Supply woes deepen the risk of ‘profitless prosperity’

Supply chains are getting better in some places, but the snail-like pace of improvement sets manufacturers up for a make-or-break moment come summer. 

Outside of a handful of stragglers that will report over the next few weeks, earnings season is wrapping up for large industrial companies. It hasn't been pretty: On average, shares fell about 1% in the first trading period after S&P 500 industrial companies reported results. Still-snarled supply chains and Covid-related worker shortages curbed revenue, while associated production hiccups and added costs weighed on margins. First-quarter earnings forecasts were broadly weaker than expected as CEOs warned that logistical strains would linger and inflation would continue to bite. The slow start leaves many banking on a material turnaround in the operating environment in the second half of the year to meet their annual guidance. Fortive Corp., for example, forecast 2022 core sales growth of as much as 8.5% and adjusted operating margin expansion of up to 140 basis points despite anticipating only a 4.5% revenue increase at best and 30 basis points of profitability gains in the first quarter. Does that seem realistic?

Inflation isn't expected to reverse, but the pace of cost increases should at least start to slow. 3M Co. said it's already seeing evidence of this. That should give manufacturers more breathing room and allow the multiple rounds of price increases they've enacted to have a greater effect. Because inflation was hot and supply chains were a mess in the second half of 2021, the comparisons also become easier as this year goes on. Optically speaking, that should make margin performance look better — assuming inflation doesn't reaccelerate and demand doesn't collapse. The biggest variable remains supply chains: No one truly knows when they will normalize. 

There have continued to be incrementally positive signs of untangling. Manufacturing supplier-delivery performance improved for the third consecutive month in January, according to data this week from the Institute for Supply Management. Dover Corp. can now buy raw materials such as steel for less than what it paid to build existing inventory, while Rockwell Automation Inc. is having an easier time procuring resins. Fastenal Co. expressed optimism that Covid absenteeism among its workforce had peaked after recording 600 cases in just the first two weeks of January, compared with 3,400 since the pandemic started. General Motors Co. said semiconductor access had improved enough to support as much as a 30% increase in production volumes this year, while Honeywell International Inc. said it's already locked in 90% of its needs for this year. Paccar Inc. had some 7,000 trucks that it couldn't ship in the third quarter because of component shortages; it cleared that backlog in the final stretch of 2021 and said production is steadying. Pentair Plc said it's taking less time to build pools. 

But broad-based stabilization remains elusive. For every positive anecdote about supply chains, there's a counterweight. Caterpillar Inc., for example, isn't seeing any progress on chip availability. To get around shortfalls, it paid up and moved engine controllers by air both internally and externally during the fourth quarter to try to meet more customer demand. Caterpillar also elected to keep its factories running even when it lacked components so it could produce as much as possible. It raised prices materially in the final stretch of 2021, and that was enough to cover increases in input costs but not the impact of all the premium shipping and factory inefficiencies. Air-conditioner maker Lennox International Inc. is having fewer issues tracking down aluminum, steel and packaging materials, Chief Executive Officer Todd Bluedorn said this week. But the highly transmissible omicron variant hit its workforce hard: on certain days in the fourth quarter, a factory in Arkansas was missing 25% of its hourly production staff because of Covid cases. 

"The supply chain is healing," Bluedorn said on a call to discuss fourth-quarter results. "I just think every time I want to declare victory, Covid takes a slightly different direction."

This drawn-out unscrambling shouldn't be a surprise. To date, the best description of the supply-chain recovery that I've heard is a comparison to the boa constrictor in "The Little Prince" that's attempting to digest an entire elephant: The process takes a while. That's fine as long as the recovery keeps progressing in the right direction. But the trouble with digesting elephants or unraveling supply chains is that there can be unexpected hiccups and side effects. With prognostications for supply-chain normalization already having been repeatedly pushed back, it's fair to wonder whether manufacturers are being too optimistic about the back half of this year. The long-awaited shift in consumer spending back to services and away from physical goods that need to be shipped into overloaded ports is finally starting to happen, and that should ease the pressure on supply chains. But it remains to be seen whether the omicron variant will cause wide-scale factory disruptions in China or if looming contract negotiations for workers at the West Coast ports turn contentious and lead to devastating shutdowns. Either scenario would effectively put manufacturers back at square one — or worse. 

There are many reasons to be optimistic about industrial demand. Companies are ratcheting up capital expenditures materially in 2022, and that's before budgeting for the $550 billion US infrastructure bill or the nearly $150 billion in new US factory spending announced recently by semiconductor, electric-vehicle and battery manufacturers. Honeywell, for example, is boosting its spending by 25% year-over-year in 2022 with projects in advanced recycling, low-global warming refrigerants and quantum computing and adding an extra $200 million of research and development investments. The risk is that supply chains remain stubbornly tangled and that margins fail to bounce back, setting the industrial sector up for a period of "profitless prosperity," Melius Research analyst Scott Davis wrote in a report this week. 

"Particularly in today's world, I mean, it's hard to get somebody to ride on the back of a truck and throw trash." — Waste Management Inc. CEO James Fish

Fish made the comments this week on a call to discuss Waste Management's fourth-quarter earnings. While hiring overall surpassed economists' estimates in January despite omicron disruptions, the manufacturing sector added just 13,000 workers last month, according to a Labor Department report on Friday. That was short of forecasts for 20,000 jobs and the smallest monthly gain since April, the last period in which employment in the sector declined. All in, the manufacturing industry is operating with close to 240,000 fewer workers than it had at the end of 2019. The waste management and remediation services sector — which includes trash collection — lost 1,500 positions in January, Labor Department data show. "You've heard me talk about my daughter saying in her high school class nobody wants to drive a truck or operate a piece of heavy equipment," Fish said. "So this is not something that just came to us in the last three months."

Like many industrial companies, Waste Management is responding to the tight labor market by accelerating investments in automation, with a goal of eliminating the need for as many as 7,000 jobs over the next four years. On the labor inflation front, it's worth noting that manufacturing CEOs continue to see this as a mostly North American problem. Emerson Electric Co. Chief Operating Officer Ram Krishnan said the company is seeing "normal" levels of inflation in India, Europe and China, as opposed to the US and Mexico, where entry-level wages are climbing materially. To the extent that CEOs are evaluating a larger North American factory footprint, that dynamic will likely mean automation takes on even greater importance.

Deals, Activists and Corporate Governance

United Airlines Holdings Inc. is considering selling a minority stake in its frequent-flier program, people familiar with the matter told Bloomberg News. Such a deal would mark the next evolution of airlines' efforts to monetize their loyalty plans, which throw off a lot of cash and tend to be less volatile than ticket revenue. With the help of Goldman Sachs Group Inc., United pioneered a debt-financing vehicle backed by its frequent-flier program during the pandemic. American Airlines Group Inc., Delta Air Lines Inc., Spirit Airlines Inc. and Hawaiian Holdings Inc. then followed suit. United is reportedly contemplating selling a small holding (15% or less), but that's still material relative to the nearly $22 billion valuation that was assigned to the MileagePlus loyalty program in 2020 when it did the debt deal. Retaining majority control of the operations may help the airline avoid the pitfalls that Air Canada and Gol Linhas Aereas Inteligentes SA ran into when they spun off their own frequent-flier plans. Independent ownership created an inherent conflict of interest: the primary idea for the airline is to boost loyalty among customers, but an operator that doesn't care as much about ticket sales may seek to maximize profit through the sale of mileage credits to third parties such as credit-card partners. Air Canada and Gol both reabsorbed their frequent-flier programs. United reportedly sees an opportunity in tapping outside expertise to better monetize the reams of data collected on fliers through MileagePlus. 

Aerojet Rocketdyne Holdings Inc., the missile-component manufacturer whose planned sale to Lockheed Martin Corp. is at risk of falling apart because of regulatory pushback, is now also facing internal drama. Steel Partners Holdings, the investment firm of Aerojet Executive Chairman Warren Lichtenstein and one of the company's largest shareholders, said this week it would launch a proxy fight to replace certain directors, including CEO Eileen Drake. While Steel supports the $4.4 billion sale to Lockheed Martin, the Federal Trade Commission's move to block the deal means Aerojet "needs to focus on ensuring that it is optimally positioned to continue the business as a standalone entity," the investor wrote in a filing. Aerojet separately said it's been conducting an investigation into Lichtenstein through a committee of independent directors, some of whom were left off of Steel's opposing slate. Aerojet said the investigation isn't related to the company's operations or financial reporting and accused Lichtenstein of launching the proxy fight to protect his personal position on the board. Steel Partners said the investigation has to do with a dispute between Lichtenstein and Drake and questioned Aerojet's decision to disclose the matter now. It's all very messy and none of it is particularly helpful in terms of convincing investors of Aerojet's prospects as a stable, stand-alone business. 

Triumph Group Inc. agreed to sell a Florida wing and fuselage assembly plant to France's Daher SA. Jefferies analyst Sheila Kahyaoglu estimates $150 million in proceeds. The divestiture completes the unwind of Triumph's aircraft-structures business. That mostly leaves it with a component and services business that generates about $1 billion in revenue and could attract takeover interest of its own. Elsewhere in aerospace and defense M&A, the controlling shareholder of ManTech International Corp., co-founder George Pedersen, is exploring a sale of the $3 billion IT services contractor as part of his estate planning, Reuters reports. 

SIG Combibloc Group, a Swiss maker of juice boxes and soup cartons, agreed to buy Scholle IPN for 1.36 billions euros ($1.6 billion), including the assumption of debt. Scholle makes bag-in-a-box packaging, including for wine and condiments, as well as pouches of pureed food, yogurt and apple sauce that are popular with toddlers. It's SIG's largest acquisition since going public in 2018. Separately in packaging deals, Five Star Holding Corp., a closely held manufacturer of films, bags and pouches, is reportedly considering a sale that could value it at more than $1.5 billion. 

Marina M&A! Centerbridge Partners LP will combine the second- and third-largest owners of US marinas, the Wall Street Journal reported. The investment firm, already the largest shareholder in Suntex Marinas, will now purchase Westrec Marinas for about $400 million. Waterside properties have become more attractive in recent years after an Internal Revenue Service rule change gave them more favorable tax treatment and the pandemic spurred a renewed interest in outdoor recreation. 

Brooke Sutherland is a Bloomberg Opinion columnist covering deals and industrial companies. She previously wrote an M&A column for Bloomberg News.

Disclaimer: This article first appeared on Bloomberg, and is published by special syndication arrangement.