In the last few weeks, EY surveys and reports have taken the temperature of the UK’s capital confidence, earnings forecasts and the economy. In this week’s blog, we’re pulling this together and picking out five essential takeaways. UK companies face an extraordinary range of challenges; but they are also taking extraordinary measures, doing more than their global peers to adjust their capital structures to the changing landscape. More deals, more portfolio reviews, more investment in CVCs – and more competition from PE. It all adds up to a dynamic UK deal market in 2018.
1. The ‘low gear’ UK economy
In recent months, a striking gap has emerged between the low-gear UK economy and the accelerating Eurozone. The EY ITEM Club Autumn Forecast predicts that GDP growth will fall from 1.8% in 2016 to 1.5% in 2017 and 1.4% in 2018. Meanwhile, the Eurozone is set to grow around 1.7% in 2017. Our Capital Confidence Barometer (CCB17) reflects a broader divergence with UK companies showing greater confidence in the global, rather than UK, economic outlook.
It’s taken a long time for Brexit to have a palpable impact– primarily due to sustained consumer confidence. But, consumer confidence appears to be wilting in the face of the longest period of falling living standards in six years. Savings and credit can only maintain consumer spending for so long. Business investment too remains a concern – as we shall see.
The chances of a transitional Brexit agreement have risen, but trade & labour market uncertainties still need to be factored into business’ plans. Growth is out there – at home and abroad – but it’s getting tougher to find in the UK.
2. Divergence drives action
EY’s Analysis of UK Profit Warnings underlines this contrast and its impact on earnings. There is a visible gap between FTSE sectors exposed to demand and cost-pressured UK markets and more buoyant global growth – with exports being aided by a still weak pound. General Retailers issued the most Q3 warnings since 2008, whilst warnings from ‘Industrials’ have fallen significantly – with a rising oil price also providing earnings support. Construction & Materials and Support Services are the main exceptions, but their well-documented vulnerability to domestic pricing pressures effectively proving the rule.
CCB17 also shows UK companies showing greater confidence in overseas than their domestic earnings. But we need to beware oversimplification. UK businesses have a complex web of exposures – and responses. Even in pressured UK consumer sectors there are outperformers. In fact – as we’ve discussed – the overall rise in profit warnings is partly due to a rise in multiple warnings from weaker companies trapped on the wrong side of sector trends. It’s interesting to note in this context that CCB17 shows UK companies are more likely to be actively reorganising their geographic operations and have more regular portfolio reviews than their global peers.
UK companies clearly working hard to stay on the front foot and reassessing their portfolios amid this maelstrom of change. Acquisition intentions are also ahead of global peers driven by strong incentives to use domestic and outbound M&A to mitigate domestic demand/cost pressures. Inevitably some companies will be left behind – especially if they lack the capital to adapt.
3. The digital imperative
Clearly, the digital challenge is another big M&A driver. According to CCB17, the biggest strategic acquisition driver for UK companies is “acquiring innovation”. Corporate venture capital investments (CVCs) are currently being used by 68% of UK respondents, ahead of the global average of 49%. Sector convergence is also driving deals, with new markets created by technology, but led by customer need.
Why is the UK so active in this area? UK companies could be using deals as a lower-risk alternative to R&D. This would be a positive perspective on what is still a very worrying investment picture. Business investment dipped by 0.4% in 2016 for the first time since 2009 and is only expected to increase by 1.5% in 2018, according to a special report from EY ITEM Club. This could be followed by an increases of 2.7% in 2019 – but Brexit remains the uncertain element.
We expect to see companies explore more ways of bringing innovation into their business. Traditionally, technology companies have been at the forefront of CVC investing, but other sectors have now developed CVC expertise, especially life sciences, industrials and consumer products. Finding investments can be a challenge
4. The PE ‘comeback’
Just over half of UK respondents expect to see greater rivalry for assets and 59% of those expect this to come from PE. The private equity comeback looks set to be one of the biggest global stories over the next 12 months.
As we commented recently, private equity clearly has the wind in its sales due a mountain of dry powder and a helpful credit market. The higher expectation in the UK market is perhaps a product of pent-up demand. Post-Brexit uncertainty remains, but firms need to put capital to work. But greater competition also means higher valuations – a continuing issue for companies and PE alike.
Our research shows private equity’s focus on value creation is levelling the field in the race for assets. But, should this always be a race? Are companies and PE possible friends, not foes as firms change investment models?
5. Alive and kicking?
So, where does that leave the UK? It’s certainly a more testing time for parts of the UK economy. Last Thursday’s interest rate rise from inflationary concern, not economic strength – which is why ITEM think it’s unlikely to be repeated before the end of 2018 at the earliest.
But, CCB17 shows that the UK remains the third most popular M&A destination amongst global executives – so we must be getting something right! UK respondents are also more optimistic than they were six months ago about the UK’s economic outlook. Perhaps this is linked to the hopes of a Brexit transition deal? Or perhaps, it’s UK businesses’ confidence in their ability to react and adapt? The UK isn’t alone in the world in facing big challenges and the openness, resilience and flexibility in UK responses to CCB17 are great qualities to have right now.
Don’t assume that the UK is out of bounds for buyers. I’d love to hear the views of all our readers, but especially those from outside the UK looking in. Is the UK still an attractive investment destination?