UK M&A activity confirms UK corporate confidence remains fragile

Our research suggests UK businesses are more confident in the global economy than in their domestic economy.

Our 12th Global Capital Confidence Barometer found a consistent pattern in business sentiment: corporates across the globe were much more confident in the outlook for the global economy than they were for their own domestic economy. This was true for all of the major economies we surveyed with the exception of Spain, where the recovering domestic economy was reflected in a positive surge in local business sentiment and India, where corporate sentiment was almost balanced between local and global views, reflecting the increased confidence in the Indian economy that we have seen in recent months. But these 2 countries were the exceptions.

Reported UK business confidence was very much in line with the observed global trends: 91% of UK businesses reported confidence in the global economy improving over the next year but only 45% saw the UK economy improving over the same period. This was also reflected in relative confidence in future earnings: 99% of UK businesses were confident in global earnings but only 62% were confident in UK earnings.

Based on the research, we forecast that UK business were increasingly likely to turn to international acquisitions as the major part of their acquisition led growth strategies. UK businesses would move to acquire companies with strong earnings in markets expected to grow, rather than in a UK economy that they were somewhat more uncertain about. The ONS has now published first quarter data for UK M&A and we can now explore how our findings and predictions sit alongside actual results.

Still no sign of a significant upturn in UK M&A…

The ONS M&A data for Q1 reveals little sign of an increase in UK M&A activity with the results confirming that UK transaction volumes remain very low by historic standards. There were 90 transactions in total involving UK companies in the first quarter of 2015, compared with a quarterly average of 289 between 2002 and 2006 and 255 over the longer period of 1997 to 2014. M&A activity has yet to recover from the impact of the financial crisis.

…either by domestic oriented businesses …

In the first quarter there were only 28 transactions between UK companies which is the lowest figure since records began in 1969. The average volume of deals between 1997 and 2014 was 193 a quarter which illustrates just how low this figure really is in historic terms. The same story holds for average deal value which at £1.1 million is around one sixth of the £6.4 million average value between 1997 and 2014.

…or by foreign investors…

It is the same story for investment into the UK by foreign companies with only 21 transactions completed, the lowest first quarter volume since 1988 and some way off the long run average since 1997 of 49 transactions per quarter.  There was a better story on average values with the Q1 performance about half the average value of deals since 1997.

…but the story is more positive on outbound transactions.

The one positive note was the increase in the volume of outbound transactions: UK businesses acquiring foreign companies. In Q1 2015 there were 41 acquisitions, an increase of 71% on the average number between 2012 and 2014 and about half the long-term average volume of activity. On values, performance was much stronger with the average deal value of £8.5 million being higher than the running average since 2001.

So should we worry? Does the UK have a confidence problem?

It is clear that the financial crisis has cast a long shadow and any stumbles or increased uncertainty surrounding the UK economy quickly transmit to business confidence and activity levels.  As the EY ITEM Club Spring forecast noted, UK business confidence has fallen since the end of Q3 2014.

The CCB results also suggest that the true level of confidence in the UK economy is almost certainly lower than the headline figures. UK business confidence is a mix of higher confidence in the global economy and lower confidence in the UK, so it is likely that the average overstates actual confidence in the domestic outlook and points to a more fragile environment than we have been assuming.

The hope is that the decline in confidence was due to increased political uncertainty at the end of 2014 and that with the General Election now over, businesses will start to move forward. However, as shown by our UK Attractiveness Survey, the looming EU Referendum is likely to impact foreign investor confidence. The M&A performance in the first quarter suggests that confidence remains fragile and there is likely to be a rocky road ahead.

Way out in front but where next? Can UK inward investment success drive productivity improvement?

Another strong year, the UK pulls away from the pack…
Once again, the UK turned in an outstanding performance in attracting FDI in 2014. The numbers speak for themselves: a record number of 887 projects, up 11% on 2103; increased European market share; and a market leading 31,198 jobs created.

…with strength across a range of sectors and geographies…
The UK’s success was broad based.  Despite a second year of decline in Business Services projects across Europe, the UK grew its Software and Financial Services sector projects, captured 35% of all European HQ moves and led Europe in R&D projects . The UK achieved a leading market share of 29% of US projects in Europe and was the top destination for investment in Europe from France, Japan, Australia, Canada, India and Ireland.

…winning more Manufacturing projects than Germany.
The UK secured 164 Manufacturing projects in 2014 beating the 131 projects secured by Germany. This was based on strong growth in the Automotive, Food and Machinery & Equipment sectors. We have become used to being told that the UK cannot compete in manufacturing but the results suggest that there is untapped potential and more attention should be given to the makers.

With resurgent regional investment…
2014 saw significantly improved performance across the English regions, Northern Ireland and Wales. Yorkshire with a 140% increase in projects, the South East up 49% and the West Midlands with a 38% rise led the way. In total, the English regions secured 344 projects, the highest total since 1998 and a sign that UKTI’s attempts to support economic rebalancing are bearing fruit.
The upcoming referendum on European Union membership is a major risk to FDI…
Stability and political predictability feature prominently in the list of desirable attributes mentioned by investors and the UK has traditionally scored very well in this respect. The UK Government is committed to a referendum on the future of the UK’s membership of the European Union. With 72% of investors citing access to the European Single Market as important to the UK’s attractiveness the referendum has the potential to change perceptions of the UK dramatically, posing a major risk to FDI .  31% of investors told us they will either freeze or reduce investment until the outcome is known.

…but the good news is that investors view devolution very positively.
The EU Referendum risk comes at a time when FDI values are falling worldwide and a reviving Eurozone is likely to mean more competition to the UK for FDI in future years. One piece of good news is that proposals to devolve more economic decision-making power to the UK regions are seen as positive for UK attractiveness by 48% of investors.

Where next? No time to rest, the UK must maximise the economic contribution of FDI.
The UK’s performance in attracting FDI is a huge success story: rising numbers of projects, higher market share and large numbers of jobs created. Yet since the financial crisis, FDI projects have increased by 29%, a much faster rate of growth than both the UK economy as a whole and GDP per head. Even more strikingly, FDI volumes have grown much faster than productivity in the UK. This does raise a question as to the potential contribution of FDI to UK economic performance. Why do we appear to see very little impact on productivity from ever rising levels of FDI? What does this tell us about the desired future strategy for attracting FDI?

The priority for action: understand if the UK attracts the “right” FDI projects?
Since 2008, annual FDI project numbers secured by the UK have grown from 686 to 887 in 2014.  Unsurprisingly, there have been significant shifts in the mix of projects during this period. Sales & Marketing investments, typically when a foreign company sets up an office in the UK, have been the main driver of growth increasing from 314 to 466 projects over the 6 year period, a growth of 48%. After a dip in 2011, R&D projects have recovered and are about 10% up over the period. Recent success in attracting HQs to the UK has seen a doubling of projects since 2011 but volumes are still over 25% below the 2008 figure. Since 2012, and especially in the last 12 months, the real UK story has been the growth in Manufacturing and Logistics projects, led by the Automotive sector, up 34% on a combined basis. Does this offer an alternative way forward for the UK?

On a first review, there does appear to be a question about how significant an economic impact the dominant growth of Sales & Marketing investments has delivered to the UK. Any investment will stimulate economic activity but if the primary driver is to sell goods and services in the UK then the economic benefit may be less than from investments that bring capital investment and knowhow and potentially create a platform for export growth. The investments in the Automotive sector are a good example of productivity and export enhancing activity. Using our data, we plan to dig deeper into the relationship between FDI and productivity and to understand if changes in the mix of FDI could help boost productivity.

Two weeks is a very long time in economics: profit warnings continue to rise despite a growing economy

I thought you said things were going well?

Two weeks ago, EY’s Capital Confidence Barometer reported increased economic confidence amongst UK businesses. Last week, the EY ITEM Club forecast strong UK economic growth in 2015, especially post the election assuming business investment recovers after the end of political uncertainty. This week, EY’s latest analysis shows more companies issued profit warnings in Q1 2015 than the same period last year. How can we reconcile these conflicting results?

It is certainly the case that profit warnings are higher than we would expect given the level of GDP growth in the UK economy. A level of about half the current rate would be more usual for the stage in the cycle.  Given the improving economic outlook therefore, it’s tempting to make the oil price the chief culprit for this year-on-year rise – particularly as one in five warnings cited its dramatic fall. However, there’s more to this story and we need to dig into the details to understand what is happening.

It is true, there are some challenges out there.

UK quoted companies issued 77 profit warnings in Q1 2015, three more than the same period of 2014, but sixteen fewer than the previous quarter.  Overall, 5.5% of UK quoted companies issued profit warnings in Q1 2015 – the highest first quarter percentage since 2009.

Yes, the rapid fall in oil price at the end of 2014, contributed to 16 profit warnings in the first quarter. This includes a record eleven warnings from within oil & gas sectors and five from elsewhere, primarily the FTSE Industrial Engineering sector.But it’s not all about oil. The FTSE sectors leading profit warnings in Q1 2015 were Oil & Gas Producers (8), Support Services (8), Software & Computer Services (7) and General Retailers (6): a wide sector spread.

When we delve into the reasons cited for profit warnings, it becomes clearer that the problems businesses are encountering go beyond a falling oil price.

EY’s analysis found that:

  • Increasing competition and pressure on prices contributed to 22% of profit warnings in Q1 2015. This includes most retail profit warnings.Rising consumer spending power helped to keep retail profit warnings in single figures, despite deepening price deflation. But, the constant fight to keep prices low and meet rising consumer expectations continues to create a testing retail environment.
  • A quarter of profit warnings cited contract delays or cancellations in Q1 2015, highlighting the impact of rising market uncertainties and just how little room companies have for manoeuvre. The FTSE Support Services sector is geared to the economic cycle and contract cycles. This leaves it well placed to benefit from the upturn, but also open to election uncertainties. Over 50% of the sector’s profit warnings blamed contract delays or cancelations in Q1 2015.
  • Volatile exchange rates and the strong pound continued to complicate the forecasting environment, contributing to 10% of profit warnings in Q1 2015.  This is down on last year’s high, as companies adjust and sterling eases against most currencies, although not the Euro.

A fresh look

Profit warnings matter: the median share price fall on the day of warning was 10.8% last quarter. In  this maelstrom of change and volatility, it’s imperative that companies take a fresh look at their strategies, business models and portfolios. There are significant benefits for companies who can build a business that has the capital, market, operational and stakeholder resilience to can meet the challenges of this recovery and implement more effective planning and decision-making. Not least because companies can now expect a greater interest in how they perceive the future from activist stakeholders and regulators.

Accurate, scenario based forecasting is crucial. Let’s consider outsourcing as an example. The aftermath of the 2010, election created contract uncertainty and increased margin pressure to the sector, as the new Government reassessed existing contracts. We recorded 30 profit warnings citing election related delays or ‘austerity’ related issues in the year after May 2010 – 13 from FTSE Support Services companies. The chief concern in 2015 – for both the public and private sectors – is the potential for a drawn out process that stalls contracts and creates indecision in the wider economy. Now is the time to make sure plans are in place for alternative scenarios to avoid an unpleasant time 6 or 9 months down the road.

The “Phoney war” is nearly over, are you ready for life after May 7th?

Politics has had a limited impact on economic prospects to date…

Hard though it sometimes is to believe given the full on media coverage, the General Election campaign is drawing to a close. The EY ITEM Club UK Spring forecast suggests the UK economy will weather the Election storm and GDP will grow by 2.8% this year, in line with last year’s upwards-revised figure. CPI inflation will average 0.1%, this year, effectively taking base rate increases off the agenda until next spring.

EY ITEM Club UK Spring forecast 2015 April 3

As the forecast states,

“There is a wide gulf between the Conservatives and Labour on vital economic issues like fiscal consolidation and the EU …. Although there have been surprisingly few jitters in the financial markets, business investment growth has already fallen back from the strong figures we saw last summer. The housing market has also slowed and construction output has been falling as projects are put on hold. However, barring major upsets in the election, favourable developments in commodity and export markets should outweigh the effect of political uncertainty. “

Businesses now need to ensure they are fully prepared to make the appropriate decisions once the General Election result is known.

…and it will be back to business on May 8th

Whatever the result of the election, the rebalancing of the global economy is set to continue. As EY’s recently published Capital Confidence Barometer demonstrated, corporate confidence in the global economy is high, and actually running ahead of confidence in domestic economic prospects in most major economies. The shifting global outlook is most noticeable in the Eurozone with the combination of lower oil prices, the impact of QE on the exchange rate and financing costs, an easier fiscal regime and a more stable banking sector making economic prospects brighter than for some time.

It is not just the Eurozone economy that is in better health. Sentiment in India has improved and the USA continues to grow, albeit at a slower pace than some forecasters expected. The results from the CCB are consistent with developments in M&A and equity markets, all of which indicate a rebalancing in corporate investment priorities and a pivot back to the developed markets. Only India and China of the emerging markets feature in the top 10 investment priorities amongst the 1,600 companies surveyed for the CCB. Now is the time to review your geographic portfolio.

It also seems clear that the election is unlikely to curb the growth in UK consumer spending. EY ITEM Club forecast that household disposable Income will grow by 3.7% in 2015, the fastest growth for over 20 years. This seems sure to translate into increased consumer spending in the UK economy. With good retail sales data and strong car purchases so far in 2015, it does appear that the consumer recovery is becoming increasingly robust. Businesses need to make sure that their plans are such as to allow them to capitalise on this spending and avoid missing out on the consumer revival.

EY ITEM Club note that business investment has eased since the rapid growth in 2014. This probably reflects both a loss of confidence in the pace of UK economic growth in late 2014 and concerns over the election result. However the EY ITEM Club forecast is positive about UK economic growth all the way through to 2018, with growth averaging just under 3% per year for the period. This is healthy growth and ought to create opportunities for business but exploiting this growth will most likely require investment. UK business needs to ensure it has the capacity to invest to capture the available returns in the growing UK economy.

Once the election result is known and the identity of the future government known, business must work through the implications of likely policy for the economy. The different plans for fiscal policy are an obvious area as could be the UK’s relationship with the EU. Moreover, whatever the composition of the new government, immigration policy is likely to impact business. Appropriate analysis and contingency planning is required to ensure there are no nasty shocks in future.

Business confidence is improving but pragmatism means it is steady as we go with a pivot to developed markets.

Corporates increasingly confident in the global economy…

EY’s 12th Capital Confidence Barometer, a survey of around 1,600 decision makers globally, shows that 83% of respondents are confident that the global economy is improving, a significant increase from the 53% who felt this way in October 2014. This positive outlook extends beyond the economy with business having a positive view of global corporate earnings, credit availability and equity market conditions..

This is something of a surprising finding. In January the IMF downgraded its forecasts for global growth, while the problems faced by previously rapid growing markets such as Brazil and Russia are well known and the slowdown in China has cast a shadow over many emerging markets. Why is business so confident in the global economy?

…rather than their local markets…

The confidence that businesses have in the global economy is in marked contrast to their views on their own domestic economies. As the chart below shows, corporates are significantly more confident in the prospects of the global economy compared to their local economy. Spain is the only major economy with business executives having more confidence in the local than global economy.

The economy is improving

Graph 1. The economy is improving

…and the global risks are not being ignored.

Yes business is more confident in the prospects for the global economy but corporate leaders are still very aware of the risks that exist. Political instability and currency and commodity volatility are both prominent in the list of most significant economic risks identified by respondents. His is no surprise: the global political outlook has dominated the news in recent months and the challenge posed by major shifts in currency values has become clear through the recent earnings reporting season.

What do you believe

Graph 2. What do you believe to be the greatest economic risk to your business over the next 6 to 12 months?

Should we twist or stick?

The mixed picture of business confidence and risk makes decision-making for corporates very challenging. Is now the time to seek to exploit stronger global economic conditions or should the focus be on the domestic business or on risk avoidance? The answers in our survey suggest that the preferred way forward is a pragmatic approach seeking to manage across the various conflicting issues.

On one hand, despite increasing confidence in the global economy, 54% of respondents state that their primary focus is on cost management compared to 31% focussing on growth. This is a reversal of the relative positions in October 2014 when the respective figures were 37% and 40%. Consistent with this cautious approach, the intentions to hire staff have fallen from 52% to 29% of respondents since October 2014 although 65% of businesses plan to maintain staffing levels

On the other hand, despite the focus on costs, 56% of businesses plan to make an acquisition in the next 12 months, up from 40% six months ago. And, reflecting the strong confidence that corporates have in the global economy, 84% of those deals are expected to be outside of the company’s primary domestic market.

However, most M&A activity, 81% of it, is expected to be deals of under £250 million and only 5% of companies plan deals of over £1 Billion in the next 12 months. We can conclude that both cost management and acquisition strategy are actually very much carefully managed incremental programmes rather than ambitious transformation strategies. Business is confident but cautiously so and this translates into balanced strategies.

Back to the developed markets

However the most striking demonstration of how corporates are seeking to balance their conflicting views on confidence and risk is provided by the change in their geographic focus. Investment intentions in the next year are very much international: only 16% of M&A is expected to be domestic, 54% is regional and 30% further afield. Corporates do appear to believe the grass is greener outside of their home market and are searching for growth beyond their domestic borders.

Acquisition capital

Graph 3. What percentage of your acquisition capital are you going to allocate to the emerging markets in the next 12 months?

But this is still cautious international expansion with a significant reduction in the amount of capital allocated to emerging markets. 65% of companies expect less than 10% of their investment to be in emerging markets and another 15% expect to allocate less than 25% of their capital spend to these geographies.

There is a clear pivot back to the developed markets with only China and India of the emergers making the top 10 destinations identified by respondents to our survey. In an uncertain world, the upturn in the Eurozone and relatively good performance in the USA and UK has changed perceptions. Cautious corporates are looking internationally for growth but increasingly, and for the first time in a long while, to the developed markets.

 

 

Scattergun approach to UK industry won’t be enough to deliver on reshoring opportunity

Rather than picking industry winners, the Chancellor has taken a ‘scattergun’ approach to supporting UK business. From the investment in the new Energy Research Accelerator and the Croxley rail link, to the expanded support for postgraduate research and plans to extend the Oxford Science Vale Enterprise Zone.

As we demonstrated in our Reshoring report, the UK has a once in a generation opportunity to grow its manufacturing base. Changes in global economic conditions, corporate strategies and consumer tastes have put future manufacturing investment in play. The UK will not regain the 700,000 plus jobs it offshored between 1995 and 2011, but a sector focussed strategy could capture 300,000 jobs over the next decade.

Our analysis suggests that sectors such as Life Sciences, Chemicals, Advanced Engineering, Aerospace and Automotive offer real opportunities for the UK. However, success requires a joined up long-term plan over two Parliaments with investment in skills, changes to tax, and investment in infrastructure all required.

The plans announced today address several of the sectors identified but not on the scale required to drive real growth as the OBR’s forecasts appear to confirm. In 2019, there is a planned increase in Government investment of £5 billion but this is too little too late: the opportunity is large scale and immediate, and the UK risks missing out.

Look beyond the “caretaker” Budget, business needs to pay close attention to the future shape of fiscal policy

EY ITEM Club expect a “caretaker” Budget

With the General Election looming, the EY ITEM Club believes that a “caretaker” Budget is the most likely scenario on March 18th. Nevertheless, the Chancellor’s statement should continue some positive news. With expected Tax receipts rising and interest rates on Government debt falling – even since the Autumn Statement – EY ITEM Club expect that the Chancellor will be able to announce a reduction in the Office for Budget Responsibility’s (OBR) forecast of borrowing for the current year of just over £2 billion and a possibility of a £6 billion reduction for the following year. It is hard to imagine any Chancellor not wanting to play up these positive developments.

Budget infographic

Beyond this though, it is unlikely that there will be a significant number of major policy initiatives announced in the Budget. The Chancellor may well pull one or two rabbits out of his hat but the politics of a Coalition close to an election are likely to limit his scope for broad-based change. This Budget is more likely to mark the start of the fiscal policy debate for the next Parliament and this is what business should be focusing on understanding.

…but the medium-term is much harder to predict…

Paul Johnson of The Institute for Fiscal Studies recently commented that the gap between the fiscal plans of the two largest UK political policies is as wide as it has been since 1992. The Conservative Party has stated it wants to eliminate the entire government deficit and run a small surplus during the next Parliament. Duncan Weldon estimates this would require spending cuts or tax rises worth between 4.3% and 5.3% of GDP (national income), depending on how large a surplus was desired.

Labour, by contrast, only wants to balance the current budget (current government spending excluding capital investment). That means that, under their plans, the government would still be borrowing in the next Parliament to make investments. Labour’s plans imply spending cuts or tax rises of 3.0% according to Duncan Weldon’s analysis.

…although business seems to have a clear position…

Chris Giles of the Financial Times has surveyed the attitudes of business leaders to government spending. Support for deficit reduction before the end of the next Parliament was very strong with 39% wanting this achieved wholly through spending cuts rather than tax rises.

In terms of where the cuts should fall, 84% of the business leaders interviewed want to see welfare spending reduced compared to only 4% who wanted an increase. A majority of 54% to 46% wanted the NHS ring fence ended and 71% wanted the ring fence on international aid removed. And 85% saw more private provision of public services as one way to help achieve these aims.

However, 90% wanted an increase in the capital spending budget of more than the planned 2% and there was a majority of more than 2 to 1 in favour of maintaining the protection of the school’s budget.

…but may need to be careful what it wishes for…

The position of corporate leaders on public spending seems clear: overall they would like less except in selected areas, which presumably have a clear benefit to business. However the position may be more complicated than they realise: the benefits to business may flow in ways that are not obvious from the headline numbers.

Kevin Farnsworth of the University of York has calculated that “socio-corproate welfare” and “corporate welfare” as he describes them, could have delivered something of the order of £85 billion of taxpayers’ money in benefits to the corporate sector in 2012. This estimate includes wage support, training assistance and pensions in the first category and subsidised lending, export insurance, marketing by the Department for Business Innovation & Skills and other departments and public purchases from the private sector amongst the second. The approach used is a very specific one and may not be accepted by all business leaders as valid, but it does show the challenges of understanding how fiscal policy changes may impact the economy.

For example, there is research available to support the view that public sector funding of Research & Development can have major benefits for the private sector. Grants and other support may also be important to certain companies. Businesses need to be clear on the specifics of policy if they are to be in a position to make informed decisions.

Even the potential impact of welfare spending is not that straightforward to analyse. Something of the order of 47% of benefits accrue to pensioners. Cutting this could well reduce consumer spending and disproportionately impact businesses exposed to this segment. If this spending is protected then policy might mean schemes that benefit lower income workers are targeted. This could have significant implications for labour intensive sectors such as the hospitality industry.

…and now is the time to do the numbers.

Government finances are a complex are. When listening to politicians, it’s easy to believe the choices are straightforward. The reality is different especially when policy differs between the parties to the extent it currently does. Business must get to grips with the detail and plan accordingly.