Parthenon-EY Diversified Industrial Products practice

By Jamie Bader, Managing Director

The growth dilemmaHow engineered component manufacturers build a second act

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The growth dilemma: How engineered component manufacturers build a second act

Parthenon-EY Diversified Industrial Products practice

The growth dilemma: How engineered component manufacturers build a second act

Sustained top-line growth is one of the clearest avenues to driving shareholder

value. After years of creating value through cost efficiencies, growth has once

again become a focus for business leaders and investors. At Parthenon-EY,

we regularly work with industrial companies and their investors to identify growth

opportunities. In our experience, there is one group of companies whose

characteristics pose unique challenges to maintaining long-term growth. We

define these companies as “engineered component manufacturers.” We are

interested in these companies due to the place they occupy in the value chain

and their growth characteristics. Our research indicates that many of these

companies deliver above-average profitable growth for a time. However, they

invariably reach a point where it is difficult for them to sustain their momentum

and build a second act. We call this “the growth dilemma.”

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Table 1: Illustrative value chain

A virtuous nicheEngineered component manufacturers are companies that sell highly technical components to original equipment manufacturers (OEMs). They occupy a “virtuous niche” in the product value chain, which allows them to achieve above-market growth and profitability. These companies’ products share three distinct features:

The components are highly technical and value-added. These companies develop components that outperform existing market solutions, sometimes significantly so. In addition, the components require unique technical knowledge and are sometimes patent-protected, making them difficult to recreate. This creates high barriers to entry, making them less susceptible to competition. The result is rapid adoption and high penetration rates, leading to above-market growth rates and high margins.

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The components are often “spec’d in” by OEMs. This is a technical sale, and OEMs often choose to single-source these products. Many even design their products around the component capability. This significantly raises customer switching costs, reducing customer churn.

The components are mission-critical and have a high cost of failure relative to their cost. The end user will experience costly repairs or downtime if the component fails. Because these components are mission-critical and are usually low-cost relative to the cost of failure, OEMs are willing to pay a high price premium.

We have seen engineered component manufacturers carve out this virtuous niche in many different industries, such as consumer electronics, photonics, test and measurement, fluid handling and power transmission. Table 1 summarizes the characteristics that lead to high growth and margins for engineered

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Company size Very large Mid-size Varied Large

Engineering Value Add Low Very high Low Varied

Customer Switching Cost Low Very high Low Varied

Competitive Environment High Low High Varied

Relative Market Share Varied High Low Varied

Operating Margin Low High Low Varied

Characteristics End customers

OEMs/ SIs

Raw Materials

Components/Subsystems

Engineered Commodity

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The growth dilemma: How engineered component manufacturers build a second act

Parthenon-EY Diversified Industrial Products practice

components and contrasts them with characteristics of players in other places in the value chain:

• Raw material suppliers generally provide commodity products and compete on scale. Competition is fierce and share gain opportunities are limited. Their growth is dependent on end-user demand and margins are low. Examples include steel and plastics providers.

• OEMs may have more attractive competitive dynamics, but often are no more than component/ subsystem integrators. As such, their engineering value-add can be low and differentiation may be difficult. Growth is limited by end-market demand and margins are suppressed. The personal computer industry is the classic example.

• Commodity component companies also generally depend on scale and are often dual-sourced by OEMs; competition is high and margins are low. This is true of electronic components, such as printed circuit boards, and certain automobile parts, such as radiators.

Consider the metal cutting laser industry as an example. Laser manufacturing requires many commodity components, such as electronic componentry, where growth and margins are low. OEMs in this industry add considerable expertise and value, but they are only able to grow as fast as their customers’ demand for metal cutting applications. Competition in relatively undifferentiated products can lead to margin pressure.

The highly engineered optical components company we highlight in Figures 1 and 2, however, has significantly outperformed its OEM peers over an extended period of time. Its technical expertise allowed it to grow rapidly as it penetrated the laser OEM customer base while maintaining high operating margins.

Figure 1: Component company performance vs. OEMs, growth, profitability, 2004–2014

10 year average EBITDA margin

Figure 2: Component company vs. OEMs indexed growth, 2004–2014

0

1

2

3

4

5

2004 2006 2008 2010 2012 2014

Years

ComponentOEM

30%

20

10

-10

0

0 10 20 30 40%

Componentcompany

OEM

6 ye

ar re

venu

e CA

GR

(200

7–20

13)

$1,500M

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The same dynamics that make these companies so attractive will eventually cause their growth to stagnate. Once the companies achieve high penetration, it becomes difficult to grow above the market rate. When the OEMs have adopted the technology, the component manufacturers’ growth will track the growth of those OEMs, mirroring end-user demand growth.

All of the business units shown in Figures 3 and 4 saw rapid market adoption between years ~4 and ~10, but struggled with growth once their market share reached a certain level. This is the growth dilemma for engineered component manufacturers: how can these companies continue to achieve above-market growth once their products have seen widespread adoption?

A compounding factor is that many of the standard growth options are unavailable to engineered component manufacturers, as illustrated in Table 2 (see next page). Market share and share of wallet are not options once high penetration has been attained. Both forward and backward integration require entering completely different businesses, and are therefore not reasonable options. And acquisition/consolidation is rarely available, due to the unique technology content and high market share. In fact, once high market share is attained, the company’s position is so favorable that other acquisitions can seem unattractive.

Figure 3: Component manufacturer segment or application revenue over time

Traditional growth options may not be available

Figure 4: Component manufacturer segment revenue growth during high and low growth periods

0

100

200

300

$400M

1 2 3 4 5 6 7 8 9 10Years

11 12 13 14 15 16 17

TheoreticalCompany segment medical imaging componentsCompany segment highly engineered bearingsCompany segment material processing laser components

0

3

5

6

10

13%

Highly EngineeredBearings

Material Processing LaserComponents

Medical ImagingComponents

High growth

Low growth

First 11 years

First 14 years

First 10 years

Last 3 years

Last 4 years

Last 4 years

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The growth dilemma: How engineered component manufacturers build a second act

Parthenon-EY Diversified Industrial Products practice

Building a second actWe have identified potential growth options that may be suited to component manufacturers, each with its own set of unique challenges:

• De-feature technology De-featuring a technology or providing lower performing components can open up new, sometimes larger, customer opportunities. However, engineers accustomed to designing highly engineered products very often have difficulty designing a cost-competitive, defeatured product.

• Repositioning technology Repositioning the technology for new applications opens up new markets/customers and can reignite high growth through new market penetration.

However, penetration often requires application knowledge that may not exist within the company.

• Subsystems Opportunities If subsystems exist that are dependent on the component for performance, often times the component manufacturer can “move up the value chain” to become a subsystem provider. However, subsystem opportunities don’t always exist. If they do, it may require competing with current customers, an often difficult transition to manage.

We have seen companies attempt to pursue these options, only to fail because they did not fully under-stand the challenges. Each option requires in-depth research and careful analysis to decide whether or not it can and should be employed to drive profitable, above-market growth.

Table 2: Traditional growth options

Growth Option Rationale Difficulty for Component Manufacturers

Market Share

Converting ‘greenfield’ or competitor customers enables existing product growth

• Design-in cycles are long, and if not designed-in, suppliers cannot displace competitors

• Successful component manufacturers often already have high share

Share of WalletStrengthens customer relationships and increases supplier power

• Successful component manufacturers are typically the primary/sole source of the component for the OEMs and already have a very high share of wallet

Forward Integration

Selling complete systems or subsystems allows manufacturers to capture OEM margin

• A typical OEM is a large company with system integration capabilities

• Component manufacturers would typically not have the size or capability to forward integrate

Backward IntegrationIntegrating into raw material gives manufacturers complete control over sourcing

• Raw material markets tend to be commodity markets with heavy competition and scale requirements

Acquire Competitors

Concentrates supplier power with manufacturer and often confers pricing power

• With an already high market share, acquiring a competitor if available is less likely to have an impact on enhancing overall market presence

• Anti-trust issues may arise given high share

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The Parthenon-EY approachParthenon-EY has developed an opportunity identifica-tion process that helps business leaders of component manufacturing companies efficiently identify, prioritize and act on available opportunities.

The approach is fact-based and rigorous and relies heavily on a deep understanding of the precise market in which companies operate. It is collaborative, incorporating input from all levels of the organization, and is repeatable and systematic,

built around frameworks that allow an organization to refresh its strategy over time.

Through the process of identifying potential growth strategies, assessing the operating requirements of each, quantifying the likely impact of each and developing an action plan to take advantage of the most promising, component manufacturers can build a second act for their companies out of a single product line.

Approach conclusion In an environment where it is increasingly difficult to drive above-market growth, engineered component manufacturers are able to deliver consistently. However, the characteristics that make these companies so attractive also can cause growth challenges long term. Only through a systematic and in-depth evaluation of market dynamics and internal capabilities can business leaders choose the growth strategy that will deliver maximum value to the organization. By following this approach, investors and business leaders can extend a component manufacturer’s above-market growth indefinitely and overcome the growth dilemma.

Parthenon-EY’s opportunity identification strategy

Assess potential opportunities

Conduct deep dives on prioritized opportunities

Develop action plan

Strategy road map

Potential growth opportunities

Deliverables • Develop a proprietary opportunity assessment score card

• Construct a detailed fact base through primary and secondary research

• Generate a list of prioritized opportunities with an action plan

• Create a detailed fact base for the prioritized opportunities

• Conduct detailed primary research on opportunity

• Assess the likely potential under each opportunity and related investments, risks and timing

About Parthenon-EYParthenon joined Ernst & Young LLP on 29 August 2014. Parthenon-EY is a strategy consultancy, committed to bringing unconventional yet pragmatic thinking together with our clients’ smarts to deliver actionable strategies for real impact in today’s complex business landscape. Innovation has become a necessary ingredient for sustained success. Critical to unlocking opportunities is Parthenon-EY’s ideal balance of strengths – specialized experience with broad executional capabilities – to help you optimize your portfolio of businesses, uncover industry insights to make investment decisions, find effective paths for strategic growth opportunities and make acquisitions more rewarding. Our proven methodologies along with a progressive spirit can deliver intelligent services for our clients, amplify the impact of our strategies and make us he global advisor of choice for business leaders.

About Parthenon-EY Diversified Industrial Products practiceParthenon-EY’s Diversified Industrial Products practice advises a broad range of products and services companies across every major industrial sector. We deploy tested analytic tools and draw upon a deep bench of experienced professionals to help mid-market industrial companies achieve above-market growth and operational improvements. Our experience has allowed us to address an array of business challenges, including market entry strategies, commercial due diligence, value-chain positioning and pricing strategies, competitive assessments, and cost optimization for clients throughout North America, Asia, and Europe.

AuthorJamie BaderManaging Director+1 617 478 4621Jamie.Bader@parthenon.ey.com

Contributors

Jeff Bates Consultant

Becca McGovern Associate

EY | Assurance | Tax | Transactions | Advisory

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Max Pinto Senior Consultant