Chapter 6

1. Chapter 6 IndustryAnalysis

2. Objectives • Explain the phases of the industry life cycle • Relate dividend policy to the life cycle • Describe the various economic structures of industries

3. Objectives continued • Explain the effect that government regulation can have on an industry • Describe how to compare performance of many companies within the same industry • Explain the concept of rotational investing

4. Industry Analysis • Industry Life Cycles • Industry Structure • Pharmaceutical Industry: An Example • Industry Groups and Rotational Investing

5. Five-stage Industry Life cycle

6. Development –Stage I • Companies getting started with new idea, product, or production technique that makes them unique • Usually privately owned and financed with owner’s money, as well as capital from friends, family, and/or a bank • If successful, may attract venture capital • Pays no dividends because all profits are reinvested into the firm • Risky investment with large potential return

7. Growth– Stage II • 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 need for capital declines or new sources of capital appear • Risky investment with large potential return

8. Expansion– StageIII • Sales and earnings continue expanding, but at a decreasing rate • Crossover point • Change from accelerating growth to decelerating growth • More competition enters the market • Asset expansion slows • Cash dividends • Increase in dividend payout ratio • Stock dividends and splits still common • Stock prices may decline as investors realize growth rates will be declining

9. The Crossover Point

10. Maturity–Stage IV • Industry sales grow at rate equal to the economy as measured by long-term GDP growth • Plant and equipment are in place • Financing alternatives are available domestically and internationally • Cash flow from operations usually sufficient to meet growth requirements of firms • Dividends may range from 40 – 50 percent of earnings • Often compared to growth rate of S&P 500 Index

11. S&P 500 Total Return vs. Real GDPWith Dividends Reinvested

12. Grocery Store Sales vs. Real GDP

13. 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 • Weakest companies fail • Bankruptcy • Dividend payout ratios sometimes rise to 100% or more of earnings, followed by drastic cuts or elimination of dividends

14. Motor Vehicle Sales vs. Real GDP(seasonally adjusted)

15. Dividend Policy and the Life-Cycle Curve • Dividend payout ratio has important effect on company growth • The lower the payout – the greater the opportunity for growth • Dividend policy assists analysts in determining where the company is on the life-cycle curve

16. Growth in Non-growth Industries • Growth companies may exist in mature industries • Not all firms within an industry experience same growth path in sales, earnings, and dividends • Some firms • Are better managed • Have better people • Have more efficient assets • Invest more in research and development • Some mature firms might be good investments

17. Growth in Non-growth Industries continued • Growth by expansion abroad • International demand greater than domestic demand • Utilities in areas of rapid population growth

18. Industry Structure • Determines potential profitability of firms • Special considerations such as government regulation that positively or negatively impact the industry • Cost advantages and product quality that may create a dominant company within the industry

19. Industry – Economic Structure • Monopolies • single firm is the whole industry • not common in United States except as public utilities • almost always in mature industries • regulations tend to limit growth and profitability

20. Industry – Economic Structure continued • Oligopolies • few firms in open rivalry • common in large, mature U.S. industries • Automobiles, steel, oil, airlines, 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

21. Industry – Economic Structure continued • 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

22. Industry – Economic Structure continued • Other Economic Factors to Consider • Supply and demand relationships • Cost variable • Availability of raw material • Energy costs • Government Regulation • Some industries face increasing regulation • Other industries face deregulation and more competition • Government expenditures

23. 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

24. Global industry High barriers to entry Drugs have predictable life cycles Development process Approval process Remainder of life under patent protection (10 years maximum) Pharmaceutical IndustryAn Example

25. Leading Pharmaceutical Companies - 2005

26. Life-Cycle Analysis Most large pharmaceuticals in expansion stage of life cycle Individual firms go thru cycles as patents expire on popular drugs Portfolio of product life cycles are well diversified Industry growing faster than economy or S&P 500 Index Growth is decelerating (not accelerating) Test of sustainability is firm’s R&D capability to generate new products and get FDA approval Mergers have led to large firms Pharmaceutical IndustryAn Example

27. Comparative Company Analysis Health Care: Pharmaceuticals – Panel A

28. Comparative Company Analysis Health Care: Pharmaceuticals – Panel B

29. Government Regulation These firms sell their products throughout the world and are regulated by many governments The U.S. Food and Drug Administration (FDA) one of the most risk-averse and strict enforcement agencies in world Quite often, drugs are approved for use in other countries before being approved for sale in the United States by FDA Can take up to ten years of R&D before submission to FDA for approval Pharmaceutical IndustryAn Example

30. New Drug Filings with the Food and Drug Administration

31. Research and Development Large amounts of money invested in research and development (R&D) Benchmark is the ratio of dollars spent on R&D as a percentage of sales Small firms disadvantaged because of limited funds to devote to R&D and thus fewer drugs 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 IndustryAn Example

32. Research and Development Expenditures

33. Research and Development Recent company mergers have: created large companies able to pool resources to develop larger economies of scale been the result of large firms unsuccessful at research buying smaller innovative companies Pharmaceutical IndustryAn Example

34. Top Prescription Drugs of 2005

35. Other issues: Product Diversity Large and small companies with industry Unusual to find more than three drugs with high market share treating the same problem Within industry, not much direct competition Usually one or two drugs dominate the market Value of pharmaceutical company influenced more by potential “blockbuster” drugs in pipeline than current drugs that may come off patent protection in next few years Pharmaceutical IndustryAn Example

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 important issue since many countries violate or do not enforce international patents Pharmaceutical IndustryAn Example

37. Other issues continued: Demographics and Managed Care As world population ages, demand for drugs will grow 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 IndustryAn Example

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 http://www.mhhe.com/edumarketinsight Pharmaceutical Industry

39. Industry Groups and Rotational Investing • Industries can be classified into groups that may exhibit similar behavior during different phases of the business cycle • Different industries benefit from economic changes that accompany the business cycle • Rotational investing • the practice of moving in and out of various industries over the business cycle

40. Dow Jones Industry Groups

41. Industry Groups and Rotational Investing continued • Example: • Falling interest rates • Housing, home building, lumber, household durable good stocks • Rising interest rates • Food, pharmaceutical, beverage, tobacco stocks • Rising inflation • Basic materials, energy stocks and commodities