chapter

6
Industry and Company
Analysis

Problems

The following information relates to Questions 1–6

Angela Green, an investment manager at Horizon Investments, intends to hire a new invest-
ment analyst. After conducting initial interviews, Green has narrowed the pool to three can-
didates. She plans to conduct second interviews to further assess the candidates’ knowledge of
industry and company analysis.
Prior to the second interviews, Green asks the candidates to analyze Chrome Network
Systems, a company that manufactures internet networking products. Each candidate is pro-
vided Chrome’s financial information, presented in Exhibit 1.

Exhibit 1 Chrome Network Systems Selected Financial Information ($ millions)

Year Ended:

2010 2011 2012

Net sales 46.8 50.5 53.9

Cost of sales 18.2 18.4 18.8
Gross profit 28.6 32.1 35.1
Selling, general, and administrative 19.3 22.5 25.1
(SG&A) expenses
Operating income 9.3 9.6 10.0
Interest expense 0.5 0.7 0.6
Income before provision for income tax 8.8 8.9 9.4
Provision for income taxes 2.8 2.8 3.1
Net income 6.0 6.1 6.3

29
30 Problems

Green asks each candidate to forecast the 2013 income statement for Chrome and to out-
line the key assumptions used in their analysis. The job candidates are told to include Horizon’s
economic outlook for 2013 in their analysis, which assumes nominal GDP growth of 3.6%,
based on expectations of real GDP growth of 1.6% and inflation of 2.0%.
Green receives the models from each of the candidates and schedules second interviews. To pre-
pare for the interviews, Green compiles a summary of the candidates’ key assumptions in Exhibit 2.

Exhibit 2 Summary of Key Assumptions Used in Candidates’ Models

Metric Candidate A Candidate B Candidate C

Net sales Net sales will grow at the Industry sales will Net sales will grow 50 basis
average annual growth rate grow at the same rate points slower than nominal
in net sales over the as nominal GDP, but GDP.
2010–2012 time period. Chrome will have a
2 percentage points
decline in market share.
Cost of sales 2013 gross margin will be 2013 gross margin will 2013 gross margin will
the same as the average decline as costs increase increase by 20 basis points
annual gross margin over by expected inflation. from 2012.
the 2010–2012 time period.
Selling, 2013 SG&A/net sales 2013 SG&A will grow 2013 SG&A/net sales ratio
general, and ratio will be the same as at the rate of inflation. will be the same as the
administrative the average ratio over the 2012 ratio.
(SG&A) expenses 2010–2012 time period.
Interest expense 2013 interest expense 2013 interest expense 2013 interest expense will
assumes the effective interest will be the same as the be the same as the average
rate will be the same as the 2012 interest expense. expense over the 2010–
2012 rate. 2012 time period.
Income taxes 2013 effective tax rate will 2013 effective tax rate 2013 effective tax rate will
be the same as the 2012 will equal the blended be the same as the average
rate. statutory rate of 30%. effective tax rate over the
2010–2012 time period.

1. Based on Exhibit 1, which of the following provides the strongest evidence that Chrome
displays economies of scale?
A. Increasing net sales
B. Profit margins that are increasing with net sales
C. Gross profit margins that are increasing with net sales
2. Based on Exhibit 2, the job candidate most likely using a bottom-up approach to model
net sales is:
A. Candidate A.
B. Candidate B.
C. Candidate C.
3. Based on Exhibit 2, the modeling approach used by Candidate B to project future net
sales is most accurately classified as a:
A. hybrid approach.
B. top-down approach.
C. bottom-up approach.
Chapter 6 Industry and Company Analysis 31

4. Based on Exhibits 1 and 2, Candidate C’s forecast for cost of sales in 2013 is closest to:
A. $18.3 million.
B. $18.9 million.
C. $19.3 million.
5. Based on Exhibits 1 and 2, Candidate A’s forecast for selling, general, and administrative
expenses in 2013 is closest to:
A. $23.8 million.
B. $25.5 million.
C. $27.4 million.
6. Based on Exhibit 2, forecasted interest expense will reflect changes in Chrome’s debt level
under the forecast assumptions used by:
A. Candidate A.
B. Candidate B.
C. Candidate C.

The following information relates to Questions 7–12

Nigel French, an analyst at Taurus Investment Management, is analyzing Archway Technologies, a
manufacturer of luxury electronic auto equipment, at the request of his supervisor, Lukas Wright.
French is asked to evaluate Archway’s profitability over the past five years relative to its two main
competitors, which are located in different countries with significantly different tax structures.
French begins by assessing Archway’s competitive position within the luxury electronic
auto equipment industry using Porter’s five forces framework. A summary of French’s industry
analysis is presented in Exhibit 3.

Exhibit 3 Analysis of Luxury Electronic Auto Equipment Industry Using Porter’s Five Forces Framework

Force Factors to Consider

Threat of substitutes Customer switching costs are high

Rivalry Archway holds 60% of world market share; each of its two main
competitors holds 15%
Bargaining power of Primary inputs are considered basic commodities, and there are a large
suppliers number of suppliers
Bargaining power of buyers Luxury electronic auto equipment is very specialized (non-standardized)
Threat of new entrants High fixed costs to enter industry

French notes that for the year just ended (2014), Archway’s cost of goods sold was 30% of
sales. To forecast Archway’s income statement for 2015, French assumes that all companies in
the industry will experience an inflation rate of 8% on the cost of goods sold. Exhibit 4 shows
French’s forecasts relating to Archway’s price and volume changes.

Exhibit 4 Archway’s 2015 Forecasted Price and Volume Changes

Average price increase per unit 5.00%

Volume growth –3.00%
32 Problems

After putting together income statement projections for Archway, French forecasts Arch-
way’s balance sheet items; he uses Archway’s historical efficiency ratios to forecast the compa-
ny’s working capital accounts.
Based on his financial forecast for Archway, French estimates a terminal value using a
valuation multiple based on the company’s average price-to-earnings multiple (P/E) over the
past five years. Wright discusses with French how the terminal value estimate is sensitive to key
assumptions about the company’s future prospects. Wright asks French:

“What change in the calculation of the terminal value would you make if a technological develop-
ment that would adversely affect Archway was forecast to occur sometime beyond your financial
forecast horizon?”

7. Which return metric should French use to assess Archway’s five-year historic performance
relative to its competitors?
A. Return on equity
B. Return on invested capital
C. Return on capital employed
8. Based on the current competitive landscape presented in Exhibit 3, French should con-
clude that Archway’s ability to:
A. pass along price increases is high.
B. demand lower input prices from suppliers is low.
C. generate above-average returns on invested capital is low.
9. Based on the current competitive landscape presented in Exhibit 3, Archway’s operating
profit margins over the forecast horizon are least likely to:
A. decrease.
B. remain constant.
C. increase.
10. Based on Exhibit 4, Archway’s forecasted gross profit margin for 2015 is closest to:
A. 62.7%.
B. 67.0%.
C. 69.1%.
11. French’s approach to forecasting Archway’s working capital accounts would be most likely
classified as a:
A. hybrid approach.
B. top-down approach.
C. bottom-up approach.
12. The most appropriate response to Wright’s question about the technological development
is to:
A. increase the required return.
B. decrease the price-to-earnings multiple.
C. decrease the perpetual growth rate.

The following information relates to Questions 13–18

Gertrude Fromm is a transportation sector analyst at Tucana Investments. She is conducting
an analysis of Omikroon, N.V., a publicly traded European transportation company that man-
ufactures and sells scooters and commercial trucks.
Chapter 6 Industry and Company Analysis 33

Omikroon’s petrol scooter division is the market leader in its sector and has two competi-
tors. Omikroon’s petrol scooters have a strong brand name and a well-established distribution
network. Given the strong branding established by the market leaders, the cost of entering the
industry is high. But Fromm anticipates that inexpensive imported small petrol-fueled motor-
cycles may become substitutes for Omikroon’s petrol scooters.
Fromm uses return on invested capital as the metric to assess Omikroon’s performance.
Omikroon has just introduced the first electric scooter to the market at year-end 2014.
The company’s expectations are as follows:

• Competing electric scooters will reach the market in 2016.

• Electric scooters will not be a substitute for petrol scooters.
• The important research costs in 2015 and 2016 will lead to more efficient electric scooters.

Fromm decides to use a five-year forecast horizon for Omikroon after considering the
following factors:

Factor 1: The annual portfolio turnover at Tucana investments is 30%.

Factor 2: The electronic scooter industry is expected to grow rapidly over the next 10
years.
Factor 3: Omikroon has announced it would acquire a light truck manufacturer that
will be fully integrated to its truck division by 2016 and will add 2% to its
total revenues.

Fromm uses the base case forecast for 2015 shown in Exhibit 5 to perform the following
sensitivity analysis:

• The price of an imported specialty metal used for engine parts increases by 20%.
• This metal constitutes 4% of Omikroon’s cost of sales.
• Omikroon will not be able to pass on the higher metal expense to its customers.

Exhibit 5 Omikroon’s Selected Financial Forecasts for 2015 Base Case (€ millions)

Petrol Scooter Commercial Electric Scooter

Division Truck Division Division Total

Sales 99.05 45.71 7.62 152.38

Cost of sales 105.38
Gross profit 47.00
Operating profit 9.20

Omikroon will initially outsource its electric scooter parts. But manufacturing these
parts in-house beginning in 2016 will imply changes to an existing factory. This factory cost
€7 million three years ago and had an estimated useful life of 10 years. Fromm is evaluating
two scenarios:

Scenario 1: Sell the existing factory for €5 million. Build a new factory costing €30
million with a useful life of 10 years.
Scenario 2: Refit the existing factory for €27 million.
34 Problems

13. Using Porter’s five forces analysis, which of the following competitive factors is likely to
have the greatest impact on Omikroon’s petrol scooter pricing power?
A. Rivalry
B. Threat of substitutes
C. Threat of new entrants
14. The metric used by Fromm to assess Omikroon’s performance takes into account:
A. degree of financial leverage.
B. operating liabilities relative to operating assets.
C. competitiveness relative to companies in other tax regimes.
15. Based on Omikroon’s expectations, the gross profit margin of Omikroon’s electric scooter
division in 2016 is most likely to be affected by:
A. competition.
B. research costs.
C. cannibalization by petrol scooters.
16. Which factor best justifies the five-year forecast horizon for Omikroon selected by Fromm?
A. Factor 1
B. Factor 2
C. Factor 3
17. Fromm’s sensitivity analysis will result in a decrease in the 2015 base case gross profit
margin closest to:
A. 0.55 percentage points.
B. 0.80 percentage points.
C. 3.32 percentage points.
18. Fromm’s estimate of growth capital expenditure included in Omikroon’s property, plant,
and equipment under Scenario 2 should be:
A. lower than under Scenario 1.
B. the same as under Scenario 1.
C. higher than under Scenario 1.