The European machinery sector continues to operate within an uncertain and volatile macroeconomic environment characterized by the ongoing war in Ukraine, the resulting energy crisis, and persistent supply chain challenges. Some companies have fared better than others. Our research suggests companies that weathered the crisis of 2020 were able to solidify their advantages, emerge stronger than before, and deliver sustained growth in the subsequent two years.
The road ahead offers both new challenges and new opportunities for the machinery industry. A solid order intake for the future indicates continued demand for machinery products and services. However, profitability is again under pressure, largely because inflation is raising material costs and consequently the cost of goods sold.
To stay competitive, European machinery companies will need to address the growing labor shortage by attracting, developing, and retaining skilled talent. They will also need to spur technological innovation at scale and at pace, decarbonize, and shift toward sustainable energy sources. A programmatic M&A strategy can advance these efforts, enable the digitalization needed to implement improvements, and support integrated solutions and services to unlock potential recurring revenue streams and create additional value for customers and companies alike.
The state of the industry: A regional perspective
McKinsey’s Machinery Benchmark finds that across multiple financial and operational metrics, European machinery companies are on a slower trajectory than their North American counterparts (see sidebar “About the research”). Despite strong revenue growth, the European sector has lagged behind in margin growth, M&A activity, and productivity (Exhibit 1).
Steady revenue growth across regions
European and North American machinery companies have continued a revenue growth trajectory following the initial disruption of the COVID-19 pandemic in 2020. Revenues in the European sector increased by roughly 18 percent in 2022, while the North American sector’s annual revenue grew at a stable but much more modest 7 percent.
European EBIT margins continuing to lag behind North American
While both regions experienced strong margin recovery in 2021, the two regions diverged, slightly but significantly, in 2022. In Europe, EBIT margins fell by roughly 1.3 percentage points to around 8.6 percent.1 In North America, companies experienced a slightly smaller decline of around 0.7 percentage points but sustained strong EBIT margins around 10.4 percent. The drop in EBIT margins for both regions was roughly half of the drop that occurred during the initial COVID-19 disruptions in 2020.
Only 40 percent of the companies in our benchmark managed to improve their margins in 2022, and about three-quarters of these same companies also delivered margin improvements in 2021. This suggests that companies that successfully bounced back from the immediate aftermath of the pandemic were able to sustain profitable growth through 2022. We expect this trend to continue, and to affect European and North American players equally.
A link between M&A activity and margin performance?
After a sharp drop in the second half of 2020 following the onset of the COVID-19 pandemic, M&A and divestiture activity rebounded within a year (Exhibit 2). At times, M&A and divestiture activity has even surpassed prepandemic levels, with more than 50 mergers and acquisitions recorded during some quarters in 2021 and 2022. A closer look at the regional distribution reveals a correlation between M&A activity and margin performance. In particular, the Nordic countries and North America have a similar rate of M&A activity and, as discussed in the foregoing section of this article, a similar upward trajectory in margin development. This suggests that continuous M&A supports margin resilience. Divestitures, on the other hand, have no obvious link to geographic regions. The North American companies in our benchmark lead on divestitures for the most part, with the highest share among their peers. This suggests a greater openness toward divestitures in North America and a tendency to protect the core business in Europe.
Variations in inventory stockpiles
North American inventory ratios remain stable around 19 percent, but a decline of inventory stockpiles is expected by the end of 2023.2 European players, on the other hand, continued to build up their inventories, reaching an average of almost 23 percent in 2022—an increase of around two percentage points. This is the highest inventory ratio since 2015, the year we began tracking this metric.
Good news on productivity across the industry
Average productivity in the European machinery sector increased by almost 10 percent from 2021 to 2022, following an 8 percent increase during the previous year.3 Less than 10 percent of the firms in our benchmark reported a decline in productivity. North American players also reported strong productivity growth of 9.5 percent, on the heels of 9.0 percent growth in the previous year. This is a positive development for both regions, especially in light of ongoing labor shortages, and affirms that they have the capacity to overcome production delays and avoid order backlogs.
Order backlogs across regions
Despite the increase in productivity for machinery players in the benchmark, order backlogs have continued to increase (Exhibit 3). The rise in incoming orders after a pandemic-related drop in orders led to a spike in backlog, which was exacerbated by labor and supply shortages. The German machinery industry’s order backlog began to rise in 2020 and reached an all-time high in late 2022. By April 2023, order intake had dropped significantly, by 25 percent, similar to the drop experienced during the pandemic. Though this drop will temporarily help ease the backlog, the long-term solution is to mitigate Germany’s labor shortage (see sidebar “Spotlight on the German machinery sector”).
Advancing labor, innovation, and decarbonization: The road ahead
Increasing the supply of qualified skilled labor is essential to the future of manufacturing in Europe. Automation continues to displace workers in some sectors and heighten the need for machinery workers trained to operate, service, and optimize robots and other advanced technology. The rising pressure to innovate in what is becoming an increasingly commoditized market means machinery players must compete for tech talent. And, as efforts to achieve net-zero targets intensify, companies must equip themselves to not only lower their operating emissions but also contribute low- and zero-carbon products and services.
A widening labor gap
The global manufacturing sector continues to grapple with a widespread labor shortage. In the European region, the number of open jobs rose by approximately 70 percent between 2020 and 2022.4 Since the beginning of 2022, this number has hovered slightly above 500,000 vacancies.5
The German machinery sector alone had approximately 250,000 vacancies in 2022—an increase of more than 100 percent from the previous year. Despite the staggering demand, the number of young people in Germany without the minimum education required for many career paths remained stable at 6 percent from 2011 to 2021 (Exhibit 4).6 This labor shortage has significant implications for the future of the sector, which requires a highly skilled workforce to operate and innovate at pace. Manufacturing vacancies as a share of total vacancies in Germany also increased between 2020 and 2022, rising by more than ten percentage points from an already high share of 38 percent to almost 50 percent.
The vacancy situation in Europe varies significantly by country. For instance, in the Czech Republic, the country with the second-highest number of manufacturing vacancies, the absolute vacancy level remained stable between 2020 and 2022, leading to a decrease in the relative share of vacancies.7 This means that the Czech Republic can acquire talent for open positions while continuing to grow.
Education and training programs can help address the shortage of skilled workers in the machinery sector, improve the quality of products and services, and spur economic growth and development. In particular, machinery companies and associations can experiment with specialized programs to recruit and integrate workers without traditional educational credentials, who represent an untapped source of potential talent.
Leaning in on R&D to lead innovation
Europe’s wave of innovation continued in 2022. After a slight decline over the course of the COVID-19 pandemic, the number of patent applications submitted to the European Patent Office (EPO) increased by more than 2.5 percent to more than 193,000—surpassing the record set the previous year.8 However, the overall number of patents granted by the EPO fell to 81,754, leaving many submitted innovations unrecognized and unprotected.9 No country in our benchmark maintained its pre-2022 level of granted patents.10 Of the top ten countries, China’s decline in granted patents was the smallest at around 15 percent, while Japan’s decline was the largest, at almost 30 percent.
While Germany remains the second-largest patent initiator in Europe (in absolute numbers), its share of patents fell by 4.7 percent between 2021 and 2022,11 and its R&D ratio has fallen each year since 2020. Some European regions, such as the Nordics and Switzerland, maintained a steady R&D ratio during the same period.
In the United States, the Inflation Reduction Act of 2022 includes provisions to expand domestic manufacturing capacity by encouraging investment; boost purchases of critical supplies from domestic or free-trade partners; and advance R&D and deployment for carbon capture and storage (CCUS), clean hydrogen, and other innovative climate technologies.12 To maintain their competitive edge in innovation, Germany machinery players should reevaluate their current R&D strategies, especially as growing labor and energy costs place them at a disadvantage relative to companies in other regions.
Globally, the number of patents for specialized machines decreased by 1.8 percent in 2022.13 The Nordic countries of Sweden, Denmark, and Finland rank in the top five in our benchmark for the number of patent applications as a share of population.14 Switzerland remains the undisputed leader, with more than twice as many applications as second-ranked Sweden.15 Trends in Europe have been promising, but patent issue growth in the past decade has been inconsistent. Only China and Denmark have experienced stable growth in the number of issued patents across all major sectors (Exhibit 5). This trend is particularly concerning for Germany, where average growth in the number of patents issued has remained low in most machinery categories, with the exception of handling and other machines. China, on the other hand, has experienced high growth in all categories except textiles, machine tools, and paper machinery.
Because the labor shortage is the bottleneck for the machinery industry’s output, companies remain focused on securing talent as well as seeking opportunities to automate production. The digital space, meanwhile, remains largely untapped, despite its potential to help create value and new revenue streams.
Innovation will be a strategic differentiating factor for European companies in the future as companies based in regions with lower operating costs continue to improve on product quality metrics.
Accelerating sustainability efforts
Along with raw materials, energy is a vital input to production in the machinery sector. Every process, from forming and forging to milling, is energy intensive. Because of the complexity and variety of parts in machines, the cumulative energy demand is considerable. Given the push toward decarbonization, access to sustainable energy is poised to become a key differentiator in the next few years.
European countries rank first in the world for share of sustainable energy relative to total energy production.16 Within Europe, Norway and Denmark lead, generating 98.6 percent and 85.8 percent of their energy from renewable sources, respectively, followed by Sweden at 63.2 percent, Finland at 59.8 percent, and Switzerland at 59.1 percent. In contrast, China has a roughly 27 percent renewable-energy share, and the United States trails at 22 percent (Exhibit 6).
The adoption of sustainable production is a necessary step across all industries to meet 2050 net-zero-emissions targets.17 Sustainability not only provides a reputation boost for companies that offer low-carbon products but can also improve quality across all products in a portfolio. This long-term trend toward product improvement can in turn support the opportunity for price premiums and more resilient margins in the future.
As machinery and industrial companies embrace science-based targets and make bold net-zero commitments, reducing carbon emissions becomes a nearer-term endeavor (Exhibit 7). Machinery leaders need to incorporate a sustainability perspective into their strategic decisions about sourcing parts or about where production facilities should be located.
Boosting the value of European machinery through programmatic M&A
As mentioned previously, M&A activity correlates with margin improvements. And McKinsey empirical research analyzing 20 years of data has shown that programmatic M&A, compared with other approaches to M&A, carries significantly lower risk and is more likely to enhance performance.18 Programmatic M&A strategy is organized around a central business case or theme and involves acquiring meaningful total market capitalization through at least three deals each year.
European leaders will need to leverage programmatic M&A to form partnerships that close the capability gap and keep the machinery sector on the leading edge of technological innovation. They must also invest in innovation governance and capabilities at scale and at pace. This means implementing agile practices and customer-centric approaches to manage high-risk, long-term projects. Companies will need to raise or reallocate funds for long-term innovation and business development on a larger scale than ever before. And just as important, they will need to build the skills and the capabilities to innovate.
The European machinery sector cannot afford to lag behind on innovation. A 2022 McKinsey Global Institute analysis revealed that Europe leads on only two of ten transversal technologies—technologies that span sectors—that will shape the global competitive landscape of the future.19 These technologies are characterized by their relevance across all major sectors in terms of their disruptive potential and include applied AI, distributed infrastructure, next-generation computing, and bio revolution. European machinery companies will need to invest in transversal technology sectors such as next-level process automation and the future of connectivity to become global technology leaders in the decades ahead.20
Partnerships with technology organizations and experts not only address the machinery sector’s shortage of transversal technology skills but also provide a competitive edge in attracting skilled labor. These collaborations enable more efficient digitalization as well as access to external knowledge and expertise, ensuring sustained competitiveness in the ever-evolving digital economy. Additionally, such partnerships play a crucial role in driving innovation toward decarbonization of machinery products, leading to significant reductions in emissions (Scopes 1, 2, and 3) across both the machinery sector and the industries it serves. Engaging low-carbon and carbon-neutral companies in regions rich in renewable energy sources may soon become a higher priority than labor and other operating costs.
Programmatic M&A can help to scale and expand the core business and can succeed even under seemingly adverse conditions. As McKinsey has outlined elsewhere, there are four approaches to deploying programmatic M&A.21 Machinery companies can yield considerable benefit by applying these approaches:
- Technology-driven acquisition. These types of acquisitions focus on securing patents and technological capabilities as well as on creating digital innovations to improve existing products.
- Acqui-hiring. The key objectives for these acquisitions are to help mitigate the industry’s skilled labor shortage and to save time and costs associated with training and hiring.
- Product expansion. These acquisitions have dual benefits: expanding an existing ecosystem to realize synergies and immediate growth in revenue and the customer base.
- Regional expansion. This type of acquisition typically focuses on a similar product or service offering that provides access to local market knowledge. Leveraging the existing structure, customers, and value chain accelerates market entry.
Labor shortages and global economic volatility notwithstanding, European machinery players have options available to address present challenges while strengthening the entire sector for the long term. Investments in education, training, new products, and renewable energy can help them realize fundamental, global goals of expanding the employment pipeline and achieving net-zero emissions. Companies that deploy such investments strategically, bolstering them with programmatic M&A, can fast-track innovation and forge new paths to growth.