Risks of industry sector
Category: Corporate Banking
1. Threats and opportunities of an industry
A sound lending decision can only be made if the credit officer knows and understands his corporate client’s industry and business. Balance sheets can only be interpreted correctly if one knows industry-specific ratios. Without comprehensive knowledge about the business and industry of a firm, a credit analyst would hardly know which questions he should ask his client, or what he should look for in the balance sheet.
The so called SWOT-Analysis provides a financial analyst with a systematic approach towards checking the risks connected with the firm’s specific business and industry. SWOT stands for an examination of the Strengths and Weaknesses of a company, by which it reacts to the Opportunities and Threats posed by the industry in which it operates.
Framework for assessment of industry risk
| Economics, demographics | Social issues | Politics |
| New competition: Threat of entry | ||||
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Suppliers |
Companies currently operating in the industry |
Demand dynamics (Customers) |
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Product substitution |
| Taxes, subsidies | Government Regulations | Licensing, tariffs |
Every industry is governed by five competitive forces. These are:
— the jockeying for position among current competitors,
— the threat of new competitors entering the market,
— the bargaining power of customers,
— the bargaining power of suppliers and
— the threat of substitute products or services.
The collective strength of these forces defines the profit potential of an industry. Every industry has an underlying structure or a set of fundamental technological or economic characteristics that
give rise to these competitive forces. In the early eighties, the steel industry was under immense pressure from foreign competitors producing at very low costs, and from substitute materials such as plastics or carbon fibre. Manufacturers of vacuum tubes, which once were used in radios, were not threatened by new competitors but by substitute products. So the vacuum tube was substituted by the transistor, which in turn was replaced by microchips.
The following gives an overview of each of the five forces determining an industry:
a. Existing competition
The companies currently operating in the industry will try to gain market share, or to defend their piece of the cake. So, the nature of the market can present risks or opportunities to existing companies: The distribution of market share will depend on whether we have a monopolistic, oligopolistic or fragmented market. Is the market itself growing or shrinking? What are the cost dynamics in the industry? These and other factors will be decisive for the tactics which the existing players will apply to increase their market share. A credit analyst should know about the number of existing competitors, the growth rate of the industry, and some specific ratios, such as the level of fixed costs. A market could be shaped by strong brand names such as the soft drink market is dominated by brands like Coca-Cola. Available capacities, switching costs or entry barriers are other factors to be considered.
b. New competition: Threat of entry to market
New competitors may enter the market and pose a threat to existing firms. In recent years, many manufacturers from Eastern Europe took advantage of their cost structure, that enabled them to produce goods at very low costs. Thus, they became a threat to many existing companies in Western Europe, which suddenly felt the effects of their enormously high labour costs. On the other hand, there are entrenched markets with very high barriers to entry. So, the market for very large passenger airplanes with a seat capacity of 400 and more is dominated by Boeing’s 747 Jumbo Jet. It would involve tremendous costs for another airplane manufacturer, e.g. Airbus, to develop, produce and sell another airplane of this size. Since Boeing has fully amortized the research and development cost for its 747, it could simply cut the price of its Jumbo Jet, which currently has a price tag of about 150 million USD, if Airbus tried to enter this market. For Airbus, it would be almost impossible to produce at such costs and sell the high prices that are necessary to make such a venture profitable.
Other businesses may only be profitable if a new contestant has to come in on a very large scale or accept a cost disadvantage. These economies of scale can act as hurdles in costs, sales force distribution networks, financing and so on. Korean car manufacturers have recently started to conquer a share of the German auto market which is dominated by brands like Volkswagen, Ford, Toyota etc.. They have already sold many cars, have established a dealer and service network, offer financing and have recruited effective sales forces. All this requires enormous investment and had to be set up by the Koreans before they could sell their first car in Germany. The first results, so far, have been rather discouraging. Producing a good car is not enough.
New entrants may have to overcome customer loyalty due to brand names. Brand identification is perhaps the most important entry barrier in industries like soft drinks, over-the-counter-drugs, cosmetics, automobiles etc. Why should a car driver switch from his German made Ford to a Korean Hyundai if he is satisfied with his Ford car — and has been so for the last ten years?
The need to invest large financial resources in order to compete creates a barrier to entry, particularly if the investment is required for unrecoverable expenditures like up-front advertising or research and development. Capital is required for fixed assets, for customer credit, stocks and for absorbing start-up losses. Even major companies could be deterred from entering certain markets, e.g. very large passenger planes.
Well-established companies may still have other advantages that are not available to potential new rivals. These advantages can stem from their experience (and the learning curve), proprietary technology, patents, favorable locations, government subsidies or simply from a fiercely loyal customer base.
A newcomer must secure distribution of its product. Getting a new detergent onto the supermarket shelves may prove to be very difficult despite good quality and competitive pricing. The more limited the whole sale or the retail channels are, and the more these are tied up by existing competitors, then obviously the harder it will be to enter the industry. Sometimes a new entrant even has to create its own distribution system to overcome this barrier.
Finally, there may be government regulations; limiting access to an industry. Although these barriers have been lowered by deregulation in many countries, certain sectors such as agriculture, steel and mining are still subsidized in some countries. The telecommunications market in most European countries in still state-owned. Major privatization efforts, like the going-public of Germany’s Telekom, will be taken, however, still in 1996. The government keeps on playing a major role by setting standards for air and water pollutio, safety regulation, taxes and so on.
c. Bargaining power of suppliers
Suppliers can exert bargaining power on participants in an industry by raising prices or reducing the quantity or quality of purchased goods and services. Powerful suppliers can thereby have a significant effect on the cost structure of an industry. They can squeeze profitability out of an industry that is unable to recover cost increases in its own prices. By raising their prices, the soft drink concentrate producers have contributed to the erosion of profitability of bottling companies because the bottlers could not raise their prices accordingly. This was due to intense competition from powdered mixes, fruit drinks and other beverages that did not raise prices. .
Suppliers can exert bargaining power if the following characteristics apply:
They sell a product that is unique or at least differentiated, or that has built up switching costs. Switching costs are fixed costs buyers must pay if they change their supplier.
The industry is not an important buyer of the supplier group.
The supplier group is dominated by only a few companies. This lack of competition can make it easier to raise prices.
The product itself is scarce, or its availability is limited.
The industry’s labour force is a supplier as well. Labour prices will increase if it is hard to find skilled workers. If the labour force is heavily unionized, its availability could be hurt by strikes.
d. Bargaining power of customers
Customers can force down prices or demand higher quality and more service. They can play competitors off against each other at the expense of industry profitability.
A buyer group is powerful if, e.g., it purchases large volumes. If the purchased products are standard or undifferentiated, the buyers can easily find other suppliers. This threat is the larger, the lower the switching costs are. If the buyer’s profits are low, he normally is very price sensitive and willing to switch to a lower-cost supplier. In some industries, there is a trend towards backward integration. This means that the buyers stop purchasing a product and self-manufacture it. Consumers as a buyer group may be influenced by fashion, prestige, value-for-money, price sensitivity or even environmental attitudes.
e. Substitution of Products
Substitute products can place a ceiling on prices that can be charged for a product, or they can even make a product obsolete, as the transistor did to vacuum tubes. In any case, it severely limits the potential of an industry. Substitute products limit earnings not only in normal times, but they can even reduce the profits that can normally be expected in boom times. As the producers of fiberglass insulation enjoyed unprecedented demand as a result of high energy costs and strong winters, their ability to raise prices was limited by the appearance of insulation substitutes such as rock wool and Styrofoam.
2. Worksheet: SWOT-Analysis
SWOT-Analysis
Industry Analysis