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Manufacturing a future

In the midst of a multi-decade manufacturing slump, some industrials can still deliver investment gold.

Does manufacturing have a future in South Africa? In the rich world, factory jobs have been disappearing for decades. But they have also been disappearing in middle income countries and some developing ones.

Jobs have been shed in Brazil, India, South Korea and, of course, South Africa. Even China, the great export-oriented industrial growth story, has seen manufacturing jobs stay stagnant since the mid 1990s.

So you’d be forgiven for thinking investors should shun the sector. Yet on examination there are clear opportunities. How can this be?

First, look at the bad news. The deindustrialisation debate usually occurs in terms of jobs or the share of overall GDP that manufacturing accounts for. By those measures, SA has clearly been deindustrialising. The sector accounted for 19% of GDP in 1993, but now accounts for around 12% according to StatsSA figures (see graph). 

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Since the end of 2008 to early 2015, 176 000 jobs were lost in manufacturing. Economist Mike Schüssler tells us that there are fewer people employed now in manufacturing than there were in 1972 – and that’s despite the population having more than doubled in the period.

In 2014 manufacturing growth was exactly zero, though in 2015 for the year it managed 0.1%. Those growth rates mean it continues to shrink as a proportion of GDP. The RMB/BER Business Confidence Index, which has been in negative territory since mid-2011 indicates that the sector is pessimistic about the future.

Manufacturers have faced significant increases in costs, particularly energy and labour costs. Against that though, the weak rand has been a help for those which focus on the export market, but has been a double-edged sword for those that depend on imported inputs.

That makes it sound like you wouldn’t want manufacturing businesses anywhere near your investment portfolio. But that doesn’t follow. The first thing to note is that jobs and GDP contribution are not the same as profits. Even within a shrinking sector it is possible for profits to be increasing, provided firms are becoming more efficient. Some of the global evidence does suggest this is a reason for the decline in jobs, as technology has allowed manufacturing processes to achieve the same output with lower labour inputs.

The trend in the United States, for example, has been a drift to more complex high tech manufacturing, much of which can deliver good returns to shareholders. This is not good news from a policy perspective, as such change drives employment down particularly for unskilled workers while increasing demand and wages for high skilled workers, contributes to rising inequality.

South Africa has certainly seen services growth and the trend is still firmly in place. In 2015 the tertiary sector grew at 1.7% while the economy as whole grew 1.3%. In 2014 the figures were 2.1% and 1.5%. That suggests SA is in part following the trend of developed nations. Another supporting fact is that the manufacturing sector accounts for the same proportion of total wages paid in the economy as it did a decade ago, indicating that wages are going up relative to other sectors.

So it could also see a shift to more technology-intensive manufacturing that could deliver the returns investors need to be attracted to the sector. But the binding constraint is skills. “We lost quite a few of the skills through people retiring and emigrating,” says Schüssler. “We also lost the training colleges that used to be there as well as the training at state-owned enterprises that used to take place – that all disappeared from the late 1980s onwards. They are replaced now, partly by Setas and the SET Colleges and a few other things, but there was a gap period.”

Overall, the trend has seen large energy-intensive manufacturing such as smelting and steel production decline, while food, plastics, chemicals and beverages have done comparatively better. Those that provide reasonable prospects for investors have focused on improved technology and the sectors that are offering better growth prospects. Here are our top picks:

Omnia

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Omnia is suffering due to the downturn in the global mining sector and the drought in southern Africa. That has driven its share price down 40% over the past 18-months. But we think its current price offers value.

Omnia is a company with compelling fundamentals and a strong management team. Even in the face of the turmoil, its profitability has remained largely stable and the balance sheet strong. Its business model has been tried and tested, and shows what is possible even in a declining sector.

Over the years Omnia has accumulated intellectual capital and technologies which are just not easy to replicate by competitors. It tailors its products and services to the specific and changing needs of its customers which builds client loyalty and makes it extremely difficult for clients to switch to other providers. This model is further strengthened by targeted backward integration through the installation of high cost technologically advanced plants which are used to manufacture core materials.

How is it responding to the current challenges?

Its mining division, heavily exposed to mining in SA and West Africa, has reacted rapidly to changes in the sector. Management rationalised its West African operations and is actively investigating new market opportunities to negate these changes and to rebuild the production base. In SA, the division invested in assets that would reduce costs of operation and increase efficiencies. It is currently monitoring the performance of its newly introduced underground portable explosives pump technologies, commissioned an emulsion production unit and automated some of its production lines. The new emulsion unit is expected to result in improved logistics costs and increased production capacity in the long run while the other units will reduce labour and operating costs and also significantly improve operational efficiencies. Within its chemicals division it focused on reducing administration costs by combining all its units in the division under the label of ‘One Protea’, and reducing the number of low margin product lines.

Omnia generates a substantial proportion of its income from selling agricultural chemicals to farmers. This unit produces nearly all the raw materials used by its mining division and has developed a competitive advantage through significant economies of scale in its supply chain. 

omnia-chart-453-308

With the agriculture and mining markets rarely underperforming at the same time, this provides a good hedge. Margins are lower in the agricultural business but given the better prospects and its dominant position in Southern Africa it cushions the group against the downturn in the mining industry.

Omnia also has extensive reach in markets beyond SA. It operates in 15 other countries on the African continent, including South Africa, with focused operations also in Australasia, Brazil, China and Mauritius. This doesn’t only provide good geographic diversification but also positions it to benefit from the rand weakness.

Rolfes
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Our second pick is also a manufacturer of specialty chemicals which is going through a growth stage. Similar to Omnia, Rolfes’ success is also built on diversification and focusing on niche markets where it possesses intellectual property and has pricing power.Rolfes manufactures and distributes a diverse range of chemical products to diverse industries.

Over the past two years, the group has been consolidating acquisitions and streamlining which is unlocking synergies. It discontinued its loss making resins business, sold its lower-margin businesses in the agricultural and chemicals divisions and expanded existing higher margin agriculture and water businesses through minority buyouts. These actions are likely to enhance shareholder value in the long run.

Additionally, the group concluded the acquisition of Bragan Chemicals, an importer and distributor of chemicals used in the food industry. Bragan, which comes with higher operating margins than Rolfes’ existing operations, diversifies the group’s sector exposure while also providing opportunities to supply current product range into Bragan’s customer base.

rolfes-chart-433-294

In its first three months since acquisition, Bragan contributed about a third to Rolfes’ interim operating profits and we are expecting it to contribute more than half of the group’s profits in the medium to long term.

These developments are boosting the group’s profitability. Its share ratings don’t seem demanding. Trading at R2.95/share, the stock sports a 12-month trailing price: earnings (PE) ratio of around 6.8. If we factor in our earnings projections its forward PE ratio falls to 5.4, which appears generous for a company whose past performance has been decent when compared with its peers whose over-dependence on the mining industry has seen them faltering since the collapse of commodity prices.

Bowler Metcalf

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Our third pick is also a niche operator which despite increasing pricing pressures in the plastics packaging industry has been able to generate cash flows and profits needed to pump out good dividends since its listing more than two decades ago. It has achieved this performance by simply sticking to its specialist plastic packaging offering to the personal care and food/beverages sectors and running a leaner and meaner business.

Judging by its share price history, Bowcalf is certainly not a stock that one would expect to fly but given its solid earnings record and a superb dividend yield of 4.14%, its shares should appeal to investors seeking steady capital growth and steady dividend. This is also supported by a good asset underpin (net asset value of R8.06 which is 80% of current share price) and an undemanding price: earnings ratio of just 8.9.

The company has been going through restructuring and is now well positioned for sustainable profit growth. Management decided to exit the group’s full ownership in its integrated beverage facility which has been a drag on profitability in exchange for a 43% ownership in a new, bigger and separately managed entity called SoftBev.

bowler-metcalf-chart-412-280

SoftBev is expected to have revenue of around R1.2 billion per year which is higher than that of Bowcalf. The move which management said was imperative to allow them to focus on their core business is already paying off. Its recently released interim results show that earnings were 44% higher than the comparable period. SoftBev is also now planning to list on the JSE which will also unlock value for Bowcalf shareholders if successful.

Transpaco
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Transpaco is relentless in its growth ambitions, both organically and by acquisition. Its recent purchase of Eastrand Plastics was sold by Astrapak after the plant was gutted by fire. It was a smart move. Eastrand plastics has not only made an immediate impact on both Transpaco’s top and bottom lines but has diversified its revenue stream. The new business has been integrated successfully, in a very short period of time, which speaks to management’s tenacity. The group is set to leverage on the new operation’s proven processes, impressive production facility and scalable business model.

Smart acquisitions have been augmented by internal efficiencies including higher production volumes. Higher input costs have been recovered through astute price increases, so margins have expanded while scale has kept average costs under control. This is a bit unusual for a company bedding down a new business. Compare it to Nampak, which has experienced abnormal expenses and shrinking margins while bedding down newer operations. Transpaco’s increase in production volumes is being complemented by a tireless sales team which saw the group gain market share in an industry characterised by overcapacity. Additionally, a robust working capital culture has seen a rise in free cash flows which should help company valuation.

Over the past few years it has expended capital to modernise operations and results show efficiency improvements. The three years leading to FY13 had shown a decline in margins and management efforts are paying off as there has been a gradual margin improvement ever since.

The group is trading at a lower multiple of 8 compared with its industry’s 16. Even the 20% share price increase which followed its release of good half-year results end-December has not changed this skewed relationship, which makes Transpaco a nice value stock. To couple this, is a historically high dividend payout, with the yield north of 5%. This is low risk value stock with potential for a huge upswing if it continues to deliver on its strategy of improving efficiency, expanding output and gaining or developing new markets as well as acquiring good business. A weakness in its model is the lack of export markets but management promises to remedy that.

transpaco-chart-458-311

Transpaco raised debt to acquire Eastrand Plastics, which moved it from an ungeared position to a net debt: equity ratio of 14%. This is a decent ratio given that Nampak stands at 77% and it also improves its weighted cost of capital which should leverage its market valuation. Also the increase in finance charges was more than offset by the rise in profitability as such headline earnings jumped more than 50% in the just-announced interim results. It will be reporting off a low base at year end and a positive surprise is in the offing. This looks like a stock set for both short term and long term upside, though trading in the share is thin.

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