Buffett’s Machines and the Rise of Asia’s Wide-Moat Machine Innovators – Bamboo Innovator Weekly Insight

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BAMBOO LETTER UPDATE | July 6, 2015
Bamboo Innovator Insight (Issue 90)

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Dear Friends,

Buffett’s Machines and the Rise of Asia’s Wide-Moat Machine Innovators

“CTB, which operates worldwide in the agriculture equipment field.. since we purchased it in 2002.. again set an earnings record. Vic Mancinelli, its CEO, followed Berkshire-like operating principles long before our arrival. He focuses on blocking and tackling, day by day doing the little things right and never getting off course. We purchased CTB in 2002 for $139 million. It has subsequently distributed $180 million to Berkshire, last year earned $124 million pre-tax and has $109 million in cash.”

– Buffett in Berkshire Hathaway 2011 Annual Letter to Shareholders

“I checked with Howie; he told me CTB was an absolute first-class company and he’d heard good things about Vic. Howie would rather spend an evening on a tractor in the field than a date with Angelina Jolie, which is not true of all members of the family, but that’s true of Howie.. I spent a little time talking to Vic and I knew that he was the right guy and CTB was the right company, and, boy, was that a lucky day for Berkshire. Ever since then, the operational results, the acquisitions that you’ve made, everything has exceeded my expectations.. Vic is a manager that could run any company in the Fortune 500. He’s done a wonderful job for us.. CTB has been moving ahead every year since we bought it. We’ll hit a bump in the road every now and then but we’re looking at a superhighway out there in front of us.. You know, this may be a tougher year economically than some we’ve had in the past, but we’re going to own CTB forever. So over the next 100 years we’re going to have some bad farm years, we’re going to have some bad years in the economy, but just look at the progress you’ve made over time, and I hope you keep doing more of the same.”

– Buffett address to CTB employees in a video posted on CTB’s website that he refused an initial proposal to bid for CTB, reversing his decision only after Mancinelli made a trip to Omaha, that his son Howard had recommended CTB and that CTB may produce profits beyond the year 2200.

Warren Buffett learnt about the power and business model of “machines” very early on. There is plenty for value investors to learn from Buffett’s wisdom about the business of “machines” to identify Asian wide-moat machines innovators.

In his senior year of high school, Buffett bought a broken pinball machine that had an original price of $300 for $25, and went to his friend Don Danly to fix it. Together they started Wilson’s Coin-Operated Machine Company, named after a fictitious Mr. Wilson to give the teens an air of credibility and authority. They asked a local barber if they could put the machine in the back of his shop, in exchange for half the money they raised. In just a single day, enough customers at the barbershop played pinball to make four dollars. Within a week Warren had enough money to reinvest to buy more pinball machines, which he negotiated into other barber shops, get it delivered and installed, handle maintenance and repairs, and he had to collect the coins from the machine. In terms of customer service, the boys always told the barbers that they would blamed Mr. Wilson for any unpopular decisions they had to make, such as why they were not able to replace older machines with newer ones. Buffett later sold the business to a War Veteran for $1,200.

As Buffett becomes the world’s most successful value investor, he added more powerful machines into his own acquisitive mega machine Berkshire Hathaway. One of these machines is CTB Inc., a worldwide leader in equipment systems for the poultry, pig, egg production and grain industries which was acquired for $139 million on its 50th anniversary in 2002. Buffett revealed in his 2011 annual letter to shareholders that CTB had performed very well and praised its CEO Victor Mancinelli. The business has – in a decade – distributed well over 100 percent of its purchase price in cash to Berkshire and its pre-tax earnings are roughly the acquisition price.

What accounts for the growing success of CTB?

Outfitting a farm can be a multi-year commitment. Knowing that the company you are buying from has a global network to provide outstanding customer service provides peace of mind to the purchaser. CTB operates from multiple locations in various countries around the world and serves its customers through a worldwide network of independent dealers and distributors. The depth of offering from CTB meant they are able to equip the entire farm to provide a one-stop solution, saving the farmer the trouble of attempting to get disparate systems to operate together. Once a CTB system is installed, switching to another is a highly costly transaction. CTB also undertook at least eight bolt-on acquisitions to expand its product offerings and integrate them into a total solution at a competitive price to outfit the entire farm, enhancing the farmer’s user experience.

Buffett also recently disclosed in March 2015 a 5% ownership in Deere & Company (NYSE: DE, MV $32.2bn), the largest farm equipment manufacturer in the world known for its high quality tractors, construction equipment, mowers, and other farm machinery. Buffett used a special confidentiality rule to delay disclosing the increased position he was building in 2014 in Deere, which has paid steady or increasing dividends since 1987, giving it a streak of 28 consecutive years without a dividend reduction.

Buffett’s experiences from the pinball business to CTB highlight several important axioms for value investors seeking to invest in machines or capital equipment companies. Value investors tend to overly focus on the observable, including the price-to-book valuation ratio, the order book to bill ratio, and the cyclical price-earnings ratio given that capital equipment sales tend to cyclical according to the industry’s business cycle, and overlook the wide-moat business model underlying the generation of the numbers. From the customer’s perspective in their purchase decision of machines, even if a company offers excellent products, they won’t buy from it if it doesn’t offer excellent and speedy repair services, given that breakdown in machines are inevitable which will be disruptive and costly to operations.

Thus, this is the major problem and constraint – and wide-moat opportunity if the problem is solved – in the business model: One Buffett cannot service 100 barber shops customers and “Mr Wilson” cannot be put to blame forever, which limits the scalability of the pinball machine business. In the case of CTB, some of the most important steps that Victor Mancinelli had undertaken since Berkshire acquired it, besides the successful bolt-on acquisitions, was the restructuring into Business Units and introducing the Rapid Customer Response (RCR) to bring “people closer to the customer” so that they have a “better sense of customer challenges” and are “more responsive to changing customer needs” to “continue to provide innovative solutions”. By valuing its employees, enabling their growth through training in lean manufacturing principles and techniques and getting everyone to understand department and business operations in detail, CTB creates employee engagement and ongoing commitment that improves productivity. These actions resulted in winning Buffett’s praise in his 2010 annual letter that sales per employee had more than doubled from $189,365 when they purchased CTB in 2002 to $405,878 in 2010. Thus, understanding the dynamics of this stall point can illuminate important lessons for both the Asian entrepreneur trying to scale his or her enterprise to a greater height and the diligent value investor wanting to generate sustainable compounding returns in machine or capital equipment stock.

With this Buffett wisdom in our pocket, value investors can travel to Asia with greater confidence to identify wide-moat companies beyond the quant screens and checklists. Let’s make the first stop at Mount Fuji in Japan to witness the breath-taking poetry in motion scene of robots making robots at the world’s largest – and most secretive – robot manufacturer. Then we travel to Kyushu, the third largest island of Japan and most southwesterly of its four main islands, to visit its rival who had developed a katana-wielding robot as an example of its capabilities and know-how with robots. Finally we will go back to Tokyo to visit another world-class wide-moat machine innovator that is arguably even better managed than the earlier two global champions and understand its management strategy called Lanchester Strategy that is named after the British aeronautical engineer F.W. Lanchester (1868-1946) who had researched attrition in land, sea and air combat, and developed the “3:1 rule” of Lanchester Laws.

Machines

Interestingly, despite the US producing the first industrial robot in the early 1960s and also having a robust auto sector, there are no US companies that are dominant in industrial robot manufacturing globally. We think one of the reasons why Japan has a robust industrial robot industry is because during the 1980s, Japanese auto manufacturers were early in recognizing the benefits of using robots in their assembly processes, which in turn facilitate the development of the Japanese robot industry.

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Read more at the Moat Report Asia: http://www.moatreport.com/updates/

PS: We are grateful to be presenting for the third time as one of the instructors in the 3rd Wide Moat Investing Summit on July 7-8. Instructors include: Thomas A. Russo, Managing Member, Gardner Russo & Gardner LLC, Paul Lountzis, President of Lountzis Asset Management; Todd Sullivan, Managing Partner, Rand Strategic Partners; Robert Deaton, Managing Partner of Fat Pitch Capital; and many more. Do join the global community of ValueConferences attendees, including professionals from Artisan, Baillie Gifford, Baupost, Bestinver, Chieftain, Citadel, Citigroup, Diamond Hill, GAM, Gardner Russo, GMO, GoldenTree, Goldman Sachs, IVA, Invesco, Merrill Lynch, J.P. Morgan, Raymond James, Rothschild, Ruane Cunniff, Schroders, Third Avenue, Tiger Global, Tweedy Browne, and many smaller funds, advisors, analysts, and individuals, to gain access to the best wide-moat investments.

Warm regards,

KB

The Moat Report Asia

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This month of July, we highlight Asia ex-Japan’s largest maker of a mission-critical automotive electronics part that is dubbed the “nervous system” in cars whose electronic content is rising due to the Green, Connected, and Autonomous automotive trends. Without this “nervous system”, the various auto parts cannot start and work. While it is considered a Tier-2 auto parts supplier, [Company’s name] directly participates in the design process of Tier-1 suppliers for most of its [Flagship product’s name] to be “designed-in” and as a result, enjoys sole supplier rights during the first 2-3 years following a new model launch. In addition, [Company’s name] has changed its sales model in China from a distributor model to direct selling, forging Tier-1 relationship with the major Chinese automakers, including accounting for over 50% of [Flagship product’s name] used in emerging electric vehicle maker BYD (1211 HK). Its top ten customers account for around 44-50% of sales. [Company’s name] has pursued the strategy of a diversified customer base to lower operating risk so that “no one “no one customer can seal the life and death of [Company’s name]”, and the rest of sales are contributed by hundreds of customers.

In the ruthless cut-throat automotive industry, the fact that [Company’s name]’s EBITDA margin at 33% is twice that of world-class Bosch India (BOS IN), arguably the best auto parts company listed in Asia, and [Company’s name]’s ROE of 20.5% is also higher than Bosch’s 14.5% speaks volume about [Company’s name]’s wide-moat advantage in securing long-term pricing power and earnings sustainability with the major OEM carmakers by winning their trust to strike long-term partnership. Bosch India trades at an expensive valuation premium of EV/EBITDA 42.9x compared to 12.2x for [Company’s name]. [Company’s name], with its technical superiority in developing low-cost innovative solutions and in generating higher profitability and growth, deserves to command comparable a higher valuation. Short-term downside is protected by a decent cash dividend yield of 4% and supported by a healthy net-cash balance sheet generated from internal free cashflow as opposed to external equity or debt funding.

Led by the highly inspiring Mr. C, [Company’s name] has toiled for more than 10 years since it entered China before bearing some of the fruits. [Company name]’s sales has climbed nearly 31% since FY11 while EBITDA growth is stronger at 78% with the impressive improvement in gross margin from 34.2% to 42.1% due to greater sales weight of higher value-add products that include [Flagship product’s name] for electric vehicles (EVs). Now the growth momentum has hit the tipping point for [Company’s name] to accelerate its profitability significantly in its visible long runway to supply the mission-critical automotive electronics part that is dubbed the “nervous system” in cars whose electronic content is rising due to the Green, Connected, Autonomous automotive trends. Net profit and EBITDA could potentially double in the next 5 years by FY2020, pointing towards a doubling in market value.

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About bambooinnovator
KB Kee is the Managing Editor of the Moat Report Asia (www.moatreport.com), a research service focused exclusively on highlighting undervalued wide-moat businesses in Asia; subscribers from North America, Europe, the Oceania and Asia include professional value investors with over $20 billion in asset under management in equities, some of the world’s biggest secretive global hedge fund giants, and savvy private individual investors who are lifelong learners in the art of value investing. KB has been rooted in the principles of value investing for over a decade as an analyst in Asian capital markets. He was head of research and fund manager at a Singapore-based value investment firm. As a member of the investment committee, he helped the firm’s Asia-focused equity funds significantly outperform the benchmark index. He was previously the portfolio manager for Asia-Pacific equities at Korea’s largest mutual fund company. KB has trained CEOs, entrepreneurs, CFOs, management executives in business strategy, value investing, macroeconomic and industry trends, and detecting accounting frauds in Singapore, HK and China. KB was a faculty (accounting) at SMU teaching accounting courses. KB is currently the Chief Investment Officer at an ASX-listed investment holdings company since September 2015, helping to manage the listed Asian equities investments in the Hidden Champions Fund. Disclaimer: This article is for discussion purposes only and does not constitute an offer, recommendation or solicitation to buy or sell any investments, securities, futures or options. All articles in the website reflect the personal opinions of the writer.

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