Manufacturing activity continued its decline with the September 2019 ISM PMI printing its lowest level (47.8) in the past five years, which represents a sequential decline from August 2019 (49.1) and well below the five-year peak (60.8; August 2018), according to the Institute for Supply Management.1 We note the wide disparity in credit profiles and outlooks due to the “diversified” nature of the sub-sector. We believe it is late cycle and these credits are cyclical with operating leverage but the degree of cyclicality (volatility) ultimately depends on the end- market cycle length/exposure (U.S. vs. International; short vs. long; Aerospace & Defense (A&D) vs. “Industrial” vs. Energy vs. Food & Beverage vs. Healthcare vs. Auto, etc.). Macro headwinds remain concerning with some impact from incremental tariffs and knock-on impacts from weaker business confidence plus reduced demand from potentially slowing global gross domestic product (GDP) growth. Leveraged merger and acquisitions (M&A) and/or spin-offs remain a persistent source of risk given a clear willingness of companies to execute transactions to sustain growth or appease shareholders. Thematically, we see Industrial conglomerates as higher risk given the potential for Activism.
Our Industry Assessment is supported by:
Level of Competition
Companies with strong competitive positions typically exhibit barriers to entry including economies of scale, existing installed equipment bases, global distribution networks, brand names, superior technology and intellectual property. Generally, this characterizes the well-known companies in the space. Competition varies across product lines, geographies and sub-sectors with stronger performers and higher margins typically attributed to engineered content backed by intellectual property and/or business “know how.” Certain sub- sectors, such as Power related manufacturing, face headwinds from declining fossil fuel demand impacting turbine or engine component demand while oil and gas end-market exposure exhibits above average volatility, resulting in challenged sustained profitability.
Due to the diversity of some companies, the regulatory framework varies widely across the industry and it is difficult to generalize the regulatory environment.
Legacy liabilities related to environmental exposures (PFAS/PFOS/PFOA/ Asbestos) remain top of mind and could potentially pressure balance sheets or result in a more contentious regulatory or legal response.
Elevated but varies across the space; thematically, industrial conglomerates are higher risk relative to pure plays given the easier activist “story” that spin-offs can “unlock shareholder value.”
Merger and Acquisition (M&A) Risk
Elevated with several having announced meaningful mergers, acquisitions and/ or portfolio divestitures in the prior two years. Several acquisitions have been largely debt funded pressuring balance sheets while spin-offs or separations are generally negative for business mix diversity and relative scale albeit adding operational focus.
Environmental, Social and Governance (ESG) and Transformational Risk
- Threat of New Entrants: Emerging competitors, horizontal M&A, technological advancement and/or new products/services remain long-term risks.
- ESG: Carbon transition/fossil fuel related end-markets (power; oil and gas; coal) remain questionable long-term sources of demand. Environmental liabilities could pressure balance sheets resulting in lower financial flexibility to address fundamental industry change. Other relevant considerations include product quality/safety, hazardous waste, employee health/safety, materials sourcing and energy management.
Position in Credit Cycle
Varies across sector due to highly diversified end-markets. Generally view sector as being “late-cycle” with an overhang from the ongoing Trade War with China, which could pressure global GDP growth and end-market demand.