on the plus side…
1. The high cost of entry into a capital-intensive business can act as a barrier to competition. For example, almost anyone can come up with the money to open a restaurant. But if a big semi-submersible offshore drilling rig costs $100 million, the number of new parties that can give the industry a try is very limited.
2. First mover advantage can be considerable. Site location can be important, for example, for proximity to raw materials, customers or transportation of the final product. A beachfront or a spectacular view can make a difference to a hotel.
Just as important, if a market is only big enough to support one entrant, an intelligent competitor will realize that his entry may create chronic overcapacity and eliminate the possibility of profits for either. So he’ll look elsewhere. If he can’t figure this out, his bankers or potential equity investors may withhold the funds he needs.
3. Lead times for new capacity can be long. This is not a question of the time it takes to raise capital. But permitting for new construction may be arduous–a locality may not want another new chemical plant. Actual construction may take a year or two. Therefore, even if booming demand justifies adding new capacity, it can be several years before it arrives on the market.
4. High operating and financial leverage means profits in good times can be enormous. A hotel, for example, may have to run at about 50% of capacity to cover its cash operating costs, and at about 60% to break even if we include depreciation of the plant and equipment. But, since the out-of-pocket cost of renting a room is, say, $12 (cleaning, and replacing the soap) the income from selling one more room is high. And, when occupancy rises high enough, the hotel can hike the price of all the rooms it rents–raising profits exponentially. There have been times in Manhattan, for example, when, in a strong economy, hotel rooms have rented for over $800 a night.
…and the minus
It’s a characteristic of capital-intensive businesses that the owners take the risk of buying the long-lived assets that will drive the profits of the firm at the outset. So they may not have a lot of control or flexibility in what happens afterward. They may be price takers. They have fixed capacity and demand rises and falls with the business cycle.
From an investor’s point of view, this is perfectly acceptable. These companies can be very rewarding investments. You just have to keep in mind that they may be highly cyclical and you can’t fall in love with them and forget this. There’s a time to sell as well as a time to buy.
There are two big worries for the capital-intensive company, though, other than the fickleness of stockholders: overcapacity and technological change.
Overcapacity is not just the cyclical ebb and flow of demand. Say you operate a mid-range hotel located at the intersection of two highways and catering to traveling businessmen. You have 200 rooms, which are occupied 80% of the time during the work week, and you’ve almost completed construction of a new wing with another 75.
One day, a competitor chain starts to build a 250 room hotel right across the street. This makes no sense. There isn’t enough business for two hotels of any type, let alone two targeting exactly the same audience.
When the new hotel is open, occupancy for both you and the other guy will probably max out at 40%–not enough to cover out-of-pocket costs. Even worse, a price war will inevitably break out as you both vie to capture what traffic there is.
When the competitor realizes he’s made a horrible mistake, his goal shifts from making a profit to extracting as much of his capital from the location as possible. This is bad.
Even worse (for you and the overall market), suppose you “win” the price war and the other guy goes into bankruptcy. The physical assets will still be there. They’ll be sold at auction, probably at a bargain price, to a new competitor who will probably have a lower cost of ownership than you do.
I’ll write about the internet in another post. It’s the mother of all technological change.
The more traditional example of the effects of technological change on an industry is the advent of the electric arc furnace in the steel mini-mill.
Up until the mini-mill, steel had been produced in blast furnace mills. These plants can cost several billion dollars, take years to build, have mammoth capacity and must run 24 hours a day. Location is invariably a compromise among access to raw materials and the need to transport end products to many different customers. None of this mattered, because for a long time it was the only game in town.
Then in the 1980s, a better mousetrap in the form of the electric arc furnace came along. A plant cost about 20% of what a blast furnace did and used cheaper inputs and labor. It could be located closer to a customer, lowering transportation costs. And it didn’t need to run continuously. It very quickly took a third of the steel market in the US away from the blast furnaces.
The advent of the mini-mill caused a twenty-year slump in the traditional steel industry, one it only came out of at the beginning of the new century.