17.

6 Industry Analysis
Industry analysis is important for the same reason that macroeconomic
analysis is. Just as it is difficult for an industry to perform well when the
macroeconomy is ailing, it is unusual for a firm in a troubled industry to perform
well. Similarly, just as we have seen that economic performance can vary widely
across countries, performance also can vary widely across industries. Figure 17.6
illustrates the dispersion of industry performance. It shows return on equity based
on 2009 profitability for several major industry groups. ROE ranged from 7.6% for oil
and gas companies to 34.9% for the computer systems industry.
Defining an Industry
Although we know what we mean by an industry, deciding where to draw
the line between one industry and another can be difficult in practice. Consider, for
example, one of the industries depicted in Figure 17.6 , application software firms.
Industry ROE in 2009 was 25.9%. But there is substantial variation within this group
by focus, and one might well be justified in further dividing these firms into distinct
subindustries. Their differences may result in considerable dispersion in financial
performance. Figure 17.8 shows ROE for a sample of the firms included in this
industry, confirming that 2009 performance did indeed vary widely: from 8.3% for
Adobe to 41.6% for VeriSign.
Sensitivity to the Business Cycle
Once the analyst forecasts the state of the macroeconomy, it is necessary to
determine the implication of that forecast for specific industries. Not all industries
are equally sensitive to the business cycle.
Sector Rotation
One way that many analysts think about the relationship between industry
analysis and the business cycle is the notion of sector rotation . The idea is to shift
the portfolio more heavily into industry or sector groups that are expected to
outperform based on ones assessment of the state of the business cycle.
Industry Life Cycles
Examine the biotechnology industry and you will find many firms with high
rates of investment, high rates of return on investment, and low dividend payout
rates. Do the same for the public utility industry and you will find lower rates of
return, lower investment rates, and higher dividend payout rates. Why should this
be?
The biotech industry is still new. Recently, available technologies have
created opportunities for highly profitable investment of resources. New products
are protected by patents, and profit margins are high. With such lucrative

investment opportunities, firms find it advantageous to put all profits back into the
firm. The companies grow rapidly on average.
Start-Up Stage The early stages of an industry are often characterized by a
new technology or product such as VCRs or personal computers in the 1980s, cell
phones in the 1990s, or the new generation of smart phones introduced more
recently.
Consolidation Stage After a product becomes established, industry leaders
begin to emerge. The survivors from the start-up stage are more stable, and market
share is easier to predict. Therefore, the performance of the surviving firms will
more closely track the performance of the overall industry. The industry still grows
faster than the rest of the economy as the product penetrates the marketplace and
becomes more commonly used.
Maturity Stage At this point, the product has reached its full potential for
use by consumers. Further growth might merely track growth in the general
economy. The product has become far more standardized, and producers are forced
to compete to a greater extent on the basis of price. This leads to narrower profit
margins and further pressure on profits. Firms at this stage sometimes are
characterized as cash cows, having reasonably stable cash flow but offering little
opportunity for profitable expansion. The cash flow is best milked from rather than
reinvested in the company.
We pointed to VCRs as a start-up industry in the 1980s. By the mid-1990s it
was a mature industry, with high market penetration, considerable price
competition, low profit margins, and slowing sales. By the late 1990s, VCR sales
were giving way to DVD players, which were in their own start-up phase. Within 10
years, DVD players had entered a maturity stage, with standardization, price
competition, and considerable market penetration.
Relative Decline In this stage, the industry might grow at less than the rate
of the overall economy, or it might even shrink. This could be due to obsolescence
of the product, competition from new low-cost suppliers, or competition from new
products, as illustrated by the steady displacement of VCRs by DVD players.

Industry Structure and Performance The maturation of an industry

involves regular changes in the firms competitive environment. As a final topic, we
examine the relationship among industry structure, competitive strategy, and
profitability. Michael Porter has highlighted these five determinants of competition:
threat of entry from new competitors, rivalry between existing competitors, price
pressure from substitute products, bargaining power of buyers, and bargaining
power of suppliers.

Threat of Entry New entrants to an industry put pressure on price and

profits. Even if a firm has not yet entered an industry, the potential for it to do so
places pressure on prices, because high prices and profit margins will encourage
entry by new competitors. Therefore, barriers to entry can be a key determinant of
industry profitability. Barriers can take many forms. For example, existing firms may
already have secure distribution channels for their products based on long-standing
relationships with customers or suppliers that would be costly for a new entrant to
duplicate. Brand loyalty also makes it difficult for new entrants to penetrate a
market and gives firms more pricing discretion. Proprietary knowledge or patent
protection also may give firms advantages in serving a market. Finally, an existing
firms experience in a market may give it cost advantages due to the learning that
takes place over time.
Rivalry between Existing Competitors When there are several
competitors in an industry, there will generally be more price competition and lower
profit margins as competitors seek to expand their share of the market. Slow
industry growth contributes to this competition, because expansion must come at
the expense of a rivals market share. High fixed costs also create pressure to
reduce prices, because fixed costs put greater pressure on firms to operate near full
capacity. Industries producing relatively homogeneous goods are also subject to
considerable price pressure, because firms cannot compete on the basis of product
differentiation.
Pressure from Substitute Products Substitute products means that the
industry faces competition from firms in related industries. For example, sugar
producers compete with corn syrup producers. Wool producers compete with
synthetic fiber producers. The availability of substitutes limits the prices that can be
charged to customers.
Bargaining Power of Buyers If a buyer purchases a large fraction of an
industrys output, it will have considerable bargaining power and can demand price
concessions. For example, auto producers can put pressure on suppliers of auto
parts. This reduces the profitability of the auto parts industry.
Bargaining Power of Suppliers If a supplier of a key input has
monopolistic control over the product, it can demand higher prices for the good and
squeeze profits out of the industry. One special case of this issue pertains to
organized labor as a supplier of a key input to the production process. Labor unions
engage in collective bargaining to increase the wages paid to workers. When the
labor market is highly unionized, a significant share of the potential profits in the
industry can be captured by the workforce.
The key factor determining the bargaining power of suppliers is the
availability of substitute products. If substitutes are available, the supplier has little
clout and cannot extract higher prices.