Ken Lindsay of private equity firm ECI Partners looks at industry performance figures and reveals what the firm is looking for in potential investments...
Recent weeks have seen a surge of positive news for the manufacturing sector:
• Manufacturing sector insolvencies in the first half of 2010 are almost 50% down on the same period last year.
• The Begbies Traynor “Red Flag Alert” survey suggests that 37% fewer manufacturing companies are showing signs of financial distress than was the case last year.
• Rumours are circulating that United Biscuits is to be put up for sale with a £2 billion price tag (having been bought by its current owners for £1.6 billion only 4 years ago).
• Almost half the regional winners in the recently announced BVCA Portfolio Company Management Awards have manufacturing activities, ranging from food through stair lifts to high technology products.
Does all this mean that UK manufacturers can now relax, confident that the worst impacts of the recession and economic crisis are all firmly behind us?
Here at ECI Partners, we have been researching the impact of the global downturn on mid-sized (£10m – £500m revenue) UK manufacturing businesses. We were keen to understand how well positioned the sector is for any economic recovery when it comes. We discovered a complex and varied picture, but also reasons for cautious optimism.
Our analysis focussed on 2009. This was the year the economic crisis hit with a vengeance. The manufacturing sector was amongst the hardest hit with (according to some statistics) a c10% reduction in activity levels in the year. The 25% depreciation in sterling that occurred in late 2008 and subsisted for most of 2009 assisted exporters considerably though of course it had the opposite impact on those who rely on imports of raw materials or goods. How did these opposing factors net out for manufacturers?
On the revenue side, some 12% of the companies reviewed saw very significant revenue declines of 25% or more during 2009. For those affected, such declines can of course be extremely serious. However, the average UK manufacturer managed to hold their revenues flat in 2008, and saw them fall by only 6% during 2009.
Reported profitability however suffered more badly than the revenue figures suggest. In 2009, average profits fell 15% below 2008 levels, themselves 15% down on 2007. These averages again hide a massive range of performance. Two thirds of manufacturers saw profits fall in 2009, but one third were able to successfully maintain or in many cases grow profitability during what was an extremely difficult year. Indeed, 10% of manufacturers reviewed were able to report year on year profit growth of more than 30%, which is truly impressive
Sector management generally showed an ability to respond rapidly to the economic downturn and declining profitability. Most tangibly, average employee numbers in the companies examined fell by almost 10% over the course of 2009 highlighting the pressure on businesses from the deteriorating economic situation. Our data sources did not allow us to investigate the extent to which extended part-time working or pay cuts were implemented by companies to retain skilled staff whilst still cutting costs, but anecdotal experience suggests such actions were reasonably widespread.
Finally (though not unexpectedly), companies clearly focussed on reducing external borrowings during the course of 2009. The sector delivered a creditable average 10% reduction in total borrowings over the course of the year.
On its own and viewed in absolute terms, this level of debt repayment is impressive. However, the profit falls across the sector mean that debt levels relative to profitability actually increased over the year. Our discussions with Banks confirm this picture, but suggests that many manufacturers nevertheless successfully managed the resulting cashflow pressures and remained within covenants.
Across the sector and its numerous subsectors, there are of course many exceptions. Construction product businesses typically found 2009 more challenging than many food businesses. Similarly, many defence companies prospered whilst some aerospace component businesses struggled as aftermarket sales dried up.
The detailed picture is complex and varied. However, taken as a whole, our analysis suggests that UK manufacturing generally entered 2010 in a better condition than might have been feared. Profits were badly down, but not as disastrously as in previous recessions. Management had clearly responded to the economic environment by reducing costs where possible, and by conserving cash to reduce bank borrowings. And banks have been generally supportive (though they have often driven hard bargains in return for continued support) and have been less ready to run for the insolvency exit when businesses hit problems. And there are pockets of extremely strong performance by individual businesses or subsectors. Overall, the sector generally is probably in not too bad shape for this stage of the economic cycle, and businesses are generally leaner and meaner than before, even if they have been left bruised by the recession.
So what comes next?
Economic data suggests the sector has had a good start to 2010, with industrial output growing steadily though not spectacularly. Our own experience has seen performance in our manufacturing investee companies generally strengthening as the year has progressed, though the strength of recovery does noticeably vary across different end-product and geographic markets.
However, the debate over whether or not the UK will see a double-dip recession in the coming months remains unresolved. Government spending cutbacks will have a direct or indirect impact on many businesses, and impending personal tax rises are sure to have an impact on consumer spending.
Against this backdrop of considerable uncertainty and (at best) weak recovery, what are the factors that will allow some manufacturers to grow and prosper whilst others will continue to struggle?
As a private equity investor, we have a range of windows onto the industrial sector. We see the performance both of the businesses we own ourselves but also of the many businesses that approach us each year seeking investment. Whilst it is impossible to develop absolute rules as to which companies will do well in the current environment, our experience allows us to draw certain lessons from the past:
• Successful businesses need to be in the right end markets
Whilst not something that can be changed quickly, we have seen businesses that have been preparing for a downturn throughout the boom times by establishing a broad customer base across multiple market segments. They sought to ensure they were properly positioned in market segments that would remain robust in any downturn. Those businesses are generally coming out of recession faster and more strongly or, in many cases, have continued to grow strongly throughout of the economic slowdown
• Successful businesses have developed genuine competitive advantage and barriers to entry
Businesses that have established some form of genuine competitive advantage over their peers tend to have more sustainable positions in their marketplace. This may come from technology and R&D, or it may come from superior attention to customers. Many UK businesses have genuinely world-beating technologies and expertise. Successful businesses have continued to innovate and invest through the downturn and have portfolios of new products available to attract existing and new customers.
These competitive advantages typically evidence themselves in the form of higher profit margins. Our analysis suggests that businesses with higher margins have tended to prove more robust and grow faster over the last two years. So long as the end market is right, greater value-added translates into better profitability and into higher growth rates.
• Successful businesses have a ruthless focus on the customer
I am often amazed at how few businesses actively monitor and measure the quality of their customer service. Many justify poor service on the basis they are still “in line with the industry norm” or that delivery delays are not due to them but to their component suppliers. Many businesses regard one delivery late in ten late as an acceptable or even a good level of service. We have seen business growth rates transformed when good manufacturing businesses begin to focus ruthlessly on delivering industry-leading levels of customer service as well as industry-leading products.
Whether through product or service, good manufacturing businesses can develop a strong brand identity and reputation with the ultimate end customer. This can be achieved even by component suppliers – the strength of the “Intel inside” message is a good example.
• Successful businesses have great management and sales teams in place ready for the upturn
It is often tempting in tough economic times for businesses to skimp on management and sales resource. They might tolerate poor performance to avoid the cash cost of replacing the individual concerned. Or they might fail to invest in bringing in the new skills necessary to grow the business in the future. Either way, they find themselves ill-prepared to pursue opportunities as the market recovers. The most successful businesses have used the downturn wisely to improve the quality of their management and sales teams.
At ECI, we continue to find examples of great manufacturing businesses with these characteristics. The UK has many great manufacturers, and many are truly world class. Not all, but many are.
So, do I believe UK manufacturing is out of the woods yet?
The answer is no, not yet. Challenging economic times still lie ahead, and companies are likely to find increasing challenges in growing their revenues whilst seeing increasing pressure on their prices over the coming months and years. However, for those businesses that have managed to establish themselves in strong positions in attractive end markets with good management teams – and there are many of them out there – we remain confident that they can and will outperform and prosper.
