What exactly is Rule of 3?

Every industry has typical phases or stages of growth. During the early growth stage, there are many competitors. For example, in the automobile market and specifically two wheelers there were many firms, which now is limited to only three big names – Hero Honda, Bajaj, and TVS. Same was the case with automobile industry in US – where General Motors, Ford, and Chrysler were able to survive and grow.

As the industry matures, three firms that adapt better survive and thrive, and typically command 70-90% of the market share. Within these to three firms also, the first two firms have the substantial market share whereas the difference between second and third player is greater. Within the top two firms first and second firm, the difference between market shares is generally more than 10%. For example, in Indian Aviation sector since no airline is having such dominance, a lot of consolidation can be expected. These three firms are referred as generalists. The generalists just need to maintain their market share and will be growing along with the market. Large in the size, they also get the better opportunities and areas to improve.

Jagdish Sheth and Rajendra Sisodia, in their a book titled The Rule of Three: Surviving and Thriving in Competitive Markets had put an interesting concept of ‘Rule of Three’, theory that suggests that cyclical and systemic market forces make it possible to predict the evolution of competitive industries such as aviation, automobile, telecom, consumer products etc. We carry forward the concept that it can be also applied as a general management principle and for enabling various M&A strategies by the companies. In this article, we take a closer look at our hypothesis.

In the industry there are also some players which focus on a particular segment, may be geographical, customer etc. These are the players who acquire a market share by way of customized solutions for a particular segment and hence can command a premium for their products or services. These players to a great extent are protected from the industrial downturn because of their niche. In turn, they command a better market valuation when compared to generalists. These players with a niche are referred to as Specialists.

There are some companies having between 1-5% market share each of which co-exists with numerous product/market/niche specialists. The Rule of Three structure is optimal because the big three act as the tripod that stabilizes the industry against hyper competition or collusion. In other words, it offers an optimal mix of competition (innovation, quality), collaboration (efficiency, profitability), customer satisfaction (variety, affordability, accessibility, value co-creation). Those firms with 1-5% market share (i.e., slum dwellers) can neither benefit from economies of scale and efficiency of being a generalist, nor can they can they gain from the effectiveness and focus of serving a niche market. They are expected to perform worse than their generalist or specialist Counterparts.

In the past few years, being number one or two in a field has been the announced strategy of a wide variety of companies in every industry. It has become a cliché in company mission statements. This doctrine of avoiding being number three or below has become an MBA staple and is a commonplace business journalism.

General application of the Rule

Internationally it has always been like this. The big three in the American auto market- General Motors, Ford, and Chrysler or the dominance of Federal Express, UPS, and DHL in the global express courier and logistics market.

A similar pattern is now emerging in India. From bikes, cars, consumer durables, mobile handsets, paints, tires, steel, aluminum, airlines, hotels to cement, an increasing number of sectors in India are now led by a set of top three players, with rest of the companies being forced to become niche players or if not then perish.

Take the passenger car market for example. Though there are over dozen Indian and multinational players in the industry and new players entering every year, Maruti Udyog, Tata Motors and Hyundai together account for over 80% all cars sold in domestic market. Whereas others like GM, Toyota can be regarded as specialists focusing on the luxury car market.

Same is the case with the two-wheeler makers in India which is dominated by Hero Honda, Bajaj Auto, and TVS Motors. The big-three, now account for over 90% of the market.The phenomenon is not restricted to manufacturing sector alone. The service sector is witnessing an equally large polarization. Passenger airlines sector in India had half a dozen thriving players with the new entrants eating away the market share of the existing players. Post Jet Airways and Air Sahara deal, however, the top three -Jet-Sahara combine, Kingfisher, and Indian Airlines rule the market with over 60% of the domestic aviation market.

Move over to the hospitality sector. Despite the expansion of international chains, the three Indian majors — Indian Hotels (Taj), ITC Hotels and Oberoi Hotels continue to dominate the luxury and business hotels segment.

A similar equation has emerged in the fast-growing mobile handset market. While new entrants from China (Bird, Haier & TCL), Korea (LG & Samsung) and Taiwan (Benq) are launching their products in India, the sales volume continue to be dominated by the troika of Nokia, Samsung and Sony Ericsson, closely followed by Motorola. In this market also the niche players like Apple do exist.

How Rule of 3 drives M&A

  • Automobile IndustryPresently the two-wheeler industry in India has three big players- Hero Honda followed by Bajaj Auto and these two being followed by TVS Motors. The first two players have garnered a substantial chunk of market share in past years by innovative product offerings, clear focus on the respective segments and optimizing the product mix. There are some niche players in the market like Kinetic who cater to a specific segment. Now when the difference between the market share of Bajaj Auto and TVS Motors is less than 10%, the Bajaj Auto will like to consolidate the position perhaps by expanding the markets or acquiring the other companies.Now as a part of the strategy, the better fit for acquisition for Bajaj Auto (which is a generalist) will be another generalize like TVS Motor and not any specialist like Kinetic. The reason is that the acquisition of Kinetic would make it hard for the Bajaj Auto to integrate the operations with itself. The specialist may be richly valued as compared to generalists, because of its relative isolation from the industry downturns. However, with the acquisition of specialist Bajaj Auto cannot expect the same valuation being applied to itself because in that case market will value the combined entity based on the strategic fit the specialist makes with the Bajaj Auto, which is not present in this case. Instead, if the Bajaj Auto acquires a generalist like TVS Motors, it can command a better control over its own business segment and a market will value the combined entity at a richer valuation. Similarly, when the Kinetic decides to acquire a company, it should acquire a specialist and not a generalist.
  • Aviation SectorIn Indian Aviation Sector, the top three carriers are Jet Air, Kingfisher, and Air India. There are some niche players like Paramount that have gained a reasonable market share by differentiating between the type of category to which they serve viz. executive class and geographical predominance. Paramount is recognized to be the only airline in India to be profitable. It is mainly due to the services and customer base differentiation. There are some at the lower end in the sector such as Spice Jet, Indigo and Go Air which do not have a niche nor a substantial market share. These typically can be considered a takeover target by generalists.As of now, the difference between the market share of Jet and Kingfisher is less than 10%, Jet is in the unsecured zone and there is always a chance that Kingfisher can go ahead of it. At the same time, Kingfisher has to ensure that the market share between itself and Jet Airways does not exceed 10% which otherwise would make it hard to gain the top spot. Since there are no dominant players in the sector, the sector can be said to possess good consolidation opportunities.The Kingfisher is trying to create a niche by providing premium services at a higher price and at the same time has also acquired a low-cost carrier- Air Deccan. From the strategic point of view, Kingfisher will acquire smaller players like Spicejet and consolidate its presence to go ahead for the Top spot. Another strategy can also be an alliance with international carriers who are also generalists.

Conclusion

When a business unit decides to grow inorganically i.e. through M&A, advisors look at its valuation, strategic fit, synergies etc. Seldom are such targets and their valuation vetted through various management strategies, which as mentioned above is equally important. Rule of 3 can help an acquirer to reduce likely targets by looking at only generalists or specialists as the case may be. In any case, an acquirer who is generalist is looking at specialists then it should have a definite plan to convert that niche product into a mass product or apply substantially lower valuation parameters so that acquisition is EPS accretive and create value for its stakeholders.

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