The emergence of China as a low-cost source of manufactured goods has created significant upheaval in the U.S. manufacturing sector-a key area of investment focus for middle-market private equity firms. Nonetheless, a recent survey of senior private equity professionals reveals that some 60% of the respondents view the “China Effect” as an opportunity to create value whereas only 22% see it as having a negative impact on their portfolio. Despite the dominance of a more optimistic outlook, navigating today’s highly dynamic manufacturing landscape poses significant challenges for private equity firms.
To help determine which industries to invest in/avoid and how best to take advantage of the “China Effect” in a private equity portfolio, let’s first take a closer look at the overall U.S. manufacturing landscape. Then, let’s apply some meaningful guidelines that help proactively uncover investment opportunities and give private equity firms an edge in seeking out good deals. Finally, let’s apply these guidelines to the U.S. manufacturing sector and hone in on some segments that present opportunities either because they are relatively “protected” from low-cost competition or they are not protected but offer value creation because of as yet untapped low-cost-sourcing-driven margin improvement opportunities.
Changing Manufacturing Landscape
While the ongoing discussion on the loss of U.S. manufacturing jobs is valid (manufacturing employment has declined by over 2 million jobs since 2001), persistent alarms sounding the demise of U.S. manufacturing are not. Actually, the manufacturing sector has slightly increased its share of U.S. GDP since 2001 (from 13.5% in 2001 to 13.9% in 2004), maintaining its status as a key contributor to U.S. economic health (14.3 million jobs, or over 10% of total U.S. employment, in 2004).
Investigating the key trends that have eroded U.S. manufacturing employment provides important context for understanding both the threats and the opportunities from the “China Effect.” Three trends stand out:
U.S. manufacturing exports have remained flat around $575 billion since 1996 (although in 2004, exports were at $642 billion, primarily due to the weakness of the dollar). With the growth in demand of manufactured goods in developing countries, U.S. manufacturing companies are finding that there is now enough scale to establish “local” supply bases abroad rather than relying on U.S. manufactured goods. While sales of foreign affiliates of U.S. manufacturing firms grew (from $1.3 billion to $1.4 billion) from 1999 to 2002, the portion of sales imported from the U.S. declined (from 10.5% to 8.6%) in the same period.
While the growth in imports of U.S. manufactured goods consumption (import intensity) has been only moderate (from 27.4% in 2001 to 29.2% in 2004), the major change has been in the source of imports-from developed countries to low-cost countries. For example, from 1997 to 2004, Japan’s share of imports has dropped (from 16% to 10%), while China’s share has doubled (from 8% to 16%). In short, the U.S. is not importing significantly more than previously; rather we are now buying goods from countries with cost structures significantly lower than our own.
The widening cost gap between domestic production and imports has driven overall productivity increases in the U.S. manufacturing. Sectors with higher import competition experience higher productivity growth. For example, the Transportation Equipment sector with a 40% import intensity showed a 4% annual productivity growth from 1998 to 2003, while Food Manufacturing sector with a low 6% import intensity showed only a 2% annual productivity growth over the same period.
Understanding these trends helps “demystify” the outsourcing discussion that continues to play in the media. And, as discussed below, digging deeper into these trends reveals a multitude of attractive investment opportunities.
Overall Guidelines On Desirable Characteristics
Traditionally, when analyzing the investment potential of a particular industry, a private equity firm would evaluate the market opportunity and characteristics of the industry against the investment criteria of the private equity firm. Typically, investment criteria would translate into a focus on such characteristics as growth profile, cyclicality, pricing environment, customer concentration, distribution structure, capital intensity, and margin structure. In the new era of low-cost competition, while these characteristics remain important and must be evaluated, they no longer constitute a sufficient framework to properly address and identify the value-creation potential of a manufacturing industry. To ensure robust evaluation, private equity firms must also gain a thorough understanding of positioning of an industry vis-a-vis low-cost imports.
When assessing the level of competition from low-cost imports, the tendency is to focus on the labor cost profile of the industry in question. However, labor cost is only one of many characteristics that make an industry more or less susceptible to low-cost imports. Some of these characteristics are:
Cutting-Edge Knowledge: The characteristics of the products an industry makes. If products are highly engineered and require cutting-edge R&D and/or complex manufacturing processes, U.S. manufacturers have an advantage over low-cost competition due to the innovation leadership of U.S. companies/research institutions and a developed engineering/skilled labor base.
Location Advantage: Whether domestic manufacturing has an advantage over sourcing product from distant locations. Location advantage can result from: better access to critical raw materials (e.g., industries using agriculture and mining products); perishability of products (e.g., food products); products that are expensive to ship relative to product value (e.g., high weight of cement); low-volume, customized, or erratic demand (which makes inventory and/or shipping costs prohibitive if imported); and customer requirements for close-by production.
Regulatory Environment: Certain industries are protected from import competition due to the U.S. regulatory environment (e.g., domestic manufacturing requirement for defense products, tariffs and import quotas, FDA regulation for medical products). On the other hand, strict labor and environmental standards in the U.S. may make countries with more lenient regulatory regimes better alternatives.
Labor Profile: If an industry’s labor content is low then the cost savings from manufacturing in low-cost location may not be enough to justify imports. On the other hand, if the value-added per worker is low (which indicates commoditized products), it is tough to justify using expensive U.S. labor to manufacture goods.
Applying these key characteristics to ensure a robust assessment of import susceptibility indicates that of the 473 sectors comprising U.S. manufacturing, 69 (or 34.2% of U.S. manufactured goods consumption) have a “low” susceptibility and, thus, are relatively “protected.” In fact, only a small portion of our manufactured goods consumption (4.2%) is attributable to the 52 industry sectors that rank “high” in susceptibility. The bulk of the sectors (352) and our consumption (61.6%) face “medium” susceptibility to low-cost imports.
What this import susceptibility profile shows is several categories of opportunity for which a private equity firm can develop a viable investment thesis for value creation:
Opportunities that take advantage of “protected” industry sectors
Opportunities to create new and sustain existing barriers to low-cost imports within the lower to mid range of the “medium” susceptibility sectors
Opportunities to lead a transition to leveraging low-cost sourcing as the dynamics change and to serving international markets in industries at the higher end of “medium” susceptibility (falling within 65 and 75).
Obviously, there are myriad factors to consider when looking at these various types of opportunities, including the level of any required post-acquisition investment, the target period of ownership, the risk posture of the private equity firm, and the particulars of the deal.
An Example Of Attractive Manufacturing Segments
The 473 industry sectors that make up U.S. manufacturing can be grouped in 4 broad segments: (1) Food, Beverage & Tobacco; (2) Textiles, Apparel & Leather; (3) Materials; and (4) Industrial. As summarized in Exhibit A, each segment offers varying level of opportunities for private equity value creation:
Food, Beverage & Tobacco consists of 56 industry sectors (or 13% of manufactured goods consumption) and offers significant value creation opportunities as the most protected segment of U.S. manufacturing. This protection comes from location advantage (local availability of raw materials, perishability, or freight sensitivity) and a relatively low labor content. Industries in this segment also offer stable growth, thus, generating steady, increasing cash flow. Further, there are a significant number of small-to-medium players and recent market trends (namely, consolidation of distribution channels and change in consumer preferences) that provide opportunities vis-a-vis a private equity value creation model. When evaluating industries in this segment, key areas to look at are potential low-cost competition (e.g., Frozen Seafood Processing), positioning vis-a-vis operational and marketing requirements in the Wal*Mart world, potential to leverage changes in consumer preferences (e.g., health, ethnic, time-saving, portable), and opportunities for further productivity improvements (this segment has only had a 1.4% annual productivity improvement from 1998 to 2003).
Textile, Apparel & Leather consists of 54 industry sectors (or 5% of consumption) and offers only limited value creation opportunities for private equity firms as the most import-susceptible segment. However, some industries in this segment (e.g., Nonwoven Fabric Mills) focus on innovative, industrial textile products where there are some niches that private equity firms can invest in and help fend off import competition.
Materials segment consists of 123 industry sectors (or 29% of consumption). While this segment is large and has “low” import susceptibility, member industries offer only moderate opportunity for private equity investment as they are exposed to commodity pricing cycles, are capital-intensive, and are made up of large companies. Opportunities center on niche, value-added material specialists (such as specialty chemicals, packaging, engineered materials) that possess a cutting-edge knowledge advantage and serve consuming sectors that have an attractive growth profile (e.g., single-serve packaging, healthcare supplies).
Industrial segment is the largest component of U.S. manufacturing (240 sectors and 53% of consumption) and has “medium” import susceptibility. Industries in this segment are experiencing significant new low-cost competition (China’s share of imports doubled to 18% from 1998 to 2003) and any investment decision must include a careful assessment of their positioning vis-a-vis low-cost competition. While overall this segment offers high growth, a cutting-edge knowledge advantage from highly engineered products (e.g., R&D spending is at 5.4% of sales for this segment vs. 1.9% for the rest of manufacturing), and customized demand, it has a high labor content (11.5% vs. 7.5% for the rest of manufacturing), opening the door for low-cost competition. Private equity success depends on proper segmentation of products and value chain for import susceptibility and creation of a global supply base for segments that are most susceptible to imports, a “local” presence to service new geographies where demand is growing and import barriers are high, and leveraging of U.S. operations for innovation/cutting-edge and other areas of existing or potential advantage.
Proactivity Is Key
There are still many opportunities for private equity firms to invest in U.S. manufacturing both despite and because of the “China Effect”. To find and leverage these opportunities, one must proactively understand and stay on top of the import-susceptibility profile of the business (and industry) in question.
Deepak Agrawal is a co-founder and the managing director of Gotham Consulting Partners LLC, which specializes in helping private equity firms identify investment opportunities, conduct operational due diligence, and create operating value in their portfolio. He can be reached at 212-497-9201, or at