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OCTOBER 20, 2008 Analyzing Your Industry: Market Concentration By Clint Reiser Keywords Market Concentration, Strategic Analysis , Market Intelligence, Analysis Tools ARC Advisory Group produces Market Overview Outlook Studies that provide valuable Companies can apply the data in market studies to information on technology markets. evaluate the structure of a market across numerous Companies can apply the data in market dimensions. Market concentration is one such di- studies to evaluate the structure of a market across numerous dimensions. Market concentration is one such dimension of interest to strategic mension of interest to strategic planners. Understanding the distribution of market share among the suppliers within the market can provide insight into the degree of competition within the planners. Understanding the market or segment analyzed. The two commonly distribution of market share among the used measures of concentration are the Herfindahl- suppliers within the market can provide Hirschman Index (HHI) and the Four-firm Concen- insight into the degree of competition tration Ratio. The Four-firm Concentration Ratio is within the market or segment analyzed. an easier calculation requiring much less data. The higher the concentration ratio, the greater the mar- ket share held by the top four firms. As a general rule, a ratio of greater than 60 percent is considered highly concentrated and a ratio of less than 40 percent is considered an indication of a competitive market. Concentration measures can be a useful indicator of the degree of competition in a market, but they should be supplemented with other information to determine a market’s structure. Applying Market Research ARC Advisory Group produces Market Outlook Studies that provide valuable information on technology markets. These studies provide market size, segmentation, and growth estimates, in conjunction with qualitative information that discusses the drivers within the market. The content and THOUGHT LEADERS FOR MANUFACTURING & SUPPLY CHAIN ARC Insights, Page 2 format of these studies is designed to serve as an effective planning guide for incumbent suppliers within the market, potential market entrants, and buyers. Suppliers can utilize the research data to enable informed investment decisions in areas such as product development expense allocation and the evaluation of potential merger and acquisition candidates. Market Concentration Companies can apply the data in market studies to evaluate the structure of a market across numerous dimensions. Market concentration is one such dimension of interest to strategic planners. Understanding the distribution Information on market concentration can be used to evaluate relevant factors such as a supplier's ability to influence of market share among the suppliers within the market can provide insight into the degree of competition within the market or segment ana- pricing, the likelihood of market lyzed. This information can be used to evaluate consolidation in the future, and the relevant factors such as a supplier's ability to attractiveness of a segment for a new influence pricing, the likelihood of market con- entrant. solidation in the future, and the attractiveness of a segment for a new entrant. Research studies, such as ARC Market Outlook Studies, estimate the overall size of a market and the market's segments and provide the names and shares of leading suppliers. This valuable information can be supple- mented with other standard methods for evaluating the concentration of the market. These standard concentration measures are in widespread use by governments and economists. They are also available to the public and can serve as a framework to compare and contrast the concentration of your market with the concentration of similar markets. Market Concentration Measures The two commonly used measures of concentration are the HerfindahlHirschman Index (HHI) and the Four-firm Concentration Ratio. The HHI is the summed square of the 50 largest firms within a market. In a competitive market, the HHI is a small number. In an uncompetitive market (one or two firms dominating), the HHI is a large number. The Four-firm Concentration Ratio is an easier calculation requiring much less data. It is simply the sum of percentages of market sales attributed to the four largest firms in the market. The higher the concentration ratio, the greater the market share held by the top four firms. As a general rule, a ©2008 • ARC • 3 Allied Drive • Dedham, MA 02026 USA • 781-471-1000 • ARCweb.com ARC Insights, Page 3 ratio of greater than 60 percent is considered highly concentrated and a ratio of less than 40 percent is considered an indication of a competitive market. In the United States, the census bureau publishes the 4, 8, 20, and 50 largest firm concentration ratios for numerous industries categorized by the NAICS codes. Four-firm Concentration Ratio in the EAM/CMMS Market The Four-firm Concentration Ratio in 2002 for Software Publishers (NAICS 511210) in the United States was 39 percent. The ratio for this broadly defined market falls just inside 40 percent, the generally accepted boundary of a competitive market. According to ARC research, the Four-firm ratio for the 2006 Worldwide EAM/CMMS market is 42 percent and the North America EAM/CMMS market is 40 percent1. This comparison indicates that the concentration of the 2006 EAM/CMMS software market is comparable to the concentration of the broadly defined Software Publisher market in 2002. Market Year Geography 4 Firm Concentration Software Publishers 2002 United States 39 percent EAM/CMMS 2006 Worldwide 42 percent EAM/CMMS 2006 North America 40 percent EAM/CMMS Tier 3 2006 Worldwide 33 percent PAM 2006 North America 70 percent Example Four-firm Concentration Ratios A strategic planner may utilize the ratio of the worldwide EAM/CMMS market to gauge the relative attractiveness of the market segments within the EAM/CMMS market as a whole. For example, the concentration ratio for the EAM/CMMS market for Tier 3 customers is 33 percent, indicating a market segment that is more fragmented than the market as a whole. This confirms ARC's view that the Tier 3 market is less concentrated than the market for larger customers. A company may believe, all other things remaining equal, that a less concentrated market is more attractive for new 1 ARC's definition of North America consists of the United States and Canada ©2008 • ARC • 3 Allied Drive • Dedham, MA 02026 USA • 781-471-1000 • ARCweb.com ARC Insights, Page 4 entrants than a highly concentrated market. In this situation, the concentration ratio can serve as a rough cut analysis from which further analysis on marketing opportunities can be directed. A concentration ratio can be used to evaluate: Different segments within the same market The same market over time The structure of an adjacent or complementary market The Four-firm ratio can also be utilized to evaluate an adjacent market in which the firm in considering entry. For example, many EAM systems integrate with Plant Asset Management (PAM) systems that feed information on the health of production and automation assets up to EAM for input into predictive maintenance plans. A large EAM/CMMS firm may be inter- ested in determining if expanding into the PAM market would be profitable. In this situation, a quick calculation of the North American PAM market would result in a concentration ratio of 70 percent, an indication of a highly concentrated market. A ratio at this level is indicative of a market where incumbents may have substantial pricing power. It may also indicate that the market has high barriers to entry and would be most sensible to enter through a partnership rather than a product extension. A concentration ratio may also be used on the same market or segment over time - a time series analysis. The analysis of a market concentration over time can provide a gauge of the degree to which a market is consolidating. This information may be useful for determining the maturity of a market and for predicting the trend of the average selling price within the market. For example, average selling price and margins may be above normal when a market is maturing. When a market has matured, prices tend to drop and margins decrease. However, a mature market that has experienced a high degree of consolidation may begin to experience less competition that can lead to higher prices and profit margins. This information can be particularly useful to large market participants attempting to gain share of a mature market. Last Word Concentration measures can be a useful indicator of the degree of competition in a market, but they should be supplemented with other information to determine a market’s structure. Concentration ratios do not take into consideration barriers to entry into a market, relationships with suppliers ©2008 • ARC • 3 Allied Drive • Dedham, MA 02026 USA • 781-471-1000 • ARCweb.com ARC Insights, Page 5 and buyers, growth prospects, the profitability of current suppliers, or one's own market position. A Concentration ratio is a "rough-cut" market or industry evaluation method. The results are influenced by the scope and geographies being analyzed. For example, the national market for heavy equipment rental is likely to have many participants while there is likely to be only a handful of participants in a specific local metropolitan area. Those who utilize these ratios in their analysis should do so in conjunction with other means of evaluating the status and attractiveness of a market. For further information or to provide feedback on this Insight, please contact your account manager or the author at [email protected]. ARC Insights are published and copyrighted by ARC Advisory Group. The information is proprietary to ARC and no part of it may be reproduced without prior permission from ARC. ©2008 • ARC • 3 Allied Drive • Dedham, MA 02026 USA • 781-471-1000 • ARCweb.com