Save Yourself From Commoditizing Industries

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It's early 2009. You've just witnessed that global solar photovoltaic capacity jumped almost 70% year over year -- a high-growth sector. Even more encouraging is that solar electricity is becoming price-competitive to established fossil fuels and nuclear power, making it a huge potential disruptor to an aging industry. Looking for a top dog, you single out First Solar (NAS: FSLR) . Not only is the company one of the largest solar players, but also has technology that allows it to produce a solar cell much cheaper than its competition. You invest.

Fast-forward to today, and you're looking at a 90% loss in share value.

What happened, and what should you take away from this lesson?


An ill industry
Many things went wrong for First Solar. It admitted that its solar technology experiences higher failure rates in hot climates, forcing it to increase the amount it set aside for warranties. A very public and political bankruptcy of Solyndra, which received a $500 million federal loan, brought a dark cloud over the future of the industry. And European governments that are struggling in a rough economic climate have cut incentives for installing solar cells. These issues alone might have been manageable, but the larger issue has put First Solar in its deathbed: commoditization.

The deadly disease
To most consumers today, a solar panel is a solar panel, with the only difference being the price. In other words, solar panels are now commodities. China's solar industry has boomed with help from over $30 billion in government subsidies, and this has produced a glut in the market. According to GTM Research, the global solar industry will have the capacity to build 59 gigawatts by the end of the year, but there will be demand for only 30 gigawatts. Accordingly, the price for panels fell 50% in 2011, crimping margins for panel producers. The U.S. instituted new tariffs on Chinese solar panels to help bolster prices, but this move might be too late for major bankruptcies in the industry.

The lesson
The story of solar panels is not too different from many other products that can be mass-produced and offer nearly identical features across brands. Televisions, computers, and cellphones are just a few examples, with respective losers like Sony, Hewlett-Packard, and Nokia.

How can you avoid companies that are bound for this kind of value destruction? Look closely at brand and management.

The power of a premium brand
Consumers will pay for quality and what purchasing a product says about them. For commodity-like products, quality can be equal across companies, but marketing can push consumers to one brand over another. Take Apple (NYS: AAPL) . According to a SquareTrade report, Apple laptops had a 17.4% chance of malfunctioning over three years, whereas Asus, Toshiba, and Sony laptops all had a lower failure rate. Even so, Apple bests its competitors in perceived reliability in the annual PCWorld survey. This gap between actual and perceived performance can be attributed to marketing. Even if Apple computers don't perform as well, consumers don't see it that way and happily pay up for an Apple laptop. This gives Apple a 30% profit margin, while other laptop makers languish around single digits.

If you can't beat 'em
There are commodities that can't be branded, however, but still offer excellent business models. This is because of great management. Take Nucor (NYS: NUE) , which produces steel. Nucor's organization includes a relatively flat hierarchical structure, performance-based incentives, and pride in never laying off an employee due to a poor economy. With great management and culture, Nucor was able to squeeze a profit margin of 4.3% in 2011, compared to competitor Steel Dynamics at 3.3%. It also helps that Nucor shipped over 20 million tons of steel in 2011, compared to Steel Dynamics shipping just over 5 million tons. With better sales and lower costs, poorly performing competitors are squeezed out of an industry and the winners gain more scale, further lowering costs.

Future commoditization
Can we predict if a new industry like 3-D printing will become commoditized? Profit margins at 3D Systems (NYS: DDD) recently peaked during the second quarter last year at 24%, and have since fallen to 8%, and its competitor Stratasys (NAS: SSYS) has also recently trended downward:

SSYS Profit Margin Chart

SSYS Profit Margin data by YCharts.

Fool colleague Alex Planes also writes on the threat of 3-D consumer commoditization:

MakerBot was selling inexpensive consumer 3-D printers when the Cube was just a gleam in 3D Systems' eye, and the start-up is committed to the open-source model. Thousands of MakerBots have been bought since 2009, and the company's Thingiverse already is what 3D Systems hopes its Cubify community will become -- a repository of designs made by loyal users. Shapeways is another 3-D printing design community with quite the selection of designs. One open-source 3-D printing concept, the RepRap, is a self-replicating printer that can effectively print new versions of itself, or at least most of itself. If that's not a threat to the big players, I'm not sure what is.

Really, it's up to management and marketing to ensure the success of these companies. If the brand continues to hold value and that value can be translated into higher margins, companies will succeed. If commoditization is inevitable, efficient management can produce returns even in a heavily commoditized industry.

Apple's premium brand isn't all it has going for it. Get the whole scoop by reading the Fool's new premium research report on Apple. For one stock pick that has very little chance of becoming a commodity, read our free report: "Discover the Next Rule-Breaking Multibagger." This highlights a company following in the footsteps of a proven profitable model.

At the time this article was published Fool contributor Dan Newman holds no position in any of the above companies. Follow him @TMFHelloNewman.

The Motley Fool has owns shares of Apple and 3D Systems, has sold shares of Sony short, and has written calls on 3D Systems. Motley Fool newsletter services have recommended buying shares of 3D Systems, Nucor, and Apple, as well as creating a bull call spread position in Apple. The Motley Fool has a disclosure policy. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. Try any of our Foolish newsletter services free for 30 days.

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