Conventional financial analysis often involves formulating projections and forecasting future returns, and then assigning a valuation based on those estimates. This usually assumes no major structural changes in the external forces that shape the economic and business landscapes. In 2017, in a challenge to that approach, RBC Capital Markets embarked on a six-month study of the global drivers of extreme transformative change. A fairly large number of “change forces” were identified that RBC Capital Markets’ analysis suggested would catalyze a metamorphosis of the world around us. These were laid out in some detail in a subsequent report entitled Imagine 2025.
Following up on that work, the Global Industrials Research team provided a roadmap in a recent report, Gearing up for the next Industrial Revolution, to help investors navigate the change forces that are reshaping the global industrial landscape.
Ultimately, RBC Capital Markets argues, a new industrial revolution may be upon us. Advances in artificial intelligence (AI), big data, and digitization, among others, set against an uncertain geopolitical and environmental backdrop, are forcing industrial players to increase their agility in order to survive.
These change forces will catalyze a metamorphosis of the industrial landscape
- A changing population
- Changing work environments
- Fluid generation
- Rise of women
- Big data
- AI & Cognitive computing
- Autonomous cars
- Digital engagement
- The new reality
- Cyber security
- Food & AG technology
- Expanding e-commerce
- Automation in the workplace
- Protectionism prevails
- New resource shortages
- Climate change
- Energy source uncertainty
- Evolution in pollution
- Geopolitical uncertainty
- Climate change policy
- Private enterprising
Source - RBC Capital Markets
Transformation is afoot
RBC Capital Markets believes cutting-edge innovations, such as AI, autonomous transportation, and cloud technology, could completely upend the industrial marketplace within the next 5–10 years and for the foreseeable future. With this in mind, we argue that investors should increasingly focus beyond the next few quarters and into the years ahead.
Below we highlight the long-term effects of some of these change forces on three areas of the industrial complex, namely automation, smart water systems, and 3D printing. These forces are already having a growing impact on current stock valuations.
We also lay out why today’s heavily discounted valuations within the Industrials sector make this an especially opportune time to seek out the groups and companies that are likely to establish competitive advantages in this transforming industrial world.
Automation: Manufacturing the future
Advances in factory automation could be reaching the point where “lights-out” manufacturing plants become widely feasible. Such facilities would be fully autonomous, with no human interaction on site. At the extreme, companies could save on energy costs (e.g., no lighting, no heating, and lower ventilation and air conditioning costs), labor and scrap costs, and achieve higher-quality production. They would enjoy smaller and more cost-effective factory footprints, and achieve better asset utilization.
We are years away from the fully automated plant and robots have been on the factory floor for about 50 years. But today we are seeing a deluge of new applications for robotics and automation. RBC Capital Markets believes it is only a matter of time before lights-out manufacturing becomes not only practical but also widely adopted.
A related theme is warehouse automation, where advances are improving throughput and limiting downtime, while helping control labor costs. Uptake of warehouse automation should track that of e-commerce, in our view. Growth in this large and often ignored subsector could reach 10 percent to 15 percent annually over the medium term, according to RBC Capital Markets.
Smart water systems: Waste not, want not
Smart water systems represent one of the biggest growth opportunities, in RBC Capital Markets’ view. These encompass all sensors and connected devices such as pumps and meters, as well as the information technology and analytics to help water utilities automate and optimize their water treatment.
One of the biggest pain points for water utilities today is rampant water leakage in the aging infrastructure, both in the developed and developing world. Smart water systems can be deployed to detect leaks using sophisticated acoustic devices that can listen for the audible signature of a leak, or to identify small changes in pressure that could predict a water main break, allowing water utilities to pre-emptively maintain and optimize their infrastructure.
Meanwhile, global water crises are escalating as water shortages threaten over a quarter of the human population. This dire situation has been exacerbated by climate change, which is making rainfall more erratic and the planet warmer overall, causing water to evaporate from reservoirs and threatening global water supplies. In addition, water consumption has tripled over the past 50 years, largely due to agricultural and industrial usage.
Apart from better water resource management and conservation, the two most popular and sustainable solutions to expand the world’s supply of freshwater are desalination and water reuse/recycling. By 2025, we expect these two proven solutions to be increasingly adopted by cities.
Water desalination (creating freshwater from salt water) is a drought-proof solution, and technological advances have made it much more cost effective.
Water reuse (also known as water reclamation or recycled water) is the process of converting wastewater back into potable water that can be used for agriculture, environmental and aquifer restoration, commercial and industrial applications, or even drinking. The water is treated and refined until it can meet stringent quality standards and is deemed hygienically safe and free of bacteria and other contaminants. For now, most of the recycled water globally is being used for irrigation and commercial applications, but there are some cities that have integrated water reuse into their drinking water supplies, such as Singapore. Recycled water is roughly half as costly to produce as desalinated water.
Despite the attractive economics and proven technologies, the biggest hurdle to the mass adoption of water reuse in the U.S. as a source of potable water remains public acceptance. We expect that water reuse in the U.S. will be mostly limited to agricultural and industrial/commercial applications for the time being. That said, indirect potable reuse—whereby the recycled water is injected into the environment or natural bodies of water, rather than directly into a municipality’s drinking water supply—has been received more openly by the U.S. population.
3D printing: Layer by layer of opportunity
3D printing technology, also known as additive manufacturing, lays several layers of materials, ranging from metallic to polymeric materials, over each other to create an object. The versatility of this technology offers opportunities denied by traditional methods. In particular, it can increase geometric freedom compared to traditional welding and machining methods.
3D printing thus speeds up the design-build-test cycle and enables the production of customized components on a small scale, while reducing the manufacturing footprint and waste. It can also lower transport costs while making low-volume production economically viable.
RBC Capital Markets calculates that eight engineers with a single digital file can use 3D printing to build what may have involved 60 engineers and 300 parts via conventional processes.
The power of this technology is best illustrated by a recent example. General Electric needed to completely redesign a new fuel nozzle tip for its next-gen LEAP aircraft engine. The earlier-generation design was overly complex, requiring 20 different parts that had to be welded together, a task difficult to scale up efficiently in traditional manufacturing. GE turned to 3D printing to solve this challenge, and the company has produced 30,000 fuel nozzle tips for its state-of-the-art LEAP engine. GE utilizes more than 40 3D printers to make parts from metal powders at one facility in Alabama.
RBC Capital Markets expects to see many more examples of additive manufacturing applications over the next decade.
Difference between traditional manufacturing and 3D printing
3D printing resets supply-chain cost equation
Left: Cost per unit of traditional manufacturing goes up as complexity increases; cost per unit of 3D manufacturing stays stable regardless of complexity.
Right: Cost per unit of traditional manufacturing decreases with mass production; cost per unit of 3D manufacturing stays stable even for small quantities.
Source - RBC Wealth Management
Traditionally, the Industrials sector has not been the focus of investors at such a late stage in the economic cycle. Indeed, this time around, trade war anxiety and tariff pressures have amplified the sector’s woes. There has been an epidemic of operating misses since Q2 2019, and this may well continue in the short term with manufacturing momentum still quavering. Sector CEOs are particularly cautious.
But therein may lie an opportunity. Lori Calvasina, RBC Capital Markets, LLC's head of U.S. Equity Strategy, points to the sector’s deeply compelling valuations relative to the S&P 500, which are near the lows seen during the financial crisis. Moreover, the Industrials sector tends to outperform when value beats growth. It is less vulnerable to fears of a potential Democratic sweep in 2020 than other cyclical sectors. Industrials companies are also actively buying back stock and could benefit should the U.S. and China reach a détente in their trade war ahead of the U.S. presidential election in November 2020.
S&P 500 Industrials relative valuations
Industrials valuations are distressed
Source - RBC Capital Markets; relative valuations based on the Z score, or how far two-year forward price-to-earnings ratios are from the historical average since 2004.
We would focus on the highest-quality, defensive companies in the Industrials sector, particularly those that can derive a competitive advantage from the transformational changes that RBC Capital Markets has identified in Gearing up for the next Industrial Revolution.