This installment of my series on how Porter's Five Forces impact the telecom operator segment of the telecommunications industry will continue to break down the "Power of Buyers" that was started in the last installment. Porter's Five Forces are a framework for assessing the competitive structure of an industry and can be used to analyze the effectiveness of the strategies of companies in the industry.
The previous installment discussed those aspects of the "Power of Buyers" that applied to both business and individual consumer customers. The focus turns now to those aspects that are applicable only to business customers, and specifically to Frontier Communications (FTR) and its competitors. These subcomponents are 1) the business customers' profit margins, 2) the possibility of backward integration by business customers, and 3) the ability of business customers to influence their own customers' purchases. As was the case in the last installment, investors need to try to determine how easy it is for buyers to drive up prices of the products and services offered by the companies in the telecom operator sector.
When examining the profit margins of business enterprise customers, Porter's model indicates that the higher the profit margins of buying companies, the less price sensitive they are and the greater the power of the selling industry or company. In other words, those companies that have a low profit margin are more sensitive to the costs of their purchases and thus retain greater power over the telecom operators because they will aggressively pursue product or service alternatives.
This insight assumes holding constant the price of the selling industry's product or service as a percentage of the buyers' total costs. Frontier and other telecom operator companies do not disclose which industry sectors make up their business customers. In order to analyze this subcomponent of the "Power of Buyers," we need an alternative method of deducing profit margins and price sensitivity of business customers. I make the assumption that telecom operators serve business customers across the full range of industry sectors so comparing profit margins of the overall market against the telecom industry's average margins, and to Frontier in particular, gives us a picture of relative profit margins. The telecom utility sector, which is roughly analogous to telecom operators, had an operating margin of 15.8% as of January 2012, compared with 17.2% for the overall market, 23.9% for Frontier, and 15.8% for AT&T (T). From this fact, I conclude that on average, Frontier's business customers have some buying power over it and that business customers do not have buying power over the telecom operators as a group.
This analysis suggests Frontier is in an inferior position to some of its competitors because it has higher profitability, which may erode over time to a level closer to the industry standard. However, the profit margin aspect of the "Power of Buying" force becomes a mixed picture when considering net profit margins. On this metric, also as of January 2012, Frontier has a margin of 4.0%, compared with 8.3% for the overall market, 10.9% for AT&T, and 8.5% for the telecom operator segment. This suggests that Frontier is in a superior position to its competitors, because it has lower profitability.
A third profitability measure we can use to evaluate the margins of telecom operators and their business customers is gross margin. The overall market had a gross margin (before depreciation) of 43.3% compared with the telecom operators at 59.6%. Frontier does not classify Cost of Goods sold on its income statement thus I assume that its gross margin is comparable to the industry. These figures suggest that both the telecom operator segment and Frontier are in a weak position relative to the business customers because their gross margins are greater. The overall conclusion that I draw from these three profit metrics is that there is a balance between the telecom operator segment and its business customers and that Frontier occupies a neutral position within the segment.
The next subcomponent of the "Power of Buyers" force is the possibility of backward integration by business customers. As stated above, telecom operators and Frontier specifically do not break out the composition of their business enterprise customers by sector. Therefore, I have made the assumption that since all types of businesses consume the voice services of the telecom operators, all business segments are customers of the industry as a whole. I believe there is very little incentive for the overwhelming majority of the telecom operators' business customers to integrate backwards, primarily due to the previously discussed "Barriers to Entry." However, another aspect of this subcomponent is that business customers that have the ability (but not necessarily the motive) to integrate backward may have knowledge of the true costs of the telecom industry and thus have power to negotiate prices. Because I can not quantify the share of total revenue to any single industry, I cannot comprehensively analyze this factor, but I do believe it to be of minor significance given the probable diversity of the telecom business customer base.
Finally, there is the ability of the business customer to influence his or her own customers' purchases. When business customers are able to influence their own customers' purchases and they are selling goods supplied by the industry in question (telecom operators), these business customers wield significant buying power. In other words, industries that are one link in a supply chain are subject to the buying power of the next link into which it sells if that next link has the power to influence its customers. Examples include retail jewelry, appliances or sporting goods. In the case of the telecom operator segment where voice, data, internet and access services are being sold to other businesses, this aspect of the "Power of Buyers" is not highly relevant. The only business line that could be part of a supply chain is equipment sales and this constitutes a very minor portion of the overall industry. Approximately 100% of Frontier's sales are from voice, data, internet and access services with essentially none from equipment sales.
The "Power of Buyers" is an important force for an investor to consider when analyzing companies and their industries. My conclusion is that the telecom industry is at a definite but not overwhelming disadvantage to its individual consumer customers and at a larger disadvantage to its business customers. The most significant aspects of the "Power of Buyers" that impact the buying power of consumer customers are the commoditized nature of telecom services and the ease of switching, which were presented previously.
The commoditized nature of telecom services is the single biggest factor in the advantage that business customers have over the telecom operators while the percentage of costs and the number of buyers play secondary roles in their buying power.
I believe Frontier is well positioned relative to its industry competitors, thus I maintain my stance about the "Power of Buyers" impact on the company. In the next installment of this series, I will move on to the fourth and fifth of Porter's Five Forces, which are the "Threat of Substitutes" and "Competitive Rivalry."