IFT Notes for Level I CFA^® Program

R40 Introduction to Industry and Company Analysis

Part 2

5. Describing and Analyzing an Industry

Objective of Industry Analysis

The objective is to identify industries that offer the highest potential risk-adjusted returns, i.e., industries that generate high return on invested capital relative to the weighted average cost of capital. In this context, it is important to recognize that not all industries perform well at any point in an economic cycle. Economic fundamentals and, hence, economic profits can vary substantially across industries.

Why strategic groups are important in industry analysis?

When performing an industry analysis, it is useful to consider strategic groups. Strategic groups are groups of companies sharing distinct business models or catering to a specific market segment. For example, consider the airline industry in the U.S. and the low cost carriers (LCC) within it. LCC is a strategic group in the airline industry comprising of companies such as South West airlines, JetBlue, etc.

We now look at a commonly used framework for industry analysis. Designed by Michael Porter, the framework is also known as Porter’s Five Forces.

The table below summarizes what each of these five forces means:

Porter’s Five Forces
Force	Description
Threat of substitute products	If substitutes to a company’s products are easily available, then the threat is high and demand for the company’s products will decrease. Customers may switch to alternative products if switching costs are low. Ex: Low-priced brands are close substitutes to premium brands; low-cost mobiles from China are substitutes to Samsung or iPhone; If coffee prices increase substantially, coffee drinkers may switch to tea; or during a recession, movie goers may prefer to watch movies at home, using substitute forms instead of going to the cinema. If this force is strong, it will weaken the pricing power of the market players.
Bargaining power of customers	Customers enjoy bargaining power in industries with large volumes and smaller number of buyers. The price competition and profitability is low as customers demand low prices. Ex: Airlines ordering numerous aircrafts from Boeing or Airbus. Since airlines typically order a large number of aircrafts, they have high bargaining power.
Bargaining power of suppliers	Suppliers enjoy pricing power in industries where suppliers are small and the supply of key inputs to a company is scarce. Ex: Consumer products companies have limited control over price.
Threat of new entrants	If barriers to entry are high, then the threat of new entrants is low. Conversely, if barriers to entry are low, then the threat of new entrants is high. Ex: The threat of new entrants is high in the mobile handset market.
Intensity of rivalry among existing competitors	Industries with high fixed costs, high exit barriers, little differentiation in products, and similar size experience intense rivalry. Ex: Boeing and Airbus.

5.1. Principles of Strategic Analysis

We will now focus on the internal competitive forces within an industry: barriers to entry, industry concentration, pricing, capacity, market share stability, and the stages in its lifecycle. All these forces play an important role in an industry’s competitiveness.

Barriers to Entry

Barriers to entry is an important concept from a testability perspective. Do not confuse barriers to entry with barriers to success. For example, in the United States, it takes an investment of only $150,000 to start a new mutual fund. The initial capital requirement may be low but that does not guarantee success. Will investors invest in a fund without a track record?

Here is a simple way of looking at barriers to entry:

If the barriers to entry are high, then it discourages new entrants from entering the industry.

Example of high barriers to entry: Global credit card networks such as Visa and MasterCard.

Low barriers to entry implies new entrants can enter the industry.

Example of low barriers to entry: Starting a restaurant as it requires a modest amount of capital and culinary skills.

High barriers to entry does not imply high pricing power under the following conditions:

Price is a large percentage of the customer’s purchase decision. Consider the aircraft manufacturing industry. The two big players in this industry are Airbus and Boeing and the competition between these two companies is high. Major airlines buy from either of them, but price is a big consideration in their purchase decision given the number of aircrafts each airline buys and the price of an aircraft. So, even though the barriers to entry are high, there is a downward pressure on pricing for the manufacturers as airlines would otherwise switch to the other supplier, for example, if Boeing prices its Boeing-777 aircraft substantially higher than an Airbus A-320.
Industry has high barriers to exit. The auto industry has high barriers to entry as the initial capital requirement is high to set up manufacturing facilities, building a dealership network, building the brand etc. This makes it difficult for a new company to enter the industry. At the same time, it is not feasible for the existing players to exit the market. Consequently, when demand is low (perhaps due to a sluggish economy), car makers are forced to reduce prices.

Industry Concentration

In concentrated industries, each player generally has high pricing power because the fortunes of the company are tied with the industry and they have more to gain by keeping prices high even though cutting prices might increase market share.
In segmented industries, each player generally has low pricing power because companies gain more by undercutting competition in an effort to increase market share.
However, there are exceptions to this rule. Do not automatically assume that high concentration leads to high pricing power, or that fragmented industries have weak pricing power.

While industry fragmentation is a good indicator of a competitive industry with limited pricing power, there are a few fragmented industries with strong pricing power (the bottom left quadrant in the table below). The following table shows the role of concentration in pricing and competition.

Two Factor Analysis of Industries: Concentration & Pricing Power
	Strong Pricing Power	Weak Pricing Power
Concentrated	Low capital requirements. Differentiated products. Less number of players. Less price competition Ex: Soft drinks (Coke, Pepsi). US Defense. US Railroads. Alcoholic beverage industry.	Generally capital intensive and sell commodity like products. Fierce competition between them. Relative market share matters more than absolute market share. Little or no differentiation in products. Ex: Commercial aircraft (Boeing, Airbus). Integrated oil companies (Exxon, Mobil, BP).
Fragmented	If one or two players are larger than the others, they compete with small players and not among themselves. Highly price-competitive. Each player has a smaller absolute market share. Ex: Asset Management Companies (Fidelity). If the customers are not price sensitive, then the players have high pricing power. Home Improvement (Home Depot– 11% and Lowe’s – 7% market share).	Ex: Consumer packaged goods (Procter & Gamble, Unilever) Airlines. Retail. Homebuilding. Restaurants.

Industry Capacity

Tight or limited capacity results in high pricing power as demand exceeds supply.
Overcapacity leads to price cuts and a very competitive environment.

When evaluating the impact of industry capacity on pricing, the following points should be considered:

Current capacity as well as future capacity levels must be evaluated. Such an analysis might reveal the capacity crunch is temporary.
It is quicker to shift financial and human capital to new uses but tough to shift capital invested in physical assets. Physical capital takes a relatively long time to establish. Capacity is fixed in the short term, and variable in the long term – new factories may be built to add capacity.

Market Share Stability

Stable market share implies less competitive industries.
Unstable market share implies highly competitive industries and limited pricing power.
Factors that impact market share stability include: barriers to entry, switching costs, new product introductions, complexity of products, and pace of innovation.
If barriers to entry are high, switching costs are high and new product introductions are low, then the market share stability will be high.
If barriers to entry are low, switching costs are low and new product introductions are high, and the market share stability will be low.

Price Competition

If price is a major factor in customer buying decisions, then competition will be high. Ex: commercial aircraft industry. Price is a major factor in an airline’s purchase decision. This weakens pricing power for Boeing and Airbus.

Industry Life-Cycle Model

There are five stages in the life cycle of any industry: embryonic, growth, shakeout, mature, and decline. The characteristics of each stage are depicted in the diagram below:

Embryonic

Slow growth, high prices.
Product still not positioned in the market; buyers unaware; distribution channels to be developed.
High investment and high risk of failure.
Low volumes; no economies of scale.

Growth

Rapidly increasing demand; new customers.
Falling prices as economies of scale are achieved.
Low barriers to entry; threat of new entrants.
Low competition leads to increased market share and profitability.

Shakeout

Slowing growth, intense competition, and declining profitability.
Market is saturated; no new customers.
Investment to add capacity leads to overcapacity. To boost demand, prices are cut which decreases profitability.
Focus is on reducing costs and building brand loyalty.
Ex: deregulation of telecom companies in the 1990s.

Mature

High barriers to entry; consolidation takes places resulting in oligopolies.
Little or no growth.
Market is saturated; it is a stable competitive environment.
Companies with superior products gain market share.

Decline

Growth is negative.
Excess capacity leads to price cuts resulting in price wars.
Competition increases.
Weaker companies exit.

The life-cycle model is a well-defined framework to understand any industry’s evolution. But it is not a cookie-cutter model that all industries adhere to. There are external factors which significantly affect how an industry evolves causing some stages to be shorter or longer than expected. These are technological, social, regulatory, and demographic changes which we will see in detail in the next section.

Limitations of the Industry Life-Cycle Model

It is less practical for analyzing industries going through rapid changes or periods of economic instability.
Not all companies in an industry will perform the same. For example, there are consistently profitable companies even in a highly competitive industry such as consumer goods, or retail.