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Paulo LeitaoMercurio Capital Ltd

Business Mathematics Made Simple

Industrial sector economics and the wealth

of nations

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We will cover

• (15 -20 minutes presentation)• Overview industrial production in different

countries• Capital Intensive (high Capex) – the basics• Cost of equity• Conclusion• Q&A (20-25 minutes)• Ask for footnotes

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Natural resources make a country rich. Capital intensive sectors are old-fashioned. Investors can make more money in digital

economy than in heavy industry. Germany is very successfull with their

industrial and manufacturing sector. UK economy will never have a strong

industrial sector.

Agree/disagree?

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UK auto industry exports more cars than it imports. Last time this happened:1976

UK place in world Industrial production 1895: 1st (15%) UK place in world Industrial production 2015: 9th (2.3%)

Labour force in manufacturing: China: 100 million UK: 2.3 million

UK industrial success stories: Automotive Food & Drink Pharmaceutical Semiconductors Aerospace and defense

Some numbers...

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Germany’s industrial sector weight on GDP: 29,1% (25,1% industry, 4% construction)

UK’s industrial sector weight on GDP: 21% (14,6% industry, 6,4% construction)

This difference in numbers...GDP difference impact between 25,1 and 14,6: £ 192 billion*Jobs: 612.000 extra jobs**Would make the UK 5th largest in World GDP, from 6th***

* UK GDP 1.832 trillion X 10,5% (25,1-14,6) = 192 billion**(Labour fource 31 million X 18,8% industry related jobs) * 10,5%*** World Bank, United Nations, CIA Wold Factbook data

Comparison between Germany and UK industrial sector weight on GDP

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Everything is produced in China, nothing is produced in the UK. UK industrial components are often buried somewhere in an end-consumer product, with

final assembly in China.

Industrial units are big polluters of the environment. Potentially a fact.

“EU red tape” hinders and limits UK businesses. The Manufacturers Organisation (www.eef.org) manifesto includes campaigning to stay in

the EU.

Public cash help doesn’t make a difference when financing industrial “high risk” projects. Government “Business Finance Partnership” program has helped create £ 5 of lending for

each £ 1 of government guarantees*.

There’s financial resources competition between different sectors of the economy. Potentially a fact. Finance and construction seem to be linked, seeking “low risk”

investments rather than industrial “high risk”.

“Continental style” of capitalism provides better ecosystem for long-term industrial investments.

Anglo-Saxon style of capitalism led industrial production for most of last century (UK, USA).

Fact or Fiction?

*https://www.gov.uk/government/publications/business-finance-partnership-activity-report

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Capital intensive (high Capex) - basics

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Capital Intensive (HIGH CAPEX) versus

“cash-light” sectors

High Capex – low Opex/Low Capex – high Opex Liquidity premium (business plan and business

model lack of flexibility) Sensitivity to country/national risk

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Two typical capital intensive premiums

Liquidity Premium

Square root to payback and/or breakeven in years: (Initial

investment – salvage value)

Country Risk Premiums

Economist Intelligence Unit Country Risk

Reports (score system):

Standard & Poors Sovereign 10-year

yields

10-year Sovereign bond yield

%100scorecountryhome

scorecountryhomescorecountryndestinatioX

1cos

cos1

lifeproject

tasset

valuescraplesstasset

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Biggest risk: Feasibility & Capital Budgeting events

Time1 2 3 4 5 6 7 8 9

0

5

10

15

20

25

30

35

40

ReturnRisk

Licensing Build Operation

Biggest Strength: High entry barriers to competitors

The biggest risk and the biggest strength of capital intensive investments

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Project Finance as a typical industrial financial design

Project is the guarantee, not the company’s balance sheet or the director’s equity.

Locking the Risk: Income streams Futures Interest rates Swaps Currency forwards

Long term offtake contracts (5 to 20 years).

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Cost of Equity

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Cost of Equity

Return needed to keep the equity in the company

Intrinsic Risk & External non-controllable variables

Business Risk + Liquidity + Country Risk Main challenges with Equity:

Not visible (not cash/accounting cost)

Measured indirectly (Mkt multiples,Quantitative Methods, Benchmarking, Ungeared Beta, etc)

For private companies, more difficult to measure

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How does Cost of Equity climb/decrease?

1 2 3 4 5 6 7 8 9 10 11 120

10

20

30

40

50

60

70

Seed

Startup

Early Growth

Late Expansion

IPOMature

Cost of Equity (Required Rate

ofReturn)

Time

Event drivenTIO“T” - Technology“I” - Implementation“O” - Operation

Build

Present value

Future value

20% 20% 20% 20% 100 120 144 173 207 207

10% 8% 6% 4% 100 110 119 126 131 131

Purely financial dynamic: time

sensitivity

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Financial design - Cost of Equity – for capital intensive projects

1 2 3 4 5 6 7 8 9 10 11 12 13 14 15

Licensing

Business Premium

Build

Business Premium

StartUp

BP BP BPBP

BPBP BP BP BP BPBP

LiquidityPremium

LP LP LP LP LP LP

Country Premium

CP CP CP CP CP CP CP CP CP CP CP

EXIT Sweet SpotUncertainty

Years

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Conclusion

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Management Go/NoGo decision & “Design freeze”

Investment logic & capital

structure

Capital Budgeting

Operational logic

What are the ingredients of a successful industrial project decision making?

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Natural resources make a country rich. Capital intensive sectors are old-fashioned. Investors can make more money in digital

economy than in heavy industry. Germany is very successfull with their

industrial and manufacturing sector. UK economy will never have a strong

industrial sector.

Agree/disagree?

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Thank you!

Mercurio Capital Ltdwww.mercurio-capital.com

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