Chapter Six

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

2. Sales ($) Time Industry Life Cycles are created because of economic growth, competition, availability of resources, and the resultant market saturation… • Stage I: Development • Stage II: Growth • Stage III: Expansion • Stage IV: Maturity • Stage V: Decline Consider Individual Company Growth Even In Mature Industries Just getting started . . . Logarithmic scale Acceptance, profits, increasing growth Sales, earnings grow at decreasing rate Sales grow only as GDP does, market saturated Sales decline at destructive innovation occurs I II III IV V &

4. Real World of InvestingIn Analyzing an Industry or Company, What’s a Brand Name Worth? • A brand name can be worth as much as brick and mortar • Business Week (BW) now publishes a list of the 100 most valuable brand names in the world and their value* • Interbrand Corp. measured this value for BW: the present value of the future impact of the power to increase sales and earnings from brand name recognition *”The Best Global Brands,” Business Week, August 6, 2001, pp. 50-55.

5. Real World of InvestingIn Analyzing an Industry or Company, What’s a Brand Name Worth? The Power to Increase Sales and Earnings From Brand Name Recognition Worth of Brand Name = The Future Impact Present Value of of

6. Real World of InvestingIn Analyzing an Industry or Company, What’s a Brand Name Worth? Top Ten Firms in Business Week’s Survey of the Best Global Brands* (in billions of dollars) *”The Best Global Brands,” Business Week, August 6, 2001, pp. 50-55.

7. Real World of InvestingIn Analyzing an Industry or Company, What’s a Brand Name Worth? Value of Top Ranked Brand Names in Two Industries Where Brand Name Recognition Is Particularly Important (in billions of dollars) *”The Best Global Brands,” Business Week, August 6, 2001, pp. 50-55.

8. Development –Stage I • Companies getting started with a new idea, product or production technique that makes them unique • Usually privately owned financed with owner’s money and with capital from friends, family, and/or a bank • If successful, may attract venture capital • Pays no dividends because needs any profits to reinvest in new productive assets

9. Growth– Stage II • An industry or company that has achieved market acceptance for its products or services • Retains earnings for reinvestment • Sales and returns on assets growing at an increasing rate • Becomes profitable • Pays stock dividends to preserve capital • May pay low cash dividends as time passes

10. Expansion– StageIII • Sales and earnings continue to expand but at a decreasing rate as competition fights for market share • Asset expansion slows • Firms more able to pay cash dividends • Stock dividends and splits still common • Dividend payout usually increases from 5 – 15 to 25 – 30 percent of earnings

11. Maturity–Stage IV • Industry grows only as overall economy does • Plant and equipment are in place • Financing alternatives (both domestic and international) and the cash flow from operations are sufficient to meet growth requirements of firms • Dividends may range from 40 – 50 percent of earnings

12. Decline– Stage V • Industries suffer declines in sales if product innovation has not increased product base over the years • May be specific to a country • Industry may undergo consolidation • Dividend payout ratios often rise to 100% or more of earnings, followed by cuts or elimination of dividends

13. Growth in Non-growth Industries • Growth companies may exist even in a mature industry • Not all firms experience same growth path in sales, earnings, and dividends • Some firms • Are better managed • Have better people • Have more efficient assets • Invest more in productive research and development creating new or improved products • Some mature firms might be good investments

14. Industry 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 • Economic Structure • Competitive Structure

15. Industry – Economic Structure • Monopolistic Competition – many small firms, some product differentiation • Pure Competition – many firms, none significant in size, no product differentiation • not widely found in the United States • companies compete intensely, try to create perceived differences in product quality or service

16. Industry – Economic Structuredetermines how companies compete • Monopolies – single firm is the whole industry • Not common in United States except as public utilities • Regulations tend to limit growth and profitability

17. Industry – Economic Structuredetermines how companies compete • Oligopolies – few firms in open rivalry • Quite common in large, mature U.S. industries • Such as autos, steel, oil, airlines, and aluminum • Competition between firms can be intense • Profitability may suffer from price wars and fights over market share • Increasingly face international competition altering their strategies

18. Industry – Economic Structure determines how companies compete • Monopolistic Competition – many small firms, some product differentiation • Pure Competition – many firms, none significant in size, no product differentiation • Not widely found in the United States • Companies compete intensely, try to create perceived differences in product quality or service

19. Industry – Competitive Structure • Porter’s five forces • Threat of entry by new competitors • Threat of substitute goods • Bargaining power of buyers • Bargaining power of suppliers • Rivalry among existing competitors

20. Relatively stable Individual firms go thru cycles as patents expire on popular drugs Test of sustainability is firm’s R&D capability to generate new products and get FDA approval Mergers have led to large firms International regulation, price controls, and HMO bargaining power have been problems Relatively low but fluctuating long-term debt to equity ratios in many cases Pharmaceutical Industry- An Example

21. Table 6-6 Dow Jones Industrial Groups Overview • Basic Materials • Consumer, Cyclical • Consumer, Noncyclical • Energy • Financial • Health Care • Industrial • Technology • Telecommunications • Utilities

22. 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

23. Table 6-6 Dow Jones Industrial Groups • Consumer, Cyclical

24. Table 6-6 Dow Jones Industrial Groups • Consumer, Noncyclical

25. Table 6-6 Dow Jones Industrial Groups • Energy

26. Table 6-6 Dow Jones Industrial Groups • Financial

27. Table 6-6 Dow Jones Industrial Groups • Health Care

28. Table 6-6 Dow Jones Industrial Groups • Industrial

29. Table 6-6 Dow Jones Industrial Groups • Technology

30. Table 6-6 Dow Jones Industrial Groups • Telecommunications

31. Table 6-6 Dow Jones Industrial Groups • Utilities

32. Government Regulation These companies sell their products throughout the world Are regulated by governments across the globe The U.S. Food and Drug Administration (FDA) is considered one of the most risk-averse and strict enforcement agencies in the world Quite often, drugs are approved for use in other countries before being approved for sale in the United States by the FDA Pharmaceutical Industry

33. Industry Groups and Rotational Investment Rotational investment refers to the practice of moving in and out of various industries over the business cycle to benefit from economic changes

34. Research and Development Uniquely important in this industry is the large amounts of money invested in research and development (R&D) Benchmark is the ratio of dollars spent on R&D as a proportion of sales Small firms are at a disadvantage because of their limited funds to devote to R&D and thus their drug pipeline With only a 3.3% success in passing FDA approval much R&D is spent on failures but a success can reap large profits for a firm Pharmaceutical Industry

35. Other issues: Product Diversity It is unusual to find more than three drugs with high market share treating the same problem Usually one or two drugs dominate the market Value of a pharmaceutical company is influenced more by the potential “blockbuster” drugs in the pipeline than current drugs that may come off their patent protection in the next few years Pharmaceutical Industry

36. Other issues: Patents and Generic Drugs U.S. Patent Office issues patents that protect drugs from competition for a limited number of years After a patent runs out, generic copies reduce profitability Global patent protection is an important issue because many countries violate or do not enforce international patents Pharmaceutical Industry

37. Other issues continued: Demographics and Managed Care As the world population ages, the demand for drugs will grow The drive to restrain the rise in drug prices through both managed care and government programs will put downward pressure on profit margins New Medicare drug coverage may create enough of an increased demand to compensate for possible pricing constraints imposed on the pharmaceutical industry Pharmaceutical Industry

38. Other issues continued: It pays to keep up-to-date on this or any other industry you are interested in analyzing by referring to Standard & Poor’s Industry Surveys Pharmaceutical Industry

39. Summary • Industry analysis is the second step in the top-down valuation process • Used to predict potential growth rate in sales, earnings, and cash flow • Position of a firm on its life-cycle curve suggests how fast a company can grow • Iife-cycle approach to an industry includes: 1. Development, 2. Growth, 3. Expansion, 4. Maturity, and 5. Decline

40. Summary • Industry structure and competition: • Monopoly, oligopoly, & pure competition structures affect pricing & returns • Government regulation affects many industry’s profits, product quality, energy consumption, transportation and education

41. Summary • Industry structure and competition: • International competition, supply and demand relationships, availability of raw materials, and energy costs among other things also must be observed • The pharmaceutical industry was given special attention because of its important