Showing posts with label matured companies. Show all posts
Showing posts with label matured companies. Show all posts

Saturday 29 April 2017

Industry Life-Cycle Analysis

Stages of Life-Cycle of Business / Industry

  • Embryonic
  • Growth
  • Shakeout
  • Mature
  • Decline

Embryonic

Industries in this stage are just beginning to develop.

They are characterised by:
  • Slow growth as customers are still unfamiliar with the product.
  • High prices as volumes are too low to achieve significant economies of scale.
  • Significant initial investment.
  • High risk of failure.
Companies focus on raising product awareness and developing distribution channels during this stage.


Growth

Once the new product starts gaining acceptance in the market, the industry experiences rapid growth.

The growth stage is characterised by:
  • New customers entering the market, which increases demand.
  • Improved profitability as sales grow rapidly.
  • Lower prices as econmies of scale are achieved.
  • Relatively low competition among companies in the industry as the overall market size is growing rapidly.  Firms do no need to wrestle market share away from competitors to grow.
  • High threat of new competitors entering the market due to low barriers to entry.
During this stage, companies focus on building customer loyalty and reinvest heavily in the business.


Shakeout

The period of rapid growth is followed by a period of slower growth.

The shakeout stage is characterised by:
  • Slower demand growth as fewer new customers are left to enter the industry.
  • Intense competition as growth becomes dependent on market share growth.
  • Excess industry capacity, which leads to price reductions and declining profitability.
During this stage, companies focus on reducing their costs and building brand loyalty.

Some firms may fail or merge with others.


Mature

Eventually demand stops growing and the industry matures.

Characteristics of this stage are:
  • Little or no growth in demand as the market is completely saturated.
  • Companies move towards consolidation.  They recognize that they are interdependent so they stay away from price wars  However, price wars may occur during downturns.
  • High barriers to entry in the form of brand loyalty and relatively efficient cost structures.
During this stage, companies are likely to be pursuing replacement demand rather than new buyers and should focus on extending successful product lines rather than introducing revolutionary new products.

Companies have limited opportunities to reinvest and often have strong cash flows.  

As a result, they are more likely to pay dividends.


Decline

Technological substitution, social changes or global competition may eventually cause an industry to decline.

The decline stage is characterised by:
  • Negative growth
  • Excess capacity due to diminishing demand.
  • Price competition due to excess capacity.
  • Weaker firms leaving the industry.




Limitations of Industry Life-Cycle Analysis

The following factors may

  • change the shape of the industry life cycle, 
  • cause some stages to be longer or shorter than expected, or 
  • even result in certain stages being skipped altogether.
These factors are:
  • Technological changes
  • Regulatory changes
  • Social changes
  • Demographics

Industry life-cycles analysis is most useful in analyzing industries during periods of relative stability.

It is not as useful in analyzing industries experiencing rapid change.

Not all companies in an industry display similar performance.

Tuesday 6 December 2011

Characteristics of Mature Companies and their Value Drivers


Characteristics of Mature Companies

            There are clear differences across mature companies in different businesses, but there are some common characteristics that they share. In this section, we will look at what they have in common, with an eye on the consequences for valuation.
1.     Revenue growth is approaching growth rate in economy: In the last section, we noted that there can be a wide divergence between growth rate in revenues and earnings in many companies. While the growth rate for earnings for mature firms can be high, as a result of improved efficiencies, the revenue growth is more difficult to alter. For the most part, mature firms will register growth rates in revenues that, if not equal to, will converge on the nominal growth rate for the economy.
2.     Margins are established: Another feature shared by growth companies is that they tend to have stable margins, with the exceptions being commodity and cyclical firms, where margins will vary as a function of the overall economy. While we will return to take a closer look at this sub-group later in the book, event these firms will have stable margins across the economic or commodity price cycle.
3.     Competitive advantages? The dimension on which mature firms reveal the most variation is in the competitive advantages that they hold on to, manifested by the excess returns that they generate on their investments. While some mature firms see excess returns go to zero or become negative, with the advent of competition, other mature firms retain significant competitive advantages (and excess returns). Since value is determined by excess returns, the latter will retain higher values, relative to the former, even as growth rates become anemic.
4.     Debt capacity: As firms mature, profit margins and earnings improve, reinvestment needs drop off and more cash is available for servicing debt. As a consequence, debt ratios should increase for all mature firms, though there can be big differences in how firms react to this surge in debt capacity. Some will choose not to exploit any or most of the debt capacity and stick with financing policies that they established as growth companies. Others will over react and not just borrow, but borrow more than they can comfortably handle, given current earnings and cash flows. Still others will take a more reasoned middle ground, and borrow money to reflect their improved financial status, while preserving their financial health.
5.     Cash build up and return? As earnings improve and reinvestment needs drop off, mature companies will be generating more cash from their operations than they need. If these companies do not alter their debt or dividend policies, cash balances will start accumulating in these firms. The question of whether a company has too much cash, and, if so, how it should return this cash to stock holders becomes a standard one at almost every mature company.
6.     Inorganic growth: The transition from a growth company to a mature company is not an easy one for most companies (and the managers involved). As companies get larger and investment opportunities internally do not provide the growth boost that they used to, it should not be surprising that many growth companies look for quick fixes that will allow them to continue to maintain high growth. One option, albeit an expensive one, is to buy growth: acquisitions of other companies can provide boosts to revenues and earnings.
One final point that needs to be made is that not all mature companies are large companies. Many small companies reach their growth ceiling quickly and essentially stay as small, mature firms. A few growth companies have extended periods of growth before they reach stable growth and these companies tend to be the large companies that we find used as illustrations of typical mature companies: Coca Cola, IBM and Verizon are all good examples.



Mature companies: Value Drivers

Operating Slack

When valuing a company, our forecasts of earnings and cash flows are built on assumptions about how the company will be run. If these numbers are based upon existing financial statements, we are, in effect, assuming that the firm will continue to be run the way it is now. The value of a firm is a function of five key inputs and changes in three of them can increase operating asset value. The first is the cash flow from assets in place or investments already made, the second is the expected growth rate in the cash flows during what we can term a period of both high growth and excess returns (where the firm earns more than its cost of capital on its investments) and the third is the length of time before the firm becomes a stable growth firm. Figure 11.2 captures these elements:
Determinants of Value

A firm can increase its value by increasing cash flows from current operations, increasing expected growth and the period of high growth, by reducing its composite cost of financing and managing its non-operating assets better.

Financial Slack

There are two aspects of financing that affect the cost of capital, and through it, the value that we derive for a firm. First, we will look at how best to reflect changes the mix of debt and equity used to fund operations in the cost of capital. Second, we will look at how the choices of financing (in terms of seniority, maturity, currency and other add-on features) may affect the cost of funding and value.
            The question of whether changing the mix of debt and equity can alter the value of a business has long been debated in finance. While the answer to some may seem obvious – debt after all is always less expensive than equity – the choice is not that simple.  Debt has two key benefits, relative to equity, as a mode of financing. First, the interest paid on debt financing is tax deductible, whereas cash flows to equity (such as dividends) are generally not.[1] Therefore, the higher the tax rate, the greater the tax benefit of using debt. This is absolutely true in the United States and partially true in most parts of the world. The second benefit of debt financing is more subtle. The use of debt, it can be argued, induces managers to be more disciplined in project selection. That is, the managers of a company funded entirely by equity, and with strong cash flows, have a tendency to become lazy. For example, if a project turns sour, the managers can hide evidence of their failure under large operating cash flows, and few investors notice the effect in the aggregate. But if those same managers had to use debt to fund projects, then bad projects are less likely to go unnoticed. Since debt requires the company to make interest payments, investing in too many bad projects can lead to financial distress or even bankruptcy, and managers may lose their jobs.  Relative to equity, the use of debt has three disadvantages—an expected bankruptcy cost, an agency cost, and the loss of future financing flexibility.
      The expected bankruptcy cost has two components. One is simply that as debt increases, so does the probability of bankruptcy. The other component is the cost of bankruptcy, which can be separated into two parts. One is the direct cost of going bankrupt, such as legal fees and court costs, which can eat up to a significant portion of the value of the assets of a bankrupt firm. The other (and more devastating) cost is the effect on operations of being perceived as being in financial trouble.. Thus, when customers learn that a company is in financial trouble, they tend to stop buying the company's products. Suppliers stop extending credit, and employees start looking for more reliable employment elsewhere. Borrowing too much money can create a downward spiral that ends in bankruptcy.
      Agency costs arise from the different and competing interests of equity investors and lenders in a firm. Equity investors see more upside from risky investments than lenders to. Consequently, left to their own devices, equity investors will tend to take more risk in investments than lenders would want them to and to alter financing and dividend policies to serve their interests as well. As lenders become aware of this potential, they alter the terms of loan agreements to protect themselves in two ways. One is by adding covenants to these agreements, restricting investing, financing and dividend policies in the future; these covenants create legal and monitoring costs. The other is by assuming that there will be some game playing by equity investors and by charging higher interest rates to compensate for expected future losses.  In both instances, the borrower bears the agency costs.
      As firms borrow more money today, they lose the capacity to tap this borrowing capacity in the future. The loss of future financing flexibility implies that the firm may be unable to make investments that it otherwise would have liked to make, simply because it will be unable to line up financing for these investments.
The fundamental principle in designing the financing of a firm is to ensure that the cash flows on the debt match as closely as possible the cash flows on the asset. Firms that mismatch cash flows on debt and cash flows on assets (by using short term debt to finance long term assets, debt in one currency to finance assets in a different currency or floating rate debt to finance assets whose cash flows tend to be adversely impacted by higher inflation) will end up with higher default risk, higher costs of capital and lower firm values. To the extent that firms can use derivatives and swaps to reduce these mismatches, firm value can be increased.

Probability of management change

There is a strong bias towards preserving incumbent management at firms, even when there is widespread agreement that the management is incompetent or does not have the interests of stockholders at heart. Some of the difficulties arise from the institutional tilt towards incumbency and others are put in place to make management change difficult, if not impossible. In general, there are four determinants of whether management will be changed at a firm:
1.     Institutional concerns: The first group of constraints on challenging incumbent management in companies that are perceived to be badly managed and badly run is institutional. Some of these constraints can be traced to difficulties associated with raising the capital needed to fund the challenge, some to state restrictions on takeovers and some to inertia. 
2.     Firm-specific constraints:  There are some firms where incumbent managers, no matter how incompetent, are protected from stockholder pressure by actions taken by these firms. This protection can take the form of anti-takeover amendments to the corporate charter, elaborate cross holding structures and the creation of shares with different voting rights. In some cases, the incumbent managers may own large enough stakes in the firm to stifle any challenge to their leadership.
3.     Corporate Holding Structures: Control can be maintained over firms with a variety of corporate structures including pyramids and cross holdings. In a pyramid structure, an investor uses control in one company to establish control in other companies. For instance, company X can own 50% of company Y and use the assets of company Y to buy 50% of company Z.  In effect, the investor who controls company X will end up controlling companies Y and Z, as well. Studies indicate that pyramids are a common approach to consolidating control in family run companies in Asia and Europe. In a cross holding structure, companies own shares in each other, thus allowing the group's controlling stockholders to run all of the companies with less than 50% of the outstanding stock. The vast majority of Japanese companies (keiretsus) and Korean companies (chaebols) in the 1990s were structured as cross holdings, immunizing management at these companies from stockholder pressure.
4.     Large Shareholder/Managers: In some firms, the presence of a large stockholder as a manager is a significant impediment to a hostile acquisition or a management change. Consider, a firm like Oracle, where the founder/CEO, Larry Ellison, owns almost 30% of the outstanding stock. Even without a dispersion of voting rights, he can effectively stymie hostile acquirers. Why would such a stockholder/manager mismanage a firm when it costs him or her a significant portion of market value? The first reason can be traced to hubris and ego. Founder CEOs, with little to fear from outside investors, tend to centralize power and can make serious mistakes. The second is that what is good for the inside stockholder, who often has all of his or her wealth invested in the firm may not be good for the other investors in the firm.


Little Book of Valuation
Aswath Damodaran

Monday 25 January 2010

The Company when It's Old (3): Why you might invest in these?

By now you might be wondering what's the point of investing in a stodgy old company such as IBM, GM, or US Steel? 

There are several reasons you might do this. 
  • First, big companies are less risky, in that they generally are in no danger of going out of business.
  • Second, they are likely to pay dividend.
  • Third, they have valuable assets that might be sold off at a profit.
These corporate codgers have been everywhere and seen it all, and they've picked up all sorts of valuable property along the way.  In fact, studying an old company and delving into its finances can be as exciting as rummaging through the attic of a rich and elderly aunt.  You never know what amazing stuff you'll find stuck in a dark corner.

Whether it's land, buildings, equipment, the stocks and bonds they keep in the bank, or the smaller companies they've acquired along the way, old companies have a substantial "break-up value."  Shareholders act like the relatives of that aged rich aunt, waiting to find out who will get what.

There's always the chance an old company can turn itself around, as Xerox and American Express have been doing in the past couple of years.

On the other hand, when an old company falters or stumbles as badly as these companies did, it may take 20 or 30 years before it can get itself back on track.  Patience is a virtue, but it's not well rewarded when you own stock in a company that's past its prime.

The Company when It's Old (2): Alcoa, GM & IBM

There's a lesson here that may save you some grief in the future.  No matter how powerful it may be today, a company won't stay on top forever.  Being called a "blue-chip" or a "world-class operation" can't save a company whose time is past, any more than Great Britain was saved by having the word "Great" in its name.

Long after Great Britain had lost its empire, the British people continued to think of their country as stronger and mightier than it really was, the same as the shareholders of US Steel.

International Harvester, the dominant force in farm equipment for an entire half-century, peaked in 1966 and never came back, even though it tried to change its luck by changing its name to Navistar.  Johns-Manville, once number one in insulation and building supplies, topped out in 1971. 

The Aluminium Company of America, better known as Alcoa, a Wall Street darling of the 1950s when the country was discovering aluminium foil, aluminium siding, and aluminium boats, rose to $23 a share in 1957 (adjusted for splits), a price it didn't see again until the 1980s.

General Motors, the dominant car company in the world and the bluest of the automotive blue chips, reached a peak in October 1965 that it wouldn't see again for nearly 30 years.  Today, GM is still the largest company in the US, and first in total sales, but it's far from the most profitable.  Sometime in the 1960s, its reflexes began to slow.

The Germans came ashore with their Volkswagens and their BMWs, and the Japanese invaded with their Toyotas and Hondas.  The attack was aimed directly at Detroit and GM was slow to react.  A younger, more aggressive GM might have risen to this challenge more quickly, but the older GM was set in its ways.

It continued to make big cars when it could see that small foreign cars were selling like crazy.  Before it could build new models that could compete with the overseas models, it ad to overhalul its outmoded factories.  This cost billions of dollars, and by the time the overhaul was complete, and small cars were rolling off the GM assembly lines, the public had switched back to bigger cars.

For three decades the largest industrial company in the US has not been largely profitable.  Yet if you had predicted this result in 1965, when GM was riding the crest of its fame and fortune, nobody would have believed you.  People would sooner have believed that Elvis was lip-synching.

Then there's IBM, which had reached middle age in the late 1960s, about the time GM was in decline.  Since the early 1950s, IBM was a spectacular performer and a great stock to own.  It was a top brand name and a symbol of quality - the IBM logo was getting to be as famous as the Coke bottle.  The company won awards for how well it was managed, and other companies studied IBM to learn how they should run their operations.  As late as the 1980s, it was celebrated in a best selling book, In Search of Excellence.

The stock was recommended by stockbrokers everywhere as the bluest of the blue chips.  To mutual fund managers, IBM was a "must" investment.  You had to be a maverick not to own IBM.

But the same thing happened to IBM that happened to GM.  Investors were so impressed with its past performance that they did not notice what was going on in the present.  People stopped buying the big mainframe computers that wer the core of IBM;s business.  The mainframe market wasn't growing anymore.  IBM's personal computer line was attacked from all sides by competitors who made a less-expensive product.  IBM's earnings sank, and as you probably can guess by now, so did the stock price.

By now you might be wondering what's the point of investing in a stodgy old company such as IBM, GM, or US Steel? 

The Company when It's Old (1): Woolworth & US Steel

Companies that are 20, 30, 50 years old have put their best years behind them. 

You can't blame them for getting tired.  They'd done it all and seen it all, and there's hardly a place they can go that they haven't already been.

Take Woolworth.  It's been around for more than 100 years - several generations of Americans grew up shopping at Woolworth's.  At one point, there was a Woolworth's outlet in every city and town in America.  That's when the company ran out of room to grow.

Recently, Woolworth has suffered a couple of unprofitable years.  It can still make a profit, but it will never be the spectacular performer it was when it was younger.  Old companies that were great earners in the past can't be expected to keep up the momentum.  A few of them have - Wrigley's, Coca-Cola, Emerson Electric, and McDonald's come to mind.  But these are exceptions.

US Steel, General Motors, and IBM are 3 prime examples of former champions whose most exciting days are behind them - although IBM and GM are having a rebound.  US Steel was once an incredible hulk, the first billion-dollar company on earth.  Railroads needed steel, cars needed steel, skyscrapers needed steel, and US Steel provided 60% of it.  At the turn of this century, no company dominated its industry the way US Steel dominated steel, and no stock was as popular as US Steel stock. It was the most actively traded issue on Wall Street.

When a magazine wanted to illustrate America's power and glory, it ran a picture of a steel mill, with the fire in the furnaces and the liquid metal poureing like hot lava into the waiting molds.  We are a nation of factories then, and a good deal of our wealth and power came from the mill towns of the East and the Midwest.

The steel business was a fantastic business to be in, and US Steel prospered through both world wars and six different presidents.  The stock hit an all-time high of $108 7/8 in August 1950.

This was the beginning of the electronic age and the end of the industrial age and the glory of steel, and it would ahve been the perfect time for investors to sell their US Steel shares and buy shares in IBM.  But you had to be very farsighted and unsentimental investor to realize this.  After all, US Steel was classed as a blue chip, Wall Street's term of endearment for pretigious companies that are expected to excel forever.  Hardly anyone would have predicted that in 1995, US Steel stock would be selling for less than it sold for in 1959.

To put this decline in perspective, the DJIA was bumping up against the 500 level in 1959, and it's gone up more than 4000 points since.  So while stocks in the Dow have increased in value more than 8 times over, US Steel has gone downhill.  Loyal shareholders have died and gone to heaven waiting for US Steel to reclaim its lost glory.