In recent weeks, investors in the Diversified Industrials space have been flying to safety. Defensive, high quality cyclicals (see ‘Defining Quality In Industrials’, May 2018) have been the primary beneficiaries, which has pushed the high quality premium to a historical peak just shy of 40%. The Diversified Industrials universe is being decisively split in two, with cyclical factors now only piling on structural ones.
Isn’t the same split occurring within each company, with only the mix varying from one firm to another? The Great Industrial Split may find its expression in the financial markets, but it may originate at the micro-economic level. If so, it would raise metaphilosophical questions for each company alongside strategy, business model, resources allocation and, last but not least, corporate culture, with its implications for attracting talent. In extreme cases, it could lead to a corporate form of dissociative identity (multiple personality) disorder.
Here is an end-game thesis. Two distinct industrial segments could eventually emerge as the sector moves with the times into higher tech territory, each with its own value drivers, specific set of core competencies, financial profile and public market characteristics:
1. Cyclical companies operating in large, mature industries with average or below-average return on capital levels, seeking to achieve maximum scale alongside the whole value chain, and implementing an active consolidation strategy to support both growth and profitability (0–2% annual organic growth, 7–12% EBIT margin, trading significantly below 10x EBITDA); and
2. Resilient firms with assets benefiting from superior pricing power (niche markets, technology, captive aftermarket, regulation, etc.) in addition to an above average return on capital and executing a bolt-on M&A strategy (4–6% annual organic growth, 17–22% EBIT margin, trading significantly above 10x EBITDA)
Neither would be better than the other. They would simply be inherently different from one another, with each segment being attractive from a value-creation perspective, and in aggregate more so than if the Split did not occur.
This admittedly represents an overly simple depiction of a complex reality. That said, a discussion with bankers covering the Chemicals space suggests that a similar split was successfully engineered in this neighboring industrial world over the last ten years. Its potential application to the Diversified Industrials space is worth at least a debate.