By: Neel Kulkarni October 8th, 2016
Q3 ended, and we got 6% from the S&P 500. Not bad, right? If you’d gone into hibernation in mid-January while your fellow bear brethren were wreaking havoc on Wall Street, you would have basically woken up last week to find that:
- OPEC hadn’t decided on an output cut
- The Fed hadn’t raised rates
- Britain hadn’t exited yet
- Earnings were still negative
- There was no US presidential favorite
- The financial system hadn’t collapsed
So on paper, it doesn’t seem like anything really changed for equities to run up so much. 6% is a high number…are investors really that confident in near-future cash flows? There are reasons to think this may be short lived. Equity prices have been heavily driven by multiple expansion rather than earnings growth. Fiscal policies from the strangest US election ever show full signs of loading up on debt, no matter who wins. Rate expectations are building, and quick moves in bond yields will hurt; a 25 basis point change on a 4% base wouldn’t matter much, but today, that base itself is 25 basis points. Factor in dicey European bank balance sheets and pressure on the same sectors that have been bid up for their dividends; investors should hope those airpods are good at cancelling noise – we’re going to need some help in separating it from longer-term fundamentals as the year ends.
In any case – this is as good a time as ever to think long term. So many interesting things are going on regarding human progress in a global, connected marketplace; the last 30 years have shown higher life expectancy, information access, poverty reduction, more financing capability, greater gender equality, and numerous other positive trends. Technology and open markets have heavily driven them, and in hindsight, it isn’t all that difficult to comprehend. The world is changing rapidly, and it’s likely the rate of change will only increase given tech continues to embed more and more in our daily lives; we may want to reconsider it not being a standalone sector…in a few years, every company out there could be classified in a part as a tech firm, if you think about it.
The last two articles here focused on technology trends in healthcare, and the potential for the space economy. This post covers manufacturing – a subject I believe to be highly underappreciated on the current disruption party scene – it isn’t as glamorous as VR, AI, driverless cars, the cloud, space, or big data – but that’s partly why everyone is speaking about them, and not the humble factories that churn out the goods we love. After all, each of the trends above are based on physical entities: a car, a server, a headset, and a machine, for example. The kicker? You’ve got to make them! Here are my thoughts on why investors might want to start thinking about manufacturing in the next wave of change:
First, the context. Manufacturing consists of the production of goods. So, while one might instinctively zoom in on the industrials, note that over 70% of the S&P 500 firms are actually manufacturers, given they actually make products. As of a couple of years ago, manufacturing comprised over 16% of global GDP and employed over 15% of the developed world’s population, with a higher percentage in the emerging and frontier world – including informal employment. Exports, R&D, trade deficits and regional economic epicenters are all highly related to it – the same factory that employs people also creates the need for laundry, food, housing, transportation and pretty much everything else that mayors could dream about in the area. So, it’s a pretty large and influential playing ground. Industrial growth, including manufacturing, was always a mainstay on the path to development for countries: you start by reaping natural resources through agriculture or mining (and battle off colonial rulers, if applicable), then move into industrialization, and then – after years of labor – reach the holy grail of services. Over the decades, steam, electricity, automobiles and other catalysts helped trudge the world along; the 1990s ushered in the era of low cost manufacturing as nations opened borders: China rose with low wages, and today, numerous countries including Bangladesh and Vietnam are banking on the same kick start. India has made it a mission as well – use low cost labor and locally educated workforces to attract capex and stimulate growth. The phenomenon is hardly only in emerging regions; Trump, Brexit, and German ADR supporters have made it pretty clear that the whole idea of such jobs moving abroad is a no-go.
I believe, however, that the concept of manufacturing as a whole may be totally overhauled in the next decade. What if you just don’t need people? What if the need for faster speed to market is too high for the current setup? What if you don’t need numerous assembly lines?
What if you just don’t need factories at all?
Bear with me here:
Imagine a regular production floor. Some assembly areas, a few workers per line, churning out products at a less-than-100% output rate; the downtime goes to machine breakdowns and changeovers for different product specs; a 24×5 setup, which goes into day 6 – overtime – in case there’s additional demand. Is this methodology fit for the future?
First, let’s consider demographics. Millennials and Generation Z folks are known for needing customization; mass market products just don’t cut it if you want to express yourself. In that case, does a low cost factory have any edge? Fixed/variable costs considered, churning out the same piece en masse might be warranted – that’s what the era of Walmart ushered in – but that concept doesn’t apply anymore. One also has to consider instant gratification – an equal necessity to today’s consumers. As The Economist put it, Walmart taught people the value of money; Amazon, however, taught people the value of time. An hour is the new going rate for deliveries; 2 days is the norm. Waiting 1 week for a new jacket? Ridiculous!
In that case, combine instant gratification and customization: how does a supply chain ranging multiple continents deliver? The answer: it just can’t, and that’s why the current model is inadequate for this world. We’re going to need local factories that are more nimble and on-demand, are able to double-up as R&D centers, and can generate with more efficiency and less waste; sustainability and carbon footprints, after all, are other characteristics people will watch for. Adidas, highlighted in Bloomberg BusinessWeek, is a study on how things might get done: it introduced a new product recently called Futurecraft, knitted by robots in a new German factory to reach buyers right away; a second factory is opening in Atlanta next year to run limited quantities of shoes, to be close to the key American market. In-store robots might be next, with the ability to assemble shirts for a perfect fit. The strategy’s got game – and the stock price has shown it, having doubled over the past year. You can bet that every consumer firm out there is watching and thinking similarly. In other words, time is money, and to cater to today’s needs, overseas manufacturing might just be too far away.
Costs, though….Adidas can pull it off given its size, but doesn’t cheap labor justify going overseas for margin-constrained firms?
Sure, but headlines often ignore productivity: when factoring that in, China’s low wages are barely 4% lesser than the US, per Oxford Economics. Enter the next generation competitors – Thailand, Vietnam, Bangladesh, etc. As more service jobs open, the pay is at least 10-20% higher than manufacturing jobs in emerging regions, per NBER data. Service jobs are arriving: there will be more McDonalds, more banks, and more airlines. Why wouldn’t people switch into them over manufacturing? To prove the point, per a recent BCG study, factory jobs are shrinking pretty much everywhere worldwide as a share of total employment – service jobs, meanwhile, are increasing. Goods producing firms that choose to stay with the status quo manufacturing ideology will be faced with union issues, higher wage concerns, speed-to-market worries, and random stuff including massive container ship companies that seemingly go bankrupt while millions of dollars’ worth of goods are on board in the middle of the Atlantic (the case of Hanjin). Last year’s Los Angeles port disruption was another wake-up call. So, it’s fair to say that most CEOs out there are rethinking their global supply chain: wages have risen, productivity hasn’t kept up, and there’s too much uncertainty in logistics when time is precious.
Enter automation. This is the answer to the issues above, and in my opinion, companies will enable much higher capex to it moving ahead.
Keep the factory – but can’t the same line just adjust itself to make a shoe of size 10 after a size 8 rather than 2 hours of manual changeover routines? Do you need multiple lines for multiple products; can’t the same line just make them all? Can’t sensors detect malfunctions right before they occur, and a 3-D printer on-site create the replacement part? And if not, can’t the cloud beam down historical data on equipment maintenance times to the original manufacturer, to ship over replacement parts before things go downhill? If a Tesla can get software upgrades while the owner is sleeping, why can’t manufacturing lines? And if all of this needs to be done, doesn’t manufacturing also fit well in the developed world, where IP can be protected, skilled labor is at hand and your test market is easily accessible for new products? I believe yes, and therefore, we’re in for a structural change. Investment will be necessary, and Wall Street’s attention is slowly coming around to this.
Now, the shift is definitely happening – both geographically and technologically. However, given the tectonic size of manufacturing, the entire move is barely in its infancy. The current industrial robotics market, for example, is around $40 billion, per some estimates; that’s less than what Apple makes in a quarter. While projections currently have it doubling in the next 5 years, I find a 15% growth rate is highly underestimating the potential: a 10-year approach might show massively exponential growth here. Why? Consider the sheer size: the S&P 500 engages in approximately $600 billion in capex annually; remove, say, 30% of it as the energy sector plays an outsize role, and we’re still rolling in $400 billion of spends. In a world where growth rates are projected to be 1-2% lower than the pre-recession era – assume, say, 4% globally, firms will be laser focused on market share growth, more cost-saving and productivity boosts. Again, this points to supply chain overhauls, given the vast potential. The BCG estimates that automation will cut labor costs by as much as 30%, while boosting productivity by nearly 35% in developed regions. Wall Street emphasizes a focus on R&D costs, debt levels, and free cash flow for obvious reasons; costs of goods sold, however, sometimes fly below the radar, as does productivity, or revenue generation per employee. The advent of AI – to be specific, machine learning, alongside data analytics and the cloud is perfectly placed for the next wave to involve a manufacturing transformation: make it quicker and more efficiently. How can this occur? With robots, sensors, and peripheral systems that can utilize all the data generated before…if a manufacturing trial has done well in one region, does another continent really need to repeat it? In precision-based industries, can’t sensors just figure out defects on the line, rather than during finished product testing? The answers are fairly straightforward, and cost-reduction will drive the change towards automation.
So, where are we today? The International Federation of Robotics tracks robot shipments, and as of 2014, they were up 29% YoY to 229,000 – the base being 60,000, back in 2009. Again, these are incredibly low numbers given we’re looking at multi-trillion dollar markets. What’s interesting is that while Asia showed the most growth, 70% of the robot sales went to 5 nations – China, Japan, the United States, Korea and Germany. Leaving aside China, which has very distinctly started to enter advanced manufacturing, almost all of the others are developed markets…consequently, one could presume that as the trend continues, industrial robotics investment could catalyze the shift in manufacturing back to developed regions. The IFR is calling it Industry 4.0, linking real-life factories with virtual realities, and human-robot collaboration leading the way. Should emerging markets be reconsidering their thrust? Absolutely…to compete, the regions will need a higher skilled workforce, a domestic consumption appetite, and an emphasis on intellectual property rights. In either case, technology’s impact on manufacturing will be tremendous – and global in nature.
Robots, of course, form just a segment of industrial automation – you have sensors, physical equipment and the systems industry all alongside. For those, the estimates range wildly – IDC estimates the total market to be nearly $150 billion in 5 years, but again, any watcher should not be hung up on a linear growth pattern. In 1980, McKinsey had predicted there would be 900,000 cell phone users in 2000; that lowballed it by about 99%. The key is that it’s not just the existing firms that might convert – you also have to imagine that small companies, or service oriented ones, could start manufacturing their own goods rather than buying them from other firms. Thinking further, it could be as basic as using 3-D printing or a different form of automation to create a shelf in your own home. Wouldn’t you want a butler-robot roaming around? iRobot’s Roomba was a hit, and so has been Amazon’s Alexa. What’s to stop a more advanced physical version? Expect manufacturing to evolve with AI, data, speed-to-market needs and demographic trends all combining at the same time.
Enough of that. Who’s involved? The giants provide a solid start here. ABB (ABB), Siemens (SIEGY) and Rockwell Automation (ROK) have all made their intentions clear in the automation space; on the smaller side, you have companies including Teradyne (TER) and Sensate (ST). The basics here all involve their industrial automation strength, productivity enhancement products, existing networks in the global supply chain, and substantial R&D budgets to define what can and can’t be done on the manufacturing floor. Others include Fanuc Corporation (FANUY), which is a much purer robotics play, Yaskawa Electric (YASKY), and Kuka – each of them has revenues above $2 billion, so don’t expect any magical returns, but unlike other sectors, clients will likely be willing to pay up for these guys given their existing brand equity and intellectual property; robots, after all, are a very long term investment and not worth the short-change from poor quality. The cloud, of course, provides lucrative potential – customer relationships and enterprise resources aside, it’s only a matter of time until collaborative machines, empirical data usage, machine learning via artificial intelligence and equipment communication through the internet of things gathers speed here: SAP (SAP), Salesforce (CRM) and Oracle (ORCL) might enter the field, and iRobot (IRBT), Faro Technologies (FARO), and other sensor and peripheral hardware systems that currently serve computers are all fair game around the broader space. The field is surely expanding. Amazon (AMZN) acquired Kiva systems in 2012, which designed robots for warehouse goods transportation. Logistics and distribution enhancement has made the front pages; the focus will slowly begin shifting to the assembly line.
From the outside, the industrial world can be perceived as massive, complicated and at times as a ‘back-end’, if you will. The next technological wave, however, is likely to substantially alter manufacturing – and the regions and companies that are ahead of the game will be best prepared, as will the companies that supply the automation.
What it means for you: China property bubbles, a strengthening dollar, rate hikes, valuations…numerous headlines out there are pretty concerning. Then again, do they really matter? There’s enough data to show that short term trading doesn’t pay off for most humans – the average investor, for example, has made 2.1% annually over the past 20 years, compared to the S&P 500’s 8%. Why? Perhaps because they’re running with the herd, trying to capitalize on momentum, and following emotions, among other reasons. The deceptive nature of noise as a replacement for information will never go away. What does work, though? Long term investing. The markets have always had a positive bias – always – and in a world where capital continues to widen its reach, access to information continues to improve, and technological progress continues to break barriers, market participants should stay invested, and stay optimistic. Manufacturing is a key area to watch. The world is transforming before us, and Wall Street is set for a fascinating ride in the global supply chain in the coming years. Investors should gear up.
