Industry 4.0 is sweeping Central Europe, indeed the world. How does this affect your business?

We have organized this article according to the following sections: (a) What is Industry 4.0? (b) Rationale and Readiness for Industry 4.0 in Central Europe; (c) Our hypothesis as to how Industry 4.0 may affect businesses; and (d) Evidence supporting our hypothesis.

a, What is Industry 4.0?

The four industrial revolutions are usually defined as follows:

• The First Industrial Revolution used water and steam power to mechanize production;
• The Second used electric power to create mass production;
• The Third used electronics and information technology to automate production.
• Industry 4.0 is defined as the “ongoing automation of traditional manufacturing and industrial practices, using modern smart technology. Large-scale machine-to-machine communication (M2M) and the internet of things (IoT)¹ are integrated for increased automation, improved communication and self-monitoring, and production of smart machines that can analyse and diagnose issues without the need for human intervention “². In other words, the entire supply chain is networked and can communicate, enabling new ways of production while analyzing large amounts of data to solve problems.

b, Rationale and Readiness for Industry 4.0 in Central Europe⁵ Industry 4.0 offers Central European companies the potential to remain competitive in light of increasingly scarce labour and rapidly rising wages. (Whereas in 2010, only 5% of companies in CEE countries³ reported labour shortages, this increased to 40% by Q3 2018)⁴.

A 2019 report ranked the Central European countries by readiness to adopt industry 4.0, taking into account three main criteria: Technological competencies, entrepreneurship/innovation and governance.

Exhibit 1: 2019 Readiness for Industry 4.0 in Central Europe c, Our hypothesis as to how Industry 4.0 may affect businesses We would predict that early adopters of Industry 4.0 would enjoy higher valuations:

• First, because more efficient and productive companies would enjoy higher margins and EBITDA; and
• Second, because buyers are generally more prepared to value a business at higher multiples when a business is competitive.

To provide an oversimplified example:

• Let’s assume that pre-Industry 4.0 a company makes an EBITDA of EUR 1 million, and a buyer is prepared to give a 7X multiple, Enterprise Value would be in the range of EUR 7 million.
• Let’s assume that post Industry 4.0, on similar revenues, EBITDA goes to EUR 1.5 million, and buyers are prepared to pay a 10X multiple— Enterprise Value would be in the range of EUR 15 million—more than a doubling in value. (Of course, it may take several million euros of equipment costs, design, consultancy, etc. to implement Industry 4.0). But for those companies early-to-adopt and early-to-exit, the valuation premium can be quite substantial.
• Late adopters, however, will see their margins squeezed—and valuation fall. For example, due to high labour costs, and labour shortages (possibly even missing out on orders), let’s assume EBITDA falls to EUR 0.6 million. A buyer might only pay a 5X multiple. In these circumstances, Enterprise Value would fall to EUR 3.0 million. (Assumptions as to EBITDA and multiples are purely arbitrary, merely to illustrate the point).

In the longer-term, however, one would expect businesses with shrinking EBITDA’s to be driven out of business, and for Industry 4.0 to become the new normal, at which point, Industry 4.0 companies would no longer enjoy a premium, as competitors would have similar levels of technology.

d, Evidence supporting our hypothesis

We are not aware of any studies comprehensively comparing the value of business that have adopted Industry 4.0 compared to those that have not.

There is, however, some weaker evidence supporting our hypothesis. A report by William Blair studied a universe of industrial technology companies that in 2015 had gross profit margins in the range of 40% and EBITDA margins in the range of 20% and Enterprise Values at 8-12X EBITDA; by 2019, companies that had introduced Industry 4.0 gross profit margins increased to over 50%, and EBITDA to over 25% on average, with Enterprise Values augmented to 12-14X EBITDA.

In conclusion, we believe that those companies that adopt Industry 4.0 will tend to be the consolidators while the non-adopters will, in many cases, be driven out of business. A company owner who has not yet begun implementation of Industry 4.0 really has three choices: (a) do nothing and risk that the company may be see a substantial decline in value or be driven out of business; (b) sell the company before the effects of industry 4.0 become too pronounced; or (c) go full speed ahead to implement Industry 4.0.