Question 5 - 29273

Connie Sallie, CFA, is a media and entertainment analyst for ABC Investment Research, Inc. In recent weeks, Sallie has been researching a relatively new trend in the entertainment industry ・satellite radio. The following are excerpts from Sallie痴 report.

Exhibit 1: Satellite Radio Industry Report

Satellite radio is seeking to do for the radio business what cable has done for the TV broadcasting business. Satellite radio allows listeners to have access to multiple music, news, and talk stations, all without the commercial interruption that is common with traditional FM and AM radio. The general business model for satellite radio operates on a subscriber basis. Customers contract with the satellite radio company, and pay anywhere from $6.95 to $10.95 per month for content. The business model is a significant departure from the traditional radio business model where content is free, but radio stations make money by selling advertisements which are broadcast along with the radio programming. Some are skeptical if consumers will actually be willing to pay for something that they are used to getting for free; however, the cable TV industry has definitely shown that consumers are willing to pay for a wider variety of content.

Since the concept痴 introduction, the number of subscribers in the satellite radio industry has grown at an annualized rate of 25 percent over the last 3 years. Because of the novelty of satellite radio, some customers are willing to pay a premium price in order to try the new technology. Profit margins are currently 44 percent, compared with profit margins of 12 percent for the cable TV industry, and 8 percent for the average media company.

Firms coming in to the satellite radio industry must be licensed with the FCC. The licensing process consists of filing an application and paying a nominal application fee. Currently the radio receiver equipment used to receive satellite radio is broadcasts is specific to each firm. However there are some efforts to create a standard method of broadcasting which would mean that any receiver could receive any satellite broadcast. Most firms produce their own proprietary receiver equipment, as the technology used to manufacture receivers is not complex and has existed for decades.

The satellite radio industry consists of three main companies.

·   Galileo Radio (Galileo) is the largest company in the industry with over 2,000,000 subscribers and 100 channels comprising a broad mix of news, talk radio, and music. Galileo charges a monthly fee of $8.95 per month and often provides the equipment customers need to receive Galileo痴 broadcast signal for no additional charge as part of a 2-year subscription agreement. In a meeting with Galileo痴 management, they have said that they are actively trying to add stations in all three major categories (talk, music, news) to increase economies of scale in their operations and appeal to a wider array of customers. They are also constructing a new factory that will allow them to produce radio receiver equipment at a cost that is 20 percent less than their current cost.

·   Copernicus Radio (Copernicus) has 1.2 million subscribers and offers 86 channels of news, music, and talk radio. Monthly subscriptions are $10.95 per month with a 1-year minimum, and signal receiving equipment is sold at a discounted price when customers subscribe. Copernicus has the exclusive rights to talk radio shows from Henry Grim and Benjamin Scmeck, two of the most popular talk radio hosts in the U.S. They also have an exclusive agreement with FNN, a popular financial news network. In a meeting with management, Copernicus stated that they will actively pursue exclusive agreements in the music industry despite the lucrative fees to the talent involved.

·   Columbus Radio (Columbus) is the smallest of the three companies with only 60,000 subscribers and only 42 channels. The firm charges $50 up front to consumers for the radio signal receivers and a subscription fee of $8.95 per month with no minimum commitment. Of the 42 channels offered by Columbus radio, 35 of them are news stations which include Asian news, South American news, and European news stations not offered by the other companies.

Sallie is being assisted in her research by Nathan Munn, a junior analyst who recently joined the firm. Sallie wants to make sure Munn understands the concept of the industry life cycle. Sallie believes that asking Munn to identify which stage of the industry life cycle satellite radio is in would be too easy of a question, so instead, she asks him to provide a brief report containing two statements regarding industry life cycle phases. A copy of Munn痴 report is below.

Exhibit 2: Munn痴 Report on Industry Life Cycle Phases

A) The growth phase is the earliest stage of the industry life cycle during which sales and earnings are accelerating at a rapid pace.

B) The mature stage is characterized by decelerating growth and consolidation among participants.

Part 1)

Given the information in Sallie痴 report, which of the following best describes the generic competitive strategies being employed by Galileo and Columbus?

Part 2)

Sallie identified three potential risks associated with Copernicus・generic competitive strategy.

Which of the following best describes the generic competitive strategy followed by Copernicus, and which statement(s) correctly identifies a risk of that strategy?

Part 3)
In her report, Sallie includes a section that uses Porter痴 five forces to assess the profitability of the companies in the satellite radio industry. Which combination of Porter痴 five forces will have the most impact on the pricing power of a firm?

Part 4)

Based on Sallie痴 report, which of the following best describes the current bargaining power of buyers and the threat of new entrants for the satellite radio industry?

Part 5)
Which of the following is least likely to influence industry pricing practices and trends?

Part 6)
Which of the following regarding the statements made in Munn痴 Industry Life Cycle report is TRUE?

Question

Part 1)
Your answer: B was correct!

Based on the information in Sallie’s report, Galileo’s strategy would be best described as cost leadership. A successful cost leader earns a higher profit margin than the rest of the companies in its industry because its prices are comparable and its costs are lower. The information in Sallie’s report states that its monthly fees are $8.95 (right at the average of the $6.95 and 10.95 range for the industry). A cost leader will be an above average performer if the product is priced at or just below the average industry price (comparable price, lower costs). The report also tells us that Galileo is seeking to achieve operational economies of scale by offering more channels, and is looking to construct a factory that will decrease the production costs of their receiver equipment. Both of these items are indicative of a firm looking to lower costs and support the conclusion that Galileo is following a cost leadership strategy. Note that a cost focus strategy involves seeking a competitive cost advantage of a narrow sector of the market, forsaking the competitive advantage in others. It appears that Galileo is seeking to reduce costs in more than one area (radio receiver production, delivering content), therefore cost leadership is clearly the best answer.

With a differentiation focus strategy, a firm tries to achieve differentiation in a narrow segment of the industry. Columbus appears to be focusing on news broadcasts (a narrow segment of the industry) that are not offered by its competitors.

Part 2)
Your answer: B was correct!

Based on Sallie’s report, Copernicus has or is seeking exclusive content deals across the music, talk, and news segments and charges a higher price for its product – both of these factors are indicative of a differentiation strategy. Note that a differentiation focus strategy would only seek to achieve differentiation in a narrow segment of the industry (such as Columbus ’ focus on news).

The main risks associated with a differentiation strategy are:

• Not achieving cost parity because of high costs required to differentiate

• Failing to maintain differentiation because of a change in customer preferences or imitation by competitors

• Losing out to differentiation focusers in each segment

Only Statement 1 pertains to a differentiation generic strategy. Statement 2 is a main risk of a cost leadership strategy, while Statement 3 is a risk of a differentiation or cost focus strategy.

Part 3)
Your answer: B was incorrect. The correct answer was C) Rivalry among existing competitors, threat of new entrants.

Revenue for an industry is mainly influenced by price and quantity. When analyzing the risks associated with revenue forecasts, an analyst should evaluate the strength of existing and potential competition to evaluate how that competition will exert downward pressure on prices and quantity sold. Although all of Porter’s forces five forces may influence pricing power to a degree, those directly related to competition – rivalry among existing competitors and the threat of new entrants will play the largest role in determining the type of pricing power available to a firm.

Part 4)
Your answer: B was incorrect. The correct answer was A)

The bargaining power of buyers is a function of bargaining leverage and price sensitivity. Based on the information in Sallie’s report, for a consumer to switch to a new satellite radio provider, they would need to purchase new equipment and enter into a new monthly contract, meaning switching costs are high. We are also told that buyers are currently willing to pay a premium price to try the new technology. The current bargaining power of buyers would be best classified as low.

The threat of new entrants is a function of economies of scale, product differentials, brand identity, capital requirements, access to distribution channels, government policy, and cost advantages. Sallie’s report addresses some of these components. It appears that it is relatively easy to obtain a broadcast license with the FCC. In addition, although the equipment used is proprietary, the fact that it is not complex and that the technology has existed for decades suggests that capital requirements are low. Based upon the facts cited in the report, the best conclusion is that the threat of new entrants is high.

Part 5)
Your answer: B was incorrect. The correct answer was C) Government regulation.

Factors that are most likely to influence pricing trends for the industry are related to Porter’s five competitive forces and product segmentation. Product segmentation refers to the firm’s ability to differentiate its product (e.g. branded versus generic products). Industry concentration and capital outlays are related to Porter’s five competitive forces. While government regulation may impact pricing practices for certain industries it is not generally a factor in predicting industry pricing trends.

Part 6)
Your answer: B was incorrect. The correct answer was C) Statements A and B are both incorrect.

The pioneer stage is the earliest stage in the product life cycle. In this stage acceptance of the product or service is uncertain and failures are common. The growth stage represents the second stage where accelerated sales and earnings are common for firms that survived the pioneering stage. It appears Munn forgot about the pioneer stage, therefore Munn’s first statement is incorrect.

In the mature stage, industry growth is more in line with the general economy. The decline stage is characterized by falling profit margins as a result of shifting tastes or new technologies overtaking the industry. Industry participants in the decline stage consolidate, reinvent themselves, or fail. It appears that Munn confused the decline and maturity stages, therefore his second statement is incorrect.