Note: In last month’s Equity Focus, Neel Kashkari concluded that while corporate profit margins in general should be sustainable in the near future, certain sectors will likely face margin pressure. Our view is that the global industrial sector is one of these areas.
Overall, global manufacturing industries have enjoyed cycle-on-cycle profit margin expansion over the past two decades, led by better management of capital, global labour arbitrage and strong fixed-capital formation growth in emerging markets. However, we believe that many of the tailwinds driving this growth are now diminishing (and not just for industrial companies) and could actually reverse, becoming headwinds in the period ahead. We foresee profit-pool dislocation in various value chains leading to lower cycle-on-cycle global aggregate industrial profitability. Companies that compete against newly globalising Chinese competitors could be particularly vulnerable.
Emerging markets fueled growth
Some of the factors driving profit margin expansion in the global industrial sector include:
Globalisation: The breakdown of global trade barriers has provided a tremendous profit boost for industrial companies that sell globally competitive products. In particular, the growth and opening up of emerging economies has been a win-win in many cases, bringing both higher top-line growth and enhanced profit margins when compared to mature markets and highly competitive local markets (see Figure 1).
EM fixed capital formation growth: With a strong focus on infrastructure and productive capacity growth over the past 10-15 years, emerging markets have been the primary global force driving equipment-related capital expenditures (see Figure 2). However, until recently, most of the equipment used to build roads and factories in these emerging markets has come primarily from companies in developed economies and Korea. As China moves up value chains, it is able to supply more of this demand domestically.
A focus on profitability: In the mid-1990s, management of many global manufacturing companies started to focus on capital allocation strategies and assessing the weighted average cost of capital. This led to much more orderly pricing behaviour in a number of industries and the end of the wasteful over-investment seen in past years, which had caused underutilized capacities and depressed profits. Figure 3 shows average annual operating profit margins for the global ball bearing industry, which is one example that illustrates this trend.
Global labour arbitrage: With the advent of the World Trade Organization (WTO) and China’s entrance into the WTO, global manufacturing companies have generally been able to reduce exposure to expensive labour in developed market economies and shift more value-added tasks to emerging market economies such as Taiwan and India (see Figure 4).
Changing dynamics threaten the trend
Some of the potential headwinds facing the global industrial sector include:
Mega-cycles under pressure: Looking at the three largest economic zones – North America, Asia and Europe – expectations for economic growth remain muted. GDP growth is likely to be slower over the next two to three years than in the previous decade, on average. If this caution proves correct, major drivers of top-line growth (such as infrastructure spending in China or automotive demand in Europe and the U.S.) could disappoint.
Rising labour rates: In general across emerging markets, workers are demanding, and getting, a higher share of the value they are creating. This is particularly noteworthy in some of the world’s largest labour pools, such as China (see Figure 5). This is causing a shift of low value-added tasks to lower-cost regions with smaller labour pools.
Global deleveraging: European banks have been at the heart of trade finance in a number of global industries. We are finding that as these banks increase reserve ratios, they are withdrawing from certain markets, such as shipbuilding and civil aircraft. Whilst Asian lenders are filling some of the gap, we are seeing weakness in new orders being placed in part because of this bank delevering. This increases overall risk and lowers margins.
Desertification of industrial profit pools
If China’s economy slows, not only will the volume of goods and raw materials exported to China be affected, but we believe profit margins will be especially hard hit in the manufactured goods area. Here’s why: Across the spectrum of goods that are exported to China (as well as produced inside China by joint ventures, such as autos), we have found that profit margins are often higher than global averages, and importantly in many instances, MUCH higher than global averages. For example, according to our industry research, German luxury car producers still tend to sell top-end models for 30%+ more in China than they sell for in Germany or the U.S., and this 30% is pure profit. Our research has also shown similar situations in Swedish compressors, British actuation pumps and Japanese heavy hydraulics.
The rise of Chinese competition in particular is a secular challenge to margins from which we believe there will be no escape for many developed market companies – even many of those that have Chinese production bases. Thus far, many developed market companies have enjoyed the “protection” of strong quantum growth in China absorbing incremental Chinese capacity and also providing extra profits for companies that can remain ahead of the so-called commoditization curve. However, profits will likely be affected if the explosion of Chinese production (for example, Chinese car production is set to grow 15% per annum in 2012-15 according to ACEA, Insight and JQL forecasts) meets lower domestic demand growth. In fact, we could see a terrifying “negative triple play” that would potentially affect Chinese and non-Chinese companies alike, emanating from the cyclical and morphing into the secular:
- Global margins for multinational corporations that have ridden the China boom wave could suffer “market mix dilution” if Chinese volumes disappoint.
- China could become a global “swing” supplier, selling excess domestic inventory (e.g. construction equipment, machine tools, steel, etc.) into export markets at prices that could cause global profit margins in multiple profit pools to contract significantly.
- Rapid advancement up the value chain could enable Chinese manufacturers to be able to grow sales in international markets faster in the future. Weak Chinese markets are causing exporters to expand distribution now, even though many of their products are not fully competitive. However, these efforts can position them better for when higher value-added products are available in two to five years’ time.
This triple play could mean the rapid evaporation of numerous global manufacturing profit pools. Our core position for the past several years has been that strong Chinese growth would cushion global companies as China rose up the value chain, enabling a somewhat “gentlemanly” domino-effect to play out. But this triple play would mean China could rise step by step in its indigenous capability, bringing the “China price” crashing down on global margins, as we have seen in solar, telecom equipment, etc.
Conclusion: Segments are vulnerable
We believe profit margins are most at risk in product areas where emerging market companies are benefiting from state capitalism and seek to take local advantages global. We have seen this situation in solar and telecom equipment areas and believe such change will occur in time across a wide range of product areas, from ball bearings to offshore engineering, aerospace and defence products. As profit margins in these industrial profit pools weaken, the number of highly paid employees could shrink and income tax receipts in those nations could decline. In time, this trend could become an important contributory factor to keeping GDP growth in developed markets at or below stall speed. In addition, developed market companies will likely need to raise R&D spending to maintain market superiority.
In contrast, we believe that companies we refer to as China-proof rulers and survivors (see Global Equities: Building a Research Mosaic for the Information Age, April 2012), such as high-end luxury car producers and similar branded goods, as well as companies benefiting from high barriers to entry, such as North American agriculture equipment companies, remain attractive.