Industry Analysis – Firm performance is closely tied to industry performance – a firm’s profitability is circumscribed by industry profitability and the firm’s relative position within the industry – Knowing the industry adds to your understanding of the firm – According to Porter’s framework, industry profitability is determined by Degree of actual and potential competition Potential profits in an industry is a function of the price that customers are willing to pay for a product. This price is in part determined by the degree of competition among the firms in the industry. Bargaining power of buyers and suppliers The actual profits depend on the firms’ bargaining power with suppliers (i.e., the price they pay for their inputs) and buyers (i.e., the price they get for their output.) 1

Degree of actual and potential competition – Rivalry among existing firms Industry growth rate – Determines how intensely firms have to compete with each other for market share. For example, firms in mature industries will have to compete more for market share, compared to firms in high growth industries. – High growth industries also tend to attract potential competitors. Concentration and balance of competitors – The number of firms in an industry as well as the relative size of the firms determine the level of competition in an industry. For example, one large firm can set the price in an industry. Alternatively, a group of similarly sized firms can cooperate and set prices at a high level, or, they may engage in price wars. Degree of differentiation and switching costs – Are the products differentiated enough such that customers could have strong preferences about which product to buy? Scale/learning economies and the ratio of fixed to variable costs – Economies of scale and learning typically encourage fierce competition among firms already in the industry. 2

Excess capacity and exit barriers – Firms in industries with excess capacity are more likely to cut prices. – Similarly, high exit barriers (e.g., specialized equipment, high sunk costs) could cause firms to utilize excess capacity (and lower prices) rather than leave. These also serve as deterrents to potential competitors. – Threat of new entrants Economies of scale – Large investments in capacity will tend to discourage potential entrants into the industry. First mover advantage – First mover advantage refers to the competitive advantage (e.g., costs, learning, set industry standards) gained by the first firm/s to enter an industry. Access to channels of distribution and relationships – Potential competitors are discouraged from entering an industry if it is difficult to have an avenue to sell their products. For example, an auto manufacturer will have to set up a dealer network. Legal barriers – Includes licenses, patents, copyrights. 3

– Threat of substitute products Customers are likely to be more sensitive to price if there are close substitutes (e.g., air versus train travel) Bargaining power of buyers and suppliers – Bargaining power of buyers Price sensitivity. Buyers will be more sensitive to price if – the item comprises a big proportion of total cost/expenses – sellers produce undifferentiated products – the item has little or no effect on the quality of the buyer’s product or service Relative bargaining power – Size and concentration of buyers relative to suppliers. Buyers will have bargaining power if they are few in number and make large purchases. For example, HMOs purchase healthcare from doctors and hospitals at a much lower cost. – Buyer’s information. Buyers will be able to bargain more if they know the suppliers prices and costs. – Bargaining power of suppliers Arguments would be similar to bargaining power of buyers, with the roles reversed. 4

Industry classifications – Global Industry Classification Standard (GICS) – Thomson Reuters Business Classification – Standard Industrial Classification (SIC) – North American Industry Classification System (NAICS) – Others 5

Opportunities based on industry life cycle – Emerging industries are characterized by Technological uncertainty Strategic uncertainty High but steeply falling costs Large numbers of newly formed companies First-time buyers Altered entry barriers A firm may be able to establish product standards or define the business model Early commitments to suppliers and customers can produce loyalty and favored treatment 6

Opportunities based on industry life cycle – Mature industries are characterized by As product and market penetration increases, competition focuses more on market share Customers are knowledgeable, competition focused on cost and service Reduced growth in personnel and productive capacity Fewer opportunities for new product and process development opportunities Increased international competition Reduced profits Focus on operational efficiency Cross selling Acquisition opportunities International market opportunities 7

Alternatives to Porter’s view – Value net and mixed business relationships Complementor – if customers value a firm’s product more when they have the other firm’s product than when they have the firm’s product alone Competitor - if customers value a firm’s product less when they have the other firm’s product than when they have the firm’s product alone – Innovation based industry analysis 8

Sources: – English, Applied Equity Analysis – Palepu and Healy, Business Analysis and Valuation Using Financial Statements, 4 th ed. – Grant, Contemporary Strategy Analysis, 7 th ed. – Valentine, Best Practices for Equity Research Analysts 9