Industrials’ success squeezes suppliers

So far, this earnings season has been good to industrial companies.

In Europe, the US and Asia, many big manufacturers have been reporting healthy profits and forecasting slow-but-steady growth to come. While not universal – GE’s second-quarter results, for example, underwhelmed investors – the trend underlines how the industrial sector has been leading the recovery in developed economies.

As Peter Löscher, chief executive of Siemens, put it last week after revealing that the German engineering group had an €89bn ($116bn) order backlog – the highest in its 163-year history: “Germany is benefiting from its industrial strength and export power.”

In part, the strong profits reflect the global nature of demand, with much of the earnings driven by strength in emerging markets. Manufacturers have also been helped by stable pricing for raw materials. However, what for large multinationals is a source of strength has contributed to the weakness of some of their smaller suppliers, which slashed capacity to such an extent that they are now struggling to ramp up production.

“In the downturn, companies were extremely quick to turn off the tap,” says Gautam Dalal, head of diversified industrials at KPMG, the consultancy, in London. “In some cases this caused suppliers to cut back greatly on capacity and in some cases to go out of business altogether.

“Now that the big companies want to turn the tap back on again, they are finding it difficult to do this effectively.”

As well as the logistical problem of adding capacity quickly, many small and medium-sized suppliers are also continuing to find it difficult to secure loans at reasonable rates. The Financial Times reported last month that US small businesses are having to pay more to borrow relative to the Federal Reserve’s benchmark rate than at any time in at least 25 years.

The pace of industrial production is expected to moderate in the rest of the year. Coupled with continuing uncertainty about the global economy, that is leading suppliers to be cautious about re-investing.

The supply chain is arguably more important to big manufacturers than in previous cycles, since many large groups have re-oriented their strategies towards outsourcing, putting more onus on suppliers to ramp up deliveries than in the past, when more capacity was kept in-house.

This pressure has been aggravated by the strength of the recovery in industrial demand, which took many groups by surprise.

“We’ve seen some of our facilities go from zero to up 50 per cent, 60 per cent, 70 per cent this year and a supply chain that had zero notice,” Ed Rapp, Caterpillar’s chief financial officer, said last week.

“We’re just in this kind of middle of the year where we’ve had to digest all of this as the supply chain ramps up from a dead stop in the last part of ‘09.”

Supply chain problems are not happening in all sectors and regions. Electronic component makers are among the companies struggling most.

The global semiconductor industry is operating at 94 per cent capacity, according to the most recent data from the Semiconductor Industry Association, up from 56 per cent in the same period last year.

Infineon, the German chipmaker, said last week it was having a hard time to catch up with rapidly rising orders. “Since the end of the second quarter, our plant utilisation …ranges between 90 and 100 per cent and it is therefore close to the capacity limit,” said Peter Bauer, Infineon chief executive. “This will persist until the end of 2010.”

In the US, Altera, the semiconductor-maker, said its lead times have lengthened from a maximum of 16 weeks to 26 weeks.

Europe and the US appear to be the regions most affected by supply chain difficulties. Japanese manufacturers, by contrast, tend to work more closely with their suppliers, sometimes extending credit to help fund capacity expansion, a relationship that has traditionally protected them against cyclical shortages.

However, a move toward more overseas production in recent years has exposed Japanese groups to new risks – illustrated by recent strikes at Chinese parts makers affiliated to Honda and Toyota, which disrupted output at the carmakers’ Chinese assembly plants.

In the US and Europe, while some manufacturers are trying to keep inventories low, others are said to be stockpiling scarce components as a buffer in case supplies run out.

Big manufacturers may well take the lesson that careful stewardship of the supply chain is important at all stages of the cycle. “Many of them are starting to realise that they should have paid more attention [in the early stages of the recession] to keep supply lines going at least from their most critical suppliers,” says Mr Dalal.

Additional reporting by Daniel Schäfer in Frankfurt and Jonathan Soble in Tokyo