The uneven recovery and its impact on UK industry sectors

As part of our new programme, ‘The uneven recovery’, we look at the performance of the key industry sectors in the UK.

Key takeaways

• Lockdown restrictions appear to have profoundly impacted leverage and profitability within the accommodation / food sector resulting in a significantly reduced FSS compared to the UK median and compared to historic averages.
• Manufacturers are significantly outperforming the UK median in terms of growth, and we believe that this outperformance is enduring and will survive any temporary Covid-19 induced effects.
• When using Return on Assets as a measure of efficiency, the outperforming sectors are broadly in line with expectation albeit with some notable surprises most notably the manufacturing sector.
• There is significant variability between and within sectors when accounting for both short- and long-term debt obligations which speaks to the unique characteristics of each sector and how a ‘one size fits all’ approach to considering the suitability of debt financing for SMEs does not work.
• Prevalence of SMEs aged between 0-3 years is significantly higher within the 15-25% insolvency rate bucket which goes some way to validating the widely held view that those early years are vital for SMEs in securing their long-term future.
• When looking at the most challenged segment of the SME market, it is apparent that the mining and education sectors have the highest share of SMEs with a 15-25% insolvency rate whereas the wholesale / retail sector has the lowest blended risk.

The lockdown and its impact on all sectors

It comes as no surprise to us that SMEs within the accommodation / food sector, SIC divisions 55 and 56 appear more distressed than the UK average as measured by the Distress Warning Score (DWS). However, the size of delta has surprised us as we expected the difference to be manifestly larger.

Whilst the sector remains an outlier overall, our analysis has revealed that the indicators feeding into the DWS are not yet picking up key input data compared to the FSS score which is presenting us with data that is more consistent with our assumptions with respect to SMEs in SIC divisions 55(*1) and 56(*2) as detailed below.

The impact on leverage and profitability

Lockdown restrictions appear to have profoundly impacted leverage and profitability within the accommodation/food sector resulting in a significantly reduced FSS compared to the UK median and compared to historic averages.

In contrast to the DWS, results using the FSS suggest a dramatically different outlook for SMEs active within SIC divisions 55 and 56 that have a score of 16 compared to the UK median of 49 – the delta is much higher in the case of FSS compared to DWS for SMEs in SIC divisions 55 and 56.

Based on closer examination of the SMEs financial position, our analysis reveals elevated levels of indebtedness and far lower levels of profitability both of which are bearing down very heavily on key financial ratios that drive FSS performance. Cash reserves have been run down as they trade under significant working capital pressure. Our analysis suggests that they will continue to remain challenged this year and our expectation is that their FSS will not materially improve and may in fact worsen as we approach Q4.

For the same reasons that SMEs in the Accommodation/ Food sector have come under significant pressure, SMEs active in Public Administration, Health/Social Work have improved their standing in the past two years compared to historic averages.

Interestingly, SMEs in the Agriculture/Forestry/Fishing sector in SIC divisions 01, 02, 03 are the standout private-sector performers with an FSS that is significantly outpacing the UK median of 49. Our analysis suggests that this is largely driven by a significant increase in retail prices which have in turn fed into improved margins for many food producers.

Manufacturers leading the way… for now

Manufacturers are significantly outperforming the UK median in terms of growth, and we believe that this outperformance is enduring and will survive any temporary Covid-19 induced effects.

When accounting for Covid-19 related impacts, we believe that SMEs active in the manufacturing sector – in SIC divisions 10-33 inclusive – are likely to maintain their relative outperformance even when allowing for pandemic-related effects.

Whilst it is too early to draw any firm conclusions from the data emerging from Clarity, we are seeing early indications of higher than historic levels of capital investment suggesting that confidence is growing within the sector. This is leading to planned improvements in capacity and productivity to meet anticipated growth in the demand as consumers increasingly orient themselves towards a more ‘made in the UK’ attitude in the wake of Brexit. However, this needs to be carefully considered. The recently ratified Trade and Cooperation Agreement does not fully replicate EU-UK trading relationships that existed before Brexit and firms now must contend with higher administrative barriers to trade and a constrained labour force that may take some time to heal despite improving sentiment and confidence amongst SMEs.

Start-ups and younger businesses at most risk

The number of SMEs aged between 0-3 years within the 15-25% insolvency rate bucket is high, validating the widely held view that early years to SMEs is vital to secure future viability.

It is often said that new business mortality is the highest within the first three years following incorporation and Clarity reveals granular evidence to support this claim. Thereafter, there is a broadly inverse relationship between age and mortality.

The distribution of SMEs by age is broadly consistent across insolvency rate buckets except for companies aged between 0-3 years which appear somewhat overrepresented in the 15-25% bucket.

The sectors at most risk of insolvency

When looking at the most challenged segment of the SME market, it is apparent that the education and mining sectors have the highest share of SMEs with a 15-25% insolvency rate whereas the wholesale/retail sector has the lowest blended risk.

On the face of it, the results appear somewhat surprising. However, when looking into the details of the activities undertaken by SMEs in the education sector, namely, those in SIC division 85(*3), it is perfectly understandable why such SMEs now face an elevated risk of failure. Given that most SMEs active in the sector are public sector, the elevated risks relate to those SMEs whose activities have been severely curtailed by the lockdown restrictions. Similarly, for SMEs in the wholesale/retail sector, namely those in SIC divisions 45-47 inclusive(*4), and consumption-led spending over the past two years, it is entirely defensible why such SMEs have the lowest blended insolvency risk of the most challenged segment.

However, it is still worth noting that for SMEs to fall within the scope of our insolvency propensity model, it must have an insolvency risk that is at least 4 times greater than the UK average of 1%.

Footnotes

(*1) Includes hotels, short-stay accommodation, camping grounds.

(*2) Includes restaurants and take-aways, event caterers, pubs, and clubs.

(*3) Includes pre-primary, primary, and secondary education, higher education, sports, and recreation education, driving school activities, educational support activities.

(*4) Includes wholesale and retail trade of vehicles, raw materials, food, beverage, tobacco, household goods, live animals, machinery, fuels, building materials, information, and communications.