Industries

1. Airline Industry

2. Oil Services Industry

3. Precious Metals

4. Automobiles

5. Retailing Industry

6. Banking Industry

7. Biotechnology

8. Semiconductor Industry

9. Insurance Industry

10. Telecommunications Industry

11. Utilties Industry

12. Internet Industry

Internet Industry

Let's face it, the current climate for internet portal companies is a cold one. In the wake of the internet market crash, portal players are taking a closer look at their business models. The pressure is on to transform users into paying customers - converting them into hard cash. While seeking to reduce churn and reach new markets, they are also searching for new revenue streams - ones that actually produce the goods.

The first web portals were online services, such as AOL, that provided access to the web. Others were search engines like Alta Vista and Excite that offered users ways of finding the information they were looking for on the web. But by now most of the traditional search engines have transformed themselves into multipurpose web portals to attract and keep a larger audience. At a consumer internet portal like Yahoo!, a whole host of information and services can be found. Check email, update you investment portfolio, shop for a car or vacation, do research for a term paper or even join a discussion group. Portals users can do it all.

Users rarely have to pay a dime for portal services. In a bid to replicate the broadcast TV revenue model, portals supply free content and services that will attract enough users to make a profit from advertising alone. Indeed, as online usage continues to increase - thanks at least in part to the vast amount of free information and services that are offered - this appears to make sense.

Yet at the same time, it costs money to service such a vast pool of freeloaders. Costs associated with attracting and keeping users - namely the costs of marketing, sales, content purchasing and production, plus reliable delivery - could actually eliminate bottom-line gains from greater usage. Over-reliance on the advertising as the prime, and more frequently, the sole revenue stream can be a risky proposition, especially given the volatile nature of the advertising market.

A portfolio of revenue-generation sources appears to be the way forward, and portal operators are starting to open up to new models. The search for real revenues has led the move toward charging for content. The big challenge will be to significantly expand paid services without alienating users who've come to expect portals to be free. Meanwhile, portals are pitching themselves as eCommerce sites, hoping to enjoy some of the same successes of online retail portals like Amazon.com.

Key Ratios/Terms

Click-Through Rate (CTR): Measures what percentage of people clicked on the ad to arrive at the destination site. As such, the CTR is regarded as a measure of the immediate response to an online advertisement.

"Stickiness" Factor: Otherwise known as the average time spent per user on a web portal, this metric directly relates to the loyalty of users, which translates into brand and market power.

Burn Rate: The rate at which a portal is spending its capital while waiting for profitable operation. Most internet companies, still in their early stages of development, tend to spend cash faster than they can generate revenue.

Alliances: Who are the portal's customers, allies and distribution partners? Obviously, this is a difficult factor to measure. But without a strong network of alliances, especially distribution partners, which are key to audience reach and expansion, a portal will have a hard time surviving.

X-Rated: The dirty secret of the internet, porn portals account for vast amounts of traffic and enormous revenues. This sub-industry offers lessons for the whole internet industry: when users really value online content, they pay for it.

Analyst Insight
Survivors of the dotcom crash range from loss-making portal operators with extremely questionable merit, to a handful of firms able to squeeze out some profits. Given online companies' brief track records, combined with the sharp swings in growth trends and profitability, investment decisions can be challenging, to say the least.

One thing is for sure: the biggest portals attract the biggest advertising revenue. The bulk of web advertising spending consistently goes to sites with the highest volumes of traffic.

Reliance on the advertising-supported model as the prime revenue stream for portals can be risky. Ad spending has a big discretionary component that is subject to the whims of often fickle and volatile advertising buyers. Shifting consumer demand and corporate investment levels have a big impact. For a lot of portals, this translates into unpredictable revenues; in down markets, non-advertising internet players tend to enjoy better valuations than advertising specialists. In a nutshell, investors should keep a close eye on current trends in advertising, and try to monitor the pulse of leading advertisers.

Analysts typically rely on comparative ratios to gauge value. One measure has gained general acceptance: the ratio of stock price to annualized sales, or revenue per share. The popularity of the price to sales ratio (reflects the belief that it's more important for internet portals to grow revenue than profit; revenue is a proxy for marketplace acceptance and market share.)

EV/EBITDA is another common, albeit increasingly criticized, industry yardstick. EV, or enterprise value, is equivalent to the company's market capitalization less any long-term debt. Earnings before interest, tax, depreciation and amortization (EBITDA) is calculated as revenue minus expenses (excluding tax, interest, depreciation and amortization). (For more insight, read EV Gets Into Gear.)

Both price/sales and EV/EBITDA, comparisons are not as straightforward as traditional price-earnings ratios (P/E ratio). Earnings means essentially the same thing regardless of industry or sector, but revenue and EBITDA demand closer consideration of the nature of the business.

Consider Yahoo!, a multipurpose service portal, and retail portal Amazon.com. Comparing the two can be tricky. Retailers' revenues and expenses differ markedly from those of service providers. Amazon immediately pays out of revenue the cost of merchandise and shipping. Yahoo doesn't sell merchandise; its revenues come from selling ad space to those who do. The costs of supporting additional content, advertisers and usage are tiny compared to paying for books and CDs. Expect Yahoo! to enjoy a premium valuation over Amazon.

But simply comparing portal stocks against one another says nothing about their intrinsic value. When there is a major correction in the overall stock market, or simply in the internet sector, portals that appear under-valued relative to peers can be battered just as hard, if not even more. Indeed, the news and sentiment that so heavily impacts portal stocks can wipe out quantitative measures of valuation. With empirical value carrying less weight than in other sectors, internet investors will find that it pays to be cautious.

Porter's 5 Forces Analysis

1. Threat of New Entrants. You do not need to look far to realize that the cost of entry has fallen fast. It used to costs an arm and a leg to launch a portal. The price of computer software and servers and network bandwidth - of which portals consume a substantial amount - was enormous. Yet costs are falling fast, as off-the shelf systems can now do what only customized technologies could do just a few of years ago and at a fraction of the price. At the same time, brainy web developers, which were scarce at the height of the internet market boom, are now much easier for new entrants to find and have become more affordable keep. However, the apparent success of companies like Amazon, is not based on their low entry cost into book retailing, but the very large sums of money spent on promotion and growing their business. Entering a new market with a new brand still calls for deep pockets.
2. Power of Suppliers. Portals generally have little power over suppliers. Basically, this is because they don't actually own much. Most of the information and services they deliver to users is supplied by outside companies – stock brokerages, new magazines and the like. Expect content suppliers to enjoy growing power, especially considering portals will not able to give content away forever. At the same time, internet portals rely on telecom network operators for a steady diet of internet bandwidth. Granted, the telecom bandwidth business is getting increasingly competitive and prices are falling fast. But once systems are hooked up to telecom operator networks, it can be awfully difficult to switch to a new supplier.
3. Power of Buyers. Internet portals have two sets of buyers: visitors and advertisers. Both enjoy considerable power over portals. Competing sites are just a click away; URL book-marking makes the job of switching to other sites even easier for users. In fact, portals are in constant danger of a mass desertion of users to other sites because in most cases, customers make no financial commitment to the service. Portals' heavy reliance on advertising dollars means that ad spenders can squeeze increasingly better terms for banner space.
4. Availability of Substitutes. Internet portals must defend themselves from a raft of substitutes. The most obvious are other websites that offer the same, or similar, information and services. Most portals do little more than aggregate information and services that already exists on the internet; original content suppliers represent a readily available set of substitutes. In most cases, they are just a click away. There are more, less obvious substitutes as well, such as television and magazines. Television's clear, moving images never suffer slow connections; magazines can be rolled up and carried on the bus. Don't forget that the good old telephone directories - both white and yellow pages - are still very convenient business search tools.
5. Competitive Rivalry. Feeble barriers to entry, a slew of substitutes and steadily increasingly buyer power combine to create a disturbing impact: fierce competition and industry rivalry. Portal competitors now must lure customers with lower prices and heavy investment in more exciting content services. All of this tends to drive industry profitability down, threatening the survival of players who can't compete.

Key Links

• Internet Week - Industry news and analysis
• Traffick - The information portal for the portal and search engine industry
• Nielsen/NetRatings - Provides a listing of the most-visited Internet sites, updated weekly and monthly

Utilties Industry

You've probably noticed that the utilities industry is not quite what it used to be. Once considered the quintessential safe widow-and-orphan stocks, electricity companies are undergoing big changes as they respond to regulatory changes, demand fluctuations and price volatility and new competition.

In the past, big regional monopolies ran the whole show, all the way from power generation through to retail supply. But we are starting to see some disintegration of the industry structures that once led the electricity industry. Broadly speaking, the industry is breaking down into four supplier segments:

• Generators: These operators create electrical power. While established utilities continue to build and operate plants that produce electricity, a growing number of so-called "merchant generators" build power capacity on a speculative basis or have acquired utility-divested plants. These companies then market their output at competitive rates in unregulated markets.
• Energy Network Operators: Grid operators, regional network operators and distribution network operators sell access to their networks to retail service providers. Heavily regulated, they operate as so-called natural monopolies, because investments made to duplicate their far-reaching networks would be not only overly expensive, but also redundant.
• Energy Traders and Marketers: By buying and selling energy futures and other derivatives and creating complex "structured products," these companies do something very useful: they help utilities and power-hungry businesses secure a dependable supply of electricity at a stable, predictable price. Traders can also boost their returns by wagering on the direction of power prices.
• Energy Service Providers and Retailers: In most U.S. states, consumers can now choose their own retail service providers. In places where the electricity grid has been opened to third parties, new players are entering the market. They buy power at competitive prices from transmission operators and energy traders and then sell it to end users - often competitively bundled with gas, water and even financial services.

Expect consumption of electricity to swell as the world becomes increasingly electrified. The Energy Information Administration projects that 355 gigawatts of new electric generating capacity - or more than 40% more than the industry currently supplies - will be needed by 2020 to meet growing demand.

While upward consumption growth is almost guaranteed over the coming decades, the short-term direction of the market still remains a risky bet. Demand for electricity - whether it's used to run heaters or air conditioners - fluctuates on a daily and seasonal basis. An unusually mild winter, for instance, can moderate consumption and squeeze generator revenues. Gauging the appropriate level of investment in generation capacity is never an easy task.

At the same time, wholesale electricity prices are no longer set by regulatory agencies; for the most part, they are free to fluctuate with supply and demand. This heightens the risk of uncontrollable price increases. Electricity typically costs $10 to $20 per megawatt hour. But if conditions are right, it can very quickly go to $5,000 or $10,000 per megawatt hour. Wrestling with pricing risk is a full-time job for utility managers. In a deregulated market, forwards and futures options provide energy buyers with the tools to help hedge against unexpected price swings.

Despite efforts to loosen up the industry, authorities are still not completely comfortable leaving utilities alone to the vagaries of the market. The U.S. wholesale market was deregulated in 1996, and the industry has been further liberated on a state-by-state basis since. The process, however, is often marked by political wrangling between consumer and other special-interest groups. Regarded by authorities as natural monopolies, transmission and distribution operations will likely remain highly regulated service areas. Legislators, sensitive to fall-out from unexpected price spikes, want to have a say on retail pricing.

Power generation is a lightning rod for environmental regulation. Approval for new coal-powered plants is tough to obtain, despite much progress in developing so-called cleaner coal. Natural gas burns cleaner than coal, but still creates some emissions. Nuclear plants, which supply about 20% of U.S. electric power, still operate under the shadow of the Three Mile Island and Chernobyl accidents. The push for cleaner energy ignites interest in renewable sources like hydro power but also solar, wind and biomass. Regulation and environmental issues will likely remain at the top of utility boardroom agendas.

Key Ratios/Terms

Power Purchase Agreements (PPA): A contract entered into by a power producer and its customers. PPAs require the power producer to take on the risk of supplying power at a specified price for the life of the agreement - regardless of price fluctuations.

Megawatt Hour: The basic industrial unit for pricing electricity, equal to one thousand kilowatts of power supplied continuously for one hour. One kWh equals 1,000 watt hours. One kWh = 3.306 cubic feet of natural gas. An average household uses 0.8 to 1.3 MWh/month.

Load: The amount of electricity delivered or required at any specific point or points on a system. The load of an electricity system is affected by many factors and changes on a daily, seasonal and annual basis. Load management attempts to shift load from peak use periods to other periods of the day or year.

Federal Energy Regulatory Commission (FERC): Regulation in the U.S. electricity industry is provided by the Federal Energy Regulatory Commission, which oversees rates and service standards as well as interstate power transmission.

Public Utility Holding Company Act: Enacted during the Great Depression, this act was designed to prevent industry consolidation. Utility executives speculate that the act's repeal will unleash a wave of mergers among publicly traded utility firms.

Analyst Insight
The allure of utility and power as investment safe havens has faded as new and riskier business models populate the industry. Utility monopolies once attracted investors with reliable earnings and fat dividends; today the same companies, operating in open markets, divert cash into expansion opportunities while they try to keep growth-hungry competitors at bay. As the utility industry evolves, as markets grow more volatile and as regulations change, investors can expect more lucrative opportunities. Simultaneously, they must learn to embrace more risk.

Firms that make the bulk of their money from wholesale trading, arguably carry the highest risk. Their shares react instantaneously to wholesale energy markets' wild price swings, credit ratings, and news headlines. Power trading companies can make a lot of money for investors, but they can also lose them a lot. They demand close investor scrutiny.

Risk-averse investors should, for the moment, seek out players with features that best reflect those of the old fashioned monopolies: power transmission and distribution. Still regulated, these companies are largely buffered from wild swings of commodity trading and prices. On the other hand, they offer - at best - only modest returns.

Investors ought to keep an eye on debt levels. High debt puts a strain on credit ratings, weakening new power generators' ability to finance capital expenditure. Poor credit ratings make it awfully difficult for traders to purchase energy contracts on the open market. Leverage, measured as debt/equity ratio, offers a good instrument for comparing indebtedness and credit worthiness. Rating agencies like Moody's and Standard & Poor's (S&P) say 50% is a prudent ratio for merchant power operators. Companies in more stable, regulated markets can afford debt/equity ratios that are a tad higher.

While utility stocks are no longer synonymous with big dividends, that doesn't mean that dividends no longer matter. Utilities still go to great lengths to ensure distribution of cash to shareholders; relative to others, the industry offers good income potential. Dividend yield, measured as the annual dividend/market price at the time of purchase, probably offers the best tool for gauging the income generated by utilities stocks. Besides, a solid dividend yield suggests a more attractive proposition for conservative investors.

Don't ignore the good old price-earnings ratio (P/E) P/E ratio. It remains the key yardstick for comparing players in the industry.

Value in the utilities industry will be determined not only by the health of the companies' balance sheets and income statements, but by their corporate reputations as well. In an industry that is under constant scrutiny by regulators, environmentalists and ordinary people, corporate image really matters.

Porter's 5 Forces Analysis

1. Threat of New Entrants. Incumbent utility players enjoy considerable barriers to entry. Setting up new generation plants carries high fixed costs and new power producers need a lot of upfront capital to enter the market. Gaining regulatory approval to build new plants can be a long and complicated process for merchant generators. Achieving brand-name recognition and the trust required to convince consumers to switch from incumbent utility providers is not just costly but also time consuming. Meanwhile, once a power plant is built and a market established, the cost of serving one more customer or offering one more kilowatt-hour is minimal. This is a barrier because new entrants can only hope to realize similar unit costs by rapidly capturing a large market share. There is also a relative shortage of talented, experienced managers for which new entrants must compete. Nonetheless, the structural unbundling trend does offer entry opportunities, especially at the trading and retailing end of the market where upfront capital requirements are less onerous.
2. Power of Suppliers. The power systems supply business is dominated by a small handful of companies. There isn't a lot of cut-throat competition between them; they have significant power over generation companies. Meanwhile, as the industry's vertical structures dissolve into a chain of generation suppliers, network suppliers, traders and retailers expect the leverage of any one of them to be reduced. As profits are spread over more players, each one's share will shrink.
3. Power of Buyers. The balance of power is shifting toward buyers. Because one company's electricity is no different from another's, service can be treated as a commodity. This translates into buyers seeking lower prices and better contract terms from energy providers. Commercial and industrial customers, in particular, have great leverage. Long-term power purchasing agreements, for instance, are now the norm for commercial buyers; by replacing more traditional short-term contracts, these shift much of the risk associated with wholesale pricing from buyers and onto utilities. Meanwhile, consumers are forming online communities and buying groups and cooperatives in bids to bolster their market power. As the industry becomes more competitive, customers ought to enjoy more power over utilities.
4. Availability of Substitutes. Power doesn't have a substitute; it is a necessity in the modern world. Short-term demand for power is inelastic. This means that price hikes do little to diminish consumption, at least in the near term. However, while there are no existing substitutes for electrons or natural gas, there are alternative ways of generating them. Industrial groups have launched programs to develop small generators. Microturbines and fuel cells are on the market horizon. These small generators could allow users to bypass traditional power grids altogether, or to limit the use of the grid when prices rise too much over time.
5. Competitive Rivalry. Rivalry among competitors is getting increasingly fierce. Utilities must fight for market share in order to create the economies of scale needed to lower costs and remain competitive. Because nearly everybody already uses a utility, competitors are forced to rely mainly on lower prices and to capture market share. This tends to drive industry profitability down. Competitors try to break out of commoditization by trying to differentiate services, segmenting the market and bundling value-added services. However, the characteristics of the electricity market threaten to neutralize such efforts.

Key Links

• Platts Global Energy - A comprehensive source of online business new/analysis
• Energy & Utilities Review - Published by the Financial Times - online news and analysis/special reports
• McKinsey Quarterly - This energy, resources and materials page contains useful articles covering industry issues

Telecommunications Industry

Think of telecommunications as the world's biggest machine. Strung together by complex networks, telephones, mobile phones and internet-linked PCs, the global system touches nearly all of us. It allows us to speak, share thoughts and do business with nearly anyone, regardless of where in the world they might be. Telecom operating companies make all this happen.

Not long ago, the telecommunications industry was comprised of a club of big national and regional operators. Over the past decade, the industry has been swept up in rapid deregulation and innovation. In many countries around the world, government monopolies are now privatized and they face a plethora of new competitors. Traditional markets have been turned upside down, as the growth in mobile services out paces the fixed line and the internet starts to replace voice as the staple business.

Plain old telephone calls continue to be the industry's biggest revenue generator, but thanks to advances in network technology, this is changing. Telecom is less about voice and increasingly about text and images. High-speed internet access, which delivers computer-based data applications such as broadband information services and interactive entertainment, is rapidly making its way into homes and businesses around the world. The main broadband telecom technology - Digital Subscriber Line (DSL) - ushers in the new era. The fastest growth comes from services delivered over mobile networks.

Of all the customer markets, residential and small business markets are arguably the toughest. With literally hundreds of players in the market, competitors rely heavily on price to slog it out for households' monthly checks; success rests largely on brand name strength and heavy investment in efficient billing systems. The corporate market, on the other hand, remains the industry's favorite. Big corporate customers - concerned mostly about the quality and reliability of their telephone calls and data delivery - are less price-sensitive than residential customers. Large multinationals, for instance, spend heavily on telecom infrastructure to support far-flung operations. They are also happy to pay for premium services like high-security private networks and videoconferencing.

Telecom operators also make money by providing network connectivity to other telecom companies that need it, and by wholesaling circuits to heavy network users like internet service providers and large corporations. Interconnected and wholesale markets favor those players with far-reaching networks.

Key Ratios/Terms

Earnings Before Interest, Taxes, Depreciation and Amortization (EBITDA): An indicator of a company's financial performance calculated as revenue less expenses (excluding tax, interest, depreciation and amortization).

Churn Rate: The rate at which customers leave for a competitor. Largely due to fierce competition, the telecom industry boasts - or, rather, suffers - the highest customer churn rate of any industry. Strong brand name marketing and service quality tends to mitigate churn.

Average Revenue Per User (ARPU): Used most in the context of a telecom operator's subscriber base, ARPU sometimes offers a useful measure of growth performance. ARPU levels get tougher to sustain competition, and increased churn exerts a downward pressure. ARPU for data services have been slowly increasing.

Broadband: High-speed internet access technology.

Telecommunications Act: Enacted by the U.S. Congress on February 1, 1996, and signed into law by President Bill Clinton in 1996, the law's main purpose was to stimulate competition in the U.S. telecom sector.

Analyst Insight
It is hard to avoid the conclusion that size matters in telecom. It is an expensive business; contenders need to be large enough and produce sufficient cash flow to absorb the costs of expanding networks and services that become obsolete seemingly overnight. Transmission systems need to be replaced as frequently as every two years. Big companies that own extensive networks - especially local networks that stretch directly into customers' homes and businesses - are less reliant on interconnecting with other companies to get calls and data to their final destinations. By contrast, smaller players must pay for interconnection more often in order to finish the job. For little operators hoping to grow big some day, the financial challenges of keeping up with rapid technological change and depreciation can be monumental.

Earnings can be a tricky issue when analyzing telecom companies. Many companies have little or no earnings to speak of. Analysts, as a result, are often forced to turn to measures besides price-earnings ratio (P/E) to gauge valuation.

Price-to-sales ratio (price/sales) is the probably simplest of the valuation approaches: take the market capitalization of a company and divide it by sales over the past 12 months. No estimates are involved. The lower the ratio, the better. Price/sales is a reasonably effective alternative when evaluating telecom companies that have no earnings; it is also useful in evaluating mature companies.

Another popular performance yardstick is EBITDA. EBITDA provides a way for investors to gauge the profit performance and operating results of telecom companies with large capital expenses. Companies that have spent heavily on infrastructure will generally report large losses in their earnings statements. EBITDA helps determine whether that new multimillion dollar fiberoptic network, for instance, is making money each month, or losing even more. By stripping away interest, taxes and capital expenses, it allows investors to analyze whether the baseline business is profitable on a regular basis.

Investors should be mindful of cash flow. EBITDA gives an indication of profitability, whereas cash flow measures how much money is actually flowing through the telecom operator at any given period of time. Is the company making enough to repay its loans and cover working capital? A telecom company can be recording rising profits year-by-year while its cash flow is ebbing away. Cash flow is the sum of new borrowings plus money from any share issues, plus trading profit, plus any depreciation.

Keep an eye on the balance sheet and borrowing. Telecom operators frequently have to ring up substantial debt to finance capital expenditure. Net debt/EBITDA provides a useful comparative measure. Again, the lower the ratio, the more comfortably the operator can handle its debt obligations. Credit rating agencies like Moody's and Standard & Poor's (S&P) take this ratio very seriously when evaluating operators' borrowing risk.


Porter's 5 Forces Analysis

1. Threat of New Entrants. It comes as no surprise that in the capital-intensive telecom industry the biggest barrier to entry is access to finance. To cover high fixed costs, serious contenders typically require a lot of cash. When capital markets are generous, the threat of competitive entrants escalates. When financing opportunities are less readily available, the pace of entry slows. Meanwhile, ownership of a telecom license can represent a huge barrier to entry. In the U.S., for instance, fledgling telecom operators must still apply to the Federal Communications Commission (FCC) to receive regulatory approval and licensing. There is also a finite amount of "good" radio spectrum that lends itself to mobile voice and data applications. In addition, it is important to remember that solid operating skills and management experience is fairly scarce, making entry even more difficult.
2. Power of Suppliers. At first glance, it might look like telecom equipment suppliers have considerable bargaining power over telecom operators. Indeed, without high-tech broadband switching equipment, fiber-optic cables, mobile handsets and billing software, telecom operators would not be able to do the job of transmitting voice and data from place to place. But there are actually a number of large equipment makers around. There are enough vendors, arguably, to dilute bargaining power. The limited pool of talented managers and engineers, especially those well versed in the latest technologies, places companies in a weak position in terms of hiring and salaries.
3. Power of Buyers. With increased choice of telecom products and services, the bargaining power of buyers is rising. Let's face it; telephone and data services do not vary much, regardless of which companies are selling them. For the most part, basic services are treated as a commodity. This translates into customers seeking low prices from companies that offer reliable service. At the same time, buyer power can vary somewhat between market segments. While switching costs are relatively low for residential telecom customers, they can get higher for larger business customers, especially those that rely more on customized products and services.
4. Availability of Substitutes. Products and services from non-traditional telecom industries pose serious substitution threats. Cable TV and satellite operators now compete for buyers. The cable guys, with their own direct lines into homes, offer broadband internet services, and satellite links can substitute for high-speed business networking needs. Railways and energy utility companies are laying miles of high-capacity telecom network alongside their own track and pipeline assets. Just as worrying for telecom operators is the internet: it is becoming a viable vehicle for cut-rate voice calls. Delivered by ISPs - not telecom operators - "internet telephony" could take a big bite out of telecom companies' core voice revenues.
5. Competitive Rivalry. Competition is "cut throat". The wave of industry deregulation together with the receptive capital markets of the late 1990s paved the way for a rush of new entrants. New technology is prompting a raft of substitute services. Nearly everybody already pays for phone services, so all competitors now must lure customers with lower prices and more exciting services. This tends to drive industry profitability down. In addition to low profits, the telecom industry suffers from high exit barriers, mainly due to its specialized equipment. Networks and billing systems cannot really be used for much else, and their swift obsolescence makes liquidation pretty difficult.

Key Links

· Telecommunications – A monthly magazine and that website provides news and analysis on the global telecom industry.

· The Federal Communications Commission – The U.S. government's telecom regulatory body.

Insurance Industry

As a result of globalization, deregulation and terrorist attacks, the insurance industry has gone through a tremendous transformation over the past decade.

In the simplest terms, insurance of any type is all about managing risk. For example, in life insurance, the insurance company attempts to manage mortality (death) rates among its clients. The insurance company collects premiums from policy holders, invests the money (usually in low risk investments), and then reimburses this money once the person passes away or the policy matures. A person called an actuary constantly crunches demographic data to estimate the life of a person. This is why characteristics such as age/sex/smoker/etc. all affect the premium that a policy holder must pay. The greater the chance that a person will have a shorter life span than the average, the higher the premium that person will have to pay. This process is virtually the same for every other type of insurance, including automobile, health and property.

In the U.S., the Gramm-Leach-Bliley Act of 1999 legislated that banks, brokerages, insurance firms and other types of financial institutions can join together to offer their customers a more complete range of services. In the insurance business, this has led to a flurry of merger and acquisition activity. In fact, a majority of the liability insurance underwritten in the U.S. has been through big firms, which have also been scooping up other insurance names.

Ownership of insurance companies can come in two forms: shareholder ownership or policyholder ownership. If the company is owned by shareholders, it is like any other public company. That is, its shares trade on an exchange like the NYSE, and it is required to report earnings on a quarterly basis. The other type of ownership is called "mutually owned insurance companies." Here the company is actually owned by the policyholders, so an account called policyholder's surplus, rather than shareholder's equity, appears on the balance sheet. It should be mentioned that in recent years many of the top mutual insurance companies have gone through demutualization to become shareholder-owned. Today, only a small handful of companies are still policyholder-owned.

Types of Insurance
There are several major types of insurance policies. Some companies offer the entire suite of insurance, while others specialize in specific areas:

• Life Insurance - Insurance guaranteeing a specific sum of money to a designated beneficiary upon the death of the insured, or to the insured if he or she lives beyond a certain age.
• Health Insurance - Insurance against expenses incurred through illness of the insured.
• Liability Insurance - The miscellaneous category. This insures property such as automobiles, property and professional/business mishaps.

There are many factors to examine when looking at insurance companies. More than anything, both consumers and investors should concern themselves with the insurer's financial strength and ability to meet ongoing obligations to policyholders. Poor fundamentals not only indicate a poor investment opportunity, but also hinder growth. Nothing is worse than insurance customers discovering that their insurance company might not have the financial stability to pay out if it is faced with a large proportion of claims.

Over the years, there has been a big shift in the life insurance industry. Instead of offering straight insurance, the industry now tends to sell customers on more investment type products like annuities. As a result, insurance companies have been able to compete more directly with other financial services companies such as mutual funds and investment advisory firms. To capitalize on this, many insurance companies even offer services such as tax and estate planning.

Key Ratios/Terms

Return on Equity (ROE): Net Income
Shareholder's Equity

ROE indicates the return a company is generating on the owners' investments. In the policyholder owned case, you would use policy holders' surpluses as the denominator. As a general rule for insurance companies, ROE should lie between 10-15%.


Return on Assets (ROA): Net Income + Interest Expense
Total Assets

ROA indicates the return a company is generating on the firm's investments/assets. In general, a life insurer should have an ROA that falls in the 0.5-1% range.

Return on Total Revenue: Net Income
Total Revenue

This is another variation of the profitability ratios. The insurance industry average return is approximately 3%. If possible, use the premium income and investment income as the numerator to find the profitability of each area.

ROA indicates the return a company is generating on the firm's investments/assets. In general, a life insurer should have an ROA that falls in the 0.5-1% range.

Return on Total Revenue: Net Income
Total Revenue

This is another variation of the profitability ratios. The insurance industry average return is approximately 3%. If possible, use the premium income and investment income as the numerator to find the profitability of each area.

ROA indicates the return a company is generating on the firm's investments/assets. In general, a life insurer should have an ROA that falls in the 0.5-1% range.

Return on Total Revenue: Net Income
Total Revenue

This is another variation of the profitability ratios. The insurance industry average return is approximately 3%. If possible, use the premium income and investment income as the numerator to find the profitability of each area.

ROA indicates the return a company is generating on the firm's investments/assets. In general, a life insurer should have an ROA that falls in the 0.5-1% range.

Return on Total Revenue: Net Income
Total Revenue

This is another variation of the profitability ratios. The insurance industry average return is approximately 3%. If possible, use the premium income and investment income as the numerator to find the profitability of each area.

ROA indicates the return a company is generating on the firm's investments/assets. In general, a life insurer should have an ROA that falls in the 0.5-1% range.

Return on Total Revenue: Net Income
Total Revenue

This is another variation of the profitability ratios. The insurance industry average return is approximately 3%. If possible, use the premium income and investment income as the numerator to find the profitability of each area.

ROA indicates the return a company is generating on the firm's investments/assets. In general, a life insurer should have an ROA that falls in the 0.5-1% range.

Return on Total Revenue: Net Income
Total Revenue

This is another variation of the profitability ratios. The insurance industry average return is approximately 3%. If possible, use the premium income and investment income as the numerator to find the profitability of each area.

Reinsurance: This is the process of multiple insurers sharing an insurance policy to reduce the risk for each insurer. You can think of reinsurance as the insurance backing primary insurers against catastrophic losses.

The company transferring the risk is called the "ceding company"; the company receiving the risk is called the "assuming company" or "reinsurer."

Lapse Ratio: Lapsed Life Insurance Specified Period
Contracts in Force (in effect) at Start of Specified Period

This ratio compares the number of policies that have lapsed (expired) within a specified period of time to those in force at the start of that same period. It is a ratio used to measure the effectiveness of an insurer's marketing strategy. A lower lapse ratio is better, particularly because insurance companies pay high commissions to brokers and agents that refer new clients.

A.M. Best Ratings: A.M. Best dubs itself "The Insurance Information Source." This company provides data and research on almost every major insurance company in North America and abroad. Many analysts equate the quality of A.M. Best ratings to Moody's or Standard and Poor's bond ratings. A.M. Best ratings are so widely followed because they can usually obtain company information that wouldn't be accessible to the average person.

The A.M. ratings range from A++ (superior quality) to F (the company is in liquidation). If you are analyzing an insurance company, you may want to consider looking for the A.M. Best rating.

Analyst Insight
There are three major factors that we must consider when analyzing an insurance company. Coincidently, these are the same ones that the A.M. Best ratings (among other things) take into account.

1. Leverage. The first things you want to check when considering an insurance company are the quality and strength of the balance sheet. Everyday insurers are taking in premiums and paying out claims to policyholders. The ability to meet their obligations toward these policy holders is extremely important. Companies should strike a balance between high returns while keeping leverage intact. A company that is highly leveraged might not be able to meet financial obligations when a large catastrophic event occurs. The following three things act to increase leverage:
   
   1) Writing more insurance policies
   2) Dependence on reinsurance
   3) Use of debt
   
   Reinsurance allows a company to pass off some of the risk exposure to other insurers (usually a good thing), but be careful. Too much dependence on reinsurance means that the company is not keeping a fair portion of responsibility for each premium dollar.
2. Liquidity. The first test of an insurer's ability to meet financial obligations is the acid test. It tests whether a firm has enough short-term assets (without selling inventory) to cover its immediate liabilities. Also take a close look at cash flow. An insurer should almost always have a positive cash flow. Other things to keep an eye on are the investment grades of the company's bond portfolio. Too many high and medium risk bonds could lead to instability.
3. Profitability. As with any company, profitability is a key determinant for deciding whether to invest. For an insurance company, there are two components of profits that we must consider: premium/underwriting income and investment income.
   
   Underwriting income is just that: any revenue derived from issuing insurance policies. By averaging the premium's growth rates of several past years, you can determine the growth trends. Growing premium income is a "catch 22" for insurance companies. Ideally, you want the growth rate to exceed the industry average, but you want to be sure that this higher growth does not come at the expense of accepting higher-risk clients. Conversely, a company whose premium income is growing at a slower rate might be too picky, looking for only the highest quality insurance opportunities. The one thing to remember is that higher premium collections do not equate to higher profits. Lower numbers of claims (via low risk clients) contribute more to the bottom line.
   
   The second area of profitability that you need to include in your analysis is investment income. As we mentioned earlier, a greater proportion of an insurer's income comes from investments. To evaluate this area, take a look at the company's asset allocation strategy (usually mentioned in the notes of the financial statements). You aren't likely to find any secrets in this area. A majority of the assets should be invested in low-risk bonds, equities or money market securities. Some insurers invest a substantial portion of their assets in real estate. If this is so, take a look at what type of property it is and where it is located. A building in New York City is much more liquid than one in Boise, Idaho.
   
   ROA, ROE, and the lapse ratios (discussed above) are also useful for evaluating the profitability of the insurer. Calculate the ROA and ROE numbers over the past several years to determine whether management has been increasing return for shareholders. The lapse ratio will help to tell whether the company has managed to keep marketing expenses under control. The more policies that remain in force (are not canceled), the better.

Other Factors
Another major item that affects the performance of an insurance company is interest rate fluctuations. Insurance companies invest much of the collected premiums, so the income generated through investing activities is highly dependent on interest rates. Declining interest rates usually equate to slower investment income growth. Another downside to interest rate fluctuations (not exclusive to insurance companies) is the cost of borrowing. Find out when the company's debt matures and how high the interest rates are. If the company is about to borrow or reprice its debt, there could be a big shock to cash flows as interest expense rises.

Demographics play one of the largest roles in affecting sales for insurance, particularly life insurance. As people age, they tend to rely more and more on life insurance products for their retirement. Death benefit policies ensure that beneficiaries are financially secure once the insured dies, but in more recent years, the insurance industry has made great headway in offering investment/savings type insurance products. Because baby boomers are quickly approaching retirement age, take a close look at the suite of insurance products that the company is offering and, from that, see if it stands to benefit from this large portion of the population getting older.

The one problem with analyzing insurance companies is that the disclosure usually isn't enough. Proper analysis requires substantial disclosure of things like reserve ratios, exposure to catastrophic/environmental loss and details of the company's operations. This isn't to say that the financial statements are not enough for adequate analysis, but to dig really deep, a person needs more information. We should also note that A.M. Best ratings take all of this information and more into account when they determine their ratings.

Porter's 5 Forces Analysis

1. Threat of New Entrants. The average entrepreneur can't come along and start a large insurance company. The threat of new entrants lies within the insurance industry itself. Some companies have carved out niche areas in which they underwrite insurance. These insurance companies are fearful of being squeezed out by the big players. Another threat for many insurance companies is other financial services companies entering the market. What would it take for a bank or investment bank to start offering insurance products? In some countries, only regulations that prevent banks and other financial firms from entering the industry. If those barriers were ever broken down, like they were in the U.S. with the Gramm-Leach-Bliley Act of 1999, you can be sure that the floodgates will open.
2. Power of Suppliers. The suppliers of capital might not pose a big threat, but the threat of suppliers luring away human capital does. If a talented insurance underwriter is working for a smaller insurance company (or one in a niche industry), there is the chance that person will be enticed away by larger companies looking to move into a particular market.
3. Power of Buyers. The individual doesn't pose much of a threat to the insurance industry. Large corporate clients have a lot more bargaining power with insurance companies. Large corporate clients like airlines and pharmaceutical companies pay millions of dollars a year in premiums. Insurance companies try extremely hard to get high-margin corporate clients.
4. Availability of Substitutes. This one is pretty straight forward, for there are plenty of substitutes in the insurance industry. Most large insurance companies offer similar suites of services. Whether it is auto, home, commercial, health or life insurance, chances are there are competitors that can offer similar services. In some areas of insurance, however, the availability of substitutes are few and far between. Companies focusing on niche areas usually have a competitive advantage, but this advantage depends entirely on the size of the niche and on whether there are any barriers preventing other firms from entering.
5. Competitive Rivalry. The insurance industry is becoming highly competitive. The difference between one insurance company and another is usually not that great. As a result, insurance has become more like a commodity - an area in which the insurance company with the low cost structure, greater efficiency and better customer service will beat out competitors. Insurance companies also use higher investment returns and a variety of insurance investment products to try to lure in customers. In the long run, we're likely to see more consolidation in the insurance industry. Larger companies prefer to take over or merge with other companies rather than spend the money to market and advertise to people.

Key Links

• A.M. Best - An excellent source for insurance related information and statistics.
• Insure.com - An insurance guide comparing hundreds of companies, and offering thousands of educational articles.

Semiconductor Industry

The semiconductor industry lives - and dies - by a simple creed: smaller, faster and cheaper. The benefit of being tiny is pretty simple: finer lines mean more transistors can be packed onto the same chip. The more transistors on a chip, the faster it can do its work. Thanks in large part to fierce competition and to new technologies that lower the cost of production per chip, within a matter of months, the price of a new chip can fall 50%.

As a result, there is constant pressure on chip makers to come up with something better and even cheaper than what redefined state-of-the-art only a few months before. Chips makers must constantly go back to the drawing board to come up with superior goods. Even in a down market, weak sales are seen as no excuse for not coming up with better products to whet the appetites of customers who will eventually need to upgrade their computing and electronic devices.

Traditionally, semiconductor companies controlled the entire production process, from design to manufacture. Yet many chip makers are now delegating more and more production to others in the industry. Foundry companies, whose sole business is manufacturing, have recently come to the fore, providing attractive outsourcing options. In addition to foundries, the ranks of increasingly specialized designers and chip testers are starting to swell. Chip companies are emerging leaner and more efficient. Chip production now resembles a gourmet restaurant kitchen, where chefs line up to add just the right spice to the mix.

Broadly speaking, the semiconductor industry is made up of four main product categories:

1. Memory: Memory chips serve as temporary storehouses of data and pass information to and from computer devices' brains. The consolidation of the memory market continues, driving memory prices so low that only a few giants like Toshiba, Samsung and NEC can afford to stay in the game.
2. Microprocessors: These are central processing units that contain the basic logic to perform tasks. Intel's domination of the microprocessor segment has forced nearly every other competitor, with the exception of Advanced Micro Devices, out of the mainstream market and into smaller niches or different segments altogether.
3. Commodity Integrated Circuit: Sometimes called “standard chips”, these are produced in huge batches for routine processing purposes. Dominated by very large Asian chip manufacturers, this segment offers razor-thin profit margins that only the biggest semiconductor companies can compete for.
4. Complex SOC: “System on a Chip” is essentially all about the creation of an integrated circuit chip with an entire system's capability on it. The market revolves around growing demand for consumer products that combine new features and lower prices. With the doors to the memory, microprocessor and commodity integrated circuit markets tightly shut, the SOC segment is arguably the only one left with enough opportunity to attract a wide range of companies.

Key Ratios/Terms

Moore's Law: The productivity miracle that has kept the number of transistors on a chip doubling every two years or so. Gordon Moore, a co-founder of Intel, predicted that this trend would continue for the foreseeable future. The challenge now faced by semiconductor research and development (R&D) teams is to push the performance envelope and keep pace with the law.

“Fabless” Chip Makers: Semiconductor companies that carry out design and marketing, but choose to outsource some or all of the manufacturing. These companies have high growth potential because they are not burdened by the overhead associated with manufacture, or "fabrication".

R&D/Sales: Research and Development Expenses
Revenue


The greater the percentage spent on R&D, the more opportunities are available for developing new chip products. In general, the higher the R&D/Sales ratio, the better the prospects for the chip maker.

Yield: The number of operational devices out of all manufactured. In the 1980s, chip makers lived with yields of 10-30%. To be competitive today, however, chip makers have to sustain yields of 80-90%. This requires very expensive manufacturing processes.

Book-to-Bill Ratio: Describes the technology industry's demand/supply ratio for orders on a "firm's book" to number of orders filled.

This ratio measures whether the company has more semiconductor orders than it can deliver (if the ratio is greater than 1), equal amounts (equal to 1), or less (less than 1). This monthly figure is widely published by financial newspapers and websites.

Analyst Insight
If semiconductor investors can remember one thing, it should be that the semiconductor industry is highly cyclical. Semiconductor companies face constant booms and busts in demand for products. Demand typically tracks end-market demand for personal computers, cell phones and other electronic equipment. When times are good, companies like Intel and Toshiba can't produce microchips quickly enough to meet demand. When times are tough, they can be downright brutal. Slow PC sales, for instance, can send the industry – and its share prices - into a tailspin.

Surprisingly, the cyclicality of the industry can provide a degree of comfort for investors. In some other technology sectors, like telecom equipment, one can never be entirely sure whether fortunes are cyclical or secular. By contrast, investors can be almost certain that the market will turn at some point in the not-so-distant future.

At the same time, it doesn't make sense to speak of the "chip cycle" as if it were an event of singular nature. While semiconductors is still a commodity business at heart, its end markets are so numerous - PCs, communications infrastructure, automotive, consumer products, etc., - that it is unlikely that excess capacity in one area will bring the whole house down.

While cyclicality offers some comfort, it also creates risk for investors. Chip makers must routinely take part in high stakes gambling. The big risk comes from the fact that it can take many months, or even years, after a major development project for companies to find out whether they've hit the jackpot, or blown it all.

One cause of the delay is the intertwined but fragmented structure of the industry. Different sectors peak and bottom out at different times. For instance, the low point for foundries frequently arrives much sooner than it does for chip designers. Another reason is the industry's long lead time – it takes years to develop a chip or build a foundry, and even longer before the products make money.

Semiconductor companies are faced with the classic conundrum of whether it's technology that drives the market or the market that drives the technology. Investors should recognize that both have validity for the semiconductor industry. Here is a summary of key drivers and risks that impact fundamentals and stock prices.

What Drives Semiconductor Fundamentals and Stock Prices?

Drivers	Impact	Measured By
Market share gains	Drives revenue and earnings increases	Units shipped vs. competition
Higher margins/profits	Absorption of higher fixed costs contributes to lower unit costs	Manufacturing process efficiencies
Higher product performance vs. the competition	Stimulates greater enthusiasm for end products and support	Performance results based on industry benchmarks

What Can Go Wrong?

Risks	Impact on Fundamentals
Weak economy and/or product environment	Shipment volumes may be negatively affected
Delayed delivery of products	Loss of revenues, profits and competitive position; potential reduction in demand for current chips
Sever price competition	Shrinking profit margins
Failure to keep up with technology	Increasing chip complexity requires more advanced processes to keep costs under control
A slowdown in pace of computer replacement	Depresses industry organic growth rates.

Porter's 5 Forces Analysis

1. Threat of New Entrants. In the early days of the semiconductors industry, design engineers with good ideas would often leave one company to start up another. As the industry matures, however, setting up a chip fabrication factory requires billions of dollars in investment. The cost of entry makes it painful or even impossible for all but the biggest players to keep up with state-of-the-art operations. It comes as no surprise, then, that established players have had a big advantage. Regardless, there are signs that things could be changing yet again. Semiconductor companies are forming alliances to spread out the costs of manufacturing. Meanwhile, the appearance and success of "fabless" chip makers suggests that factory ownership may not last as a barrier to entry.
2. Power of Suppliers. For the large semiconductor companies, suppliers have little power - many semiconductor companies have hundreds of suppliers. This diffusion of risk over many companies allows the chip giant to keep the bargaining power of any one supplier to a minimum. However, with production getting hugely expensive, many smaller chip makers are becoming increasingly dependent on a handful of large foundries. As the suppliers of cutting-edge equipment and production skills, merchant foundries enjoy considerable industry bargaining power. The largest U.S.-based foundry belongs to none other than IBM – which is also a top chip maker in its own right.
3. Power of Buyers. Most of the industry's key segments are dominated by a small number of large players. This means that buyers have little bargaining power.
4. Availability of Substitutes. The threat of substitutes in the semiconductors industry really depends on the segment. While intellectual property protection might stop the threat of new substitute chips for a period of time, within a short period of time companies start to produce similar products at lower prices. Copy-cat suppliers are a problem: a company that spends millions, if not billions, of dollars on the creation of a faster, more reliable chip will strive to recoup the R&D costs. But then along comes a player that reverse engineers the system and markets a similar product for a fraction of the price.
5. Competitive Rivalry. The industry is marked by intense rivalries between individual companies. There is always pressure on chip makers to come up with something better, faster and cheaper than what redefined the state-of-the-art only a few months before. That pressure extends to chip makers, foundries, design labs and distributors – everyone connected to the business of bringing chips from R&D into high-tech equipment. The result is an industry that continually produces cutting-edge technology while riding volatile business conditions.

Key Links

• Semiconductor Magazine - News and analysis