Value creation

in industrials

November 2020
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Contents

5 Preface

7 Acknowledgments

8 Executive summary

11 Introduction: The industrials sector

17 Historical performance and key drivers

49 Learnings from top performers

57 Impact of COVID-19

63 Imperatives for future value creation

69 Conclusion

71 Glossary

Value creation in industrials 3

Preface

The industrials sector is large and diverse, with close to four thousand public and private
companies in the US. It powers the US economy, contributing 13 percent of the market
capitalization and 13 percent of employment (as of 2018–19). Its segments are diverse,
ranging from giant industrial machinery to tiny electronic components.

This report assesses the sector’s performance over the past five years with a view toward
helping executives make well-informed decisions about driving value creation going forward.
We begin by exploring how the sector’s performance has changed from 2014 through 2019,
compared with the previous 15 years. In so doing, we share our analysis by micro-verticals
(sets of companies with a similar product and end-market focus) to identify which factors
most contributed to overall performance. Most importantly, we explore the contribution
of different elements—operational performance, leverage, and multiples expansion—to a
company’s performance, measured as total shareholder returns. We then explore COVID-19’s
impact on the sector, particularly how the pandemic has forced executives to reevaluate their
priorities. The report closes with our perspectives on areas that executives must focus on as
they chart a path to short- and long-term success in value creation.

We welcome your questions or requests for additional information.

Nick Santhanam
Senior Partner, Americas Leader, Industrials Practice
Silicon Valley

Shekhar Varanasi
Partner, Industrials Practice
Silicon Valley

Akshay Sethi
Associate Partner, Industrials Practice
Chicago

Nidhi Arora
Engagement Manager, Industrials Practice
Seattle

Value creation in industrials 5

Acknowledgments

We thank the McKinsey experts whose insight and guidance were critical to our work—in
particular, David Kohn, senior knowledge expert in McKinsey’s New York office, and Robert
Uhlaner, senior partner in the San Francisco office.

We are particularly indebted to our project team: Lindsay Allison, Kinshuk Mitra, Bilal Shaikh,
and Paolo Tosato.

Eileen Hannigan provided assistance with communication and outreach.

Ashish Kumar led the design and production of this report.

Value creation in industrials 7

 Executive summary

The industrials sector underwent a period of turmoil during the financial crisis of 2008–10.
Our prior research—the 2017 report Industrials: A phoenix ready to rise again?— showed that
the sector recovered from the challenges posted by the crisis. Our more recent investigation,
summarized in this report, shows that some industrial companies are still stronger than they
were before the financial crisis but others are now struggling to generate shareholder returns
because of recent headwinds related to the global pandemic and international trade tariffs.

Understanding the factors that shape performance in the industrials sector, which accounts
for a significant share of market capitalization, revenues, and employment, can help executives
equip their companies to maintain a robust long-term trajectory. We explore these factors by
focusing on value creation, measured as annual growth in total shareholder returns (TSR).

Overall, the industrials sector performed well over the past five years, with a compound annual
growth rate (CAGR) in TSR of 11 percent from 2014 to 2019—400 basis points higher than
returns in the previous 15 years. Performance has varied across the sector’s ten segments,
however.

There is also significant variance in performance across “micro-verticals”—clusters of

similar companies defined by product portfolio and end-market focus. Our analysis found a
2,600-basis-point differential in TSR between top- and bottom-quintile micro-verticals.
Top-performing micro-verticals tended to be in markets that have experienced favorable
consumer demand and that benefited from tailwinds such as regulatory and policy changes.
Meanwhile, bottom-performing micro-verticals were concentrated in mature segments that
bore the brunt of punishing headwinds.

These seeming structural strengths and disadvantages are not permanent: 45 percent of
micro-verticals moved two or more levels of relative performance over the past five years as
the impact of headwinds and tailwinds have waxed and waned. Furthermore, the headwinds
and tailwinds affecting a micro-vertical are not the only factors determining a company’s
performance. Around 30 percent of companies performed significantly above or below what
their micro-vertical classification would have predicted, suggesting that companies still control
their own destinies.

Breaking down TSR into its key constituent parts reveals that it is most dependent on a
company’s operational performance. Furthermore, within operational performance, margin
improvement was the key determinant of TSR performance. Other drivers, mainly leverage
and multiples, appear to matter less when compared with operational performance, although
they do matter and, in the case of leverage, differ in their impact on top-performing and
bottom-performing companies. Assessing the performance of top companies showed that
they focused on three steps to drive value creation: leveraging technology to achieve profitable
growth, improving corporate oversight, and building a platform to enter new markets or gain
scale in existing ones.

8 Value creation in industrials

Along with the many factors shaping value creation, COVID-19 has posed major issues in
the global economy, and industrials have certainly not been spared. Companies with strong
2019 balance sheets have performed better on average, which means that the pandemic has
exacerbated the gap between top and bottom performers. Although the economic outlook
is cause for concern, many companies are using the pandemic and its economic fallout
as an opportunity to accelerate fundamental shifts in how they operate—for example, by
restructuring their workforce, accelerating adoption of digital, and restructuring supply chains.

Executives, boards, and investors have crucial roles in orchestrating these shifts and
steering their companies to greater heights. Together they can equip their companies for
success despite the pandemic. The effort will involve identifying the factors that will most
affect performance, including the headwinds and tailwinds affecting their micro-vertical(s).
Stakeholders must also develop the right playbook to drive holistic margin transformation and
identify enablers that will increase the odds of success.

Value creation in industrials 9

10 Value creation in industrials
Introduction: The industrials sector

The industrials sector underwent a period of turmoil during the financial crisis of 2008–10.
But the sector’s financial performance during and after that period indicates that the industry
overall emerged from the crisis quickly. Its performance since then has flattened, however, and
results may vary from segment to segment and from company to company. By studying these
differences, we can better understand what makes particular segments and companies thrive.

This knowledge is of far more than academic interest, since industrials constitute a major
component of the US economy and represented around 13 percent of the total market
capitalization on US stock exchanges as of December 2019. The sector’s combined market
capitalization, at around $5 trillion in the same month, is larger than that of energy, real estate,
materials, utilities, and most other sectors. Industrials are first in revenues. They account for 18
percent of US revenues, with financial services in second place at 12 percent. Industrials also
are a major source of US jobs: 21 million in 2018–19, or 13 percent of total employment that year.

Diversity of the industrials sector

The industrials sector is far from monolithic. It can be grouped into ten segments based on broad
product portfolio and position in the value chain. Each of these segments—for example, industrial
machinery or industrial trading and distribution—includes companies that are household
names and have become synonymous with technical innovation and quality. The breadth of the
industrials sector means that even one segment can be so broad as to encompass many different
types of companies. For example, the industrial-machinery sector includes food-processing-
equipment and metalworking-machinery companies, which are significantly different in terms of
where they fall in the value chain and the business landscape.

To get a better sense of historical performance and prospects for the future, it’s necessary to go
one step further by categorizing companies into micro-verticals—groups whose members have
similar products and end-market focus. Exhibit 1 shows examples for each industry segment. The
industrials sector has 90 micro-verticals, which we have analyzed to determine the factors that
influence performance (see sidebar “About the research”).

Value creation in industrials 11

 Exhibit 1
Industrial companies were grouped into ten segments, divided into 90 micro-verticals.

Number of US traded Number of

Segments public companies micro-verticals Sample micro-verticals

Automotive and ancillaries 105 12 Agricultural and farm machinery Motor vehicles and passenger cars
Auto parts and service Commercial-vehicle parts

Aviation, aerospace, and defense 46 3 Aircraft/aerospace parts and equipment Ordnance and accessories
Aviation and defense OEMs

Electrical components 32 5 Electric lighting and wiring equipment Solar modules

and equipment Electrical storage and distribution equipment Motors and generators

Electronic components 156 21 Automation and control Communications components

and equipment Laser and related devices Test and measurement sensors

Home and building 101 12 Fire and security equipment Cooling and heating equipment
products and technology Building-material distributors Building exterior products

Industrial diversified 23 2 Industrial diversified

Industrial-focused PE

Industrial machinery 81 11 Industrial tools Fluid handling (pumps, valves, meters)

Metalworking machinery Food-processing equipment

Industrial materials 17 3 Industrial gases

Specialty/engineered materials

Industrial services 94 15 Industrial-waste solutions Waste collection and disposal

Industrial engineering, procurement, construction Engineering services

Industrial trading and 33 6 Wholesale trade - durable goods Aircraft - equipment rental and leasing
distribution
Container/marine - equipment rental & leasing Services - equipment rental and leasing

Total 688 90

Source: S&P Capital IQ, SICcode.com, EDGAR, McKinsey analysis

12 Value creation in industrials

 About the research

To understand the factors that affect performance, we analyzed the total shareholder returns
(TSR) for the 90 micro-verticals. The industrial-machinery segment, to pick just one, includes
11 micro-verticals. One such micro-vertical is fluid handling, whose companies—for example,
Crane, Flowserve, IDEX, Mueller, and Pentair—manufacture pumps, valves, meters, and
compressors for fluids. We gathered information on these companies to understand their
micro-vertical and followed a similar procedure for the 89 other micro-verticals.

Micro-verticals are clusters of similar companies defined by product portfolio and

end-market focus.

Segments Micro-verticals Badger Meter

Automotive and ancillaries 1 Engineered products and components Circor

Crane
Aviation, aerospace, and defense 2 Engines and turbines
Colfax
3 Fluid handling (pumps,
Home and building products and technology
valves, meters, etc) Evoqua

Flowserve
Electrical components and equipment 4 Food-processing equipment

Franklin Electric
Electronic components and equipment 5 Food service equipment Graco

Industrial diversified 6 Industrial tools Gorman-Rupp Pumps

IDEX corporation
7 Metalworking machinery
Industrial machinery
ITT
8 Packaging equipment
Industrial materials Mueller
9 Pipes and metal
Pentair
Industrial services
10 Specialty flow control Watts Water Technologies

Industrial trading and distribution 11 Specialty industrial machinery Xylem

Source: S&P Capital IQ, SICcode.com, EDGAR, McKinsey analysis

For each micro-vertical, we arranged companies into quintiles based on their total shareholder
returns (TSR).1 Examination of the micro-verticals by quintiles helped us isolate the relative
impact of the headwinds and tailwinds facing the industrials industry. Further, it shows how,
despite their micro-vertical endowment, companies can control their destiny by focusing on
operating performance, leverage, and investor sentiment (multiple growth).

1
TSR measures any changes to the share price and dividends.

Value creation in industrials 13

 Public and private companies

Discussions of industrials often focus on public companies, but listed companies tell only part
of the story. The sector has five times more private companies than public ones (Exhibit 2).
In addition, around 80 percent of public companies are small- to midcap companies, and many
private companies are family or private-equity-owned businesses that have created a profitable
niche for themselves.

Exhibit 2
Most industrial companies are private, and more than 80 percent of listed companies are
small or midcap.

Number of industrial companies in the US, Size of public companies1

as of Dec 2019 % in category

Large cap
Public 688
17
Midcap

~5x 35

Private 3,308

49

Small cap 83
1 Capitalization defined based on 2019 revenue; large cap, >$5 billion; midcap, $1 billion–$5 billion; small, <$1 billion.

14 Value creation in industrials

Industrial private companies constitute 38 percent of the top 1,000 private companies ranked
by revenue across all sectors, a fact that further reinforces the sector’s significance in the US
economy. These 380 private industrial companies have a combined revenue of about
$250 billion and posted a compound annual revenue growth rate (CAGR) of 4.2 percent in the
five-year time period from 2013 to 2018—outpacing revenue growth of S&P 500 companies
(average CAGR of 2.9 percent).

The success of private companies can be attributed to three main factors:

1. The culture, ethos, and network of family-owned businesses helps employees motivate and
protect each other, as well as adjust quickly to a new “normal” as needed.

2. Decision making can be sped up, especially in the face of any disruptions, as decisions don’t
need to be passed up a chain of command or put in front of a board.

3. The much lower level of reporting requirements for private companies opens up strategic
options free from investor pressure to deliver short-term earnings.

These factors enable private companies to be nimble and adaptive as they deploy strategic
options in response to disruptions.

Clearly, the industrials sector is a significant one. Given its size and diversity, performance
variations among segments, micro-verticals, and companies are not surprising. In the next
chapter, we will look for patterns in these differences, since they offer clues about what makes
particular micro-verticals and companies thrive.

Value creation in industrials 15

16 Value creation in industrials
Historical performance and key drivers

Despite some dramatic swings in the economy, the industrials sector has been resilient overall.
The prospects vary from segment to segment, micro-vertical to micro-vertical, and from
company to company, however. We can find patterns and drivers for success by drilling down
from industry-level performance to value creation by segment, micro-vertical, and company.

1. Sector performance: A track record of value creation

Our analysis of the industrial sector focuses on value creation, and we have used two metrics to
assess this: return on invested capital (ROIC) and total shareholder returns (TSR). ROIC provides
insight into the underlying operating results and allows for easy comparison to the weighted
average cost of capital (WACC)—the cost at which companies fund their capital spend. A number
higher than WACC suggests that a company generated profit in excess of the costs of capital
invested. TSR measures the gains to shareholders resulting from changes to the share price and
dividends.

Since the beginning of this century, value creation in industrials has gone through three distinct
phases (Exhibit 3). First, from 2001 to 2007, rapid growth occurred in value creation, with ROIC
improving from a low of 6 percent to 11 percent, which is higher than the typical 8 to 10 percent
WACC for industrial companies in the US. This meant that by end of the period, companies were
generating more value for their shareholders than the cost of capital invested. Then came the
financial crisis of 2008 to 2010, when there was a rapid slump, followed by a rapid recovery.
Since then, in the years from 2011 to 2019, the sector has enjoyed stable performance, with the
ROIC mainly around 13 percent until 2018, when there was an increase.

Value creation in industrials 17

 The most recent level of ROIC marks an improvement over the range of 4 to 11 percent
measured from 2001 to 2009. This stable ROIC performance has allowed the sector to
generate higher shareholder value as the sector has continued to invest in growth.

Exhibit 3
Since the recovery in 2008-10, ROIC performance has remained largely flat for the sector.

Return on invested capital for industrials,1

%

2001-07 2008-10 2010-19

Rapid growth Slump and recovery Flat performance

20 18
18 16
16 14
13 13 13 13 12
14
11 11 12 11
12 10
10
10 8
8 7
8 6
6 4
4
2
0
2001 02 03 04 05 06 07 08 09 10 11 12 13 14 15 16 17 18 2019

1 Based on analysis of 688 companies listed on key US exchanges; some of these companies may not have revenues for all years since 2002; Weighted average across all
companies, excluding companies with insufficient data to calculate ROIC in a given year.

Source: S&P Capital IQ, SICcode.com, EDGAR, McKinsey analysis

18 Value creation in industrials

 Driven by this improvement in ROIC and in excess of WACC, the industrials’ TSR increased by
400 basis points, with the TSR CAGR increasing from 7 percent during the 2001–14 period to 11
percent in the 2014–19 period (Exhibit 4). Indeed, industrials trailed only information technology,
consumer discretionary, and communications services in TSR.

Exhibit 4
Industrials performed well over the past five years, generating TSR about 400
basis points higher than in prior years.

Comparison of sector-level TSR,1 2014–19 vs 2001–14

TSR CAGR,2 2001–14, %

12 12
10
9
6 7 7 7
6
5
3

Financials Communication Healthcare Utilities Consumer Industrials Information Energy Materials Real Consumer
services staples technology estate discretionary

TSR CAGR,2 2014–19, %

20

14 14
11 11
8 9 10
8
5

-3
Energy Materials Real Consumer Healthcare Financials Utilities Industrials Communication Consumer Information
estate staples services discretionary technology

400 basis points Improvement in industrials’ position

compared with other sectors

1 Total shareholder returns, calculated as weighted average TSR on market cap of companies belonging to a particular sector.
2 Compound annual growth rate.
Source: S&P Capital IQ, SICcode.com, EDGAR, McKinsey analysis

Value creation in industrials 19

 2. Segment performance
We looked beneath the sector’s top-line numbers to analyze TSR performance of the various
segments and micro-verticals from 2014 to 2019. At the segment level, we observed wide
variations in TSR performance during that period. For example, TSR CAGR varied from
4.1 percent for electrical components and equipment to 17.3 percent for electronic components
and equipment (Exhibit 5). We also observed that segments changed their relative positions over
time. Two of the lowest-performing segments in 2001–14 (electronic components and equipment
and industrial services) rose to positions in the top three segments in TSR performance during
the 2014–19 period. The fastest-growing sector during 2001–14—industrial trading and
distribution, at 14.2 percent—saw significantly lower TSR growth from 2014 to 2019 and hence
ended up near the bottom in the later period.

Exhibit 5
The industrial-services segment improved most, followed by electronic components
and equipment

Segment TSR performance,1 2001–14

CAGR,2 %

14.2
12.2 12.3
10.4 10.9 11.0
9.5
6.8
4.6
4.5

Electronic Industrial Industrial Electrical Industrial Automotive and Home and building Industrial Aviation, Industrial trading
components diversified services components machinery ancillaries products and tech materials aerospace, and distribution
and equipment and equipment and defense

Segment TSR performance,1 2014–19

CAGR,2 %

15.6 17.3

11.2 12.7
8.1 9.6
6.6 7.3
4.1 4.7

Electrical Industrial Automotive and Industrial trading Industrial Home and building Industrial Industrial Aviation, Electronic
components diversified ancillaries and distribution machinery products and tech materials services aerospace components
and equipment and defense and equipment

1 Total shareholder returns, calculated as weighted average TSR of all companies belonging to specific segment within industrials.
2 Compound annual growth rate.
Source: S&P Capital IQ, SICcode.com, EDGAR, McKinsey analysis

20 Value creation in industrials

 Analysis at the micro-vertical level highlights a similar variation in performance (Exhibit 6).
Within the top-ranked segment, electronic components and equipment, the micro-vertical for
fabless semiconductors far outperformed display technologies. This segment also observed
largest variation among micro-verticals.

Exhibit 6
Within each segment, performance varied significantly across micro-verticals.
Not Exhaustive

17.3
TSR performance,1 2014-19, CAGR,2 % 15.6

12.7
11.2
9.6
8.1
6.6 7.3

4.1 4.7

Electrical Industrial Automotive Industrial trading Industrial Home and building Industrial Industrial Aviation, Electronic
components diversified and ancillaries and distribution machinery products and tech materials services aerospace, components
and equipment and defense and equipment

Number of
micro-verticals 5 2 12 6 11 12 3 15 3 21

25
Aircraft/aero- Fabless
20 space parts semiconductor
Services – Corporate
15 Food- Fire and Uniform rental and equipment
Industrial Equipment Industrial
Agricultural processing security
10 Motors and diversified rental and gases
farm equipment
5 generators leasing Aviation and
machinery
defense
0 OEMs
Modular Paper and
-5 Solar Railroad
Industrial- Container/ building/ paper
modules equipment Industrial waste
-10 focused PE marine – container product mfg
Equipment office disposal and
-15
rental and Engines and recycle
-20 Display
leasing Turbines
technologies
-25

1 Total shareholder returns, calculated as weighted average TSR of all companies belonging to specific segment within industrials.
2 Compound annual growth rate.
Source: S&P Capital IQ, SICcode.com, EDGAR, McKinsey analysis

In summary, the industrials sector continues to play a dominant role in the global economy.
It clearly rebounded from the financial crisis, but how widely and for what reasons? How do
we explain the differences in performance across micro-verticals? Can this performance
be predicted?

Value creation in industrials 21

 3. Micro-vertical performance
While we observed overall growth in value creation for the industrials sector, we found dramatic
differences in TSR performance across micro-verticals. To gain insight into what is causing these
differences, we studied the performance of 87 of the 90 micro-verticals (the ones for which
sufficient financial data were available) between 2014 and 2019.

These differences are significant. Viewing the sector overall, we found that, on average, top-
quintile micro-verticals had a TSR CAGR that was 2,600 basis points higher than the growth
in TSR for bottom-quintile micro-verticals (Exhibit 7).1 While industrials overall delivered TSR
growth at a rate of 11 percent per year, 13 of the 18 micro-verticals in the bottom quintile posted
declines. In contrast, the 18 top-quintile micro-verticals all had a TSR above the industrial-sector
average of 11 percent.

With the performance variation well observed and established, we then drilled down further to
understand the drivers of these differences. In particular, we focused on trends that shaped the
performance of micro-verticals.

Exhibit 7
Top-quintile micro-verticals delivered 2,600 basis points higher TSR than bottom-quintile
micro-verticals.

Micro-verticals, by TSR CAGR,1 2014–19

CAGR,2 %

2,600
basis
points

Bottom quintile Middle Top quintile

1 Total micro-verticals = 87; excludes 3 micro-verticals with no information on TSR growth in 2014–19.
2 Compound annual growth rate; based on median TSR of companies within the micro-vertical.
Source: S&P Capital IQ, McKinsey analysis

1 Excludes three micro-verticals with no information on TSR growth from 2014 to 2019.

22 Value creation in industrials

Trends impacting micro-vertical performance

Our research on micro-verticals revealed five categories of trends that had considerable impact
on company performance.

Regulatory
Regulatory actions take many forms, including new policies and tariffs. A particularly significant
area of regulation consists of tariffs that affect the competitive landscape for international trade.
For example, the new round of tariffs levied by the US and China governments are affecting
companies focused on those goods. Recent tariffs on solar panels, washing machines, steel,
aluminum, airplanes, cars, and steel piping have had a dramatic impact on fortunes of micro-
verticals where these are either primary end products or a key raw material.

Other actions could directly affect certain industrial segments. For instance, the recent ban on
the import of certain plastics and paper waste by China has affected the global plastic-recycling
supply chain. For US recycling-services companies, the ban on plastics imports significantly
disrupted the supply chain and cost base. Other regulations have been enacted to improve
traceability in supply chains, including some for pharmaceuticals; these served as a boon for
tracking solutions, as they drove growth in the micro-vertical. In general, regulatory moves can
be momentous and have the potential to make markets uncompetitive or provide significant
impetus to growth.

Value creation in industrials 23

 Consumer and socioeconomic
Micro-verticals face a host of changes in consumer demographics, lifestyle, and behavior.
Important factors, such as changing consumer consumption patterns, life expectancy,
disposable income, and urbanization, affect micro-verticals in different ways, so monitoring
this aspect of the business environment is complex. A case in point is consumers’ shift toward
the use of e-commerce coupled with greater demand for just-in-time services. In response, the
e-commerce industry is focusing investments on asset-tracking and inventory-management
solutions.

Another another recent trend involves increased awareness among consumers (especially
millennials) and industries about the benefits and sustainable advantages of recycling waste.
The global market for waste-recycling services reached about $50 billion in 2019 and is
expected to grow at a 5 percent CAGR over the next five years. This is expected to create multiple
opportunities for micro-verticals, such as recycling services and waste collection and disposal,
as new methods of treatment and disposal emerge.

Technological
New technologies can directly stimulate demand across multiple micro-verticals within
industrials. For example, according to research conducted by McKinsey Global Institute, artificial
intelligence (AI) adoption by companies continues to increase and will reach 50 percent over the
next ten years. This is encouraging developers to create more applications for AI across different
industries, including manufacturing and automotive. As a result, manufacturers are seeking
more control-systems and automation technology for preventive maintenance. In a similar vein,
AI-assisted self-driving cars are creating demand for sensors and cognitive equipment.

Another technology trend involves the rollout of 5G technology, which is likely to increase
spending in infrastructure, thereby boosting the market for OEM components and
instrumentation.

24 Value creation in industrials

Environmental
As combating climate change becomes a greater priority across sectors, shifting preferences,
such as the move to renewable energy and a growing aversion to plastic, can influence demand.
For example, by the end of 2017, China’s solar capacity reached 131.1 gigawatts, while the United
States came in second, at 51 gigawatts. This increasing adoption of solar energy is playing a
significant role in demand for solar operations and maintenance. It is also having an impact on
certain clusters within industrials, including solar-module manufacturers, energy and electrical
storage, and distribution equipment. At the same time, consumers’ aversion to plastics could
slow demand for recycling services.

Industry structure and player moves

Consolidation of players, new competition, and the advent of start-ups can reshape the
competitive landscape within segments and micro-verticals. This process is now occurring
in the waste and recycling market in the United States, which has rapidly consolidated over the
past three years. This space has seen interest from both industry players and private-equity
funds, with the latter representing about 45 percent of deal volume in 2019. The top three
industry players accounted for majority of the volume. Such consolidation will prove beneficial,
since larger companies are much more likely to improve profitability and efficiency. In addition,
large players that integrate smaller companies into their organization will increase the density
of their regional operations, thereby reducing truck-driver time and coverage—a shift that will
decrease costs.

Tailwinds or headwinds?

Each of these trends may create either tailwinds or headwinds—often both. Their impact will
vary by micro-vertical. Not surprisingly, for top-performing micro-verticals, these trends have
generally had a positive effect and acted as tailwinds for revenue growth or margin expansion.
For some of the bottom micro-verticals, these trends have had the opposite effect. Our examples
all refer to the years 2014–19.

Regulatory changes have the greatest impact. An example of headwinds would be uncertainty
about US trade with China, which led companies in the metalworking-machinery micro-vertical
to a cautious stance on investment, contributing to slower TSR growth over the five-year
period.2 An example of regulations generating tailwinds would be the 19 percent TSR CAGR
enjoyed by companies offering tracking solutions when they entered new markets, particularly
in pharma and medical devices, thanks to new regulations in life sciences (see sidebar “Tracking
solutions micro-vertical: Headwinds from costs, tailwinds from demand”). Similarly, the test and
measurement equipment micro-vertical benefited from standards opening up new markets.
Fast Healthcare Interoperability Resources (FHIR) standards contributed to 9 percent growth in
medical devices.

2 Each CAGR in this section is based on the median of companies within the micro-vertical.

Value creation in industrials 25

 Tracking solutions micro-vertical: Headwinds from costs, tailwinds
from demand

The tracking-solutions micro-vertical had a robust compound annual growth in TSR of

25 percent for 2014–19. Key sources of growth were revenue growth over the first five years,
which was above average for industrials, and company-specific strengths in margin expansion
and investor confidence.

Within tracking solutions are four segments with varying opportunities. The first two, label
production and label application, are somewhat commoditized. Label production is competitive,
with multiple players serving national and regional markets with an undifferentiated, low-cost
product. Label application is a low-tech process that may be automated as part of a longer
assembly line and must keep costs low to allow scaling and track large volumes. The other
two segments offer more potential for differentiation. The first, data capture, is high tech and
capital intensive, with solutions customized by use case, providing options for higher margins.
The second, data capture, is a high-margin, feature-rich service with extensive customization to
serve particular industry sectors. These two segments include vertically integrated players with
extensive product portfolios, often including label-production services. Some companies, which
we call “national tracking players,” are vertically integrated, active in all segments of the value
chain, and serve many industry segments.

Overall, the tracking-solutions micro-vertical has strong demand but faces headwinds from
rising costs and pricing pressure due to commoditization. Revenue is increasing from the
pharmaceutical and medical-devices industries, which are observing an increase in demand for
bar codes and RFID chips to deter counterfeiting. The micro-vertical also benefits from the need
for shipment tracking as US e-commerce sales continue to grow (increase of 15.5 percent from
2014 to 2019). Tailwinds also come from relatively high investor confidence in companies that
serve the life-sciences and consumer-electronics sectors.

Headwinds facing the micro-vertical include rising labor costs (which reduced gross margins
by 2 to 4 percent over five years), increased operating expenses from integration activities, and
the R&D needed to diversify offerings. Select business segments are also facing intense margin
challenges because of price pressures related to the commoditization of label-production
solutions. Without a shift in the product mix, costs may cut into companies’ margins. However,
companies could counter the cost headwinds by driving manufacturing efficiencies. Larger
players are also well positioned to augment their capabilities and consolidate the market
through M&A.

26 Value creation in industrials

In terms of consumer trends, a notable example of tailwinds is the impact of increases in
disposable income on the recreational-vehicles (RV) micro-vertical. In 2018, real wages in the
United States increased by 2.5 percent (supported by a GDP increase of 2.9 percent), thereby
driving personal consumption on leisure. Boomers, who account for nearly 25 percent of the
population, have a retirement rate of 65 percent, which further provides a boon to investments in
RVs. As a result, the micro-vertical enjoyed a revenue CAGR of 18 percent that was a contributing
factor to TSR CAGR of 14 percent. A consumer trend providing headwinds is the slowing of
activity in end markets like oil and gas, steel, and construction over the five-year period. This
trend created uncertainties for the top lines of industrial-waste solutions companies. As a result,
the micro-vertical observed revenue CAGR of only 1 percent and a below-sector average TSR
CAGR of 9 percent during the same period.

Technological trends often provide tailwinds by enabling new product offerings. While rising
5G and millimeter-wave (mmWave) research and deployment applications drive demand for
test and measurement equipment, the data center build-out is further creating opportunities
in high-speed monitoring and digital testing. At the same time, changes in network standards
and protocols for equipment testing spur demand for new equipment, such as 5G/6G, Wi-Fi 6,
and USB-C. These technology tailwinds have driven both revenue and margin expansion for the
micro-vertical and resulted in a TSR CAGR of 20 percent.

Environmental concerns and regulations may impose costs or open up opportunities to address
new sources of demand. Aviation, aerospace, and defense original equipment manufacturers
(OEMs) obtained revenue growth (CAGR of 3 percent) by meeting the need to replace customers’
existing product base to comply with environmentally motivated regulatory changes.

Value creation in industrials 27

 This contributed to a healthy TSR CAGR of 18 percent during the same five-year period for the
micro-vertical. In contrast, engines and turbines had a TSR CAGR of −25 percent, caused by
environmental trends, such as a growing demand for renewables, rising competition from low-
cost countries, and cost increases driven by tightening regulation. And industrial waste disposal
and recycling services saw its TSR fall at a CAGR of −13 percent. For this micro-vertical, the ban
on plastics imports in China significantly disrupted companies’ supply chain and cost base.

Impact of these trends

Across micro-verticals, regulatory, consumer, and socioeconomic trends have the most impact
(Exhibit 8). Regulatory trends have the ability to open up whole new markets and demand forces;
the Drug Supply Chain Act, for example, helped expand the contribution of medical & pharma to
the tracking solutions market, driving a revenue CAGR of 19 percent. Regulations were in fact the
primary performance driver for more than 75 percent of top- and bottom-quintile micro-verticals
studied.

Exhibit 8
Regulatory and consumer/socioeconomic trends emerged as primary drivers of micro-
vertical performance.
Impact Low High

Impact on micro-vertical performance

Regulatory Primary driver for >75% of micro-verticals
Most important determinant of micro-vertical performance; impact
overshadows other trends, as it opens or shuts entire market sectors,
significantly affecting demand

Consumer and Key driver for >50% of micro-verticals

socioeconomic
Primarily affected revenue and investor confidence; further impact to
performance over a longer time period

Technological Driver for ~33% of micro-verticals

Drives both top-line growth (demand from new products and services) and
margin expansion through improved efficiency

Environmental Affected <10% of micro-verticals, typically businesses dependent

on natural resources

Industry structure Affected 20–30% of micro-verticals, primarily those with

and player moves undifferentiated competition
Source: S&P Capital IQ, industry reports, company 10-K and investor presentations, analyst reports, McKinsey analysis

28 Value creation in industrials

Consumer and socioeconomic trends are a significant factor for more than 50 percent of top-
and bottom-performing micro-verticals. Generally, they act by boosting revenue and improving
investor confidence. A 13.2 percent growth in US e-commerce from 2014 to 2019, for example,
added significantly to the $32 billion shipping market. Consumer spending on recreational
vehicles grew by 7 percent over the same period, enabling the $38.5 billion market to grow at a
CAGR of 6 percent.

Our analysis found that the remaining three trends had less of an impact on overall performance.
Technological trends generate new market demand or enhance margins through greater
efficiency. New fabrication lasers now account for 50 percent of the $6 billion laser and related-
devices micro-vertical, for example (see sidebar “Laser and related devices micro-vertical:
Headwinds are intensifying”). Likewise, 5G technologies resulted in greater R&D spending in the
test and measurement micro-vertical: a 21 percent increase in spending on academic R&D and a
9 percent increase in commercial R&D.

Value creation in industrials 29

 Laser and related devices micro-vertical: Headwinds are
intensifying

The laser and related devices micro-vertical comprises of companies that develop and
manufacture laser devices for industrial applications, communications and optical storage,
measurement devices, medical applications, and scientific and military research. With strong
revenue growth of 11 percent and improvement in investor confidence, the micro-vertical
enjoyed TRS CAGR of 22 percent for the five-year period from 2014 to 2019.

The value chain for this micro-vertical extends from components to laser sources, subsystems,
systems (turnkey processing systems), and measurements (output measurements and
instruments for industrial process control). The largest players are vertically integrated and
active in all areas of the value chain. The top four players hold roughly 45 percent of the total
market.

Consistent with global trends in industrials, key markets for laser and related devices are other
industrials and data services. China is both a fast-growing market and a source of competitive
pressure, driving down average sales prices. In addition, tariffs have contributed to a slowing
in volume, as has lower-than-expected demand for 5G and OLED screens. The micro-
vertical’s high asset intensity and high fixed costs offer a competitive benefit during growth
periods, but during slowdowns and downturns, these characteristics become a source of
headwinds. The industry consolidation has provided efficiencies but at a cost of more limited
flexibility, which has led to margin erosion when growth slowed.

Nevertheless, demand in some areas continues to provide tailwinds—for example, in medical

applications, defense applications, laser-enabled autonomous driving, and the continuing
transition to laser-based manufacturing. Customer demand for electronics sophistication,
coupled with increasing data-transfer bandwidth, has driven growth in laser devices, including
laser-diodes used in telecommunication, as well as chips and sensors used in manufacturing.
For medical applications, past growth in laser use has been spurred by increased investment
in pharmaceutical research and diagnostic, coupled with the rising trend of aesthetic
treatments. In general, headwinds and tailwinds are tightly linked to overall macroeconomic
trends and US trade policies (particularly tariffs).

30 Value creation in industrials

 Changes in industry structure or moves by individual players significantly affect the
approximately 33 percent of top- and bottom-quintile micro-verticals that are susceptible to
undifferentiated competition. Take the micro-vertical for industrial-waste solutions. In 2016,
companies in this area undertook 33 M&A deals, leading to greater consolidation. This trend,
in turn, improved economies of scale and enabled the micro-vertical to weather anemic growth
rates of around −1 percent.

Environmental trends have a significant impact on the 15 percent of top and bottom micro-
verticals that are highly dependent on energy, with some prompting substantial shifts. In the
aviation, aerospace, and defense micro-vertical, for example, the EU carbon-credit trading
scheme helped to support a 40 percent reduction in double-aisle plane usage within EU
boundaries, limiting emission-production costs.

The headwinds and tailwinds that result from these five trends affect all aspects of micro-vertical
performance, as can be seen by comparing the top and bottom quintiles (Exhibit 9). From 2014
to 2019, the micro-verticals in the top quintile achieved an average revenue CAGR of 8 percent,
which is more than 500 basis points higher than the revenue growth of bottom-quintile micro-
verticals. The best performers also achieved earnings expansion that was about 360 basis points
higher than for the bottom quintile,3 as well as an earnings multiple of 14.4, versus 10.2 for the
bottom quintile.4

Exhibit 9
Top-quintile micro-verticals outperformed bottom-quintile micro-verticals on all aspects
of performance.
Performance1 2014-2019

Micro-vertical Revenue, TSR Revenue EBITDA Multiple (EV/

performance Companies, 2019, CAGR,2 CAGR,2 margin change,3 EBITDA),4
quintile number $ billion % % basis points 2019

Top 134 660 19 8 451 14.4 Top-quintile

performance, vs
bottom quintile
2nd 115 863 10 5 32 14.8
+500 basis points
Revenue growth
3rd 125 415 7 6 -70 11.4

+360 basis points

4th 171 604 6 6 104 13.9 EBITDA expansion

Bottom 143 336 0 3 10.2

+40%
83
Multiples

Industrials 688 2,879 95 5 135 13.8

1 Calculated for 62 micro-verticals with more than 2 companies that have complete data from 2014 to 2019 for performance analysis.
2 Compound annual growth rate of total shareholder returns or revenues, calculated as average across companies within micro-vertical quintile.
3 Calculated as delta of average earnings before interest, taxes, depreciation, and amortization (EBITDA) margin in 2019 vs. 2014 for companies within the micro-vertical.
4 Calculated by aggregating enterprise value (EV) and EBITDA for companies within the micro-vertical.
5 Simple average TSR (vs weighted average TSR of 11%).

Source: S&P Capital IQ, McKinsey analysis

3 Calculated as delta of average earnings before interest, taxes, depreciation, and amortization (EBITDA) margin in
2019 vs. 2014 for companies within the micro-vertical.
4 Calculated as enterprise value (EV) divided by EBITDA, aggregating EV and EBITDA for companies within the micro-vertical.

Value creation in industrials 31

 Is micro-vertical endowment permanent?

It appears that the structural advantages that individual micro-verticals enjoy are not permanent,
since nearly 45 percent have shifted two or more quintiles over the past five years (Exhibit 10).
For example, if we rank micro-verticals by TSR CAGR during the 2014–17 period, just half of
those in the top quintile were also in the top or second quintile for the 2017–19 period. Further,
around four in ten of the micro-verticals that were in the top two quintiles for CAGR from 2014 to
2017 dropped to the bottom two quintiles for the period from 2017 to 2019.

Exhibit 10
Structural advantages and disadvantages of top-quintile micro-verticals were
not permanent.

Micro-verticals, categorized by quintile on TSR CAGR1 Improvement Decline

% of micro-verticals² (n = 87)

2017 – 19
Top quintile 2nd quintile 3rd quintile 4th quintile Bottom quintile

Top quintile 3 7 2 3 5

2nd quintile 3 2 6 5 3

~45%
of micro-verticals
2014 – 17

3rd quintile 3 6 2 5 saw performance

3
improve or decline
by 2 or more
quintiles over the
period
4th quintile 5 3 5 3 3

Bottom quintile 6 2 5 3 5

1 Based on median across companies within a micro-vertical.

2 Excludes 3 micro-verticals with no information on TSR growth for 2014–19.
Source: S&P Capital IQ, McKinsey analysis

Underpinning many of these shifts is the waxing and waning of headwinds and tailwinds that can
have an abrupt and substantial effect on micro-vertical performance (Exhibit 11). The TSR CAGR
for the laser and related devices micro-vertical, for example, was 42 percent for the 2014–17
period. However, from 2017 to 2019, its CAGR was −18 percent because of regulatory and
technology issues, such as the 2018 imposition of a 25 percent tariff on certain imports in the
United States and a reduction in demand following the delay in the rollout of 5G.

32 Value creation in industrials

Exhibit 11
Micro-vertical performance changed as headwinds and tailwinds intensified and subsided.
Not exhaustive / illustrative
TSR CAGR,1 %

Micro-vertical 2014–17 2017–19

Declining performance Laser and related devices 42

-18

Tracking solutions 27

Increasing performance Recreational vehicles 36

-11

Test and measurement equipment 34

12

17
Measurement and detection devices
10

1 Compound annual growth rate of total shareholder returns, based on median across companies within the micro-vertical. Graphs across micro-verticals not drawn to scale.
Source: S&P Capital IQ, industry reports, company 10-K and investor presentations, analyst reports, McKinsey analysis

Improvements in performance can be just as swift. The TSR CAGR of the test and measurement
equipment micro-vertical for 2017–19 was 34 percent, compared with 12 percent between 2014
and 2017. Various factors were behind this shift, including growth in the US defense budget, a
shift in demand mix from higher average selling price, and an increase in the value of the medical
industry. The TSR CAGR of the measurement and detection devices micro-vertical increased
from 10 percent to 17 percent over the same period, due in part to a 53 percent demand increase
for factory automation as high-cost geographies sought to balance out trade-conflict-related
fragility in the global supply chain.

Value creation in industrials 33

 While hindsight is 20-20, monitoring micro-vertical-specific leading indicators could help
decision makers predict performance trends (Exhibit 12). Stagnant disposable income
and a decrease in the retirement rate could, for example, be early-warning indicators of
poor performance in the recreational-vehicles micro-vertical. Conversely, an increase in
R&D spending or defense budgets could foreshadow steady performance in the test and
measurement equipment micro-vertical.

Exhibit 12
Leading indicators could have helped predict the impact of headwinds and tailwinds.

Not exhaustive / illustrative

Micro-vertical Key trends impacting micro-vertical performance in 2017 Leading indicators

Declining Laser and Regulatory Declining relations with China; investigations by US China market access (accounts
performance related devices Trade Representative to study impact of tariffs on for 1/3 of demand)
aluminum and steel on national security

Technology Delays in 5G rollout (6-month or longer delay Demand growth ( from

anticipated) communication equipment)

Tracking Consumer/ Slowdown in motor vehicle sales (~3% decline, Demand from auto, a key end market
solutions socioeconomic 2017–18)

Regulatory Declining relations with China; encouragement Supply-chain impact from tariffs
from US administration to move operations (higher costs and lower investor
outside of China confidence)

Recreational Consumer/ Declining consumer demand (average sales price Mix shift toward cheaper RV camping
vehicles socioeconomic decline of 3.2% in 2016–17, followed by volume trailers
decline of 4.3% in 2017–18)

Regulatory Declining relations with China; investigations by US Increase in cost of goods sold from
Trade Representative to study impact of tariffs on higher cost of aluminum and steel
aluminum and steel on national security

Increasing Test and Regulatory Rising tension between US and China; diversion of R&D spend in key end markets
performance measurement spend on allies’ defense budget to home (3% growth, (eg, defense, medical devices)
equipment 2017–18)

Measurement Technological Faster adoption (eg, 240% spending growth, 2017–18) Demand for factory automation
and detection of new tech in robotic process automation; 18% growth solutions
devices projected for 2017–18 from additive manufacturing

Source: S&P Capital IQ, industry reports, company 10-K and investor presentations, analyst reports, Factiva, Laserfocus, FDA, Thomson One, Statista estimates, Grand View Research, Wohler
Associates, McKinsey analysis

An understanding of past trends, as well as proven leading indicators, can help companies
improve decision making and determine if they will face headwinds or tailwinds in particular
micro-verticals. For instance, the 2017 decline in revenues of RV companies was foreshadowed
by a 3.2 percent decrease in their average selling price from 2016 to 2017. Further, the shift in
consumer preferences to lower-priced camping trailers foreshadowed the
4.3 percent decline in sales volumes from 2017 to 2018.

34 Value creation in industrials

Some organizations and companies are already examining trends and leading indicators to look
for clues. For instance, the Office of the US Trade Representative undertook a study on the
impact of tariffs on aluminum and steel prior to levying tariffs. Results from such studies could
serve as leading indicators for companies wherein these metals are a significant portion of the
cost base.

As headwinds and tailwinds wax and wane, their impact on micro-vertical performance is
expected to be noteworthy. But what does this mean for the prospects of the individual
companies? Do all companies struggle or soar equally, or can they find an updraft on which they
can rise to deliver TSR performance that separates them from the flock? If yes, how do they do it?
We explore this in the next section of this chapter.

Value creation in industrials 35

 4. Company performance
Performance varies widely not only within industry micro-verticals but also at the individual-
company level. To understand the impact of “neighborhood”—that is, the conditions of the micro-
vertical—on company performance, we grouped companies according to their performance by
quintile and also categorized their micro-verticals by quintile, based on their five-year (2014–19)
TSR CAGR. After combining the two measures, we found that 30 percent of the companies either
outperformed or underperformed their micro-vertical (Exhibit 13).

Exhibit 13
Despite the headwinds and tailwinds affecting micro-vertical performance, companies
controlled their destiny.
Better than In line with Worse than
micro-vertical micro-vertical micro-vertical
Company quintiles vs micro-vertical quintiles,
% of companies1

13% of companies
(n = 51) above entitlement
Micro-vertical quintiles
Top 2nd 3rd 4th Bottom

Top 10 5 1 2 1

2nd 4 8 3 3 2
~30%
Company quintiles

of companies either
underperformed or
3rd 2 5 5 5 3
overperformed their
micro-vertical

4th 1 4 2 7 5

Bottom 2 4 2 4 8

15% of companies (n = 60) below entitlement

1 Includes 406 companies that have complete data from 2014 to 2019 for all metrics included in TSR decomposition (n = 404).
Source: S&P Capital IQ, McKinsey analysis

36 Value creation in industrials

 Further, between the top and bottom performers in 90 percent of micro-verticals, the spread
in TSR was more than 1,000 basis points (Exhibit 14). This finding shows that success does not
depend merely on being in the “right” micro-vertical; a company’s actions also matter. Individual
companies can do much to control their destiny, even as headwinds and tailwinds affect micro-
vertical performance. This chapter will help decision makers set priorities when selecting
improvement initiatives.

Exhibit 14
Within each micro-vertical, company performance varied significantly.
TSR growth for individual companies by micro-vertical,1 CAGR,2 2014–19, % Individual companies in the micro-vertical

80
70
60
50
40
~90% of
30 micro-verticals had
20 >1,000
10 basis points
0 spread in TSR
between top and
-10
bottom performers
-20 in micro-verticals
-30
-40
Bottom Middle Top
micro-verticals micro-verticals micro-verticals

1 Each column represents 1 micro-vertical (n = 406 companies in 62 micro-verticals out of 87). 62 mircro-verticals included here as they map to 406 companies that had complete
info for TSR decomposition from 2014 to 2019.
2 Compound annual growth rate.
Source: S&P Capital IQ, McKinsey analysis

Value creation in industrials 37

 A significant and growing performance gap

Top-quintile companies performed, on average, 3,800 basis points better than bottom-
quintile companies in terms of their TSR growth from 2014 to 2019 (Exhibit 15). Bottom-quintile
companies saw an average TSR CAGR of −11 percent, while top-quintile companies grew by an
average of 27 percent. The quintiles between the top and bottom grew by 15 percent, 9 percent,
and 2 percent, respectively.

Exhibit 15
Top-quintile companies achieved 3,900 basis points higher TSR than bottom-quintile
companies.
TSR growth, by company quintile, CAGR,1 2014–19, % TSR CAGR spread (max – min) in percentage points (pp)

Number of companies

Bottom 4th 3rd 2nd Top

quintile quintile quintile quintile quintile

27

15

9 3,800
basis
2
points

-11

33 pp 8 pp 6 pp 6 pp 58 pp

82 81 81 81 81

1 Compound annual growth rate for total shareholder returns, based on average across companies within a quintile. Includes 406 companies (out of 688 overall for industrials) that
have complete data for all metrics for TSR decomposition from 2014 to 2019.
Source: S&P Capital IQ, McKinsey analysis

The range in TSR growth rates within the top and bottom quintiles is also large. In the top quintile,
there was a 58-percentage-point gap between the best- and worst-performing companies. In
the bottom quintile, the gap was 33 percentage points.

Furthermore, the gap between top and bottom performers actually increased by 1,400 basis
points over the prior period. From 2004 to 2014, the average TSR CAGRs for top- and bottom-
quintile companies were 19 percent and −5 percent, respectively.

38 Value creation in industrials

 Variations within micro-verticals

As previously noted, a significant portion of companies over- or underperformed relative to their

micro-vertical average. Further, top-performing companies came from all categories of micro-
verticals: out of the 82 top-quintile companies, almost half of the companies were from outside
the top-quintile micro-verticals. The TSR growth of the these top-performing companies was, on
average, 1,300 basis points higher than the average for their micro-vertical. Around 20 percent
(15 of 82) of top-quintile companies are players in the micro-verticals that we placed in the lowest
two quintiles, and these companies, on average, had 1,900 to 2,500 basis points higher TSR than
the micro-vertical average (Exhibit 16).

Exhibit 16
Although their micro-vertical mattered, top companies found a way to shape their destiny.

Company quintiles vs micro-vertical quintiles, Better than micro-vertical xx Company TSR

delta (average) vs
number of companies1 In line with micro-vertical (within ±5%) micro-vertical
(average)
Worse than micro-vertical
Micro-vertical quintiles
Top 2nd 3rd 4th Bottom Total

Top 42 22 3 9 6 82
9% 14% 13% 19% 25% 13%

2nd 16 33 11 14 7 81
Top-performing
-3% 5% 7% 9% 15% 5% companies had
Company quintiles

3rd 7 22 21 19 12 81 1,300 basis

-9% -1% 2% 3% 9% 2% points
higher TSR than
4th 4 17 10 28 22 81 their micro-vertical

-15% -8% -6% -4% 1% -4%

~20%
(15 of 82) came
Bottom 9 16 8 17 32 81 from micro-verticals
-27% -20% -14% -15% -12% -16% in the bottom 2
quintiles

Total 77 110 53 87 79 406

1 Includes 406 companies that have complete data from 2014 to 2019 for all metrics included in TSR decomposition.
Source: S&P Capital IQ, McKinsey analysis

Conversely, being in a top-performing micro-vertical did not guarantee that a company would
be a top performer. About 17 percent (13 of 77) of companies squandered their starting position
of being in a top-quintile micro-vertical and ended up in the bottom two quintiles of company
performance.

Value creation in industrials 39

 Decomposing TSR to measure drivers of company performance

To determine what company-level actions matter, we first decomposed the TSR performance of
individual companies (see sidebar “TSR decomposition methodology”). We first broke TSR into
three broad elements (Exhibit 17):

1. Operating performance refers to how a company uses its capital to increase revenues and
expand its operating margins; this category also includes the impact of endowment—in other
words, a company’s ability to generate value for its shareholders in a no-growth and as-is
profitability scenario.

2. Leverage impact refers to how companies use debt to enhance their TSR performance.

3. Multiple expansion refers to opportunities to benefit from changes in investor outlook.

Exhibit 17
Decomposing company TSR into its core elements offers insights into how companies
secured their position.
Illustrative

TSR decomposition, CAGR,1 %

1 Operating performance Revenue growth 30

Margin expansion 10

Investment -5

Zero-growth return 15

TSR from performance 50

2 Leverage impact Leverage impact 30

3 Multiple expansion Change in multiple 15

Other 5

Realized TSR 100

1 Compound annual growth rate of total shareholder returns.

Source: S&P Capital IQ, McKinsey analysis

40 Value creation in industrials

TSR decomposition: How it works

To uncover the drivers of company-level TSR performance, we disaggregated TSR into its core
elements. We applied this methodology to 406 industrial companies (out of a total of 688) for
which complete financial information was available across the required metrics to conduct the
TSR decomposition from 2014 to 2019. These 406 industrial companies mapped to 62 micro-
verticals out of the total 90.

These are the core elements of our TSR decomposition:

— Operating performance: a measure of shareholder returns attributable to the company’s

operating performance, further broken down into four metrics:

• Revenue growth: the revenue CAGR for 2014–19

• Margin expansion: a measure of the company’s profitability and its contribution to TSR;
calculated as the spread between CAGR for margins and CAGR for revenues—in both
cases, for 2014–19

• Investment: a measure of the impact of investments (capital expenditures plus working

capital, including goodwill) to drive operating performance; calculated as the average of
change in invested capital every year (for the five-year period) divided by the enterprise
value (EV) at the beginning of the year

• Zero-growth return: a measure of value generated in a no-growth scenario or base

profitability

— Leverage impact: a measure of shareholder value generated from changes in leverage;

calculated as the average across five years of incremental value available each year for
shareholders—specifically the change in enterprise value each year plus free cash flow,
summed and divided by enterprise value, multiplied by the debt-to-equity ratio

— Change in multiple: a measure of the impact of changes in investor outlook on shareholder

value, calculated as CAGR of multiples for 2014–19

Based on this methodology, we arrive at a TSR decomposition—that is, a breakdown of TSR

performance into its constituent elements.

Value creation in industrials 41

 Operating performance
Among the three elements of TSR, operating performance was the strongest predictor of TSR
CAGR from 2014 to 2019 for all quintiles (Exhibit 18). Operating performance had the highest
coefficient of correlation with TSR performance, at 50 percent, followed by leverage (around 30
percent) and multiple expansion (around 10 percent). Looking at TSR performance of the top-
quintile companies, operating performance contributed 18 percentage points of the 27 percent
TSR growth. At bottom-quintile companies, operating performance accounted for
−6 percentage points of the −11 percent TSR growth.

Exhibit 18
Operating performance had the strongest correlation with company TSR.
Strong Weak/limited
TSR decomposition,2 2014–19, %

Number of TSR performance2 Operating Leverage and other Multiple

Quintile = + +
companies1 2014–19, CAGR, % performance impact3 impact

Top 82 27 18 1 8

2nd 81 15 14 -1 2

3rd 81 9 9 -1 1

4th 81 2 5 -3 0

Bottom 81 -11 -6 -9 4

Correlation with 0.5 0.3 0.1

TSR performance

1 Includes 406 companies that have complete data from 2014 to 2019 for all metrics included in decomposition of total shareholder returns (TSR).
2 Based on the average across companies within the respective quintiles for TSR and the underlying decomposition metrics.
3 “Other impact” typically accounts for impact of changes in nonoperating income, interest expense, and share issuances.
Source: S&P Capital IQ, McKinsey analysis

42 Value creation in industrials

 Within operating metrics, margin expansion was a key contributing factor and also the
strongest determinant of company’s TSR performance (Exhibit 19). With a correlation of 90
percent to operating performance, expansion in profitability (margin) contributes an average
of eight percentage points to the 18 percent operating performance of top-quintile companies
and takes away eight percentage points at bottom-quintile companies, where operating
performance averages −6 percent.

Exhibit 19
Among operating metrics, margin expansion (often enabled by technology) was the
key determinant of company TSR.
Strong Weak/limited

Operating performance decomposition2, contribution to performance, 2014-19, %

Number of Operating Revenue Margin Zero-growth

Quintile companies1 performance = growth + expansion + return + Investment

Top 82 18 12 8 6 -8

2nd 81 14 6 7 6 -5

3rd 81 9 5 2 6 -5

4th 81 5 3 0 6 -4

Bottom 81 -6 1 -8 5 -4

Correlation with
0.4 0.9 0.3 0.2
operating performance

1 Includes 406 companies that have complete data from 2014 to 2019 for all metrics included in TSR decomposition.
2 Based on average across companies within the respective quintiles for all the operating-performance metrics.
Source: S&P Capital IQ, McKinsey analysis

The impact of average revenue growth differs significantly by quintile. Revenue growth
contributed 12 percentage points to realized TSR for top-quintile companies and one
percentage point for those in the bottom quintile. Compared with margin expansion, its level of
correlation is lower, which underscores the importance of profitable growth among industrial
companies.

A company’s zero-growth return—the TSR a company would generate in a scenario of no

growth and current profitability—contributes five to six percentage points in TSR CAGR for the
top four quintiles, but it has a negligible impact for the bottom quintile. The limited influence of
zero-growth return, a measure of starting position, on a company’s overall TSR performance
shows that actions taken by company overshadow the starting position it may have.

Value creation in industrials 43

 Case study: What’s driving TSR performance at a small-cap
security-technology company

We conducted TSR decomposition of a small-cap security-technology company with a TSR

CAGR of 44 percent from 2014 to 2019. The analysis revealed that operating performance had
been responsible for 29 percentage points—around 75 percent—of the company’s realized
TSR. The biggest contributor to this strong operational performance was margin expansion. The
company’s gross margins increased by 11 percentage points, and margin expansion contributed
18 percentage points to realized TSR. The next-biggest contributor was revenue growth;
revenues grew by 7 percent, contributing seven percentage points to realized TSR.

The company achieved this strong financial performance through several successful initiatives:

— shifting the location of its low-cost manufacturing facility to avoid tariff concerns

— becoming the sole provider of all three legs of a security stool that could be connected,
thereby enabling more efficient monitoring and communication than competitors

— generating strong recurring revenue growth from innovative products made available as a
monthly subscription package

Multiple expansion and leverage impact were responsible for 13 and two percentage points of
this security technology company’s realized TSR, respectively. The company saw significant
impact from operating leverage with revenue growth because of high fixed costs and low
operating costs at the company’s manufacturing facility.

44 Value creation in industrials

 Leverage impact
Leverage had a negative impact on TSR performance for companies in the bottom quintile. In
contrast, for the 82 companies in the top quintile, leverage had a positive TSR impact. Around 85
percent—70 of these 82 top-quintile companies—increased their debt from 2014 to 2019 (Exhibit
20). Measuring leverage as the ratio of debt to EBITDA, companies with a ratio of less than 1 saw
leverage contribute an average of five percentage points to realized TSR. Companies with a debt-
to-EBITDA ratio of 3 and 4 had a leverage contribution of 14 percentage points. However, moving
from a debt-to-EBITDA ratio of 3–4 to a ratio of 4–5 made no difference, on average, to TSR.

Exhibit 20
For top-quintile companies, TSR contribution from leverage plateaued
for companies with a debt/EBITDA ratio of 3x to 4x.

Change in leverage at top-quintile companies, % (n = 82)

Increase in debt Average contribution of leverage to TSR,1 by end-period
No change or decrease in debt debt/EBITDA ratio, %

14 14

15

5
4

85

<1x 1x to 2x 2x to 3x 3x to 4x 4x to 5x

1 Contribution based on decomposition of total shareholder returns (TSR), 2014–19. End-period ratio is the change in debt to earnings before interest, taxes, depreciation, and
amortization (EBITDA) from 2014 to 2019.
Source: S&P Capital IQ, McKinsey analysis

Value creation in industrials 45

 Coming back to the bottom-quintile companies, we notice that leverage can become a concern
and hurt when margins decline. Thirty percent of bottom-quintile companies—24 companies in
total—saw a negative TSR impact from leverage (Exhibit 21). For 21 of these 24 companies, a five-
fold increase in debt levels during declining profitability (−13 percent CAGR in EBITDA from 2014
to 2019) was a drag on TSR performance. Thus, mismanagement or overextension of leverage
position in subpar operating performance can be detrimental.

Exhibit 21
When margins decline, leverage can hurt, as shown by a negative impact on 30 percent
of bottom-quintile companies.

EBITDA
CAGR,1 Debt/ Debt/EBITDA
TSR impact from leverage, Number of 2014–19, EBITDA,1 change,1
Quintile % of companies Category companies % 2019 2014–19

Negative Positive
Declining 3 18 2.6x -2x
0 leverage in a (4%)
0 companies good
with negative operating
Top
impact of environment
100 leverage
(Companies
could benefit
from more
leverage)

High leverage 21 -13 8x +5x

30 in subpar (26%)
30% = 24 operating
Bottom
companies environment Increase in debt levels
70 during declining profitability

1 Compound annual growth rate of earnings before interest, taxes, depreciation, and amortization (EBITDA) and debt/EBITDA calculated as averages across companies.
Source: S&P Capital IQ, McKinsey analysis

Multiple expansion
As observed in Exhibit 18, the top and bottom quintiles have a significant positive impact from
increases in the multiple, while the middle quintiles show a much lower impact. Multiple growth
was found in both bottom-quintile companies and their top-quintile peers, despite substantial
differences in their operating performance. From 2014 to 2019, the EV-to-EBITDA ratio of top-
and bottom-quintile companies grew by 54 percent and 31 percent, respectively; in fact, roughly
45 percent of bottom-quintile companies saw their multiples expand.

Our analysis suggests that these similar growth rates occur because investors show faith in
turnaround efforts or moves to improve performance. Bottom-quintile companies that have
made decisive moves have seen their multiples increase from two- to tenfold. A small-cap fabless
semiconductor company, for example, announced in 2018 that it would be shifting its product
focus toward innovations in 3-D sensing and new processing capabilities to integrate with tech
industry leaders. Their EV-to-EBITDA multiple increased eightfold, rising from 28 in 2018 to 168
in 2019.

46 Value creation in industrials

Similarly, an automation-and-control-focused company (in the electronic components and
equipment segment) in 2019 announced a commercial partnership with another automation
player to improve its product portfolio while promoting its 3-D technology. They were rewarded
by a threefold increase in EV-to-EBITDA multiple, from 9 in 2018 to 32 in 2019. Thus, investors
are willing to accept a short-term hit in TSR performance and place faith in future prospects if
companies have a convincing turnaround story.

All these elements of a TSR decomposition can shed light on how a particular company creates
value (see sidebar “Case study: What’s driving TSR performance at a small-cap security-
technology company”). By analyzing the contributors to TSR, decision makers can identify where
they should focus to generate growth.

In the past, the industrials sector has shown steady performance. It also shows substantial
variations among sectors, micro-verticals, and individual companies. The variations lead to the
obvious question: What do the top-performing companies get right that others may be missing?

Value creation in industrials 47

48 Value creation in industrials
 Learnings from top performers

Given that performance has varied from company to company, we studied the highest-
performing companies to glean lessons that might apply to retaining or creating a high level of
value creation. In this chapter, we describe these companies and propose a model for improving
performance.

When we focused on the study period of 2014–19, we found that around 29 percent of
companies moved to a higher quintile for TSR CAGR (Exhibit 22). More than half of companies
that were in the bottom quintile for the period 2004–14 moved to a higher quintile when we
narrowed the analysis to the 2014–19 period.

Exhibit 22
Upward mobility is possible: about 30 percent of companies moved to higher quintiles.

TSR growth by quintile, CAGR,1 2014–19, %

(n = 406)

Bottom 4th 3rd 2nd Top

quintile quintile quintile quintile quintile

n = 12 (3%)

n = 24 (6%)
29%
n = 33 (8%) Companies
moving up the
n = 49 (12%) quintile ladder
over time
(FY 2004–14)
TSR performance

1 Compound annual growth rate of total shareholder returns.

Source: S&P Capital IQ, McKinsey analysis

Value creation in industrials 49

 For underperforming companies that can complete their turnaround journey, the rewards are
considerable. Top-quintile companies generate, on average, 1,200 basis points higher revenue
growth, 680 basis points higher EBITDA expansion, and 50 percent higher EV-to-EBITDA
multiples than their bottom-quintile peers (Exhibit 23).

Exhibit 23
Top-quintile companies outperformed their peers across all TSR metrics.

Performance 2014-20191

TSR EBITDA
growth, Revenue margin change, EV/EBITDA, 2019,
Quintile CAGR,1 % growth CAGR, % basis points multiple

Top 27 11 358 18.5

Top vs bottom quintile

2nd 15 4 263 13.7 +1,200 basis points

Revenue growth

3rd 9 3 97 11.5
+680 basis points
EBITDA expansion

+50%
4th 2 2 4 12.0 Multiples

Bottom quintile -11 -1 -322 12.1

1 Compound annual growth rate calculated for 406 companies that have complete data across all metrics for TSR decomposition. Performance calculated by aggregation across
companies within each quintile. TSR is total shareholder returns; EBITDA is earnings before interest, taxes, depreciation, and amortization; EV is enterprise value.
Source: S&P Capital IQ, company 10-K and investor presentations, analyst reports, McKinsey analysis

50 Value creation in industrials

 When we focused on top-performing companies, we found that their success primarily depended
on taking three steps (Exhibit 24):

1. Leveraging technology to achieve profitable growth. Two metrics help companies

understand whether they are driving bottom-line improvements in profit faster than top-line
revenue growth. The first is profit-revenue spread (PRS), measured as change in EBITDA
above change in revenue. The second is operating-leverage multiple (OLM), measured as the
extent to which EBITDA growth outpaces revenue growth. Top-quintile companies had 80
percent higher PRS and an OLM that was 2.1 times higher.

2. Instituting better corporate oversight. An effective level of oversight is a critical building

block for a company to secure top-quintile performance. Improving oversight requires a
multipronged approach that involves securing alignment of incentives with management,
ensuring independent monitoring from external analysts, and having the appropriate mix of
leaders on the board and in the CEO position. It is no surprise that top-quintile companies
have higher levels of oversight than the bottom-quintile companies.

3. Building a platform for future expansion. Once companies establish profitable operations
and the right corporate oversight, the third step in improving value creation involves
leveraging M&A to build a platform for future growth. M&A helps companies achieve growth
and secure a strong market position by providing access to new products, customers, and
channels (see sidebar “M&A success stories”).

Exhibit 24
Top-performing companies achieved their performance by leveraging a three-step approach.

Performance

Step I.
Leveraging technology
3-step to achieve profitable growth
approach for
future value
Step II.
creation
Instituting better
corporate oversight
Platform Oversight
Step III.
Building a platform for future expansion

Value creation in industrials 51

 The following discussion shows how top performers have used these three value-creation levers
to succeed.

Profitable growth by leveraging technology

The TSR decomposition analysis showed that margin expansion is one of the key determinants of
companies’ TSR growth. Within the wholesale trade in durable goods micro-vertical, consider the
case of two companies with $3.7 billion and $5.5 billion in 2019 revenues, respectively, that both
had similar five-year revenue growth from 2014 through 2019, with CAGRs of 7 percent each.
They differed in their profitability, however. While the former had a PRS of 39 percent, the latter’s
PRS was −3 percent. With more profitable growth, the smaller of the two companies enjoyed a
TSR growth rate of 29 percent per year, while the larger company’s TSR CAGR was 12 percent.

To show how top-quintile companies were much more effective at securing profitable growth,
we calculated each company’s PRS as the percentage change in EBITDA net off the percentage
change in revenue. Then we analyzed the PRS of top-quintile versus bottom-quintile companies.
PRS was 62 percent for top-quintile companies. For bottom-quintile companies, PRS was just
−18 percent, meaning their EBITDA growth trailed their revenue growth.

Corporate oversight

The companies with top performance in value creation also demonstrate effective corporate
oversight. The relationship between these variables is somewhat complex, however, and
oversight alone does not propel a company to a top position.

To measure corporate oversight, we use McKinsey’s Corporate Oversight Index (COI), which
incorporates four elements that influence company performance:

— Ownership is expressed as the proportion of investment dollars from index funds and the
degree of alignment between management and board incentives with company performance.
It is measured using share of index funds and market value of stocks owned by top
management and board. Index funds provide stable investment dollars, and higher values of
ownership shares incentivize outsized performance.

— Analyst coverage is measured as the number of external analysts covering the company.
External analysts help keep companies accountable for delivering performance.

— Liquidity is evaluated from the average percentage of total company shares trading daily.
A high average percentage of shares traded daily means there are too many short-term
investors, resulting in lower TSR performance.

— Leadership team is defined as CEO tenure in role and diversity of board members, in terms
of relevant experience and capabilities. Data suggest that CEOs overall deliver their best
TSR performance during three to six years of tenure. Further, gender diversity, experience
working on other boards, and tenure help the board influence performance.

52 Value creation in industrials

 There is a very high correlation between COI and growth in value,5 which implies that
oversight has an important role to play in performance. But better oversight alone
cannot secure a top-quintile position: there is a 41 percent difference in COI between
bottom- and average-performing companies, but there is no difference in COI between
average and top performers (Exhibit 25). It appears that focusing on other levers—growth,
margin expansion, and leverage—is also necessary to ensure top performance.

Exhibit 25
Top-performing companies had 41 percent higher Corporate Oversight Indexes.
…with top-performing companies having
COI is correlated to performance … 41% higher COI than bottom-performing peers
COI1 at half decile vs TSR CAGR,1 %

Average COI Index R2 = 63% COI Index , by quintile

70 63 62
61
52
60 +41%
44

50

40

30
-30 -20 -10 0 10 20 30 40 50 Bottom 4th 3rd 2nd Top

1 Average COI and average TSR CAGR of 406 companies in the half deciles; Compound annual growth rate of total shareholder returns.
Source: S&P Capital IQ, McKinsey analysis

In sum, our analysis suggests that COI has the potential to drive excess TSR but cannot by itself
guarantee top performance. That said, effective oversight can prevent a multitude of problems,
and in a set of otherwise profitable companies, it can give the advantage to the player with the
keenest eye on the big picture.

Building a platform
Once companies completed the first two steps (i.e., established sustainable and profitable
growth and the appropriate corporate oversight), they benefited considerably from
building a platform through M&A to drive expansion into new markets or secure scale in
existing markets. When we looked at the acquisition trajectories of industrial companies
since 2010, it became obvious that many companies that performed well over the past
five years significantly increased the size and frequency of their deals over time.

From 2010 through 2019, the top-quintile companies undertook an average of 9.2 deals—
a figure that is 43 percent higher than the 6.5 deals for the bottom-quintile companies (Exhibit
26). To understand the quantum of M&A activity, we compared the revenue of companies that
were acquired to the acquiror’s revenue at the start of the period, that is, 2009. We observed that
top-quintile companies on average, over a period of ten years, acquired companies with revenues
totaling 58 percent of their 2009 revenues. This was 2.1 times more than that of their bottom-
quintile peers, who acquired companies with revenue totaling 28 percent of their 2009 revenues.

Value creation in industrials 53

 Exhibit 26
Top-quintile companies did more frequent and larger deals.

M&A activity, 2010–19

Total target revenue as
TSR CAGR, 2014–19, Average number of proportion of acquiror’s
% deals per company1 2009 revenue,2 %

Compared with
bottom-quintile
companies, top-
Top quintile 27 9.2 58 quintile companies had

+43% 2.1x 43%

higher deal activity

2.1x
more deal quantum as
Bottom quintile -11 6.5 28 proportion of company
revenue

1 Includes only companies that have conducted at least 1 deal.

2 Cumulative target revenue at time of acquisition as proportion of acquiror’s 2009 revenue averaged over quintile peers; data available for ~65% of deals.
3 Transaction value across of deals.
Source: S&P Capital IQ, McKinsey analysis

The three value-creation steps we have described—achieving more profitable growth by

increasing the profit-revenue spread and operating-leverage multiple, improving corporate
oversight as measured by COI, and building a platform for future expansion—have propelled a
variety of industrial companies into the ranks of the top performers. Further, these steps need
to be taken sequentially. For example, a M&A program without stable performance and strong
corporate oversight has potential to be value destructive. However, companies that followed
through on these steps have delivered TSR performance that is much higher than their peers and
have broken away from their micro-vertical endowment.

54 Value creation in industrials

M&A success stories

A notable example of how a company gained access to products via M&A is a global leading
player in fluidic systems and components with over $2 billion in revenues. The company has
a strong track record of leveraging M&A to enter technological niches of highly engineered,
mission-critical applications. Most recently, in February 2020, the company made an
acquisition to extend its expertise in highly engineered solutions for energy customers,
including refineries, chemical manufacturers, and pipeline operators. The acquiree’s
highly accurate flow measurement calibration products provide an opportunity for further
differentiation. In 2018, this global leader in fluidic systems and components acquired a
company that provided access to water-flow expertise in mission-critical fire ground-safety
applications. Overall, in the ten years from 2006 to 2015, the company has successfully
acquired 29 companies with the same strategic focus to secure its position in critical
technology niches. Its strategic choice of markets has helped it secure number-one or number-
two positions in niche markets of $1.5 billion in size.

Another success story in M&A involves a roughly $1 billion revenue company that is a provider
of optical-transport networking equipment and services. It made an acquisition in 2018 to
gain access to customers including nine of the top ten global network operators and the top
six global internet content providers. This expansion of its tier-one customer base helped the
company achieve a significant revenue increase (revenue CAGR of 32 percent from 2017 to
2019). Because there was minimal customer overlap with the acquiree, the acquisition is also
likely to reduce the company’s customer concentration, as revenue from its top ten customers
drops from 65 to 45 percent.

Finally, M&A can help with geographic expansion. A $1 billion–plus provider of optical
packaging and precision optical, electromechanical, and electronic manufacturing services
made an acquisition to enter the European electronics manufacturing market. The move gave
the company a strong foothold in Europe, given that 80 percent of the acquiree’s revenue
comes from customers in Europe. In addition, the acquisition provided access to the acquiree’s
advanced low-cost manufacturing in Thailand.

Value creation in industrials 55

56 Value creation in industrials
 Impact of COVID-19

COVID-19 has posed major challenges for companies across sectors, including industrials.
As companies navigate through these challenges, we have identified four areas that are critical to
ensuring business continuity and preserving value.

Widespread but varying consequences

Since the start of the COVID-19 pandemic, year-to-date market capitalization has varied
significantly by sector. Industrials saw a 1 percent decrease in weighted average year-to-date
local-currency shareholder returns as of July 31. Relative to other industries, this amounted
to middle-of-the-road performance (Exhibit 27). Over the same time period, industrials
underperformed the S&P 500 by 270 basis points; the index as a whole grew by 1.1 percent,
while industrials shrank by 1.6 percent.

Exhibit 27
Sectors differ significantly in their July YTD market-capitalization performance.
Weighted average year-to-date local-currency shareholder returns, by sector,1 %
As of July 31, 2020

Width of bars is starting market in $

19
20 18
15
10 8
3
5
0
-2 -1 Communication Consumer Information
-5 services discretionary technology
-5 -5 Industrials
-10 -6
Real estate Materials
-15
-20 Healthcare
-23
-25
-30 Consumer
staples
-35
Utilities
-40
-45 -41

Energy Financials

1 Data set includes top ~3,100 companies across multiple sectors. Figures as of July 31, 2020.
Source: Corporate Performance Analytics, S&CF Insights, S&P Capital IQ

Value creation in industrials 57

 Even within industrials, the year-to-date impact of the COVID-19 pandemic has varied
substantially, depending on the segment. Weighted average year-to-date local-currency
shareholder returns have ranged from −27 percent for aviation, aerospace, and defense to
28 percent in electrical components and equipment (Exhibit 28).

Exhibit 28
Within industrials, returns vary substantially by segment.
Weighted average year-to-date local-currency shareholder returns, by segment,1 %
As of July 31, 2020

Width of bars is starting market cap in $

30 28

25 21
20

15

10 9
8 8

5 3
0
Industrial Electronic components and Home and Automotive
-5 building
services equipment and
-4 products and ancillaries
-10 -8 technology
-9
-15 Industrial Industrial
diversified machinery
-20

-25 Industrial Industrial Electrical

-30 trading and materials components
-27
distribution and
Aviation,
equipment
aerospace,
and defense

1 Data set includes top companies across multiple sectors (n = ~3,100). Figures as of July 31, 2020.
Source: Corporate Performance Analytics, S&CF Insights, S&P Capital IQ

As economies shut and demand stagnated, most industrial companies saw their order volume
and top-line growth fall. While it is still too early to judge the true impact on the top line, company
revenue declined 8 percent year over year in the first quarter of 2020 (Exhibit 29), and the
situation was expected to worsen. At the time of publication, close to half the companies had
released their results for the second quarter of 2020 and were reporting a year-over-year
decline of about 20 percent.

58 Value creation in industrials

Exhibit 29
COVID-19 has hurt the top-line performance of industrial companies.

Year-over-year revenue change,

2019 vs 2020, %
Number of
companies 1st quarter1 2nd quarter2 Revenues
Large-cap 96 -7% -21% declined 8%
(>$10 billion) y-o-y in Q1’20
Midcap 185 -7% -15%
($2 billion–$10 billion) Further
Small-cap
decline of 20%
407 -11% -17%
(<$2 billion) in Q2’20
Total 688 -8% -19%
1 Based on analysis of a selected set of 688 industrial companies.
2 Based on a partial set of companies (282 of 688) that had released Q2 2020 results by the week of August 1, 2020.
Source: Corporate Performance Analytics, S&CF Insights, S&P Capital IQ

Even before the crisis hit, 38 percent of industrials faced moderate or high liquidity concerns.
When measuring liquidity risk by a company’s ability to meet both overall debt obligations (for
example, net debt to EBITDA, EBIT to interest expenditure, and debt payment in 2020 to total
debt) and near-term obligations (such as quick ratio and free cash flow), 19 percent of industrial
companies, representing 13 percent of the total industrials market cap, were at moderate risk
before the crisis. An additional 19 percent of companies, representing a further 15 percent of
total market cap, were at high risk.

The slowdown is expected to amplify liquidity issues, with 68 percent of companies likely to face
challenges if revenues drop by 20 percent, and 76 percent at risk if revenues drop by 30 percent.
Mid- and small-cap companies constitute around 90 percent of high-risk companies. Companies
in certain micro-verticals—including automotive and ancillaries, industrial services, and home
building products and technology—account for the largest proportion of high-risk companies.
Overall, the greatest risk comes from a triggering of debt covenants (for example, net debt to
EBITDA and interest service coverage ratio), which will require an immediate uplift in EBITDA
margins.

The difficulties posed by the crisis have pushed many companies to reevaluate their near-term
priorities. Many companies are using the crisis as an opportunity to accelerate fundamental
shifts in how they operate.

Based on our experience, the companies likely to emerge strong from the current crisis will
be those that have developed a detailed set of initiatives around four priority areas: protecting
employees and ensuring operational continuity, maintaining financial health, adapting sales and
marketing, and screening and safeguarding their supply chain.

Value creation in industrials 59

 Protecting employees is both a moral imperative and the strategic way to operate, given the
importance of talent to the success of any business. Companies need to enable work from
home or other safe remote locations, at least during the pandemic—and, in some cases, beyond
the pandemic if it supports recruitment, retention, and/or efficiency. For situations in which
employees must be physically present with one another or with customers, companies must
update operational procedures to enable distancing or physical barriers, including masks.
Finally, since no company can prevent all risks, companies need to develop and communicate
contingency plans to continue operations if any employees suspect or confirm they have been
infected.

To maintain financial health, companies should stress-test their own liquidity, as well as the
liquidity of vendors providing them with goods and services. It may be necessary to diversify
vendor relationships or deepen ties, depending on the circumstances. Companies also should
explore ways to improve efficiency and reduce costs to limit any impact on profitability. Once
demand is back, many companies will find advantages in supporting suppliers as they get back
on their feet, so that both companies can capture renewed growth.

60 Value creation in industrials

Sales and marketing need to adapt to changes in the pandemic and economy, however
swiftly they may occur. The marketing mix may need to include more use of digital products,
communication, and distribution. Sales channels may need to be realigned for softer demand,
perhaps making more special offers to online purchasers. Products may need added features to
address customers’ health concerns, or the product mix may need to be rebalanced in favor of
high-demand products.

Finally, during a crisis, the supply chain needs to be screened and safeguarded. Decision
makers need to understand the company’s exposure and address any anticipated shortage.
New suppliers may need to be onboarded. And supply chains should be ready to restart, with
inventory in place to meet renewed demand.

While COVID-19 has severely tested the industrials sector in the short term, companies have
shown that they can outperform the impact of micro-vertical-specific headwinds and continue to
deliver value to shareholders. For companies that seek to drive value creation in the future, what
are the guidelines for key stakeholders, including the board, investors, management team, and
shareholders?

Value creation in industrials 61

62 Value creation in industrials
 Imperatives for future value creation

Even in good times, performance across and within micro-verticals is highly variable. The
pandemic, like the financial crisis before it, added hurdles and roadblocks that challenge
companies as they develop strategies that can generate growth in the short and long term.
Nevertheless, effective management can overcome headwinds.

Executives, boards, and investors will play crucial roles in steering companies to greater
heights. Their engagement across three dimensions can help industrial companies understand
which trends will shape the business landscape and their prospects, build a playbook to
transform company performance to deliver greater value, and determine which actions to focus
on to increase the likelihood of success (Exhibit 30).

Exhibit 30
There are three main questions for industry stakeholders.
What are the forces in the competitive
environment and their likely impact on the
business?
Which headwinds and tailwinds are affecting
micro-vertical performance?
Understanding
Which indicators can help predict future impact?
headwinds and
What enablers will increase the odds tailwinds Is a change in neighborhood possible? If yes,
of success? where and how should a company pivot? If not,
What are the elements of corporate oversight what value-creation moves are available?
that affect governance? For each element,
what does good performance look like? Realizing Driving
the returns performance What set of actions can achieve a holistic
Which actors in the broader ecosystem (eg, performance transformation?
government and regulatory bodies, trade or What are the elements of a successful margin
industry associations) should be engaged? transformation? How should success be
measured?
,
How have companies achieved profitable growth?

What are the building blocks of setting up an

active M&A platform? Which capabilities are
required?

Understanding headwinds and tailwinds that are expected to

affect your micro-vertical
Business leaders in the industrial sector should ask themselves which factors will affect their
companies. This requires leadership with the necessary insights. The board of directors should
be composed of members who understand the market and the company’s position within
it; this will help keep an eye on possible future disruptions and help shape strategic plans of
their management team. Investors, too, likely understand the attractiveness of various micro-
verticals, so their decisions and reasoning can provide important insights.

Value creation in industrials 63

 Several questions need to be addressed and then revisited often:

— Which headwinds and tailwinds are currently shaping micro-vertical performance?

— Which indicators can help us predict future impact?

— Is a change to another micro-vertical possible? If yes, where and how should a company
pivot? If not, what value-creating moves can we make?

One company that successfully considered all these questions and developed a winning
path forward is a small-cap global designer and manufacturer of electrical and electronic
components. When charting a strategy, it first examined its three businesses:

— an electronics segment that focused on electronic-instrument clusters, electronic control

units, and driver information systems

— a wiring segment (primarily wiring harnesses and connectors) for electrical-power and signal-
distribution systems

— a control-devices segment for sensors, switches, valves, and actuators, as well as PST,
including vehicle audio systems, and video accessories, and security alarms

Beginning in 2014, the company orchestrated a portfolio pivot away from the markets that were
plagued by slow growth and little innovation. It first divested its wiring business, followed by the
2019 divestment of noncore switches and connectors. Simultaneously, the company began to
focus on the increased digitization of commercial vehicles and built a growing suite of embedded
electronics offerings. One major move involved acquiring a supplier of vehicle-camera solutions.
Such strategies have allowed the company to secure a 18 percent TSR from 2014 through 2019.
The company also secured over 5 percent top-line growth over the same period, despite its
business divestments.

Developing a playbook for a holistic transformation

Another necessary action is to ensure that the company’s strategy for a holistic transformation
lays out the right moves to boost performance significantly. For this, we return to two of the
three value-creation factors that have driven success for top performers in the past: achieving
profitable growth and leveraging M&A.

Achieving profitable growth

How have companies achieved profitable growth? In our experience, top-performing companies
often choose to pivot to a new portfolio or market, such as adding custom products to a line of
standard products. Consider a company with less than $1 billion in revenues from distributing
automotive paint protection, window tint films, and architectural flat-glass films. Having
established a strong product portfolio, the company embarked on a rapid growth trajectory
fueled by well-crafted joint ventures and acquisitions, one of which extended the company’s
distribution reach to Canada. Over the past five years, the company has delivered about 37
percent TSR CAGR, mostly driven by achieving revenue CAGR of over 30 percent.

Besides pursuing revenue growth, companies add the most value by seeking margin
transformation (see sidebar “Achieving profitable growth with APT: The case of a global food-
processing machinery company”). We have seen top performers execute margin-expansion
programs by reducing sourcing costs, optimizing their network footprint, reducing operating
expenses, and creating systems to optimize the price for each customer or customer type.
Product differentiation also often provides an opportunity for widening margins. Companies can
expand or enhance their offerings to customers, such as delivering software-as-a-service to
enhance the value of products and build a continuous revenue stream.

64 Value creation in industrials

Achieving profitable growth with APT: The case of a global food-
processing machinery company

Profitable growth can be elusive. Most companies need to drive aggressive efficiency
improvements while investing in R&D, their go-to-market strategy, and product development.
At the same time, factors such as culture, capabilities, fragmentation, and lack of scale may
prevent them from building cross-functional growth and operational excellence needed to meet
performance expectations.

Companies can improve the likelihood of profitable growth by following a structured method that
rapidly optimizes operations while enhancing long-term competitiveness. A tested methodology
is Accelerated Performance Transformation (APT), which is based on five pillars of performance:
growth and commercial optimization, cash management, cost of goods sold (COGS), head count,
and non-labor spend. APT addresses these with a three-step process: determining full potential,
measuring absolute results, and leveraging technology and other enablers to drive impact.
Adopting such an approach typically results in sustainable margin improvements of 500 or more
basis points within 24 months.

One company that saw results from adopting this approach is a leading food-processing
machinery player with global footprint that generates nearly $2 billion in revenue from the sale
of food-processing machinery as well as airport infrastructure. The company embarked on its
transformation journey early in 2018. They followed APT’s three steps:

1. Determine full potential. Led by management, the company began by identifying total
opportunity and committed to a margin expansion of 200 basis points, announced to
investors during their second quarter 2018 earnings call. This opportunity was determined
holistically across more than 20 sites in the company network, with more than 100 individual
initiatives across sites. These initiatives spanned all five pillars of improvement: revenue
growth and portfolio optimization, cash and balance sheet optimization, COGS reduction and
supply chain resilience, headcount rightsizing, and non-labor spend.

2. Measure absolute results. The company set up a mechanism to track progress on absolute
margin improvements across its more than 20 sites. Rather than just track incremental
benefits from each of the initiatives, the management team and other key stakeholders also
focused on absolute changes in financial performance as measured by improvements in
earnings before interest, taxes, depreciation, and amortization (EBITDA) and working capital
metrics.

3. Leverage technology and other enablers. To ensure successful implementation of the

initiatives, the company applied enablers such as technology, digital tools, and processes.
These include BI tools to track real-time progress on initiatives as well as on absolute margin-
improvement targets, a web-based portal to improve visibility and enhance scrutiny of all
non-discretionary spending, and a cloud-based budgeting and forecasting platform for
an accurate single source of truth on business performance and planning. In addition, for
consistency, all sites followed standard processes, including weekly update meetings, war
rooms, and daily huddles.

These efforts yielded significant performance improvements. The transformation exceeded the
goal by two times: the company delivered margin expansion of 400 basis points between the
second quarter of 2018 and the second quarter of 2020. Investors have rewarded the company
for the transformation with alpha returns of 900 basis points on its shares during the same time
period. The APT approach has become part of the company’s DNA. It is on track to weather
the COVID crisis and emerge stronger by drawing upon a reservoir of in-flight initiatives and a
detailed understanding of its full margin potential.

Value creation in industrials 65

 A good example of a top margin performer is a building-products manufacturer and distributor
with $8 billion in revenues. This company, which has long recognized the importance of
operational excellence, began designing improvement initiatives in 2017, and its efforts have
paid off well, even during the tough times resulting from COVID-19. Its disciplined, end-to-end
margin transformation encompassed all areas, including distribution and logistics, pricing
improvements, back-office functions, and customer integration. It also emphasized systems-
enabled process improvements. For example, the company leveraged pricing tools to scale
the improvements throughout the organization. In addition, the company has demonstrated
its commitment to operational excellence by its recent acquisition of an innovative business
that focuses on using offsite manufacturing to reduce cycle times, increase labor efficiency,
and control and accelerate construction schedules. The company’s efforts improved gross
margin from about 25 percent for the years 2015 through 2018 to 27 percent in 2019. Its strong
performance has continued through the first quarter of 2020, despite the global pandemic.

Building a platform
M&A, as we have seen, can be a key part of a company’s value-creation strategy. Mergers and
acquisitions should focus on companies that can provide access to new products or markets with
attractive potential, especially in terms of revenue growth and margin expansion.

Since its IPO in 2004, a large roofing-products company has adopted a roll-up acquisition
strategy that has given it more than three-quarters of its revenue as of 2016 (based on 43
acquisitions completed in the past decade). The company has focused on extending its product
portfolio—for example, with a 2018 acquisition to accelerate its revenue growth outside
of roofing in categories such as siding, windows, doors, decking, trim, waterproofing, and
insulation. The 2015 acquisition of a player with deep customer-service capabilities also provided
access to siding, windows, and accessories. The company has put this M&A play into motion
by strategically focusing on complementary products and geographies. It has also deployed a
management team with extensive experience in execution and integration of M&A. As a result,
the company has become a large and successful player in a fragmented market.

Enabling and sustaining the success

To further increase the odds of sustained success, companies need proper oversight. Executives
should balance their time between strategy creation and execution, frequently reassessing and
rebalancing the business portfolio. Along the way, they should look for ways to improve earning
power through rapid (two-year) cycles of margin transformation, leveraging technology where
possible. They also should make sure that the right incentives are in place.

This effort most likely needs to engage the broader ecosystem. For example, companies
need constructive relationships with government and regulatory bodies, trade and industry
associations, and others who can become the source of the micro-vertical’s next headwinds
or tailwinds.

Through our research on drivers of performance, we uncovered the contribution of strong

corporate oversight on company TSR. Corporate oversight is a function of many components
but five of them are the most noteworthy: (1) shareholding proportion of index funds and value of
ownership shares, (2) analyst coverage, (3) proportion of shares traded daily, (4) CEO tenure, and
(5) board composition and capabilities.

Take for example a heating and cooling equipment company with more than $3 billion in revenue
that secured top 10 percent position by scoring high on all components of the index. The
company had on average $10 million in stock value for each member of the management team,
ensuring strong and aligned incentives.

66 Value creation in industrials

In addition, the company is actively covered by more than 20 analysts on Wall Street (a level of
coverage typically seen in large companies) that provide transparency into company affairs and
hold the management team accountable for their performance. Further, five to eight year tenure
for the CEO ensured sufficient lead time for his or her strategic decisions to materialize and for
the board to evaluate the performance. Given that the right enablers were in place, it was no
surprise that this company found a position in the top quintile of company TSR performance.

While some companies suffered setbacks in their efforts to survive the financial crisis of
2008–10, others were prepared for the ordeal or agile enough to emerge stronger. As discussed
in our earlier report, these top performers sailed above their peers as market conditions
improved. Even as companies face new headwinds today, those that emphasize the key drivers of
value and structure the organization to sustain their successes are in the pole position to secure
their own future and carry the industrial sector to new heights.

Value creation in industrials 67

68 Value creation in industrials
Conclusion

Despite the challenges of the financial crisis and global pandemic, the industrials sector,
overall, has remained a strong contributor to the economy. In every micro-vertical of this sector,
companies have created and continue to create value for customers and investors alike. The
potential for the future is great.

Variations among sectors, micro-verticals, and companies within each micro-vertical show
us that success depends not only on external factors but also on strategic and operational
decisions made by the management. Each company will need to monitor the headwinds and
tailwinds affecting its micro-vertical now and watch for signs of new forces in the future.
Top-performing companies have leveraged a virtuous three-step approach for value creation
by leveraging technology to achieve profitable growth, instituting better corporate oversight,
and building a platform for future expansion.

Finally, to enable and sustain the business, companies need proper oversight. Executives
should balance their time between strategy creation and execution, ensure that incentives
align efforts with strategy, and engage constructively with the broader ecosystem. In these
ways, they can increase the likelihood of their companies entering or remaining within the
ranks of top performers, as well as contribute to propelling the overall value creation of this
key industry sector.

Value creation in industrials 69

70 Value creation in industrials
Glossary

CAGR Micro-vertical
Compound annual growth rate; the mean A cluster of similar companies defined by
annual growth rate over the study period or product portfolio and end-market focus; a
other period specified subset of an industry segment

Corporate Oversight Index (COI) NEV

McKinsey’s measure of corporate oversight Net enterprise value
in terms of ownership, analyst coverage,
liquidity, and leadership team NOPLAT
Net operating profit less adjusted taxes
Earnings multiple
The ratio of net enterprise value to earnings Quintiles
before interest, taxes, depreciation, and Data sets representing one-fifth of the
amortization performance values for the industry
segments, micro-verticals, or companies
EBITDA studied; in this report’s ranking of the
Earnings before interest, taxes, depreciation, members of each group (segments,
and amortization micro-verticals, or companies), the top
quintile represents the set with the best
EP performance, the second quintile represents
Economic profit; equals NOPLAT – the second-best performance, down to the
WACC × IC bottom quintile, the 20 percent with the least
favorable performance
EP/R
Economic profit as a share of revenue ROIC
Return on invested capital
GM
Gross margin TSR
Total shareholder returns, including capital
IC gains and dividends
Invested capital
WACC
Impact of change in multiple on TSR Weighted average cost of capital
A measure of impact of changes in investor
outlook on a company’s total shareholder Zero-growth return
return; typically focuses on the ratio of An organization’s ability to generate value
EV/NOPLAT for shareholders in a no-growth and as-is
profitability scenario
Impact of operating performance
on TSR
Measure of TSR impact that is attributed
to top-line growth, margin expansion, and
investments

Leverage impact on TSR

A measure of impact changes in debt levels
of a company on its total shareholder returns

Value creation in industrials 71

Value creation in industrials
November 2020
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