How Manufacturers Can Create Resilience During Downturns

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Did someone say recession? How manufacturers can create resilience during downturns

Introduction Among the exasperating aspects of recovery. This article identifies signals and economic downturns are that they are patterns in US manufacturing economic difficult to predict, they are only labeled and financial data from past recessions many months into the pattern, and they and recoveries and suggests approaches affect industry and populations in different that manufacturers could take to create ways. But one thing is known: Downturns resilience ahead of future downturns. For are a natural part of the market cycle, and a broader discussion on how recessions the more prepared a company can be affect the overall US economy, please read heading into a downturn, the more likely it “What to expect when you’re expecting … a will be able to survive and thrive during the recession.”1 Did someone say recession? How manufacturers can create resilience during downturns

Building resilience in the face of forces―from low confidence in investments, changing economic cycles Irrespective of the reason or the duration, oil shocks, or federal and financial policies both the economy and companies are to manufacturing order slowdowns, credit Since the postwar era, the US economy has likely to be impacted by a future recession. bubbles, and even housing bubbles.3 been through 12 recession periods—that The important aspect for manufacturers Therefore, the impact of each recession is, a recession every 6.1 years—each lasting is to first understand how they were is also not the same, but one constant is about 12 months (figure 1).2 During the impacted during the past recessions and that manufacturing historically suffers past two decades, the economy has been second, find ways to build resilience for worse than most other sectors. In 2020, through two recorded downturns, each the upcoming ones. the factors that could lead to a recession of which impacted industrial production could be anything from trade policies to activity. An interesting aspect, however, high debt levels, a global pandemic, or even is that the movement of manufacturing What can industrial manufacturers learn a geopolitical crisis.4 indicators from past recessions? has been erratic even during periods Historically, the impact on industrial of overall US economic stability. This manufacturing has been more severe unpredictability likely suggests that some than other industries of the traditional barometers for A look back at the past recessions suggests manufacturing health may not reflect that they can be caused by a variety of the new dynamics of today’s economy.

Figure 1. The cyclical nature of manufacturing activity amid multiple recessions

arly s arly s reat ecession monts monts monts in te nited tates monts monts monts

ndustria production: ecession indicator -1 ercentage change from a year ago ago year ercentage change from a

- 13 1 13 1 13 1 3 13 1

ecession periods ecession duration ndustria production: anufacturing NAS percent change from year ago monthy

Source: Deloitte analysis of data from the Federal Reserve Economic Research.

2 Did someone say recession? How manufacturers can create resilience during downturns

Regardless of what caused a recession, GDP, compared with only 4 percent for the analysis of historic data suggests that the overall economy. The same trend holds true Industrial manufacturers may be durable goods sector (which is inclusive for corporate profits (figure 2). more exposed to a recession and of industrial manufacturing) is a more potentially stand to lose more recession-sensitive sector and bears a higher Deep declines in industrial impact when compared with nondurables manufacturing are followed by than other industries. In fact, and services sectors.5 Durables businesses relatively faster recoveries when during the Great Recession, 4 in tend to hold back on their investments, compared with the overall economy 10 companies† that filed for and their customers tend to hold back on Even as they experience steeper declines bankruptcy were from the purchasing, during times of uncertainties. In during recessions, US manufacturers industrial manufacturing sector. comparison, the nondurables and services also tend to witness higher recoveries sectors are typically less vulnerable, because than the overall economy during the † consumers cannot really forgo purchasing postrecession periods (figure 3). It is A total of 292 companies filed for Chapter 11 bankruptcy between 2008 and 2012. Out of things like food, education, or health likely that industrial manufacturing these, 116 were companies with services.6 Industry GDP numbers reflect companies will continue to experience manufacturing NAICS codes (31–33). this. During the Great Recession, the US higher impacts during future recessions, manufacturing industry lost 10 percent of its followed by better postrecession recovery.

Figure 2. Recession impact of industrials manufacturing is more severe than other industries Declines in GDP and corporate profits during the past two recessions, US overall vs. US manufacturing

arly s recession reat ecession arly s recession reat ecession 1: 13: 1 4: : 1: 13: 1 4: : - -4 -

D oera Corporate proﬁts overall GDP manufacturing Corporate proﬁts manufacturing

Source: Deloitte analysis of data from BEA/Haver Analytics. Note: Declines measured from the peak (the month when activity reaches its highest level and begins to fall) to the trough (when activity stops falling and expansion starts again) during a recession. This analysis includes data from the early 2000s recession and the Great Recession of 2008.

Figure 3. Manufacturing observed faster recoveries when compared with the overall economy Industrial manufacturers saw, on Average 12-month post-recession recovery during the past two recession periods, average, 3x higher recoveries in US overall vs. US manufacturing corporate profits in the 12-month D Corporate proﬁts period following the past two recessions. This suggests it is 4 imperative for industrial manufacturers to be prepared to take advantage of increased business opportunities during

era economy anufacturing industry the recovery periods.

Source: Deloitte analysis of data from BEA/Haver Analytics. Note: Post-recession recovery is measured as the net change from the trough (when activity stops falling and expansion starts again) and the following four quarters. This analysis includes data from the early 2000s recession and the Great Recession of 2008.

3 Did someone say recession? How manufacturers can create resilience during downturns

Manufacturers have found ways 2012. Since early 2012, capacity utilization to enhance production efficiency has been stable at levels of 75 percent.7 This during the recovery periods indicates that manufacturers have been Another aspect for US industrial able to find new ways to produce more with manufacturers to consider is that during similar or lower capacity levels. the past two recession recovery periods, production grew 15 percent and 19 percent What has changed since the respectively (figure 4). And surprisingly, the last recession? increment in output is not a direct result For manufacturing leaders, the 21st century of incremental increases in manufacturing brought with it an operating landscape that capacity utilization (MCU)―with only is unlike anything before, affecting how the 10 percent increments following both industry operates and behaves when the next recessions. Prior to the end of 2007, MCU recession inevitably occurs. Below are several was stable at around 79 percent. During new nuances to the economic landscape that the Great Recession, MCU fell to a low of 64 affect manufacturers. percent but made a partial recovery by early

Figure 4. US manufacturing industry saw significantly higher gains in production output despite flat capacity utilization Production and capacity utilization US industrial production index vs. capacity utilization data tells us the capacity utilization is stabilized around the levels of arly s recession reat ecession 75 percent, below the historic 1: 13: 1 4: : highs of 80s in 1990, despite 1 record-high production figures observed in 2019. This indicates that the companies likely used 11 recession as an opportunity to divest their underperforming 1 assets and invest in further enhancing efficiencies.

14 1 1 14 1

ecession periods ndustria production index ndustria capacity 11 utiiation

Source: Deloitte analysis of data from Federal Reserve/FRED. Note: The recession periods are indicated in gray and measured from the peak (the month when activity reaches its highest level and begins to fall) to the trough (when activity stops falling and expansion starts again) during a recession.

4 Did someone say recession? How manufacturers can create resilience during downturns

Fiscal policies have become more to prerecession levels, a new wrinkle for the accommodating and work to smooth industry. In 2000, it took 33 months to reach peaks and valleys prerecession levels. In the period after In response to the Great Recession, the 2008, it took 59 months (figure 5). Spending US Federal Reserve reduced the interest nearly double the amount of time to recover rates from 5.22 percent in September 2007 from a future recession could have a to almost 0 percent by end of December significant impact on many manufacturers’ that year. 8 This was intended to encourage long-term viability. businesses to borrow money and, by extension, enhance capital investments. Over Riding out the next recession: the ensuing decade, the Federal Reserve Two key approaches has maintained a tight grip on rates, most recently relaxing them due to rising levels of Despite the overall US manufacturing uncertainty, falling business investment, lack industry’s recovery following the recession of of inflation, and signals of recession in the 2008–2009, the industry also witnessed more services sectors.9 than 100 industrial manufacturing companies filing for Chapter 11 bankruptcy at some point 12 The recovery in manufacturing of time during or shortly after. This likely has become protracted indicates that, while some companies may not We earlier discussed that the manufacturing have survived the downturn, other resilient industry lost approximately one-tenth of its companies were better prepared to navigate GDP during the Great Recession of 2008― through recessions and take advantage of the the highest-ever decline during the past 11 recovery periods. We performed a statistical recessions (figure 2).10 The manufacturing analysis to determine the areas where the sector also posted higher 12-month resilient companies performed better―and recoveries compared with the overall two distinct areas emerged (see appendix economy. However, what’s been changing for full details). is how long it takes manufacturing to return

Figure 5. Postrecession recovery period duration to reach similar production levels At 59 months (about 6 years), the Production contraction from Recovery from trough to Recession precrisis peak to trough precrisis peak (months) 2007–2008 recovery was the longest over the past 11 1973 recession 7.2% 24 recessions, indicating the protracted recovery time for 1980 recession 5.2% 11 manufacturers could bring 1981 recession 6.0% 9 additional strain to the industry during future downturns. 1990 recession 4.3% 15

Early 2000s recession 9.6% 33

Great Recession of 2008 22.6% 59

Source: MAPI Foundation, “The Post-Recession State of US Manufacturing.”11

5 Did someone say recession? How manufacturers can create resilience during downturns

Liquidity seems critical to survive into their operations. A better cash position recession periods and take advantage indicates higher ability to make interest and of recovery periods principal payments. Therefore, during the Liquidity emerged as the most important recession periods, when some companies are metric distinguishing recession-resilient dealing with a cash crunch, cash-flow–resilient manufacturers from others. Per our analysis, manufacturers can effectively support their manufacturers with easier access to capital operations and capital assets. This resulted and relatively lower debts were not only able in significantly higher average annual revenue to better navigate through a recession, but growth of 12.6 percent and 10.0 percent also posted higher revenue growth during during the five-year recovery period post the the recovery periods. Manufacturers with two recessions (figure 6). Other companies, in higher interest coverage (indicates how comparison, posted average revenue growth easily a company can pay interest on its figures of 7.3 percent and 4.3 percent. outstanding debt) were able to generate capital when they needed it and invest back

Figure 6. Higher liquidity before recessions bears higher returns during recovery periods Access to capital before recession and revenue growth Cash flow level before recession and revenue growth during recovery during recovery

ary s recession ary s recession recoery 15 recoery 15

reat ecession reat ecession recoery 13 recoery 13

5 1 15 5 1 15

Postrecession ﬁve-year revenue CAGR Postrecession ﬁve-year revenue CAGR

ompanies with ower access to capita efore recession N43 Companies with lower cash ﬂows before recession (N=430) ompanies with higher access to capita efore recession N Companies with higher cash ﬂows before recession (N=70)

Note: N represents the sample size. Source: Data for 500 industrial manufacturing companies (NAICS code 31–33) from CAPIQ.

6 Did someone say recession? How manufacturers can create resilience during downturns

Capital investments in assets and (figure 7). These manufacturers observed technologies can further elevate recovery better top-line growth and kept their balance When heading into a slowdown or a possible sheet strong and healthy (that is, without recession, a basic instinct is to often dial significantly altering their capital structure), down on capital investments and wait for though they also observed slightly higher the onset of recovery periods. Certain impairment charges during recovery periods, companies, however, think differently. likely due to goodwill being written off. Per Deloitte analysis, some industrial manufacturers invested more during the Such investments can be targeted at years leading to a recession. Heading into acquiring new digital equipment and the early 2000s recession (1996–2000), infrastructure―aimed at producing goods resilient manufacturers (manufacturers more efficiently. We already observed with higher capex levels, as indicated in how industrial manufacturers seem to figure 7) invested $15.10 for every $100 of be producing more with less (figure 4), revenue compared with other companies, indicating increasing production efficiency. who invested only $4.70. Similarly, during Being an asset-heavy business, the the five years leading to the Great Recession manufacturing industry requires a constant (2004–2008), the same group invested influx of investments to improve asset $14.80 for every $100 of revenue compared productivity and lower costs. Our analysis with other manufacturers, who invested of 500+ industrial manufacturers also just $3.40. As a result of these capital revealed that certain manufacturers are investments into technologies and assets, more active in finding ways to reduce asset these manufacturers observed much higher costs and increase income. Such companies revenue growth during the recovery phases. are considered asset-efficiency leaders and This measure was further enhanced when were able to better absorb the gains during manufacturers funded these investments recovery periods, posting higher revenue through cash flow from their operations gains versus their peers.

Figure 7. Higher investments before recessions bear higher returns during recovery periods Capital investment levels before recession and revenue Asset efficiency levels before recession and revenue growth growth during recovery during recovery

ary s recession ary s recession recoery 15 recoery 15

reat ecession reat ecession recoery 13 recoery 13

5 1 15 5 1

Postrecession ﬁve-year revenue CAGR Postrecession ﬁve-year revenue CAGR

ompanies with ower capex ees efore recession N43 Companies with lower asset eﬃciency before recession (N=430) ompanies with higher capex ees efore recession N Companies with higher asset eﬃciency before recession (N=70)

Note: N represents the sample size. Source: Data for 500 industrial manufacturing companies (NAICS code 31–33) from CAPIQ.

7 Did someone say recession? How manufacturers can create resilience during downturns

Approaches for manufacturers where cash flow is less predictable than •• Digital might just help early adopters to consider for navigating leadership would prefer. These areas can build recession resiliency: through downturns help manufacturers better manage current Transformation from digitization has debt levels and enhance their ability to pay emerged as one of the key factors that Prophylactic measures for manufacturers off debt. It can also improve working capital, affect manufacturing competitiveness. to better absorb the next downturn which not only elevates a company’s capacity Digital can be used to increase revenues and position themselves for the upturn to exploit new business opportunities, but by creating new offerings or to typically include better insights management also could be a strategic advantage during optimize operations to take out costs. into cash flow and making targeted times of stress. Manufacturers could make a move capital investments. towards digitization by building out Make targeted capital the enabling core that will power the Prevent liquidity crisis by increasing investments to increase asset key Industry 4.0 use cases important insights into cash flow efficiency and productivity to their industry. Manufacturers who Liquidity is critical to any business and Better cash flow management helps successfully implement digital initiatives often drives the development of processes, manufacturers increase access to capital will likely weather the next economic controls, and tools to support good business and invest into technologies, process, downturn better than the 48 percent decisions in any economic cycle. Often, it is and people. Tools and technology such as of manufacturers who have yet to recession or financial distress that prompts artificial intelligence (AI) and Industry 4.0– get started.20 organizations to pay more attention to cash related technology such as robotic process flow management.13 The usual tools used are automation (RPA) can help manufacturers New decade brings new challenges operating level cash flow statements that create a competitive edge. Manufacturers for industrial manufacturers are GAAP-driven, including net income and should focus their digital investments in one related adjustments for noncash items and The US economy avoided recession for of the following areas in the coming 12–24 changes in working capital.14 the longest time ever during the past months to ensure they are not left behind. decade. The arrival of the next decade However, cash on the balance sheet is •• Invest in process-related innovation: brings with it challenges both known and different from absolute liquidity and may not Process-based innovations can often be unknown. Economic recessions continue provide the level of insights that would help more rewarding than the more common to remain one of the uncertainties that will control cash more closely. Instead of using product- and customer-based innovations likely challenge manufacturers; their causes, indirect methods, manufacturers can pivot due to the additional spillover effects.16,17 timing, and impact continue to perplex to direct methods of cash flow management Among the many direct benefits of process the whole economy. Now is the time for that focus on including additional levels of improvements are better production manufacturers to prepare using one or an organization.15 output and inventory optimization, which more of the approaches above to shield lead to reduced costs.18 Alternatively, themselves during any future recession Measures such as direct cash flow modeling innovation that automates material and maximize growth during the recovery cover major liquidity drivers that influence movement could yield labor savings. period that follows. week-to-week cash flow while making more Such process innovations could go a high-level assumptions in areas that are long way in helping manufacturers less material and more unpredictable. This produce more with less, in turn enhancing direct cash flow modeling can likely help efficiency and productivity of their assets manufacturers identify areas of the business and employees.19

8 Did someone say recession? How manufacturers can create resilience during downturns

Appendix •• Step 1: We created two company sets Research methodology ––Set A – Active industrial manufacturing This article is part of a broader research companies (N=510) initiative in which Deloitte identified five ––Set B – Industrial manufacturing factors that are expected to have an impact companies that filed Chapter 11 between on manufacturers in the next 10 years. Each 1994 and 2018 (N=178) varies in the time horizon of its impact, the •• Step 2: Using CAPIQ, we collected data scale of disruption it could deliver, and the on various financial metrics for each set level of influence manufacturers have over of companies its progression (figure 8). Nonetheless, all five are expected to redefine how manufacturing •• Step 3: We conducted a linear discriminant will possibly look by 2030. analysis to reduce the number of dimensions (financial metrics) in a data set This article describes these economic while retaining as much information pattern shifts in detail and tries to measure as possible―leaving us with 14 metrics the impact on manufacturers. This article •• Step 4: We then determined the most also suggests some of the primary ways important variables out of a total manufacturers can create resiliency ahead 14 variables and their respective of the next economic shift. As part of this importance (on a scale of 1 to 100), initiative, we performed a linear discriminant which can likely differentiate between analysis on 700+ industrial manufacturing set A and set B companies companies from NAICS 31–33. Below is a more detailed view of the analysis. More •• Step 5: Finally, we analyzed set A than 20 metrics were analyzed as part of companies (active companies) based this analysis, with access to capital or cash on the important metrics from step 4 position and investments coming out as the top two areas.

Figure 8. Five disruptive factors expected to impact manufacturing this decade and beyond

Transformative shifts Degree of disruption Manufacturers’ preparedness Time horizon of impact

Economic pattern shifts

Trade dynamism

Digitization

Talent and future of work

Electrification

High Not prepared Short-term Moderate Somewhat prepared Medium-term Low Well prepared Long-term

Source: Deloitte analysis. Short-term is 1–3 years; medium-term is 4–6 years; long-term is 7–10+ years.

9 Did someone say recession? How manufacturers can create resilience during downturns

Authors Paul Wellener US Industrial Products and Construction Sector Leader Deloitte Consulting LLP +1 216 830 6609 [email protected]

Chris Lindsey Principal Deloitte & Touche LLP +1 908 915 0687 [email protected]

Heather Ashton Senior Manager Deloitte Research Center for Energy & Industrials Deloitte Services LP +1 617 380-4982 [email protected]

Ankit Mittal Senior Analyst Deloitte Research Center for Energy & Industrials Deloitte Support Services Private Limited +1 615 718 1950 [email protected]

Acknowledgements The authors would like to thank the following people for their contribution to this research effort: Danny Bachman from the US economics team; John Little, Kirk Blair, and Nate Malone from Deloitte & Touche LLP; Arun Tom, Lester Anthony Gunnion, Shreya Sachin Shirgaokar, and Bhagyashree Addanki V S, all from Deloitte Support Services India Pvt. Ltd., for providing data and research support; and Kimberly Buchanan, Whitney Garcia, Fran Kelly, Carrie Cochrane, Allie Gottman, John Bollow, Beth Schmidt, Rachele Spina, Bahar Sachdeva, Jordyn Danielson, Kelly Estes, Jack Hollander, Faith Shea, and Liam Reilly for supporting the report’s publication.

10 Did someone say recession? How manufacturers can create resilience during downturns

Endnotes 1. Dr. Daniel Bachman, “What to expect when you’re expecting … a recession,” Deloitte Insights, November 21, 2019.

2. Ibid.

3. Goldman Sachs Economics Research, “Learning from a Century of US Recessions,” January 20, 2019.

4. Yahoo Finance, “Why the Next Recession is Likely to Happen in 2020, and What it Will Mean for Housing,” July 25, 2019.

5. Dr. Daniel Bachman, “What to expect when you’re expecting … a recession,” Deloitte Insights, November 21, 2019.

6. Ibid.

7. Federal Reserve Bank of St. Louis Economic Research, “Capacity Utilization: Manufacturing (NAICS),” accessed February 24, 2020.

8. Federal Reserve Bank of St. Louis Economic Research, “Effective Federal Funds Rate,” accessed February 24, 2020.

9. Dr. Daniel Bachman, “United States Economic Forecast - Fourth Quarter 2019,” Deloitte Insights, December 19, 2019.

10. Dr. Daniel Bachman, “What to expect when you’re expecting … a recession,” Deloitte Insights, November 21, 2019.

11. MAPI Foundation, “The Post-Recession State of U.S. Manufacturing,” March 20, 2015.

12. Deloitte analysis based on data from S&P Capital IQ for NAICS codes 31, 32, and 33.

13. Tammy Whitehouse, “Don’t Wait for a Liquidity Crisis to Scrutinize Cash,” Deloitte and Wall Street Journal, accessed February 25, 2020.

14. Ibid.

15. Tammy Whitehouse, “How Direct Cash-Flow Models Help Predict Liquidity,” Deloitte and Wall Street Journal, accessed February 25, 2020.

16. Larry Keely et al., “Ten Types of Innovation,” Doblin – a Deloitte business, accessed February 25, 2020.

17. Paul Wellener, Joe Zale, and Heather Ashton Manolian, “Pathways to faster innovation: Making bold moves in the second half of the chessboard,” Deloitte Insights, July 9, 2019.

18. Paul Wellener, Joe Zale, and Heather Ashton Manolian, “Tracing innovation in manufacturing: Spotlight on patent innovation investments in manufacturing,” Deloitte Insights, July 9, 2019.

19. Ibid.

20. Paul Wellener et al., “Manufacturing goes digital: Smart factories have the potential to spark labor productivity,” Deloitte Insights, September 16, 2019.

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