Industry and Company Analysis

INDUSTRY AND COMPANY ANALYSIS A cyclical firm is one whose earnings are highly dependent on the stage of the business cycle. These firms have high earnings volatility and high operating leverage. Their products are often expensive, non-necessities whose purchase can be delayed until the economy improves. Examples of cyclical industries include basic materials and processing, consumer discretionary, energy, financial services, industrial and producer durables, and technology. In contrast, a non-cyclical firm produces goods and services for which demand is relatively stable over the business cycle. Examples of non-cyclical industries include health care, utilities, telecommunications, and consumer staples Non-cyclical industries can be further separated into defensive (stable) or growth industries. 1. Defensive industries are those that are least affected by the stage of the business cycle and include utilities, consumer staples (such as food producers), and basic services (such as drug stores). 2. Growth industries have demand so strong they are largely unaffected by the stage of the business cycle A peer group is a set of similar companies an analyst will use for valuation comparisons. More specifically, a peer group will consist of companies with similar business activities, demand drivers, cost structure drivers, and availability of capital. PORTER’S 5 FORCES MODEL One component of an analyst’s industry analysis should be strategic analysis, which examines how an industry’s competitive environment influences a firm’s strategy. The analysis framework developed by Michael Porter1 delineates five forces that determine industry competition. 1. Rivalry among existing competitors. Rivalry increases when many firms of relatively equal size compete within an industry. Slow growth leads to competition as firms fight for market share, and high fixed costs lead to price decreases as firms try to operate at full capacity. For example, the high fixed costs in the auto industry from capital investments and labor contracts force firms to produce a large number of vehicles that they can only sell at low margins. Industries with products that are undifferentiated or have barriers (are costly) to exit tend to have high levels of competition. 2. Threat of entry. Industries that have significant barriers to entry (e.g., large capital outlays for facilities) will find it easier to maintain premium pricing. It is costly to enter the steel or oil production industries. Those industries have large barriers to entry and thus less competition from newcomers. An analyst should identify factors that discourage new entrants, such as economies of scale. 3. Threat of substitutes. Substitute products limit the profit potential of an industry because they limit the prices firms can charge by increasing the elasticity of demand. Commodity-like products have high levels of competition and low profit margins. The more differentiated the products are within an industry, the less price competition there will be. For example, in the pharmaceutical industry, patents protect a producer from competition in the markets for patented drugs. 4. Power of buyers. Buyers’ ability to bargain for lower prices or higher quality influences industry profitability. Bargaining by governments and ever-larger health care providers have put downward pressure even on patented drugs. 5. Power of suppliers. Suppliers’ ability to raise prices or limit supply influences industry profitability. Suppliers are more powerful if there are just a few of them and their products are scarce. For example, Microsoft is one of the few suppliers of operating system software and thus has pricing power. FACTORS THAT AFFECT PRICING POWER     High barriers to entry prevent new competitors from taking away market share, but they do not guarantee pricing power or high return on capital, especially if the products are undifferentiated or barriers to exit result in overcapacity. Barriers to entry may change over time. While market fragmentation usually results in strong competition and low return on capital, high industry concentration may not guarantee pricing power. If industry products are undifferentiated, consumers will switch to the cheapest producer. Overcapacity may result in price wars. Capacity is fixed in the short run and variable in the long run. Undercapacity typically results in pricing power. Highly variable market shares indicate a highly competitive industry. Stable market shares suggest less intense competition. High switching costs contribute to market share stability INDUSTRY LIFE CYCLE ANALYSIS Industry life cycle analysis should be a component of an analyst’s strategic analysis. An industry’s stage in the cycle has an impact on industry competition, growth, and profits. An industry’s stage will change over time, so the analyst must monitor the industry on an ongoing basis. 1. In the embryonic stage, the industry has just started. The characteristics of this stage are as follows: a. Slow growth: customers are unfamiliar with the product. b. High prices: the volume necessary for economies of scale has not been reached. c. Large investment required: to develop the product. d. High risk of failure: most embryonic firms fail. 2. In the growth stage, industry growth is rapid. The characteristics of this stage are as follows: a. Rapid growth: new consumers discover the product. b. Limited competitive pressures: the threat of new firms coming into the market peaks during the growth phase, but rapid growth allows firms to grow without competing on price. c. Falling prices: economies of scale are reached and distribution channels increase. d. Increasing profitability: due to economies of scale. 3. In the shakeout stage, industry growth and profitability are slowing due to strong competition. The characteristics of this stage are as follows: a. Growth has slowed: demand reaches saturation level with few new customers to be found. b. Intense competition: industry growth has slowed, so firm growth must come at the expense of competitors. c. Increasing industry overcapacity: firm investment exceeds increases in demand. d. Declining profitability: due to overcapacity. e. Increased cost cutting: firms restructure to survive and attempt to build brand loyalty. f. Increased failures: weaker firms liquidate or are acquired. 4. In the mature stage, there is little industry growth and firms begin to consolidate. The characteristics of this stage are as follows: a. Slow growth: market is saturated and demand is only for replacement. b. Consolidation: market evolves to an oligopoly. c. High barriers to entry: surviving firms have brand loyalty and low cost structures. d. Stable pricing: firms try to avoid price wars, although periodic price wars may occur during recessions. e. Superior firms gain market share: the firms with better products may grow faster than the industry average. 5. In the decline stage, industry growth is negative. The characteristics of this stage are as follows: a. Negative growth: due to development of substitute products, societal changes, or global competition. b. Declining prices: competition is intense and there are price wars due to overcapacity. c. Consolidation: failing firms exit or merge. COMPETETTIVE STRATEGY Competitive strategy is how a firm responds to the opportunities and threats of the external environment. The strategy may be defensive or offensive Porter has identified two important competitive strategies that can be employed by firms within an industry In a low-cost strategy, the firm seeks to have the lowest costs of production in its industry, offer the lowest prices, and generate enough volume to make a superior return. The strategy can be used defensively to protect market share or offensively to gain market share. In a differentiation strategy, the firm’s products and services should be distinctive in terms of type, quality, or delivery. For success, the firm’s cost of differentiation must be less than the price premium buyers place on product differentiation. The price premium should also be sustainable over time. Successful differentiators will have outstanding marketing research teams and creative personnel