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Chapter 6: Industry Analysis

 Role of Industry analysis in Fundamental analysis
Industry analysis helps in understanding how each industry would be impacted under the current
economic conditions. Analysts also try to understand how the various players in the market are likely to
react and how they may affect the prospect of the industry.

Various questions to be addressed in the industry analysis:

1. What is the industry in which the company operates?
2. How much does it get impacted on account of cyclical trends in the economy?
3. What is the potential industry size?
4. How has the industry been performing in the past and what were the drivers behind the
performance?
5. What is the level of competition in the industry? How does it affect the pricing power of the
various players?
6. What are the various secular trends that affect the industry, and are they causing any value
migration?
7. Are there any regulatory headwinds or tail winds affecting the industry?

 Defining the industry

The very first step in an industry analysis is to define the industry in which the company operates. While
there are several standard industry classification system, such as National Industry Classification (NIC)
system in India or North American Industry Classification System (NAICS) in US.
An analyst should carefully consider the various factors that drive the business and should classify it as
part of the industry group which have common driving factors.

 Understanding industry cyclicality

Economic Cycles affect all business. Industries can be classified into three categories:

Defensive industries: These are industries that create products and services that have low income
elasticity i.e., a fall or rise in income elasticity i.e., a fall or rise in income does not affect the demand
significantly. These industries experience minimal impact on account of economic cycles.

Semi-Cyclical industries: These industries experience growth in sales during the expansionary phrase and
decline during recessionary phrase. Consumer durables industry has exhibited these traits.

Deep cyclical industries: These industries witness extreme cyclicality in their revenues as they are largely
driven by economic cycle and/or commodity cycles. During recessionary conditions, their sales drop
significantly.

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 Market Sizing and trend analysis

Industries that are underpenetrated have high growth potential as there is more headroom for growth.
Measuring the current market size is difficult especially if there are many unorganized players or private
companies. Studying the past trends can supplement our analysis. Market sizing can be done through
either top-down approach or bottom up approach. In a top-down approach, we measure the size of the
market or industry starting from macro-economic factors and arrive up to the industry level. In bottom-
up approach, we quantify the market by looking at individual companies and aggregating their data to
arrive at the industry size.

 Secular trends, value migration and business life cycle

Secular trends are long term trends. Various factors that drive secular trends:

1. Technological advancement:
New technology can cause disruption in many ways. It can provide alternative to an existing
product or can create new consumption pattern.

2. Change in Income levels:

People start consuming premium products compared to cheaper alternatives.

3. Demographic Changes:
Causes changes in the consumption pattern within the country.

4. Change in culture, and tastes and preferences

5. Change in regulation or government policy

 In addition to the above, many other factors may also serve as a catalyst for a secular trend.

Value Migration:
Value migration helps when a phenomenon creates long term advantage for one or more entities at
the cost of other entities.

Geographic Migration:
When a secular trend helps a country or geography as compared to other. For instance, horizontal
drilling and shale gas discovery shifted value to US based oil exploration at the cost of other oil
producing countries as US had large amount of shale gal reserve and were able to extract them at a
lower cost compared to other oil producing nation.

Cross industry migration:

When one industry gains at the cost of another. Advent of digital camera resulted in massive decline of
film rolls.

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Migration across value chain:

Some phenomenon can result in industries at the down end of value chain gain at the cost of those at
the upper end or vice-versa.

Migration across companies in the same industry:

Certain disruption may create new competitive advantage for one company or may remove a
competitive advantage enjoyed by an existing player.

 Business Life Cycle

Every industry typically goes through this following phrases:
1. Pioneering Stage: The industry is just taking shape. It is not widely adopted. The concept is still
being proven or just been proven.
2. Growth Stage: The concept is found variable and many customers start adopting the new
product. As more and more customers adopt the product, the industry witness steep growth.
3. Matured Stage: The industry has existed for long and most customers who can use their product
are already using it. Number of new (potential) customers are relatively less.
4. Declining Stage: Change in customer preference or a new technology replaces the industry’s
product with a new product. At this juncture, the industry starts losing out to the alternatives.
5. Reinvention and Revival: Although it is very rare, it is possible that the goods or services
produced by the industry finds a new use in a different application and starts a new cycle all
over again.

 Understanding the Industry Landscape

Landscape involves studying all the players in the industry and their interaction with each other. Includes
understanding competitors, customers, suppliers, regulators, and emerging technologies. Such study will
help the analyst understand how the industry may react to external market events. If the competition
intensity is high, it may create pricing pressure which will likely reduce the profits. Industry landscaping
needs to be very comprehensive. Certain established frameworks:
1. Michael Porter’s Five Force Model
2. PESTLE analysis
3. BCG Matrix
4. SCP analysis

 Michael Porter’s Five Force Model for Industry Analysis

Porter’s 5 Forces model developed by Dr. Michael Porter in 1979. This model analyses any industry on
the basis of five broad parameters. 5 forces are divided into 2 vertical and 3 horizontal ones.

Horizontal Forces:
1. Threat of Substitutes
2. Threat of New Entrants
3. Threat of Established Rivals

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Vertical Forces:
1. Bargaining Power of Suppliers
2. Bargaining Power of Customers

The below picture captures the essence of Porter’s Five Forces Model:

 Industry Rivalry
An industry where rivalry is high, the end result will be lower pricing power and lower incomes for
the industry participants. A strong competitor with deep pockets can easily adopt the tactics such
as continuously dumping products/services at prices lower than the cost to drive others out of the
industry. Intensity of rivalry would be high if:
1. Many companies exist in the business segment
2. Similar products/ services being offered by participants with little or no differentiation
3. Every industry participant tries to attract customers with similar strategies - lower prices
or longer credits
4. Switching cost for customers from one product/service to another is low or nil
“If only basis of competition in an industry is pricing, it is a self-defeating business”.

 Threat of Substitutes
The ability of an industry and company to foresee changes and to adapt to them early, will define
their success. Kodak did not see the threat, and subsequently filed for bankruptcy. Some industries
are not able to face the threat of substitutes and fail, while others reinvent themselves to stay
relevant. Threat of substitutes can be understood from the following two simple industry
characteristics. It would be high if:
1. Substitutes offer equal or better experience to customers – quality, price, ease, etc.
2. Switching cost for customers from one product/service to another is low or nil

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 Bargaining Power of Buyers

Buyers can exert a lot of pressure and dictate prices, if there are a larger number of sellers with
similar products/services. Buyers’ bargaining power can be understood from following simple
industry characteristics. It would be high if:
1. Competitive intensity in the industry is strong (continuous pricing pressure would exist on
industry participants).
2. Products/Services are standardized with little or no differentiation.
3. Close substitutes of the products/services exist and switching cost for customers is low or
nil.

 Bargaining Power of Supplies

A consumer will rarely bargain over the fees charged by hospitals or schools? The bargaining power
of suppliers is absolute and in the second case, bargaining power of suppliers is nil (until he/she is
the only vendor and close substitute is pretty far).
Suppliers bargaining power can be understood from following simple industry characteristics. It
would be high if:

1. The number of suppliers are limited and buyers are many

2. Suppliers supply some critical inputs to buyers
3. Competitive intensity in the industry is low with differentiation in products and services.
4. Products/Service do not have threat of Substitutes
5. Switching Cost for the customer is high

 Barriers to Entry (Threat of new entrants)

An industry which does not face the threat of new competitors coming in would be an attractive
industry for investors/owners. Warren Buffet calls as ‘the moat’; he says “In business, I look for
economic castles protected by unbreachable ‘moats’.” This essentially means he looks for
businesses with high entry barriers. Such businesses will have pricing power viz. can sell the
products at a premium without fear of losing customers.
Entry barriers in an industry can be understood from following simple industry characteristics. They
would be high if:
1. There are lots of licensing required in the business
2. Patents and copyrights prevent new entrants
3. Huge investments in specialized assets pose a challenge
4. Strong brands, strong distribution network, specialized execution capabilities, customers
loyalty with existing products/services exist in the business

Profitable atmosphere for the business:

1. Low competition
2. High barriers to entry
3. Weak suppliers’ bargaining power
4. Weak buyers’ bargaining power
5. Few substitutes

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If an industry is having these features, it would have strong pricing power and high profit margins
and attract investors.

 Political, Economic, Socio-cultural, Technological, Legal and Environmental (PESTLE) Analysis

PESTLE Analysis stands for Political, Economic, Socio-cultural, Technological, Legal and Environmental
Analysis. Some models also extend this to include Ethics and Demographics, thus modifying the
acronym to STEEPLED. This model primarily analyses the external environmental factors. To do
business in any country, a country, a business must know each of the above factors very well

Political Factors

Economic Factors: The economic parameters of a country such as GDP growth and its contributors,
inflation and interest rates, composition of imports and exports, balance of payment and exchange
rate stability, stable monetary and fiscal situation, well developed financial markets, taxation and
others.

Socio-Cultural Factors:
Such as the demographic profile in terms of age, education and skills, health, social values, lifestyle
factors, all affect the choices that people make in what they buy and consume.

Technological Factors:
Countries pushing R&D activities are bound to be at the forefront of technology.

Legal Factors:

Environmental Factors:
A country’s awareness of environmental issues and the policies relating to pollution control, waste
disposal, mining and protection of natural flora and fauna, rehabilitation of displaced local residents,
are all thorny issues, which if not clearly spelt out unambiguously can lead to operational and legal
issues in the future and ultimately loss of time , money and resources for a business.

 Boston Consulting Group (BCG) Analysis

BCG Analysis, developed by the Boston Consulting Group, looks at different segments of a business
unit at portfolio basis through the lenses of market growth and cash generation. BCG created a
matrix based on sensitivity of growth and cash generations as defined below in pictorial manner.

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Stars:
These are segments in a business where market is growing rapidly and company is having a large
market share. This segment generates increasing cash for the business with the passage of time.

Cash Cows:
These are segments which require low cash infusion for investment to maintain market shares
because of low growth prospects but at the same time steadily generate cash for the company from
the established market share. Colgate is example of the cash flow.

Question Marks:
Business segments in a fast growing market, but having low market share. The right strategies and
investments can help the market share of the business grow, but they also run the risk of consuming
cash in the process of increasing market share.

Dogs:
Business segments, which have slow growth rates and intensive competitive dynamics which leads to
low generation of cash are categorized as Dogs.

 Structure Conduct Performance (SCP) Analysis:

Look at the industry structure (monopoly, oligopoly), its conduct (commoditized or specialized,
seasonal or round the year, cyclical or non-cyclical etc. finally its performance (RoE, RoIC, WACC,
etc.). Structure, Conduct, Performance (SCP) analysis approaches the industry evaluation exactly with
this categorization. SCP analysis may be seen as extension of Porter’s model where probably first two
points structure and conduct were captured.

 Structure Analysis: Industry refers to the competitive intensity in the industry (number of players),
concentration of business in industry, relationship among the various players, market size, its
growth rate, etc.

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 Conduct Analysis: The structure of the industry, as described above, will define the conduct of the
business on aspects such as pricing and product innovation. Each industry will have its peculiar
behavior.

While looking for an industry’s conduct, analysts have to study several factors such as :
1. Is business cyclical in nature
2. If the business is cyclical, what are the factors affecting the business- commodity prices,
interest rates, currency prices or some other global factors
3. It is a highly specialized business which requires skilled labour
4. For skilled based business, is there enough talent available
5. How customers choose the products/services
6. How will technological changes affect this business
7. Is business heavily dependent on government policies

 Performance Analysis: Based on structure and conduct of the industry, industry would generate
financials for the investors/owners. Businesses with High return on capital/equity are the ones
which create wealth for shareholders/owners in the long run.

 Key Industry Drivers and Industry KPIs

The key performance indicator varies industry to industry. An analyst can be guided by two other
factors: (i) unit of pricing and (ii) key constraining factors.

 Unit of Pricing
Unit of pricing essentially refers to what a company considers as unit while pricing a product.

 Key constraining factors

These constraints may also gradually change over a period of time as the industry evolves. Broadly
speaking the constraints can be broken into three categories:
1. Demand side constraints
2. Supply side constraints
3. Regulatory constraints
If an industry has limited market size then industry penetration rate will be a key factor to look at.

 KPIs for select industries

Airlines and other transportation and logistics: the pricing is driven by quantity of passengers/cargo
carried and the distance it is carried. Some of the important KPIs for the industry include (i)
passengers/cargo kilo meter (km) (ii) price per passenger/cargo km (iii) capacity and utilization
rate/occupancy rate.

Automobile and capital goods: the critical metric for the industry include (i) volume and volume
growth (ii) average realizations and their growth (iii) capacity and capacity utilization rate.

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Commercial bank and NBFC: key metrics for the industry: (i) net interest margin, (ii) capital adequacy
ratio, (iii) NPA ratio, (iv) growth rates in deposits and loans, (v) cash reserve ratio and statutory liquid
reserve ratio, (vi) CASA ratio.

Consumer goods: Key metrics tracked for this industry include (i) volume and its growth and (ii)
average price and its growth.

IT services/BPO/KPO: Important metrics to track in this sector includes (i) average number of FTEs
billed (ii) average revenue per FTE (iii) bench strength (space capacity) and attrition rates (iv) constant
currency growth rates.

Media: Important metrics to track (i) Readership/viewership (TRPs)/ number of site visitors (ii)
Average ad realization per unit (iii) content acquisition cost.

Retail: Some of the key metrics tracked in the industry include (i) no. of stores and (ii) Same stores’
sales growth.

Telecommunication/Internet Service Providers: prefer to track the following metrics: (i) Average
revenue per user (ARPU) (ii) subscriber churn rate (iii) cost of subscriber acquisition (iv) market share.

 Regulatory environment/framework
Industry analysis cannot be complete without adequate knowledge of the rules of the game. Even small
changes in regulatory framework can have big impact on the businesses. Changes in the environment
policies have resulted in closure of various mines and have affected the businesses drastically.

 Taxation
Taxes are tools that a government uses to earn income which can be used to meet its expenses.
However, governments also use taxes as a tool to encourage or discourage certain businesses.

 Direct Taxes
Direct taxes refer to taxes where the incidence of the tax and liability for the tax are on the same
person. Corporate income taxes, in India, four components: (i) Income tax, (ii) MAT, (iii) Surcharge
and (iv) Cess.

Income Tax: Indian companies are required to pay 30% (25% in case total turnover was below Rs 400
Crores in a financial year)

Minimum Alternate Tax (MAT): If the income tax payable by the company on its profits is less than
18.5% of the book profits, then the company will have to pay 18.5% of book profits to the
government.

Surcharge: Surcharge is a tax on tax.

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Cess: It is an additional levy that is charged on the taxes plus surcharge. For Assessment year 2020-21,
the government levies a total cess of 4% that is meant for health and education.

Indirect taxes: Indirect Taxes are those taxes where the person bearing the tax is different from the
person liable to collect such tax and transfer to the Government. Goods and Service tax (GST) is one
example of an indirect tax.

Goods and Service Tax: Goods and service tax is a tax that is charged at the time of sale of goods or
services. These are calculated as a percentage of the invoice value and seller charge this to the
customer.

Excise Duty: Excise Duty is tax on production.

Value Added Tax (VAT): Value added tax is levied on sale of products. These taxes are currently
applicable only for liquor, petrol and diesel.

Customs Duty: Customs Duty is a tax that is levied on imported products.

 Other taxes

Road Tax: Road tax is paid by the purchasers of new automobiles.

Stamp duty: Stamp duty is payable whenever any document needs to be registered.

Security transaction test (STT): Security transaction tax is paid at the time of sale of securities.

 Sources of Information for Industry Analysis

There are several sources of information on industry
1. Industry reports from various sources – Industry journals and media reports
2. Annual reports of companies in the Industry – “Management Discussion and Analysis” section
3. Associations/ Trade bodies publications
4. Relevant ministry websites/publications

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