At a dinner in late May hosted by Yorkshire Bank and The Manufacturer, directors of several manufacturing companies based in the north-west talked to Yorkshire Bank representatives about the events that caused the recession, current economic indicators, pension deficits, relationship banking, global competition, regulation and other issues affecting manufacturers today. Tom Vosa, chief economist at National Australia Bank (Yorkshire Bank) provides an economic overview of the last 12 months and a glimpse of what the future may hold.
He began by saying: “First the people around this table should congratulate themselves that their businesses are still standing despite some hard choices that they may have had to make, during some very difficult circumstances that we’ve all felt in the last 12 months.”
Highlights of Tom’s assessment of the economy follow: The views expressed here are those of Yorkshire Bank unless otherwise stated.
Background – The 2008/09 recession
In the year to March 09, UK output collectively fell by 4.9%, meaning that the recession is now deeper than that seen in the 1980s. In Q1 2009, the UK measured its biggest fall in output since 1958 Q2. What we saw in the fourth quarter not only carried over into 2009, but actually worsened.
All global manufacturing indices and survey data are falling at more or less an identical rate. No-one was immune.
The worst is behind us. Survey data suggests lowest point in the curve was around Jan or Feb, but the output is still falling. But any talk of green shoots is grossly premature; my concern is that the green shoots that we have don’t grow up to be ‘triffids’. Even if the contraction in the supply chain has stopped, a restocking cycle by itself will not be strong enough to drive a self-sustaining upturn.
“In our minds any hopes of a V-shaped recovery or a swift upturn are misplaced.”
Fiscal stimulus: The UK is likely to see growth this year, probably in Q4. Partly a reflection of government policy and unprecedented levels of fiscal and monetary stimulus; Bank rate is now at 0.5% – the lowest levels since the Bank of England (BoE) was formed in 1694 – we’re now printing money electronically. Quantitative easing is creating electronic cash and feeding it into the banking system to try and encourage the banks to lend to businesses and households.
Regionally there is little pattern; it seems to be more sector-specific than which region you’re in. For example, steel-relevant manufacturers in Sheffield are doing OK, they have the contracts for building the London Olympics’ bridges. In the south-west in the munitions, ordnance or weapons industry, companies are also doing reasonably well because of the continued conflict in Afghanistan. Clearly though, the automotive sector has been badly hit as have energy intensive sectors.
Manufacturing has benefited from the crisis as follows:
1. Cost of debt is low – The markets are still dislocated and that will continue but Libor spreads are narrowing and the companies around this table who are on Libor- based funding should benefit from that in due course.
2. Sterling valuation – This is the first recession in the post-War period when sterling has not been overvalued. From the deindustrialisation of the UK in the 1970s and 1980s, the UK’s key problem has always been that in a downturn all the capital equipment and capital stock was exported and was never replaced. This time around we’re not seeing that. (for an explanation why Europe differs in this regard, read the online version on our website).
The fact that the UK will start in this weakened currency position means that, even though the world dinner plate, with very weak global growth, is not the most appetising it has been for the past decade, we can still scrape a lot off with a competitive exchange rate and anyone that hasn’t looked at export markets that might be relevant to their business really should do so.
Signs of recovery
In global terms, the UK cyclical position is probably behind the US, and ahead of the rest of continental Europe. It’s difficult to see growth coming out of Europe for a while. The labour and product markets are far less flexible, they have an overvalued exchange rate and the European Central bank is doing far less quantitative easing (QE). US interest rates have a floor of one per cent, in terms of QE they’re only going as far as buying covered bonds = this might be good if you are a German bank with a large mortgage portfolio but we can’t see how this flows into continental businesses, particularly manufacturing and SMEs. These companies are not going to benefit from any of this because it’s not going to affect their own borrowing costs. On that basis, the BoE’s decision to buy gilts, try and pull down the whole yield curve and therefore swap rates should certainly benefit UK industries more.
It’s not too pessimistic to think of a recovery, but we need to carefully consider how going forward we will generate the growth that we’ve been used to in the 10 years to 2007. Two big elephants in the room as we start to recover in 2010:
1. Level of household debt: How can we still consume when banks will be curtailed in their lending activity going forward?
2. Level of public debt – The UK was put on negative watch by Standard & Poor’s (rating agency) for its sovereign debt = first time in post-War history. Public sector demand will not be the driver of growth that is has been in recent years and it will not be there to support the economy; we must get used to being in a world in which consumers have less ability to spend and government will have a reduced ability to replace that gap because it has already borrowed significant amounts.
Government’s ability to raise more from taxes is limited. We’d agree with the Institute of Fiscal Studies that we’re ‘to the left’ of the Laffer curve, meaning if the government increases taxes further they could end up collecting less revenue as companies use more aggressive avoidance measures.
The ability to increase corporation tax is very limited because we’re already seeing companies changing domicility.
Spending cuts across the board will bear the burden of the adjustment. When and how? Not certain, but I suspect that the negative threat by the rating agencies will be enough to force them to start acting this year.
“I would be very cautiously optimistic about the future. But it is far too early to talk about green shoots.”
Pension deficits and taxation
Tony McManus, Ritrama: Most manufacturers will have a pension deficit as a result of the crisis and were watching for equity markets to rally around, but to then see them wiped out again was a body blow.
We’ve just had our latest scheme valuation and the pension administrator is working to suggest alternatives to minimise future impact. The drop in equity values is the prime cause of the reduced value and it was a shock to see such a dramatic drop. We expected a reduction but it’s such a big deficit now. The public sector deficit on Final Salary schemes needs urgent attention – not by larger taxes but by reducing benefits.
Tom Vosa: For private sector pension schemes, higher bond yields would be the thing that saves them. Because your discount rate suddenly increases, so a fund that is in deficit finally switches into a surplus via a great bit of compounding interest. It’s the way the actuaries account for it. The exact distribution will matter, but essentially an increase in interest rates will start to swing funds back towards surplus, because the discounted rate of return will suddenly go up.
On the public sector pension deficit – If the government wanted to raise bonds to fully fund it they’d have to issue between £800bn and £1tr depending on who you listen to. This is almost as much as we produce, where national output is about £1.4tr. It is a huge vulnerability.
My suspicion is some of the [credit] downgrading of the UK is part of this issue. For the next two parliaments in the UK, it won’t really matter who is in power because their ability to actually spend money, your discretionary spend, is simply going to keep falling because every year the tax you’re taking is all going off to pay pensions – that is your first liability.
Employment regulation and global competition
Peters: [the UK may remain the world’s 6th biggest manufacturing country but] the challenges are multiplying hugely. It’s getting more and more difficult to be an employer. It’s legislation, regulation, the way in which we interpret these versus anybody else. With every piece of legislation that is imposed, we have to go to the nth degree. That’s in any area of the business. This regulation problem is not a European thing, it’s a British problem.
TM: Is manufacturing overregulated?
Peter Weidenbaum, Trumeter: I think so. I carried out a study on this a couple of years ago – I concluded that UK regulation costs as much as 11% turnover. If you compare it with France and Italy it’s not that different, I think Germany is very high.
William Hogg, Yorkshire Bank: It’s a lot worse in France than in the UK. The legislation in place to protect the employee is far higher than it is here. Public finance / tax costs are much higher.
Vosa: In places like France, don’t they get by with this because the land prices are so much lower?
Hogg: That’s true, but to adjust your work force in France is much harder than here.
Is regulation a key issue at the moment? Fundamentally, it’s the consumer demand side of the economy that is going to be the biggest influence in the recovery. The building sector has been absolutely decimated, we are seeing a very sector-specific type of economy now, whether its automotive, construction or trades associated with building, they are having a really tough time.
We’re in for a protracted period of less money at a time when consumers will be faced with an increasing tax burden.
Weidenbaum: It’s becoming more difficult to remain competitive globally. We had to move some production abroad in order to protect our markets. But it brings other benefits. If you’re trying to share in the growth in Asia for example, you can’t export from the UK, you’ve got to manufacture goods there. And that’s the route we went. We’re getting tremendous benefits – contracts that we wouldn’t have had if we didn’t have that presence. My point is that whatever the regulation, whatever the expense here, if you want to expand you have to expand globally. And we are only an SME.
When we looked, the Chinese wanted 51 per cent of the equity. But in Malaysia you didn’t have to part with any equity, they just wanted two Malay directors on the board, which was no problem. Without that plant we wouldn’t have had the input of orders which we’re getting now because in the UK we’re seeing a 25 per cent reduction on our traditional products. We’ve been in business since 1937 and every 10 years we’ve had to reinvent ourselves.
TM: At the brewery and with your expansion there, what is your finance – cash or borrowing?
David Grant, Moorhouses Brewery: Partly cash, partly bank, partly grant funding that we’ve been able to secure because it’s a viable proposition. It started about four years ago, its been a long process and we’re still not there yet because of the hurdles put in front of you by banks or the local authority, but we’re gradually overcoming those.
TM: Had you started this process now would it have been different?
Grant: The issues we’ve had to overcome would have been the same. We might have had more of a problem with bank investment if we were to start it now. We are about 90 per cent down the route with our investors. But everyone now is looking at the potential upturn, whenever that’s going to be, and let’s say there’s an upturn in 18 months time, we’re in a pretty good position to exploit that. And this sector of the market is still improving so we’re in a fortunate position really.
Changing consumer behaviour
TM: That’s due to the speciality nature of your product?
Grant: It’s the speciality nature of what we produce but it’s also to do with the economy. When people are threatened with unemployment they turn to alcohol, they turn to going to the pub more and talking to their friends more often in a public house environment.
Certainly within our sector is people are looking for premium quality ales or drinks that they’re prepared to pay the price for because they get value for money. UK microbrewers are seeing a 15% increase across the industry in turnover this year.
It’s minute what we produce, compared to what Inbev and Coors do in the UK – we don’t have a share of the big lager market, which is down. English wine and even ‘champagne’ is doing quite well at the moment. When there are issues in the country, particularly if our political leaders are fiddling their expenses, people turn to comfort and to things they know. That’s quite difficult when the thing we all believed was safe, the institution of the bank, is no longer safe. A question mark has been put over that because certain banks have not been safe. But there are other industries in the UK that people do turn to.
Mike Peters, UPL: Also people are not buying large ticket items like new houses and cars etc, but they have more of a smaller disposable income and feel at the end of the week they can treat themselves with a better beer or a better shampoo.
Hogg: Let’s not underestimate the impact of the reduction of interest rates on the disposable income of households. They’re using that in two ways; they’re not using that to buy high ticket items, but to trade up a little in the food and drink they choose to buy. Also they’re using it to pay down some of the debt that they’ve accumulated over the last 10 years.
TM: How has the bank and customer relationship changed in the last 12 months?
Brian Colquhoun, Yorkshire Bank: We are unchanged in our approach. It’s been said that some banks have had a “one night stand” with their customers as opposed to a relationship, whereas I’m sure that is why we have fared better than some of the high street names. We believe very much in the relationship, it’s not fancy or convoluted, it is traditional prudent banking.
We really intend to retain that adviser status by talking, like this evening, unearth the problems and resolve them; rather than come in, quote a cheap price, do a deal and walk away. We say that we are “a Yorkshire bank with a Scottish accent”. We make no apologies for this.
Peters: Are you still doing the same number of deals and still (ending up) with the same amount of money?
Colquhoun: The volumes have fallen. The sector split of that has changed, but I’d also say that the requests upon us are a lot less than they were before. I can comfortably say at the moment, out of every 10 deals presented to us we’ll do nine of those deals, as we did this time last year, or two years ago, but there is not the same multiples of 10 deals coming to us. Our good long-standing clients are standing back and thinking is this the right time to move on a deal? Other people in the market are thinking “should we be thinking of changing banks at the moment, or is it better to stick to what you know?” A lot of what you see in the press is self-fulfilling, and we have not been asked on a regular basis to do the same volume of deals as we were.
Brian Dew, Thumbs Up: Headline taxes will not be raised this side of an election, so are we going to get more indirect tax increases? On capital allowances, when the first year allowance for capital purchases has gone, and the WDA allowance has fallen from 25% to 20%, it’s a big hit for manufacturers. My issue is because it was introduced 12 months ago for accounting in this year’s returns, for a tax that might get paid 10-12 months after Year End, you tend to forget about it. But it hits you two years later – it’s basically a stealth tax.
Vosa: My suspicion is that with corporation tax the Government is running at its limit.
It’s interesting, the size of some of the companies which have moved abroad – these are not huge players. If you look back at the 2007 Budget, probably one of the worst in recent years, rates on property were interesting. They decided to tax property and hotels because you cannot move these offshore. Anything that could move was going to go, so the allowances that were increased were to the benefit of less capital-intensive, intellectual property right holders who threatened to move overseas.
I think there is no more to be squeezed out from that particular stone. It won’t prevent the Inland Revenue from trying to come up with new ideas. But there’s a realisation that with corporate tax, that fact that so many were prepared to move so quickly means that they’ll treat it far more sensitively. The general view is they’re more open to debate and changing the tax afterwards, whereas with personal tax they’re not – the 10p tax rate was an example of the Government refusing to admit they’d been very daft for a long time. They felt they could tax people because they are less likely to leave the country, and despite threats of leaving, very few actually do leave.
Mergers and acquisitions
TM: It’s the bottom of the market if you want to buy. Is this a good time to consider a merger or buyout?
Colquhoun: M&A for SMEs has been one of our strongest areas over the last six to 12 months, mainly because a lot of the bigger players have withdrawn. Again, deals that we would have done 3-4 years ago still look good today, but deals that some of the others would have done 3-4 years ago, we would not have done then or today. There are Ebitda multiples within that (Earnings Before Interest, Tax and Amortisation) and a fair number of that would be in the three to four multiple, similar to the mortgage multiplier. But we heard of a deal done within the last 12-18 months where the multiple used was 17. We would never have countenanced that, even in the good times. We have a strong corporate finance team – they have punched above their weight recently. For M&A recovery in the downturn, out of every challenge there is an opportunity.
Vosa: With valuations being so low and if AIM listings are out of the question, if you have to have a look at changing ownership then management buyouts become more viable. Again it’s about bank financing; as the banking system repairs itself and funds come back online, one would expect to see some increase in MBOs, but the days when maybe private equity or AIM flotations were worthwhile rather than simply a good old fashioned MBO, may have changed.
Colquhoun: It’s not just about senior debt, but mezzanine and sub-debt, much of the availability of that has gone too. For many of the venture capitalists and private equity guys, the finance is not there.
Private equity and privately-owned businesses
TM: The UK manufacturing sector is granular – a base of mostly privately-owned SMEs with little debt and little equity owned by third parties. Is this changing?
• Unanimously, the participants believed the role of private equity in family-owned SME manufacturing businesses was nearly non-existent, in spite of the pressures on working capital exerted by the recession.
Vosa: Arguably this is all about expertise in niche markets where, if you’re a good SME, you’ll perhaps be one of the best companies of your type. Where really is your competition if you’re at the frontier? You have none.
McManus: In my limited experience, if you are privately owned you don’t want to go anywhere else. From our company’s point of view I would say no, not even a last resort. The owners remain passionate about the business.
Dew: I agree with the others, it’s about the passion. With a family-owned company you’ve gone through the market with two or three generations so you’ve probably seen a few recessions before. So I see very little case for firms like this and private equity involvement.
Peters: It’s also your life’s work. It’s what you’ve done.
Labour, employee loyalty and short hours
Peters: I started my business 33 years ago and I could not understand why we get the level of commitment, support and heartbreak from staff right throughout the company. I ask them: why do you go through this heartache, time and time again, particularly in the last two years? It’s down to the passion in what they do, they’ve grown up with it. Its probably the same for most of you, staff have worked with you for 10, 15 or 20 years – maybe their mother or father worked there before. It supplies a lot to the widercommunity, and the company is a community in itself.
Weidenbaum: We’ve got to differentiate between a family business where the family is working in the business, and businesses where they just own it. It’s not quite the same.
Hogg: I think it rubs off on management in a family business and the management then interacts with the workforce in a way where they treat people with respect, with dignity, will be considerate to them. And they get repaid in spades in the passion and effort they put into the business.
Peters: That’s a two-way thing that becomes a loyalty of place. They asked me recently if a guy who was sick could go off for six months. That’s six months out of 25 years service – that’s all. You support people like that because they’ve already given you 20- odd years of their life. You know this man.
TM: Does this loyalty aspect transfer if you asked them tomorrow to go down to a four day week – would they stick with you?
Some: Yes without question. Some: In the main.
TM: Has anyone here had to implement shorter working hours?
McManus: We know about the automotive sector taking shorter hours. People still get paid, but just shut factories down say 20 per cent of the time. Rather than pay people in automotive plants to sit around and make them turn up for work, it’s better to take some time off. We’ve looked at doing some flexi-hours. We’re OK working at local level but we’re quite unionised so at the national level that can creates a few problems. But our local unions they are no problem at all.
What is ‘normal’?
Glen Walmsley, Remploy: Looking ahead, when is ‘normal’ going to appear and what is it going to look like for both manufacturers and individuals? What do we need economically to ensure the UK is a world player in manufacturing?
Vosa: We will look at the 10 years to 2007 as the Roaring Twenties were to the Great Depression, because we had 10 years of overconsumption where we spent more than we earned, which we paid off by massive house price inflation. And Germany shows us that you can have house price falling for 10 years, if you get the demand and supply wrong. If you look at one- and two-bedroom flats across the UK there’s about five years worth of oversupply.
The new dawn is one in which junk mail is not given to you by banks who tell you have can claim an authorised credit card with a £20,000 limit. Credit will be rationed and much more expensive. Hopefully, we will not seethe degree of over-indebtedness that is currently hurting consumer spending.
For manufacturers, it is important to realise that the UK remains the 5th largest manufacturing nation. And that this is the first post-War recession which we have not entered with an over-valued exchange rate. Although global demand remains depressed that the moment, those looking to export could gain substantial advantages as the recovery eventually starts to arrive. We would expect Asia to lead the upturn, with Europe the last to see any significant upswing.
Some key points in brief: The size of public debt is too much to help the burden of society. Technology will carry on and develop further. How will the financial sector respond, will credit be freed up? – there are signs of that happening now with more capital markets deals.
Energy – In manufacturing, there are great gains to be made in technology such as in the renewable energy sector. We’ll have to change our energy policy radically. Nuclear power will be a much greater part of the mix, which will open opportunities to UK manufacturers if we have the skills. Wave power and more renewables in general will come to the fore.
Credit and government loan schemes
TM: Is there any experience of applying for bank credit in the last six months?
Weidenbaum: I know of a case where someone put a business plan forward hoping to get the enterprise loan (Enterprise Finance Guarantee) and the bank asked for personal guarantees. Now I believe things are changing, but initially certain banks were very reluctant to take it seriously. There is, however, reluctance by the banks to lend, which harms business and stifles a recovery.
Colquhoun: It was rolled out without much clarity from government. The devil is in the detail. It is still being unravelled as we speak and some people are finding it more of a barrier involved than an opportunity.
Weidenbaum: Politicians and financial institutions don’t understand this properly: if you have an opportunity to do an export deal, you need to move fast and you can’t get quick decisions to support contracts. People can’t put up with having to bargain or negotiate for weeks on end while foreign competitors are there. You need quick decisions.