1 Chapter Six McGraw-Hill/Irwin © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. Industry Analysis

11

Chapter Six

McGraw-Hill/Irwin © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved.

Industry Analysis

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Industry Life CyclesIndustry Life Cycles

Stage I: DevelopmentStage I: Development Stage II: GrowthStage II: Growth Stage III: Expansion Stage III: Expansion Stage IV: Maturity Stage IV: Maturity Stage V: DeclineStage V: Decline

Consider Individual Company GrowthConsider Individual Company Growth Even In Mature Industries Even In Mature Industries

Sales ($)

Time

I II III IV V

&

are created because of economic growth, competition, availability of resources, and the resultant market saturation…

Loga

rithm

ic s

cale

Just getting started . . .

Acceptance, profits, increasing growth

Sales, earnings grow at decreasing rate

Sales grow only as GDP does, market saturated

Sales decline at destructive innovation occurs

33

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Real World of InvestingReal World of InvestingIn Analyzing an Industry or Company, What’s a Brand Name Worth?In Analyzing an Industry or Company, What’s a Brand Name Worth?

A brand name can be worthA brand name can be worth as much as brick and mortaras much as brick and mortar

Business Week (BW) now publishes a list Business Week (BW) now publishes a list of the 100 most valuable brand names in of the 100 most valuable brand names in the world and their valuethe world and their value**

Interbrand Corp. measured this value for Interbrand Corp. measured this value for BW: the present value of the future BW: the present value of the future impact of the power to increase sales and impact of the power to increase sales and earnings from brand name recognitionearnings from brand name recognition

*”The Best Global Brands,” Business Week, August 6, 2001, pp. 50-55.

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Worth of Brand Name =

PresentValue of

TheFutureImpact

TheThePower to IncreasePower to Increase

Sales and EarningsSales and EarningsFromFrom

Brand Name RecognitionBrand Name Recognition

of

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Top Ten Firms in Business Week’s Top Ten Firms in Business Week’s Survey of the Best Global BrandsSurvey of the Best Global Brands**

(in billions of dollars)(in billions of dollars)


Coca-ColaCoca-Cola $70.4$70.4 NokiaNokia $29.4$29.4

MicrosoftMicrosoft 65.265.2 DisneyDisney 28.028.0

IBMIBM 51.851.8 McDonald’sMcDonald’s 24.724.7

GEGE 42.342.3 MarboroMarboro 22.122.1

IntelIntel 31.131.1 MercedesMercedes 21.321.3

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Value of Top Ranked Brand Names in Two IndustriesValue of Top Ranked Brand Names in Two IndustriesWhere Brand Name Recognition Is Particularly ImportantWhere Brand Name Recognition Is Particularly Important

(in billions of dollars)(in billions of dollars)


AutomotiveAutomotive TechnologyTechnology

MercedesMercedes $21.3$21.3 IBMIBM $51.8$51.8

ToyotaToyota 20.820.8 IntelIntel 31.131.1

FordFord 17.117.1 HPHP 19.919.9

HondaHonda 15.615.6 CiscoCisco 15.815.8

BMWBMW 15.115.1 OracleOracle 11.311.3

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Development –Development – Stage IStage I Companies getting startedCompanies getting started

with a new idea,with a new idea,productproduct or production techniqueor production technique

that makes them uniquethat makes them unique Usually privately ownedUsually privately owned

financed with owner’s moneyfinanced with owner’s moneyand with capital from and with capital from friends, family, and/or a bankfriends, family, and/or a bank

If successful,If successful,may attract venture capitalmay attract venture capital

Pays no dividends because needs any profits to Pays no dividends because needs any profits to reinvest in new productive assetsreinvest in new productive assets

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Growth– Stage IIGrowth– Stage II An industry or companyAn industry or company

that has achieved market acceptancethat has achieved market acceptancefor its products or servicesfor its products or services

Retains earnings for reinvestmentRetains earnings for reinvestment Sales and returns on assets growingSales and returns on assets growing

at an increasing rateat an increasing rate Becomes profitableBecomes profitable Pays stock dividends to preserve capitalPays stock dividends to preserve capital May pay low cash dividends as time passesMay pay low cash dividends as time passes

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Expansion– StageExpansion– Stage IIIIII

Sales and earnings continue to expandSales and earnings continue to expandbut at a decreasing ratebut at a decreasing rate

as competition fights for market as competition fights for market shareshare

Asset expansion slowsAsset expansion slows Firms more able to pay cash dividendsFirms more able to pay cash dividends Stock dividends and splits still commonStock dividends and splits still common Dividend payout usually increasesDividend payout usually increases

from 5 – 15 to 25 – 30 percent of earningsfrom 5 – 15 to 25 – 30 percent of earnings

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Maturity–Maturity– Stage IVStage IV

Industry grows only as overall economy Industry grows only as overall economy doesdoes

Plant and equipment are in placePlant and equipment are in place Financing alternatives (both domestic and Financing alternatives (both domestic and

international) and the cash flow from international) and the cash flow from operations are sufficient to meet growth operations are sufficient to meet growth requirements of firmsrequirements of firms

Dividends may range from 40 – 50 percent Dividends may range from 40 – 50 percent of earningsof earnings

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Decline– Stage VDecline– Stage V Industries suffer declines in salesIndustries suffer declines in sales

if product innovation if product innovation has not increased product base has not increased product base over the yearsover the years

May be specific to a countryMay be specific to a country Industry may undergo consolidationIndustry may undergo consolidation Dividend payout ratios often rise to 100% Dividend payout ratios often rise to 100%

or more of earnings, followed by cuts or or more of earnings, followed by cuts or elimination of dividendselimination of dividends

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Growth in Non-growth IndustriesGrowth in Non-growth Industries Growth companies may existGrowth companies may exist even in a mature industryeven in a mature industry Not all firms experience same growth path in Not all firms experience same growth path in

sales, earnings, and dividendssales, earnings, and dividends Some firmsSome firms

• Are better managedAre better managed• Have better peopleHave better people• Have more efficient assetsHave more efficient assets• Invest more in productive research and developmentInvest more in productive research and development creating new or improved productscreating new or improved products

Some mature firms might be good investmentsSome mature firms might be good investments

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Industry StructureIndustry Structure

• Economic StructureEconomic Structure• Competitive StructureCompetitive Structure

• Helps determine potential profitability of firms

• May induce special considerations such as government regulation that positively or negatively impact the firms and industry

• Determines whether cost advantages and product quality create a dominant company within the industry

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Industry – Economic Structure Industry – Economic Structure

Monopolistic Competition – many small Monopolistic Competition – many small firms, some product differentiationfirms, some product differentiation

Pure Competition – many firms, none Pure Competition – many firms, none significant in size, no product significant in size, no product differentiationdifferentiation• not widely found in the United Statesnot widely found in the United States• companies compete intensely, try to create companies compete intensely, try to create

perceived differences in product quality or perceived differences in product quality or serviceservice

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Industry – Economic StructureIndustry – Economic Structuredetermines how companies compete

Monopolies – single firm is the whole Monopolies – single firm is the whole industryindustry• Not common in United States except as public Not common in United States except as public

utilitiesutilities• Regulations tend to limit growth and profitabilityRegulations tend to limit growth and profitability

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Industry – Economic StructureIndustry – Economic Structure determines how companies compete

Oligopolies – few firms in open rivalryOligopolies – few firms in open rivalry• Quite common in large, mature U.S. Quite common in large, mature U.S.

industriesindustries

• Such as autos, steel, oil, airlines, and Such as autos, steel, oil, airlines, and aluminumaluminum

• Competition between firms can be intenseCompetition between firms can be intense

• Profitability may suffer from price wars and Profitability may suffer from price wars and fights over market sharefights over market share

• Increasingly face international competition Increasingly face international competition altering their strategiesaltering their strategies

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Industry – Economic StructureIndustry – Economic Structure

Monopolistic Competition – many small Monopolistic Competition – many small firms, some product differentiationfirms, some product differentiation

Pure Competition – many firms, none Pure Competition – many firms, none significant in size, no product differentiationsignificant in size, no product differentiation• Not widely found in the United StatesNot widely found in the United States• Companies compete intensely, try to create Companies compete intensely, try to create

perceived differences in product quality or perceived differences in product quality or serviceservice

determines how companies compete

2020

Industry – Competitive Structure Industry – Competitive Structure

Porter’s five forces

1.Threat of entry by new competitors

2. Threat of substitute goods

3. Bargaining power of buyers

4. Bargaining power of suppliers

5. Rivalry among existing competitors

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Pharmaceutical IndustryPharmaceutical Industry- An Example - An Example

Relatively stableRelatively stable Individual firms go thru cycles as patents expire Individual firms go thru cycles as patents expire

on popular drugson popular drugs Test of sustainability is firm’s R&D capability to Test of sustainability is firm’s R&D capability to

generate new products and get FDA approvalgenerate new products and get FDA approval Mergers have led to large firmsMergers have led to large firms International regulation, price controls, and HMO International regulation, price controls, and HMO

bargaining power have been problemsbargaining power have been problems Relatively low but fluctuating long-term debt to Relatively low but fluctuating long-term debt to

equity ratios in many casesequity ratios in many cases

2222

Table 6-6 Dow Jones Industrial Groups Overview

•Basic Materials•Consumer, Cyclical•Consumer, Noncyclical•Energy•Financial•Health Care•Industrial•Technology•Telecommunications•Utilities

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Table 6-6 Dow Jones Industrial Groups

•Basic Materials• Chemicals• Chemicals, commodity• Chemicals, specialty• Forest products• Paper products• Aluminum• Mining, diversified• Other nonferrous (e.g., aluminum)• Precious metals• Steel

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•Consumer, Cyclical AdvertisingAdvertising FurnishingsFurnishings BroadcastingBroadcasting RetailersRetailers PublishingPublishing Retailers, apparelRetailers, apparel Auto manufacturingAuto manufacturing Retailers, broadlineRetailers, broadline Auto partsAuto parts Retailers, drug-Retailers, drug-

basedbased CasinosCasinos Retailers, specialtyRetailers, specialty EntertainmentEntertainment Clothing and fabricsClothing and fabrics Recreation products and Recreation products and servicesservices

FootwearFootwear

RestaurantsRestaurants AirlinesAirlines ToysToys LodgingLodging Home constructionHome construction

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•Consumer, Noncyclical Consumer Consumer servicesservices

Food retailer & Food retailer & wholesalerswholesalers

Distillers and Distillers and brewersbrewers

Consumer productsConsumer products

Food productsFood products Household products, Household products, durablesdurables

Soft drinksSoft drinks Household products, Household products, Cosmetics and Cosmetics and personalpersonal

carecare

TobaccoTobacco

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•Energy CoalCoal Oil, secondaryOil, secondary Oil and gasOil and gas Oil, drillingOil, drilling

Oilfield Oilfield equipment equipment and servicesand services

Oil, integrated majorsOil, integrated majors PipelinesPipelines

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•Financial BanksBanks Specialty financeSpecialty finance Insurance, compositeInsurance, composite Real estate Real estate

investmentinvestment Insurance, full lineInsurance, full line Insurance, lifeInsurance, life Insurance, property and Insurance, property and casualty casualty

Financial Financial services,services, diversifieddiversified

Securities Securities brokersbrokers

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•Health Care Health care providersHealth care providers Medical productsMedical products

Pharmaceutical Pharmaceutical andand

biotechbiotech Advanced medical Advanced medical devicesdevices

BiotechnologyBiotechnology

Medical suppliesMedical supplies PharmaceuticalsPharmaceuticals

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•Industrial Aerospace and defenseAerospace and defense Building materialsBuilding materials Heavy constructionHeavy construction Containers and packagingContainers and packaging

Heavy machineryHeavy machinery Industrial servicesIndustrial services Pollution control and Pollution control and

waste managementwaste management Industrial diversifiedIndustrial diversified Industrial transportationIndustrial transportation Industrial equipmentIndustrial equipment Air freight and couriersAir freight and couriers Advanced industrial Advanced industrial equipmentequipment

Marine transportationMarine transportation

Electronic components and Electronic components and equipmentequipment

RailroadsRailroads TruckingTrucking

Factory equipmentFactory equipment Transportation Transportation

equipmentequipment

3030


•Technology Hardware and Hardware and equipmentequipment

Office equipmentOffice equipment

Communications Communications technology technology

Semiconductor and Semiconductor and related related

ComputersComputers SoftwareSoftware

3131


•Telecommunications Fixed line Fixed line communicationscommunications Wireless Wireless communicationscommunications

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•Utilities ElectricElectric GasGas WaterWater

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Pharmaceutical IndustryPharmaceutical IndustryGovernment RegulationGovernment Regulation

• These companies sell their products throughout These companies sell their products throughout the worldthe world

• Are regulated by governments across the globeAre regulated by governments across the globe• The U.S. Food and Drug Administration (FDA) The U.S. Food and Drug Administration (FDA)

is considered one of the most risk-averse and is considered one of the most risk-averse and strict enforcement agencies in the worldstrict enforcement agencies in the world

• Quite often, drugs are approved for use in other Quite often, drugs are approved for use in other countries before being approved for sale in the countries before being approved for sale in the United States by the FDAUnited States by the FDA

3434

Industry Groups and Industry Groups and Rotational InvestmentRotational Investment

Rotational investment refers to the Rotational investment refers to the practice of moving in and out of practice of moving in and out of various industries over the business various industries over the business cycle to benefit from economic cycle to benefit from economic changeschanges

3535

Pharmaceutical IndustryPharmaceutical IndustryResearch and DevelopmentResearch and Development

• Uniquely important in this industry is the large Uniquely important in this industry is the large amounts of money invested in research and amounts of money invested in research and development (R&D)development (R&D)

• Benchmark is the ratio of dollars spent on R&D Benchmark is the ratio of dollars spent on R&D as a proportion of salesas a proportion of sales

• Small firms are at a disadvantage because of Small firms are at a disadvantage because of their limited funds to devote to R&D and thus their limited funds to devote to R&D and thus their drug pipelinetheir drug pipeline

• With only a 3.3% success in passing FDA With only a 3.3% success in passing FDA approval much R&D is spent on failures but a approval much R&D is spent on failures but a success can reap large profits for a firmsuccess can reap large profits for a firm

3636

Pharmaceutical IndustryPharmaceutical IndustryOther issues:Other issues:

• Product DiversityProduct Diversity• It is unusual to find more than three drugs with It is unusual to find more than three drugs with

high market share treating the same problemhigh market share treating the same problem• Usually one or two drugs dominate the marketUsually one or two drugs dominate the market• Value of a pharmaceutical company is Value of a pharmaceutical company is

influenced more by the potential “blockbuster” influenced more by the potential “blockbuster” drugs in the pipeline than current drugs that drugs in the pipeline than current drugs that may come off their patent protection in the may come off their patent protection in the next few yearsnext few years

3737

Pharmaceutical IndustryPharmaceutical IndustryOther issues:Other issues:

• Patents and Generic DrugsPatents and Generic Drugs• U.S. Patent Office issues patents that U.S. Patent Office issues patents that

protect drugs from competition for a limited protect drugs from competition for a limited number of yearsnumber of years

• After a patent runs out, generic copies After a patent runs out, generic copies reduce profitabilityreduce profitability

• Global patent protection is an important Global patent protection is an important issue because many countries violate or do issue because many countries violate or do not enforce international patentsnot enforce international patents

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Pharmaceutical IndustryPharmaceutical IndustryOther issues continued:Other issues continued:

• Demographics and Managed CareDemographics and Managed Care• As the world population ages, the demand for As the world population ages, the demand for

drugs will growdrugs will grow• The drive to restrain the rise in drug prices The drive to restrain the rise in drug prices

through both managed care and government through both managed care and government programs will put downward pressure on profit programs will put downward pressure on profit marginsmargins

• New Medicare drug coverage may create New Medicare drug coverage may create enough of an increased demand to enough of an increased demand to compensate for possible pricing constraints compensate for possible pricing constraints imposed on the pharmaceutical industryimposed on the pharmaceutical industry

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Pharmaceutical IndustryPharmaceutical IndustryOther issues continued:Other issues continued:

• It pays to keep up-to-date on this or any It pays to keep up-to-date on this or any other industry you are interested in other industry you are interested in analyzing by referring to Standard & Poor’s analyzing by referring to Standard & Poor’s Industry SurveysIndustry Surveys

4040

SummarySummary Industry analysis is the second stepIndustry analysis is the second step

in the top-down valuation processin the top-down valuation process• Used to predict potential growth rate in sales, earnings, Used to predict potential growth rate in sales, earnings,

and cash flowand cash flow• Position of a firm on its life-cycle curve suggests how Position of a firm on its life-cycle curve suggests how

fast a company can growfast a company can grow• Iife-cycle approach to an industry includes:Iife-cycle approach to an industry includes:

1. Development, 2. Growth, 3. Expansion,1. Development, 2. Growth, 3. Expansion,

4. Maturity, and 5. Decline4. Maturity, and 5. Decline

4141

SummarySummary Industry structure and competition:Industry structure and competition:

• Monopoly, oligopoly, & pure competition Monopoly, oligopoly, & pure competition structures affect pricing & returnsstructures affect pricing & returns

• Government regulation affects many Government regulation affects many industry’s profits, product quality, energy industry’s profits, product quality, energy consumption, transportation and educationconsumption, transportation and education

4242

SummarySummary Industry structure and competition:Industry structure and competition:

• International competition, supply and International competition, supply and demand relationships, availability of raw demand relationships, availability of raw materials, and energy costs among other materials, and energy costs among other things also must be observedthings also must be observed

• The pharmaceutical industry was given The pharmaceutical industry was given special attention because of its important special attention because of its important

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WEBSITEWEBSITE COMMENTSCOMMENTSwww.hoovers.comwww.hoovers.com Provides limited free Provides limited free

information about sectors information about sectors and industries. and industries.

cbs.marketwatch.comcbs.marketwatch.com Contains news and industry Contains news and industry performance on a daily performance on a daily basis.basis.

www.smartmoney.comwww.smartmoney.com Provides sector and market Provides sector and market performance—feature is performance—feature is map of market.map of market.

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WEBSITEWEBSITE COMMENTSCOMMENTSwww.wsj.comwww.wsj.com Provides limited info about Provides limited info about

industry data; has searchable industry data; has searchable archive on articles about archive on articles about companies and industries – companies and industries – Most content requires Most content requires subscription to access.subscription to access.

www.www.corporateinformationcorporateinformation.com.com Provides links to info on Provides links to info on industries and by country – industries and by country – Requires free registration. Requires free registration.

www.ita.doc.govwww.ita.doc.gov Provides access to industry Provides access to industry reports that are fee based. reports that are fee based.

www.investorguide.comwww.investorguide.com Has links to sites providing Has links to sites providing sector and industry info.sector and industry info.

Documents

1 Chapter Six McGraw-Hill/Irwin © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. Industry Analysis