September 18th, 2012
ECO2506Risk Management for Financial Managers
Notes to Lecture 3
Industry Risk Analysis
To support Corporate Risk Evaluation
The returns to a lender are composed of an interest rate and, in some circumstances, a defined fee. The firm’spayment of these expenses takes precedence over any return to shareholders. Since these payments are fixed, the lender does not participate in any of the profits earned by the firmwhich are reserved entirely to shareholders. At the same time, if the firm’s cash flows turn out to be insufficient to cover debt service, lenders will suffer a loss. To estimate net returns, a lender must thereforeevaluate the potential forloss on each loan.
Analysis of the credit-worthiness of a borrower will focus on the specific characteristics of the particular firm. This analysis, however, must be set within the broader context of the industry in which the firm operates. The key drivers of profitability and of risk of the industry have a high impact on the strength of the firms within it. Credit analysis, therefore, should always start with an examination of the dynamics of the industry.
Industrial Organization – IO – is a branch of economics that is based on the theory of the firm. It includes the theory of monopolistic competition, and real world frictions such as imperfect information and barriers to entry.(An overview can be found in Tirole, J., The Theory of Industrial Organization, MIT Press, 1988.) Beyond this theoretical structure, there is a very deep set of literature on how particular industries work – their characteristics and the drivers of both their profitability and their volatility. In addition to this academic literature, reports on the structure and current outlook for particular industries are regularly produced by rating agencies and services such as CreditSights.
Some of the issues that will be addressed in evaluating industry risk include:
1.Nature of the demand for the industry’s output:
- its volatility, and the drivers of this volatility
- price volatility, and its drivers
- degree of competition among purchasers for the industry’s products
- importance of non-price issues such as quality, reliability of supply and
flexibility of response to unexpected customer demands
2.Nature of the markets for the inputs for the industry
- are these competitive markets
- are increases in supply readily available
- are prices relatively stable, or are they volatile with the business cycle or changes in technology?
3.The nature of the production process:
- is there high technical change?
- is it capital intensive?
- is the technology complex
- are there economies of scale?
- is production tied to particular locations?
4.Nature of competition in the industry
- how many competitors are there? What is their financial strength?
- are there barriers to entry such as brand strength or complex technology?
5.Nature of the market for the product
- is there a wide variety of customers, or is the demand concentrated
among few customers
- is the technology of customers changing in a manner that may affect the
demand for the product?
- might changing tastes affect demand for the product?
6.Regulation: are there any regulatory regimes that might affect
- firms in the industry
- any suppliers or customers
- are there applicable anti-trust issues?
The analysis of these issues will be structured to identify the drivers of industry revenues, costs and margins.
Different industries have quite different characteristics. Some simple examples can be given:
a) resource based industries where primary product prices suffer from well known and pronounced cyclical swings (eg. base metals, oil and gas, paper, etc.)
b) industries with high technological change and new product cycle risk – (eg much of the high tech industry.)
c) industries with heavy off-shore competition from low-cost foreign producers such as the South-East Asian ‘tigers’, Mexico, and now increasingly India and China. (eg. high tech, increasingly automotive parts, and now some service industries such as programming data entry, call centres and base level financial analysis for major investment banks.)
d) ‘fad’ type industries, typically in consumer goods, where product cycles may be short and extremely difficult to predict.
e) regulated industries where government regulations and regulators can have a major impact on the success of the industry and on individual firms within the industry. Such industries exhibit the ‘stroke of a pen’ risk where governments can change profitability very significantly, and where the risk of changed regulation is difficult to predict (eg. US health care companies, regulated utilities (remember the Californian utilities that went bankruptcy after ‘reform’ in the Californian electricity market, etc.)
f) capital intensive industries where the marginal cost of production is low and there is overcapacity, companies will tend to produce to marginal cost and suffer ongoing margin pressures (eg. airlines, steel, auto, petroleum refineries, hotels etc.). Pricing to marginal cost that does not cover capital costs will produce high losses. The results of companies in such industries are often highly cyclical.
The two tables shown below point to two conclusions: heavy loan losses occur largely during recessions, and they are concentrated in specific industries. These industries have:
- high assets to sales
- high rate of capital expenditure
- high liabilities to relative to assets and equity,
- high costs of debt servicing – interest plus principal repayments
- low marginal costs of production
- competition in the industry
And hence
- ahigh risk of rapid price declines should excess capacity emerge.
Some examples can be given.
In the late 1990’s, the outlook for new fibre optic telecom networks was bright. The demand for long distance data transfer was growing rapidly propelled by new TV, video game and other data intensive applications. In response, various firms such as Global Crossing undertook major new fibre optic network investments. Each of these firms believed that they had an edge on their competitors and could generate high net cash flows.
Such firms shared each of the characteristics noted above. The high capex and heavy borrowing saddled the firms with high debt service commitments. By the late 1990’s it became clear that the rate of installation of new capacity had seriously outrun the growth in demand. When the extent of the excess capacity became clear by around 2000, buyers of capacity were able to negotiate stunningly low rates. The marginal cost of carrying an extra message approaches zero on such networks, and in the highly competitive environment providers found themselves forced to price down towards marginal cost. Cash flows at many firms fell to levels far below mandatory debt service coverage. Losses to lenders were high - recoveries on loans to fibre optic firms were often in the range of 10% or less.
The automotive industry provides another example of an industry sharing the characteristics outline above. The industry is highly capital intensive.For several decades, the industry has been experiencing a high rate of technical change. Advances in material sciences (plastics and metals) and in electronics continue to offer significant new opportunities for better car construction at lower cost. Huge advances in manufacturing techniques and quality control systems continue to revolutionize the design process for vehicles and the shop floors of factories. Innovation in the industry is extremely capital intensive. The development of a new model requires high outlays on design, on the production of the required tools and dies (for forming metal and plastic parts), and on the supporting production-line equipment. Yet the cost performance of new production lines was attractive enough that investments continued at a high rate. Older capacity remained in service. The result was that by the early 2000’s, overcapacity in the industry had risen to around to 15% to 20% of vehicle sales.
For the 3 major North American producers, the results showed up in high levels of debt, including obligations for pension and health benefits under union contracts, and high servicing costs on these obligations. The marginal costs of producing an extra vehiclewere low. Labour costs were fixed through labour contracts that placed an extremely high penalty for any redundancy. Marginal costs were limited mainly to raw material costs of perhaps $3,000 to $5,000 per vehiclefor raw materials – mostly steel and plastics. When demand began to slip in the recession after 2007, companies began to price towards marginal cost. “Incentives” of ever increasing size were offered to potential car buyers. The result of these mechanisms forced both GM and Chrysler into their highly publicized bankruptcy.
These tables are drawn from Crean, J.F., and Milne, F., “The Anatomy of Systemic Risk”, Working Paper, 2012. This Working Paper provides a full analysis of the characteristics of these industries, and how these characteristics drive volatility and hence high loan losses.
John F. Crean
© John F. Crean, 2012
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