German industrial manufacturing giant Siemens’ (FRA:SIE) focus on automation and emerging new technologies has helped it weather a recent downturn in national business sentiment.

Worries about the corporate German landscape have been intensifying, as companies have been growing increasingly dissatisfied with their current situation, according to the ifo.

The ifo said its business climate index in manufacturing fell “markedly,” amid business expectations that turned negative for the first time since May 2016.

Clemens Fuest, president of the ifo Institute, noted that manufacturers have scaled back their production plans, and while their assessments of the current business situation remain at a high level, they have deteriorated “slightly.”

The ifo manufacturing component plunged 16.4 year-on-year to a level of 14.8 in December and dipped 3.2 from the prior month. Overall, the ifo Business Climate Index fell to 101 in December from 102 in the previous month.

Siemens focuses on the digital world, while German engines sputter

Against this backdrop, shareholders appear to have grown somewhat nervous about Germany’s industrial sector.

The SPDR MSCI Europe Industrials UCITS ETF (SPYQ), whose top holdings include Siemens and courier service Deutsche Post (FRA:DPW), has seen its price plunge nearly 15.5% since roughly the start of 2018.

Meanwhile, Siemens’ stock has fallen by around 19.7% over about the same period, with its share price Tuesday trading at about €100.68.

Against this backdrop, the behemoth conglomerate said it has been busy reorganizing its operations, which is slated for completion by the end of the second quarter of fiscal 2019. As part of its new structure, its industrial businesses will be comprised of three operating companies, including gas and power, smart infrastructure and digital industries.

Siemens’ digital-related segments appear to be picking up the slack from other underperforming divisions.

The firm’s gas and power segment, for example, has been undergoing stress, which has been underscored in the latest quarter by broad-based revenue declines, along with a €301m severance charge and decreased demand for its turbine business.

Fitch Ratings analyst Çidem Cerit recently said she expects the power and gas segment to continue to lag “significantly” behind other divisions, due to structurally lower demand for its large gas turbines, as well as increased pricing pressure led by overcapacity issues in original equipment manufacturers (OEMs). However, Fitch noted that it anticipates the stressed profitability in that business will be mitigated by “a strong pickup in profitability in the digital factory and automation-related businesses.”

While profit in the gas and power division swung into negative territory in Q4 2018 from the same year-ago period, businesses such as building technologies (+18%), digital factory (+28%) and process industries and drives (+18%) were large gainers.

All told, profit in Siemens’ industrial business rose slightly to €2.145bn from €2.137bn a year earlier.

The cost of connecting everything to everything

Spending on the industrial internet of things (IIot) is expected to ramp up considerably in the near term.

IIoT generally involves embedding technology in physical items and applications to enable intelligent communication between objects, the environment, and people.

The International Data Corporation (IDC) recently said it anticipates spending on IIot will surge to a compound annual growth rate (CAGR) of 13.6% through 2022 when it could reach as much as US$1.2tn.

Carrie MacGillivray, IDC’s group VP of IoT and mobility, said that the IoT market is “at a turning point,” where projects are moving from proof of concept into commercial deployments. She continued that organizations are “looking to extend their investment as they scale their projects, driving spending for the hardware, software, services, and connectivity required to enable IoT solutions."

IDC added that it thinks manufacturing and transportation will each exceed US$150bn in expenditures in 2022, “making these the two largest industries for IoT spending.”

For its part, Siemens has been deploying IIoT in certain of its profitable divisions.

Activities in the company’s process industries and drives segment, for example, remain focused on the use of information and communication technologies to speed up its digital transformation of processes. The division is also involved in advancing simulation, digital twin technology and data analytics provided by digital consulting services.

Also, Siemens’ digital factory business centers on automation technologies used in manufacturing, such as for factories, which are supplemented in part by its cloud-based IIoT operating system MindSphere – connecting machines and physical infrastructure to the digital world.

The company argued that its digital factory will likely benefit from more surgical investment strategies in the wake of tighter monetary policies among some central banks, as well as from protectionist moves.

Siemens noted that the trend from globalization to regionalization is aimed at either protecting local economies or to better adapt solutions to local needs, and the trend towards digitalization “spurs companies to modernize their production performance to keep or increase their competitiveness.”

Buoying the bottom line

Siemens’ focus on emerging new tech has generally helped keep its profitability stable and maintain its credit profile in the investment-grade sphere.

Fitch, for example, recently affirmed its ‘A’ rating on Siemens despite large M&A, including France-based Alstom, as well as amid continued pressure in its energy-related business segments.

The ratings agency expects the firm’s credit profile to remain in line with its ratings in the medium term,
with funds from operations (FFO) net leverage hovering below 1.5x, backed by moderate free cash flow (FCF) generation, as well as additional cash proceeds stemming from its healthcare IPO.

The market’s perception of Siemens’ creditworthiness also appears to be aligned with Fitch’s assessment, with spreads on the company’s five-year credit default swaps (CDS) having tightened by around 2bps over the past three months to a relatively low level of 26bps.

Some of its U.S. dollar-denominated bonds have also recently increased in price, with its debt due May 2045 having reemerged into premium territory. The notes have risen by about 2.1% to US$100.96 after falling from a high of US$105.098 set at the end of May.

The yield on the U.S. Treasury Bond has fallen roughly 23bps over the past 12 days to around 3.11%.

Overall, it is likely Siemens may weather Germany’s weakening economic conditions as it continues to capitalize on new technologies and automation efficiencies to drive growth.

Looking ahead to fiscal 2019, the firm said it expects a profit margin of between 11-12% for its Industrial business based on its current organizational structure, excluding severance charges. Moreover, it anticipates basic EPS from net income in the range of €6.30 to €7.00 – also excluding severance charges.