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What’s ahead for industrials?

By Richard Jones, Felix Recht, Nick Santhanam, Xiaoran Tong, and Shekhar Varanasi

To stay competitive, companies need to sustain momentum while developing new capabilities, offerings, and operating models.

The industrial sector is a large and diverse one, encompassing a broad array of companies that power the global economy. The sector’s sweeping impact is demonstrated by the breadth of its subsectors, ranging from industrial machinery and mechanical power transmission to electronic components and test and measurement equipment.

Our new report on industrials provides a comprehensive assessment of the sector’s historical performance and outlook. It begins with an analysis of overall performance in the past 15 years, including the three distinct cycles of economic-profit creation that characterize this period. The analysis then deaverages performance across the different subsectors and companies to shed light on four levers that leading industrials companies have employed to outperform their peers. The report closes with our perspective on the sector’s future and the strategies industrial companies can deploy to reignite value creation.

Industrials performance in the past 15 years

In our analysis, industrials ranked third among 60 sectors by economic-profit creation, behind only pharmaceuticals and oil and gas, outperforming both software and technology. As a result, shareholders benefited: total returns to shareholders for 2001 to 2015 averaged 8.6 percent per year, outperforming the S&P 500 at 8.2 percent per year.

The past 15 years were not, however, a single period of uninterrupted growth for industrials. Our analysis of the past 15 years found three distinct periods of economic-profit creation: rapid growth (2001–07), slump and recovery (2008–10), and flatlining (2011–15). Each period was guided by broader macroeconomic drivers, most notably the end of the tech bubble and the ramifications of the financial crisis. Other factors, such as increasing globalization and shifting demographics, also played a role.

Rapid growth (2001–07). Industrials rebounded from economic losses of $13.2 billion at the end of the tech bubble in 2001 to economic profit of $52 billion in 2007, right before entering the global financial crisis. Economic profit as a share of revenue (EP/R) rose to 2.8 percent in 2007, from –1.4 percent at the beginning of the period.

Slump and recovery (2008–10). With other sectors, the industrials sector saw its economic-profit creation fall because of the crisis. Total economic profit dropped in 2009 to $9.9 billion, at 0.6 percent of revenue, less than a quarter of the sector’s performance just two years earlier. Critically, EP/R never dropped below zero during this period, despite difficult market conditions. By 2010, industrials had recovered to nearly pre-crisis levels, with $51.7 billion in economic profit at 2.6 percent EP/R.

Flatlining (2011–15). The post-crisis period saw industrials’ economic profit remain largely flat but near the level of pre-crisis peaks. In 2014, total economic profit hit $50.8 billion before dipping slightly in 2015. During this cycle, EP/R did not resume its pre-crisis growth, ultimately netting out flat.

Economic-profit creation in the first period was driven primarily by margin expansion, which accounted for $165 million of the growth in average annual economic profit per company from 2001 to 2007. In contrast, improvements in capital productivity yielded only about one-third that amount, or $50 million. As the sector entered the flatlining period, companies on average saw their annual economic profit decline, because they couldn’t further expand margin or improve capital productivity.

How subsectors fared

Deaveraging the 12 subsectors that make up the industrials sector shows that performance varied significantly across subsectors and over time.1 Several subsectors were consistently at either the top or the bottom, while others saw their fortunes rise or fall depending on the economic-profit-creation cycle (Exhibit 1). In total, all subsectors generated a positive economic profit from 2001 to 2015, with the exception of cables and wires. However, three subsectors in particular—multi-application components, building technologies, and test and measurement—outperformed the others.

Industrials performance varied considerably by subsector.

Our analysis also segmented industrials companies by EP/R performance within their subsector (and product segments) through all three periods. The segmentation showed four performance patterns, which we used to categorize the companies in terms of their performance:

  • Leading companies were consistently in the top quartile of the product segment.

  • Rising companies moved up to the top quartile over the period studied.

  • Declining companies dropped to the bottom quartile from a higher position.

  • Trailing companies were consistently in the bottom throughout the cycle.

Key drivers of performance

We next sought to understand whether leading companies followed different strategies than trailing companies. We measured three company attributes (size, level of capital expenditure, and R&D spend) and four management choices—quality of revenue growth, margin management, M&A strategy, and resource allocation. We determined whether any of these were associated with being a leading or trailing company. Our results showed that what differentiated “leading” companies was the management choices they made, rather than any of their starting attributes (Exhibit 2).

Starting attributes did not matter; management choices drove performance.

There was no correlation between a company’s size, level of capital expenditure, or R&D spend and its ability to generate economic profit in the same cycle or subsequent cycles. Small companies were as likely to generate economic profit as large companies or companies that had limited capital-expenditure or R&D budgets. This result stands in stark contrast to other sectors, in which a company’s endowment often plays a critical role in determining future success.

Perspective on new value-creation levers

The historical drivers of success will remain critical going forward, both for leading companies to remain at the top and for trailing companies to rise. However, acting on the same playbook of the past 15 years is unlikely to suffice.

As we look to the future, we believe six megatrends will shape the next phase of value creation for industrials: demographics, geography and regions, social, geopolitical/regulatory, technology, and end markets. Shifts in these areas will create opportunities for companies willing to embrace change. Capturing these opportunities will require companies to pursue the “3 Ns”—new capabilities, new offerings and business models, and new operating models. Companies that can both deliver on the existing playbook and quickly figure out how to move forward in each of the 3 Ns will be best positioned to achieve sustained value creation.

Download the full report on which this article is based, Industrials: A phoenix ready to rise again? (PDF–7.35MB)

About the author(s)

Richard Jones is an associate partner in lapetitemort.info’s New York office, Felix Recht is a consultant in the Southern California office, Nick Santhanam is a senior partner in the Silicon Valley office, Xiaoran Tong is a consultant in the Silicon Valley office, and Shekhar Varanasi is a partner in the Silicon Valley office.
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