Strong Business Models is one of the 6-Key focus areas that we at Surge look for when we evaluate any investment opportunity.
Historically this focus area has led us to some of our biggest winners like those of Tips Industries, Suven Pharma and IEX.
In this post, we will highlight what to look for in Strong Business Models and one good framework to identify strong business models in manufacturing businesses.
In theory, moats are what gives businesses strength, which could be something like brands, distribution etc. But this is the old & simple way of looking at things, but businesses and markets are no longer that simple now. The real & new moat is companies that are doing value addition for their customers.
The more the value addition the stronger the business model.
Costco is a clear example of value addition business model. The business model for Costco is straight forward that we only want to make a small fixed margin of say 4% and then whatever cost & scale benefits we derive, we will keep passing the same to our customers and keep on increasing the value for them.
And one of the most important things to understand here is that this model of value addition to a large extent is also driven by the mentality/mindset of the management. Everyone knows the model of Costco, but no one has been able to replicate the same. And the reason for this is because not everyone has this mindset of limiting their profitability to a certain level, everyone wants to make more profits. And thus, business model driven by the value addition mindset are so much stronger.
One such value addition model that we have discovered on the manufacturing side of things is around low volume-high value-high customization manufacturing businesses.
B2B Manufacturing businesses are typically not a great business to be in. Manufacturing is highly capital-intensive business with high fixed overheads and thus running plants at maximum utilization as much as possible is important. And this is relatively easy to achieve by doing manufacturing of a single or couple of large volume mass market products that are required round the year on a continuous basis.
But in such a model, it is very difficult to establish a differentiation compared to other players whom you are competing with; resulting in a situation wherein the power rests with your customers, resulting in lower margins and lower stickiness of business.
However, there are few ways in which one can differentiate-
1. Being the lowest cost producer (This allows stickiness but rarely high margins)
2. Ability to produce something that no one else can on the back of some patented process or technology (Rare situations)
3. Provide Value Addition
Value Addition can be provided by addressing customer’s requirements around areas of-
Low Volume Production:
Some customers’ requirements are very small, wherein they do not require a product every week or every month round the year; rather they require small batches of products maybe couple of times a year. Not everyone can do this given that it would result in only part utilization of capacity and thus requires one to acquire large number of projects in order to utilize capacity well. Further, small volumes are typically required by premium customers with high-end products and it is difficult to acquire such premium customers.
Servicing Large SKUs:
Manufacturing large variety of products is difficult for most manufacturers as either it would require separate production line for each product or it would need switchover in the plant & machinery every time a different product is required to be produced, resulting in downtime and thus lower utilization. However, in some industries the requirements are such that large variety of products are required to meet diverse requirements of various customers. This further adds a level of complexity as one needs to maintain high level of inventory given that it is not possible to produce say 500 kinds of products each month, one must manufacture say 100 SKUs in one month & 100 SKUs in another month and keep the inventory ready to meet a customer’s demand.
This adds to another level of complexity for the manufacturer as providing a customized product as per customer requirement would mean that the manufacture would have to invest time & resources to develop the product and implement the custom process in its manufacturing process.
We have seen that a manufacturer whose business model is such that
-It Can Accommodate Low Volume Products
-Service Large SKUs & Maintain Large Inventory
-Offer Customization To Its Customers
Command Premium Pricing, Higher Margins, Better Client Stickiness and High Growth Opportunities, resulting in a Strong Business Model.
And here again we see that mindset aspect play out. Most people want to run a business wherein they can fully utilize their capacities day in & day out making some standard products and not work with 100s of customers & products. And this is not possible in the above highlighted model.
Some examples of such value-added manufacturing businesses are-
1. Contract Manufacturing for Innovators in Pharma Space (CRAMS/CDMO)
CRAMS/CDMO business models are working on the same principles that we discussed above
a. They are manufacturing drugs for Large Pharma companies that are under development and thus are needed in only small quantities.
b. Their customers do not require these drugs round the year, instead they require the same maybe once-twice a year.
c. CRAMS/CDMO players undertake larger number of such low volume projects in order to utilize their capacities well.
d. Not everyone is able to do CRAMS/CDMO with innovators given that it is difficult to establish relation with such Large Pharma Companies. But once the relationship is established, it continues for decades.
e. Each product that they must manufacture are different and are highly customized as per requirements of their customers.
The result of this value addition reflects in the extremely strong margins that companies like Suven & Divis make-
2. Off-Highway Tires Industry
Off-Highway Tiers are tires for Agriculture, Construction, Mining vehicles etc. The industry dynamics are such that a manufacturer needs to work with low volumes & high varieties of products. Reason for the same being that these vehicles are not mass-market products and their tires are huge and thus are not mass produced, but are produced in batches and that too in a variety of configurations. And since not everyone can handle low volumes & high varieties, the industry is said to be highly concentrated with top 4 players commanding ~70% global market share. Balkrishna Industries is an Indian tire company that has focused on this low-volume & high variety manufacturing and using the low-cost base of India created a very strong business model; and have created huge wealth for investors.
Using this framework of value-added manufacturing, we were able to zero in on RACL Geartech as an investment opportunity. RACL’s business model is based on the same principles of value addition wherein they make low volume & high value products for high end automobiles, resulting in sector leading EBITDA margins of >20%.
The above examples are from our research report on RACL Geartech. You can read the full report here- https://www.surgecapital.in/sample-report
There are many more such Strong business models across various industries; and not just in manufacturing.
If you are interested in more such actionable research, do consider Surge’s Membership. We have a lot of interesting ideas that we have recently added, that you can consider for your portfolio.
Link to our previous blog-
Disclosure: www.surgecapital.in (here in referred to as Surge Capital) is a domain owned by Ankush Agrawal. Ankush Agrawal offers independent equity research services under SEBI (Research Analyst) Regulations 2014. SEBI Registration No: INH000008941.
The above blog and examples given are in no means a recommendation in any manner and should be used for educational purposes only. We may or may not have vested interest in the examples above.