Assessment of competitive advantage using a quantitative method suggested by Greenwald and Kahn in their book Competition Demystified.

1. Assessing Competitive Advantage in Flow Control Industry
Using Chapter 4 of Competition Demystified to Test Existence of Competitive Advantage at Flowserve
John Yannone
Fall 2016

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3. There are several challenges to performing a competitive analysis that has utility for making investment decisions.
While at first I thought of using Porter’s 5 Forces, I decided against it because this tool is very subjective and requires a
lot of guessing. This is because most companies will not share full details of their competitive advantage (e.g. strengths
and weaknesses) in order to remain competitive.
I decided to turn to Greenwald and Kahn and use the analysis discussed in chapter 4 of Competition Demystified: A
Radically Simplified Approach to Business Strategy.
While this book agrees with the “Porter’s view that five forces—Substitutes, Suppliers, Potential Entrants, Buyers, and
Competitors within the Industry—can affect the competitive environment”, it also suggests that one of them, barriers to
entry, is “much more important than the others”.
Chapter 4 provides a framework for assessing competitive advantages:
1. Identify the competitive landscape in which the firm operates. Which markets is it really in? Who are its
competitors in each one?
2. Test for the existence of competitive advantages in each market. Do incumbent firms maintain stable market
shares? Are they exceptionally profitable over a substantial period?
3. Identify the likely nature of any competitive advantage that may exist. Do the incumbents have proprietary
technologies or captive customers? Are there economies of scale or regulatory hurdles from which they benefit?
The following tables lists 7 firms that compete with Flowserve in the flow control industry (pumps, valves and related
components and services). Revenue data (mostly obtained from Morningstar) was converted to US dollars as needed
(using average exchange rate for each year since revenue is earned throughout the year) and compared against the total
market for flow control technology (Using Freedonia World Pump Report published in January 2015 as a proxy for ½
value of pump and valve industry combined). Market shares were computed for the industry as a whole and for this
group of 8 leading firms (General Electric and Emerson Electric were excluded since flow control is not reported as a
business segment and there was no easy way to determine what percentage they represented for the segment).

4. Greenwald and Kahn suggest that “as a first rule of thumb, if you can’t count the top firms in an industry on the fingers
of one hand, the chances are good that there are no barriers to entry”. They also suggest “as a second rule of thumb, if
over a five-to eight-year period, the average absolute share change exceeds 5 percentage points, there are no barriers
to entry; if the share change is 2 percentage points or less, the barriers are formidable”.
Based on above, we can clearly see the flow control market is highly fragmented (8 leading firms represent less than
20%) and as a result very competitive with low barriers to entry. Flowserve was the dominant firm in 2013 and was
second place in 2008.
Next, Greenwald and Kahn suggest “within a given industry, there are two primary approaches to gauge profitability.
One uses [operating] income as a percentage of revenue, the other income as a percentage of the resources employed
in the business.” The following is 10 year operating margin figures for these firms.
For the ten year period 2006-2015, the average operating margin was 7.2%. Flowserve’s operating margin at 13.2% for
the period was the highest and every year shown was higher than the mean for all of the companies. Flowserve also had
one of the lowest coefficient of variation (only SPX flow was lower but did not have full data). This data suggests
Flowserve could have some form of competitive advantage.
The following is 10 year ROIC figures for these firms.
In general, industry pure players Flowserve and KSB were more profitable than the other firms suggesting specialization
in flow control industry offers some advantage.
In the 5th edition of Koller et al. VALUATION: MEASURING AND MANAGING THE VALUE OF COMPANIES, Chapter 4 titled
Return on Invested Capital there is a table that shows median ROIC for various industries. Koller et al. offer:
“ROICs differ by industry but not by company size. Industries that rely on sustainable competitive advantages such as
patents and brands (for example, pharmaceuticals and personal products) tend to have high median ROICs (15 to 20
percent), whereas companies in basic industries, such as paper, airlines, and utilities, tend to earn low ROICs (5 to 10
percent).

5. The median ROIC for the overall Machinery industry is 12%
Now let’s go back and answer the questions Greenwald and Kahn ask with respect to Flowserve and it’s industry:
1a. Identify the competitive landscape in which the firm operates. Which markets is it really in?
We combined pumps, valves and related components and services into “flow control” industry.
1b. Who are its competitors in each one?
We identified 8 important firms Crane Co., Ebara, Flowserve, ITT Corp., KSB, SPX Flow, Sulzer and Weir Group
that have global operations. All of them compete with Flowserve. With highest market share (only ~4%)
Flowserve had 1.5x revenue of KSB and more than 2.5x revenue of all the others in 2013.
2a. Test for the existence of competitive advantages in each market. Do incumbent firms maintain stable market shares?
Incumbent firms do not seem to maintain stable market share when using Greenwald and Kahn’s rules of
thumb. However, an absolute change of 5.05% is not much more than 5% suggesting there could be some
barriers to entry. Flowserve had a normalized market share of 22.7% in 2008 that grew to 28.7% in 2013.
2b. Are they exceptionally profitable over a substantial period?
Incumbent firms had a median ROIC of 13.7% over the period 2006-2015 making them above average.
Flowserve had a high mean ROIC of 16.9 over the same period.
3a. Identify the likely nature of any competitive advantage that may exist. Do the incumbents have proprietary
technologies or captive customers?
Incumbent firms do have special know-how and proprietary technologies that are protected by patents for some
time.
Incumbent firms also have brands that could lead to their selection over new entrants. As the products are used
in critical applications, it is safer to go with a known brand with demonstrated quality or performance rather
than an unknown brand even if there is significant cost saving.
The incumbents also have large installed customer base that may provide captive advantage (or lock-in) due to
switching costs or added cost to search for a replacement.
3b. Are there economies of scale or regulatory hurdles from which they benefit?
These incumbent firms operate on a global scale and do have economies of scale that favor them over new
entrants. Flowserve has been taking advantage of it global footprint by using lower cost local resources and
procuring raw materials and using contract manufacturing from low cost regions.
In the Nuclear end market, the N-Stamp certification adds a layer of protection from new entrants.
Taken together, all of this suggest Flowserve could have some competitive advantage
John Yannone
November 2016

6. Appendix