#31 Disruption gets too much attention
What some Tech companies could learn from the big industrials of our time
We are back in earnings season. Companies are again presenting their results and we find some Tech companies with their feet turned. After a crazy decade of endless new hires every quarter, skyrocketing costs, reducing productivity, and increasing wages, winter has come and many companies have started to announce massive lay-offs.
In today’s post, we are going to see how some industrial companies founded during the last century managed to excel in a fast-changing environment with tools "easily" applicable to any company.
Welcome to Edelweiss Capital Research! If you are new here, join us to receive investment analyses, economic pills, and investing frameworks by subscribing below:
In today's world, with rampant inflation threatening to impoverish us all, investors listen to Mr. Buffett and try to look for asset-light businesses that can defend from inflation with better "structural" tools.
However, this should not make us forget the old economy. Some industrial companies have been able to adapt to changing times and compound capital at rates that many technology companies would wish to emulate. They have done so through tools that are often scorned as processes not applicable in the new productive world.
However, we are seeing right now, while we face the first fears of recession, technology companies are adapting to the new situation: Google's CEO criticized weeks ago the drop in productivity, Snap plans to lay off 20% of the workforce, Amazon acknowledged a few quarters ago that it had overinvested and was overstuffed. Clearly, some controls are not working in technology companies.
The success achieved in the last decade has caused companies to become permissive and wasteful. And let's not forget, all this misallocation of capital hurts us all. Not only as investors but also as a society.
The lesson is that even the worst industries or business models have examples of success. Just like the best asset-light businesses like software have examples of failure. The commonalities for success are pretty clear, and it's rarely about having an exceptionally disruptive product offering. Instead, it's about doing the little things right, with systems that ensure a consistent approach, even as leadership changes or business conditions change. Let’s see how some industrial companies have managed to watch time go by while compounding value.
Cost discipline and incremental process improvement
The most successful industrial companies have always emphasized the establishment of systems and processes over quick fixes. Systems that incentivize and drive continuous improvement throughout the organization over a long period of time. That almost always means being an excellent manufacturer, using tools like Lean Manufacturing. Think of how many companies with poor manufacturing processes have achieved long-term success. Those that manufacture brilliantly can get away with a lot of mistakes. The ones that do it badly have to rely on developing top-notch products with increasingly impossible consistency. Or they have to do a lot of big M&A deals to eclipse underlying weaknesses.
Operational excellence is absolutely critical to success. It is that excellence that drives above-average margins and subsequent cash generation. A very simple example. Apple's incredible productivity has always been talked about. Their small operating teams and their efficiency. How many hardware companies have those margins?
Lean manufacturing is the most common system in factories. Lean principles became popular with Toyota in the 1980s. In essence, Lean seeks to eliminate waste in the production process. If done well, the result is faster production time to meet customer demand that is difficult to predict, lower inventory levels, and higher product quality (fewer defects), all of which lead to a more efficient allocation of capital and a higher cash generation.
How many inefficient processes do we find in many companies today? Long meetings with a huge number of people who are wasting their time and from which the necessary conclusions and actions are not drawn because the decision-makers are not present. Non-optimized processes are repeated over and over again because they have always been done that way. The key is a compulsive attitude in building more productive systems, practicing continuous and consistent improvement over time, until the culture is built in all layers of the company through a system of incentives that ensures success.
That's why the best apply systematic tools to all their functions, including R&D, sales, purchasing, distribution, and back office. General Electric was on top of the world, winning in almost every aspect, but over time it took winning for granted and stopped focusing on the little things. GE let its factories starve, completely lost its focus on costs, and had to make bigger and bigger financial bets to hide its decline. All this while Honeywell and Danaher were doing the opposite and becoming two of the most respected companies in the United States. All three had deep pockets, and all three could "buy" wins, but one failed miserably. Remind you of anything? A company has to always be on the lookout for cost and efficiency. ALWAYS.
Capital deployment into higher return opportunities
Investing in the future is essential, in ways that people don't always understand. The key to long-term success is to create a powerful advantage over rivals, necessary to survive when the inevitable downturn arrives. Superior quality of technically complex products, marketing processes, or advantageous distribution networks are not achieved immediately. Companies have to build a moat with sustained investments in important competitive areas. If done well, these investments should end up yielding higher and higher returns. More profits, invested at the higher rate of return generated by the moat, lead to even more profits, and so on, the power of compounding, the flywheel.
Companies can invest cash internally in operations and new products or externally in acquisitions; it depends on the opportunities available. The key is to generate returns on that investment, translated into cash flow, that show compound earnings growth. Even better, companies that master capital allocation (regularly shifting in search of the highest return: organic growth, acquisitions, dividends, or share buybacks) earn lower funding costs, as investors pay for that success and debt rating agencies see better execution. Lower funding costs translate into higher capitalization, which gives those companies the resilience essential to survive for long periods. And that is largely a function of the ability to maintain profits and stable cash flow when conditions deteriorate. Companies like Danaher, Roper, and TransDigm, even in their more cyclical pasts, were able to limit losses during recessionary periods.
How can companies achieve compounding? As we have seen, operating discipline is essential. If every employee, process, or piece of manufacturing equipment improves by even 1% per year, profits will take a hit. And productivity gains of 2 to 3 percent a year are usually seen by those with true continuous improvement cultures. Those are the companies that really shine over time.
Surprisingly, cost efficiency is not explicit in the business model of many companies today. They prefer to work on strategic investments with very uncertain returns, or they lack the organizational strength to act decisively and change the allocation in a meaningful way.
Sometimes, industrial companies have chosen to change radically the business model and collective mindset of the entire organization. Buffett already did this decades ago by using Berkshire Hathaway's profits to invest in better businesses, leaving the legacy textile manufacturer to die a gradual death. Danaher went from a legacy tool company to a healthcare company through bold spin-offs and opportunistic deals. Honeywell dropped its best-known line of business, thermostats, to focus on warehouse automation and software.
Roper's history is quite interesting. In 2001, when Brian Jellison took over Roper as CEO, it was a 600 million revenue oil and gas supplier with a product line of pumps and test and measurement equipment. Its business was deeply cyclical, with near-death experiences every time oil prices entered a down cycle. Jellison ran an M&A playbook in pursuit of $100 million to $500 million targets with three requirements: lower asset intensity than Roper's existing portfolio, good businesses within specialized sectors, and excellent management to foster a decentralized organization with clear compensation and incentive schemes. Convincing the board of directors of his plans was no easy task. Many board members flatly rejected the idea. Other board members wanted Roper to stay at its core and divest other pumping assets. The results and performance are public for all to see.
These examples are less common, but they are emblematic of the extremes to which the strongest companies go in their quest for sustainable competitive advantage.
A ring to rule them all
Culture is another notion that many companies focus on, but often do not understand what it represents and how to develop and maintain it. We often read about customer-centric, excellence, ethical, or inclusive cultures. Mostly bullshit.
Culture isn’t something you can force or even actively promote using just words. It’s purely a result of the concrete directions and examples you give to people. It’s usually driven by whatever the leaders focus on, their actions, and the incentives set around the organizational deliverables. Leaders can’t impose a culture through just words, but if they embrace a system, use it consistently, and broadcast it to the organization, then eventually you get a culture pretty close to whatever that system encourages. The more consistent the message and the longer the duration of the effort, the stronger the culture.
Most successful companies measure pretty much anything that can be measured but narrow their focus to match up with the goals of the enterprise. They benchmark to compare internal operations. They benchmark to best-in-class peers and to those outside their own industry. They allow humility to reign. There is always someone out there with higher margins, better growth, and a higher market valuation. In continuous improvement cultures, benchmarking can be highly motivational.
As for specific data that companies utilize, we can find the 8 key metrics Danaher is using to rate its performance, focusing on its 3 key stakeholders: shareholders, clients, and employees.
Danaher has one of the most focused sets of metrics, perfected over many iterations. Again, little improvements over a long period of time. At its very foundation, Danaher is highly focused on cash flow. CFOs at Honeywell and Danaher offer up cash flow as the single most important metric they fixated on day after day, quarter after quarter. They both argued that a cash flow–focused firm typically has better risk controls, a sales organization with more price discipline, and a manufacturing organization with little choice but to embrace Lean principles.
Most of the best companies add an asset-return metric such as return on invested capital, but that can disincentivize investment and be manipulated, so it has to emphasize earning a return on new investment and allow time for that return to come to fruition. Good investments often take multiple years to really prove out. And ROIC doesn’t necessarily fit at every level within every organization. Plant managers are prone to underinvest, for example, because they rarely stay in that specific role or location long enough to reap the benefits of a modernization project. So there is a risk to a one-size-fits-all model. In any event, senior leaders need to be held accountable for investment decisions, particularly over the longer term. The best companies seem to have found the right push-pull on metrics, with the awareness that point-in-time targets conflict with continuous improvement and the flywheel. The last thing an organization wants to emphasize is the “sprint to the goal line” behavior that is now so common in business. It’s just not healthy, sustainable, or culturally positive.
The best companies have strong cultures, but only as the output of years of sensible actions, disciplined processes, and incentives set by leadership. Every employee knows the mission and works toward some facet of it every day. It’s a fairly obvious trait when you get to know it.
The idea for this whole article came after reading Lessons from the Titans, released in 2020 by 3 former sell-side analysts at Morgan Stanley, Barclays, and Lehman Brothers. I highly recommend it to discover what companies in the new economy can learn from the great industrial giants to drive sustainable success.
If you enjoyed this piece, please give it a like and share!
Thanks for reading Edelweiss Capital Research! Subscribe for free to receive new posts and support our work.
If you want to stay in touch with more frequent economic/investing-related content, give us a follow on Twitter @Edelweiss_Cap. We are happy to receive suggestions on how we can improve our work.
#31 Disruption gets too much attention
great coverage as always, thank you!