Industrials and materials: orders, capacity and cycles
Read order intake, backlog, book-to-bill and capacity utilisation, and see how operating leverage and cost curves shape profits through the cycle.
What you will learn
- How order intake, backlog and the book-to-bill ratio act as leading indicators
- How operating leverage makes industrial profits swing more than sales
- Why capacity utilisation and the capital-spending cycle matter for materials producers
- How a cost curve shows which producers make money at a given price
Explanation
The business cycle was covered in lesson 2, and the link between commodity producers' shares and commodity prices is treated in the course "Commodities: Oil, Gas, Metals & Agriculture". Here we focus on the company metrics that tell you where a firm is in its own cycle.
Industrials and materials
Industrials include machinery, electrical equipment, aerospace and defence, construction and engineering, and transport companies. Materials include chemicals, steel, aluminium and other metals, mining, construction materials and packaging. Both depend strongly on investment spending by other companies and governments.
Orders come before sales
- Order intake: the value of new orders signed in a period.
- Backlog (order book): orders received but not yet delivered and invoiced.
Backlog end = backlog start + order intake − revenue(ignoring cancellations and currency effects). - Book-to-bill ratio: order intake divided by revenue. Above 1 means the backlog grows; below 1 means it shrinks.
- Backlog coverage: backlog divided by monthly revenue, giving the number of months of work already secured.
A machine builder with a long backlog can show rising revenue for many months after orders have started to fall. That is why order intake often turns earlier than revenue and earnings. Check whether orders are cancellable and whether large single contracts distort one quarter.
Operating leverage
Operating leverage describes how strongly operating profit (EBIT, earnings before interest and taxes) reacts to a change in revenue. Factories, staff and machines are largely fixed costs. When revenue falls, fixed costs stay, so profit falls much faster than revenue. A simple model: EBIT = revenue × contribution margin − fixed costs, where the contribution margin is the share of revenue left after variable costs.
Capacity and the capital-spending cycle
Capacity utilisation is actual output divided by maximum possible output. When utilisation is high, producers can raise prices and margins widen. High profits then encourage new investment (capital expenditure, or capex). Because new plants or mines take years to build, much new capacity often arrives together, sometimes just as demand slows. Prices then fall, and investment is cut. This repeating pattern is called the capex cycle.
Inventories add another swing. When customers reduce their stocks (destocking), producers' orders can fall more than final demand. When customers rebuild stocks, orders can rise faster than final demand.
The cost curve
Many materials are commodities: products of the same quality regardless of producer, so each producer is a price taker. A cost curve ranks all producers from lowest to highest cash cost per unit (operating costs excluding depreciation) and shows their capacity. In the long run, the price tends to be set by the cost of the highest-cost producer still needed to meet demand, the marginal producer. Low-cost producers stay profitable in downturns; high-cost producers may lose cash. Position on the cost curve is a key quality measure in materials.
Worked example
Hypothetical example: a machine builder starts the year with a backlog of €3,000 million. During the year it receives orders of €2,400 million and records revenue of €2,600 million. Fixed costs are €900 million per year and variable costs are 60% of revenue (contribution margin 40%). Cancellations, currency effects, interest and taxes are excluded.
- Book-to-bill: €2,400m ÷ €2,600m = 0.92. The backlog is shrinking.
- Backlog end: €3,000m + €2,400m − €2,600m = €2,800m.
- Monthly revenue: €2,600m ÷ 12 = €216.7m. Backlog coverage: €2,800m ÷ €216.7m = about 12.9 months.
- EBIT this year: €2,600m × 0.40 − €900m = €140m (EBIT margin 5.4%).
- If revenue falls 10% next year to €2,340m: EBIT = €2,340m × 0.40 − €900m = €36m.
- Change in EBIT: (36 − 140) ÷ 140 = −74%.
A 10% revenue decline cuts operating profit by about three quarters. The book-to-bill below 1 is an early hint that such a decline could come, even though almost 13 months of work are still secured.
Common mistake
Practice activity
Hypothetical aluminium market: four producers, each with capacity of 10 million tonnes per year. Cash costs per tonne: A €1,600, B €1,900, C €2,200, D €2,600. Demand is 30 million tonnes. On paper: (a) draw the cost curve, (b) find the marginal producer and the approximate long-run price floor, (c) state what happens to producer D if the price is €2,300.
Show solution
(a) Order the producers from low to high cost: A (0–10 Mt), B (10–20 Mt), C (20–30 Mt), D (30–40 Mt).
(b) Demand of 30 Mt is met by A, B and C. Producer C is the marginal producer, so the price tends to settle at or above C's cash cost of about €2,200 per tonne in the long run.
(c) At €2,300, D loses €300 cash per tonne (€2,300 − €2,600). D will tend to cut output or close capacity. A earns a cash margin of €700 per tonne, B €400, C €100.
Limitations: real cost curves change with energy prices and currencies, producers do not close immediately, and the price can stay below cash costs for a while.
Key takeaways
- Order intake and book-to-bill usually turn before revenue; backlog coverage shows secured work.
- High fixed costs create operating leverage: profits move much more than revenue.
- Capacity built in good times often arrives together and depresses prices later.
- In commodity materials, position on the cost curve decides who survives a downturn.
Next step
In the next lesson you will analyse two very different interest-rate-sensitive sectors: real estate and telecommunications.
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