NPTEL Course. Module-8. Session-16. Industry Analysis II

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1 NPTEL Course Course Title: Security Analysis and Portfolio Management Instructor: Dr. Chandra Sekhar Mishra Module-8 Session-16 Industry Analysis II Outline Industry life cycle Analysis of industry competition (Porter s Five Forces Model) Select Financials of Select Industries In the previous section, we discussed about importance of industry analysis, business cycle, sector rotation in response to different stages of business cycle. This session deals with industry life cycle, different mechanism of industry analysis among other things. The Industry Life Cycle At a given point of time, different industries perform differently. While one reason could be because of the business cycle prevailing then another reason is the stage of the particular industry. Industries go through different stages. In the initial stage, very high growth is observed and lot of investment takes place. At this time the players have got fist mover advantage and protect and subsequently very high rate of returns are earned by the players in the industry, which attracts new entities into the industry and subsequently because of this the initial players loose the advantages or superiority over others. An industry goes through four distinct phases as depicted by figure Figure 16.1: Industry Life Cycle In the introduction or start up stage, one sees a rapid and increasing sales growth that becomes stable in consolidation phase. In maturity stage, the sales growth declies and during decline stage sales growth 1

2 becomes negative. The duration of different phases of industry life cycle varies from one industry to another. For industries where technological obsolescence is high, the duration becomes shorter. One should find the securities of firms that are able to capitalize on technological change. An alternate way of analyzing the industry life cycle is to divide the same into five stages with unique features in each stage as provided in table Table 16.1: Industry Life Cycle An Alternate Approach Stages of Industry Life Cycle Salient Features Pioneering Development Rapid Accelerating Growth Mature Growth Stabilization and Market Maturity Deceleration of Growth and Decline Industry Structure and Performance: Modest Sales Low or negative profit margin Major Development Costs High sales growth Limited number of competitors Very high profit margin Higher than normal sales growth More number of competitors High but declining profit margin Longest phase Normal sales growth Lower profit margin Declining sales growth Low or negative profit margin Very low rate of return on capital Source: Reilly and Brown (2006) Besides forecasting growth in sales and earnings in different stages of industry and identifying the opportunities to invest, one should anlayse the competitive structure for the industry. Michale Porter has provided five competitive forces that determine the competitive structure of the industry. Those are explained as below. 1. Threat of New Entrants: While existing firms in a particular industry compete among themselves, there are always possibilities of new firms entering the market. If the barriers to entry are high or strong then the existing players can benefit. The barriers to entry can take different forms. Certain industries require very high investment in technology and other resources thus limiting the number of players. New players may have to abandon their existing facility and technology to enter a new market. Existing players might have got good relationship with suppliers and customers in the supply chain. This might be difficult for the new entrants to emulate. There are also regulatory constraints that prohibit other players entering a market. For example, unless a new telecom company has got the license for spectrum, cannot enter mobile service market in India. There are other resources like mines for which licenses are required to be taken from the Government before starting a business. Entry barriers exist for firms from other countries. 2

3 Existing firms might have cost advantage because of experience and scale of activity which might be difficult to achieve for new players. Figure 16.2: Forces Driving Industry Competition (Michael E. Porter) Source: Competitive Strategy: Techniques for Analyzing Industries and Competitors by Michael E. Porter, Free Press, Rivalry among Existing Firms: If there are several players in the market, there will be very high completion for price and profit margins are likely to be lower. If firms are of similar size, the rivalry becomes more severe. Firms tend to price the products very low. Because of exit barriers like existing agreements with input suppliers, firms might operate with below-average or negative return. In a slow growth industry the rivalry becomes worse because expansion for a particular firm will come at the cost of an existing player. This will lead to further price wars. 3. Threat of Substitute Products or Services: Substitute products pose threat in terms of keeping the price lower in a particular industry. However the substitute has to be close in its functionality and utility. In food industry, one can see lot of substitutes. In cooking appliances industry, induction cookers are very close substitute for gas burners. Thus, there is likely to be limited rise in price of gas burners. 4. Bargaining Power of Suppliers: If suppliers are limited in number, they can pose threat to the industry in terms of high input costs. The firms will be always on their toes. It becomes further difficult if the number of players is relative large compared to suppliers industry. Suppliers include labor which can be organized and critical input for the firms. Availability of substitutes for inputs make the suppliers weak. 5. Bargaining Power of Buyers: Buyers can impose restrictions for the firms by asking for lower prices and superior quality. This is possible for buyers who are very large in size [like retail chains]. The players in passenger car or commercial vehicles industry have considerable influence on suppliers of automobile components. This can lead to lower profitability for auto components industry. As an investor, one has to analyse all the above factors to assess the intensity of competition in a particular industry its impact on the long run profitability of the industy. Select Financials of Select Industries: The financial performance of industries vary over time as well as among industries at a particular point of time. The following table shows the financial performance in terms of three parameters for three select industries. 3

4 Table 16.2: Financials of Select Industries in India Year Asset Turnover Net profit Margin (%) Return on Assets (%) Total Assets / Equity RoE or RoNW (%) Capital Goods FMCG IT Capital Goods FMCG IT Capital Goods FMCG IT Capital Goods FMCG IT Capital Goods FMCG Average Source: Prepared with data from CMIE-Prowess Table 16.2 shows the return on equity which is a function of three other financial parameters as below: RoE = Net Profit Equity = = Profit Margin x Total Net Income Sales Total Assets x x Sales Total Assets Equity Asset Turnover x Financial Leverage The financial data as given in Table 16.2 are shown in different charts so that one could compare the performance among different industries. Figure 16.3 IT 4

5 Figure 16.4 Figure 16.5 Figure

6 Figure 16.6 There is widespread dispersion observed in the performance of different industries. Risk analysis and measurement for different industries are necessary. Valuation ratios differ for different industries. It is also essential to perform industry analysis on a global scale. Individual company analysis is also important besides industry analysis. 6

7 References: Bodie et al (2009), Investments, 8e, Tata McGraw Hill, New Delhi Mayo, Herbert B. (2009), An Introduction to Investments, 1/e, Cengage Learing Porter, Michael E.: Competitive Strategy: Techniques for Analyzing Industries and Competitors, 1998 Reilly and Brown (2006), Investment Analysis and Portfolio Management, 8e, Thomson (Cengage) Learning, New Delhi Prasanna Chandra (2008), Investment Analysis and Portfolio Management, 3e, Tata McGraw Hill, New Delhi Source of Data: Prowess Database, Center for Monitoring Indian Economy 7

8 Questions and Answers Q.1: What are the different stages of industry cycle and the main features of such stages? Ans.: The various stages of industry cycle are broadly divided into four: Start-up; Consolidation; Maturity and Relative Decline. An alternate framework of industry life cycle and the salient features of each stage is given below: Stages of Industry Life Cycle Salient Features Pioneering Development Rapid Accelerating Growth Mature Growth Stabilization and Market Maturity Deceleration of Growth and Decline Modest Sales Low or negative profit margin Major Development Costs High sales growth Limited number of competitors Very high profit margin Higher than normal sales growth More number of competitors High but declining profit margin Longest phase Normal sales growth Lower profit margin Declining sales growth Low or negative profit margin Very low rate of return on capital Q.2: What is five-force analysis and its utility for industry analysis? Ans.; As per Michael E. Porter, average profitability of an industry is influenced by the five forces (as shown in the following figure). According to this framework, the intensity of competition determines the potential for creating abnormal profits by the firms in an industry. Whether or not the potential profits are kept by the industry is determined by the relative bargaining power of the firms in the industry and their customers and suppliers. Forces Driving Industry Competition (Michael E. Porter) 8

9 Q.3: State the different attributes of the five competitive forces identified by Michael E Porter. Ans.: I. Rivalry among existing competitors: a. Concentration and balance of competitors b. Diversity of competitors c. Product differentiation and switching costs for customers d. Excess capacity and exit barriers e. Cost conditions i.e. ratio of fixed to variable costs. II. III. IV. Threat of new entrants: a. Economies of scale b. Absolute cost advantages c. Capital requirements d. Product differentiation e. Access to distribution channels f. Government and legal barriers g. Retaliation by established producers Pressure from substitute products a. Buyer propensity to substitute b. Relative prices and performance of substitutes Bargaining power of buyers a. Size and concentration of buyers relative to producers b. Undifferentiated products 9

10 c. Buyers switching costs d. Buyers information e. Buyers ability to backward integrate V. Bargaining power of suppliers a. Few large supplier dominates market b. No substitute for input c. Switching cost from one supplier to another high d. Possibility of supplier s integrating forward- to get higher margin e. Buying industry low barrier to entry 10