Friday, 26 July 2013

Rationalising exuberance

We have written in the recent past about how capital discipline in the corporate sector is improving, and that this suggests we remain in the early part of the current economic cycle. Companies’ renewed focus on costs in the face of lower revenue growth is consistent with this view.

When supply in an economy is tight, and capacity utilisation is high, companies focus all their efforts on increasing output in order to be able to extract every last unit of profit. In this environment, maximising volume is more important to companies than minimising costs, and so inefficiencies inflate the cost base. When demand falls and companies are left with overcapacity, there is a large scope to cut costs and improve productivity from simple rationalisation and common sense, often even without any technological advances.

Plenty of examples are available among the mid and large cap UK listed shares. BT has been very successful cutting costs by in-sourcing (last year it recruited 1,600 engineers and in-sourced 4,000 roles). BT believes that in-sourcing gives it better control over processes leading to reduced failures, which ultimately cost more and reduce service levels. This has been working. Between the 2011 and 2013 financial year it reduced underlying operating costs by 9.4%, which allowed it to increase operating profit by 15%, despite revenues being down by 9%.

BT's year-on-year change in total operating costs before D&A and specific items

Source: company reports, Brewin Dolphin. Excludes specific items, depreciation and amortisation
Kingfisher (the DIY retailer which owns B&Q in the UK and Castorama in France) is also in-sourcing, but this time on the procurement side. It hopes to make savings by standardising its product range across geographies (e.g. stock the same line of paint brushes in France as it does in the UK). It is targeting 50% of sales from common products by 2017 from 2% in 2012. It also plans to save third party commissions by increasing the proportion of products sourced direct from manufacturers. It is targeting 35% of sales of direct sourced products by 2017, up from 15% in 2012. 

Utilities do not tend to go through boom and bust cycles but provide good examples of cost and productivity improvements. National Grid has also been in-sourcing and reducing suppliers. In its gas distribution business it has cut the number of strategic partners it uses for predictable repeat work (such as replacing old pipes) from eight to four. In addition it has put in place systems to prioritise the emergency workload and introduced more flexible working hours in order to reduce reliance on more expensive overtime.

SIG (the pan-European building insulation distributor) has been benefiting from rationalising its distribution network. Simply ensuring that delivery trucks are almost full for each journey has yielded material improvements to wafer-thin distribution margins. It is also improving performance in areas such as procurement, e-commerce, supply chain logistics and re-branding, all of which it hopes will increase operating margins by 60-75%.

Cost for the corporate sector can benefit cyclically and structurally. Mining companies are a good example. When demand growth was high and mined commodity prices were well above their marginal costs of production, companies focused on producing every tonne of material they could. Unit costs rose very quickly driven by labour, consumables (like diesel and explosives) and capital goods (like tyres, and plant machinery). One often-quoted metric is that Australian mine truck drivers can earn A$85-100k per year. Unit costs at Rio Tinto’s Pilbara complex increased by around 40% between 2009 and 2012, yet the mine still reported an operating profit margin of 62% in 2012 (see the chart below). 

Now that commodity prices are likely to be lower than in the past, the companies should benefit from lower costs of commodity inputs and consumables. Management focus has shifted to cost-cutting without reducing volumes in order to bring unit costs back under control. Rio Tinto has been working on driverless trucks which not only save on labour costs, but also improve fuel economy, tyre wear and safety. BHP Billiton has completed a global benchmarking exercise which measures the performance of every function, the objective being to move all sub-optimal operations toward the best ones.

Rio Tinto is trying to cut operating costs to maintain margins despite weak commodity prices

Source: company reports, Brewin Dolphin 

Despite the fact the Aerospace remains a strongly growing industry; costs are still a focus for management teams. Rolls-Royce has opened a new factory in Singapore in order to be closer to its customers. It plans to save on transportation costs on servicing contracts, as engines do not have to be shipped back to existing facilities in Derby. Other initiatives include reducing the number of ‘tier one’ suppliers from over 400 for the RB-211 engine (an older model) to less than 100 for the newer Trent 1000 and Trent XWB engines, recruiting external managers to introduce best practices from other industries, and automation.

At times of weaker demand, some companies can grow profits by cost-cutting even in cases where revenues are falling. Right now, many companies are in-sourcing in order to control their businesses better, which can also help reduce costs. Improving productivity simply by focussing on the cost base are part of the normal economic cycle, and should have a beneficial impact on inflation for the whole economy. Such rationalising, however, argues against the suggestion exuberance is emerging that would mark the end of the current economic cycle.

Nik Stanojevic CFA
Divisional Director

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