderate to High Threat of new entrants Low to Moderate Low Threat of substitute Products Moderate Moderate Bargaining Power of Customers High Low to Moderate Bargaining Power of Suppliers Low Low Rivalry among existing firms When measuring industry competition, it is essential to consider rivalry among existing firms. In most industries profitability is greatly influenced by the rivalry amongst firms. If an industry has low competition, firms will focus on things like innovation and goodwill. On the other hand, if an industry has high competition amongst firms, firms will engage in price competition in order to be profitable. This first force, rivalry among existing firms, can be segregated into different components such 18

19 as industry growth, competitor concentration, differentiation, switching costs, economies of scale, learning economies, excess capacity, and exit barriers. Industry Growth If an industry is contracting, firms will attempt to grow by grabbing market share from other players usually by price wars. On the other hand, if an industry is growing rapidly, firms usually do not attempt to steal market share in order to grow. When this is the case, firms will engage in strategic pricing strategies to lower the cost of their product, yet at the same time still being able to cover their marginal costs (i.e. Firms will try to set price until marginal benefit and marginal price are equal). In order to measure the growth of an industry, net sales are the primary focal point. The following is a graph showing industry net sales as well as Brunswick net sales in the fitness industry from 2003 to Net Sales % Change In Sales Brunswick Corporation

20 Cybex International ICON Health N/A Nautilus Industry % change As the graphs above indicate, revenues for the fitness industry show mixed signals. In 2007, two competitors experienced gains of over ten percent during fiscal year On the other hand, Nautilus experienced losses of over ten percent during the same fiscal year. The 2007 industry growth is skewed due to ICON health not filing a K. Overall, potential for industry growth remains positive. The fitness category has more participants than any athletic category. Currently, forty four percent of Americans exercise on a regular basis (regular meaning exercising more than fifty days per year) with an additional fifteen percent being opposed to exercising. This means roughly forty percent of the U.S. population is the target of opportunity for the fitness industry (U.S. Fitness Industry: Treadmills are #1 Attraction). The following graphs show the current growth trends of the marine industry. An indicator of the industry s growth can be found through net sales because it reflects the consumers ability to purchase marine recreational products. 20

21 The trends above prove that the marine industry has recently seen a decrease in industry sales. One reason could be that consumer discretionary spending is tight right now; therefore, customers are less willing to spend their money on recreational products. However, it is important to recognize that all competitors are experiencing decreases in net sales; no one firm is performing significantly better than the others. 21

22 Concentration of Competitors The number of firms within an industry and their relative size determine the degree of concentration. If the sizes and market share of the firms are comparable, firms will usually collude with each other to price their products. On the other hand, if the industry is fragmented relative to size and market share, then firms will engage in destructive pricing strategies. Fitness: Market Share (as a % of Total Industry Sales) Brunswick Corporation Cybex International ICON Health N/A Nautilus Industry Sales (in millions) The market share for fiscal year 2006 indicates fragmented concentration levels of the industry. As shown above, the market share is large for Brunswick and ICON health, however, the other two competitors hold less than one percent of the market. It is important to point out that Brunswick captured market share from ICON health 22

23 during the fiscal year Brunswick grew over seven percent while ICON health contracted over two percent. With each competitor maintaining scattered market share over the past five years, we can conclude that the fitness industry is high concentration and relatively high price competition. Marine Industry Market share in % Sales 2007 Brunswick 94% Fountain Powerboats 1% Yamaha 0% Marine Products 5% Marine boats and engines is a fragmented industry, (Marine Products K). This means that the marine industry will have pricing wars. As the graphs above show, industry leaders such as Brunswick hold dominant market share because of their global competitiveness and low cost manufacturing processes, therefore enabling the company to charge competitive prices. Levels of Differentiation 23

24 If the production process of competitors is similar, the industry is classified as low degree of differentiation. A low degree of differentiation means that customers will switch from one competitor to the next simply on the basis of price. Hence, these firms are said to be extremely price competitive. In the fitness industry, competitors offer similar products that provide the same functions. As a result, this industry is classified as having low levels of differentiation, which means it is price competitive. In the marine recreational products industry many products can be fairly similar to each other. Due to this factor firms tend to protect themselves by having certain patents or trademarks on their products and brand names. These slight differences can create consumer preferences which helps add to the value of the product. The overall differentiation in recreational boats and engines is low. Economies of Scale If a steep learning curve or other types of scale economies exists in an industry, size becomes an important factor for firms, (Palepu and Healy, 2-3). A larger production capability creates an advantage over a competitor producing large quantities at cheaper prices. This enables a firm to sell its product at a lower price than competitors, often eliminating smaller competition. In the marine and fitness industries, most firms produce specialized products that require a large initial investment in order to mass produce. Thus, small to medium size competitors will struggle to succeed or capture sizeable market share from dominant competitors. One measure for production assets is the total assets held by each competitor relative to industry size. The following tables and graph illustrate this further for both the fitness and marine industries respectively. Fitness: 24

25 Total Assets (in millions) Brunswick Corporation Cybex International ICON Health Nautilus Fitness The table and graph above follows economies of scale. Brunswick Corporation and ICON health prove to be industry giants over other competitors such as Cybex International and Nautilus. They hold far more total assets, therefore having the capacity to mass produce domestically and internationally and gain dominating market share. Marine: 25

26 Marine Total Asset (in millions) Honda Power products N/A N/A N/A 294,170 N/A Brunswick Marine 1, , , , Yamaha Marine Products 1, , Fountain Power Boat Industry 13,381,819 17,134,786 13,023,588 12,460,218 7,648,996 Marine Products 86, , , , ,726 Industry Net Sales 13,471, ,243, ,135, ,878, ,791, % Changes 0.11% 28.00% 0.00% 0.47% 0.93% Brunswick % change 69.15% 31.66% 58.48% % 99.17% Total Sales (in thousands) HMC Power Products 315, , , ,621 N/A Brunswick Marine 526 4, , , , Yamaha Marine Products 2, , , , , Fountain Power Boat 52,557,084 59,296,964 71,182,069 79,226,224 68,829,987 Marine Products 193, , , , ,273 The table above represents the total assets held by four main competitors in the marine industry. In the marine recreational products industry many products can be fairly similar to each other. Due to this factor firms tend to protect themselves by having certain patents or trademarks on their products and brand names. These slight differences can create consumer preferences which helps add to the value of the product. The overall differentiation in recreational boats and engines is low. Switching Cost The degree of switching costs directly relates to direct competition and commitment to the industry. In a high switching cost industry, such as the fitness industry, it creates a commitment to specialize within the industry. In other words, the product produced will not be sold to different industries. In the fitness industry, competitor s production lines will produce extremely customized machines that are directed for one purpose. Companies will still compete against each other in price for similar machines, however, industry giants prove to prevail. Brunswick has a high industry asset percentage, therefore, we can generalize that Brunswick competes in an 26

27 industry with high switching costs. As for the marine boats and engines markets the degree of switching costs are moderate. Primarily due to the ability of some firms being able to coordinate their assets efficiently compared to those who can not easily switch their assets into another type of industry. Learning Economies The marine and fitness industries have a high level of learning economies. Most firms in these industries need highly skilled blue collar workers with a high level of education or industry experience. This is due to the complex nature of manufacturing boats, engines, and health equipment. For example, one of Brunswick s manufacturing facilities is highly automated. It is capable of making both fitness equipment and marine products from the same factory. Highly educated workers are needed to operate the machines and when needed, they can switch the machines to produce whichever product they need to. By doing this allows them to save costs on building extra manufacturing plants and allows them to produce only what is necessary. Therefore, the highly technological manufacturing process depends on man hours. Hence, employees need a good background in engineering, some kind of applied physical science, and craftsmen with raw materials to be a successful worker in this industry. Other important activities that companies with large learning economies engage in are research and development and securing patents. In the marine industry, excluding HMC and Yamaha for reasons of poor disclosure, had an average R&D expense over the past five years of $ million. Furthermore, the fitness industry had an average R&D expense for the past five years of $41.34 million. This is a significant amount because these firms realize the importance of product innovation in both industries. Especially as their competitors are constantly looking for new and better product designs to manufacture and sell. Once these firms develop new products or further enhance old ones they often patent them so competitors can t use them. For example, firms in the marine industry often patent such things like: inboard/outboard engine designs, drive-trains, and motor mounts. Some common patents firms in the fitness industry utilize are certain characteristics like 27

28 equipment designs and styles. Overall, it is important for firms with large learning economies to invest in R&D, patents, and highly skilled employees as it may help them gain competitive advantage over their competitors. Fixed-Variable Cost Industry costs can be variable and fixed. Variable costs are defined as costs that in total change in direct proportion to changes in volume of activity. These costs often are incurred in the manufacturing process as the costs of goods sold. Fix costs tend to be costs that will not change in direct proportion to changes in the volume of activity. These typically encompass PP&E, SG&A, and R&D. If a company can save money on certain fixed costs, it will open more funds in areas such as research and development. Fixed costs are often what handicap smaller companies from competing or gaining market share from larger companies. If a firm has a high fixed to variable cost ratio, firms will reduce prices to utilize all production resources and lower average cost per unit in order to capture market share. In the fitness industry, fixed assets and labor are essential in producing quality products that work correctly over a long period. Fixed assets are high so firms reduce prices to utilize all resources. The marine industry typically has high fixed costs with high variable costs too. This is due to the large facilities needed to build hulls and engines, and the amount of raw materials they must purchase in order to manufacture their products. For example, Fountain Powerboat Industries has about 40 to 45 plants in different states (Fountain Powerboat Industries 10-K). The size of these facilities can range from 10,000 square feet to 106,000 square feet. Do to the size of these manufacturing plants the fixed costs for electricity, mechanical equipment, specialized tools, skilled labor, and other fixed costs tend to be high in this industry. Furthermore, Brunswick also had a fair amount of their fixed costs in manufacturing facilities alone. Their average fixed costs in the past five years have been roughly 12% of sales. Also, because firms need a good deal of raw materials like aluminum, steel, plastic, fiber glass, wood and other raw materials they tend to have high variable costs because they 28

29 are at the mercy of their suppliers costs. Take Brunswick for example. For the past five years they have had an average variable cost of goods sold of roughly 86% of total sales. In most cases firms view having an excess or too large an inventory to be a bad idea because of the costs associated with such. If a high excess capacity exists, firms will cut prices to decrease inventory to avoid surpluses of inventory on their books. If a low excess capacity exists, demand will exceed supply, enabling firms to overcome aggressive pricing. In the fitness industry, many public and private firms compete to sell new technologies. The overall industry seems to be growing at different paces for different competitors; however, the ability to mass produce products globally proves to be a significant factor in the fitness industry. In the marine industry, one determinate that can affect the excess capacity is weather and economic conditions. If there is good weather, customer demands for marine products may increase, where as bad weather may decline the demand for marine products. The same holds true for economic conditions. Because marine products are such a high cost luxury item people are more inclined to buy them when times are good. However, when times are not good sales have the tendency to decline dramatically. In 2008, the financial crisis has sent the marine industry into a downward spiral. In a press release in October 2008 Dustan E. McCoy CEO. of Brunswick stated The poor economy and the accompanying weak consumer sentiment have pressured marine markets, eroding the demand for boats and engines these past few months at a swifter pace than originally anticipated. In an attempt to lower their excess capacity Brunswick planes to reduce their fixed costs by $300 million by They are speeding up this process and plan to shut down 4 manufacturing facilities which will put 1,450 hourly and salary paid employees looking for work by next year (Boating Industry Canada). This is important for firms to understand because it can allow them to control their assets more effectively. A good measure of a firm s excess capacity is to determine the net sales to property, plant, and equipment ratio Net Sales/ PP&E

30 Brunswick Corporation Cybex International ICON Health N/A Marine Products Fountain Powerboats As the chart above shows the ratios from 2003 to 2005 are increasing for all companies except Icon Health. This is due to a rising amount of sales in proportion to an increasing amount of PP&E. However, from 2006 to 2007 the ratios go on a decline. This is due to a decrease in the amount of sales for each firm while the amount invested in PP&E remained unchanged. Exit Barriers Exit barriers are high when the assets are specialized or if there are regulations which make exit costly, (Palepu and Healy, 2-3). Exit barriers may take the form of legal obligations or most commonly the liquidation of assets to the extent that they can leave the market. Firms tend to have high exit barriers when they have many fixed costs to run production assets. The more investment a firm has in its long term assets, the longer they will stay in the industry despite taking yearly losses. Firms would rather take yearly losses because leaving the industry would prove to be more costly. In the fitness and marine industries, many of the assets are extremely specialized or, in other words, this industry has high exit barriers. Conclusion Rivalry among firms proves to be vital when measuring competitors. Industry growth, concentration of competitors, differentiation, economies of scale, excess capacity, and exit barriers need to be evaluated to gain a perspective of the actual and potential competition within the industry. The fitness and marine industry prove to have moderate to large economies of scale, switching costs, and exit barriers. On the other hand, the industry has low growth rates, differentiation, and concentration. In 30

31 these industries, production assets are extremely specialized, therefore the rivalry amongst firms is high competitive. Threat of New Entrants Three potential sources of competition exist in an industry. The threat of new entrants is the second competitive force. New firms are eager to venture into a new industry to increase the potential for earning abnormal profits because of the threats of new entrants. It can potentially limit the pricing of the preexisting firms in the industry. Also, the easier a new firm can enter into an industry, the more of a possibility it has to be profitable. However, it is not easy for new entrants to jump into a new industry and be competitive. Several barriers have to be overcome in order to surpass a profitable firm. The barriers to the threat of new entrants include; economies of scale, first mover advantage, access to channels of distribution and relationships, and legal barriers. These barriers tend to weed out the threat of new entrants. The threat of new entrants will always be an ongoing process for any industry especially for the fitness and marine industries. In the following sections, the threat of new entrant s barriers will be analyzed for both industries. Also it will reveal how the top firms in each industry have been able to overcome these barriers and stay the top profitable firms in their respective industry. Economies of scale An economy of scale is the process of decreasing unit production cost as the size of operations increase. In the fitness and marine industries, economies of scale are the ability of a firm to have the lowest cost possible, while being able to manufacturer large amounts of finished products. Firms already existing have been able to achieve this by outsourcing much of their manufacturing needs to other countries, allowing them to have lower final product costs to attract many buyers. One way Brunswick helps cut costs in this aspect is that they use a number of manufacturing facilities for both fitness and marine products, primarily because both products have highly 31

32 automated manufacturing processes. This is a big barrier for new entrants because the amount of capital it takes to mass produce a product without the benefit of having the access to the channels of distribution and relationships. Due to the economies of scale and the position of older firms in the industry, new firms do pose little threat of entrance in both industries. First Mover Advantage First Mover Advantage is defined as the advantage gained by the initial occupant pioneering firm of a market segment ( This advantage enables the first entrant to gain control of resources. Followers may not be able to match such resources, which allow the firms to be more profitable and have a competitive advantage over the follower firms. According to Lieberman and Montgomery, three sources or mechanisms lead to First Mover Advantage; technology leadership, control over resources, and buyerswitching cost. In both industries, technology leadership plays a big role. For example, Brunswick uses technology to make their manufacturing process more efficient by using highly automated machines that can produce either fitness products or marine products very easily. This further helps cut cost by reducing the quantity of machines they need to purchase. Being able to keep unit production cost to a minimum proves to be one of the main sources of technology leadership; hence, why most of the new firms will not make it in these industries. The top firms keep production cost low by cutting down unnecessary expenditures in each segment by outsourcing their manufacturing processes to other countries and utilizing technology. Another way the major firms maintain technology leadership is the amount of money each invests in research and development. This allows the firms to not only be able to research and test new ideas for new fitness equipment and new motor designs, but to find new and cheaper ways to manufacture the equipment. The chart below represents the average amount of money that is invested in research and development by the top firms in both industries. Figures were taken from the 10-Ks of each of the 32

33 top firms and averaged together over the past five years to get the overall amount of money invested. As the graph above shows both industries spend a high amount of money in R&D. The marine and fitness industries over the past five years have been increasing the amount of money they are investing. One can assume the significant difference in the quantity spent between the two industries is due to the complex nature of marine products to fitness equipment. However, both industries see the importance of R&D as they are spending increasing amounts of money. The last part of technology leadership is the acquisition of patents for new innovations of fitness and marine products. Original firms enjoy this because it makes it even harder for follower firms to be competitive in an industry where technology is constantly changing. The second source of first mover advantage is control over resources. First movers have an advantage over a new entering firm by controlling the necessary resources needed to compete in that industry. The top resources for the fitness industry are positioning and placing equipment in major sporting good stores and fitness facilities. As for the marine industry, one of their resources is having patents on a majority of their engines and boat products. The top firms in both industries have a leading edge over the new firms due to their brand recognition, personal ties to 33

34 consumers, and legal patents. The last source of first mover advantage is buyerswitching cost. Buyer-switching cost is the advantage the first firm gets by attracting customers first. As a result, follower firms have to invest more money and time in their product to attract them away from the first mover firms, which in the end drive up their prices. Therefore, new comers will struggle to get into the mainstream of the fitness industry. The institution market is mostly controlled by the first movers and comprised of fitness centers, universities, government agencies, and military. With many institutions having pre-existing ties and contractual agreements with first mover firms, it s harder for new firms to attract new customers. Due to the first movers advantage, follower firms pose little threat to pre-existing firms in the fitness and marine industries. Access to Channels of Distribution and Relationships Creating new channels of distribution and relationships prove to be a big part of any industry. The new channels give a firm an advantage over competitors who have not made these connections. The older firms hold an advantage over new firms trying to enter because of the access to the channels. They allow a firm to cut cost and potentially increase productivity by being able to outsource and operate in the most efficient way. New firms struggle to create new channels because of the extra funds spent trying to create these ties. As this is the case for the marine industry. According to Brunswick s 10k their sole supplier of engine blocks for their engine segment comes from General Motors. This is a key distribution channel for Brunswick which adds to their advantage over new firms attempting to enter into the market. The institutional market makes up the biggest part of fitness sales. As a result, many of the older firms have set contractual agreements and position rights with these institutions making it hard for the new firms to be competitive in this market. The biggest barrier for new firms trying to gain access to these channels is the amount of capital it costs to gain them. Furthermore, without these healthy relationships, new firms will struggle to be as productive in marketing their product to the mainstream. These relationships to both industries pose a moderate threat to new entrants. 34

35 Legal Barriers Legal Barriers are the last barrier to the threat of new entrants. Because the profitability of the fitness and marine industry is based on new technology and innovations of their respective products, new entrants struggle to produce new products due to patents and trademarks of the existing firms. For example, ICON Health has one hundred and ninety five patents for their products (ICON Health, 10K). Older firms have an advantage because they are aware of consumer preferences and new technology. Along with patents, both industries have several safety and environmental regulations and standards to abide by in order for their product to be eligible for sale. An example of this would be that the U.S. government sets certain emission and environmental standards on marine engines, and in order for them to produce and sell engines they must meet the certain expectations set forth. Therefore, problems, especially lawsuits, for less experienced firms exist. In conclusion, legal barriers show potential problems to new entrants. As long as the new firms can stay parallel with new technology and make new innovations to their product, they will be able to patent their product and be competitive with existing firms in either industry. Conclusion In the fitness and marine industries, the threat of new entrants is minimal. Due to the barriers that new firms face, many will struggle to succeed. A firm can enter the industry in two ways and still be competitive amongst the top firms. One way is making connections through the right channels that give a firm the best economies of scale. The other is to be a leader in technology and innovations that will make a product superior to competitors. Threat of Substitute Products 35

36 Any industry faces potential substitute products, but in a specialized segment, such as fitness equipment, that threat is lower than in many of the broader ones. The functions of the products can be very specific with a relatively small number of substitutes. However, with little product differentiation and low switching costs, many of the products share similar functions so they must compete for the customer on a cost basis. The marine industry acts in the same way because boats and boat options are very similar to one another. Therefore, the marine industry competes on a cost basis. The threat of substitute products depends on the relative price as far as performance is concerned, and the customer s willingness to switch. Marine and fitness industries encompass many products with each facing some form of threat from substitute products. It s important to understand that not only do the different industries face different forms of threats, but also the different segments within that industry. Relative Price and Performance For firms that want to be leaders in the fitness industry it is important for them to develop products that perform as good or better than existing products. This allows them to compete with on relative price and performance. For example, Brunswick recently introduced a treadmill line that features seamless ipod integration in their consoles (Brunswick 10k, 2007). While most firms sales are made to health clubs and fitness facilities buying large quantities, which allow them to choose the best price available. If the equipment performs the similar functions, then customers are going to want the one at a lower cost. Therefore, when firms incorporate new performance characteristics, it may allow them to sell their product for a higher price. This is important because a very high level of cost competition exists in the fitness industry. For the smaller clients, such as private gyms and households, competition is not quite as cost based. A simple substitute for cardio equipment could be going outside and running or riding a bike. To attract these customers, low product cost is important. If the price is low enough, the customer could choose the convenience of doing cardio in their air conditioned home over running outside. Also, a variety of high end products 36

37 compete with others based off innovation and performance rather than cost. The threat of substitute goods for this type of target market is smaller than for customers purchasing in bulk. In the marine industry boats can be separated into two different categories: smaller recreational boats and yachts. The smaller boats, fishing boats, and powerboats have more available substitutes with slightly lower levels of differentiation; therefore the threat is greater in those areas. This can cause price competition against other large boat dealers and the specialized dealers such as Fountain Powerboats Inc. While customers want products that are capable of quality performance, if the perceived trade off of price for quality is not great, they will definitely go with the cheaper product. However, with the luxury boat line, the level of competition is lower than other segments because of the differentiation between products. Substitute products are going to be performance or luxury based, not price based. This can be viewed as a good thing for companies that offer both types of boats, because it can help diversify funds. For example, if a firm is a leading seller on their smaller boats line, then they can use some of the excess profits to plow back into their less profitable line. By doing this may allow the firm to produce a superior line of yachts and increase sells. The marine engine portion of the marine industry competes against substitute products on technology and performance rather than cost. In this industry, the threat of new technology can make old engines obsolete or less valued. Here, in the United States and other foreign countries are customers who demand the best performance. Therefore, it is quite common for firms to patent their products and designs to help assure that their competitors can t use the same features. This is important because it creates differentiation which allows the firm to charge a higher price. Customer willingness to switch Brand loyalty does not usually exist in the fitness industry. With low switching costs for the customer, it is essential to keep prices low to maintain a suitable market share. Furthermore, firms compete on a cost basis and satisfy customers with superior 37

38 product innovation and performance. Also, some customers may not be as quick to jump to the lowest price if it means sacrificing technology or quality. If a firm holds a large market share in the marine industry, the switching costs for the customers can be quite high in some cases, while relatively low in others. As stated before, the marine industry can be broken into two categories. Customers in the market for smaller recreational boats are more willing to switch products because the level of competition is high and more substitutes are closely related in these product lines. However the switching costs can still be high with regards to the high end line yachts. This is due to customer preferences, because people who are willing to spend such high amounts of money on a yacht will be more likely to switch brands on the basis of specific product features. The switching costs for the marine engine segment can be high because of product differentiation between different types of motors. Therefore, whoever has the best technology and quality motors at the lowest price is ultimately going to keep the customer. Also, many engines are sold independently to engine dealers. These engine dealers switching costs are lower, and they will always choose the best perceived value. Conclusion To be successful in the fitness industry, a firm needs large chains as customers as well as a significant amount of individual consumers. This is a highly competitive market with little differentiation and low switching cost for the customers, therefore the level of price competition is quite high. In the marine industry product differentiation accompanied by aggressive pricing tactics is essential to have a good market share. The overall threat of substitutes in the marine industry is moderate. Bargaining Power of Customers Bargaining power in both industries can be directly influenced by the structure of each industry. The industry structure flows from suppliers of raw materials to manufacturing firms who sell to customers. Customers in both industries have the 38

39 ability to purchase products in both a bulk fashion or on an individual basis. Bargaining power directly affects profitability on both sides. Suppliers with high bargaining power produce products that have few substitutes. Customers with high bargaining power can bargain on price. In the fitness and marine industries, suppliers have low bargaining power because of the various equipment substitutes. Also, suppliers of raw materials tend to sell in bulk which gives more bargaining power to the firm purchasing them. Customers have high bargaining power because they can choose which substitutes fit their budget. Due to the customer bargaining power, the firms in these industries must compete on price. Price Sensitivity Customers are more sensitive to price when few substitutes are offered, or there are small switching costs. If a firm has high switching costs, then they can charge high prices regardless if they lose customers. If a firm has low switching costs, customers can seek alternatives, which means firms have to charge low prices to compete. In the fitness industry, low switching costs exists. Customers can easily seek out of other equipment to meet their needs and budget. When ordering fitness equipment for a new gym, it would be pointless for a place like Gold s Gym to pay more for a Brunswick product than an ICON health product. The products are very similar and provide similar results. Differentiation is moderate due to smaller private products; however, key competitor s products are similar. The number and volume of buyers are unlimited with the spread of fitness corporations and household use. In the marine industry, price sensitivity of customers relies heavily on both the cost of the product and most important the quality (value) that customers are looking for. When switching costs (the cost a consumer experiences to switch brands) are relatively low and easy to achieve, then price sensitivity is higher and relies more on product differentiation. Buyers ask themselves two things; what features am I looking for and what am I willing to spend on a boat. An important aspect to understand with boats is that they are long term investments. In order to get quality product differentiation producers manufacture a wide variety of boat sizes, accessories, and 39

40 inboard/outboard engines. All of these three factors affect the price in which the boat will be sold. As a customer, a person can negotiate with producers to get just exactly what they are looking for. By doing this, it allows producers and customers to compete with prices of similar (quality) boats, but also to allow a wide range a differentiation. Relative Bargaining Power Relative bargaining power determines the point to which customers can force price to decrease. When we look at this power, we determine the cost each party will suffer if business is broken. In the fitness industry, large customers are usually fitness corporations, but independent gymnasiums, and households still hold business value. It is harder for fitness corporations to seek alternatives because fewer companies can produce the amount and diversification they need. However, it would still cost the supplier more if business was broken because alternatives still exist. Therefore, customers have the upper hand when it comes to relative bargaining power. Industry market share remains the focus with corporate clients. Independent gymnasiums and households have more relative bargaining power because of the number of private fitness that companies that specifically target this sector. All together, bargaining power of customers is high because of low switching costs and alternatives. In the marine industry, customers bargaining power can be determined by a number of different variables like the amount of customers in the boat market relative to suppliers, volume of purchases by a single customer, availability of competitors products, and switching costs associated in a particular market. The bargaining power of customers is fairly moderate; due to many competitors in the industry trying to gain a competitive advantage over one another in terms of price and quality. Since most of the industry s customers are dealers, customer s low switching costs allow them to negotiate fairly lower prices. Furthermore, due to the nature of such an investment, many customers only buy limited amounts of boats for a longer period of time. As a result, this limits the amount of return customers and increases the importance of keeping each potential dealer. Conclusion 40

41 In the fitness and marine industries, customers have significant bargaining power over companies. The various alternatives and low switching costs enable customers to readily take their funds to other competitors. With corporate clients, orders usually are in bulk which makes them hold more bargaining power because it would be that much more costly to the supplier. All in all, in the fitness industry, the customers have the upper hand in bargaining power. Number of Suppliers Switching Costs Differentiation Price Sensitivity Price Sensitive Price Sensitive Low Price Sensitivity Relative Bargaining Power High High Low Bargaining Power of Suppliers The bargaining power of suppliers is based up on the demand for their product and the number of suppliers in the industry. Many outside forces affect the demand in the economy for luxury items like boats i.e. rising oil and gas prices, favorable economic conditions, overall consumer confidence and discretionary income levels (Brunswick 10k). If the industry has many suppliers, suppliers are not powerful. On the other hand, if the industry only has few suppliers, suppliers have more bargaining power. Also, the more product demanded will directly affect the number of suppliers. More demand means more suppliers, and vice versa. In the fitness and marine industries, many suppliers and alternatives exist; therefore suppliers have little amounts of bargaining power. Demand is still manageable due to low positive growth rates, but as stated earlier, it is more beneficial for companies in this industry to take yearly losses than shut down. Price Sensitivity The fitness industry proves to be price sensitive because of the large amounts of alternatives and numerous suppliers. Corporate clients are the money makers for the larger firms and often they alone will compete for market share. For example, Gold s 41

42 Gym has a contract with ICON health that expires in six months and states that for every store Gold s Gym opens, they must buy an allotted amount of equipment for ICON. At the same time, Gold s Gym plans to open ten more stores, or fitness facilities, in the next three years. At the time of near expiration, competitor s like Brunswick will make offer equipment of the same quality, but slightly cheaper. In this industry, price sensitivity is a result of low switching costs. Except this switching costs deals with the cost that a customer receives if they opt to switch suppliers. For example, most fitness equipment consists of steel. If this was the main cost of the company, the company would need to research prices from steel suppliers. Ultimately, the fitness industry is price sensitive because of the abundance of alternatives and low switching costs from suppliers and even suppliers of suppliers. While the marine industry focuses on differentiation among products to enhance product sales, this enables suppliers to be less price sensitive than they would be if all manufactures sold the exact same types of marine products. While switching costs are low causing producers to be price sensitive, certain patents and trademarks allow companies to differentiate their products. This allows companies to enhance the quality of their products and allows them to charge higher prices. Furthermore, the greater number of dealerships in the market adds to an increased market share competition. This leads dealers to be fairly price conscious. For example, suppliers don t want to shy any potential customers away to a similar product that may not be as high in quality, but offered at a lesser cost to the customer. Few customer switching cost, differentiation between products and a higher volume of marine suppliers contributes suppliers bring fairly price sensitive. Relative Bargaining Power The more profitable the relationship between the customer and supplier, the less bargaining power exists between the two. Relative bargaining power deals with the cost of the customer-supplier relationship. The lower the cost, the less relative bargaining power will exist because it is more profitable for customer and supplier to do business. As the switching costs decrease, the bargaining power of the customer 42

43 increases. As the switching costs increase, the bargaining power of the supplier increases. In the fitness industry, the supplier has little bargaining power, which is partly due by low switching costs and prevalent alternatives. In addition, suppliers lack bargaining power due to large amounts of suppliers within the industry. As the number of suppliers increase, the lower the bargaining power for suppliers. Gold s gym among others can do thorough research to ensure they are getting quality and price. Price is where suppliers compete to gain market share. Finally, one way a supplier can increase its bargaining power is forward integration. Forward integration is the expansions of a business products and/or services to related areas in order to more directly fulfill the customer's needs ( For example, Brunswick could by the supplier who provides them with steel to make all their products. This would reduce costs, therefore giving them a production advantage over competitors. In the marine industry, a fine line distinguishes who has more bargaining power over one another. For example, if a particular customer is in the market for a specific boat with certain features that are only offered by one or two suppliers, then the bargaining power for the supplier will be higher. However, if a particular customer is indifferent of certain features and does not care switching to another supplier (i.e. low switching cost), then the supplier loses bargaining power. Also, the number of suppliers relative to the number of customers in the market reduces the bargaining power of suppliers. Ultimately, product differentiation helps increase suppliers bargaining power over certain customers. Yet factors like low switching costs for customers and the high number of competitors forces suppliers to have fairly lower bargaining power over their customers. Number of Suppliers Switching Costs Differentiation Price Sensitivity Price Sensitive Price Sensitive Moderate Price Sensitivity Relative Bargaining Power Low Low High 43

44 Conclusion All together, high price sensitivity and low bargaining power give suppliers low bargaining power. Low switching costs give more bargaining power to customers. Suppliers will directly compete with each other for market share. Aggressive pricing strategies to obtain market share will determine the price for industry products. ANALYSIS OF KEY SUCCESSS FACTORS FOR VALUE CREATION IN THE INDUSTRY A firm s profitability is also influenced by its strategic position, or the angle is takes at competing in the industry. Business strategies provide direction and focus to firms; it is crucial for firms to identify specific business strategies relative to their industry. Two of the basic types of business strategies are cost leadership and differentiation. The fitness and marine industries are driven primarily by cost leadership; however, differentiation is also prevalent. Therefore, both perspectives are important and how each plays different roles in the industry. Cost Leadership As previously stated, the fitness and marine industries produce similar products with many alternatives and low switching costs relative to their industries. As a result, firms must focus on cost leadership strategy, or in other words, compete on price in order to gain market share. Key components that lead to cost leadership are as followed: economies of scale, efficient production, lower input costs, cost control, and research and development. 44

45 Economies of Scale and Efficient Production Processes The fitness industry mass produces products though efficient production processes; the industry has high economies of scale due to their production assets. The increase in products will decrease the average cost per unit, therefore, giving that firm a competitive edge through efficient production processes. When the average cost per unit decreases, it allows firm s to charge lower prices and capture additional market share in the price sensitive market. Firms in the marine industry have strong economies of scale. Large firms such as Yamaha, Honda, and Brunswick have the ability to purchase high amounts of raw material at discounted prices. Small firms such as Fountain Powerboat Industries, Inc, have the better ability to manage labor costs. Brunswick Corporation, Honda, and Yamaha are able to produce larger quantities than smaller competitors so they are able to spread their fixed cost over a much greater number of units. This decreases the cost of good sold per unit. In the marine industry, efficient production is limited because some processes are not as automated as others (i.e. quality control and product testing). More specifically boats need to be checked for balance to have good buoyancy and engines need to meet government regulations on emissions output. The industry does not really compete on simpler product designs because boats and engines have specific requirements and are complex in nature. Overall, the industry is limited with efficient production and simpler produce designs activities. Lower Input Costs One way a firm can lower total costs is to create a price sensitive market with their suppliers by purchasing large quantities of raw materials. As stated earlier, the primary material used in the fitness and marine industry is steel and fiber glass. These firms can exercise control over suppliers because of low switching costs and the bargaining power of the firms in each industry. Also, firms can choose to use the power of forward integration to eliminate middleman costs. Usually, in a price sensitive industry, material suppliers, such as steel and fiber glass, are forced to compete with each other on price to maximize profitability. 45

46 Cost Control In order to compete in the fitness industry, firms must cut prices when needed to maintain their competitive advantage in the price sensitive market. Due to highly specialized production assets, this industry holds a high fixed to variable cost ratio. Therefore, any unnecessary costs are holding the company down from increasing competitive advantage. Slight cost cuts allow company to cut overall cost just enough to help capture competitor market share. This can be done by taking the amount of money saved and plowing it back into other areas of the company like R&D. Take for example Brunswick. They are currently reducing $300 million in fixed costs by closing 4 manufacturing facilities. They can then take those savings and utilize them in areas that can help them become more profitable. In the marine industry, costs control can be very difficult to maintain because of the high cost to make a boat or engine. Plus, the marine industry is fragmented. Small firms are able to control labor costs better than larger ones because of their relative sizes, but are not as capable in controlling the cost of raw materials. The opposite occurs for large firms. Larger firms are able to utilize their size and purchase higher quantities of materials at a discounted price. Differentiation Differentiation is the act of setting one firm apart from another by a way of improved business process, brand image, and many other things. In order for firms to compete with competitors, three things must be done. First, one or more attributes of a product customers value must be identified. Next, a unique angle must be taken to meet those certain attributes. Finally, a firm must value the product at a lower price than the customer is willing to pay for the differentiated project. The key is that the attribute must set the company apart and fit the needs of customers at the same time. In the fitness industry, usually low manufacturing costs and production efficiency 46

47 provide differentiation. A high level of differentiation exists in the marine industry since most companies have a hard time competing on cost. Differentiation in any industry must have quality products, variety products, customer service, flexible delivery time, trademarks, research and development, and limited cost on innovation and creativity (Palepu & Healy). Another example would be in the automotive industry, with regards to things like brand image, quality, and research and development. Hence the difference in the experience when driving a Cadillac as opposed to a Honda. Quality Quality is linked to the product s level of grade. In the fitness industry, quality is extremely important because the machines are high specialized to perform specific fitness functions. If a corporate firm chooses a supplier to purchase fitness equipment from, it is instilling trust and liability in those products. Personnel are going to use these machines so they must perform at a high level to ensure safety and desired results. For example, if Gold s Gym realizes an increase in machine maintenance on its books, the firm will, most likely switch suppliers to offset this rise in cost. With regards to the marine industry quality is important to the extent that the firm wants repeat customers. If a customer spends a significant amount of money on a poor product they will be less inclined to purchase that brand again. Therefore, they want to keep quality costs at a minimum but still meet consumer quality expectations. Product Variety In the fitness industry, companies that can produce a variety of products from free weights, machines, treadmills, etc. are more valuable to the industry. For example, ICON health produces multiple fitness equipment and captures dominating market share. On the other hand, companies that are limited to household fitness equipment are limited to the variety, which limits market share. The same holds true for the marine industry. By offering more than just one type of product they are able to tap into the market share of the different variety of boats like fishing boats, recreational boats, and yachts. 47

48 Research and Development Research and development drives innovation in products and manufacturing technologies. It deals with the introduction of new products and enhancing existing products. In this fitness industry, product and design are key components of differentiation. Large competitors spend millions each year in research and development with the goal of designing new products that can be sold before competitors. The following is a chart that explains the amount of R&D as a percentage of total sales in each industry Fitness Industry: 2.15% 2.39% 2.67% 2.81% 4.65% Marine Industry: 2.58% 1.98% 1.96% 2.02% 2.06% The chart above explains that the fitness industry spends a considerable amount more in R&D in relation to their sales. The ratios are increasing from 2003 to 2007 at a steady rate. As for the marine industry there is some validity that is caused by an increase in the amount of marine sales in retrospect to R&D expenses in 2004 to In 2006, Brunswick and ICON health alone spent twenty six million dollars on research and development (Brunswick 10K, ICON health 10K). Along with the revenues, new technologies can influence brand imaging by sending messages to customers that the company is constantly improving products to meet consumer needs. Creative Product Appearance Product appearance is related to the reaction of consumers when viewing products. In the fitness industry, product appearance plays a key role in differentiation. Products must have innovative designs to look up to date. For example, new machines need to look new and specify directions for all intended uses muscles being worked. 48

49 Owners and users desire machines that look and feel reliable. This is why you often see fitness gyms constantly changing their facilities. For example, a local fitness gym in Flower Mound (Health and Athletic Center) just recently did a complete makeover of their facility. When asked as to why they were doing so they replied that it was in order to keep up with the new gyms (Lifetime Fitness) that where offering the latest in fitness equipment. Their sharp decline in memberships was directly related to the fact that people want the latest in fitness equipment. The same holds true for the marine industry. If product appearance is better from product to product, the one that provides the best appearance will gain differentiation. This is why you see new models of boats from year to year. People are less inclined to buy last years model when the new one provides new things like improved sound systems, passenger towers, and better engine designs that offer more power. This is further supported by the fact that companies spend large amounts of money on research and development; to constantly keep up with the latest in product appearance and performance. Conclusion Cost leadership is the single most important strategy in creating a competitive advantage. Industry customers desire quality machines at low prices. However, differentiation also provides a competitive advantage. If a product or process is better than competitors, a firm will have differentiation in that industry. In the fitness industry, low cost and differentiation together combine to control market share. In the marine industry, recreational boats and engines depend on some cost leadership, but heavily on differentiation. Cost leadership strategy allows firms to control some cost; but cost is necessary to make boats and engines and some of the raw material cannot be purchased at a discount. Differentiation plays big role in the industry, allowing small and big firms to compete together. FIRM COMPETITIVE ANALYSIS 49

50 Although many business strategies exist, the two general strategies are cost leadership and differentiation. After performing an industry analysis of the success factors and competitive strategies of the fitness industry, Brunswick Corporation can be categorized to be a cost leader. Brunswick strives to obtain quality and innovation globally at the right cost ( Economies of Scale Brunswick Corporation produces highly specialized equipment. They are able to buy high volumes of raw material to help minimize the input costs and receive large orders. Brunswick had the highest net sales in the industry for both boats and engines. With mass unit production, their fixed costs are spread out over the mass. Brunswick also operates in three different industries; however, their production assets can perform operations in multiple industries. For example, Brunswick s production asset molds steel into different shapes so therefore it can be used to mold steel for fitness equipment and boats. These assets are what make Brunswick because by having this competitive advantage, it lowers their production cost which rolls over to overall price of product. Below is a chart that represents the amount invested in PP&E for all of Brunswick s competitors. Net PP&E (in millions) Brunswick Corporation Cybex International ICON Health N/A Fountain Powerboats Marine Products As the table shows, Brunswick net property, plant, and equipment dominant all other competitors. Granted it competes in three industries, but Brunswick production assets allow them to be industry leaders in all three by being extremely efficient. By being efficient, it has allowed Brunswick to lower prices and maximize growth in the industry. 50

51 Another way that Brunswick capitalizes on their overall size is their ability to spend large amounts of money on capital expenditures and acquisitions. Below is a chart that shows how much money Brunswick spent on capital expenditures and acquisitions over the past five years. (in millions) Capital Expenditures Acquisitions As time goes on Brunswick has increased the amount of money spent on capital expenditures and decreased the amount spent in acquisitions. Some of the various capital expenditures and acquisitions they take part in are purchasing manufacturing plants, marinas, and research. By purchasing manufacturing plants it enables them to increase flexibility, productivity, and efficiency with regards to production. Also, by expensing money to research allows them to develop new software and other information technology resources. Cost Control/ Input Costs Brunswick Corporation has experienced growth despite the slowing on consumer spending on recreational products. Brunswick has a competitive advantage because of their low global cost of manufacturing products. Brunswick achieves this by having production assets that can do multiple operations for different industry products. Also, it has production plants in multiple segments of the world, which decrease the amount of transportation cost of materials and products. However, one indication might hint that the price of steel could increase due to a global demand for steel ( If the price of steel increases, input costs will increase, and firms will have to be extremely careful to not lose market share when resetting prices to offset the increase. Spot prices for steel are up $649 from last year. U.S. Steel Corporation s stock is up 4.38%. The graph below dictates the price of stock for U.S. Steel Corporation. 51

52 As the graph shows, the price of stock has recently decreased due to a decrease in demand for steel, which translates to lower input costs for the fitness and marine industries. Product Variety Brunswick Corporation competes in four different industries; therefore the firm offers a variety of products. In this fitness industry, Brunswick operates under the brands Life Fitness, Hammer Strength, and ParaBody. Each of these brands offers different fitness equipment ranging from elliptical machines, treadmills, strength machines, and free weights. In the marine industry, Brunswick operates under the brands such as Sea Ray, Mercury, and Mariner. Under these brands, Brunswick operates using the cost leadership strategy. This strategy allows Brunswick to compete with competitors using its own products to its advantage. In other words, Brunswick s different brand names and products to compete against each other to control market price and capture market share. Research and Development Brunswick Corporation considers research and development important in recreational sports. The company strives to improve its competitive position in all of its segments by continuously investing in research and development to drive innovation in its products and manufacturing technologies (Brunswick, 10K). Brunswick spent 52