merger and acquisition

63

' I Describing and Analyzing an Industry 5.1.7 Industry Comparison

To illustrate how these elements might be applied, Exhibit 7 uses the factors discussed in this reading to examine three industries.

Branded Pharmaceuticals Oil Services

Major Companies Pfizer, Novartis, Merck, Schlumberger, Baker Hughes, GlaxoSmithKline Halliburton

Barriers to Entry/ Very High: Substantial Medium: Technological Success financial and intellectual expertise is required, but high

capital required to compete level of innovation allows niche effectively. A potential new companies to enter the industry entrant would need to create and compete in specific areas. a sizable R&D operation, a global distribution network, and large-scale manufacturing capacity.

Level of Concentration Concentrated: A small number Fragmented: Although only a of companies control the small number of companies bulk of the global market provide a full range of services, for branded drugs. Recent many smaller players compete mergers have increased level effectively in specific areas. of concentration. Service arms of national

oil companies may control significant market share in their own countries, and some product lines are concentrated in the mature U.S. market.

Impact of Industry NA: Pharmaceutical pricing Medium/High: Demand can Capacity is primarily determined fluctuate quickly depending on

by patent protection and commodity prices, and industry regulatory issues, including players often find themselves government approvals of with too few (or too many) drugs and of manufacturing employees on the payroll. facilities. Manufacturing capacity is of little importance.

Industry Stability Stable: The branded Unstable: Market shares may pharmaceutical market shift frequently depending is dominated by major on technology offerings and companies and consolidation demand levels. via mega-mergers. Market shares shift quickly, however, as new drugs are approved and gain acceptance or lose patent protection.

Life Cycle Mature: Overall demand does Mature: Demand does fluctuate not change greatly from year with energy prices, but to year. normalized revenue growth is

only mid-single digits.

219 r I

Confections/Candy

Cadbury, Hershey, Mars/ Wrigley, Nestle

Very High: Low financial or technological hurdles, but new players would lack the established brands that drive consumer purchase decisions.

Very Concentrated: Top four companies have a large proportion of global market share. Recent mergers have increased level of concentration.

NA: Pricing is driven primarily by brand strength. Manufacturing capacity has little effect.

Very Stable: Market shares change glacially.

:I

Very Mature: Growth is driven I i

by population trends and I i

pricing.

(continued) i!

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Price Competition

Demographic Influences

Government & Regulatory Influences

Social Influences

Technological Influences

Growth vs. Defensive vs. Cyclical

Branded Pharmaceuticals

Low/Medium: In the United States, price is a minimal factor because of consumer- and provider-driven, de-regulated health care system. Price is a larger part of the decision process in single- payer systems, where efficacy hurdles are higher.

Positive: Populations of developed markets are aging, which slightly increases demand.

Very High: All drugs must be approved for sale by national safety regulators. Patent regimes may differ among countries. Also, health care is heavily regulated in most countries.

NA

Medium/High: Biologic (large-molecule) drugs are pushing new therapeutic boundaries, and many large pharmaceutical companies have a relatively small presence in biotech.

Defensive: Demand for most health care services does not fluctuate with the economic cycle, but demand is not strong enough to be considered "growth:'

Note: "NA" in this exhibit stands for "not applicable:'

Reading SO •Introduction to Industry and Company Analysis

Oil Services

High: Price is a major factor in purchasers' decisions. Some companies have modest pricing power because of a wide range of services or best-in-class technology, but primary customers (major oil companies) can usually substitute with in-house services if prices are too high. Also, innovation tends to diffuse quickly throughout the industry.

NA

Medium: Regulatory frameworks can affect energy demand at the margin. Also, governments play an important role in allocating exploration opportunities to E&P companies, which can indirectly affect the amount of work flowing down to service companies.

NA

Medium/High: Industry is reasonably innovative, and players must re-invest in R&D to remain competitive. Temporary competitive advantages are possible via commercialization of new processes or exploitation of accumulated expertise.

Cyclical: Demand is highly variable and depends on oil prices, exploration budgets, and the economic cycle.

Confections/Candy

Low: A lack of private-label competition keeps pricing stable among established players, and brand/familiarity plays a much larger role in consumer purchase decisions than price.

NA

Low: Industry is not regulated, but childhood obesity concerns in developed markets are a low-level potential threat. Also, high-growth emerging markets may block entry of established players into their markets, possibly limiting growth.

NA

Very Low: Innovation does not play a major role in the industry.

Defensive: Demand for candy and gum is extremely stable.

1

Company Analysis

Exhibit 8 provides a checklist of points to cover in a company analysis. The list may need to be adapted to serve the needs of a particular company analysis and is not exhaustive.

Corporate Profile

• Identity of company's major products and services, current position in industry, and history

• Composition of sales

• Product life-cycle stages/experience curve effects16

• Research & development activities

• Past and planned capital expenditures

• Board structure, composition, electoral system, anti-takeover provisions, and other corporate governance issues

• Management strengths, weaknesses, compensation, turnover, and corporate culture

• Benefits, retirement plans, and their influence on shareholder value

• Labor relations

• Insider ownership levels and changes

• Legal actions and the company's state of preparedness

• Other special strengths or weaknesses

Industry Characteristics

• Stage in its life cycle

• Business-cycle sensitivity or economic characteristics

• Typical product life cycles in the industry (short and marked by technological obsolescence or long, such as pharmaceuticals protected by patents)

• Brand loyalty, customer switching costs, and intensity of competition

• Entry and exit barriers

• Industry supplier considerations (concentration of sources, ability to switch suppliers or enter suppliers' business)

• Number of companies in the industry and whether it is, as determined by market shares, fragmented or concentrated

• Opportunity to differentiate product/service and relative product/ service price, cost, and quality advantages/disadvantages

• Technologies used

• Government regulation

• State and history of labor relations

• Other industry problems/opportunities

(continued)

16 A product life cycle relates to stages in the sales of a product. Experience curve effects refer to the ten- dency for the cost of producing a good or service to decline with cumulative output.

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230 Reading SO • Introduction to Industry and Company Analysis

Analysis of Demand for Products/Services

• Sources of demand

• Product differentiation

• Past record, sensitivities, and correlations with social, demographic, economic, and other variables

• Outlook-short, medium, and long term, including new product and business opportunities

Analysis of Supply of Products/Services

• Sources (concentration, competition, and substitutes)

• Industry capacity outlook-short, medium, and long term

• Company's capacity and cost structure

• Import/export considerations

• Proprietary products or trademarks

Analysis of Pricing

• Past relationships among demand, supply, and prices

• Significance of raw material and labor costs and the outlook for their cost and availability

• Outlook for selling prices, demand, and profitability based on current and anticipated future trends

Financial Ratios and Measures (in multi-year spreadsheets with historical and forecast data)

I. Activity ratios, measuring how efficiently a company performs such functions as the collection of receivables and inventory management:

• Days of sales outstanding (DSO)

• Days of inventory on hand (DOH)

• Days of payables outstanding (DPO)

11. Liquidity ratios, measuring a company's ability to meet its short-term obligations:

• Current ratio

• Quick ratio

• Cash ratio

• Cash conversion cycle (DOH+ DSO- DPO)

Ill. Solvency ratios, measuring a company's ability to meet its debt obligations. (In the following, "net debt" is the amount of interest- bearing liabilities after subtracting cash and cash equivalents.)

• Net debt to EBITDA (earnings before interest, taxes, depreciation, and amortization)

• Net debt to capital

• Debt to assets

• Debt to capital (at book and market values)

• Financial leverage ratio (Average total assets/Average total equity)

Company Analysis

• Cash flow to debt

• Interest coverage ratio

• Off-balance-sheet liabilities and contingent liabilities

• Non-arm's-length financial dealings

IV. Profitability ratios, measuring a company's ability to generate profitable sales from its resources (assets).

• Gross profit margin

• Operating profit margin

• Pretax profit margin

• Net profit margin

• Return on invested capital or ROIC (Net operating profits after tax/ Average invested capital)

• Return on assets or ROA (Net income/Average total assets)

• Return on equity or ROE (Net income/ Average total equity)

V. Financial statistics and related considerations, quantities and facts about a company's finances that an analyst should understand.

• Growth rate of net sales

• Growth rate of gross profit

e EBITDA

• Net income

• Operating cash flow

e EPS

• Operating cash flow per share

• Operating cash flow in relation to maintenance and total capital expenditures

• Expected rate of return on retained cash flow

• Debt maturities and ability of company to refinance and/or repay debt

• Dividend payout ratio (Common dividends/Net income available to common shareholders)

• Off-balance-sheet liabilities and contingent liabilities

• Non-arm's-length financial dealings

To evaluate a company's performance, the key measures presented in Exhibit 8 should be compared over time and between companies (particularly peer companies). The following formula can be used to analyze how and why a company's ROE differs from that of other companies or its own ROE in other periods by tracing the differences to changes in its profit margin, the productivity of its assets, or its financial leverage:

ROE = (Net profit margin: Net earnings/Net sales)

x (Asset turnover: Net sales/Average total assets)

x (Financial leverage: Average total assets/Average common equity)

231