2015, Study Session # 14, Reading # 49

INTRODUCTION TO THE INDUSTRY AND COMPANY ANALYSIS

CA
IA
ILC
MS

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Company Analysis
Industry Analysis
Industry Life Cycle
Market Share

49.a

Industry analysis is important for CA because;

It provides a framework to understand the firm.

Business conditions (growth, competition, risk) the firms in an industry face.

In credit analysis industry conditions provide information about default risk.

Active management = IA indentify undervalued or overvalued industries.

Industry rotation change industry weights based on current phase of business cycle.

Performance attribution analysis Industry classification schemes play a role in
performance attribution.

49.b

Products & services (principal business activity is one way to group companies into an
industry).

Sector group of related industries.

Classifications by sensitivity to business cycle include cyclical & non-cyclical firms.
Statistical Methods

Group firms that have had highly correlated returns

historically.

Groups formed then with low correlation b/w groups.

Limitations

Historical correlation may not be the same in the future.

Grouping of firms may differ over time & across countries.

Grouping may be non-intuitive.

Grouped by a relationship that occurs by chance.

Industry Classification Systems

Commercial Classification

Government Classification

Several indexes provide classification of firms (three or four levels).

Use fundamentals to classify firms.

A description of representative sectors is as follows:

Organize statistical data according to type of

industrial or economic activity & to make
comparison of data across time and among
countries.

Methodologies of govt providers differ from
commercial providers as:

Govts. dont identify individual firms in a group.

Govt systems are updated less frequently.

Govt. classification systems dont distinguish
b/w small & large firms, private & public etc.

Classifications

Basic material & processing

Building materials.
Chemicals.
Paper and forest products.
Containers and packaging.
Metal, mineral and mining
companies.

Consumer Discretionary

Automotive.

Apparel.

Hotels and restaurants.

Consumer Staples Firms

Food.
Beverage.
Tobacco.
Personal care products.

Financial Services

Energy

Energy exploration.
Refining.
Production.
Energy equipment.
Energy services.

Banking & finance.

Insurance.
Real estate.
Asset management.
Brokerage services.

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Health Care

Pharmaceuticals.
Biotech.
Medical devices.
Health care equipment.
Medical supplies.
Providers of health care services.

2015, Study Session # 14, Reading # 49

49.b

Classifications

Industrial & Producer Durables

Technology

Heavy machinery and

equipment.

Aerospace.

Defense.

Transportation.

Commercial services and
supplies.

Computers.
Software.
Semiconductors.
Communication equipment.
Internet services.
Electronic entertainment.
Consulting and services.

49.c

Cyclical Firms

Earnings are highly dependent on
business cycle stage.

High earning volatility & operating
leverage.

Normally expensive, non-necessity
products (e.g. auto, technology etc).

Defensive Industries

Least affected by stage of business
cycle.

Examples include utilities, consumer
staples etc.

Non-Cyclical Firms

Stable demand over the business
cycle.

Examples include health care,
utilities, food etc.

Growth Industries
Largely unaffected by business cycle
stage.

growth defensive & cyclical descriptors must be used with caution e.g;

Cyclical industries may include growth firms that are less business cycle
dependent.

Non-cyclical may be affected by severe recessions.

Defensive industries may not always be safe investments.

49.d

Peer group set of similar companies which an analyst used for
comparisons.

Peer group is formed by identifying firms in same industry classification.

Analyst might include a company in more than one peer group.

Analyst follows certain steps to form a peer group.

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2015, Study Session # 14, Reading # 49

49.e

A thorough IA should include following elements;

Evaluative relationship b/w macroeconomic variables & industry
trends.

Estimate industry forecasts using different approaches & scenarios.

Compare projections with other analyst projections to identify
differences.

Determine relative valuation of different industries.

Determine volatility of industry performance.

Analyze industry prospects based on strategic groups (firms that are
distinct from rest of industry).

Industry life cycle stage classification.

Experience curve (cost per unit relative to output).

Consider external factors that affect industries & determine
competition.

49.f

External Factors

Macro Economic Factors

Technology

Cyclical or structural trends.

Economic output (GDP), interest rates,
credit availability and inflation are some
examples.

Demographic Factors

Introduction of new or improved

products.

Examples are computer hardware, radical
improvements etc.

Governments

Age distribution, population size &

composition.

Population aging means healthcare
industrys demand increases & population
in twenties means residential furniture &
related industries demand increases.

Can affect business through taxes &

regulation.

Examples setting terms to industry
entry, heavy taxes to some industries.

Social Influences

Relates to how peoples live in society
(work, play, spend money etc).

Example women entering into
workforce promotes day care industries.

49.g

ILC component of analysts strategic
analysis.

Industrys stage has an impact on competition,
growth & profits & industry analysis should be
continuous process.

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2015, Study Session # 14, Reading # 49

49.g

Stages of ILC

Embryonic Stage

Growth Stage

Industry has just started.

Slow growth (unfamiliar product).

High prices (no meaningful economies of
scale achieved).

Large investment required & high risk of

Shakeout Stage

Rapid demand growth (new consumers).

Limited competitive pressure.


Prices &  profitability (economies of
scales achieved).

Decline Stage

Growth has slowed (demand saturates).

Intense competition &  in overcapacity.

Profitability &  price cuts.
 Failures (weaker firms liquidate or
merge with others).

Negative growth (societal changes,

substitute products etc).


Price (increased competition & price
wars).

Weaker companies exit, merge or
redeploy capital into different products
and services.

Mature Stage

Slow growth (demand is for replacement
only).

Consolidation (oligopoly).

 Barriers to entry (brand loyalty & low cost
structures).

Stable pricing (avoid price wars).

Firms with superior products gain market
share.

Growth firms focus on reinvesting CF (growth focus) while mature firms distribute CF
to shareholder (cost efficiency focus).

Analyst should be concerned if firms dont act according to their stage (mature firm
want to  size).

Stage may be longer or shorter than anticipated or it may be skipped altogether.

Some firms in industry may have competitive advantage / disadvantage.

49.h

IndustryIndustry
Concentration

High concentration does not guarantee pricing power.

Firms relative market share matters as much as their absolute market share
(firm having 50% share may have a competitor with 50% share).

Undifferentiated & commodity-like products low pricing power.

Costly to enter & exit, overcapacity result in intense price competition.
Ease of Entry


Barrier to entry suggests industries have low
pricing power.

Same firms dominance over no. of years may suggest entry is probably
difficult.

High barrier may not necessarily mean high pricing power (e.g. strong
competition among existing firms).

Capacity
Under capacity demand > supply pricing power.
Overcapacity supply > demand price cutting.
Capacity is fixed in short & variable in long run.
Capacity may not be physical (e.g. demand for insurance) &
reallocated to new industries more quickly.

If capacity is physical & specialized overcapacity can exist for
an extended period.

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2015, Study Session # 14, Reading # 49

49.h

Market Share Stability

Variable market share competitive industry little pricing power.

Factors affecting MS;

Barrier to entry.

New products & innovations.

Switching cost (cost of changing one firms product to other).

 Switching costand stable MS.

49.i

Economic profit return on invested capital

opportunity cost of funds.

Strategic analysis examines industrys competitive
environment that influence a firms strategy
Porters Five Forces

Rivalry among Existing Competitors

Fragmented industry  rivalry.

Slow growth leads to competition (fight
for MS).

 Fixed cost leads to
price (firms try to
operate at full capacity).

 Barriers to exit or undifferentiated
products,  competition.

Threat of Substitutes

Limit profit potential.

Commodity-like products 
competition
prices & vice versa in
differentiated products.

Threat of New Entrants

Barriers, premium pricing &

competition from new comers.

Identify factors that discourage new
entrants.

Bargaining Power of Suppliers

Bargaining Power of Buyers

Few suppliers with scarce products 

suppliers power &
industrys profitability.

 Buyers power,
prices & profitability.

Barriers & concentration,
competition.

Overcapacity intense price competition.

Stability in MS &  price sensitivity in buying decision  competition.
Industry maturity,
growth.

49.j
Illustration of candy / confections industry.

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2015, Study Session # 14, Reading # 49

49.k

Company analysis analyzing firms financial

condition, products & services.

Competitive strategy how a firm responds to the
opportunities & threats of the external environment.

Competitive Strategies

Cost Leadership Strategy

Differentiation Strategy

Firm seeks to be lowest cost producer.

Strategy can be used defensively (protect
market share) or offensively (to gain
market share).

Predatory pricing firm hopes to derive
out competitors &  prices later.

Operational efficiency is required.

Firms products & services should be

distinctive in terms of type, quality or
delivery.

For success, cost of differentiation < price
premium.

Usually outstanding research team &
creative personnel.

Company analysis should include:

Firm overview & industry characteristics.

Product demand & product cost.

Pricing environment.

Projected financial statements & financial ratios.

Spread sheet modeling to analyze & forecast company fundamentals.

Problem model complexity can make their conclusions seem precise.

Analyst must consider which factors are likely to be different going
forward & how this will affect firms net earnings.

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