Engineering and Capital Goods with Service Element

I have been thinking about this for quite some time. Recently, I came across a video about a crane operator that let me pen down my thoughts in this post. These are companies in engineering and capital goods sector.

Let’s take a look at this video of a company whose business is to provide crane services to wind farms.

Wind Turbines

The business of a wind turbine operator is to produce electricity out of the wind and when the wind turbine stops, the productivity goes to zero.

Let’s say you are a wind farm operator and you install one wind turbine per year. The wind turbine requires heavy maintenance once, every year. So, after 1st year you will start to see one turbine appear in your repair bucket in addition to the one turbine you have to install that year. In other words, you will have to work on two turbines starting from year one, one in “new bucket” and one in “repair bucket”. If the same goes for another year, at the end of the second year you will see one turbine in “new bucket” bucket and two in “repair bucket”.  In the case of wind turbines, we are dealing with moving parts such as rotors, bearings, gear, etc., that requires routine maintenance.

What’s the difference in the real world? The answer is the scale. In the real world, the scale is high and the number of units will be in 1000’s added to that the sector may grow at a rate of let’s say 10% a year.

Companies whose customers want them to win

I first came to know about this term from Steve Jobs in this video where he talks about IBM.

If we apply the same frame of mind to the business of a crane operator, we can say that wind farm operator needs a highly efficient crane company like the one we saw in the first video. We don’t want to the get into the MOAT of these businesses. There may be several other factors that would make this company an investment candidate which is not the focus of this discussion. A big wind farm operator may invest in their own cranes or a strong competition between two crane operators may erode the profit margin. Assuming that the wind farm don’t have a choice – except to use this crane company and assuming that this crane operator is so efficient to restore the productivity in short time and assuming that the cost of service is competitive, we can say that this is the type of a company whose customers want them to win.

There is another element to this. A business like renting a house or a wind turbine operator can be considered as perishable goods. Time is a critical element here, if we don’t use it then we loose it. In other words, the duration under which a house is under repair or a duration under which the wind turbine is not functioning, the company cannot produce any output.  The productivity is zero until it’s repaired, therefore it is essential that you repair them quickly. There is also a level of expertise and training required to be a technician to repair them. End of the day, you don’t want to repair them using a third party technician because you don’t want to compromise your productivity which will have a direct impact on the revenue and to the bottom line of the company.

Service Element

I would like to focus on the service element of a business like a crane operator. Let’s take John Deer to decode the service element in detail.

Please watch the video in Columbia Business School website to understand John Deer’s earnings (around the time 52:30).

Video Link: http://www8.gsb.columbia.edu/centennial/value-investing-live

As mentioned in the video, before, the earnings of John Deer (I haven’t done any research on John Deer – I’m just using the video to express my thoughts) came from manufacturing of machines and is therefore heavily dependent on investment cycles. The earnings go hand-in-hand with the business cycle and the earnings will take a hit when the business cycle turns south or when the economy hits a recession.

Today, it is not just a manufacturing company that produces tractors and diesel engines. John Deer produce heavy pieces of equipment with sophisticated technology that requires frequent upgrade and maintenance. This could be a GPS enabled tractor that would allow the farmer to plow the land via programming them in a touch screen or this could be a harvester that collects spinach leaves using laser or radar guided cameras. Irrespective of the category, these pieces of equipment have highly integrated hardware components and software that can be serviced only by an authorized professional. I recently read a news about farmers hacking the software to fix tractor components by themselves.

This may not be a new thing, consumer durable companies have tried the model in products like printers since a long time. I have a printer that requires the ink cartridges manufactured by the same brand,  those cartridges have chips in them that would prevent me from using a third party cartridge. In the case of a printer, I could take a cheap solution, but every time when I try to do that, I realize a friction in terms of experience. This is not the case with capital goods. These are capital-intensive investments that are depreciated over a decade. Like in the case of windmill operator, we wouldn’t want my production to stop. This is even critical in vertically integrated business like textiles or cement.

The service element could also make the company’s earning less affected to business cycles. The earnings during a slow growth period may be compensated by cash flow from service components like maintenance and repairs. The consumer-facing companies with service element may also have a loan book that could create a cash flow in addition to selling goods and services. These businesses could dominate the local markets and may have a high barrier to entry through network effects, cost, and service.

Design Thinking and Feedback Loop

The design thinking has been with software technology for quite some time. This is something I came across a few years ago from Nordstrom, a fashion specialty retailer in the United States.

Design Thinking

You may also enjoy the video where the Nordstrom team applies design thinking to a solve real world problems and the insights they gain from talking directly to customers.

 

I also came across this beautiful page from IBM which explains everything. Please make sure to dive into Observe, Reflect and Make to understand IBM’s philosophy about Design Thinking.

IBM Design Thinking: https://www.ibm.com/design/thinking2/loop/

I believe, the same thought process can be applied to manufacturing companies. The feedback loop creates a breeding ground for innovation where a manufacturer or service provider constantly learns about customer problems, gain insights and create an effective solution to their customer.

Conclusion

There is this concept called loop length. If we define loop as a continuous cycle of understanding customer’s problem, gaining insights and providing suitable solutions, we can think of loop length as the length of this loop in terms of time and cost.

As technology penetrates deeper into the manufacturing sector, a manufacturing company with service element would be very powerful as it brings the company closer to their customers – thereby shortening the loop length. This constant feedback loop also enables the company to provide greater value to their customers by providing solutions that it solved for one customer to their next customer. This also enables these companies to create higher customer value in the long run.
Disclaimer: This post is for educational purpose only.

 

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