Brexit – what next for the investment dealmakers evaluating business and market attractiveness?
The UK’s vote to leave the EU when elements of the economy are still on comparatively shaky legs eight years after the financial crisis creates further substantial uncertainty for business managers and owners, and with wider ramifications for their financial backers. CSA explores the risks of Brexit and its possible consequences for private equity and debt lending dealmakers evaluating target-company business and market attractiveness in this new environment.
European political risk
Negotiating power rests with the EU
The UK’s trade deficit in goods and services with the EU reached nearly £85bn in June. Whereas the UK earns 15% of its GDP through exports to the EU, the rest of the EU earns under 5% of its GDP through its exports to the UK. This immediately sets the tone and context of Brexit-Article 50 supply/buy side negotiating power.
The reality is that no EU member state is going to permit the UK to be seen to escape lightly at the conclusion of the exit negotiations. No country has withdrawn before and the founding nations do not want to see a second nation follow suit. Additionally, certain club members may also have a Euro-politic ‘axe to grind’ arising from their own internal opposition to home-grown separatist/leave activists; expect a show of collective solidarity serving to work against the interests of the UK.
One can therefore safely assume round upon round of tortuous negotiations on the subject of the UK’s exit which will ultimately result in numerous tariff and non-tariff barriers imposed on UK/EU trade: importers and exporters will face increases in duty rates; consumers, higher prices; and businesses, changes in customary regulations.
The UK’s economy is too tightly integrated into EU regulation for a withdrawal to have anything other than a negative, material impact on trade. Secondly, the concept of continuous free-trade going forward is a ‘busted flush’. Realistically, there is no way to keep trade free from duty whilst also reducing immigration and withdrawing payments made into the EU – the two principal demands of Leave campaigners.
Exchange rate risk
UK assets marked down
The financial market bet ahead and had been in favour of Remain, awakening on the morning of June 24th to find ‘it got it wrong’. Sterling promptly slumped against benchmark currencies, notably the Euro and US$. The pound’s fall is likely to push up CPI inflation in the short term, hastening its return to the 2% target set by the government and the Bank of England and probably causing it to rise above this level. Furthermore, near-term weakness in demand brought on by consumer uncertainty is likely to open up a margin of spare capacity in the economy, including an eventual rise in unemployment, suggesting that the UK is likely to see little growth going forward into 2017.
With interest rates unable to go lower and remain in positive territory, additional monetary easing by the BoE at this point is unlikely to impact demand. The issues is one of confidence and this will remain muted until such times as exit terms become clear to the UK as a nation – and to foreign inward investors looking to use the UK to sell to Britain’s neighbours.
A national budget deficit of £75bn, 7% of GDP, and public sector debt of £1.6tn are substantial UK constraints, but it is to be hoped that the government can make its case that borrowing for investment is different from borrowing to feed current expenditure. In relaxing earlier austerity, it will not wish to be seen as being overly imprudent by financial markets. Nevertheless, the pressure on Sterling over the coming two to three years can be predicted to be downwards.
Whether or not the UK avoids technical recession during this period, the economy is likely to flat-line. In such an environment, businesses will find it difficult to pass on higher import costs and the choice for most will be between maintaining profit margins or market share.
Supply chain inertia
…pushing up import costs, inflation and spare capacity in the economy…
In theory, a weaker currency makes exports cheaper and therefore more competitive overseas. Internal demand should rise as imports become more expensive so consumers start substituting expensive foreign products with cheaper local ones.
Unfortunately, trade improvements require time to materialise as supply chains are unwound and procurement specifications renegotiated. Import prices may therefore rise faster than exports gain traction, resulting in an initially negative J-curve pattern of growth symptomatic of the market lag effect. However, this timeline is also dependent on macroeconomic global growth fundamentals and competition between exporting countries
…before new deals with countries outside of the EU slowly compensate.
A quarter of a century ago, world trade was entering into a period of fruitful globalisation with the productivity gains of liberated financial services and a booming IT sector. China became the world’s largest holder of foreign reserves, valued at an all-time high of USD 3.99tn in June 2014, and the premier lender to Western governments, happy to exist fiscally on IOUs. In the process, China’s march to industrialisation as an exporter of manufactured goods sucked in commodities on a vast scale. So much has changed.
The UK’s Leave vote comes at a time when China and other emerging market economies have started to mature, slowing global trade. Western populations are giving fiscal austerity the ‘thumbs down’, prompting increasingly nationalist politicians to seek to protect local interests and turn their backs on international trade agreements. In the process, central banks around the world lead interest rates towards zero or into negative territory, driving an effective international currency war.
In relatively muted world markets for UK exporters to prosper they must take market share – reversing a trend of the last 20 odd years. The traditional trading partners of the UK have been the developed economies of the USA, Eire and the rest of the EU. Other countries, such as Germany, maintain substantially stronger export links into the emerging markets of Asia and China in particular, and also elsewhere – a tacit export strength and capability that the UK may find hard to replicate, even with the benefit of a weaker currency. Exports by the UK to the EU in 2015 were valued at over £220bn, nearly 45% of total. By comparison, China and India together account for only about 5% of the UK’s exports. New trade deals made by the UK with countries outside of the EU are unlikely to compensate for trade to date with the EU – and certainly not quickly.
So much, so broad-brush. The question is how might individual industry sectors react to Brexit?
Oil & gas
The issue for the oil and gas exploration and production industry is less about Brexit and more to do with abundant global supply, high stock levels and muted demand which has combined to drive the price of a barrel of oil down from over $140 in 2008 to around the $45/50 mark.
The competitive standoff between the national oil majors of Saudi Arabia, Russia, Nigeria and Iran amongst others in addition to the shale-oil producers of the USA is not likely to ease any time soon. Consequently, oil remaining at under $60pbl until the end of the decade is a credible prospect, rendering much E&P business uneconomical, particularly in the area of the UK Continental Shelf.
North Sea O&G production is still worth about £35bn to the national economy, although the sector has seen output and investment fall consistently since the turn of the century.
UKCS oil is relatively expensive to drill. The average cash cost to produce a barrel of oil, based on data from March 2016, for the UK was just below $45. This can be compared to $25-30 in Nigeria and Venezuela, $20 in Russia and less than $10 across most of the Middle East. Advances in technology, notably horizontal drilling and hydraulic fracturing, has additionally reduced US shale to around $25pbl.
UK offshore capital investment in 2015 was almost £12bn, excluding further operational costs of over £8bn. Less than £1bn of fresh investment is expected to be sanctioned in 2016, one eighth of the average of the last five years. The UKCS still holds up to 20bn barrels of oil equivalent, but over the last year the number of fields expected to close has risen by 20% to over 100. The physical interconnectivity of these fields creates a ‘domino effect’ risk.
Adding Brexit, anyone in the UK offshore sector buying in dollars and selling in Sterling is clearly faced with an uncomfortable ride – although industry participants selling in dollars and with a cost base in Sterling should prove more resilient.
In the absence of oil returning to $100 per barrel any time soon only those sector services which, by and large, remove industry overhead and lower breakeven thresholds will remain in material demand. For example, services associated with the sharing of common industry infrastructure between operators.
Retail, tourism and leisure
Positive for UK tourism, less so for importers of consumer retail goods
A notable feature of the 2008 crisis was its lack of real impact on UK employment, which otherwise could have brought down consumer spending. Since then, largely because of a happy alignment of the stars, the economy of the UK in common to that of other advanced nations has benefited from markedly lower oil and other commodity prices. Near zero inflation handed consumers a one-off ‘freebie’ pay rise, in effect without employers having to ‘fork out’, sustaining retail spending.
With 75% of people presently in employment – the highest since comparable records began in 1971 – and average earnings growth of 2.3% massively outstripping inflation, the retail sector would very likely have continued to represent something of a boom market for investors and business managers in a Remain environment. Brexit will cool things considerably if rising inflation brings this comparatively buoyant period of improved living standards to an end.
Retailers who have been benefiting in recent years from low-cost imports will see their fortunes reverse as overseas import costs rise. The clothing industry in particular pays in dollars for large quantities of imported goods – and certain segments have already flagged price increases of over 5% in 2017 in what could be an early indication of where sector prices could be heading. Attempts by retailers to raise prices will also have to overcome cyclical changes taking place in the sector, making price increases difficult. Deflation in elements of the fashion clothing sector, for example, has been running at over 5% recently; driven by a shift in consumer spending habits towards eating out and other leisure activities. Attempts by sellers to protect margins by raising prices to compensate for cost inflation will most likely see market share reduction.
One can expect rising import costs to progressively feed through to prices and profit margins, particularly in the second half of next year and after allowing for the effects of foreign currency hedging practised by most retailers to pass through. In the interim, London and other major destination cities can be expected to witness greater tourist footfall as overseas shoppers take advantage of the new found strength of their currencies against Sterling. Outside of those regions, the situation in other parts of the UK may become more difficult; retail footfall is reducing and the number of shops standing empty is already at a two year high.
Grocers may fair better, particularly in connection with food staples – people need to eat. However, premium brands may be allowed less shelf space. Certain (German) discounters, so successful in taking market share in recent years with prices for shoppers coming in about 20% cheaper than the big-four supermarket groups, will see their competitive advantage and appeal decline since they buy more of their products in Euros.
The timing of the pound’s fall in the early months of this summer’s holiday season has already brought benefits to the UK’s tourism industry. Aside from overseas shoppers cramming London’s Oxford Street plus Edinburgh’s Prince’s Street, et al, UK nationals are being persuaded to holiday at home. The number of Caravan holidays in England increased last year to over 100m, compared to 90m in 2014. Activity theme parks, leisure centres, hotels and B&B’s should all benefit from this increase in demand should Sterling stay low.
By the opposite token, expect travel companies to see overseas booking numbers decline – along with the airline carriers. The pound’s weakness hits holidaymakers and business travellers alike and impacts point-of-sale business and margins for all UK carriers, especially where figures are reported in Euros.
After several years of bumper orders, attention within the global commercial aircraft manufacturing industry is turning to the question of ongoing demand in a slower world economy and, particularly for the European aircraft industry, the issue of Brexit.
Airbus booked nearly 1,040 net commercial aircraft orders in 2015, down from 1,460 a year before. The airframe builder splits most of its production operations across locations in France, Germany and the UK; a business model which, like many trans-European concerns, relies extensively on the ability to move products, people and IP across the EU without restrictions. Airbus sells most of its passenger aircraft in dollars, but costs are mainly in Euros and Sterling. Whilst tariffs and a hard border with the UK could hamper operations management, any lasting fall in Sterling could serve to make UK operations more competitive.
A low oil price eases the financial burden on carriers, where fuel costs are a major operational overhead, but it curbs their need to buy the new, fuel-efficient breeds of aircraft and aircraft engines; somewhat adding to the complexity of the overall industry setting, aside from the question of Brexit. This combination of positive and negative market drivers raises the uncertainty level across the length and breadth of the manufacturing supply chain, taking in the sector’s large, tier-1 firms of original equipment manufacturers and the myriad of smaller, tier-II, subcontractors on who the OEM’s depend for speciality engineering, logistics and other support services.
60% of car components are imported from Europe, increasing UK costs
The automotive sector is one of the UK’s biggest industries with annual sales valued at over £70bn. Given low financing rates and cheap fuel, car and light vehicle sales boomed following the financial crisis. From an annualised level of 9m in February 2009, total light vehicle sales reached 18m in October 2015. Over 1.5m cars were made last year, the UK industry’s most productive year in a decade. Furthermore, nearly 900,000 cars were produced between January and June this year, 13% more than a year ago.
Many of the world’s car brands have significant manufacturing operations in the UK and about 80% of this production is exported, of which about 40% is sent to the EU. Almost 60% of components are imported from continental Europe. In an effective market oligopoly, stalled sales induce car manufacturers to curtail production capacity and discount in order to preserve market share. The prospect of trade tariffs introduced as a direct result of Brexit will force car groups to re-evaluate their business positions, including the levels and locations of future investments. For example:
- Ford, the UK’s biggest car brand, has announced price increases for vehicles sold in the UK before the end of 2016 to counter falling revenues as a result of Sterling’s fall against the dollar, and;
- Vauxhall/Opel, which sells more cars into the UK than any other European country, intends to reduce production at its two plants in Russelsheim and Eisenach in Germany owing to the softer pound and an anticipated drop in UK consumer demand.
Offshored engineering work will return to the UK
Precision engineered components and assemblies of the type that find their way into everything from Formula-1 motor sport to nuclear energy plant and equipment can be comparatively price-insensitive, due to their specialist nature and high IP content. In general, such product engineering services are difficult to replicate and this type of work has remained in the UK on grounds of both the quality and lead-time on delivery expected by customers, rather than migrate to low-cost regions in Asia and elsewhere.
However, many engineering subcontractors are SME type businesses. Although often highly successful within their chosen field of activity, many find it difficult to expand outside of these zones of specific market specialism, owing to high pre-qualification and approval costs which inhibit new customer acquisition in parallel industry verticals and so limit further market growth and expansion.
Brexit should strengthen the competitive position of many of the UK’s indigenous precision engineering services companies, particularly where costs are in Sterling and sales in dollars and euros. Additionally, a more competitive pound may see the trend in recent years to offshore low value-add engineering production start to reverse, bringing further volumes of components and fabrications work back to the UK.
People shy away from making house purchasing decisions in the shadows of economic uncertainty and job insecurity. In 2007, over 180,000 new builds were recorded in England. This fell to 75,000 in 2009 and, presently, it stands at around 145,000. Over the wider UK, housing construction is growing at an annual rate of about 2%, buoyed mainly by the continuing strength of the London market.
Cheap mortgage rates and other low-cost repayment mechanisms based on near zero interest rates are designed to tempt house buyers into the market. Brexit may cool housing demand. This volatility imposes further turbulence in the trading activities of those secondary markets that live to feed off of residential property, such as kitchens, bathrooms and other fixtures and fittings. For example one leading European kitchens retailing group reports continuing first half 2016 market volume growth in the UK, but weaker gross margins due to lower sales values in a sector where the macro-economic outlook for the UK is uncertain.
Brexit – practical steps for businesses
Business will require to be diligent in its assessment of the post-Brexit opportunity
The Chancellor of the Exchequer has indicated a change in UK spending policy and set expectations for a new industry strategy and investment framework for energy, roads, rail and aviation. In theory, if the government ‘primes the pump’, then the private sector will follow suit. However, politicians do have a habit of changing their minds and postponing decisions.
On June 23, Sterling reached highs of $1.50 and €1.30. It then cratered and has since averaged $1.30 and €1.20. This is some 15% less than a year ago on trade weighted terms. This reflects the views of the currency markets that the total asset footprint of the UK has been marked down against the rest of the world.
Consequently, companies that do business in or through the UK – and their financial backers – could be advised to look carefully at plans made for business growth and expansion in order to re-examine the founding assumptions on which those trading forecasts are based. Specifically:
- Will the business need to alter its normal planning horizon
Many businesses plan 2-3 years ahead with an order book of 6-12 months forward trade visibility. Business planning structures and timelines may need to be stretched. Article 50 ‘Brexit’ negotiations will not start before 2017 and may not start for another 1-2 years; they will not be quick to conclude. Can business managers produce an accurate 5-7 year plan to bridge these periods of uncertainty?
- How is the company’s addressable market defined and characterised?
In the new world, post-Brexit, what barriers to market entry will remain the same/change? Buyers/suppliers cannot always easily or quickly switch existing supply chain arrangements. Specification criteria have to be unpicked and re-packed. Which of those are key and may determine project priorities?
- What market lead or competitive advantage is maintained over nearest rivals
What USP, core competency and tacit skill does the business bring to the market? Can customer references confirm these traits? How much elasticity/inelasticity is built into pricing in a new era of £:€:$ exchange rates?
- What resources will sustain the business’s desired market position?
Where are the gaps that may need to be corrected in people, physical assets and asset location? Is the level of resource allocation within the business likely to remain the same? Is it in need of being stretched or refinanced?
The post Brexit economy will test many companies’ mettle and may require senior managers, owners and other stakeholders to re-examine long-term strategy. The future for many businesses remains uncertain, but central risks to trading can be sensitised and mitigated with appropriate management planning and business advice.