- Intensity of competition
- The relative profitability of the industry
- The outlook for Industry Profitability
- Concentration of the market
- Size of market
- Barriers to entry and ease of exit
- Regulatory, accounting & fiscal regimes
- Market growth potential
- Threat of substitute products / services
In respect of companies that are in research and development of software, biotechnology, life sciences etc., the companies could be in a strong market position due to the patents and royalties that they receive on their products. The assessment of intellectual property rights in such companies assumes greater importance to understand the market position of such companies.
2. Operating Risk: The companies that operate with high fixed cost in terms of investment in plant and machinery are subject to higher operating risk. Also the companies which are spread out and have large number of divisions and impact, any are considered. The other element of the operational risk is the management of inventory, the process of procurement of raw materials, quality control, production planning and control, capacity utilization of huge machinery etc. The companies that have sustainable raw material advantage in terms of location as well as who have higher productivity due to state of art machinery will score over others.
3. Commodity Management: Many manufacturing companies have to enter into long term contracts for their raw materials and some of these long term contracts can be a source of competitive advantage for them. In addition, the companies have to manage the risk of commodities prices. Some of these companies might use the commodity futures either in India or abroad and try to manage the price risk of these commodities. Such risk management hedging policies are considered by Brickwork.
4. Technology: Technology is an important element today not only for hardware and software companies but also for almost every manufacturing company. If IT systems are designed well, the manufacturing company’s productivity can go up, due to enhanced processes in all these sectors. Brickwork looks at the technology adoption as well as the way the company is poised for use of technology in its day to day operation.
5. People: People factor plays a very critical factor in today’s world, where talent is scarce. While the country may be producing large number of graduates, the employability and finding the right kind of resource has always been a problem for a number of employers. Effective HR process management can result in a high competitive advantage. Companies with excellent recruitment, interview process, training, performance appraisal and motivation plans can build a successful talent team that cannot be easily replicated by a new company entering the industry.
6. The Financial Risk Analysis: The financial risk analysis of the company follows the Brickwork’s standard process. Brickwork looks at a number of financial ratios that give clue for further study of some aspects of the corporation. The financial ratios that Brickwork studies are liquidity ratios, inventory turnover & asset turnover ratios, asset quality, earnings quality and profitability ratios, leverage and interest coverage ratio. Brickwork discounts the earnings quality as reported by the company, based on auditor qualifications. Brickwork also checks if the accounting numbers show a major deviation year to year or show a wide departure from the industry averages. Brickwork looks at the cash flow projections as well as the past cash flows. The cash flow analysis typically focuses on the operating cash flows to verify if the firm provides positive cash flows or not. Sometimes the companies adopt favorable revenue recognition models and show higher incomes. When it comes to operating cash flows however they cannot be fudged as easily. Brickwork also looks at investing as well as financial cash flows and their stability in its analysis. Funds that get tied up in maintaining high inventory as well as funds that get locked up due to bad receivables management receive particular attention.
7. Management Quality: Important considerations include strengths and weakness of key members of management, depth and stability of top management, and recent and prospective management changes. Management strategies are also a material determinant in differentiating firms and in establishing a company's business profile. The assessment also encompass financial policies, corporate goals, strategies, tactics, and plans for both regulated and diversified businesses, as well as analysing how effectively they are implemented.
The assessment of management is based on such factors as tenure, industry experience, a grasp of industry issues, and knowledge of customers and their needs. Management's ability and willingness to develop workable strategies to address its system's needs, to execute reasonable and effective long-term plans, and to be proactive in leading its company into the future are assessed. Thoughtful balancing of any public and private priorities, a record of credibility, and effective communication also indicate management quality with the public, regulatory bodies, and the financial community.
Key financial policy considerations include management's ability to achieve cost-effective operations and, of utmost importance, management's relative commitment to credit quality. Evaluating accounting and financing practices, and capitalization and common dividend objectives can assess this. The company's philosophy regarding growth and risk taking incorporates a discussion of diversification plans:
What type of exposure will the company accept in terms of business risk and sovereign risk if it is expanding geographically?
Will it limit the concentration of investments in a particular business or country?
Will it participate in consortiums to spread the risk?
8. Financial flexibility incorporates a firm’s financing needs, plans, and alternatives, as well as its flexibility to accomplish its financing program under stress without damaging creditworthiness. External funding capability complements internal cash flow therefore a firm's ability to tap capital markets on an ongoing basis should be considered. Relationships with banks and the availability of bank lines also are reviewed.
Brickwork looks at the financial standing of the company in the market. Some companies with higher debt but better standing in the financial market are able to borrow money more easily. This resource mobilization is of vital importance for companies to tide over the temporary liquidity difficulties. Such companies that have been active in the market and able to borrow money in various instruments that are rated a bit higher.
A firm’s debt capacity reflects other aspects of the analysis such as profitability, capital structure, and cash flow. Market access at reasonable rates is restricted if a sound capital structure is not maintained and the company's operational and financial prospects dim. Common dividend policy also has a direct bearing on liquidity and financing flexibility to the extent that sufficient cash is retained to reinvest in the business. High dividend payout ratios should be viewed poorly, particularly if a firm has a challenging construction program.
Brickwork Analysts would also review indenture and bank loan covenants, where possible. Certain restrictions, such as a limit on the ability to issue additional debt, provide some comfort as well as provisions such as interest coverage tests that restrict the distribution of dividends. Alternatively, very tight covenants can raise default risk by limiting a firm’s financial flexibility to raise cash in times of crisis.
For investor-owned companies, a further consideration is a company's capacity and willingness to issue common equity. This is affected by various factors, including stock price, dividend policy, and any regulatory restrictions regarding the composition of the capital structure. For government-owned firms, analysis focuses on a government's willingness and ability to inject equity as needed or to forgo receipt of dividends.
Evaluating Companies Active in More Than One Sector
For the purposes of this methodology an “integrated company” is defined a utility company engaged in – or expected to be engaged in - more than one type of activity and generates at least 15% of its revenue from secondary activities (or is expected by the analyst to achieve this mix of revenue within 5 years).
For companies with non-material secondary activities (i.e. representing less than 15% of revenue from the activities) the company is evaluated on the basis of its core (or primary) activities using the guidelines specific to that activity.
When a company engages in several types of operation each material activity should be separately evaluated using the guidelines specific to the activities concerned. An activity would be regarded as non-material if it represented less than 5% of total revenues - provided the analyst is comfortable that such an activity does not have the potential to adversely (or favourably) influence the company’s results disproportionately.
While evaluating individual business risk factors for a particular activity the analyst would consider whether the factor is positively, negatively or neutrally impacted by the utility’s other business activities. |
