Porter’s 5 Force Analysis essay

The Industry Handbook http://www. investopedia. com/features/industryhandbook/ Thanks very much for downloading the printable version of this tutorial. As always, we welcome any feedback or suggestions. http://www. investopedia. com/contact. spx Table of Contents 1) The Industry Handbook: Introduction 2) The Industry Handbook: Porter’s 5 Forces Analysis 3) The Industry Handbook: The Airline Industry 4) The Industry Handbook: The Oil Services Industry 5) The Industry Handbook: Precious Metals 6) The Industry Handbook: Automobiles 7) The Industry Handbook: The Retailing Industry 8) The Industry Handbook: The Banking Industry 9) The Industry Handbook: Biotechnology 10) The Industry Handbook: The Semiconductor Industry 11) The Industry Handbook: The Insurance Industry 12) The Industry Handbook: The Telecommunications Industry 13) The Industry Handbook: The Utilities Industry 14) The Industry Handbook: The Internet Industry Introduction
Industry analysis is a type of investment research that begins by focusing on the status of an industry or an industrial sector. Why is this important? Each industry is different, and using one cookie-cutter approach to analysis is sure to create problems. Imagine, for example, comparing the P/E ratio of a tech company to that of a utility. Because you are, in effect, comparing apples to oranges, the analysis is next to useless. In each section we’ll take an in-depth look at the different valuation techniques and buzz words used in a particular industry, complete a 5-forces analysis on the state of the market and point you in the direction of industry-specific resources. Page 1 of 65) Copyright © 2010, Investopedia. com – All rights reserved. Investopedia. com – the resource for investing and personal finance education. Porter’s 5 Forces Analysis If you are not familiar with the five competitive forces model, here is a brief background on who developed it, and why it is useful. The model originated from Michael E. Porter’s 1980 book “Competitive Strategy: Techniques for Analyzing Industries and Competitors. ” Since then, it has become a frequently used tool for analyzing a company’s industry structure and its corporate strategy. In his book, Porter identified five competitive forces that shape every single industry and market.
These forces help us to analyze everything from the intensity of competition to the profitability and attractiveness of an industry. Figure 1 shows the relationship between the different competitive forces. Figure 1: Porter’s five competitive forces This tutorial can be found at: http://www. investopedia. com/features/industryhandbook/ (Page 2 of 65) Copyright © 2010, Investopedia. com – All rights reserved. Investopedia. com – the resource for investing and personal finance education. 1. Threat of New Entrants – The easier it is for new companies to enter the industry, the more cutthroat competition there will be. Factors that can limit the threat of new entrants are known as barriers to entry. Some examples include: o o o o o o

Existing loyalty to major brands Incentives for using a particular buyer (such as frequent shopper programs) High fixed costs Scarcity of resources High costs of switching companies Government restrictions or legislation 2. Power of Suppliers – This is how much pressure suppliers can place on a business. If one supplier has a large enough impact to affect a company’s margins and volumes, then it holds substantial power. Here are a few reasons that suppliers might have power: o o o There are very few suppliers of a particular product There are no substitutes Switching to another (competitive) product is very costly The product is extremely important to buyers – can’t do without it The supplying industry has a higher profitability than the buying industry o o . Power of Buyers – This is how much pressure customers can place on a business. If one customer has a large enough impact to affect a company’s margins and volumes, then the customer hold substantial power. Here are a few reasons that customers might have power: o o o o Small number of buyers Purchases large volumes Switching to another (competitive) product is simple The product is not extremely important to buyers; they can do without the product for a period of time This tutorial can be found at: http://www. investopedia. com/features/industryhandbook/ (Page 3 of 65) Copyright © 2010, Investopedia. com – All rights reserved. Investopedia. om – the resource for investing and personal finance education. o Customers are price sensitive 4. Availability of Substitutes – What is the likelihood that someone will switch to a competitive product or service? If the cost of switching is low, then this poses a serious threat. Here are a few factors that can affect the threat of substitutes: o o The main issue is the similarity of substitutes. For example, if the price of coffee rises substantially, a coffee drinker may switch over to a beverage like tea. If substitutes are similar, it can be viewed in the same light as a new entrant. 5. Competitive Rivalry – This describes the intensity of competition between existing firms in an industry.
Highly competitive industries generally earn low returns because the cost of competition is high. A highly competitive market might result from: o o o Many players of about the same size; there is no dominant firm Little differentiation between competitors products and services A mature industry with very little growth; companies can only grow by stealing customers away from competitors The Airline Industry Few inventions have changed how people live and experience the world as much as the invention of the airplane. During both World Wars, government subsidies and demands for new airplanes vastly improved techniques for their design and construction.
Following the World War II, the first commercial airplane routes were set up in Europe. Over time, air travel has become so commonplace that it would be hard to imagine life without it. The airline industry, therefore, certainly has progressed. It has also altered the way in which people live and conduct This tutorial can be found at: http://www. investopedia. com/features/industryhandbook/ (Page 4 of 65) Copyright © 2010, Investopedia. com – All rights reserved. Investopedia. com – the resource for investing and personal finance education. business by shortening travel time and altering our concept of distance, making it possible for us to visit and conduct business in places once considered remote. For more on the airline industry, read Is That Airline Ready For Lift-Off? ) The airline industry exists in an intensely competitive market. In recent years, there has been an industry-wide shakedown, which will have far-reaching effects on the industry’s trend towards expanding domestic and international services. In the past, the airline industry was at least partly government owned. This is still true in many countries, but in the U. S. all major airlines have come to be privately held. The airline industry can be separated into four categories by the U. S. Department of Transportation (DOT): ? ? ? ? International – 130+ seat planes that have the ability to take passengers just about anywhere in the world.
Companies in this category typically have annual revenue of $1 billion or more. National – Usually these airlines seat 100-150 people and have revenues between $100 million and $1 billion. Regional – Companies with revenues less than $100 million that focus on short-haul flights. Cargo – These are airlines generally transport goods. Airport capacity, route structures, technology and costs to lease or buy the physical aircraft are significant in the airline industry. Other large issues are: ? ? ? Weather – Weather is variable and unpredictable. Extreme heat, cold, fog and snow can shut down airports and cancel flights, which costs an airline money.
Fuel Cost – According to the Air Transportation Association (ATA), fuel is an airline’s second largest expense. Fuel makes up a significant portion of an airline’s total costs, although efficiency among different carriers can vary widely. Short haul airlines typically get lower fuel efficiency because take-offs and landings consume high amounts of jet fuel. Labor – According to the ATA, labor is the an airline’s No. 1 cost; airlines must pay pilots, flight attendants, baggage handlers, dispatchers, customer service and others. Key Ratios/Terms Available Seat Mile = (total # of seats available for transporting passengers) X (# of miles flown during period) This tutorial can be found at: http://www. investopedia. om/features/industryhandbook/ (Page 5 of 65) Copyright © 2010, Investopedia. com – All rights reserved. Investopedia. com – the resource for investing and personal finance education. Revenue Passenger Mile = flown during the period) (# of revenue-paying passengers) X (# of mile Revenue Per Available Seat Mile = (Revenue) (# of seats available) Air Traffic Liability (ATL): An estimate of the amount of money already received for passenger ticket sales and cargo transportation that is yet to be provided. It is important to find out this figure so you can remove it from quoted revenue figures (unless they specifically state that ATL was excluded).
Load Factor: This indicator, compiled monthly by the Air Transport Association (ATA), measures the percentage of available seating capacity that is filled with passengers. Analysts state that once the airline load factor exceeds its breakeven point, then more and more revenue will trickle down to the bottom line. Keep in mind that during holidays and summer vacations load factor can be significantly higher, therefore, it is important to compare the figures against the same period from the previous year. Analyst Insight Airlines also earn revenue from transporting cargo, selling frequent flier miles to other companies and up-selling in flight services. But the largest proportion of revenue is derived from regular and business passengers.
For this reason, it is important that you take consumer and business confidence into account on top of the regular factors that one should consider like earnings growth and debt load. (For more about the consumer confidence survey, see Economic Indicators: Consumer Confidence Index. ) Business travelers are important to airlines because they are more likely to travel several times throughout the year and they tend to purchase the upgraded services that have higher margins for the airline. On the other hand, leisure travelers are less likely to purchase these premium services and are typically very price sensitive. In times of economic uncertainty or sharp decline in consumer confidence, you can expect the number of leisure travelers to decline.
It is also important to look at the geographic areas that an airline targets. Obviously, more market share is better for a particular market, but it is also important to stay diversified. Try to find out the destination to which the majority of an airline’s flights are traveling. For example, an airline that sends a high number of flights to the Caribbean might see a dramatic drop in profits if the outlook for leisure travelers looks poor. A final key area to keep a close eye on is costs. The airline industry is extremely sensitive to costs such as fuel, labor and borrowing costs. If you notice a trend of This tutorial can be found at: http://www. investopedia. om/features/industryhandbook/ (Page 6 of 65) Copyright © 2010, Investopedia. com – All rights reserved. Investopedia. com – the resource for investing and personal finance education. rising fuel costs, you should factor that into your analysis of a company. Fuel prices tend to fluctuate on a monthly basis, so paying close attention to these costs is crucial. Porter’s 5 Forces Analysis 1. Threat of New Entrants. At first glance, you might think that the airline industry is pretty tough to break into, but don’t be fooled. You’ll need to look at whether there are substantial costs to access bank loans and credit. If borrowing is cheap, then the likelihood of more airliners entering the industry is higher.
The more new airlines that enter the market, the more saturated it becomes for everyone. Brand name recognition and frequent fliers point also play a role in the airline industry. An airline with a strong brand name and incentives can often lure a customer even if its prices are higher. 2. Power of Suppliers. The airline supply business is mainly dominated by Boeing and Airbus. For this reason, there isn’t a lot of cutthroat competition among suppliers. Also, the likelihood of a supplier integrating vertically isn’t very likely. In other words, you probably won’t see suppliers starting to offer flight service on top of building airlines. 3. Power of Buyers.
The bargaining power of buyers in the airline industry is quite low. Obviously, there are high costs involved with switching airplanes, but also take a look at the ability to compete on service. Is the seat in one airline more comfortable than another? Probably not unless you are analyzing a luxury liner like the Concord Jet. 4. Availability of Substitutes. What is the likelihood that someone will drive or take a train to his or her destination? For regional airlines, the threat might be a little higher than international carriers. When determining this you should consider time, money, personal preference and convenience in the air travel industry. 5. Competitive Rivalry.
Highly competitive industries generally earn low returns because the cost of competition is high. This can spell disaster when times get tough in the economy. Key Links ? ? ? Federal Aviation Administration – Get the latest regulation news, airport delays, etc. AviationNow. com – Information and news on the airline/aerospace industry. AirWise. com – Airport and aviation news This tutorial can be found at: http://www. investopedia. com/features/industryhandbook/ (Page 7 of 65) Copyright © 2010, Investopedia. com – All rights reserved. Investopedia. com – the resource for investing and personal finance education. The Oil Services Industry There is no doubt that the oil/energy industry is extremely large.
According to the Department of Energy (DOE), fossil fuels (including coal, oil and natural gas) makes up more than 85% of the energy consumed in the U. S. as of 2008. Oil supplies 40% of U. S. energy needs. (Visit the U. S. Department of Energy’s Energy Sources information page for more insight. ) Before petroleum can be used, it is sent to a refinery where it is physically, thermally and chemically separated into fractions and then converted into finished products. About 90% of these products are fuels such as gasoline, aviation fuels, distillate and residual oil, liquefied petroleum gas (LPG), coke (not the refreshment) and kerosene. Refineries also produce non-fuel products, including petrochemicals, asphalt, road oil, lubricants, solvents and wax.
Petrochemicals (ethylene, propylene, benzene and others) are shipped to chemical plants, where they are used to manufacture chemicals and plastics. (For more insight, read Oil And Gas Industry Primer. ) There are two major sectors within the oil industry, upstream and downstream. For the purposes of this tutorial we will focus on upstream, which is the process of extracting the oil and refining it. Downstream is the commercial side of the business, such as gas stations or the delivery of oil for heat. Oil Drilling and Services Oil drilling and services is broken into two major areas: drilling and oilfield services. ? Drilling – Drilling companies physically drill and pump oil out of the ground. The drilling industry has always been classified as highly skilled.
The people with the skills and expertise to operate drilling equipment are in high demand, which means that for an oil company to have these people on staff all the time can cost a lot. For this reason, most drilling companies are simply contractors who are hired by oil and gas producers for a specified period of time. (For related reading, see Unearth Profits In Oil Exploration And Production. ) In the drilling industry, there are several different types of rigs, each with a specialized purpose. Some of these include: o Land Rigs – Drilling depths ranges from 5,000 to 30,000 feet. o Submersible Rigs – Used for ocean, lake and swamp drilling.
The bottom part of these rigs are submerged to the sea’s floor and the platform is on top of the water. o Jack-ups – this type of rig has three legs and a triangular platform which is jacked-up above the highest anticipated waves. This tutorial can be found at: http://www. investopedia. com/features/industryhandbook/ (Page 8 of 65) Copyright © 2010, Investopedia. com – All rights reserved. Investopedia. com – the resource for investing and personal finance education. o Drill Ships – These look like tankers/ships, but they travel the oceans in search of oil in extremely deep water. (For more information on the drilling industry, check out on the Rigzone website. ) ? Oilfield Services – Oilfield service companies assist the drilling companies n setting up oil and gas wells. In general these companies manufacture, repair and maintain equipment used in oil extraction and transport. More specifically, these services can include: o Seismic Testing – This involves mapping the geological structure beneath the surface. o Transport Services – Both land and water rigs need to be moved around at some point in time. o Directional Services – Believe it or not, all oil wells are not drilled straight down, some oil services companies specialize in drilling angled or horizontal holes. The energy industry is not any different than most commodity-based industries as it faces long periods of boom and bust.
Drilling and other service firms are highly dependent on the price and demand for petroleum. These firms are some of the first to feel the effects of increased or decreased spending. If oil prices rise, it takes time for petroleum companies to size up land, setup rigs, take out the oil, transport it and refine it before the oil company sees any profit. On the other hand, oil services and drilling companies are the first on the scene when companies decide to start exploring. Oil Refining The refining business is not quite as fragmented as the drilling and services industry. This sector is dominated by a small handful of large players. In fact, much of the energy industry is ruled by large, integrated oil companies.
Integrated refers to the fact that many of these companies look after all factors of production, refining and marketing. For the most part, refining is a slow and stable business. The large amounts of capital investment means that very few companies can afford to enter this business. This handbook will try to focus more on oil equipment and services such as drilling and support services. Key Ratios/Terms BTUs: Short for “British Thermal Units. ” This is the amount of heat required to increase the temperature of one pound of water by one degree Fahrenheit. This tutorial can be found at: http://www. investopedia. com/features/industryhandbook/ (Page 9 of 65) Copyright © 2010, Investopedia. com – All rights reserved. Investopedia. om – the resource for investing and personal finance education. Different fuels have different heating values; by quoting the price per BTU it is easier to compare different types of energy. Dayrates: Oil and gas drillers usually charge oil producers on a daily work rate. These rates vary depending on the location, the type of rig and the market conditions. There are plenty of research firms that publish this information. Higher dayrates are great for drilling companies, but for refiners and distribution companies this means lower margins unless energy prices are rising at the same rate. Meterage: Another type of contract that differs from dayrates is one based on how deep the rig drills.
These are called meterage, or footage, contracts. These are less desirable because the depth of the oil deposits are unpredictable; it’s really a gamble on the driller’s part. Downstream: Refers to oil and gas operations after the production phase and through to the point of sale, whether at the gas pump or the home heating oil truck Upstream: The grass roots of the oil business, upstream refers to the exploration and production of oil and gas. Many analysts look at upstream expenditures from previous quarters to estimate future industry trends. For example, a decline in upstream expenditures usually trickles down to other areas such as transportation and marketing.
OPEC: The Organization of Petroleum Exporting Countries is an intergovernmental organization dedicated to the stability and prosperity of the petroleum market. OPEC membership is open to any country that is a substantial exporter of oil and that shares the ideals of the organization. OPEC has 11 member countries. Output quotas placed by OPEC can send huge shocks throughout the energy markets. Below is a chart of the world’s top exporters of petroleum. OPEC members are denoted by “*”. Indonesia and Qatar are also members, but they don’t make the top twelve. Top World Oil Net Exporters, 2006 Country 1) Saudi Arabia* 2) Russia Net Exports (million barrels per day) 8. 65 6. 57 This tutorial can be found at: http://www. investopedia. om/features/industryhandbook/ (Page 10 of 65) Copyright © 2010, Investopedia. com – All rights reserved. Investopedia. com – the resource for investing and personal finance education. 3) Norway 4) Iran* 5) United Arab Emirates* 2. 54 2. 52 2. 52 2. 20 2. 15 2. 15 1. 85 1. 68 1. 52 6) Venezuela* 7) Kuwait* 8) Nigeria* 9) Algeria* 10) Mexico 11) Libya* 12) Iraq* 1. 43 Source: Energy Information Administration Analyst Insight Analysts and investors often disagree on specific investment decisions, but one thing that they do agree on is their approach to analyzing energy companies. A top down investment approach is almost always the best strategy. We will go through the top down steps below. For more insight, read A Top-Down Approach To Investing. ) Economics/Politics The oil industry is easily influenced by economic and political conditions. If a country is in a recession, fewer products are being manufactured, not as many people drive to work, take vacations, etc. All of these variables factor into less energy use. The best time to invest in an oil company is when the economy is firing on all cylinders and oil companies are making so much money that using excessive amounts of energy themselves has little effect on their bottom line. Some analysts believe that rather than analyzing energy companies, you should just predict the trend in energy prices.
While more analysis is needed for a prudent investment than simply looking at price trends in oil, it’s true that there is a strong correlation between the performance of energy companies and the commodity price for energy. Supply and Demand Oil and gas prices fluctuate on a minute by minute basis, taking a look at the historical price range is the first place you should look. Many factors determine the price of oil, but it really all comes down to supply and demand. Demand typically does not fluctuate too much (except in the case of recession), but supply shocks can occur for a number of reasons. When OPEC meets to determine oil supply for the coming months, the price of oil can fluctuate wildly.
Day-to-day This tutorial can be found at: http://www. investopedia. com/features/industryhandbook/ (Page 11 of 65) Copyright © 2010, Investopedia. com – All rights reserved. Investopedia. com – the resource for investing and personal finance education. fluctuations should not influence your investment decision in a particular energy company, but long-term trends should be followed more closely. You can find the latest energy supply/demand statistics at the Energy Information Administration. Rig Utilization Rates Another factor that determines supply is the rig utilization rates; its close relationship to oil prices is not a coincidence. Higher utilization rates mean more revenue and profits.
For drilling companies, it is important to take a close look at the company’s rig fleet, because older rigs lack the ability to drill in remote locations or to bore deep holes. Some other factors to consider are the depth of water that the offshore rigs can drill in, hole depth and horsepower. Higher quality rigs will have higher utilization rates, especially during weak periods. This will lead to higher revenue growth. Sometimes this is a double-edged sword; while higher utilization is better, a company that is at its capacity will have difficulty increasing revenues further. Contracts The contracts through which an oil services company is paid also play a large role in supply. Pay close attention to the dayrates, as falling dayrates can dramatically decrease revenues.
The opposite is true should dayrates rise. This is because many of the drillers’ costs are fixed. Financial Statements After these wide scale factors have been considered, it’s time to get down to the nitty gritty – the financials. And when it comes to the financials, the same old rules apply to oil services companies. Ideally, revenues and profits will be growing consistently, just as they do in any quality company. It’s worth digging deeper to see if there are any one-time events that have dramatically increased revenues. Also, the P/E ratio and PEG ratios should be comparable to others within the industry. On the balance sheet, investors should keep an eye on debt levels.
High debt puts a strain on credit ratings, weakening their ability to purchase new equipment or finance other capital expenditures. Poor credit ratings also make it difficult to acquire new business. If customers have the choice of going with a company that is strong versus one that is having debt problems, which do you think they will choose? To do a test for financial leverage, take a look at the debt/equity ratio. The working capital also tells us whether the company has enough liquid assets to cover short term liabilities. Rating agencies like Moody’s and S&P say 50% is a prudent debt/equity ratio. Companies in more stable markets can afford slightly higher debt/equity ratios.
If profits are of the utmost importance, then the statement of cash flow is a close second. Oil companies are notorious for reporting non cash line items in the This tutorial can be found at: http://www. investopedia. com/features/industryhandbook/ (Page 12 of 65) Copyright © 2010, Investopedia. com – All rights reserved. Investopedia. com – the resource for investing and personal finance education. income statement. For this reason, you should try to decipher the cash EPS. By stripping away all the non-cash entities you will get a truer number because cash flow cannot be manipulated as easily as net income can. (For further reading, see Advanced Financial Statement Analysis. ) Porter’s 5 Forces Analysis 1. Threat of New Entrants.
There are thousands of oil and oil services companies throughout the world, but the barriers to enter this industry are enough to scare away all but the serious companies. Barriers can vary depending on the area of the market in which the company is situated. For example, some types of pumping trucks needed at well sites cost more than $1 million each. Other areas of the oil business require highly specialized workers to operate the equipment and to make key drilling decisions. Companies in industries such as these have higher barriers to entry than ones that are simply offering drilling services or support services. Having ample cash is another barrier – a company had better have deep pockets to take on the existing oil companies. 2. Power of Suppliers.
While there are plenty of oil companies in the world, much of the oil and gas business is dominated by a small handful of powerful companies. The large amounts of capital investment tend to weed out a lot of the suppliers of rigs, pipeline, refining, etc. There isn’t a lot of cut-throat competition between them, but they do have significant power over smaller drilling and support companies. 3. Power of Buyers. The balance of power is shifting toward buyers. Oil is a commodity and one company’s oil or oil drilling services are not that much different from another’s. This leads buyers to seek lower prices and better contract terms. 4. Availability of Substitutes.
Substitutes for the oil industry in general include alternative fuels such as coal, gas, solar power, wind power, hydroelectricity and even nuclear energy. Remember, oil is used for more than just running our vehicles, it is also used in plastics and other materials. When analyzing an energy company it is extremely important to take a close look at the specific area in which the company is operating. Also, companies offering more obscure or specialized services such as seismic drilling or directional drilling tools are much more likely to withstand the threat of substitutes. (For more on oil substitutes, see The Biofuels Debate Heats Up. ) 5. Competitive Rivalry. Slow industry growth rates and high exit barriers are a particularly troublesome situation facing some firms.
Until quite recently, oil refineries were a particularly good example. For a period of almost 20 years, no new refineries were built in the U. S. Refinery capacity exceeded the product demands as a result of conservation efforts following the oil shocks of the 1970s. At the same time, exit barriers in the This tutorial can be found at: http://www. investopedia. com/features/industryhandbook/ (Page 13 of 65) Copyright © 2010, Investopedia. com – All rights reserved. Investopedia. com – the resource for investing and personal finance education. refinery business are quite high. Besides the scrap value of the equipment, a refinery that does not operate has no value-adding capability.
Almost every refinery can do one thing – produce the refined products they have been designed for. Key Links ? ? ? Department of Energy – Get the latest regulation news and statistics. You name it, this site has it. ODS-Petrodata – Both free and fee-based data on rig counts and other key figures in the oil services industry. Rigzone. com – News and statistics on the oil and gas industry. Precious Metals The precious metals industry is very capital intensive. Constructing mines and building production facilities requires huge sums of capital. Long-term survival requires heavy expenditures to finance production and exploration. Technology has played a big role in the computer and internet industry, but t has also greatly changed the mining industry. Gold is the most popular precious metal for investors. As you may know, gold is a commodity, and, as such, the price for gold fluctuates on a daily basis in the commodity markets. While there is a lot of overlap between the basics of mining gold and silver, the primary focus of here is on the gold market. Silver is less valuable than gold, and, as such, it is usually discovered either by accident or as a byproduct of gold/lead/copper mining. Gold prices are influenced by numerous variables that include fabricator demand, expected inflation, return on assets and central bank demand. Gold is strongly pegged to supply-and-demand patterns.
In general, low prices result in low production, and high prices result in high production. Market forces determine price. A company’s attempt to control costs is critical to maintaining financial health and production levels in the face of declining gold prices. (For related reading, see Does It Still Pay To Invest In Gold? ) The metals industry is not vertically integrated like other industries such as oil and energy. In the metals industry, the companies that mine the gold typically do This tutorial can be found at: http://www. investopedia. com/features/industryhandbook/ (Page 14 of 65) Copyright © 2010, Investopedia. com – All rights reserved. Investopedia. com – the resource for investing and personal finance education. ot refine it, and refiners rarely sell it directly to the public. The industry encompasses three types of firms: 1. Exploration. These companies have very little in the way of assets. They explore and prove that gold exists in a particular area. The only major assets owned by exploration firms are the rights to drill and a small amount of capital, which is needed to conduct drilling and trenching operations. 2. Development. Once a gold deposit is discovered by exploration companies, they either try to become development firms, or they sell their gold find to development firms. Development firms are those operating on explored areas that have prove to be mines.
The only real difference between development and exploration is that, for development firms, their area has proved to be a gold deposit. 3. Production. Producer firms are full-fledged mining companies that extract and produce gold from existing mines; this production can range from a hundred thousand ounces to several million ounces of gold production per year. Each operator in the supply chain has its own strengths and weaknesses. Some companies do well at extracting the metal from the earth, some refine, while others smelt and transform the commodity into a finished product. Most gold that is mined today is used for jewelry, perhaps because of its beauty, or perhaps because it doesn’t rust or corrode.
Other uses for gold include tooth filings, electronics manufacturing and collectibles, but these make up a very small portion of overall demand. Unlike other industries, companies in the mining industry come in all shapes and sizes. Much of the production is done by large blue chip companies, but the exploration side of the industry is full of junior companies looking to hit a home run with a large gold find. The mining industry has plenty of opportunities for speculators and others for income investors. (To learn more, read Getting Into The Gold Market. ) Key Ratios/Terms Mine Production Rates: Serious gold investors follow the Gold Survey very closely, published by Gold Fields Mineral Services. Each year, it lists the worldwide mine production statistics.
Increasing production rates means more supply, which ultimately means a lower price for gold – if demand remains stable. Scrap Recovery: Another statistic published in the Gold Survey, scrap This tutorial can be found at: http://www. investopedia. com/features/industryhandbook/ (Page 15 of 65) Copyright © 2010, Investopedia. com – All rights reserved. Investopedia. com – the resource for investing and personal finance education. recovery refers to the worldwide supply of gold from sources other than mine production. This includes recovered old jewelry, industrial byproducts, etc. Throughout the 1990s, more than 15% of the world’s gold supply came from scrap recovery. Futures Sales by Producers As you probably know, gold trades in the futures markets.
Gold producers are constantly monitoring the prices in the futures markets because it determines the price at which they can sell their gold. The Gold Survey lists statistics on producer sales. If producers are selling an increasing amount in the futures market, it could mean that prices will fall very soon. By purchasing futures contracts the producer “locks-in” a price. Therefore, if the price of gold falls in future months, it won’t affect the producer’s bottom line. Conversely, if prices continue to rise after the producer locks in, they won’t be able to capitalize on the higher prices. Bullion: This denotes gold and silver that is refined and officially recognized as high quality (at least 99. 5% pure). It is usually in the form of bars rather than coins.
When you hear of investors or central banks holding gold reserves, it is usually in the form of bullion. Ore: This refers to mineralized rock that contains metal. Gold producers mine gold ore and then extract the gold from it using either chemicals, extreme heat, or some other method. There are different types of ores, of which the most common are oxide ores and sulphide ores. Analyst Insight The price of gold fluctuates on a minute-by-minute basis, so taking a look at the historical price range is the first place you should look. Many factors determine the price of gold, but it really all comes down to supply and demand. Demand typically does not fluctuate too much, but supply shocks can send prices either soaring or into the doldrums.
The difference between production costs and the futures price for gold equals the gross profit margins for mining companies. Therefore, the second place you want to look is the cost of production. The main factors to look at are the following: ? ? Location – Where is the gold being mined? Political unrest in developing nations has ruined more than one mining company. Developing nations might have cheaper labor and mining costs, but the political risks are huge. If you are risk averse, then look for companies with mines in relatively stable areas of the world. The costs might be higher, but at least the company knows what it’s getting into. Ore Quality – Ore is mineralized rock that contains metal.
Higher quality ore will contain more gold, which is usually reported as ounces This tutorial can be found at: http://www. investopedia. com/features/industryhandbook/ (Page 16 of 65) Copyright © 2010, Investopedia. com – All rights reserved. Investopedia. com – the resource for investing and personal finance education. ? of gold per ton of ore. Generally speaking, oxide ores are better because the rock is more porous, making it easier to remove the gold. Mine Type – The type of mine a company uses is a big factor in production costs. Most underground mines are more expensive than open pit mines. Cost of Production The cost of production is probably the most widely followed measure for analyzing a gold producer.
The lower the costs, the greater the operating leverage, which means that earnings are more stable and less volatile to changes in the price of gold. For example, a company that has a cash cost around $175/ounce is, for obvious reasons, in a much better position than one whose cost is $275/ounce. The low-cost producer has much more staying power than the marginal producer. In fact, if the price of gold declines below $275/ounce, the higher-cost producer would have to stop producing until the price goes back up. Producers usually publish their cost of production in their annual report; this cost includes everything from site preparation to milling and refining.
It doesn’t include exploration costs, financing, or any other administrative expenses the company might incur. Aside from looking at costs, investors should carefully look over revenue growth. Revenue is output times the selling price for gold, so it may fluctuate from year to year. Well-run companies will attempt to hedge against fluctuating gold prices through the futures markets. Take a look at the revenue fluctuations over the past several years. Ideally, the revenue growth should be smooth. Companies with revenues that fluctuate widely from year to year are very hard to analyze and aren’t where the smart money goes. Debt Levels Investors should keep an eye on debt levels, which are on the balance sheet.
High debt puts a strain on credit ratings, weakening the company’s ability to purchase new equipment or finance other capital expenditures. Poor credit ratings also make it difficult to acquire new businesses. (For related reading, see Debt Reckoning. ) P/E As a final caveat (beware), never analyze a precious-metals company based on the price-to-earnings ratio. In general, a high P/E means high projected earnings in the future, but all gold stocks have high P/E ratios. The P/E ratio for a gold stock doesn’t really tell us anything because precious metals companies need to be compared by assets, not earnings. Unlike buildings and machinery, gold companies have large amounts of gold in their vaults and in mines throughout the world.
Gold on the balance sheet is unlike other capital assets; gold is seen This tutorial can be found at: http://www. investopedia. com/features/industryhandbook/ (Page 17 of 65) Copyright © 2010, Investopedia. com – All rights reserved. Investopedia. com – the resource for investing and personal finance education. as currency of last resort. Investors are therefore willing to pay more for a gold company because it is the next best thing to physically holding the gold themselves. There are a few valuation techniques that analysts use when comparing various precious metal companies. The most popular and widely used ratio is market capitalization per ounce of reserves (market cap divided by reserves).
This indicates to investors what they are paying for each ounce of reserves. Obviously, a lower price is better. Porter’s 5 Forces Analysis 1. Threat of New Entrants. Financing is a principal barrier to entry in the precious-metals industry, which is heavily capital intensive. Constructing mines, production facilities, exploration and development and mining equipment all require large sums of capital. This capital is required before the mine is in production. Therefore, favorable financing terms are extremely important. In short, long-term survival in the precious-metal market requires significant capital. 2. Power of Suppliers. The only supply-side issues that miners face deal with government regulations and rules.
The supply of land is plentiful, but gaining approval and permits to mine the land can be difficult, especially if environmental risks are high. 3. Power of Buyers. Gold is a commodity-based business, so the gold from one company is not that much different from another’s. This translates into buyers seeking lower prices and better contract terms. 4. Availability of Substitutes. Substitutes for the precious metals industry include other precious metals such as diamonds, silver, platinum, etc. These are worthy substitutes for gold, but they are not as widely accepted as gold. Gold has the advantage of being standard for a world currency, so a gold bar in the U. S. s worth the same as it is in Ecuador. As other forms of precious metals such as diamonds gain popularity, they may also become more threatening as substitutes. 5. Competitive Rivalry. Gold companies don’t compete on price, mainly because the prices are determined by market forces. But gold companies do compete for land. The backbone of a precious metals company is its reserves, and the only way to beef up reserves is to explore for good mining areas. Companies go to great lengths to discover gold deposits, and the discovery is on a first-come-first-serve basis. Key Links ? InfoMine. com – Get the latest news and statistics on mining companies. Mining USA – Here is more data and information on mining. This tutorial can be found at: http://www. investopedia. com/features/industryhandbook/ (Page 18 of 65) Copyright © 2010, Investopedia. com – All rights reserved. Investopedia. com – the resource for investing and personal finance education. ? Mining Glossary – When you are analyzing a mining company you are bound to come across industry-specific terms you don’t understand Automobiles Similar to the invention of the airplane, the emergence of automobiles has had a profound effect on our everyday lives. The auto manufacturing industry is considered to be highly capital and labor intensive.
The major osts for producing and selling automobiles include: ? ? ? Labor – While machines and robots are playing a greater role in manufacturing vehicles, there are still substantial labor costs in designing and engineering automobiles. Materials – Everything from steel, aluminum, dashboards, seats, tires, etc. are purchased from suppliers. Advertising – Each year automakers spend billions on print and broadcast advertising; furthermore, they spent large amounts of money on market research to anticipate consumer trends and preferences. The auto market is thought to be made primarily of automakers, but auto parts makes up another lucrative sector of the market.
The major areas of auto parts manufacturing are: ? ? ? Original Equipment Manufacturers (OEMs) – The big auto manufacturers do produce some of their own parts, but they can’t produce every part and component that goes into a new vehicle. Companies in this industry manufacture everything from door handles to seats. Replacement Parts Production and Distribution – These are the parts that are replaced after the purchase of a vehicle. Air filters, oil filers and replacement lights are examples of products from this area of the sector. Rubber Fabrication – This includes everything from tires, hoses, belts, etc. In the auto industry, a large proportion of revenue comes from selling automobiles.
The parts market, however, is even more lucrative. For example, a new car might cost $18,000 to buy, but if you bought, from the automaker, all the parts needed to construct that car, it would cost 300-400% more. Over and above the labor and material costs we mentioned above, there are other developments in the automobile industry that you must consider when analyzing an automobile company. Globalization, the tendency of world investment and businesses to move from national and domestic markets to a This tutorial can be found at: http://www. investopedia. com/features/industryhandbook/ (Page 19 of 65) Copyright © 2010, Investopedia. com – All rights reserved.
Investopedia. com – the resource for investing and personal finance education. worldwide environment, is a huge factor affecting the auto market. More than ever, it is becoming easier for foreign automakers to enter the North American market. (To read more about this issue, see The Globalization Debate. ) Competition is the other factor that takes its toll on the auto industry; we will discuss this in more detail below under the Porter’s 5 forces analysis Key Players In North America, the automobile production market is dominated by what’s known as the Big Three: ? ? ? General Motors – Produces Chevrolet, Pontiac, Buick and Cadillac, among others.
Chrysler – Chrysler, Jeep and Dodge. Ford Motor Co – Ford, Lincoln and Volvo. Two of the largest foreign car manufacturers are: ? ? Toyota Motor Co Honda Motor Co Key Ratios/Terms Fleet Sales: Traditionally, these are high-volume sales designated to come from large companies and government agencies. These sales are almost always at discount prices. In the past several years, auto makers have been extending fleet sales to small businesses and other associations. Seasonally Adjusted Annual Rate of Sales (SAAR): Most auto makers experience increased sales during the second quarter (April to June), and sales tend to be sluggish between November and January.
For this reason, it is important to compare sales figures to the same period of the previous year. The adjustment factors are released each year by the U. S. Bureau of Economic Analysis. Sales Reports: Many of the large auto makers release their preliminary sales figures from the previous month on a monthly basis. This can give you an indication of the current trends in the industry. Day Sales Inventory = Average Inventory Average Daily Sales The sales reports (discussed above) are released monthly. Most automakers try to make dealerships hold 60 days worth of inventory on their lots. Watch out This tutorial can be found at: http://www. investopedia. com/features/industryhandbook/ (Page 20 of 65) Copyright © 2010, Investopedia. om – All rights reserved. Investopedia. com – the resource for investing and personal finance education. if sales inventory climbs significantly above 60 days worth. Sales fluctuate month-to-month, but you shouldn’t see sustained periods of high inventory. Analyst Insight Automobiles depend heavily on consumer trends and tastes. While car companies do sell a large proportion of vehicles to businesses and car rental companies (fleet sales), consumer sales is the largest source of revenue. For this reason, taking consumer and business confidence into account should be a higher priority than considering the regular factors like earnings growth and debt load. For more about the Consumer Confidence Survey, see Economic Indicators: Consumer Confidence Index. ) Another caveat of analyzing an automaker is taking a look at whether a company is planning makeovers or complete redesigns. Every year, car companies update their cars. This is a part of normal operations, but there can be a problem when a company decides to significantly change the design of a car. These changes can cause massive delays and glitches, which result in increased costs and slower revenue growth. While a new design may pay off significantly in the long run, it’s always a risky proposition. For parts suppliers, the life p of an automobile is very important.
The longer a car stays operational, the greater the need for replacement parts. On the other hand, new parts are lasting longer, which is great for consumers, but is not such good news for parts makers. When, for example, most car makers moved from using rolled steel to stainless steel, the change extended the life of parts by several years. A significant portion of an automaker’s revenue comes from the services it offers with the new vehicle. Offering lower financial rates than financial institutions, the car company makes a profit on financing. Extended warranties also factor into the bottom line. (To read more about this, see Extended Warranties: Should You Take The Bait? Greater emphasis on leasing has also helped increase revenues. The advantage of leasing is that it eases consumer fears about resale value, and it makes the car sound more affordable. From a maker’s perspective, leasing is a great way to hide the true price of the vehicle through financing costs. Car companies, then, are able to push more cars through. Unfortunately, profiting on leasing is not as easy as it sounds. Leasing requires the automakers to accurately judge the value of their vehicles at the end of the lease, otherwise they may actually lose money. If you think about it, the automaker will lose money on the lease if they give the car a high salvage value.
A car with a low salvage value at the end of the lease will simply be bought by the consumer and flipped for a profit. This tutorial can be found at: http://www. investopedia. com/features/industryhandbook/ (Page 21 of 65) Copyright © 2010, Investopedia. com – All rights reserved. Investopedia. com – the resource for investing and personal finance education. Porter’s 5 Forces Analysis 1. Threat of New Entrants. It’s true that the average person can’t come along and start manufacturing automobiles. Historically, it was thought that the American automobile industry and the Big Three were safe. But this did not hold true when Honda Motor Co. opened its first plant in Ohio.
The emergence of foreign competitors with the capital, required technologies and management skills began to undermine the market share of North American companies. 2. Power of Suppliers. The automobile supply business is quite fragmented (there are many firms). Many suppliers rely on one or two automakers to buy a majority of their products. If an automaker decided to switch suppliers, it could be devastating to the previous supplier’s business. As a result, suppliers are extremely susceptible to the demands and requirements of the automobile manufacturer and hold very little power. 3. Power of Buyers. Historically, the bargaining power of automakers went unchallenged.
The American consumer, however, became disenchanted with many of the products being offered by certain automakers and began looking for alternatives, namely foreign cars. On the other hand, while consumers are very price sensitive, they don’t have much buying power as they never purchase huge volumes of cars. 4. Availability of Substitutes. Be careful and thorough when analyzing this factor: we are not just talking about the threat of someone buying a different car. You need to also look at the likelihood of people taking the bus, train or airplane to their destination. The higher the cost of operating a vehicle, the more likely people will seek alternative transportation options.
The price of gasoline has a large effect on consumers’ decisions to buy vehicles. Trucks and sport utility vehicles have higher profit margins, but they also guzzle gas compared to smaller sedans and light trucks. When determining the availability of substitutes you should also consider time, money, personal preference and convenience in the auto travel industry. Then decide if one car maker poses a big threat as a substitute. 5. Competitive Rivalry. Highly competitive industries generally earn low returns because the cost of competition is high. The auto industry is considered to be an oligopoly, which helps to minimize the effects of pricebased competition.
The automakers understand that price-based competition does not necessarily lead to increases in the size of the marketplace; historically they have tried to avoid price-based competition, but more recently the competition has intensified – rebates, preferred financing and long-term warranties have helped to lure in customers, but they also put pressure on the profit margins for vehicle sales. This tutorial can be found at: http://www. investopedia. com/features/industryhandbook/ (Page 22 of 65) Copyright © 2010, Investopedia. com – All rights reserved. Investopedia. com – the resource for investing and personal finance education. (For further reading, check out Analyzing Auto Stocks. ) Key Links ? ? ? ? Ward’s Automotive Reports – A popular publisher of automotive data.
The Alliance of Automobile Manufacturers – Get the latest industry facts, developments, and technological innovations. Automotive Industries – A magazine covering several areas of the auto industry. US Council for Automobile Research – The umbrella organization of Daimler Chrysler, Ford and General Motors created to strengthen the technology base of the domestic auto industry. The Retailing Industry All businesses that sell goods and services to consumers fall under the umbrella of retailing, but there are several directions we can take from here. For starters, there are department stores, discount stores, specialty stores and even seasonal retailers.
Each of these might have their own little quirks; however, for the most part the analysis overlaps to all areas of retailing. This section of the industry handbook will try to focus more on general retailers and department stores. (For background reading, see Analyzing Retail Stocks. ) Over the past couple decades, there have been sweeping changes in the general retailing business. What was once strictly a made-to-order market for clothing has changed to a ready-to-wear market. Flipping through a catalog, picking the color, size and type of clothing a person wanted to purchase and then waiting to have it sewn and shipped was standard practice. At the turn of the century some retailers would have a storefront where people could browse.
Meanwhile, new pieces were being sewn or customized in the back rooms. In some parts of the world, the retail business is dominated by smaller family-run or regionally-targeted stores, but this market is increasingly being taken over by billion-dollar multinational conglomerates like Wal-Mart and Sears. The larger retailers have managed to set up huge supply/distribution chains, inventory management systems, financing pacts and wide scale marketing plans. Without getting into specific product categories within the retailing industry, the overall segments can be divided into two categories: ? Hard – These types of goods include appliances, electronics, furniture, sporting goods, etc.
Sometimes referred to as “hardline retailers. ” This tutorial can be found at: http://www. investopedia. com/features/industryhandbook/ (Page 23 of 65) Copyright © 2010, Investopedia. com – All rights reserved. Investopedia. com – the resource for investing and personal finance education. ? Soft – This category includes clothing, apparel, and other fabrics. Each retailer tries to differentiate itself from the competition, but the strategy that the company uses to sell its products is the most important factor. Here are some different types of retailers: ? ? ? Department Stores – Very large stores offering a huge assortment of goods and services.
Discounters – These also tend to offer a wide array of products and services, but they compete mainly on price. Demographic – These are retailers that aim at one particular segment. High-end retailers focusing on wealthy individuals would be a good example. Each of these has its own distinct advantages, but it’s important to know how these advantages play out. For example, during tough economic times, the discount retailers tend to outperform the others. The opposite is true when the economy is thriving. The more successful retailers attempt to combine the characteristics of more than one type of retailer to differentiate themselves from the competition. Key Ratios/Terms Same Store Sales: Used when analyzing individual retailers.
It compares sales in stores that have been open for a year or more. This allows investors to compare what proportion of new sales have come from sales growth compared to the opening of new stores. This is important because although new stores are good, there eventually comes a saturation point at which future sales growth comes at the expense of losses at other locations. Same store sales are also commonly referred to as “comps. ” Sales per Square Foot: Sales Square Footage Store space is considered to be a productive asset and the key to profitability. Successful companies generate as much sales volume as possible out of each square foot of store space.
More recently, analysts have created modifications of this concept by looking at a retailers’ gross margin per square foot. Inventory Turnover: This ratio shows how many times the inventory of a firm is This tutorial can be found at: http://www. investopedia. com/features/industryhandbook/ (Page 24 of 65) Copyright © 2010, Investopedia. com – All rights reserved. Investopedia. com – the resource for investing and personal finance education. sold and replaced over a specific period. Generally calculated as: Sales Inventory Cost of Goods Sold Average Inventory But, may also be calculated as: Although the first calculation is more frequently used, COGS may be substituted because sales are recorded at market value while inventories are usually recorded at cost.
Also, average inventory may be used instead of the ending inventory to help minimize seasonal factors. This ratio should be compared against similar retail companies or the industry average. A low turnover might imply poor sales and, therefore, excess inventory. A high ratio implies either strong sales or ineffective buying from suppliers. (For related reading, see Consumer Confidence: The Consumer Confidence Index (CCI) is put out by the Consumer Confidence Board around the middle of each month. The Consumer Confidence Survey is based on a sample of 5,000 U. S. households and is considered to be one of the most accurate indicators of confidence. Increasing confidence means more spending and borrowing for consumers – a positive for retailers. To learn more about this measure, see Economic Indicators To Know: Consumer Confidence Index. ) Personal Income & Disposable Income: Every quarter, the Bureau of Economic Analysis releases the latest income data for U. S. citizens. There is a high correlation between retail sales data and the changes in personal income. (For more insight, see Economic Indicators: Personal Income and Outlays. ) Analyst Insight As we mentioned earlier, the store type and the strategy that retailers use plays a big role in how well the company performs. The first thing to take a look at is what segment of the retail industry the company is situated in. Is the company a discounter? Department store? Specialty retailer?
The retail category to which the company belongs also helps determine the following details about the company: ? Competitors – The number and size of direct competitors is important. Ideally, you want the company to have as little competition as possible, but this rarely happens. Determine who the direct competitors are and how they are all positioned in the market. A smaller regional discount store might find it tough to compete with new Wal-mart stores opening up every month. Take a look at the big picture, find out what differentiates the company from its competitors. Do they have better prices, service, or offer This tutorial can be found at: http://www. investopedia. om/features/industryhandbook/ (Page 25 of 65) Copyright © 2010, Investopedia. com – All rights reserved. Investopedia. com – the resource for investing and personal finance education. ? ? higher quality goods than their competition? Grocery stores might find it hard to differentiate themselves from competitors: after all, an apple is an apple. Higher-end retailers, however, may have an easier time as they try to compete on service or quality. Size of the Market – Determining the overall size of the market gives us an indication of the potential for the market. If you had the choice between a company with a 25% share of a $10 million market or a 25% share of a $1 billion market, which one would you chose?
Other Factors – Some analysts even go as far as evaluating the retail strategy that the companies use. For example, does the company have a fresh look? Are their stores clean, bright and fun to shop in? Swedish retailer Ikea has done an excellent job of designing their stores for visual appeal, and quite possibly it has equated to very strong sales. Also, what are the store demographics? Does the retailer appeal more to younger people (who don’t have the money), or does it appeal to the parents (who do have the money). The performance of the economy as a whole obviously has a great impact on the retailing industry. Retailer profits have a close correlation with the overall performance of the economy.
Looking at the trends for growth in gross domestic product (GDP), inflation, consumer confidence, personal income and interest rates are extremely important when thinking about investing in the retail industry. You might not think that your shopping habits are sensitive to interest rate fluctuations, but they are. While a 50-basis-point drop in interest rates might not give you the sudden inkling to go drop $1,000 at Macy’s, for the economy as a whole, it has a big effect on spending patterns. (For more insight on this effect, see How Interest Rates Affe

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