Testing times: How TIC is shaping up under pressure

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1 Testing times: How TIC is shaping up under pressure

2 Testing times: How TIC is shaping up under pressure Opportunity remains plentiful in the TIC sector today, both for participants and for investors. But the good news comes with some caveats. Although it has existed for over a century, pre-2000 the Testing, Inspection and Certification (TIC) sector was mostly an in-house operation, siloed within industries and largely fragmented. Rapid growth ensued, forging some major players, as strong market tailwinds provided momentum. But around 2013, the wind changed direction M&A still was on the table, but organic growth was harder to come by and major players were left questioning their scale for scale s sake strategy. Today, it s a market where organic growth and M&A strategies run side-by-side. Focus is on operational efficiency and commercial quality, with sector leadership the goal. Objective: scaling up TIC companies are now making more targeted acquisitions to build scale in certain sectors and expand capabilities for customers. They also show increased appetite for outsourcing through the acquisition of customer operations, and joint ventures with customers are now viewed as a great test bed for new services and territories. Where, previously, optimisation of footprint was all about sweating the asset, the notion of commercial excellence now informs progress. This may not yet be as well developed as seen in some of the really tough B2B industries, such as facilities management, notes Bennet Summers, Partner at OC&C Strategy Consultants, but this is just a function of TIC having been a relatively benign market to date. The winning formula for commercial excellence requires slick operations within and across labs to deliver enhanced customer propositions. The opportunity for TIC leaders seeking advantage lies in better managing key accounts, more sophisticated pricing, company talent and technical development, says Summers. A supplementary source of value today, beyond the supply-side push for growth, may be derived from reinvention. This, Summers explains, can stem from building more developed customer propositions: offering a broader range of services, evolving delivery models, and buying or building new capabilities to deliver them. Beware the tech sharks The opportunity offered by digital over the next few years is potentially huge, says Summers. New demand is arising as the use and regulation of technology such as robotics, drones, autonomous vehicles and 3D printing increases. Of course, the 2 of 6

3 faster the innovation cycle, the higher the testing intensity, with further testing evolution likely. When there is a demand for a new test, it is much more likely to be outsourced from day one, driving both outsourcing and new demand in TIC, explains Summers. However, there is also a risk of digital substitution. The ability to bypass some physical testing through the use of in-built sensors, hand-held devices and software-based virtual testing could worry some TIC players. The big question is whether firms should consider hedging their bets by moving further into the software, data, analytics and even risk management and consultancy side of TIC. Summers suspects the industry will change quite a lot at the hands of technology, certainly on the fulfilment side. On the supply side, process automation, workflow tools and data analytics can accelerate results generation, providing labs with increased efficiency. This is important, particularly in the more pricecompetitive spaces. Inspection may have historically been viewed as lower margin and therefore less attractive for investment, but apply some relatively straightforward technology and, says Summers, suddenly it transforms the economics of delivery. This could be the next wave of investment opportunity, he feels. Agile newcomers at an advantage With the arrival of new entrants such as instrumentation players, engineers or platform providers customers can benefit from the stitching 3 of 6 together of conventional testing activities with advanced analytics. This too is an opportunity for further TIC evolution and investment or a threat. Lumbering old firms lacking integration and adhering to a federalised model are vulnerable to new entrants starting with clean slate, says Summers. It s quite hard to turn around an oiltanker, he muses. The big firms will not go under; they will just be left behind. Their growth rates may fall but these firms still present an investible proposition, he argues. Structurally, the market has already seen instances of the virtual TIC player more of a broker model where demand aggregation replaces physical service provision. It is, Summers notes, an area where the

4 customer relationship is owned by the provider of access to tests, which sees owning the supply in the long-term as less important. Having as few physical assets as possible may be the way forward for some. What will TIC be when it grows up? There are several future options for TIC but the likely end game varies by sector. The industry utility model is likely in sectors such as environmental testing: as consolidation increases, especially at the more commoditised end of the market, the economics of delivery will play through. This could see supply concentrated within a handful of providers or at least the predominance of the broker model in some markets. In industries with more complex value chains, the asset lifecycle management model may prevail. TIC providers have a wealth of knowledge and data concerning their customers supply chains (in oil and gas, automotive or aerospace perhaps), which can be used to improve that supply chain: moving from simple test results to offering a view on how to extend asset life or reduce lifetime maintenance costs. Other possible end-game models, such as owning QC across the supply chain, or outsourcing of the entire R&D or manufacturing process, all demonstrate opportunity for further TIC market evolution. And whilst these trends may seem far off to some, Summers warns they are closer than you think. Indeed, he counsels, conventional TIC players who don t start to evolve their propositions risk being disintermediated by players who do. Investing in evolution All this informs how public market investors are looking at the sector, its issues, valuations, recent deals and trends therein. And, in the view of Richard Probert, Managing Director and Head of EMEA Services at Barclays, TIC is still a high-valued sector. Indeed, barring a few positive and negative outliers, most of the big participants are almost all trading healthily at around a 13x forward multiple. Investing in TIC has typically made money versus the market. But there has been a challenge in the last couple of years, says Probert. There have been blips in the past couple of years (heavy oil and gas exposure, for example, has been a negative). But for pure testing companies, Probert notes a slight premium still in the market. Testing has seen growth, and those with a lab network have the ability to achieve operating leverage and therefore margin accretion. There is also some very healthy PE interest in firms of all sizes, driven in part by some generally benign financing markets and willing bank support for TIC. Indeed, with no material issues emanating from 4 of 6

5 the larger LBOs that have taken place, financing confidence is high. By using that leverage, good returns have been seen. And, as a still-fragmented sector, the ability to augment financial performance with strategic acquisitions, returns have been further improved. All this is, of course, notwithstanding ongoing currency volatilities and exposure to specific market downturns. Broadly, the market still believes in the medium to long-term secular drivers that underlie TIC, says Probert. The themes covered by Summers above indicate a change in the industry but the notions of reputation, regulation, risk, product cycles, outsourcing and so on still apply. A 0 2% organic growth over the past few years is normal. Organic growth projections in TIC for the next few years top out at around 4%. This is below the level of expectation for mid- to long-term growth and firms are looking to augment this lower-than-expected organic growth with some increased M&A, notes Probert. 5 of 6 Overall demand will remain resilient, concludes Summers. Tech revolutions will reduce costs and shake up the market but the bar in terms of regulation and self-regulation increases each time too, so the total spend on TIC continues to grow. Taking away the need for regulatory tests is not going to happen, he states. I think we can be confident about the health of future demand. For participants and investors alike, this is an environment in which opportunities will come and go, and where proactivity brings reward.

6 Key takeaways Buy and build is still important for most, but TIC players are now focusing on commercial excellence and operational efficiency to optimise their footprint Virtual testing has the potential to bypass physical, but firms must decide whether to move further into the software, data, analytics and even risk management and consultancy side of TIC Technology could transform the economics of delivery in inspection, making it a much more viable investment opportunity The end-game model that will win out varies by sector depending on the complexity of the sector and how sophisticated customers become Conventional TIC players that don t start to evolve their propositions risk being disintermediated by players who do. barclayscorporate.com Barclays is a trading name of Barclays Bank PLC and its subsidiaries. Barclays Bank PLC is authorised by the Prudential Regulation Authority and regulated by the Financial Conduct Authority and the Prudential Regulation Authority (Financial Services Register No ). Registered in England. Registered number is with registered office at 1 Churchill Place, London E14 5HP. Item Ref: BM May of 6