Margins after the resources boom

NOW is the time to start developing and implementing strategies to insulate from the inevitable margin erosion on the horizon. Inovyse director Victor Keddis writes

At some point in the future the resources boom that has been a significant driver of Australian prosperity and company profits over the last decade will fizzle out.

How far into the future and how much of a fizzle is contentious, but that the market will turn is largely beyond debate.

The signs of this downturn are slowly emerging:

1. GDP growth rates for Australia’s largest consumers of resources (i.e. China, Japan, India, and the USA) are slowly but measurably trending downwards.

2. There are significant concerns over the Chinese economy driven by several factors including over-heating leading to inflation, skilled labour shortages driven by the one-child policy and a shift towards professional education, and the unknown but certain impact of environmental degradation.

Essentially the Chinese economic system has produced good growth, but it is not an economic system that has very robust and effective institutions.

Does China have the will and capability to undertake institutional reform? — Perhaps.

At the moment there a few signs of real and deep institutional reforms.

Without institutional reform, there will be a limit on sustained quality growth within China. In addition, without institutional reform China will be exposed to any global economic and/or political shocks that may occur in the future.

3. The continuing concerns about the health of the US economy and the possibility of a significant slowdown as Net Government Debt and National Savings trend in all the wrong directions.

4. Over the next decade 100 million people in India will join the workforce. Without significant economic reform in areas such as foreign direct investment, tariffs, and labour laws and investment in transport and utilities; the economic aspirations of these people and ultimately the prosperity and growth of India will be stymied. In addition, there are real concerns about the current rate of inflation and its impact on future growth.

So what will all this mean for firms within the earthmoving sector? – Very simply: a squeeze on margins.

Since 2003 firms such as Caterpillar, Komatsu, CNH, Ingersoll-Rand, and Volvo have enjoyed significant growth in gross and operating margins.

Between 2003 and 2007 Caterpillar Inc, Komatsu, and CNH gross margins have improved by 6.1, 3.4, and 4.8 percentage points respectively. Similarly, Ingersoll-Rand and Volvo operating incomes between 2002 and 2007 have risen by 6 and 8 percentage points respectively. However, these gains have been largely due to the global resources boom and the continuing transfer of manufacturing to lower cost regions.

The picture before 2002 is quite the reverse. Between 1997 and 2003 Caterpillar Inc and CNH gross margins fell by 7 percentage points. Between 1997 and 2002 Komatsu gross margins fell by 1.2 percentage points. Operating incomes between 1997 and 2002 for Ingersoll-Rand and Volvo fell by 6.2 and 6.7 percentage points respectively.

These are not insignificant falls.

A 1.0 percentage point drop in Caterpillar Inc gross margins (at 2006 financials and assuming cost of goods stays constant) is equivalent to a loss of US$504M.

At September 2007 valuations that’s equivalent to Aus Drill and Newmont Mining becoming entirely worthless!

In summary, it takes approximately four years, a resources boom, and significant manufacturing cost shifting and reduction to deliver healthy gross margins and operating incomes.

Take away (or at least mitigate) the effects of a rampant resources boom, recognise that the benefits of manufacturing cost reductions have been largely delivered and forward thinking companies will realise that now is the time to start developing and implementing strategies to insulate them from the inevitable margin erosion on the horizon.

I will discuss some of these strategies in the December issue of Australian Mining.

Victor Keddis

Director, Inovyse

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