Renishaw: The Precision Pioneers - [Business Breakdowns, EP.181]

0:03This is Business Breakdowns. Business Breakdowns is a series of conversations with investors and operators diving deep into a single business. For each business, we explore its history, its business model, its competitive advantages, and what makes it tick. We believe every business has lessons and secrets that investors and operators can learn from. and we are here to bring them to you. To find more episodes of Breakdowns, check out joincolossus .com. All opinions expressed by hosts and podcast guests are solely their own opinions. Hosts, podcast guests, their employers or affiliates may maintain positions in the securities discussed in this podcast.

0:45This podcast is for informational purposes only and should not be relied upon as a basis for investment decisions. Welcome back to Business Breakdowns. This is Matt Russell, and today we are covering Renishaw. Renishaw is considered a leading supplier of measuring systems and manufacturing systems, specifically focused on accuracy and precision. Now, what does that mean in layman's terms? Renishaw is a picks and shovels provider to many of the fastest growing end markets in the world. So you can think about anything revolving around semiconductors, robotics, medical devices. Renishaw designs and develops systems for complete precision, control, and reliability.

1:29To break down Renishaw, I'm joined by Matt Tong, fund manager at LionTrust Asset Management. Matt helps simplify this business, bring it into layman's terms, describing both the customer base and exactly what is going on with these precision tools. Then we get into some of the unique dynamics of revenue at this business. You would expect that the current semiconductor cycle would result in a massive windfall for Renishaw, and it might not have been the case quite yet. So we get into that, and then we finish off with a lot of the dynamics around R &D, through the cycle, what this will look like, and what the opportunity set is for a business like Renishaw.

2:07This is another interesting one getting into the industrial world. So please enjoy this business breakdown of Renishaw. All right, Matt, excited to have you here to talk Renishaw. And this is a name that I will say, I will admit, as I was going through a lot of the research and trying to understand this business, I could understand it conceptually through their presentations. But I needed it to come to life a little bit more. So I went to YouTube, I was watching some of the videos that the company puts out just to get an understanding. And there's some complex operations going on here that I thought you could help just right off the top, sketch out for us to the listener who's not familiar with Renshaw, what do they do?

2:50What is their expertise? And bring it to life a little bit. So Renshaw are a world leader in metrology. Metrology is the science of measuring things. If you think about the economy today and all that precision manufacturing that goes on in various different high -tech industries, the ability to measure the thing you're making and set up your machines correctly so you have these precision measurements. Think about aerospace, where things have got to be very, very precise. What British will do is they produce thousands of different products, but generally involved in either measuring things you've made or setting up your machines so that you have a process or a procedure which has less waste, more efficiency, I guess less human intervention in the manufacturing process.

3:34precision management was the term that stood out to me. And when I was watching these videos, again, I'm going to reference these YouTube videos, which for a listener, it might be helpful to just either look at the pictures or get a sense of the videos as well. There's a lot of equipment, robotics, manufacturing going on. And are these machines Renishaw machines, or are they outsiders machines, customers machines where there's Renishaw measuring devices, measuring tools put on there? Where do they fit into that visual? The answer is both. I guess a big part of their revenue comes in what they call machine shop.

4:11So if any of your listeners or you know, you've seen a machine shop where you've got people operating lathes, bits of metal spinning around being cut. Those machines, which are now, I guess, more commonly called CNC, computer primarily controlled machines. So they will typically be made by a machine tool manufacturer so someone like fanook and on that machine you will see a renishaw probe so a renishaw probe will be attached to the coordinate measuring machine the lathe will cut some of the metal and then the renishaw probe will come and it will hit that metal and go okay this bit of metal is this thick or it's got this surface finish on it so part of their a big route to market for them is them getting specified on original equipment manufacturers machine tools that is where they started they also as the business has evolved they also now produce their own machines so they have a device for example called an equator which if you think about a production line parts are coming through a production line part of that they'll go into a Renish or Equator machine they'll be measured and that would generally typically measure them against a reference part it is on my machine still intolerance making this thing and it'll move through.

5:19So they do have some standalone products. They're also involved in, they've got some medical products as well, which are all theirs. It's a blend between the two really. And that kind of also is their route to market. Some will be end user pulling, say I want Renishaw, and others will be pushed from the machine tool manufacturer. We often talk about value chains and maybe we stop the value chain at OEM, but in reality, it goes beyond OEM in terms of who their suppliers are to create the manufacturing tools. And even a step beyond that, you can go to the steel producers, the iron ore miners. It really goes all the way back.

5:53You referenced a few of the buyer bases that Renishaw would be working with. I think you mentioned aerospace. It seems like the healthcare industry is really large here. Is there some type of breakdown or concentration that you would reference for Renishaw that's particularly important in terms of end market or industry? If you look at the way they split up business, I'm talking here about 690 million revenue last year, about 94 % of sales, they say, come in from manufacturing technologies. And they have another 6%, which is in 6, 7%, which is in what used to be healthcare division, but they also do analytical devices, so Raman microscopes.

6:32And they're looking for chemical structures, those microscopes. If you look at the manufacturing technologies, there's basically metrology, industrial metrology. So this is things like CNC machines, coordinate measuring machines. So that would be measuring a part, not when it's in a machine, but come off it basically. They also have position measurement, which is what are known as encoders effectively. So what an encoder does is that we have one in your printer at home, but an encoder basically tells you where a thing is. So the speed something's rotating or its position going backwards and forward.

7:04So Encoders is a big market for them. That's about 35%, 36 % of sales in that division. And then they've also got an additive manufacturing, which is quite new. And that's basically 3D printing machines with laser bed technology. That's about 7%. And those numbers I just gave you are analysts' forecasts. The company themselves are a pretty secretive bunch in terms of engagement with investors. So you don't actually get that breakdown from the business themselves, but you kind of know where they're selling. and they're all being sold into machine tools in one way or another. You then got different industries into which they're selling.

7:36So I think the largest is precision manufacturing. So that's anything that needs to be precisely engineered that doesn't fall into any of these other categories. Automotive is a big sector. So that's a second, that's about 17 % of revenue. So think about anything to do with a car. Specifically as well at the moment, there's a big transition to electric vehicles and the way that these machines are probably going to be a big growth area for the businesses. this happens because the processes we're making in an EV are very different to an internal combustion engine and things need measuring, obviously, to do that because they're precision engineered bits of care.

8:09You then got aerospace industry. Consumer electronics is quite a big division as well. Famously, I think Apple are a customer. So when there's a new Apple device coming out, they tend to sell a lot of product into that. Probably their largest single concentration of customer is in the semiconductor equipment manufacturing division. It's been a bit of a drag on the business in the last few years, but when you make these wafers, you need to be able to measure them down to, I think they're experts in the 300 nanometer semiconductor manufacturing. And specifically, they've got some things that can actually check that these wafers are being made correctly, effectively.

8:44So that's their biggest single, I guess, drive of that industry, because it's not obviously a very big industry. There's only going to be a few customers in that. If you listen to the analyst calls, they're always got asking about when semiconductor up they're going to pick up again because it's one of the things I can actually accurately model in the I guess look at things around is that's the biggest shock that I might have heard why has it been a drag and a headwind when literally all the signs in the industry are pointing towards this being positive yeah so if you think about what drives Renishall's revenue it's capex it's new capex these parts don't really wear out very much you need new companies putting down plant equipment really to get the big sales I'm talking again about their main division here So I think it's cyclicality due to COVID.

9:26I mean, if you look at the amount of money spent, the change in valuation of fabs constructed, it massively boomed in 2021, and it's just collapsed down to single -digit growth at the moment. In 24, 1 % growth, actually, the thing I'm looking at here. Forecast to bounce back next year. But you look at Renishaw, that's just a business, and anecdotally, they've only got about two months' order, but window, they don't really have a lot of visibility. So the Q3 earnings call, everyone's like, okay, well, is Semicon coming back? And it's like, well, I think so. But hopefully, those timing of inflections in industries are really hard to call, right?

10:01Absolutely. Yeah. The two -month window is actually quite surprising just in terms of I would have expected it to be much longer just in the world of precision and needing these tools and a lot of that. So is that the case across their business line where it's a short -term visibility in terms of the future? Yeah, it really is. And it's been like that for as long as we've tracked it, really. So they'll tend to give you forecasts, which are two, three months ahead. And I guess you can look at things like industrial production. Analysts will look at Japanese machine tool orders as lead indicators.

10:36But I think because they're, and themselves being a manufacturer of their own product, they have, and they've got thousands of different products, they have quite a lot where you don't really need a lot of visibility of order time. And then they have other bits where you might might say somebody wants a coordinate measuring machine for a bit of jcb equipment they're this enormous it's not an off -the -shelf product they'd have so they'd have to make this for you specifically and that's going to probably take four or five months maybe so obviously there will be bits of the business that have longer visibility but on average it's like a two -month order window yeah so you can imagine as a listed company what that means for their results always missing all beating numbers the whole time.

11:16Yeah, I can imagine what it means for the investor who covers the company as well and dealing with that volatility and lack of visibility. Even four to five months for a turnaround is fairly quick just in terms of having the potential to do that. In terms of the revenue model, is it simply a selling of the tools and it's a one -time sale? Is there any type of service or maintenance provided on the back of it? Anything reoccurring in nature to what they're doing? It generally is how they make the money. They design these probes or these bigger machines, make them in their own factory, and then sell them onto either an OEM or if it's just a machine to an end user.

11:58All of our distributors as well, kind of around the world. So they'll make about 60 % gross margin on that manufacturing. In terms of reoccurring revenue and recurring revenue, as I said, this stuff doesn't really wear out. They'll give you some stats around if you look at who their customers are it's the same customers year in year out so in both their encoder division which is the second biggest and also their precision measurement probes and stuff something like 70 or 80 percent of their revenue comes from existing customers those existing customers have to be selling their machine tools to other people for them to get there'll be a stocking cycle in that but they have to be successful and work with customers.

12:35I think one area they are trying to bring in more recurring, but can't sit moving the dial a lot in terms of the whole overall industry, but it's clearly software. If you think about a machine shop and all the things that are going on in a machine shop, all industrial factory, controlling that of our software, looking at which machines have been out of tolerance, looking at what needs replacing, and then working with third party providers as well as their own equipment to give these people running factories a view about what's happening on the shop floor. That's kind of an ongoing future growth avenue that they're talking about.

13:09Because they've got the probes in there. So they've got a route to customers about connecting them up and data and AI, I'm sure will be mentioned at some point. So no, it's very much not recurring income, but reoccurring from the same customer base, I guess. That makes sense. Yeah. And I guess to use the semiconductor example, which you've referenced, it would be the case that it would need to either be a new fab or a new generation chip, essentially to really drive more orders. If businesses are... NVIDIA is basically just putting out the same chip, they might already have the equipment on hand, the Renishaw equipment on hand to produce that chip.

13:46So it's going to require, to your point, some additional capacity or some new generation, which might require a slightly different precision tool to drive more revenue for Renishaw? Exactly. Yeah. It's all about CapEx, really. Before we get too far into the business, I think we might have already done it. Just going back to the origin story here, you've referenced a lot of the key drivers of today. I think we could just list them endlessly, whether it's AI, chip, automobiles, 3D printing, everything would require this type of precision. But how far back does Renishaw go? What's the origin story and any key players that played a major role in them carving out this industry?

14:26It's a really interesting story and goes along with the way that we invest as well, looking for founders. It was founded by an engineer called Sir David McMurtry, who has just stepped off being their exec chair, literally in June this year, having basically run it. When founded it, invented business in 1973 in his house in a small workshop with a guy called John Deere. So these two engineers, I think Sir David, He was a mechanical engineer by trade and he ended up working at Rolls -Royce. He was an apprentice there and then he ended up becoming the chief designer. He was working on an engine for the Concorde, if you remember that airplane, the Olympus engine.

15:02And he was getting very frustrated that they couldn't precisely measure the manufacturing process of this engine. So he went back to his workshop with John Deere, who he worked with, and invited something called the Touch Trigger Probe, which is, if you look at any of their videos, it's a bit of metal with a little blob on the end of it. and that's what they used to start measuring things. That was 50 years ago, and that's him starting it in his house. And then if you look through the history of the business, he then first moved into a workshop in 1976, had about 20 employees. They founded Renishaw Incorporated in 1981, and it flated on the London stock market in 1983.

15:39Sales of $6 .5 million, a market cap of about $20 million. It made a million quid of profit. So it was a tiny, small company back then, head of my team, And Anthony, he invested in this company basically for most of his career. He started in 1996. So it's interesting. Moved to their current headquarters in 1985. They were making about 15 and a half million. Even back then, there were sales of 90 % overseas. I was looking actually back at their 1985 annual report on Companies House. And this is a good anecdote. And it tells you a bit about the company, actually. So back then, they had this brand new factory.

16:15I'll read this out because it captured it for me. These provide both creative and advanced lab facilities for study in all branches of mechanical, electronic, optoectalontronic, and software engineering. This unique in work environment provided by the building, its location, and the company's challenging brief has attracted some of the leading specialists in their particular fields. The company is headed by one such person, Professor Keith Rathmill, who recently joined from Cranfield Institute of Technology, was Director of Research and the Head of Robotics and Automation Editives. the first of such innovation is the opt high performance laser scanning probe which they launched three years later so basically they become a an engineering excellence business attracting some really high profile people to come and work for them and continue investing in innovation so if you kind of go through the years i mean in 1995 62 million in sales made about 10 million spent three and a half million quid on r &d research and development 2000 sales hit 100 million by 2005 sales were 150 25 million of profit and they started offices in india and russia in 2001 so david was knighted for his services to innovation in the uk now interestingly in more recent history so in 2021 so back to these founders so david has run the company's entire life having started it the 70s him and john still control about half the equity which is very rare for a company of this size in the UK.

17:36You look across America, there are quite a few, but they actually said that they were going to sell the company in 2021. They're in their 80s and they want to retire and move their equity on. But they launched this formal sale process, which is one of the leading 250 engineers in the UK, and then didn't actually find a buyer. And the thing they said was, we're deemed to provide an outcome that satisfactorily met all the interests of all of our stakeholders, effectively. so they really cared about where the company were going to go and who it was going to end up with and there's not a lot of information other than they didn't lead to anything but you have the sense that these founders really wanted to protect their investment basically and interestingly actually 2024 Siemens came out so they didn't want to buy the company but that would be an natural acquirer now they're both still on the board they both still got half the equity David's son's come on as a non -exec as well I guess that's one of the question marks as a shareholder.

18:28What is the future of this company for these two shareholders on the board? And we don't really know. So that's the history of it, really. It's been a brainchild of one man who's still involved, basically. Huge success. Yeah. A couple hours of researching the business, very much from the cheap seats. M &A still seems like it could certainly be in play, given everything that you just described there. But quite an interesting history. And to see founders of the business still involved at this point, I think it's always very interesting when you have those types of businesses and stories. Over the years, have there been major competitors to Renish or who is the competitor that stands out or the competitive set that stands out in terms of doing what they do?

19:09Yeah. So, I mean, depending on which market you're looking at, there's different competitors. I think probably the biggest one in their key market would be Hexagon, which is listed in Sweden, I think, Hexagon. Carl Zeiss as well, that business. and then if you look at position measurement i think the biggest one's heiderhane in additive manufacturing they've got quite a few different competitors there got smaller ones and then in their medical division where they've just got a couple of products which are quite interesting so there's somebody like bruce or thermo fish might be competitors but it's really i guess there are competitors in it but for them it's all about investing in r &d and innovation to make sure they've got best market leading products and that's the way that they protect their economic mate, I guess, is R &D.

19:54And then also just growing their distribution network and growing their partners in terms of OEMs. Are they unique in the sense that they operate in so many different markets? It seemed like what you were suggesting there is there are niche or industry -specific competitors in most of the markets that they operate in. I'd say most of the competitors are quite big. And most of those have other divisions as well. There's not really a pure play competitor globally. There's divisions of other businesses that have metrology businesses in them, but there's not a metrology business which looks like a Renishaw, basically.

20:28If you're looking for guidance from somebody else, I mean, Hexagon is one I would look at. It certainly makes sense that it either would be part of a much larger conglomerate or maybe something vertically integrated where this stands out as the pure play operator. We've talked a little bit on the revenue model and very interesting revenue model just in terms of the visibility. How does that impact the margin profile of the business? Is there more visibility or more of a normalized operating margin that they tend to see through cycles over time? How do you frame it as an investor just on the profitability and the margin profile of the business?

21:06It's a business that's vertically integrated. And especially the last four or five years post -COVID, it's been a lot of problems for industrials to deal with in terms of wages going up, can't get semiconductors, shipping's gone through. I mean, every company globally, but specifically you're vertically integrated. And then you want to obviously sell the products onto people and make money at the end of the day. But if you take those difficult years out, and actually they went through a restructuring in 2020, took a load of cost out. and I guess similar to lots of companies globally, unsurprisingly.

21:38What they're trying to target is mid -single -digit to high -single -digit growth organically, which comes from number one and number two market shares in certain things they do, which are growing and driven by these long -term trends. But as we talked about, they don't have a lot of visibility. And they're trying to make 20 % plus EBIT margin over the cycle and a 15 % return on capital. That's what they're aiming at. Obviously, it's quite hard from year to year to control those inputs and the outputs, but that's what they're targeting through the cycle. I mean, the way we look at it is we use something called cash flow return invested capital, which is a kind of similar ROIC accepted.

22:14It was a cash flow and includes tax inflation. The last 10 years, that's been about 13 .5%, which is double what your average UK stock makes. So it's about twice as capital return efficient as your average company. Interestingly, we're investing in quite a lot of UK industrials and that margin profile is not dissimilar to others, but others will have a lot more solidity in their earnings because they have more visibility and they have longer cycles and managing to deliver those numbers through the cycle, even though you've got this variability and you've got quite a big fixed cost base of people, 5 ,000 people spending hundreds of millions on R &D and CapEx every year.

22:53So to make that, it's quite hard. And talk about the bear points, they're putting down a lot of CapEx at the moment and whether or not that's going to lead to high sales. us, we hope. Interesting to see that return profile over the past 10 years. One point I wanted to touch on that mid to high single digit organic growth. Is that top line? Is that profitability? It's an impressive number, almost regardless. Curious where in the income statement. Yeah. So that's top line. It's a mid to a single top line and 20 % plus EBIT margin. And then they'd save 15 % return on invested capital. That's basically what they're targeting.

23:29Which is, If you look what they've done the last 10 years, I've done about 10 % over 10. So they have managed it. And if you think about the long -term trends of society and the economy, I think it feels like a realistic target without being overambitious. I mean, just thinking about the end markets, thinking about pretty much any industry that we talk about that has high growth attached to it, there is some precision required in terms of whatever they're building out. So it certainly connects from the basic smell test. On the free cash flow point, on the CapEx point, what does that look like today?

24:05What do those cycles look like in terms of CapEx investment? I can understand the R &D side of things and where that might be going from the CapEx side of things. What are they investing in? Is it hard asset infrastructure to build these tools? Are there other things that you would point to? I mean, there's two big uses of the cash that the company generates. The first, as you said, is R &D. So they're spending, I guess, most of their R &D, first of all, is spent on new product design or new product development, about 20 % maintenance. And you're looking at over the last, or since 2014, over the last nine years, I've spent about $800 million on R &D in total.

24:41So every year, I mean, I hope it was about $100 million last year, 85 the year before that. And that's engineering talent, generally in the UK, investing in new products. I mean, they're spending about 13 % to 14 % of sales on R &D. which your typical industrial spend about 10. That is one of the big reasons I think they've been so successful, but it's also one of the things you could say they're overspending. And if you're a private equity firm, you come and buy them and just say, right, you're going to do 10 now. There's a massive amount probably of overspend there. And we'll talk about some of the things that haven't worked maybe in a bit, but obviously not all of R &D is successful, I would say.

25:15And then on the CapEx side, yeah, it's all about, they're an interesting company actually, because they say that their biggest customer is actually themselves, because they make and they have their own factory, which is highly automated, which has their own equipment in it, which helps it become more highly automated. So they're almost testing stuff on themselves. So a lot of this capex, they put a lot more, basically increase the manufacturing capacity in their Michigan side and Wales by about 50%. They're spending, I think it was 50 to 75 million over the next few years doing that. That's basically a big old building, which is going to be making their machines in it, specifically there.

25:49I've got a new additive manufacturing machine, which has been proving popular, I think. And they've got big hopes that that will grow. So they're putting in that. And also they're spending CapEx on their existing facilities to make them more efficient. But I would say they're generally done, say 23 and 24 are outsized because they're building the Michigan side. They're putting more into that. Probably below that, you're probably going to do 30, 40 million a year, I guess. They're more like 70, 80 the last two years. And I guess when that tails off, CapEx will come down probably. And then some of the questions have been, when you look to allocating that capital, are you going to do any share buybacks?