Telecommunications companies serve as a good example at this point. They used to be fixed-line operators. The introduction of new wireless technology changed their business models since they had to adapt their strategies to the new technological landscape. Capital expenditures were massively increased for the building of new wireless networks and the competition intensified for new wireless customers since the telecommunications market was liberalized, and alternative providers were allowed to compete with the incumbent telecommunications companies. Additionally government regulators in Europe asked for billions of dollars in fees for wireless licenses (3G). These technological and regulatory changes resulted in a tremendous increase of leverage for most of the telecommunications companies and a repricing of credit risk in this sector occurred that was accompanied by a negative industry rating trend (from AA_ to BBB_). Another example for the changing landscape of an industry is the electric utilities sector. This market undergoes a liberalization process which is in different stages according to the various jurisdictions. Changes of the regulatory environment have an impact on the development of credit quality.

The business models became riskier as the competition in the sector increased, M&A activities picked up considerably and some utility companies got involved in the risky energy trading business. Formerly low risk and stable cash flows generating businesses turned into higher risk (e.g. energy trading) and more volatile cash flow businesses.

The value chain for the automobile industry is representative for a cyclical sector. The various component makers interact with suppliers from the steel, textiles and basic materials industries. The car manufacturers assemble all parts together and finished automobiles are shipped through various distribution networks to the final consumer. Own financial services companies support the sales process. A vertical integration will increase the car manufacturers’ ability to control the entire value chain. Production costs are a major component for the success of car manufacturers. If a new technology or regulatory/deregulatory forces change the structure of an industry’s value chain the companies within this industry will try to adapt to the new situation. This means that management will change its business strategy in order to remain competitive. As a result, the capital structure may change which has a direct effect on credit quality.

The value chains for telecommunications wireless and electric utilities are examples for noncyclical sectors. Wireless operatorsinteract with equipment suppliers and their biggest cost positions are for subscriber acquisition, advertising and interconnection fees. Their customer base is divided into business clients and individual consumers. The success of a wireless operator will depend on the control of all parts of the value chain. This includes the costs for acquiring new customers, maintaining the existing customer base, the bargaining power with equipment suppliers, network costs and interconnection fees. The earnings situation will depend on the market power and degree of competition.

Fuel costs represent a big cost block for electric utilities hence their profitability depends to a large extent on raw material costs. Electric utility companies can diversify across the business segments generation, transmission, distribution and trading. The customer base is divided as industrial, commercial and residential.

Structural economic changes of industries are important in the sector selection process for corporate bond investors because they determine how an industry functions and will allow to make projections about the development of the credit quality of specific industries. It has to be determined whether certain changes in industry dynamics occur which have a material effect on the evolution of the industry structure. Examples of some driving forces for change are:

• Long-term changes of growth patterns
• Changes in the customer base (demographics)
• Changes in production costs
• Product innovation
• Changes to production processes
• Structural changes of supplementary industries
• Changes of government policy
• Exits and new competitors.

Industries with structural losses have to be avoided because their profits will fall in recession and recovery as well. Defensive industries with structural gains will experience a rise in profits during the whole economic cycle.

Industry trends have to be monitored and projections about future trends have to be made because they will influence the profitability of an industry. Some major industry characteristics are:

• Pricing and cost structures (evolution over time)
• Domestic and international competition
• Technological change (pace and adaptability)
• Asset values
• Upcoming financing needs
• Potential liabilities
• Political and regulatory environment
• Government support
• Current state of regulation/deregulation.

Oil companies’ relative profits also peak during a recession because an economic downturn is usually accompanied by high oil prices. Utilities have a noncyclical business profile and they are subject to regulated pricing. They will realize their profit peaks relative to the market during a later stage of an economic downturn.

Consumer staples is a noncyclical sector and hence the profit peak relative to the market is reached towards the end of a recession. Profits are not robust but consumers cut spending on large discretionary purchases while the demand, for example, for food and beverages remains relatively stable across the whole economic cycle.

Group sectors according to their change in profits during recession and recovery. The profits of cyclical sectors will fall in recessions and rise during a recovery. On the other side, the profit cycle of defensive companies is countercyclical. Profits will rise in recessions and they will tend to fall in recoveries. Some industries experience structural gains which means that their profits rise during recession and recovery. Other industries suffer from structural losses which means that they realize falling profits in recession and in recovery as well. Those are industries which reached a declining stage in their industry life cycles.

Capital goods, paper, and metals and mining companies realize their respective profit peaks at the later stages of an economic expansion as they produce goods and services whose demand is closely tied to economic activity. Additionally business peak cycles are accompanied by inflation as demand exceeds supply and for example, basic material industries experience higher profit margins in this environment because their production costs are not significantly affected by inflation and, on the other side, they can increase prices for the finished products. Industries with a high operating leverage benefit as well because their costs are fixed in nominal terms and revenues increase with inflation. The fixed costs in a company’s operating structure determine the operating leverage. Generally, it can be said that industries with a high fixed cost base and high inventory costs, for example, the paper and the aluminum industry, are always under pressure to keep capacity utilization rates high because decreasing capacity utilization rates will have an immediate adverse effect on profitability.

The defensive character of noncyclical sectors pays off during stages of weak economic growth. See at what stage in the economy cycle the different industries reach their profit peaks relative to the market.

This is a basis for a sector rotation strategy but the profit cycle is not the only selection criterion. Banks show a profit rebound in the early phase of a recovery because the countercyclical Fed policy that is often observed in this economic environment results in low interest rates. A steep yield curve helps banks to increase their interest margins.

Automobile manufacturers usually realize a profit rebound at the early stages of an economic rebound because consumer confidence improves and induces a higher demand for discretionary products. In this phase favorable financing is also available and especially car manufacturers can substantially increase their sales through financing initiatives like zero-percent financing and large discounts for new car sales. Cyclical industries like automobiles have a high operating leverage which means that they will benefit at the early stages of economic recovery because they experience a rise in sales. Also industries with high financial leverage benefit from rising sales volume. Fixed financial costs like interest expenses determine financial leverage.

Corporate spreads and profits showed a close relationship during past economic cycles. Deteriorating profits as a percentage of GDP go along with wider credit spreads. Market phases with improving profits are accompanied by tighter credit spreads.

The business cycle sets the parameters for the sector rotation strategy. Sectors with a high cyclical component will outperform at the early stages of an economic expansion while noncyclical sectors will tend to underperform during an expansion phase relative to the market. The cyclicality of a sector allows predictions about the development of earnings across business cycles. For example, the business of IT hardware companies depends on the capital expenditure (CAPEX) plans of other companies. In an economic slowdown when CAPEX is scaled back or postponed, IT hardware companies run a higher risk of being downgraded due to a deterioration of their credit protection measures. The most recent examples are the telecommunications equipment companies Alcatel and Ericsson. Both suffered from the lack of demand by telecommunications companies in 2002.

After analyzing industry life cycles and the competitive environment of industries the macroeconomic environment has to be incorporated in the industry analysis process. For this purpose the focus will be on business cycles and the cyclicality of industries.

Corporate profits hava a long history as a percentage of GDP across several economic cycles. Corporate profits tend to fall long before the economy goes through a recession. Corporate profits usually reach their bottom towards the end of a recession. They start to rebound with rising economic activity. During the last expansion, which was one of the longest and that stretched through the 1990s, corporate profits started to deteriorate already in 1998. Sharply rising equity valuations, a focus on shareholder value and an undisciplined build-up of leverage induced a decline in profits when the earnings growth trend reversed. Every business cycle will be different from past cycles so the task is to identify evolving trends in order to make reliable projections about future performance.