It is inevitable that many UK businesses will see their profit margins squeezed. Last week the Bank of England warned that the UK would slide into a recession as inflation could top 10%. This would mean that companies would face falling demand for their products while having to manage rising raw material and energy costs.
In the short term, this is not good news. But rising wages and commodity costs will force companies to cut spending elsewhere, potentially improving operational efficiency and leaving them poised to thrive when inflationary forces eventually subside.
“One of the problems the UK has had for some time is the lack of productivity growth but ironically as labor costs rise we should see an increase in productivity at as companies invest more in technology,” explained Simon Gergel, portfolio manager of Traders Trust (MRCH). “Supermarkets are a good example, they have invested in more electronic checkouts.”
A precedent from the 1980s
In the early 1970s, American automobile manufacturers Ford Motor (US: F) and General Motors (US: GM) were two of the five largest companies in the world. Over the next 15 years, both would see their profitability swing wildly. During the inflationary period of the 1970s, they managed to increase their profits through rising prices. But when the US Federal Reserve fund rate rose to over 20% at the end of the decade to fight inflation, the ensuing recession saw both companies slide into losses.
In 1980, GM and Ford Motor made $2.89 billion and $1.17 billion in profits, respectively. The following year, they slid to losses of $762 million and $1.54 billion. It was the first time they had been unprofitable since World War II. Rising inflation, slowing demand and increased competition from Japanese manufacturers have combined to create a potentially life-threatening crisis for two of the largest employers in the United States.
This crisis proved to be a catalyst for the American auto industry. To combat declining profitability, Ford and GM cut costs through operational improvements. When inflation declined and GDP growth returned in the 1980s, both companies were more efficient than ever. Between 1981 and 1986, real income per employee doubled in every firm. In 1986, GM and Ford made $4.0 billion and $2.5 billion in profit while employing far fewer people than in 1980.
Which companies are becoming more efficient?
The Ford and GM stories won’t be repeated by every company, but there are many in the UK that have made significant operational improvements over the past year. To identify these companies, Investor Chronicle conducted analysis on FTSE 350 companies, looking at the evolution of the difference between gross and operating margins. Financial services firms top the charts given their relatively few moving parts. So we looked at companies that could reap greater gains from more efficient operations.
Gross costs only include the cost of manufacturing the goods. This usually only includes the cost of labor and raw materials. Both of these factors are somewhat beyond the control of companies and have increased over the past year. Operating costs include gross costs plus the costs of running a business. This could include marketing, rental, travel and repair costs.
A company’s operating margin can drop due to rising labor and raw material costs. But if a company closes the gap between its gross margin and its operating margin, it is likely to make operational improvements. When inflationary pressures begin to ease, its margins should then improve.
The producer of fantastic figurines Games Workshop (GAW) saw its gross margin drop six percentage points in the six months to November. Staff costs jumped by £3m due to higher salaries and staffing levels. Entry and transport costs rose by £5.6m due to higher shipping costs and it invested £2.9m in inventory to protect against further supply shortages. ‘supply.
During the same period, operating margins fell by only three percentage points. To improve efficiency, Games Workshop has invested in five new injection molding machines at its Nottingham factory. New systems and technology have also been installed in its Memphis warehouse to dramatically increase the number of orders it can pick and pack, enabling it to settle the £5million backorders from November to here at the end of January.
Similarly, in 2021 supplier of building materials CRH (CRH) saw its gross margin increase by only 0.6 percentage points, but its operating margin increased by 3.4 percentage points. Higher raw material and energy costs were offset by a 4% price increase, resulting in a slight increase in gross margin. But the biggest expansion in operating margin was driven by “production efficiency, good business management, supply savings and overhead control.”
Consumer goods giant Unilever (ULVR) has traditionally been a safe haven during times of inflation due to the pricing power of its brands, including Dove, Marmite and Ben & Jerry’s. However, it is struggling to protect its operating margin despite a 2.9% price hike last year. In 2021, its operating margin fell by 0.1 percentage point and management expects a decline of 1.4 to 2.4 percentage points in 2022 – although it plans to continue to raise prices.
Simon Gergel saw the 8% fall in the share price since the start of the year as a good opportunity to add the consumer goods company to Merchants Trust’s portfolio. “We expect continued improvement in the product mix towards faster growing categories and believe there should be a recovery in profitability as cost inflation moderates and price increases are moderated. passed on to consumers,” he said.
The other way some companies are dealing with rising costs is by laying off employees. This may seem like a reasonable short-term cost management strategy. But it’s difficult and expensive to rehire quickly when business conditions normalize. International Airlines Consolidated (IAG) – the owner of British Airways – provides an extreme example.
British Airways cut almost 10,000 jobs during the pandemic and is now struggling to rehire just as the travel sector rebounds. The airline has already canceled thousands of flights this year and is now cutting its flight schedule by 10% between March and October due to staff shortages. IAG expects flight schedules to be at 80% of pre-pandemic levels, down from its 85% forecast in February.
High barriers onee quality
The improvement in operational efficiency is excellent. Having the ability to do this while passing on rising costs to customers is ideal. “The sector in our portfolio that is most exposed to rising costs is engineering companies, but so far there is evidence that they are able to pass costs on to customers thanks to the specialized nature of their products,” said Victoria Stevens, fund manager at the Liontrust Economic Advantage team.
Liontrust Special Situations Fund is one of the main shareholders of Spectrum (SXS) – a producer of precision measurement technology used in manufacturing. Last year, Spectris improved its like-for-like gross margin by 0.5 percentage points while increasing its operating margin by 2.4 percentage points.
Operational improvement was driven by the disposal of low-margin businesses. In 2021 it made five divestitures and last month it sold Omega Engineering for $525m (£425m). On the day of the announcement, CEO Andrew Heath said: “Spectris is a more focused, profitable and resilient business, backed by a very strong balance sheet.”
Management teams should always look for marginal efficiencies. However, it is human nature to procrastinate. Sometimes it is events as extreme as the pandemic, a war and a crisis of stagflation that are necessary to focus minds.
Inflationary pressures will eventually subside. The UK gilt market expects inflation to fall to 3.7% by 2026 and this measure has always been a very accurate predictor. At this point, it’s the companies that have made operational progress and invested in technology improvements – rather than just laying off employees – that will be well positioned to succeed.
“It would indeed be a brave investor to call the bottom in terms of market turmoil, but there are plenty of companies in the portfolio where the long-term entry point looks more attractive today than in the past. beginning of the year,” Stevens said.
If an investor had contributed Ford Motor stock in 1982, it would have generated a 920% return in 1987.