Secrets of a Good Industrial Business

Interview: Jonathan Bates-Kawachi

I met Jonathan Bates-Kawachi, CEO and Founder of n Industries, to learn how a good industrial business achieves – and keeps – their competitive advantage.

What do you think are the common misperceptions about what makes a good industrial business?

There are many more nuances to what makes a strong industrial business model than those commonly perceived by investors in the wider market, or non-industry participants.

For example, it is not necessarily all about intellectual property or patents, or scale. While something like Porter’s Five Forces is often a good starting point for thinking about competitive advantage, the nuances around what makes a good industrial business model run much deeper and can have many strands. At n Industries, as partners for our operating companies, we work with management teams to strengthen how the company’s products and services can become embedded with their customers even further.

We look for competitive advantage from multiple sources: and for these sources to be at a very low risk of disruption.

We look for competitive advantage from multiple sources: and for these sources to be at a very low risk of disruption. Ultimately, the strength of the business translates into good pricing power for the product or service!

We also look for our businesses that play in great markets, with strong structural tailwinds.

One thing worth highlighting early on is that there is no substitute for doing a good job for the customer, being a reliable supplier for them, in terms of speed and quality. Plus, of course, having a motivated set of employees and dedicated managers.

Even the best competitive advantage can unwind if the business is not looked after properly. Reputation can be lost quickly if the business is not run well.

What’s an example of a competitive advantage for an industrial business?

Yes, sure. One example is what I call the “cost of failure.” Think about the costs of running a production line or an entire factory, and the fixed cost of the workers at the plant or of the machinery if it is kept idle into the millions or tens of millions very quickly.

The factory manager of that plant will then be extremely averse to change. If something is working, especially on something that is an extremely small proportion of the overall cost of the plant, why risk a change that could result in a significant cost with no revenue? Whether it comes to continue using the same PLCs (programmable logic controllers) from Siemens or the same supplier for the tooling or a critical unique bearing in a plant conveyor system – why risk a high “cost of failure” for something that might only deliver a 10-15% saving on (much) less than 1% of the total cost of the plant?

The incentive is for the plant manager to stick with what they know works and keep using the same supplier. Managers are ultimately responsible for what happens to the plant – a significant loss could mean forfeiting a bonus or if the impact is more severe even mean risking their job and reputation! In other words, the switching cost or disruption from change can be extremely high and that gives you, the supplier, good pricing power.

What else would you look for as important competitive advantages?

Another one we look for is the company’s product or materials being specified into a long-life product (think one with a 10-15 years plus lifetime) produced by their customer, particularly within a highly regulated industry such as medical equipment, or aerospace and defence.

Once one supplier “specifies in” their particular component (for example, even a simple product such as a fastener) into the customer’s end product – the customer is typically extremely reluctant to change partly due to a variation of the “cost of failure” I just described but also due to the significant costs and time a redesign might entail. The manufacturing line, equipment or process will also be geared towards the existing components or materials used and a change can also involve a cascade in the costs involved to reconfigure or redesign these processes.

Moreover, if the end customer’s product is one which sells into a regulated industry such as medical, aerospace, defence, nuclear or one where the product has direct contact with something “consumed,” i.e. food or beverage, changing the supplier can be even more burdensome and involve attaining fresh regulatory approvals for the product – something you seriously don’t want to put yourself through unless the supplier has committed a major screw up.

You mention regulation – how do industry standards or broader regulations play into competitive advantage?

I’m glad you ask. Aside from the benefits of being specified into a regulated product where failure can mean life or death if done wrong (i.e. an aeroplane), regulation can also play an important role in defining competitive advantage for an industrial business.

You might be one of the few producers or suppliers of a safety system, for example, that has become the de facto standard for protecting workers at a plant or on a construction site. Given regulations and standards can often be country or region specific there is often a minimal incentive for a company outside of the limited sub-set of companies offering that service or product in a particular country (in our case the UK) to enter the market as it requires knowledge and expertise around a very specific subset of regulation.

A lot of technical expertise and differentiation is built around know-how, domain-knowledge and understanding of very specific application expertise that is non-patented IP.

Does a company making a technical product always require a patent or Intellectual Property (“IP”) to give them a lasting advantage?

No. We even run into examples where publishing a patent could even be counterproductive – as it almost issues a challenge for a competitor to find a work around for the patent!

A lot of technical expertise and differentiation is built around know-how, domain-knowledge and understanding of very specific application expertise that is non-patented IP. This level of technical expertise can be extremely difficult to replicate without years and years of experience. We hear many stories of competitors trying for years and years to replicate a product or process and eventually having to give up.

If your company has a proven solution and the domain expertise to mark you down as someone the customer can rely on, that in itself is often a very powerful barrier to entry – as it prevents the customer trying out other suppliers as it is not worth their time, cost or the risk. Being the incumbent itself can be a powerful barrier to entry.

There is also a shortage of technical trained employees in many disciplines within the industrial value chain of many developed markets including the UK – this makes replicating technical expertise around a specific process or product even more challenging as training staff with the requisite skills can itself at best take 4-5 years or more or at worst be close to impossible.

Some of the best businesses we see are often the only design partner a customer can turn to when designing a new product or process.

Know-how also cements competitive advantage we see as a result of “cost of failure” or being “specified-in” – having true technical expertise reduces the risk of a customer being dual source or multi-source from the very beginning of designing a product or a process. Some of the best businesses we see are often the only design partner a customer can turn to when designing a new product or process.

What are some other attractive business models within the industrial space?

There are many more attractive models that are also worth giving some airtime. Some markets can be so niche and small that it is really not worth another player entering the market as it would destroy returns for all players.

One often discussed model within industrials is an “agency pricing” model. The end customer for your product is not always the person who makes the purchase decision. On a simplistic level, when we are visited by a plumber or a locksmith at home how many of us question the piping or the valves or the locks that the plumber or locksmith proposes that they use?

In this way, many decisions are outsourced to the “agent” who knows best about which product to use. If you also save the agent time or give another benefit such as low risk of failure, you become the go-to supplier for the agent and can command a higher price to the end-customer.

Somewhat counter-intuitively, the agent actually benefits from a higher price for your product as they can pass it on to the end consumer with their own margin on top!

Agents themselves can also be attractive especially in industries which require a high level of technical expertise. Some customers may only need a particular new piece of kit every 10 or 20 years and, as a result don’t have domain knowledge in-house and need to rely on an expert agent such as a technical distributor when making the purchase decision. Other decisions are more frequent but require an expertise around automation or metrology or other technical area that the customer doesn’t have in-house – far better to outsource the decision to an expert who knows and especially one that has done a good job for you in the past.

Do you like service businesses? You haven’t mentioned them yet.

We love service businesses! And those that have a strong after-market component and especially those that service equipment which has a high cost of failure and/or is safety critical.

Everyone knows the benefits of a razor/razorblade model – these models can obviously be much more predictable and embed you with your customers. As long as you are doing a good job for the customer then there is a risk aversion to changing supplier – after-market businesses are further strengthened by the business being one which involves a technical sale or a high “cost of failure” for the customer around switching suppliers. Contracts can also be sticky – if you are a small part of the production costs for the customer and there is a risk that changing supplier can disrupt you – you don’t typically change unless something goes seriously wrong.

If you are a small part of the production costs for the customer and there is a risk that changing supplier can disrupt you – you don’t typically change unless something goes seriously wrong.

What in particular do you look for in a business if it is to become part of n Industries?

We are focused specifically on high quality UK industrial and B2B businesses. We estimate there to be more than 10,000 businesses in the UK with £2-15mn in revenue that have EBITDA margins or ROEs above 15%. That in itself doesn’t necessarily mean it is a good business or that it will be able to generate the same results in the future – which is why we analyse very closely what makes gives the business its competitive advantage and the risks of disruption.

We look for the competitive advantage at our operating companies to have many supports – for example if we can say the component produced by our operating company is not only “specified-in” but is in a highly regulated industry, requires years of technical know-how to produce and has minimal risk of disruption that is by our definition a great business for us to own, everything else being equal. If they also have a great after-market business – then even better! Ultimately, the stronger the competitive advantage of the business the better the pricing power.

Aside from competitive advantage, we also deliberately target great markets with GDP plus growth for our businesses, ones with great structural tailwinds that tie into larger societal change such as aging demographics, higher safety standards or energy efficiency.

What areas will you avoid investing in at n Industries?

Commoditised businesses where there are multiple avenues for the customer to source the same product from with minimal switching costs. Or where there is higher risk of disruption or where the company is a one-trick pony – if you are selling one particular chemical product, for example a polymer, what are the risks a better substitute product becomes available – especially as AI gets more involved in researching new material science.

Commoditised businesses are also less amenable to a decentralised approach as they require lowest cost and some form of scale advantage to make them work.

Anything else to add?

This is far from a comprehensive discussion! There are many more interesting angles on what makes a good industrial business model and it is never just one thing. There is probably a good book to be written if there isn’t one available already.

I cannot reiterate enough that while the competitive advantage of the business is what we look for – this still requires excellence in terms of culture and service levels by the operating company to ensure that it is sustained.

That is why, at n Industries, we are all about working with management teams that have developed excellent cultures for their business and ensuring they are motivated for continued success through our decentralised model.