Industrials industry outlook

INSIGHT ARTICLE  |  October 05, 2020

As industrials companies pivot to succeed long term in this environment of prolonged disruption, business leaders are evaluating all possible routes for increasing efficiency and resilience. A greater sense of urgency is compelling businesses to reassess their supply chains and the impacts of automation on the workforce, while also responding to growing demand for making environmental, social and governance (ESG) issues a priority.

Industrials production began growing again in May after the calamitous, pandemic-induced drop earlier in the year, Federal Reserve data shows. But even though production showed growth in June, July and August as well, that growth appears to have moderated. The manufacturing, automotive and energy sectors still have a lot of progress to make before they reach pre-pandemic levels of production.

The reimagining of global supply chains

Many organizations’ business continuity plans have fallen short in adapting to disruption from the pandemic, especially during the early days of the crisis. Businesses in the United States and globally had to act swiftly to mitigate supply chain shocks as the flow of materials from China ground to a halt. It is now very clear that organizations that invested in digital solutions were better positioned to weather this storm, proving more agile than peers that did not make such investments. As companies have restarted operations and moved into the recovery phase, they face the question of what manufacturing and its supply chains will look in the future.

These considerations will require companies to assess just how much they rely on a system that has become increasingly globalized over the past three decades. U.S. manufacturing production and supply chains have shifted dramatically, shaped by the relocation of some elements of production to countries with lower-cost labor (China has arguably been the largest beneficiary of this long-term trend). As international production and supply chains have grown more complex, companies’ indirect exposure to their suppliers’ supply chains has become an increasingly important factor.

Manufacturers have adapted their business models to take advantage of highly interconnected international supply chains, which greatly reduce their operating costs. Over the past few years, however, rising labor costs and growing geopolitical tensions have spurred more organizations to question globalization across many manufacturing sectors, especially for organizations dependent on China. A Gartner, Inc. survey of 260 global supply chain leaders in February and March “found that 33% had moved sourcing and manufacturing activities out of China or plan to do so in the next two to three years,” and 25% indicated that they have “already regionalized or localized manufacturing to be closer to demand.” There remain concerns that these trends may accelerate due to the pandemic and the potential for future outbreaks.

“As companies have restarted operations and moved into the recovery phase, they face the question of what manufacturing and its supply chains will look like in the future.”  

We expect organizations to undertake a rigorous analysis of their strategy and business model, especially as it relates to their global supply chains. The current environment should serve as an opportunity for organizations to evaluate the role of Industry 4.0 technologies on their organization. The concept of Industry 4.0—a term often used to describe the Fourth Industrial Revolution—is that advanced analytics, intelligent robotics and the Internet of Things will infuse all aspects of manufacturing and supply chains, revolutionizing processes and delivering enhanced productivity, agility and fostering innovation throughout an organization’s entire value chain. We also expect an acceleration in the development of regional manufacturing hubs as organizations focus on developing additional sources that are completely independent of China. However, we do not expect this to be the norm for products that are labor intensive or designed for consumption in local markets. 

Manufacturers need to act now to uncover and address supply chain weaknesses. Below are several trends that may help businesses do so, and we expect these trends to accelerate post-pandemic:

• Further digitization of supply chains. Manufacturers have been forced to develop resilience and agility in real time to deal with the pandemic, while simultaneously managing their liquidity and overall financial position. This could lead to diverging paths for organizations; some organizations might accelerate their digital transformation efforts while others are in cash preservation mode, delaying their Industry 4.0 initiatives. Consequently, as more businesses emerge from the crisis, the case for further digitization at scale will likely be stronger than ever. To that point, 82% of respondents to a recent Manufacturing Leadership Council survey indicated the pandemic brought about a greater sense of urgency about Industry 4.0 (described in the survey as “M4.0” or Manufacturing 4.0) digitization at their company to either a partial or a significant extent. As more organizations implement advanced technologies, interaction between businesses serves as the foundation for the supply chain to turn into a digital platform where all participants have access to a vast amount of data. That will enable parties to more effectively measure demand and achieve more flexibility, visibility and stability in the value chain.

• Growth in regional manufacturing innovation hubs. “Companies in two-thirds of global sectors in North America have either implemented or announced plans to pull at least a portion of their supply chains out of China,” according to a February report from BofA Global Research, “while companies in 50% of country-sectors in the Asia Pacific (ex-China) region are doing likewise.” As manufacturers seek to manage risk while fueling growth, we expect further development and greater use of regional manufacturing innovation hubs. The idea behind regional hubs is that local businesses, governments, economic development agencies and educational institutions would create a powerful collective to set a path for the growth of regional manufacturing. Better proximity to consumers, the supply of skilled labor and ecosystem synergies are all attractive benefits to the manufacturing hub model. This may also lead to more robust local supply chains, as it is more likely that intercontinental trade will shift toward final goods or components closer to the finished product.
  
  
  
  The growth manufacturers seek will typically come from new markets and demographics, as well as the development of new products and services to meet shifting customer demands. These shifts will require meeting new consumption patterns and preferences, as well as providing goods and services in new locations and formats. In response, manufacturers will have an opportunity to develop nimble, regional supply chains that meet both commercial expectations and long-term sustainability aspirations.

• Supply chain transparency and disclosure will increase. Manufacturers are continuously challenged to deliver value to their customers, invest in their workforce, deal fairly and ethically with suppliers, support the communities in which they operate, while also delivering long-term value for shareholders. In the context of high levels of uncertainty about the future of globalization and regulations that shape mandatory corporate disclosures about sourcing practices, organizations need to prepare for a variety of possible future scenarios by enhancing both visibility into supply chain practices and disclosures about those practices. Greater transparency will support businesses in the case that geopolitical tensions shift global free trade policies in favor of economic nationalism and will be valuable should free trade continue. Likewise, improving the quality and scope of supply chain disclosure will enable businesses to stand ready should regulatory requirements increase and to weather the increased stakeholder scrutiny due to the increased focus on issues related to ESG practices.

Beyond financial metrics: Companies prioritize ESG

Financial metrics are no longer the only key factors management teams and investors consider when making business and investment decisions. Climate risk, carbon footprint, supply chain diversity and responsible investing are all core concepts of sustainability that have become increasingly common in the business world over the last decade, including in the industrials space. 

The three central factors used in measuring sustainability are ESG issues. These issues have become a consideration for a variety of stakeholders: investors increasingly use ESG criteria when they vet potential investments; prospective employees take these values into account while weighing job opportunities; and consumers, more and more, demand consideration of sustainability from companies they patronize. 

The impact of ESG demands on U.S. middle market industrials suppliers is slow, but it will accelerate as the suppliers’ larger customers increasingly incorporate these values in their procurement practices and policies. Another factor in ESG adoption is the fact that the U.S. industrials sector lags behind other developed nations when it comes to emission regulations and goals.

According to the RSM US Middle Market Business Index Environmental, Social and Governance Special Report, only 39% of middle market executives said they were familiar with ESG criteria to evaluate the performance of organizations. Further, among that 39%, there was a divide between bigger and smaller companies’ familiarity with the use of ESG criteria, by 55% versus 27%.

A growing focus on ESG requires organizations not only to rethink their asset allocation strategy but also to bolster disclosures and general communication around ESG initiatives and performance. The motives behind and benefits of ESG vary among organizations and industries, but here are several foundational drivers who are common across the board:

• Superior financial performance: While investors and business leaders have debated the value proposition of ESG in recent years, case studies have shown that sustainable organizations do not risk the bottom line, and “in fact, quite the opposite,” according to a 2019 McKinsey report: “A strong ESG proposition correlates with higher equity returns, from both a tilt and momentum perspective.”
  
  
  
  Just like investors, consumers are increasingly considering sustainability when making buying decisions. Given these considerations, it is clear that ESG values are good for business; the notion that sustainability comes with a financial trade-off is an idea of the past. 
• Resilience: Even before 2020, ESG proponents were making claims that sustainability and resilience went hand in hand. Enter the COVID-19 pandemic, a real-time stress test for the theory that ESG-focused companies are more resilient than their less sustainable peers are. As of March, 59% of U.S.ESG-focused exchange-traded funds (ETFs) were outperforming the S&P 500 index while 60% of European ESG-focused ETFs were outperforming the MSCI Europe Index, according to Bloomberg research from earlier this year. So far, the market is indicating that an organization’s investment in sustainability is correlated with its ability to weather tough economic conditions.

• Risk management: The focus areas inherent to sustainability are key factors in risk avoidance and management. Regardless of the industry, ESG issues or disputes can be time-consuming and costly. Preemptive attention to matters such as labor relations, carbon footprint, community impact and corporate culture positions sustainable organizations to deal with fewer regulatory and legal issues. 

“It is clear that ESG values are good for business; the notion that sustainability comes with a financial trade-off is an idea of the past.” 

While climate change can be a challenge to certain industries, e.g., coal and oil, the global focus on this topic provides an opportunity for other industries that can help end markets reduce their carbon footprint. This is especially relevant for electric equipment manufacturers who serve the heating, cooling and lighting needs of their end markets. The pandemic has increased the focus on circular economy principles, which promote minimum wastage in the entire product life cycle.

The energy industry, by nature, is highly exposed to a range of ESG issues, and therefore, ripe for such initiatives, especially in the environmental space. However, as recent oil price tumult continues to rock the industry, it remains to be seen whether changing priorities and budget cuts will shift the focus from ESG efforts. 

 

In a survey conducted by BloombergNEF in partnership with the industry website Smart Energy Decisions, 55% of survey respondents selected budget as their greatest concern resulting from the pandemic, “as it relates to sustainability,” according to an August report from BloombergNEF. However, large energy companies are less at risk here than middle market companies. Large multinationals across the value chain have demonstrated their investment in ESG initiatives, especially around environmental issues like greenhouse gas emissions, water management and spill prevention, to name a few. BP, Baker Hughes, Total, Royal Dutch Shell, ExxonMobil and many more have committed to achieving net-zero carbon emissions by 2050. Peruse the websites of these companies and you will find pages dedicated to sustainability. These types of commitments will protect the sustainability initiatives and related budgets of these large, integrated organizations. For the middle market, less diversification and tighter budgets mean there is more risk that sustainability efforts will fall to the bottom of the priority list. 

At the same time, the importance of ESG in the face of the pandemic and the economic downturn is higher than ever. “A crash in demand for oil products during the pandemic magnifies the need for oil and gas companies to diversify their business models and report on resiliency to investors” according to Bloomberg. For middle market companies, resiliency will be key to survival. Additionally, regulation and external pressures on the environment are increasing by the day. 

According to RSM’s ESG report, only 32% of middle market executives said that environmental issues received support from their company. However, a significantly higher number, 60%, indicated that the environment was a high priority. This gap demonstrates the need for middle market companies to accelerate ESG initiatives.

Middle market companies, as suppliers to larger companies, should broaden their collaboration to understand how they can help meet end-market emission goals, incorporate smart technologies to reduce energy costs and stay relevant. In collaboration with their customers, middle market companies can develop digitally enabled service offerings that would not only deepen customer engagement but also provide a recurring source of revenue. It is crucial that companies prioritize sustainability efforts to avoid falling behind and to position themselves to emerge stronger on the other side of the downturn. 

Pandemic increases the need for greater workforce agility

In manufacturing, labor issues such as plant safety and the availability of workers with necessary skill sets have always been at the forefront. With the increasing importance of digital technologies, disruptions in business operations and reshoring of supply chains, discussions around the changing role of labor in manufacturing are increasing. Companies need to examine whether manufacturing jobs lost to pandemic-related disruptions can be recovered, or whether these changes to the manufacturing labor profile are permanent. 

Whether because of the pandemic or other major events, companies are constantly thinking of how to navigate uncertainty. Since the pandemic has accelerated the need for industrials automation and digital transformation solutions to address safety, flexibility and resilience, companies might slow rehiring efforts in order to explore what the right level and composition of labor make the most sense. Many industrials companies continue to follow aggressive cost containment measures, including shifting temporary workforce reductions to permanent reductions. Such permanent restructuring efforts may free up resources for reinvestment. 

As a supply chain resiliency measure, many companies are inclined to manufacture their high-value products in multiple locations. In such cases, the geographic dispersion of production labor becomes more relevant. For companies that are planning to expand their North American manufacturing footprint and supply chains, relevant investments in automation and technologies become critical to maintain cost efficiencies. Companies are considering flexible manufacturing technologies such as robots that can be multipurposed to perform material loading and unloading, material handling, packaging and inspection, and other line activities. Companies are also increasingly exploring remote monitoring capabilities; augmented reality and other connected worker solutions can shift a segment of supervisory workforce away from the shop floor. With all these geographic and technology developments, it is possible that companies may focus their automation investments more on the actual production processes and have labor more heavily involved in preproduction and post-production activities. “The importance of nonproduction segments will increase across all geographies, as differentiation shifts to innovation and customer experience,” according to a 2018 World Economic Forum report on The New Production Workforce.

There is little direct data on the extent of labor displaced because of technology or what role technology adoption plays in the delayed recovery of manufacturing jobs. However, companies providing and/or applying robotic and automation solutions, as reflected by the ROBOT Index have performed fairly better than broader industrials benchmarks. The ROBOT Index, provided by ROBO Global, is a benchmark for investors to track the performance of the robotics and automation industry. Levels of interest in 3D printing and robotics have also increased significantly. These technologies—automation, robotics and 3D printing—can simplify the manufacturing process and increase the efficiency of manufacturing workers, reducing the number of labor hours on the shop floor. For every single robot installed, 1.6 manufacturing workers are displaced; this is according to a 2018 robotics report by Oxford Economics. At the same time, while technology adoption has been increasing over the past two decades, productivity has not. This could be attributed to a lack of proper measurement methodologies and has been a widely debated subject.

 

It will take a while before we are able to understand the precise effects of these supply chains and technology-related developments on the extent of labor enablement or elimination, skills replacement or enhancement. But it is clear that as companies use advanced technologies to get leaner and more efficient, the role of labor—especially production labor—will continue to change.