Upgrading britain the effect of capital expenditure trends on productivity, profitability and competitiveness

This Economist Intelligence Unit report, sponsored by Lombard part of The Royal Bank of Scotland Group, reviews capital expenditure CapEx patterns within corporate Britain as the economy

A report from the Economist Intelligence Unit

Sponsored by Lombard

© The Economist Intelligence Unit Limited 2011 1

About the study

Upgrading Britain? The effect of capital expenditure trends on productivity, profitability and

competitiveness is an Economist Intelligence Unit report, sponsored by Lombard, part of the Royal

Bank of Scotland Group The report reviews the capital expenditure plans of British businesses to gauge spending trends, as well as related challenges and opportunities

The research draws on several inputs, including:

small, with revenue under £100m; 42% had revenue of between £100m and £1bn; and 34% were large, with £1bn or more in revenue All major sectors were represented, with a weighting towards IT & technology (21%); manufacturing (16%); transport and logistics (15%); and financial services (11%) The survey sample was very senior: all respondents were from a management function, with 48% representing the board or C-suite

balance sheets, along with wide-ranging desk research

and insight (listed alphabetically, by organisation):

l Andrew Pimblett, managing director, Street Crane Company

The author of the report is James Watson and the editor is Monica Woodley James Gavin and Sarah Fister Gale conducted a few of the interviews for this report

© The Economist Intelligence Unit Limited 2011



government and the private sector Such investment is crucial to maintaining the long-term competitiveness of both the country and individual businesses

This Economist Intelligence Unit report, sponsored by Lombard (part of The Royal Bank of Scotland Group), reviews capital expenditure (CapEx) patterns within corporate Britain as the economy moves slowly out of recession while still facing daunting headwinds This report considers whether firms are planning to increase CapEx and in which areas, and how the decision-making process has changed since the financial crisis

The key findings from the research include:

lCapital expenditure is lagging confidence and capital levels Planned increases in CapEx do not

reflect the degree of confidence that management hold in the economy, or the cash held on many balance sheets While more than two-thirds (67%) of respondents express confidence about the future economic climate for their business and a similar number (70%) are holding cash, just 36% plan

to increase capital expenditure For a similar number (37%), CapEx will remain flat In part, this is because many firms still have spare capacity, as demand remains below 2007/08 levels Just 23% plan

to cut back or eliminate it entirely (4%)

lMost, but not all, UK firms cut capital expenditure during the recession Nearly two-thirds (63%)

of firms cut back investment during the financial crisis and subsequent recession One-quarter of survey respondents cut back all but the most essential of spending, while 38% simply pressed pause

on all new investments Overall UK investment fell by 29% from a quarterly peak of nearly £38bn in late 2007 to just under £27bn in late 2009 However, not everyone was so cautious: some (14%) firms took advantage of the climate to invest for a competitive advantage, while nearly one-quarter of firms maintained all planned investments

lBusinesses are slowly, but surely, modernising their physical assets There is a small, but clear

shift in CapEx allocation plans, with a trend towards acquiring new assets, whether IT systems, equipment and machinery, or telecommunications infrastructure, rather than simply spending on maintenance

Executive summary

lMeeting the demands of existing customers is the main driver for investment Two-thirds of

respondents agree that this has been the key motivation for capital spending However, keeping pace with technology or delivering more innovative products may be the real motivation, rather than increased capacity Improved efficiency and expanding the business are also cited as reasons for CapEx

lMost firms believe belt-tightening has boosted productivity Over one-third (34%) of

respondents have seen productivity improve where they have focused on innovation or efficiency improvement during the downturn A further 28% say productivity has stayed the same The key question is how long this cycle can be stretched out, as this is not a sustainable strategy for the long term

© The Economist Intelligence Unit Limited 2011 5

investment This is the case from a government investment perspective, in areas such as transport infrastructure, including roads and rail But it is also true from a business investment perspective,

in terms of companies taking the decision to invest their capital in new factories, equipment and

Introduction

25.5 24.3 24.1 22.7 22.3

20.1 19.9 19.7 18.7 17.4

22.0 21.3 21.1 21.1 20.7 20.5 20.4

Portugal Spain Switzerland Austria Norway Finland Average Italy Netherlands Ireland Greece Germany Belgium France Denmark Sweden United Kingdom

Chart 1: Gross fixed investment, 1980-2009

(% of GDP)

Source: Economist Intelligence Unit.

machinery, information technology and other areas Such investment is crucial for improving efficiency and competitiveness, and expanding overall capacity to cater for future growth

From a macroeconomic perspective, the UK’s total investment, which is almost wholly comprised of the two elements above, as well as housing investment, is in fact the lowest of any country in western Europe The UK’s fixed investment as a percentage of GDP between 1980 and 2009 averaged around 17.4%, in comparison with an average of 21%, with some rates as high as 24%, across the 15 major European economies (see chart 1) During the past decade, levels of government investment in the UK tripled, while investment in housing soared during the property boom However, both of these are now being constrained, especially given the government’s plans to cut spending sharply in order to reduce its budget deficit substantially

In terms of business investment, which accounts for about 60% of total UK investment, the term trend shows several periods of pick-up, all of which have ultimately stalled In both the 1980s and 1990s, investment started increasing, with the latter closely linked to the dotcom boom and an associated surge in IT-related investments More recently, a rise in capital expenditure during the 2000s has once again been cut short by the severe financial crisis that started in 2008 (see chart 2) As

long-of the fourth quarter long-of 2010, total business investment was around £30bn, about the same at the end

of 2001

This holds critical implications for the overall performance of the economy, as investment accounts for a sizeable proportion of overall demand More importantly, it is also a key determinant of future supply: business investment helps to expand capacity by enabling firms to either supply more goods overall as demand increases, or to supply the same amount of goods with fewer inputs through increased efficiency While capacity concerns have been low during the recent recessionary period, a failure to invest will leave many businesses exposed if a pick-up in the global economy gathers pace and demand returns

Chart 2: Total UK business investment

(£ m)

Source: Office for National Statistics.

0 5,000 10,000 15,000 20,000 25,000 30,000 35,000 40,000

0 5,000 10,000 15,000 20,000 25,000 30,000 35,000 40,000

10 08 06 04 02 2000 98 96 94 92 90 88 86 84 82 80 78 76 74 72 70 68 1966

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The state of the UK economy

Taking the decision to commit to investing capital is largely driven by the level of confidence that business leaders have in the overall economy, along with their companies’ prospects for growth both domestically and abroad Quite simply, managers facing uncertainty or volatility in their industry are unlikely to sign off on major capital spending plans for new production capacity, larger premises

or other similar investments This link with confidence is reflected in the fact that levels of business investment over the past two decades have been highly volatile

In terms of the overall economy, the picture is distinctly mixed After real GDP contracted by 4.9%

in 2009, the largest annual fall since the second world war, growth in the UK resumed in 2010 at 1.3% This was sustained in part by government spending, as well as robust gains in the manufacturing sector

in particular But the underlying picture remains fragile, not least as government stimulus spending nears an end and the outlook for domestic consumer demand remains weak Growth of 0.5% in the first quarter of 2011 followed a contraction of 0.5% in the last quarter of 2010—avoiding a double-dip recession but doing little to reassure that the economy is back on course Forecast GDP growth for 2011

is the same as last year’s, at 1.3%, while in 2012 the rate is forecast to rise slightly to 1.7% (see table 1) Nevertheless, one of the core aims of the current coalition government is to rebalance the economy through the diversification of business investment and exports, in order to reduce the concentration of economic activity in a few sectors like financial services Already, the UK has seen a bounceback in the manufacturing sector during 2010, although the sector’s absolute levels of production remain about 10% below their 2008 peak Some comeback was inevitable after the recession, but a sharp drop in the value of sterling against the US dollar from its peak in 2007 has also given manufacturers a competitive boost However, manufacturers have been battling with rising commodity prices, including a spike in oil prices, which has affected their input costs This is particularly the case for those manufacturers

Table 1: Key UK data and forecasts (as of June 1st 2011)

Origin of GDP (% real change)

Prices and financial indicators

Source: Economist Intelligence Unit, (2011-12 are forecasts).

having to import raw materials “Raw materials are going up quite significantly in price,” notes Andrew Walker, the chairman of Metalrax plc, a Birmingham-based supplier of specialist engineering and consumer durables, and a non-executive director of several other firms “Quite a few of the businesses deal with polymers and they’re up 40-50% in the last year.”

Bulging corporate balance sheets

One of the other factors weighing on capital investment considerations is that many businesses have built up significant cash reserves on their balance sheets This has been a natural reaction to the recession, with firms seeking to stockpile cash in order to ensure that they can ride out the downturn Many planned projects were scrapped because firms simply did not know whether they would achieve expected returns given an uncertain demand outlook In addition, given the restriction of credit as banks sought to rebuild their own balance sheets, businesses decided they would rather hold onto their capital

By the middle of 2010, UK non-financial firms had amassed more than £140bn in cash, the highest level since 1998, according to Morgan Stanley, an investment bank Precise data on corporate cash levels are limited, but an analysis of 251 UK-listed firms that had reported their financial data for 2010 showed that firms had increased the amount of cash or cash equivalents on their balance sheets by an average of 7%, or £16.7m, from 2009 levels The aggregate increase of nearly £4bn took total cash on hand to nearly £29bn across the group

Of course, many firms are far from cash-flush, relying on what credit facilities they can get or simply surviving on month-by-month cash flows But for those with excess cash on their books, the question

is what to do with it, especially given low interest rates Sage, a business software firm headquartered

in Newcastle Upon Tyne, has substantially reduced its net debt through strong cash generation Consequently, net debt is at modest levels today Shareholders are supportive of this but of course expect the capital to be deployed in some way over time, or else will start demanding it back “But I don’t think we are there yet,” says Paul Harrison, the firm’s group finance director (see case study).But such pressures are building within many firms “The puzzle now for firms is do they invest,

or give money back to shareholders, or do something else with it,” says Professor Meziane Lasfer, a corporate finance specialist at Cass Business School

Broadly speaking, there are five main options for business leaders:

repair their balance sheets Of the 392 firms surveyed for this report, 18% are planning to pay down debt Alternatively, it will be used to prop up other liabilities, such as pension funds, according to 7%

of firms polled

acquire rivals Indeed, M&A deal volumes in the UK in 2010 increased by 10% over 2009, according to PricewaterhouseCoopers, and have continued to grow in 2011 so far

of increased dividends, which is being considered by 14% of firms This also may be done via other

© The Economist Intelligence Unit Limited 2011



mechanisms, such as share buybacks, with a view to propping up share prices In the US, share buybacks have soared over the past year

competitiveness Some 10% of firms polled say they are exploring this option

in order to bolster efficiency, replace worn out equipment or IT systems that have come to the end of their life, or add new capacity in expectation of a pick up in demand Just over one in three firms (36%) overall plan to increase their capital expenditure in the year ahead

The rest of this report considers this final option more closely, exploring which industries have the most appetite for capital investment; what this spending will be directed towards; and how the CapEx decision-making process has changed

case study : Sage Group – After strengthening the

balance sheet, options for cash return

Sage, one of the UK’s biggest business software firms with 6.3m

customers worldwide, is not a traditionally CapEx-intensive

business But Sage’s group finance director, Paul Harrison,

acknowledges the impact of the recession on spending plans,

reinforcing a focus on constraining costs and removing debt from

the balance sheet “If we go back 18 months to two years and

there were all sorts of reasonably dramatic prognoses around, this

inevitably left businesses in a cautious state,” he says “Certainly we

recognised that in the markets we serve, our customers would scale

back their investment in the software part of the business and that

would slow down new growth, which it did.”

In response, Sage cut significant costs from the business during

the recession As a firm that has used acquisitions as a key strategy,

it pared back M&A The main aim was to ensure that customer service was not compromised, so investment was sustained in providing frontline customer services As a result, the firm was able to pay down its net debt quite aggressively, to £106m at the end of March, from £219.8m at the end of last September “Our net debt was never

at troublesome levels Nonetheless, it made sense to us to knuckle down, to take costs out, to reduce net debt,” says Mr Harrison.Having now emerged with its balance sheet in stronger shape, Sage is planning to use its capital for a more concerted M&A push

“Today we have a very low level of net debt, and, quite reasonably, the agenda with some of our shareholders is slowly but surely moving back to how we intend to deploy the cash,” says Mr Harrison

“Quite rightly, shareholders want to be confident that you are using their money wisely, but what I don’t feel from shareholders is undue pressure to be acquisitive More than anything, shareholders want

to ensure that management is taking appropriate decisions.”

As the financial crisis in 2008 quickly lead to uncertainty over the broader state of the economy and

then the longest recession in the UK since modern records began in 1950, business investment in the UK plummeted From a quarterly peak of nearly £38bn in late 2007, investment fell by 29% to just under £27bn in late 2009, its lowest point, according to the Office of National Statistics (ONS) Of the firms surveyed for this report, nearly two-thirds (63%) reported cutting back their capital investment during this period One-quarter cut back all but the most essential spending, while 38% simply pressed pause on all new investments, although they continued to maintain existing equipment Logistics and transport firms were the most likely to halt investment: about one-half of firms in that sector stopped all investment, twice the overall average

The most direct reason for this was the sharp fall in demand Mr Walker recounts the sudden change among the various businesses with which he works: “By the time you got to Easter 2009, their turnover rates were about 70% of their levels in 2007 or early 2008.” As a result, many firms suddenly found themselves with spare capacity, and the pressure to maintain CapEx spending in order to bolster capacity simply dried up

Not all firms took this approach, however a small minority (14%) sought to take advantage of the situation in order to try and squeeze out a competitive advantage over rivals, while nearly one in four (23%) firms maintained all planned investments This has been particularly the case for those firms that were less reliant on domestic demand and more focused on exports, especially to emerging markets that were largely immune to the recession

Capital investment: A return to spending?

25

38 23

14

We halted all planned investment until we fully understood the effect of the financial crisis on our company, unless it was of critical importance

We maintained all planned investments through the financial crisis and recession

We took advantage of opportunities presented by the recession (eg, better deals), and as such increased investment during the crisis

We continued with regular maintenance of existing equipment, or replaced old equipment, but did not commit to any new investments during the recession, even those that we had originally planned

Chart 3: Which of the following statements best describes your company’s position on investing in the business during the financial crisis and recession?

(% respondents)

© The Economist Intelligence Unit Limited 2011 11

One such example was the Street Crane Company, a Derbyshire-based manufacturer of specialist cranes and hoists Over the past decade, it has steadily refocused its business on the export market, especially to Asia and the Gulf “We’ve certainly not touched the brakes, quite the reverse, as we’ve seen the opportunity,” says Andrew Pimblett, the firm’s managing director The majority of its spending has gone into R&D, to ensure that its products remain competitive in the international market, but the company has also invested in building additional production space Now, as demand

is returning from its UK-based clients, the company is well placed to deliver given its investments during the downturn “We’re now seeing some small manufacturing businesses investing in cranes again It’s been quite noticeable since Christmas especially, from the private sector and relatively small manufacturers,” says Mr Pimblett

CapEx plans in the year ahead

The degree to which such pick-up occurs across the broader economy, and feeds back into business confidence, will be the defining factor affecting a pick-up in business investment And although two-thirds of executives polled express confidence about the future economic climate for their business, the mixed economic outlook still clouds CapEx decisions to a degree

Overall, slightly over one-third (36%) plan to increase capital expenditure in the year ahead, even though six in ten respondents agree that new investment in their business would be worthwhile right now Overall, the sense is that companies are coasting—taking a foot off the brakes, but stopping short of actually pressing the accelerator—with 37% of firms maintaining CapEx levels compared with the previous year “It’s not to say investments aren’t going ahead, but they are the sort of investments one might have ordinarily expected so there isn’t a great splurge,” says Mr Walker “There is continued investment, but at a much lower, slower level,” adds Julie Adams, a partner at Menzies, a financial consultancy

Nevertheless, the proportion of firms planning to maintain or increase spending outweigh the one-quarter (26%) planning to cut back to some degree This by itself is an indication of improved confidence, not least as 2010 saw an improvement in business investment overall Spending in the fourth quarter of 2010 was up by more than 12% on the same quarter in 2009, according to the ONS, although it remains far below the peak established in 2007 Another aspect driving a pick-up

is an improvement in firms’ risk appetites The latest Deloitte CFO survey from April 2011 notes that although confidence remains low, risk appetites have risen sharply, in part owing to strong corporate balance sheets

A key reason that firms are not ramping up investment relates to their spare capacity which means

36 37 22

4

Increased capital expenditure this year compared to previous years Maintained capital expenditure this year compared to previous years Reduced capital expenditure this year compared to previous years Completely cut capital expenditure this year

Chart 4: Has your business:

(% respondents)

they do not need to invest immediately, even as demand returns Assessing the level of spare capacity

in the economy is difficult, but the Bank of England Inflation report from February 2011 suggests that

it is likely that companies’ supply capacity remains below pre-recession levels Colin McLean, founding partner and managing director of SVM Asset Management, an investment firm, adds that many firms will be focusing more on realigning their portfolios and improving their margins, ahead of investing for growth “For the industrial, chemicals and engineering businesses, a lot of those are still below their peak margins of the last cycle,” he says

Mr Walker notes that the firms of which he is a non-executive director are running at about 90-95%

of their peak capacity, which leaves some slack for growth Of Brintons, he adds: “The real issue is that while relatively little amounts of capacity were totally taken out in the recession, in that people might have been laid off but the machinery still exists, we had the capacity to do about 105% of what we did

in 2007 and 2008 and we are not back there yet.” Added to this, the firm also focused on efficiency gains during the downturn, such as better products and improved processes, which has further improved overall capacity

This tallies with the views of executives surveyed for the report A higher proportion of respondents see improved efficiency as a main driver for investment, than those who see it as necessary for actually expanding the business The largest proportion, however, say CapEx is necessary for helping them to meet the demands of their clients This may not necessarily be associated with increased capacity, but rather in order to keep pace with technology or deliver more innovative products

An example of this is Ultra Electronics (CEMS), a contract electronics manufacturer with facilities in several parts of the UK It supplies specialist manufacturing services to a range of industries, including aerospace and defence, energy and transport, among others The company invested in its growth, both

in terms of a 2010 acquisition and also new production capacity in 2009, as it navigated the recession largely unscathed However, while part of this has been about expansion, it has also been necessary to cater for constant advances in technology “Our 2010 acquisition has helped to diversify our business,

by extending the range of technologies and offerings we provide to our clients,” says Richard Dear, the firm’s business manager Backing this up has been specific CapEx investments, such as in advanced component coating machinery “We used to outsource a lot of this work, but we spent so much on this [acquisition] that we’ve decided to invest in this technology,” says Nick Mair, the firm’s head of sales Indeed, an inability to innovate is one of the threats that firms face from under-investment

Nearly four in ten (39%) of the companies polled believe they are falling behind their competitors because of reduced investment levels Mr Pimblett of Street Crane believes that says it is one aspect that has helped to differentiate his firm from rivals in the field “Many crane manufacturers have not invested in development, and so their products have become uncompetitive and out of date regarding international standards,” he says

Where is CapEx being directed?

After several years of tight spending controls, one likely change in the year ahead is a move away from maintaining and towards investing in new assets In comparing last year’s spending priorities with the coming year, executives surveyed note a drop in spending on maintaining IT systems, with

© The Economist Intelligence Unit Limited 2011 13

a corresponding rise in new IT assets The same is seen in telecoms infrastructure, as well as plant machinery and equipment

At an aggregate level, CapEx spending on maintaining IT systems is expected to drop by 4 percentage points in the year ahead, compared with the last financial year, while new IT spending is up

by 5 percentage points For machinery and equipment, maintenance falls by 4 percentage points, while new equipment is up by 3 percentage points, as is the acquisition of specialist equipment The same holds in telecoms, with new telecoms spending up by 3 percentage points, and maintenance down

by 2 percentage points This replacement trend has already led to a strong pick-up in both computer software and hardware investment in 2010, compared with 2009 levels Data from the ONS business investment results (March 2011) show that spending on software increased by 12.3% to £6.49bn in

2010, whereas hardware spending rose by 12.6% to £5.98bn

Nevertheless, spending in nearly all of these areas remains below the levels that executives see

as their normal levels Spending on maintenance, especially, is far below normal levels, down by 10 percentage points on IT, and by 9 percentage points on equipment and machinery In part, this may well be driven by those firms with cash on their books “When you have cash, you will buy assets to replace old ones When you don’t, you will maintain it,” says Professor Lasfer

Within specific industries, such trends vary more widely (see table 2), for a variety of reasons In financial services, for example, spending on maintaining IT systems will fall 11 percentage points, while new IT spending will shoot up 14 percentage points This is due not only to a rapid recovery in the sector, but also in order to cater for new regulations increasing the amount of data that must be held, which will require additional technology resources

Table 2: Change in investment spending across key sectors

Percentage point (pp) change in spending, next financial year over previous financial year

Tech & telecoms Transport &

logistics Manufacturing

Financial services

Source: Economist Intelligence Unit.

case study : Ford – Investing through the downturn

Even before the recession set in, Ford, a US carmaker, was in a bad

place In 2005, corporate rating agencies downgraded its bonds to

junk status, based on its huge labour costs and liabilities, falling

market share and ongoing losses In January 2006, the firm set

out its “Way Forward” plan, aimed at cutting fixed capital costs and

returning the firm to profitability by resizing the company, shedding

non-core assets and consolidating production lines globally,

including in the UK where it is the country’s biggest carmaker,

employing 15,000 people

To fund this restructuring, the firm took on US$23.5bn in loans in

2006, while credit was still cheap and available “We knew we were

going to need an extraordinary amount of cash on hand to support

the process, as it wasn’t going to be just a one-year exercise, but

several years,” says Bob Shanks, the company’s vice-president and

controller “It was really fortuitous we did that because we realised

we would need the cash to do everything we wanted to do, including protecting the company from unseen events, which is of course what happened in 2008/09.”

With capital on hand, despite enduring several years of steep losses, the recession did not derail the firm’s CapEx plans, but rather acted as a catalyst to accelerate them “It made us challenge things that maybe we would have normally just thought of as given, as

we looked for anything that could improve the business and our cash [situation],” says Mr Shanks In the third quarter of 2009, Ford posted its first quarterly profit in four years and expects to

be “solidly profitable” during 2011 Its restructuring is now also supporting strong capital investment going forward “Our outlook for the full year around the world is about US$5bn-5.5bn of capital spending,” says Mr Shanks “Before, we were more in restructuring mode, now we’re transitioning into growth.” The firm’s healthier cash position is also now being used to reduce its overall leverage and restore its balance sheet to health