Global manufacturing outlook growth while managing volatility

Global Manufacturing Outlook: Growth while Managing Volatility Global research commissioned by KPMG International from the Economist Intelligence Unit... Global Manufacturing Outlook

Global

Manufacturing Outlook:

Growth while

Managing Volatility

Global research commissioned

by KPMG International from the

Economist Intelligence Unit

Global Manufacturing Outlook: Growth while Managing Volatility is a KPMG International report that investigates how large

industrial manufacturers are dealing with market and input volatility

in a global marketplace The report was written by the Economist Intelligence Unit, which also executed the online survey and conducted the interviews on behalf of KPMG International

We would like to thank all of the executives who participated in the survey and interviews for their valuable time and insight The survey was conducted in June and the interviews in July of 2011, and both reflect the economic and financial conditions at that time.

Vice President and President,

Power Solutions, Johnson Controls

Dr Steve New

Fellow: Management Studies, Oxford

University’s Säid Business School

Martin Richenhagen

Chairman, President and Chief

Executive Officer, AGCO

Henry Yu

Chief Executive Officer, General

Steel Holdings

About the survey

A total of 220 senior manufacturing executives participated in the

survey All respondents are responsible for, or significantly involved

in, finance, supply chain, procurement or strategic development

Respondents represent the aerospace and defense, metals,

engineering and industrial products sectors, including industrial

conglomerates All participants represent companies with more than

US$1 billion in annual revenue; 40 percent hail from organizations

with more than US$10 billion in revenue Nearly half (47 percent)

of respondents are C-suite executives or board members They are

geographically split among Western Europe (31 percent), North America

(30 percent) and Asia-Pacific (25 percent), with the remainder coming

from the rest of the world

$1bn to $5bn

$6bn to $10bn

$11bn to $25bnMore than $25bn

48.18%

12.27%

18.18%

21.36%

1 What are your organization’s global annual revenues in

CEO/President/Managing director

CFO/Treasurer/Controller COO

CIO/Technology director Other C-level executive SVP/VP/Director Head of business unit Head of department Manager Other

2 Which of the following best describes your title?

Engineering and industrial products (including industrial electronics) Aerospace and defense Conglomerate (eg, multi-industry organization) Metals

h

Foreword

At the end of 2010 it looked like the long-awaited economic recovery was finally underway, but a series of global shocks throughout 2011 have taken the steam out of the positive momentum, casting doubt on a wider market recovery Despite these challenges, Diversified industrial (DI) companies –

accustomed to cyclical swings and continuous volatility – are clearly preparing themselves for the long haul

In this year’s Global Manufacturing Outlook survey, growth has emerged as a predominant theme along with a continuing focus

on cost, risk management and global supply chain resilience Today, companies are choosing to pursue growth through both product innovation and strategic alliances They are also fine- tuning product costs with more sophisticated design and process improvements, positioning production capabilities closer to growt markets, and enhancing transparency to manage global risk.

To provide context to this year’s survey results, the report contains

a broad range of insights from KPMG partners, industry experts and innovative DI companies These experts also weigh in on what it will take for companies to respond to the challenges and opportunities of today’s volatile global economy and distance themselves from the competition

Despite the prolonged uncertainties DI businesses face, many companies emerged from the 2008–2010 downturn with significantly reduced cost structures, more cash and liquidity, and a laser focus on their customers and markets In an age and industry where volatility has become a given, companies that possess these attributes and pursue these strategies will likely define the standard of success in the next five years Our report results show that DI companies are clearly positioned for growth, but they are doing so with a healthy respect for unpredictability and volatility

Executive summary The business outlook:

growth ahead, but risks loom

Despite a generally profitable year, many leaders of global manufacturing firms face a number of challenges Just as the global economy looked like it was gaining momentum, the Japanese tsunami struck, unravelling many global supply chains Since then, volatility has become a key watchword, as a wide array of macroeconomic risks – most notably the European and US debt crises – raise uncertainty over future demand and the spectre

of a “double dip” recession

Yet executives at major manufacturers – organizations polled in an Economist Intelligence Unit survey representing firms with at least US$1 billion in revenue – are cautiously optimistic that they can realign their businesses toward top-line growth while

Executive summary

Some of the key findings emerging from our research include:

• Price volatility is the biggest headache for manufacturers The number-one

challenge identified for the year ahead is that of price volatility of raw materials and other inputs Bob Kickham, senior vice president, procurement, at Luvata – a global metals and manufacturing group – recounts how a few years back a US$10 shift in copper prices in one day was an extraordinary occurrence He is now immune to daily swings of up to US$250 Selected by 44 percent of firms globally, ahead of any other issue, price volatility is especially acute for Asian firms, selected by 54 percent of respondents

• Although the push toward emerging markets continues, this does not imply the

demise of manufacturing in the West One of the more striking research findings

is that the US registers second only to China as a destination for new sourcing in the next 12 to 24 months It ranks third highest even for emerging market manufacturers

“We’re going in both directions,” says Martin Richenhagen, CEO of AGCO, a global farm equipment manufacturer, of his organization’s investment plans in both Asia and North America Of course, it is clear that emerging markets are a major driver of growth:

52 percent of manufacturers say their growth plans hinge on these markets But many plan to invest in mature markets too: 43 percent of respondents aim to expand capacity

in developed markets, more than twice the proportion that plan cutbacks

• In the pursuit of growth, manufacturers are prioritizing new products One

noticeable shift when comparing respondents’ views from the last two years versus the next two years is the added attention that firms will devote to new products Over the next two years those planning to rely on existing products in existing markets will more than halve (from 44 percent to 19 percent), whereas those planning to sell new wares in existing and new markets will increase from 37 percent to 56 percent This will put a premium on innovation, and the survey shows that organizations are placing more emphasis on research and development (R&D) Indeed, innovation/R&D will be the second-highest priority for investment/expansion, after cost management Many are opening design centers in high-growth markets In doing so, however, they will be challenged by a shortage of skills, the top human resources concern cited by executives

in those markets

• Diversification into new markets and new products will converge with a push

toward input and process standardization In response to both input price inflation

and volatility, many organizations are prioritizing increased standardization More than half of manufacturers polled (55 percent) plan to standardize production processes across sites, while nearly half (45 percent) will move toward standardized inputs across product lines Given the concomitant shift toward a greater focus on new products, however, standardization poses a risk of homogenous product lines that could fail to engage consumers Another challenge will be managing the tensions that could arise between Sales and Procurement, as one function tries to push new products into the market while the other works to standardize inputs

• Investment in supply chain risk management will continue, with a particular focus

on transparency Many organizations have already made substantial investments in

bolstering their risk management functions over the past couple of years Stung by the severity of the tsunami in Japan, this push will continue, with a particular focus on improved supply chain visibility, to better assess where potential vulnerabilities lie The use of technology to improve supply chain visibility is the number-one tool that executives plan to rely on to identify risks (selected by 49 percent of respondents)

KPMG Global Manufacturing Outlook: Growth while Managing Volatility 5

of sentiment among procurement executives, showed that as of mid-2011, confidence among manufacturers in the US had risen consistently for nearly two years

This confidence was mirrored by manufacturing executives surveyed by the Economist Intelligence Unit in June

2011 One in four survey respondents describe themselves as “very optimistic” about their organization’s prospects for the coming one to two years, while a further 53 percent are “optimistic.” Luvata, a global metals and manufacturing group with revenues of over €3 billion, is one example “2009 was a very poor year, the eye of the recession But during 2010–11, we’ve doubled our profits and

we expect to be back at 2008 levels by the end of 2011,” says Bob Kickham, the firm’s senior vice president for procurement “Next year, we see that trend continuing, with double-digit increases, while we’re cautiously optimistic in terms of growth in profitability.”

But compared with findings

highlighted in the 2010 Global

Manufacturing Outlook1, a degree of caution has crept in, primarily triggered

by the European and US debt crises that have dominated the headlines

in mid-2011 Overall, confidence is slightly down on a year ago This matches a similar drop in the PMI (see chart) European manufacturers are the most ambivalent about prospects, while Asian firms are most bullish US manufacturers were also optimistic, perhaps because at the time of the survey, the full impact of the country’s debt crisis was not known Given the potential of downside risks, such differences are unsurprising The rate

of gain in overall economic output has declined in the US and Europe, as the global economy lost some of its momentum This is filtering through

to manufacturers Joe Kaeser, the chief financial officer of Siemens, a conglomerate with revenues of €76 billion in 2010, recently advised that increased efforts would be required

to maintain growth going forward,

as “the tailwind from the economic recovery is likely over.”2

Financial crises in the euro zone have dimmed Europe’s economic outlook Japan is still recovering from the effects

of its devastating March tsunami

1 Global Manufacturing Outlook: Relationships, Risk and Reach, KPMG International, September 2010

2 Siemens sees end to ‘tailwind of economic recovery’, Financial Times, June 28, 2011

How optimistic are you about your business outlook in the next

12 to 24 months?

Source: Economist Intelligence Unit survey, 2011 and 2010.

Very optimistic optimistic norNeither

pessimistic

Very pessimistic Pessimistic

Purchasing Managers Index: Manufacturing

January 2008–July 2011, a reading above 50 indicates a general expansion; below 50 a general contraction

Source: Institute for Supply Management (ISM)

010203040506070

Integrated Finance Governance

Financial management is becoming more central in managing risk both for companies operating in Asia and for Asian companies looking to expand globally In both cases managers are becoming responsible for transactions and processes that are occurring thousands of miles away across multiple locations To get a handle on that, I have been advising my clients

to move their target operating model toward a structure with more integrated finance governance For too long

finance has been stuck at headquarters where managers have been allowed

to see their primary function as saying

“no” to spending requests Instead, the most agile organizations are seizing

on finance as a way to bring additional value in terms of analytics and insight

As the amount of data and noise proliferates, finance offers a way to gain insights and align the underlying business case I’m seeing clients move toward center of excellence models where finance professionals, skilled

in analytics, valuations, mergers, or treasury are housed together centrally where they can serve as a repository

of knowledge for outlying offices That has been a very effective way to gain strategic leverage.

The Baltic Dry Index (BDI), an index

of shipping costs, remains close

to record-low levels Developed economies are just starting to grapple with their debt burdens, with government austerity ahead

In emerging markets, the outlook is more positive, but risks lurk there too Inflation remains high while concerns mount about the overheating

of China’s economy “The global steel industry has been volatile in

past months, and is likely to remain uncertain in coming months,” says Ding Liguo, chairman of Delong Holdings, a China-headquartered steel manufacturing group with

2010 revenues of RMB9.9 billion (US$1.5 billion) He adds that steel production in China has been affected

as the country implemented tightening measures to rein in inflation and cool its housing market

credit-Price pressures

But the most pressing challenge for

manufacturers is the cost of key inputs

Although prices have eased more

recently, many commodities remain

at historically high levels Meanwhile,

a jittery global economy has increased

the price volatility of key inputs, such

as metals This is easily the biggest

headache for manufacturers, selected by

44 percent of respondents globally One

example is the price of copper, which

increased from US$3,500 per ton in 2005

to over US$9,000 by mid-2011

Unfortunately, executives do not

anticipate much relief A majority of

survey respondents expects price

increases on raw materials, energy,

and transport and distribution Some could be steep One in five respondents expect transport costs to increase by at least 20 percent in the next one to two years, while 16 percent think the same

of primary raw materials However, the greatest fear of price increases relates

to energy costs with nearly one in four executives expecting them to rise at least 20 percent Such sentiment may

be due to the fact that manufacturers are in the center of a price storm in 2011: industrial raw materials prices are expected to rise nearly 30 percent, according to the Economist Intelligence Unit, on the back of a 44.5 percent

increase last year (see Growth and price

forecasts) Some relief is forecast for 2012.

Source: Economist Intelligence Unit survey, 2011.

Price volatility on key cost inputs

Intense competition and pressure on prices

Uncertain demandRisk and reliability in the supply chain

Efficiency in R&D/product development process

Increased regulation in our industry

Managing geopolitical riskImprove technological efficiency

Prospect of tax increasesLack of access to capital or credit

What do you see as the biggest challenges for your business in the next

12 to 24 months?

Percent respondents

In the 25 years prior to 2005, the average price volatility (for copper) was minor It would be a news story

if it moved US$10 in a day But I am now immune to seeing swings of US$250 a day.

Bob Kickham

Senior Vice-President, Procurement, Luvata

KPMG Global Manufacturing Outlook: Growth while Managing Volatility 9

Emerging market manufacturers expect

future price pressures to be even more

intense than their developed market rivals

“The greatest challenge we have

seen recently has been the overall

increase in price of raw materials,

such as iron ore and coke, which

has affected our gross margin,”

says Henry Yu, CEO of General Steel

Holdings, Inc (GSI), a privately held

Chinese steelmaker that plans to

increase output to 6 million tons this

year, from 4 million tons in 2010.

Growth and price forecasts

These cost concerns are exacerbated

by intense competition and pressure to keep prices down, the second-biggest challenge, cited by 40 percent of survey respondents For many, price increases will

be unavoidable: 63 percent of executives agree that they will be forced to pass on higher costs to their clients in the year ahead Rounding off the trio of challenges

is uncertain demand (35 percent)

The aerospace and defense (A&D)

sector is used to weathering economic

ups and downs Its exposure to

the fluctuations in government

appropriations has made the industry a

leader in instituting and managing cost

controls That discipline will benefit it as

it looks to transfer those cost savings

into new growth opportunities

“There is no question that the next

few years will see a marked upturn

in mergers and acquisitions.” says

Phillips.

”With government coffers dry, A&D

companies are looking to invest in

adjacent markets and products.” The

challenge, of course, is choosing which

commercial sector to enter “A&D

organizations have a long memory,”

observes Phillips “Many got burned

in the 1980s when they turned to a

stream of private sector initiatives,

from transportation to gaming With

risk aversion high right now, many

companies are reluctant to sink money

into unproven technologies.” He adds,

“navigating the right commercial and

geographic markets to enter through

direct investment or joint venture can

be immensely difficult A&D companies know how to deliver when the market

is really, really good and really, really bad But the ‘in between’ makes it hard to know what path to take We help organizations work through that decision tree.”

“To gain clarity, organizations are coming to KPMG for help in shoring

up their fundamentals, restructuring their businesses, and spinning off unprofitable assets.”

One client had two business units with overlapping IT functions, for instance

By combining those units, they cut excess capacity and cost while also slimming down their management model

Phillips believes it may take until 2014 before the A&D market sees a reprieve

in current market conditions But, he notes, “A&D companies have a fairly high pain tolerance and they always make a point of seeing to it that the interests of shareholders are protected whichever way the market turns.”

Which of the following aspects of your business will you

prioritize most?

Top-line growthCost containmentProduct qualityCustomer relationshipsOperational efficienciesR&D/innovation (including efficiencies in product

development life cycle processes)

Back-office process efficiencies/shared services

Innovation/speed to marketImproved visibility on product costs

Source: Economist Intelligence Unit survey, 2011.

Striving for growth

Despite all these challenges, many manufacturers are clearly shifting from

a dual focus on cost containment and top-line growth to a more singular emphasis on growth This is not to say that cost containment will be forgotten

Nevertheless, it signals a shift in aspiration, after years of fire-fighting

But if growth is back at the top of the agenda, where will firms look for it and what strategies will they implement to realize it? And how are supply chains being restructured to support this growth? The rest of this report will address these questions

“A weaker US dollar and steady

demand from China have made steel

and metals one of the bright spots in

the global economy in 2011.”

But steel is a cyclical business, and

Eric Damotte, head of KPMG’s global

metals practice, warns that the

sector’s performance may be affected

by the undercurrent of uncertainty

fueled by the European debt crisis

and the tepid US economic recovery

That cyclicality is sharpening as steep

swings in the spot pricing of iron ore

squeeze profitability

The growth picture is also more clouded

“China has been the major driver of

growth representing between 40 to 50

percent of global production and demand,”

says Damotte, “but that growth rate is

probably not sustainable and foreign

entrants are precluded from getting

a piece, given Chinese government

controls.” Although some companies have

sought workarounds in the form of joint

ventures with Chinese partners, many

of these come with provisions, such as

restricted ownership and complex rules

that put into question the overall value

Where then to look for growth? With

European markets mired in the debt

crisis and the US recovery hampered

by slow growth, the metals industry

has focused its sights on countries like

Brazil, India and Russia that are rich

in mineral resources and have rapidly

expanding physical infrastructures

But those markets bring their own

challenges Damotte adds, “in some

respects, Brazil has been overly

successful The country has deep

reserves of iron ore and coking coal,

making it one of the best places

in the world to produce steel But

the accelerating economy and the

revaluation of its national currency have

made the country an expensive place

to operate.” India is another popular

beachhead, but operators must contend

with a developing infrastructure,

complex environment, and a slow

decision-making process

To compensate, Damotte says leading players are focusing on sustaining cost improvements

“There is a tremendous amount of invested capital in the steel business

To justify the heavy fixed cost, the traditional thinking was that plants needed to produce non-stop The idea

of shutting a blast furnace used to

be considered impossible, but not so anymore As technology has advanced, producers can adjust capacity to cut unnecessary costs.” The industry has gotten a lot better at flexing production capacity in line with demand and reducing what used to be a fixed cost

Intent on reducing finance and inventory risk, buyers of metals products are also keeping stock levels low “But this makes demand swings more brutal,” says Damotte “That’s because when the market anticipates possible price increases, buyers rush

in to lock up supply, prompting prices

to rocket up for a short while before dropping sharply again when the rush subsides.” As a result, better business intelligence is a top agenda item

“Scenario building has become

a real cornerstone of planning, something that has taken off over the last 12 to 18 months,” says Damotte “My clients realize they need to plot a range of variables – both quantitative and qualitative – and plan contingencies

accordingly.”

Reflecting on the sector’s near-term prospects, Damotte becomes philosophical “The economy works like a self-fulfilling prophecy When negativity abounds, results reflect that The good thing about steel, however, is that, cyclicality issues aside, there will always be a certain minimum of demand Economies are built on infrastructures, and infrastructures are built with steel.”

Growth strategies:

managing volatility

Manufacturers are reshaping their

business models in order to deal with

this more volatile world More than half

(56 percent) of survey respondents agree

that their firms are changing models in

order to cope with market dynamics

Just 15 percent say they are not For an

industry that is often perceived as being

relatively slow-moving, this is a striking

figure There are numerous shifts that

individual firms will make, but three

themes stand out:

and demand management

Operating closer to new sources of growth

As in many other industries, the macro trend of a steady shift eastwards continues in manufacturing

However, the US surprisingly topped this year’s list for expected demand in the next 12 to 24 months, just barely edging out China for the number one position.

India and Brazil both feature in the top five as well, and Germany ranked fifth

Manufacturers increasingly see emerging markets as crucial demand engines

More than half (52 percent) of survey respondents agree that their growth strategy is reliant on these markets

Emerging markets are now more important as sources of demand than for low-cost production (54 percent) Siemens, for example, is actively exploring opportunities in lesser-developed

countries such as Indonesia and Thailand

“The core of our strategy is to shift our focus and look more toward [these] markets,” says Barbara Kux, Siemens’ head of supply chain management, “in order to ensure our planned business growth.” Meanwhile, emerging market manufacturers see little reason to leave their core markets “Demand within China

is significant enough that we have not had the opportunity to explore such avenues,” says GSI’s Mr Yu Delong’s Mr Liguo says that more than 90 percent of the company’s sales go to Chinese customers

Which countries do you expect to account for the majority of your new

business growth in the next 12 to 24 months?

Top 10 only

As the world’s second largest economy,

some see China as having outgrown

its “developing nation” label, but Andy

Williams, ASPAC Leader for Diversified

Industrials, KPMG in Singapore, says

the reality is more nuanced “There is no

doubt that China has grown significantly

on a commercial level But, there are

enormous differences from region to

region within China Some areas boast

thriving business centers, while others are

still decades behind in their development.”

However, there’s no doubting the growth

trajectory By 2020 or 2030, the majority

of the world’s middle class is expected to

be in China

While that strategy may give domestic

brands something to chew on, Western

companies have a lot to learn from the

Chinese way of doing things as well

Chinese companies tend to go global

on a sector basis They consolidate

domestically first, then look to buy

outside Says Williams, “by the time a DI

sector, such as engineering, has gone

from being a thousand strong to just the

five top players, the scale, the cash on

hand and the acquisition experience are

usually massive.” That gives them the

means to move forward globally, buying

up big name companies and solidifying

their leadership on the international stage

“The Chinese are masters at planning,”

adds Williams

“The government issues a

meticulously detailed five-year plan

that gives a roadmap to the economic

and social priorities for China

Citizens, both corporate and private,

tend to follow it rigorously For

companies, that level of discipline

and planning helps them execute

with far greater consistency.”

Foreign DI companies have their own

maturity curve when it comes to

partnering with Asian suppliers According

to Williams, “one mistake foreign entities make when expanding into Asia

is to assume that the outsourcing or partnership model they follow in Europe

or the Americas will work equally well here Asia-Pacific hosts a tremendous mix of people, cultures and sub-cultures all under one regional moniker For that reason, DI companies cannot apply the same solutions unilaterally whether it be globally or even within the region itself.”

Although Williams is bullish on the DI sector in Asia, he cautions that the region’s rapid rate of growth probably cannot continue at its present pace given global economic uncertainties While the region was largely buffered from the 2008 financial crisis, Williams sees them as more exposed this time around

“Domestic consumption sustained the region during the last downturn, but inflationary pressures in China, Vietnam, Indonesia and others have cooled demand, and, as we know, global markets just aren’t buying right now.”

All this has put risk management more firmly on the table One way to manage that will be through mergers and acquisitions Says Williams,

“The smart money is at the commodities end of DI Because

if you think of the value chain it really is a case of ‘he who has the raw materials wins’.”

“As a result, I expect my clients and other Asian conglomerates will pursue a more aggressive acquisition strategy to lock in access.”

Looking out over the next 18 months, Williams remains optimistic, but cautions that folks can be overly positive “The opportunity is there; the demand is there

But, success can be squandered if the risks aren’t managed properly.”

But developed markets cannot be

discounted The Power Solutions

division of Johnson Controls, a nearly

US$40 billion global manufacturer, is

a case in point Its lead-acid batteries

sell well in emerging markets where

demand for new cars is soaring, but

sales remain steady in the US even

when car sales drop “If someone

doesn’t buy a new car, they have to

replace the battery anyway,” says Alex

Molinaroli, the division’s president

“So it’s a tale of two cities; flat or low

percentage growth in mature markets,

then emerging markets building rapidly.”

This West-East picture is even more

nuanced when it comes to sourcing

China, India and Brazil are all top-five

targets among survey respondents

But developed markets are hardly

being abandoned The US is second,

the UK fourth and Germany sixth This

development can be attributed to the

volatility of commodity costs, which

has added to the appetite of companies

to source from closer to home Higher

oil prices mean higher transport

costs, making Western companies

increasingly inclined to shorten their

supply lines Shorter and simpler

supply chains also allow firms to hold

less inventory, as restocking becomes

both simpler and quicker if your

suppliers are nearby Ever-increasing natural disasters are also causing companies to think twice about relying

so heavily on a single source or single region for key components

Even for emerging market-based manufacturers, the US is third (after China and India) as a sourcing market

For Western firms, the US narrowly leads China “We’re going in both directions,” says Martin Richenhagen, CEO of AGCO, a global manufacturer

of farm equipment with nearly US$7 billion in revenue in 2010 “We’ve got our China investments, but also in North America we’re going to invest in expanding one of our existing factories

to start manufacturing high horse power (wheel) factories, for the first time in our history.”

An emphasis on new products

A second growth theme is a greater focus on product diversification and innovation This is a significant shift from recent years Existing products will be significantly less important in existing markets, while much greater emphasis is placed on new wares –

in both existing, and new, markets

While cost management remains the top priority, innovation and R&D come

in second This will be a particular priority for US firms, which rank R&D and innovation on a par with cost management AGCO, for example, has dramatically increased R&D investment “We’ve tripled the level of spending, so it’s now close to

3.5 percent of sales,” says

Mr Richenhagen

Luvata is investing in both new products and new markets, establishing factories

in Mexico and Malaysia This helps give

it both geographic and product diversity

“The [market] changes recently have reinforced our strategy of being a global player, in multiple end-business segments It’s been a good risk mitigator for us,” says Mr Kickham “When auto was having the most horrible time known

to mankind, people were still buying MRI scanners and spending on healthcare.”

To support this drive for new products and to lower product development costs, 48 percent of manufacturers are establishing design centers in emerging markets But talent shortages will be

a concern The availability of skilled workers now tops the list of human resource concerns in emerging markets (cited by 36 percent of all respondents) There are differences between emerging and mature markets, however