United States

Manufacturing and energy industry outlook

Changing business models, ESG priorities, and the rise of EVs

Volume 9, Winter 2022

The manufacturing industry has made countless pivots in recent years, and businesses are continuing to adapt by rethinking their corporate structures and business models. In doing so, industrial companies are using advanced technologies to diversify or simplify operations, and to generate new business.

In the automotive supplier space, the rise of electric vehicles and their expected future growth continues to shift priorities not just for original equipment manufacturers and their suppliers but also for middle market energy companies. Across all industrial sectors, environmental, social and governance issues are also reshaping the ways in which companies meet stakeholder demands.

Key takeaways

  • Manufacturers are exploring alternate business models that can provide sustainable growth, provide recurring streams of revenue and/or reduce the asset intensity of a traditional industrial business.
  • Auto original equipment manufacturers and their suppliers should further invest in technology solutions to better predict and respond to supply chain and manufacturing shifts as the industry moves from internal combustion engine vehicles to electric vehicles.
  • We anticipate that performance around environmental, social and governance issues—already growing in prominence across most industries over the last few years—will become an increasingly important consideration in merger and acquisition deals.

Manufacturing business models

Rethinking corporate structures and business models

Industrial companies are rethinking corporate structures and business models as they assimilate their experiences from the pandemic. Like any crisis, the pandemic has accelerated certain trends, and industrial companies are exploring strategies to create sustainable value to their stakeholders.

Many large and midsize industrial companies cater to multiple industries and sectors, and hold diverse product and business portfolios. Such companies have long faced the question of whether to diversify and expand into new markets or simplify and focus on their core business. Before the pandemic, larger industrial companies were rushing to sharpen their focus via asset sales and spinoffs. Companies such as Johnson Controls, Honeywell, Ingersoll Rand and General Electric have shed business units and created more focused organizations. The pandemic has served as a trigger point to galvanize some of the focus on business simplicity for the middle market, too, as midsize companies increasingly reevaluate which of their existing business units complement the “core” of what they do. Midsize companies are entering into carve-out deals to spin off business units or products and rationalize operations, hoping to maximize value.

Companies realize complexity makes it difficult to navigate downturns. Successfully growing diversified businesses across geographic regions is no easy task. However, as past crises and the current pandemic have demonstrated, multi-industrials or diversified businesses are generally more stable due to risk diversification across sectors, some of which may be registering high growth and some of which may faring poorly at a given time. Diversified companies such as Pentair highlighted diversification as an asset in their third-quarter earnings. In contrast, companies focused on a single sector or business line are more prone to economic swings.

Diversified companies held their ground during the pandemic

Carbon pricing policies—aimed at applying a market price or a monetary value to carbon emissions—are already in place in many countries, including Canada, Europe and even some parts of the United States, forcing companies to take the impact of these emissions into account in their decisions to make carbon-intensive goods. Making green products can be more expensive than the status quo, but also creates the opportunity for companies to invest in advanced technologies to garner a greater share of the market. But given the focus on sustainability by countries around the world, companies ranging from glass to steel to automotive are left with no choice but to rethink product design and process.

MIDDLE MARKET INSIGHT

The pandemic has served as a trigger point to galvanize some of the focus on business simplicity for the middle market, too, as midsize companies increasingly reevaluate which of their existing business units complement the “core” of what they do.

As companies assess whether to embrace a diversified or simplified corporate structure, leaders should question efforts to diversify without strategic thought. A company seeking to diversify primarily because target multiples are low or for the sake of commanding a valuation premium, for instance, will lack the more holistic approach needed in the current environment.

Midsize companies with limited operational, managerial and financial resources should think through the expected value proposition, model out scenarios of varying levels of success, and evaluate the strategic purpose when acquiring what they consider synergistic businesses or when divesting business units they may not consider synergistic. Take, for example, Roper Technologies, a pump and valve manufacturer that successfully diversified into software solutions because it figured out an asset-light, cash-generative strategy with an aggressive focus on software acquisitions across various end markets. An intentional framework behind each acquisition or divestiture or a management strategy that glues together diversified businesses is critical.

Diversifying with technology-enabled business models

Companies are taking a closer look at their existing business models to exploit potential opportunities in an industrial ecosystem shaped by emerging technologies and changing customer preferences. Manufacturers are exploring alternate business models that can provide sustainable growth, provide recurring streams of revenue and/or reduce the asset intensity of a traditional industrial business. Some machinery manufacturers, for example, are considering “equipment as a service” offerings, where the customer pays for use of machine time rather than purchasing the machine itself. This provides the company with deeper customer relationships, recurring streams of revenue and critical data on customer behavior to improve their products, services and business model.

Large and midsize industrial companies alike have introduced industrial Internet of Things-enabled platforms that combine products, expertise and data to improve customer productivity. One example is Rexnord, a midsize bearings and couplings manufacturer that introduced a digital productivity platform to help customers maximize production uptime and lower maintenance costs. Such platforms, which are still complementary to the traditional business model, have helped companies experience the benefits of asset-light, “as-a-service” business models that enable revenue growth without traditional levels of capital investment.

On the cusp of so much change, companies need to take a closer look at their corporate structure and business models to ensure they align with the long-term strategy of the business and will be adaptable in the transforming industrial ecosystem.

Online marketplaces and direct-to-customer e-commerce business models are almost table stakes in today’s environment. Midsize industrial companies that have not developed their online delivery and data-capture capabilities are consequently forgoing huge market potential. According to Forrester Research, U.S. business-to-business e-commerce transactions are expected to reach $1.8 trillion by 2023. The industrial buyer will increasingly be a millennial, and as the “typical” buyer changes, so does the business sales process.

On the cusp of so much change, companies need to take a closer look at their corporate structure and business models to ensure they align with the long-term strategy of the business and will be adaptable in the transforming industrial ecosystem.

Here are some questions that may help leadership teams assess their readiness for change:

  • Does the company have access to relevant data and insights to help determine which markets and products it should be investing and operating in?
  • How can the company capitalize on the direct-to-customer trend with online sales and distribution capabilities? How can the organization glean better customer insights from such online capabilities?
  • Has the company performed thorough due diligence in evaluating all operational, financial, market and strategic considerations when selling or acquiring business units?

Any decisions around corporate structure or business model will have both pros and cons. While no decision is foolproof, what is important is the intentional thought process that takes into consideration long-term goals and objectives, industry and sector trends, and the realistic investments and resources needed to realize expected benefits.

EVs and the energy sector

The rise of electric vehicles and their impact on the U.S. energy industry

Over the last 18 months, the energy industry has once again shown its ability to navigate a barrage of challenges, from shutdowns to geopolitical tensions and new goals from the Biden administration. The industry continues to evolve as the energy transition away from fossil fuels accelerates. Strategies for a cleaner, less carbon-intensive future vary across sectors and will affect demand differently across the energy ecosystem.

The deftness of the automotive industry is similar; the proliferation of alternative propulsion methods has advanced in recent years at an astounding pace. With an ultimate goal of zero emissions, the industry is exploring a range of alternatives to internal combustion engines, including hydrogen fuel cell electric vehicles (FCEVs), plug-in hybrid electric vehicles (PHEVs), hybrid electric vehicles (HEVs) and battery electric vehicles (BEVs). Each alternative brings with it challenges to achieve the net-zero emissions goal and move beyond more than a century of vehicles built on the fossil fuel-dependent internal combustion engine (ICE).

Below, we explore what the future of road fuel might look like, how electric vehicles will affect the overall U.S. energy mix, and the potential impact on both manufacturers in the auto space and middle market energy companies.

The road to electrifying transportation

The concept of electric vehicles has been around since the 1800s, when inventors in Hungary, the Netherlands and the United States began experimenting with the idea. But the advent of mass production, the introduction of the Ford Model T and the proliferation of affordable, mass-produced ICE vehicles for decades blunted any hopes for growth in the electric vehicle space. The industry now faces a pivotal moment where EVs have come to the forefront and are generating the same demand and supply dynamics as ICE vehicles—all the more remarkable given that EVs were thought to have gone extinct over a century ago. Growth in the EV space will have significant supply chain implications for auto suppliers and force energy companies to adopt new technologies and practices that align with a lower-carbon future.

Global electric vehicle sales (units)

The ICE vehicle market reached its peak in 2017, and today the EV market is in full stride, with all major manufacturers promoting their commitment to the shift. Here are some examples:

  • Ford Motor Co. plans to invest $22 billion through 2025 on EV platforms, including $11.4 billion in battery manufacturing operations in Tennessee and Kentucky. The company plans to add 11,000 jobs focused on manufacturing batteries to meet its goal of producing 1 million Ford and Lincoln EVs per year.
  • General Motors has announced it will discontinue the sale of ICE vehicles by 2035.
  • Honda plans to rapidly transition away from gas vehicles and eliminate them from its fleet by 2040.
  • BMW expects to deliver 2 million electric vehicles by 2025.
  • Mercedes-Benz is set to launch only EV platforms by 2025.
  • Volkswagen announced that 70% and 40% of its models sold in Europe and the United States, respectively, will be fully electric by 2030.
  • Volvo announced that it will manufacture only EVs by 2030.

These plans and targets are not without headwinds, though. As a result of the supply chain disruption caused by the pandemic, shortages of critical semiconductor chips have hampered production of ICE vehicles and EVs alike. Even without this issue, though, the growing interest in and demand for EVs has drawn more attention to the rare earth metals necessary for battery production because of either scarce supply of these metals or supply monopoly in limited geographic regions. There is also increasing focus on the need for greater mile range, additional charging infrastructure and supportive government policies to stimulate demand.

It is critical that middle market suppliers maintain industry awareness of this ever-changing landscape beyond reading daily headlines. Staying in tune with policies developing in Washington, as well as those being discussed within the industry in real time, will help teams quickly identify changes that may affect their businesses and pivot, when necessary, to ensure alignment with the future direction of the industry.

Irrespective of these challenges, Bloomberg projects that by 2025, 16% of global passenger vehicle sales will be EVs, and that the EV share will increase to 24% and 68% by 2030 and 2040, respectively. EVs currently represent only 1% of global vehicles. Original equipment manufacturers and suppliers alike will need to be keenly aware of supply chain shifts that will result as this transition gains momentum.

MIDDLE MARKET INSIGHT

The growing interest in and demand for EVs has drawn more attention to the rare earth metals necessary for battery production because of either scarce supply of these metals or supply monopoly in limited geographic regions. There is also increasing focus on the need for greater mile range, additional charging infrastructure and supportive government policies to stimulate demand. It is critical that middle market suppliers maintain industry awareness of this ever-changing landscape beyond reading daily headlines.

Impact on transportation and climate

Given the rise in shared mobility, shifts in transportation demand, increasingly efficient engines and the growing interest in EVs, we expect the energy industry to experience significant change in the coming decades, with a particular impact on petroleum demand. The transportation sector accounts for the largest share of U.S petroleum consumption, at 66% in 2020, according to the U.S. Energy Information Administration.

The rise of EVs will also result in further changes to the energy industry’s carbon footprint. The transportation sector is responsible for approximately 29% of total U.S. greenhouse gas emissions as of 2019, according to the Environmental Protection Agency, making this sector the largest contributor. Of the sector’s greenhouse gas emissions, road vehicles account for 82%, aircraft 10%, pipelines 3%, rail 2% and ships/boats 2%.

2019 U.S. GHG emissions - transportation sector

The increase in EV sales is on track to displace road fuel demand by nearly 7 million barrels per day or approximately 16% by 2040, according to Bloomberg. That would have a significant impact on efforts to lower emissions and makes clear that EV adoption is a critical element on the path to net zero/decarbonization. But its precise impact on fossil fuel demand remains to be seen given other factors such as infrastructure development, technology, policy/legislation reform, and monetary investments by government and private industry.

Global electric vehicles sales fuel demand displacement outlook

The Biden administration’s proposed infrastructure bill aims to accelerate the transition to electric vehicles with, among other things, a proposed $15 billion investment to fund a network of 500,000 charging stations. If approved, the bill would provide much needed infrastructure enhancements to support the evolution of EVs and ultimately the path to reducing climate change.

Given the rise in shared mobility, shifts in transportation demand, increasingly efficient engines and the growing interest in EVs, we expect the energy industry to experience significant change in the coming decades, with a particular impact on petroleum demand.

Additional policy support would also allow the United States to continue to compete with countries like China that already have government incentives and policies in place that support EVs. The Biden administration wants EVs to represent 40% to 50% of new vehicle production by 2030, and also aims to create both manufacturer and consumer incentives and establish critical supply chains onshore, thereby reducing the reliance on global suppliers.

How middle market businesses can prepare

In our view, there will be enormous progress on reducing carbon emissions by midcentury, even if the road transportation sector is not currently on track to achieve net zero by 2050. However, given that the path is set, organizations—in both the energy sector and the automotive sector—must be in tune with demand variability and how it will affect their current strategic plan.

Here are some key considerations for middle market energy companies:

  • Data analytics and demand forecasting will help companies anticipate the timing and extent of energy variability. These should be priority investment areas.
  • Investment in energy-efficient technologies, such as carbon capture and storage as well as renewables such as batteries and EV charging infrastructure, should also be priorities for companies positioning themselves for the future.
  • Companies should proactively evaluate potential policy restrictions and incentives in order to drive smart tax and spending decisions.

And here are some key considerations for automotive original equipment manufacturers and their suppliers:

  • Companies will need to assess the need for supply chain practice enhancements.
  • Organizations should further invest in technology solutions to better predict and respond to supply chain and manufacturing shifts as the industry moves from ICE vehicles to EVs.
  • Companies should closely evaluate how best to make automation and workforce enhancements to achieve a sustainable mix.
  • Auto component suppliers for ICE vehicles that may end up excluded from the EV supply chain as a result of the transition should explore alternatives with an adaptable mindset. This might involve seeking a better understanding of how their products and technology can be enhanced to support EVs, or looking to adopt or acquire technologies more in demand in the EV space.
  • Leadership teams should understand potential cash flow and investment outcomes from anticipated tax code changes before such changes are finalized into law. This will help organizations be prepared for a variety of scenarios.

The key to staying ahead of these trends is proactive management of strategy, product portfolio, policy impacts and capital spending. There is little doubt that the automotive industry will move closer to zero emissions at an accelerating pace with each successive year. The energy industry will need to stay abreast of the changing energy needs that will accompany this dynamic shift.

ESG in industrials deals

Environmental, social and governance considerations in industrial deals

As the U.S. economy continues to show signs of recovery, we saw elevated merger and acquisition activity within industrials in the first half of 2021. This trend is expected to continue as stakeholders look to get deals across the line before year-end and in advance of potential changes in tax legislation that may produce a fourth-quarter result similar to 2020’s weak showing. We anticipate that performance around environmental, social and governance issues—already growing in prominence across most industries over the last few years—will become an increasingly important consideration in such deals, including performance related to diversity and inclusion.

Total industrial deal value and volume

A broader variety of stakeholders—including customers, employees, suppliers, communities and shareholders—is ramping up pressure on companies to show greater transparency around ESG issues and behaviors, and investors are taking note. Between 2015 and 2019 there was a surge in capital invested in ESG-linked projects, with such capital growing by 500% over that time to $17.67 billion, according to Morningstar.

Reporting and regulatory bodies are also invested in making ESG a standardized, reportable metric to provide transparency to shareholders. As such, ESG is becoming a critical consideration in the due diligence process in an effort to evaluate the attractiveness of assets in transactions going forward. Below, we take a look at the rising importance of ESG issues in the industrials space.

Environmental

For middle market industrial companies, the environmental aspect of ESG is a core focus, as industrial processes are a significant source of global emissions. Production of base metals like iron, steel and aluminum is notorious for high emission levels and energy consumption. Accordingly, the ESG focus is on areas such as sources of energy (clean or carbon-based), types of materials used within the manufacturing process (recyclable or non-recyclable), types of waste products (and the disposal process), and how business processes affect air, water and soil.

The extent to which companies are shrinking their carbon footprint through reduced emissions and reduced material consumption is increasingly becoming part of deal considerations. Proactive adoption of ESG initiatives and the impact on financial results—such as ability to reduce costs, optimize capital expenditure and secure more favorable lending terms—will be a key consideration for valuing businesses.

The number of companies familiar with ESG criteria has risen significantly, according to RSM’s third-quarter Middle Market Business Index special report on these issues. The report—which polled executives from July 8 through July 26 on ESG and climate change-related questions—found that 69% of executives were very familiar or somewhat familiar with using ESG criteria to evaluate performance as of Q3 2021, compared to only 39% in Q4 2019. Further, 84% of middle market organizations said they use the ESG criteria to evaluate their own performance, and 78% use it to evaluate the performance of other organizations. We expect this analysis of performance using ESG measures to continue to grow across industrial organizations within the middle market and influence new standards for investing.

MIDDLE MARKET INSIGHT

For middle market industrial companies, the environmental aspect of ESG is a core focus, as industrial processes are a significant source of global emissions. The extent to which companies are shrinking their carbon footprint through reduced emissions and reduced material consumption is increasingly becoming part of deal considerations.

Social—purpose and people

While M&A transactions focus on company performance, such deals are also largely driven by the people who make up the company culture. The “S,” or social aspect, of ESG therefore includes issues of diversity, equity, inclusion, human rights, consumer protections and animal welfare, to name a few. Businesses should strive to make an impact in these areas and have a verifiable set of values they convey in interactions with their suppliers, customers, community and employees. Companies can no longer ignore their role in these areas if they wish to maintain a positive brand and attract and retain talent, which is in the shortest supply in decades. Strength in the talent arena will be an immense advantage in the context of investment decisions and company valuations.

Job openings - Manufacturing, trade, transport, utilities

In the manufacturing sector, for instance, job openings increased nearly threefold from 302,000 in the beginning of the pandemic to 880,000 by August of this year. Unfilled positions in trade, transport and utilities similarly went from 1.05 million to 1.94 million over the same period, according to the Bureau of Labor Statistics. The glut of companies seeking employees dwarfs all numbers in recent memory, and is putting pressure on people in recruiting, hiring, training and retaining roles to do more to attract candidates.

While important to many employees, pay raises have not resulted in a broad return to work. Manufacturers and transport businesses are at a disadvantage in that many of their jobs cannot be done remotely, at a time when more employees are demanding remote work options. Therefore, industrial businesses may want to focus on understanding and responding to how employees feel about their social fit within an organization, whether they feel appreciated, and whether they believe the business cares about its larger social responsibility to society.

Companies may also have an opportunity right now to attract women into the workforce by providing flexible schedules, child care support, and opportunities for skills development and growth. The technology transformation in manufacturing requires more STEM skills and digital talent. Women are increasingly dominating men in college enrollment, and over the next few years two women will earn a college degree for every man if the trend continues, the executive director of the research center at the National Student Clearinghouse recently told The Wall Street Journal. Women can potentially play a greater role in addressing the digital talent gap, and companies that provide workplace policies and schedules that work for women will benefit.

Increased social unrest in recent years, coupled with people reassessing their jobs during the pandemic, has shone a spotlight on business to provide an appropriate response. Many companies have taken steps in the right direction. For example, job titles such as “head of diversity” grew by 107% between 2015 and 2020, according to global LinkedIn data. However, turnover in these roles is high—an average stay is three years, per LinkedIn—with a key issue being lack of commitment and support from management.

Employees and job seekers want their employers to be socially aware and have inclusive and diverse workforces. Company commitment to a strong culture and an employee’s belief that the company is genuinely committed to them can make a difference in their decision to join and stay, even when things get bumpy.

Both public and private companies must embrace the fact that business commitment to ESG is increasingly becoming mainstream, and that stakeholders evaluate ESG efforts as part of their engagement with a company.

Governance

Corporate governance, or the “G” in ESG, pertains to the governance factors of decision-making within a company and includes business ethics and risk management. While environmental and social matters appear on the front burner for most organizations, governance practices play a significant role in how companies respond to key ESG issues. As such, insufficient governance practices can have a negative impact on the bottom line and investment decisions, and proper governance should be considered a critical foundation in an organization’s operations.

Lastly, both public and private companies must embrace the fact that business commitment to ESG is increasingly becoming mainstream, and that stakeholders evaluate ESG efforts as part of their engagement with a company.

Looking forward

Investment decisions and company valuations in M&A deals will be influenced in no small part by ESG standards. Here are some key ESG considerations for manufacturing leadership teams:

  • Alongside ongoing signs of economic recovery in the United States, deal activity within the industrials space has remained strong in 2021. This trend is expected to continue through the remainder of the year, with ESG being a key factor in evaluating the attractiveness of assets in M&A going forward.
  • With this increased ESG focus, middle market industrial organizations should consider a proactive approach to ESG. This would include developing and evaluating ESG strategies and programs, which will be critical to long-term competitive success, affecting financial results and investment decisions.

Middle market industrial organizations need to begin assessing and establishing their baseline ESG metrics and performance if they haven’t already, and then put programs in place to continually show progress over time.


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