SECTOR PROFILE - Manufacturing some margin for manoeuvre

It is one of the ironies of modern life that the engineering sector seems fated to struggle on at the bottom of the City’s performance league tables, while the rest of the world sees new triumphs of electrical, mechanical and chemical engineering appearing all the time.

Where top-performing companies in the fast-moving computer industry regularly set out to achieve margins of 35% and more, the engineering sector faces a constant battle to get its margins into double digits. As Graham Mackenzie, director general of the Engineering Employers Federation, comments: “There is a good deal of evidence that the blue-chip engineering companies are looking for margins of well above 10%. The only way of achieving this is for them to drop out of products that do not do this for them any more.”

Although this sector poses some peculiarly tough challenges for FDs, it also boasts some of the most able practitioners around and may yet prove to be a highly under-valued and under-rated performer in the medium term. As Mackenzie puts it: “There are a number of players in this sector who, by dint of rationalisation and by becoming very slick, are making a reasonable living in engineering. There is a lot going on in terms of rationalisation and management buy-outs, all aimed at achieving higher margins.”

John Nutton, chairman of Robson Rhodes’ engineering industry group, points out that the engineering sector in the UK faces more than its fair share of “challenges”. Heading the list are the high strength of sterling, the imminence of Emu, turbulence in the Pacific Rim economies and the threat posed to European engineering companies by the low-wage economies in the developing nations.

“What we are finding with our mergers and acquisitions work is that companies are looking to joint ventures and strategic alliances both to open new markets and to help drive down costs,” he comments. “Companies are outsourcing the low added-value products to the cheaper economies and concentrating their production efforts in Europe on the higher added-value, more complex products – which, of course, makes a lot of sense.”

Nutton points out that even some of the tiger economies such as South Korea, categorised in the past as low wage-cost economies, are finding themselves pushed into this process of outsourcing to even lower cost economies. The Korean steel industry, for example, is moving its lower value products outside the region .

Globalisation is having a major effect on the whole sector, particularly the automotive industry which has traditionally led the way in innovative practice. “Where, in the past, car manufacturers would have bought in a host of tiny components, now they bring in much fewer, larger scale components,” Nutton says. “The capability for assembly is being pushed down the supply chain and a reduced number of suppliers have to take on responsibility for far more.”

Nutton points out that tier-one suppliers are now finding new business opportunities by being able to handle smaller batch sizes than the big manufacturers. By being more flexible than their larger clients they are finding that they can charge a premium for their efforts.

Richard Gane, the lead partner in Price Waterhouse’s automotive industry group, agrees. In advanced engineering these days, he says, the units of business seem to be either modules or systems. There is a subtle difference between these two. The module is supplied as a complete unit, ready for assembly into whatever it is that the manufacturer is making. A system, on the other hand, is a collection of parts designed together as a whole but not necessarily all supplied by the same contractor. They can be shipped to the final manufacturer as separate pieces, or sub-assembled elsewhere and then shipped on. Both have the same rationale.

“Everyone is trying to increase the value that they have on the final unit, while at the same time manufacturers are trying to cut down on the number of suppliers they have to deal with,” Gane notes. The trend towards the outsourcing of various functions is still in its infancy. But, already, an inevitable consequence of this change in the supply base is that players who want to be tier-one suppliers are increasingly having to manage a fairly complicated supplier base of their own. While the original manufacturers are able to cut back on their own purchasing and logistics departments, the tier-one engineering suppliers find themselves having to build up their purchasing, design and supplier management capabilities to levels that are completely new for them.

Although Gane believes that the model being set by the automotive industry will inevitably come to shape the way in which the engineering sector as a whole will operate in the future, he points out that it is still relatively new territory for even established tier-one automotive industry suppliers. Naturally enough, this transformation in supplier-manufacturer relationships is not without some stresses of its own. “One of the great sources of irritation right now in the car industry among manufacturers is that the suppliers are making far better margins than they themselves can hope to achieve,” says Gane. He points out that margins for car manufacturers are fixed at around 3%-5%, while component suppliers such as the TI Group have a target figure in double digits.

Gane believes the City’s view of the engineering sector is unlikely to change in the medium term. “The engineering sector was really slow in getting to grips with the primary drivers of shareholder value. It was, and still is, far too complicated a task, in many instances, to work out what the components of shareholder value are for a particular engineering company. The finance directors are now seen as the architects of these corporations, along with the CEO. They are not just bean-counters any more, so they really have to work at getting this right,” he warns.

TI Group finance director Martin Angle is probably better placed than most FDs when it comes to understanding City expectations. He was a merchant banker for 20 years before taking over as finance director from Brian Walsh. During his time as a banker Angle built up an extensive knowledge of the group, having been lead UK adviser to TI during a period of major restructuring between 1986 and 1990. According to Angle, TI’s strategy has remained constant for the last 10 years under the leadership of its chairman and CEO Sir Chris Lewinton. This strategy, he says, has been responsible for delivering a compound shareholder return of around 17% per annum over this entire period. The group seeks to develop niche global businesses that are able to command positions of sustainable technological leadership and have a high knowledge and service content.

As Angle puts it: “Engineering today is much less about cutting lumps of metal and is now all about providing a service to solve customer problems.” Moreover, ability to operate globally is going to be increasingly important for most engineering companies of scale.

Today customers want consistent quality and design expertise from region to region. When one brings these two factors of systematisation and globalisation together the result is a clear roadmap capable of guiding further acquisitions.

“It is clear that to be truly global engineering companies will have to have greater scale than we have at the moment, so we are determined to acquire the right scale, the right degree of critical mass. At the moment Siebe is two-and-a-half times our size, while Smiths Industries and GKN are about 25% as large again as we are. We are aware of the need for growth and it seems inevitable that we are going to see a consolidation in the engineering market that parallels the kinds of activities that have taken place in other sectors,” he judges.

Angle points out that many of the group’s key products go into safety critical areas where quality is of paramount importance: products such as brake and fuel lines, hydraulics and actuators for thrust reversals.

The advantage of this sort of product line-up is that once a reputation for quality has been established the relationship with the manufacturer becomes less price sensitive. The supplier is unlikely to be undercut by a newcomer simply on the grounds of price alone. In an industry where the pressures on margins are intense this point is hard to over-emphasise.

“This is where selected niches are so important. This sort of niche provides one with a level of protection which comes from the high cost of entry for new players, both in terms of capital and reputation.”

According to Angle, getting the product balance right is vital to the ongoing success of a group such as TI. The company has 20% of its portfolio in aerospace, a bit more than 30% in the automotive industry and the rest in industrial products. This means that if some sectors go flat then the others can carry the under-performers.

“It would take between three and five years to grow to twice our present size. We aim to maintain organic growth rates, to sustain double-digit sales growth and maintain organic profit growth in excess of 15%. We are looking to achieve a return on shareholders funds in excess of 15% and climbing towards 20%.”

European monetary union is not a big concern for the group, he says, pointing out that TI serves a global customer base. “Only 30% of our business is with the continent of Europe. Of the remainder, 15% is with the rest of the world and the rest is with the US. A key issue for us is whether Emu is going to make Europe more competitive,” he notes.

Angle points out that, as things stand right now, Europe is a Pandora’s box of hidden hand-outs. “These concealed subsidies place a huge constraint on our ability to do business in France and Germany, for example. However, there are cultural issues in Europe, such as employment practices, which are unlikely to be touched by Emu. These factors will continue to act as a constraint on expansion by way of joint venture. The reason why we got out of our joint venture with Messier Doughty is that it became fairly clear early on that the sort of returns that could be achieved on a 100% stake could not be achieved in a joint venture with a European partner because of cultural differences over working practices.”

Perhaps even more than TI, Siebe, the UK’s largest safety-critical systems group, has used a carefully honed acquisitions strategy to drive its growth well beyond the limited margins generally achieved in this sector. Finance director Roger Mann has played a major role in formulating and executing Siebe’s strategy.

His involvement with the group goes back to 1973 when he joined as financial controller of Siebe Gorman & Co Ltd. At the start of the 1980s, when the group’s acquisition strategy began in earnest, Siebe’s business consisted of a mixture of light and medium engineering, together with the manufacture of safety-critical systems for the diving industry.

In addition to buying an ever larger share of its core market, the group was also on the lookout for “gems” – groups with high-performing companies in sectors that Siebe understood, and to whose sales it could add impetus through its growing capacity to operate globally. In 1984, for example, in a contested takeover, it acquired Tecalmit plc which included three engineering companies specialising in controls. These companies had sales of less than #1m but gross margins in excess of 40%. Siebe’s aim was to dramatically improve the level of sales while striving to maintain as much of that excellent 40% margin as it could.

In 1985 it acquired the CompAir Group from IC Gas. That group, Mann points out, contained three “nuggets” enjoying margins in excess of 40%. “These were the niche signs we were looking for in our growth strategy,” he says.

So far this decade, Siebe’s acquisitions include the Foxboro group, bought in October 1990 at a cost of $675m; power controls specialist Unitech, acquired for #500m in 1996; and most recently the Eaton Group’s appliance controls business, a specialist manufacturer for the food, pharmaceutical and beverages industry, at a cost of #330m. “The way to understand our move into the appliance controls market is to see it as providing balance to our portfolio. The acquisition of Foxboro gave us considerable strength in chemicals, oil and gas. APV corrected our relatively light weighting in the pharmaceuticals, beverages and food sector,” he explains.

With only 8% of its sales in the UK, Siebe has a considerable interest in currency movements and its treasury function is highly important. According to Mann, the group is looking forward to Emu in the hope that it will reduce the risk and the cost of hedging.

In addition to its outward-looking acquisitive strategy, Siebe is very concerned to pare down its manufacturing costs as part of the drive to improve margins. The group has a target of reducing costs by 5% annually.

Its message to all who work in this sector is uncompromising. “If we cannot take sufficient labour costs out of our manufacturing processes we are quite prepared to move these processes to lower cost countries. At least 20% of our employees in manufacturing today are in the lower cost countries,” he says.

With China and India ready to offer top-grade engineering and electronics skills at a cost-per-hour that can be as low as 10% of typical costs in some western countries, the outlook for the UK’s indigenous engineering skills base looks bleak.