Lessons in long-term profitability

If asked to name members of the Mittelstand – Germany’s cadre of mid-size businesses – you could be forgiven for drawing a blank. Perhaps Kärcher, which makes pressure-washers, and Miele, the white goods company, would come to mind, but the majority reside in narrow, often business-to-business, market niches.

Obscure they may be, but SMEs in the rest of world should take note. What Mittelstand companies lack in profile, they more than make up for in global trading success and a record of long-term growth and profitability.

Mittelstand companies, which generally employ fewer than 500 workers and generate annual revenue of up to €50 million ($68 million), weathered the European debt crisis remarkably well, according to a 2013 study by the German Savings Banks Finance Group.

In 2011, Mittelstand companies had increased their cash reserves to 19.8% of capital from 15.1% in 2009, the study showed. They were among the most profitable enterprises in Germany with a profit margin of 6.5%, while they held their labour costs steady. Large German companies generated a profit margin of about 2% in 2011.

To a great extent, the Mittelstand companies are powering Germany’s continued economic success.

Hermann Simon, former INSEAD professor, calls Mittelstand companies “super-nichists” in his book Hidden Champions. Essentially, they are companies that focus on narrow niches to achieve global market scale.

Mittelstand companies share many similarities. Seven out of ten are family-owned, and their average age is 70 years. They have an almost obsessive focus on quality and serving customer needs, says Stephen Roper, a professor of enterprise at Warwick University in the UK, who led a July 2013 study commissioned by GE Capital into European SMEs and Germany’s Mittelstand.

“By and large, Mittelstand firms are not pre-occupied with cost and price. Instead they are superb at providing value-added services such as post-sales service and training. They are close to their customers. You often see senior managers spending a lot of time on the road, and they also have a rather obsessive attention to customer need, which can be very powerful.”

These companies are also hugely innovative, eagerly embracing technology when it can improve operations and products, and are adept at incremental innovation and investment in R&D, which often benefits from being closely tied to their manufacturing expertise. They are also often focused on one core product, and making it of the highest quality.

Take flexi, for instance, the Mittelstand company that manufactures retractable dog leads. The firm, founded by Manfred Bogdahn, who invented the lead in the 1970s, now exports all over the world and continually adapts its innovation to market demand and the latest technological advances.

Playing to strengths

“These firms realise that if you can’t achieve the benefits of scale that very large businesses can, then a focus on reliability, quality and service are vital,” Roper says. “The result is medium-size companies with a disproportionate leadership in world markets.”

Geography plays a part as well, in two different ways, says Marc Evers of Germany’s DIHK business representative and lobbying group. Germany is in the middle of Europe and so is lucky enough to have access to 500 million customers within three hours flying time. But regional geography is important, too.

Mittelstand businesses are often closely affiliated with and have a long-term commitment to their native regions, which includes their links with local saving and co-operative banks.

The resulting range of financing on offer and the close relationships many of the regional lenders have with the firms they lend to (with lenders sometimes having representation on the board) gives more chances than are available in other countries for smaller businesses to grow without taking venture capital.

The role of the CFO is important here. “Financing communication has become better,” Evers says. “They report to banks regularly, maybe every three to six months about their financing situation.”

Forward-thinking finance

The Mittelstand CFO is also likely to be concerned with the best way to reinvest profits to fund growth, being less reliant on debt. This is partly a result of the pain Germany’s Mittelstand went through a decade or so ago when the country’s economy slumped and Germany was dubbed the “sick man of Europe”, Evers says. “In crisis we had to explore new markets, make costs lower and restructure our companies. We have now earned the fruit of these hard times in terms of a rising quota of own capital. If you look at the quota of own capital in Germany in SMEs, it rose from 4% in 2001 to 24% in 2011.”

Perhaps the most important factor in the Mittelstand’s success is the diversity of the markets its members serve. German SMEs are engaged in an average of 60 markets, and even the smallest are involved in exports: Those with annual turnover of less than €500,000 are still, on average, active in seven markets. “This makes them robust against crisis,” said Evers.

Culture is key

It also means Mittelstand managers, including CFOs, travel a lot. “The first visit in a foreign country is made by the CEO, but when negotiations are in a later phase, then often the CEO is accompanied by the CFO. They have very close affiliations to new markets,” Evers says.

Beyond the enviable strength they derive from fostering such an international outlook, there are other things countries and companies can learn from Germany’s Mittelstand. One factor at play is Germany’s apprenticeship system for young people, which gives workers practical skills and builds a talent pool from which businesses can draw.

Different financing and deal-making cultures also matter. In the UK, for example, growth happens more often through M&A, which means very often companies end up diversifying rather than dominating a niche. “There is a longer-term perspective in the management strategies of many of German businesses,” Roper says. “Growth tends to be organic; they reinvest in core market segments and try to dominate their niches.”

“The Mittelstand’s medium- to long-term, organic-growth, reinvestment-type model should at least challenge the criterion by which businesses work in the UK and US, for example, but you can’t lift and transfer the model out of Germany,” Roper says.

Roper’s study shows that UK firms may be close to matching German ones (and in front of those in Italy and France) when it comes to revenue growth. It found more fast-growing companies in the UK than Germany in 2012 – those that had grown by 10% or more in a year amounted to 17% of the UK firms studied, compared with 13% in Germany. The US can also point to its own vibrant mid-size sector, perhaps most evident lately in its entrepreneurial oil and gas industry.

Keep it in the family

Crucially, more German SMEs managed to sustain 8% to 10% annual growth over a decade-long timescale. And by dominating their markets globally, they are also incredibly robust. 

Arguably the greatest single reason for this is family ownership, Evers says. CEOs are often owner-entrepreneurs (although many higher-performing Mittelstand firms are family-owned but run by non-family management teams).

“Generally speaking, the aim of an SME like us is not short-term profit but long-term success,” says Karsten Schulze, partner of Berlin-based bus company HARU Reisen OHG. “Our focus is on the handover to our sons and daughters.”

“The other difference to shareholder companies or comparable companies in Europe is liability. Most Mittelstand businesses are organised as private companies with general liability for each partner. We risk losing everything – our private houses, cars and so on – so you will be very careful with your decisions and your partners in business.

“The effect is that we calculate risk very carefully. The employed capital is mostly financed by credit from our firm’s bank and the company’s resources, so we are clearly restricted in our possibilities.”

Schulze says the family ownership structure can make Mittelstand companies nimble. “We need a very short time to make management decisions, because we are not only working together in a company, we are living the company. It is part of our life.”

This is reflected, too, Evers says, in the priorities of their finance directors. “CFOs in owner-managed business must have the same long-term focus. They must think of the financial situation of the enterprise in 10, 20, 30 years. Ongoing and sustainable success is not a result of the sum of a company’s quarterly reports, but of strategy.”