Moody's Investor Service released an Industry Outlook entitled, "North American Manufacturing: EBITDA to Grow on Strengthening Demand in Key Markets, Economic Recovery," regarding what is a positive outlook for North American manufacturers.
This report merged and replaced their previously separate industry outlooks for North American diversified manufacturers and capital goods companies. Edwin Wiest Vice President-Senior Credit Officer and chief author of the report, discusses the key points, offers insight into factors behind purchasing managers’ bullish sentiment going forward, and cautions about the potential risks that could slow such growth.
Part of Moody’s campaign is to go out and meet with its investors and subscribers, where they not only talk about the ratings of particular companies, but their overall views on their broader sectors as well. “We did this over the last six to nine months, and we found that for the most part, many of us were on the same page in terms of what the macro environment looked like,” Wiest says, adding, “And this environment was characterized by modest growth, strong profitability, and good liquidity.” Specifically, the report projects median EBITDA growth of 3.5 percent in 2014, with a modest acceleration to 4 percent in 2015. Additionally, Moody’s blended PMI, which uses Markit’s country and regional PMI indices, had a three-month average of 54.2 points for April-June in 2014, pointing to a continued expansion of economic activity.
From their observations, Wiest and his colleagues asked themselves, ‘This looks positive, but what external factors exist out there in the marketplace and beyond that could potentially shake this up in the future?’
In a second report entitled, “North American Manufacturing: North American Manufacturers Face Stronger Dollar and Other Potential Vulnerabilities”, it refers to what is called “exogenous risks”, Moody’s laid out external factors like a strengthened U.S. dollar and higher interest rates, as potential inhibitors to North American manufacturing growth through 2016. Listed below are some of the key points regarding such risks:
- The positive outlook for the North American Manufacturing sector faces a number of exogenous risks that could reduce its overall EBITDA growth rate to less than 4% and compel Moody’s to change their outlook to stable. Several of these, such as a strengthening US dollar, the potential for higher-than-expected interest rates, stagnation in Europe and slower growth in emerging markets are already occurring. Another potential challenge, rising input costs, appears more remote, but also weakens prospects for North American manufacturers.
- Several risks are correlated. Inflation concerns often drive the US Federal Reserve to boost interest rates or reduce monetary stimulus. Doing so affects the dollar’s value against other major currencies, reducing the competitiveness of US exports, lowering the landed costs of competitors’ imported products, and reducing the translated results of international subsidiaries. Meanwhile, trade sanctions and prospects for further economic conflict with Russia have dampened industrial activity in Europe. At home, a US budget or debt-ceiling impasse could reduce visibility for manufacturers, holding up investment plans.
- Any strain on a manufacturer depends on its end-markets and geographic concentration. Rising interest rates would hurt companies such as Stanley Black & Decker, Masco, Armstrong World Industries and Apex Tool Group, which provide building materials and products for home refurbishment and depend on consumer confidence. Higher nickel prices would raise production costs for Timken, while higher copper and aluminum prices will increase costs for producers of electrical goods, including Hubbell, Eaton, Crane Co., Acuity Brands Lighting, General Cable and International Wire Group Holdings, Inc.
- Other risks include US political uncertainty and slower growth in Europe. Caterpillar, Deere & Company and Terex all depend on exports and are less hedged against a strong dollar than other manufacturers such as 3M Company and Illinois Tool Works, whose manufacturing footprints include plants in international markets with costs denominated in local currencies. US budget uncertainty would hurt manufacturers serving the defense industry, such as Oshkosh. Escalating trade sanctions with Russia would prolong the slowdown that Europe has experienced in 2014, further dampening volumes.
- Event risk continues with higher dividend outflows. Modest growth, good liquidity and low interest rates can encourage management to consider acquisitions to bolster growth or expedite share repurchases. These conditions also tend to push shareholders to seek higher returns, or even pique the interest of activist investors.
Out of all these factors, Wiest says the most significant item they listed amongst these exogenous risks was that a strengthened U.S. dollar on the exchange basis is something that isn’t necessarily friendly to North American manufacturers. “There are three different ways a strengthened dollar could hurt them, the first of course being through the export market, where countries like Germany and Japan, through the euro and yen currencies, would be able to offer lower prices while still making the manufacturers highly profitable,” he says.
“Secondly, you may have to accept a lower price than what otherwise may have been the case and that can squeeze your margin,” he says, adding, “And when you’re reporting financial statements about your operations in not only North America, but those in Europe and Latin America as well, everything needs to be translated into dollars. The impact of a stronger dollar in your income statement means the results in local currencies would be valued at lower amounts, resulting in lower reported profits and revenues.”
Finally, he says that manufacturers based in Europe or Japan that are looking to bring their product to the U.S. market could be more price competitive as a result of a strengthened dollar. “The stronger the U.S. dollar, the lower the price these companies can accept in U.S. dollars when bringing their product to North America.”
While these risks could serve to hamper the expected growth for North American manufacturers over the next year or two, Wiest says it’s simply the way things work. “You can never completely eliminate risk, because the fact of the matter is that if you did, you’d also be minimizing your profit potential,” he says, adding, “However, it’s important to identify what these risks are, have the means to monitor them, and be able to effectively consider your risk tolerance areas as to how’d you respond in the face of such.”
Looking ahead, Wiest says that Moody’s would consider changing its outlook from ‘positive’ to ‘stable’ if their forecast for annual G-20 GDP growth in 2015 were to fall between 1 percent and 3 percent, and expectations for EBITDA growth were to slow to below 4 percent.
For more information on the two reports, Moody’s research subscribers can access them in their entirety at https://www.moodys.com/researchdocumentcontentpage.aspx?docid=PBC_173015 and https://www.moodys.com/researchdocumentcontentpage.aspx?docid=PBC_176198.
About the Author
Edwin H. Wiest is a Vice President and Senior Credit Officer in the Transportation and Capital Goods team and has been with Moody’s since late 2003. Ed’s current analytic responsibilities include both investment grade and high yield issuers in the diversified and heavy manufacturing sectors as well as selective issuers in aerospace & defense. Previously he had responsibility for North American automotive suppliers.
Before joining Moody’s, Ed was a First Vice President with Mellon Bank where spent 25+ years in international, corporate and institutional banking as well as Credit Policy. He served as Department Senior Credit Officer for Global Corporate Banking as well as Department Chief Credit Officer for Institutional Banking. He received his B.A. degree from the Johns Hopkins University and his M.B.A. in finance and international business from Columbia University.
About Moody’s Investor Services
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