(a) What is a market?

First of all, a market is not an economic sector as statistics institutes, central banks or professional associations would define it. Markets and economic sectors are two completely separate concepts.

What is the market for pay-TV operators such as BSkyB, Premier, Telepiù or Canal+? It is the entertainment market, not just the TV market. Competition comes from cinema multiplexes, DVDs and live sporting events rather than from ITV, RTL TV, Rai Uno or TF1, which mainly sell advertising slots to advertisers seeking to target the legendary housewife below 50 years of age.

So what is a market? A market is defined by consistent behaviour, e.g. a product satisfying similar needs, purchased through a similar distribution network by the same customers.

A market is not the same as an economic sector. Rather, it is a niche or space in which a business has some industrial, commercial or service-oriented expertise. It is the arena in which it competes.

Once a market has been defined, it can then be segmented using geographical (i.e. local, regional, national, worldwide) and sociological (luxury, mid-range, entry-level products) variables. This is also an obvious tactic adopted by companies seeking to gain protection from their rivals. If such a tactic succeeds, a company will create its own market in which it reigns supreme. Apple, with its iPad, has created a product that is neither a PDA nor a computer but a unique product. But before readers get carried away and rush off to create their very own markets arenas, it should be remembered that a market always comes under threat sooner or later, think about the BlackBerry and smartphones.

Segmenting markets is never a problem for analysts, but it is vital to get the segmentation right! To say that a manufacturer of running shoes has a 30% share of the German running shoe market may be correct from a statistical standpoint but is totally irrelevant from an economic standpoint, because this is a worldwide market with global brands backed by marketing campaigns featuring international champions. Conversely, a 40% share of the northern Swiss cement market is a meaningful number, because cement is a heavy product with a low unit value that cannot be stored for long and is not usually transported more than 150– 200 km from the cement plants.

(b) Market growth

Once a financial analyst has studied and defined a market, his natural reflex is then to attempt to assess the growth opportunities and identify the risk factors. The simplest form of growth is organic volume growth, i.e. selling more and more products.

That said, it is worth noting that volume growth is not always as easy as it may sound in developed countries given weak demographic growth (e.g. between −0.5% and +1% p.a. in Europe). Booming markets do exist (flatscreen TV sets), but others are rapidly contracting (nuclear power stations, daily newspapers) or are cyclical (transportation, paper production).

At the end of the day, in mature countries, the most important type of growth is value growth. Let's imagine that we sell a product satisfying a basic need, such as bread. Demand does not grow much and, if anything, appears to be declining. So we attempt to move upmarket by means of either marketing or packaging, or by innovating. As a result, we decide to switch from selling bread to providing a whole range of speciality products, such as baguettes, rye bread and farmhouse loaves, and we start charging € 1.10 or even € 1.30, rather than € 0.90 per item. The risk of pursuing this strategy is that our rivals may react by focusing on a narrow range of straightforward, unembellished products that sell for less than ours, e.g. a small shop that bakes pre-prepared dough in its ovens or the in-store bakeries at food superstores.

Once we have analysed the type of growth, we need to attempt to predict its duration, and this is no easy task. The famous 17th century letter writer Mme de Sévigné once forecast that coffee was just a fad and would not last for more than a week. At the other end of the spectrum, it is not uncommon to hear entrepreneurs claiming that their products will revolutionise consumers' lifestyles and even outlast the wheel!

To tackle the question of market growth, we need to look at the product lifecycle.

Growth drivers in a developed economy are often highly complex. They may include:

• technological advances, new products (e.g. TV on mobile phones);
• changes in the economic situation (e.g. expansion of air travel with the rise in living standards);
• changes in consumer lifestyles (e.g. eating out);
• changing fashions (e.g. snowboards, catamarans);
• demographic trends (e.g. popularity of cruises owing to the ageing of the population);
• environmental considerations (e.g. electric cars);
• delayed uptake of a product (e.g. mobile banking in Africa where the retail banking network was limited).

In its early days, the market evolves rapidly, as products are still poorly geared to consumers' needs. During the growth phase, the technological risk has disappeared, the market has become established and expands rapidly, being fairly insensitive to fluctuations in the economy at large. As the market reaches maturity, sales become sensitive to ups and downs in general economic conditions. And as the market ages and goes into decline, price competition increases, and certain market participants fall by the wayside. Those that remain may be able to post very attractive margins, and no more investment is required.

Lastly, readers should note that an expanding sector is not necessarily an attractive sector from a financial standpoint. Where future growth has been over-estimated, supply exceeds demand, even when growth is strong, and all market participants lose money (e.g. the solar panel industry). For instance, after a false start in the 1980s (when the leading player Atari went bankrupt), the video games sector has experienced growth rates of well over 20%, but returns on capital employed of most companies in this sector are, at best, poor. Conversely, tobacco, which is one of the most mature markets in existence, generates a very high level of return on capital employed for the last few remaining companies operating in the sector.

(c) Market risk

Market risk varies according to whether the product in question is original equipment or a replacement item. A product sold as original equipment will seem more compelling in the eyes of consumers who do not already possess it. And it is the role of advertising to make sure this is how they feel. Conversely, should consumers already own a product, they will always be tempted to delay replacing it until their conditions improve and thus will spend their limited funds on another new product. Needs come first! Put another way, replacement products are much more sensitive to general economic conditions than original equipment. For instance, sales in the European truck industry beat all existing records in 2007 when the economy was in excellent shape, but sales slumped to new lows in 2009 when the recession kicked in. Sales picked up again in 2010–2011 only to fall again in 2012.

With this in mind, it is vital for an analyst to establish whether a company's products are acquired as original equipment or as part of a replacement cycle because this directly affects the company's sensitivity to general economic conditions.

All too often we have heard analysts claim that a particular sector, such as the food industry, does not carry any risk (because we will always need to eat!). These analysts either cannot see the risks or they disregard them. Granted, we will always need to eat and drink, but not necessarily in the same way. For instance, eating out is on the increase, soda consumption is declining and consumption of fresh fruit juice is growing fast.

Risk also depends on the nature of barriers to entry to the company's market and whether or not alternative products exist. Nowadays barriers to entry tend to weaken constantly owing to:

• a powerful worldwide trend towards deregulation (there are fewer and fewer monopolies, e.g. in railways and postal services);
• technological advances (and in particular the Internet);
• a strong trend towards internationalisation.

All these factors have increased the number of potential competitors and made the barriers to entry erected by existing players far less sturdy.

For instance, the five record industry majors – Sony, Bertelsmann, Universal, Warner and EMI – had achieved worldwide domination of their market, with a combined market share of 80%. Nevertheless, they have seen their grip loosened by the development of the Internet and artists' ability to sell their products directly to consumers through music downloads – not to mention the impact of piracy!

(d) Market share

The position held by a company in its market is reflected by its market share, which indicates the share of business in the market (in volume or value terms) achieved by the company.

A company with substantial market share has the advantage of:

• some degree of loyalty among its customers, who regularly make purchases from the company. As a result, the company reduces the volatility of its business;
• a strong bargaining position vis-à-vis its customers and suppliers. Mass retailers are a perfect example of this;
• an attractive position which means that any small producer wishing to put itself up for sale, any inventor of a new product or new technique or any talented new graduate will usually come to see this market leader first, because a company with a large market share is a force to be reckoned with in its market.

That said, just because market share is quantifiable does not mean that the numbers are always relevant. For instance, market share is meaningless in the construction and public works market (and indeed is never calculated). Customers in this sector do not renew their purchases on a regular basis (town halls, swimming pools and roads have a long useful life). Even if they do, contracts are awarded through a bidding process, meaning that there is no special link between customers and suppliers. Likewise, building up market share by slashing prices without being able to hold onto the market share accumulated after prices are raised again is pointless. This inability demonstrates the second limit on the importance of market share: the acquisition of market share must create value, otherwise it serves no purpose.

Lastly, market share is not the same as size. For instance, a large share of a small market is far more valuable than middling sales in a vast market.

(e) The competition

If the market is expanding, it is better to have smaller rivals than several large ones with the financial and marketing clout to cream off all the market's expansion. Where possible, it is best not to try to compete against the likes of Google. Conversely, if the market has reached maturity, it is better for the few remaining companies which have specialised in particular niches to be faced with large rivals that will not take the risk of attacking them because the potential gains would be too small. Conversely, a stable market with a large number of small rivals frequently degenerates into a price war that drives some players out of business.

But since a company cannot choose its rivals, it is important to understand what drives them. Some rivals may be pursuing power or scale-related targets (e.g. biggest turnover in the industry) that are frequently far from profitability targets. Consequently, it is very hard for groups pursuing profitability targets to grow in such conditions. So how can a company achieve profitability when its main rivals, e.g. farming cooperatives in the canned vegetables sector, are not profit-driven? It is very hard indeed because it will struggle to develop since it will generate weak profits and thus have few resources at its disposal.

(f) How does competition work?

Roughly speaking, competition is driven either by prices or by products:

• Where competition is price-driven, pricing is the main–if not the only–factor that clinches a purchase. Consequently, costs need to be kept under tight control so that products are manufactured as cheaply as possible, product lines need to be streamlined to maximise economies of scale and the production process needs to be automated as far as possible. Market share is a key success factor since higher sales volumes help keep down unit costs (see Boston Consulting Group's famous experience curve which shows that unit costs fall by 20% when total production volumes double in size). This is where engineers and financial controllers are most at home! It applies to markets such as petrol, milk, phone calls, and so on.
• Where competition is product-driven, customers make purchases based on after-sales service, quality, image, etc., which are not necessarily price-related. Therefore, companies attempt to set themselves apart from their rivals and pay close attention to their sales and customer loyalty techniques. This is where the marketing specialists are in demand! Think about Nespresso's quality of product and service, Harrods's atmosphere or, of course, Apple.

The real world is never quite as simple, and competition is rarely only price- or product-driven but is usually dominated by one or the other or may even be a combination of both, e.g. vitamin-enhanced milk, caller-display services for phone calls, bio wine.

(a) Value chain

A value chain comprises all the companies involved in the manufacturing process, from the raw materials to the end product. Depending on the exact circumstances, a value chain may encompass the processing of raw materials, R&D, secondary processing, trading activities, a third or fourth processing process, further trading and lastly the end distributor. Increasingly in our service-oriented society, grey matter is the raw material, and processing is replaced by a series of services involving some degree of added value, with distribution retaining its role.

The point of analysing a value chain is to understand the role played by the market participants, as well as their respective strengths and weaknesses. Naturally, in times of crisis, all participants in the value chain come under pressure. But some of them will suffer more than others, and some may even disappear altogether because they are structurally in a weak position within the value chain. Analysts need to determine where the structural weaknesses lie. They must be able to look beyond good performance when times are good because it may conceal such weaknesses. Analysts' ultimate goal is to identify where not to invest or not to lend within the value chain.

When studying a value chain, analysts need to identify weaknesses where a particular category of player has no or very little room for manoeuvre (scope for developing new lines of business for selling operating assets with value independent of their current use, etc.).

(b) Production models

In a service-dominated economy, the production models used by an industrial company are rarely analysed, even though we believe this is a very worthwhile exercise.

The first step is to establish whether the company assumes responsibility for or subcontracts the production function, whether production takes place locally or whether it has been transferred to low-labour-cost countries and whether the labour force is made up of permanent or temporary staff, etc. This step allows the analyst to measure the flexibility of the income statement in the event of a recession or strong growth in the market.

In doing so, the analyst can detect any inconsistency between the product and the industrial organisation adopted to produce it. As indicated in the following chart, there are four different types of industrial organisations:

Source: Adapted from J.C. Tarondeau

The project-type organisation falls outside the scope of financial analysis. Although it exists, its economic impact is very modest indeed.

The workshop model may be adopted by craftsmen, in the luxury goods sector or for research purposes, but as soon as a product starts to develop, the workshop model should be discarded as soon as possible.

Mass production is suitable for products with a low unit cost, but gives rise to very high working capital owing to the inventories of semi-finished goods that provide its flexibility. With this type of organisation, barriers to entry are low because as soon as a process designer develops an innovative method, it can be sold to all the market players. This type of production is frequently relocated to emerging markets.

Process-specific production is a type of industrial organisation that took shape in the late 1970s and revolutionised production methods. It has led to a major decline in working capital because inventories of semi-finished goods have almost disappeared. It is a continuous production process from the raw material to the end product, which requires the suppliers, subcontractors and producers to be located close to each other and to work on a just-in-time basis. This type of production is hard to relocate to countries with low labour costs owing to its complexity (fine-tuning), and it does not provide any flexibility given the elimination of the inventories of semi-finished goods. A strike affecting a supplier or subcontractor may bring the entire group to a standstill.

The natural tendency for all industries is to evolve gradually, mirroring trends in the motor industry during the 20th century.

But readers should not allow themselves to get carried away with the details of these industrial processes. Instead, they should examine the pros and cons of each process and consider how well the company's business strategy fits with its selected production model. Workshops will never be able to deliver the same volumes as mass production!

(c) Capital expenditure

A company should not invest too early in the production process. When a new product is launched on the market, there is an initial phase during which the product must show that it is well suited to consumers' needs. Then the product will evolve, more minor new features will be built in and its sales will increase.

From then on, the priority is to lower costs; all attention and attempts at innovation will then gradually shift from the product to the production model.

Source: Utterback and Abernathy (1975)

Investing too early in the production process is a mistake for two reasons. Firstly, money should not be invested in production facilities that are not yet stable and might even have to be abandoned. Secondly, it is preferable to use the same funds to anchor the product more firmly in its market through technical innovation and marketing campaigns. Consequently, it may be wiser to outsource the production process and not incur production-related risks on top of the product risk. Conversely, once the production process has stabilised, it is in the company's best interests to invest in securing a tighter grip over the production process and unlocking productivity gains that will lead to lower costs.

More and more, companies are looking to outsource their manufacturing or service operations, thereby reducing their core expertise to project design and management. Roughly speaking, companies in the past were geared mainly to production and had a vertical organisation structure because value was concentrated in the production function. Nowadays, in a large number of sectors (telecoms equipment, computer production, etc.), value lies primarily in the research, innovation and marketing functions.

Companies therefore have to be able to organise and coordinate production carried out externally. This outsourcing trend has given rise to companies such as Foxconn, Solectron, and Flextronics, whose sole expertise is industrial manufacturing and who are able to secure low costs and prices by leveraging economies of scale because they produce items on behalf of several competing groups.

(a) Shareholders

From a purely financial standpoint, the most important men and women of a company are its shareholders. They appoint its executives and determine its strategy. It is important to know who they are and what their aims are, as we will see in Chapter 41. There are two types of shareholder, namely inside and outside shareholders.

Inside shareholders are shareholders who also perform a role within the company, usually with management responsibilities. This fosters strong attachment to the company and sometimes leads to the pursuit of scale-, power- and prestige-related objectives that may have very little to do with financial targets. Outside shareholders do not work within the company and behave in a purely financial manner.

What sets inside shareholders apart is that they assume substantial personal risks because both their assets and income are dependent on the same source, i.e. the company. Consequently, inside shareholders usually pay closer attention than a manager who is not a shareholder and whose wealth is only partly tied up in the company. Nonetheless, the danger is that inside shareholders may not take the right decisions, e.g. to shut down a unit, dispose of a business or discontinue an unsuccessful diversification venture, owing to emotional ties or out of obstinacy. The Kirch Group would probably have fared better during the early 2000s had the group's founder not clung on to his position as CEO well into retirement age and had groomed a successor.

Outside shareholders have a natural advantage. Because their behaviour is guided purely by financial criteria, they will serve as a very useful touchstone for the group's strategy and financial policy. That said, if the company runs into problems, they may act very passively and show a lack of resolve that will not help managers very much.

Analysts should watch out for conflicts among shareholders that may paralyse the normal life of the company. As an example, disputes among the founding family members almost ruined Gucci.

(b) Managers

It is important to understand the managers' objectives and attitude vis-à-vis shareholders. The reader needs to bear in mind that the widespread development of share-option-based incentive systems in particular has aligned the managers' financial interests with those of shareholders. We will examine this topic in greater depth in Chapter 26.

We would advise readers to be very cautious where incentive systems have been extended to include the majority of a company's employees. Firstly, stock options cannot yet be used to buy food or pay rents and so salaries must remain the main source of income for unskilled employees. Secondly, should a company's position start to deteriorate, its top talent will be fairly quick to jump ship after having exercised their stock options before they become worthless. Those that remain on board may fail to grasp what is happening until it is too late, thereby losing precious time. This is what happened to so-called new economy companies, which distributed stock options as a standard form of remuneration. It is an ideal system when everything is going well, but highly dangerous in the event of a crisis because it exacerbates the company's difficulties.

(c) Corporate culture

Corporate culture is probably very difficult for an outside observer to assess. Nonetheless, it represents a key factor, particularly when a company embarks on acquisitions or diversification ventures. A monolithic and highly centralised company with specific expertise in a limited number of products will struggle to diversify its businesses because it will probably seek to apply the same methods to its target, thereby disrupting the ?latter's impetus.

For instance, Daimler of Germany acquired US car producer Chrysler, but the deal never really worked because Daimler's structured and hierarchical culture was far removed from the young and innovative culture prevailing in Chrysler at the time.