TRANSCRIPT

Ken: Good day, and welcome to a special edition of our Momenta Digital Thread podcast, episode 200. Michael Dolbec and I could not think of a better person to celebrate this milestone than welcoming back Andrew Obin, Senior Multi-industry Analyst BofA Securities Equity Research. Andrew was one of our most popular podcast guests last year, discussing his multi-industry sector coverage, including Aspen, Carrier, Dover, Eaton, Emerson, GE, Johnson Controls, Rockwell Automation, and Train- and that's just to name a few. Since that discussion, Andrew and his team have published one of the most bullish trends and forecast research reports that we have seen in the industrial space. When coupled with similar sentiments shared by world leaders at the World Economic Forum in Davos, it warranted us bringing back Andrew. Andrew, welcome back to our Digital Thread podcast today.

[00:01:32]

Andrew: Well, thanks for having me back.

[00:01:33]

Ken: It's good to engage on such a great topic. To help you set the context for this report, which hopefully will be out public, at least in summary, by the time this podcast is published, can you tell us a little bit about the transformation world, the digital industry World Series and the digital machinations theme?

[00:01:53]

Andrew: Sure, absolutely. Just to understand, I work in an equity research department. In equity research, we focus on fundamental stock picking; broader Bank of America research focuses on macroeconomic analysis and stocks and bonds. But obviously, big themes are also very important for investors. We, as an organization, strive to be a global thought leader. We have several themes that we focus on as research analysts with the idea to focus more on Big Picture themes for investors rather than just individual stock picking. Digital machination is a collaborative effort with my global colleagues, particularly my industrial and software counterparts in Europe and Japan- bringing unique insights as they cover key global competitors. These reports showcased the strength of global breadth and depth of global research, and we are able to bring together global insights from the US, Europe, and Japan in this report. Digital machination thematic- This is me and my European colleague, Alex Virgo, trying to dive deeply into all things digital as they relate to industrial companies that are becoming more and more involved in software. That's the genesis of this report, to give investors an overview from a different angle, and we call it digital machination. That explains the genesis.

[00:3:27]

Mike: Thanks, Andrew. Welcome, once again. This is Mike Dolbec. I don't think the 200th would be a bicentennial because it'd be 200 years, but it's an important milestone for us to have you on our podcast. You start the most recent chapter of this research with a bold statement that the return on invested capital equation has fundamentally shifted. What's this shift? What are the implications as you see them?

[00:03:53]

Andrew: Yes, absolutely. Look, we think COVID in the post-COVID world, right? Remote work, supply chain disruption, inflation- all these factors make companies take a look at how they can drive production and production efficiency. In some cases, we have a trend that the industry shows where the key issue for the companies is simply getting the product out of the door. Software and digital thread implementation to gain efficiency- makes it easier to do it in this environment than simply getting equipment. You need to sweat the existing asset base more to get the stuff out of the door. On top of it, I would add the focus on ESG, and you guys talked about it at the IoT Congress. But if you're running your assets more efficiently, you cut emissions and energy consumption. In Europe, energy shortage drives investment and efficiency and materially increases paybacks on these investments. To bring it together, within these investments, the payoff was there. But in the post-COVID constraints of the physical world, it brought the focus to what can be done to get the product out of the door profitably.

We also think that managements were able to understand better the value of digital in a more remote work environment and inflationary and supply pressures. All of this stuff improves buyback. Finally, we are entering a world where- there's just going to be more growth in the industrial world. We'll talk about the growth drivers later, but it also means more need for working capital and assets, which also puts pressure on returns. The companies must put all the pieces of the puzzle together to offset that, and hence, the newfound focus on return on capital. Think about new constraints in the post-COVID world, right? Changing cost structure, driving payback on a lot of these investment initiatives. Finally, more growth equals more investments, but shareholders still want good returns, so you have to figure out how to get this product out of the door, more products, more efficiently.

[00:06:18]

Mike: Thank you. It summarizes as the imperative to produce and become more efficient never goes away. But there's a new set of opportunities, and companies themselves are figuring out how to exploit the tools available to their advantage and take advantage of the opportunity.

[00:06:38]

Ken: The cornerstone of our conversation today will be the five key trends, and Mike, we'll get to that in a minute. But I wanted to have a "here's the good news" conversation early on. As a result of the shift you just mentioned, you updated your State of the Union, outlining that "Automation demand is accelerating." What will those forecast growth rates look like because of this demand accelerating?

[00:07:04]

Andrew: A couple of things. There are software and hardware components. Let's start with the hardware. Automation spending and particularly in the West, has been a function of OpEx. Which in the US is now becoming growth CapEx for the first time in decades as we expand capacity to accommodate onshoring. We see automation picking up from roughly 4% to mid-teens over the past few years. As I said, in the West, the drivers need to add capacity as global supply chains fracture and undergo transition, driving the need for CapEx acceleration. Of course, out in China, what drives CapEx is the need for the Chinese economy to transition, to up their game as stuff is moving out of China- more commoditized stuff to move into more value-add industries. For software, if you look over the past 10 or 20 years, you have 78% growth fairly consistently. This is accelerating, and it's what I have described; it's easier to do than Capex. Particularly in this environment, the transition to SaaS is accelerating spending, and what will be interesting to see is that those who get it right will enjoy accelerating growth while more traditional players will fail to make the transition and will see decelerated growth, if any, at all. You put it all together, on the software side, the underlying industry spending is accelerating. But we could almost double the growth rate to mid-teens for a sustainable number of years. Finally, I would add another lever: we've done some work looking at the wage inflation, driving automation spending. Of course, when I talk about adding capacity, we're not talking about the fact that there's less labor and a lot more expensive. Historically, we've done work that shows a very tight correlation between labor inflation and investment in automation, which is both hardware and software. We think you layer it on top of the factors I've just described.

[00:09:11]

Mike: Thanks, Andrew. Let's get to the meat of the five key trends that you've outlined in this report. I have summarized each of these points. I'll tick them off, have you dive into them, and then we'll keep going. The first key trend you outline is US reshoring- nearshoring. Is it really different this time?

[00:09:37]

Andrew: Yes, we think that. If you go and look back, US CapEx has grown at 2.8% over the past cycle, and tech has been the biggest driver of US de-industrialization over the past 20 years. From that perspective, we keep bringing up semiconductor investment. It moves the needle; specifically, we look at second and third-order effects on the supply chain. The way you should be thinking about it, you have 120 billion of announced semiconductor spend in the US over the next several years. We've published- you can look up the permits, see when they will start digging the hole and can, figure out when they will start moving equipment in, etc. From that perspective, that's real, but it's $120 billion of spend on a $500 billion CapEx spend base. If you do basic math- tech, moving offshore, and incremental capacity, going to Asia over the past 20 years has been the biggest driver of the slowdown and decline in US manufacturing. It's coming back for national security reasons, but it is coming back. One of the most interesting data points is the US Census data on construction spent on computer and electronics manufacturing. It is now running at twice the spending we have seen in the last 25 years. This is the US Census data. People often ask us, "What do you see?" What's interesting is the construction data is starting to reflect it, another data point. This is the first time in several decades that manufacturing employment in the US has fully recovered after a downturn. Finally, I was just thrown at the IRA. We've done work we think people don't quite appreciate that is part of the US industrial policy to build out a world-leading decarbonization industry. You put these facts and these trends together, and that's why we think it's very different. It's bringing back semiconductor capacity in the US and for companies in my coverage- as I said, second, and third-order impact. That's what's important. IRA spending, the government spending – the data is starting to show that this is moving the needle into real-time. Thank you.

[00:12:08]

Mike: To put a point on it, you cite the most obvious trend as the semiconductor manufacturing trend. I think you're saying it's not limited to people participating in that ecosystem but might also include many other things that manufacturers are associated with.

[00:12:28]

Andrew: I'll give you an example. We were at an industry show in Chicago and met a company that makes industrial degreasers. If you make all things metal, in order to reduce the heat, you soak it with oil as you cut it. We met a gentleman who sells industrial degreases for a large industrial conglomerate. The man was probably in his late 50s. He told us the demand for industrial degreasers had been the strongest it's been in 20 years, and you would not think industrial degreasers connecting to semis- but if you think about the entire value chain, there is a place for a piece of equipment like an industrial degreaser. Something very prosaic, not very high-tech. But that's what we're talking about here.

[00:13:16]

Mike: Excellent, thanks. Let's move on to the second trend that you cite, from industrial greasers to a different topic, but it's related. Your point on this trend is industrial software, and you coined this term; it's turning SaaS-y. Can you unpack that one a bit more for us?

[00:13:36]

Andrew: What we have been seeing- and like you guys know, that industrials lag- overall enterprise software market by maybe a decade?

[00:13:45]

Mike: Just a little bit, yes.

[00:13:46]

Andrew: We've seen the shift from on-prem to subscription, then Cloud-hosted offerings, and then we're starting to undergo the shift to true SaaS. Data and analytic software look at pieces- helped by enterprise software and shift to the Cloud. What you see their Cloud players bring their scale and capabilities to the industrial vertical. Another key market is PLM, and PLM growth is more tied to the broader CapEx cycle. The trend we described- they need to do more with constrained resources. I think what drove the embrace of SaaS is COVID. Because it was a material catalyst for how management thinks about investment, we've heard a lot of anecdotes. Senior management, you finally could explain to them the value of remote work, the fact that you didn't have to go and install this piece of software manually. We think there has been this change in thinking at the top of the companies, helping to drive this change and more willingness by traditionally conservative industrial players to embrace SaaS. A. The technology has matured, and you have more traditional players going after this market. But for more traditional software like PLM, there's this understanding as to what the value of SaaS is in the post-COVID world.

[00:15:19]

Mike: Yes, great. The major software vendors have figured out how to change their business model and offer things on a subscription basis. But also, you're saying the major consumers of industrial software are becoming more comfortable, thanks to COVID and other factors, that are consuming it on a subscription basis as well. Which in various industries hasn't always been the case. All the startups we deal with would almost always prefer to sell things on a subscription basis. Still, the customers aren't always ready for it. Things are warming up and heading in their favor in terms of business conditions. The next point is interesting to us. It's titled in your report, IT vs. OT, or IT plus OT, the rise of the Cloud vendors. Can you detail that?

[00:16:17]

Andrew: Absolutely. You see companies like AWS and Azure building out the ecosystem; you see investment in capabilities. As the software model shifts from on-prem to Cloud, the added hyper scalers are starting to be material. The markets put a very different multiple on traditional software versus subscription and SaaS, so in terms of market value creation, by going after these complicated markets, the industrial vertical is becoming a lot more important, not just the source of Cloud usage. I think that's how folks have viewed AWS and Azure's role in these markets But all of a sudden, it's a market that it's important in its own right as the SaaS TAM keeps growing. Our conversations indicate that industrial companies still view traditional automation players as having a lot of domain expertise and understanding of what is happening on the factory floor. These companies are not standing still; they are investing in partnerships and capabilities. Partnering with the hyper scalers absolutely sees hyper scalers advancing slowly and steadily. They bring real resources to develop the domain expertise and figure out how to develop the right relationships in the industrial space.

Right at the IoT forum in Barcelona, it was very interesting. You go to the AWS booth and see a mix of people who have grown up inside these companies and understand the Cloud infrastructure. But then you see these new hires with gray hair and years and years of experience in the industry. I would also say what struck me is that we're still figuring out some very basic stuff, and designs that win and get tractions in the market are sometimes pretty straightforward. Nothing overcomplicated. But they solve a very real issue today for a real customer. But as I said, it all goes back fundamentally right as the industry embraces SaaS. Traditional Cloud players understand that market. Initially, maybe they did not have a lot of domain expertise, but they're building out either through partnerships or by going out and hiring players who know the industry. It was fascinating to watch.

[00:18:54]

Mike: Yes, we've noticed the quality of people at the hyper scalers who have both Cloud experience and, very importantly, industry experience- and they have simpatico with what industrial customers deal with and want to achieve. The quality of the executives has risen quite a bit, and the hyper scalers have been very generous in trying to sponsor some of the portfolio companies we have. At least several of them were present in that AWS booth at the conference you cited as part of the attempt to pull together a suite of value for larger customers to take advantage of in their Cloud.

[00:19:34]

Andrew: When I was referring to the company having a simple solution but tying itself to a Cloud vendor, I was referring to one of your portfolio companies. But it's exactly right. It's a simple solution you put on the Cloud, and suddenly, you can do way more than just a piece of hardware.

[00:19:51]

Mike: Perhaps you're referring to Shoreline IoT, which you noticed at the conference. AWS does a good job of pulling together- on the surface, it looks like a point product. But when it's part of the hyper scalers' story, they help the customer understand- This is the on-ramp to the rest of our value that comes later after you drive up onto the on-ramp. Let's keep moving, Andrew. There are a couple of more trends that that I want to hit. The next one is also close to our hearts. You describe robots as an inflation beater, which they're not often mentioned in those terms, so I'd like to hear more about that, too.

[00:20:32]

Andrew: A lot of this work- I want to make sure credit is where it's due. It's done by my European and Japanese colleagues. This is where the robot manufacturers publicly traded once.

[00:20:44]

Mike: I see.

[00:20:45]

Andrew: But when we were at, I kept referring to IMTS back in September. One of the most interesting commentaries was that robotics was simply about getting a product out of the door. Before, it was an inflation beater. It's becoming a necessity, given the labor constraints in the market. Just general shortage of qualified manufacturing, labor, inflation, and ongoing retirement of all the workforce, which take with them a lot of shop floor expertise. That's part of it. But on top of it, wages are going up, and robot costs have been going down over the past 15 years. The price of robots has been declining roughly 2% CAGR, while the wages have been increasing at 2% plus. This is not taken into full account what's happened post-COVID. We did have this material acceleration in the past two years, and the price reduction statistics also do not consider an improvement in capabilities. Now, globally, '23 could be a soft patch, the same as spending. Consumer electronics- the traditional user of robotics is under pressure. I am more US-centric, obviously, and likely to be in a more positive market in '22. We've seen robotic orders in the US were up 50% from the pre-COVID levels. China is its own market and a key driver of global growth overall. The report we're talking about is a global report, so this is an instance of a much more global perspective that brings- but the US is a very interesting case. It barely reaches the top 10 in robot unit density, with Korea and Singapore as global leaders in terms of annual installation. China is five times bigger than the number two player, Japan, in the absolute number of robots. The US is number three, just to share the size of the economy.

I just want to bring it back. A) Clearly, robotics costs keep declining, wages keep going up, and it goes back. We spent some time in the report describing the connection between wage inflation and investment in automation. Just appreciate the US industry is not that automated. You have this vision of robots on the assembly line, but the penetration is still quite low. Our view historically, there has been a very tight correlation between labor inflation and investment automation, specifically in the US, due to labor constraints in the market- these are going to drive this investment into robotics. History tells you there is a two-year lag. In a way, what's going to happen '23, '24- the cake was baked two years ago.

[00:23:35]

Mike: If I understand correctly, you're tying this trend, trend number four, robots, as a way to attack wage inflation to trend number one, the US reshoring combined with the global trends. Do you think robotics' unit growth will start to happen in the US further than it already is?

[00:23:57]

Andrew: That's exactly right.

[00:23:59]

Mike: Or expanded outside of the automotive industry where it's most present.

[00:24:03]

Andrew: That's right. But all of these trends are very interconnected.

[00:24:06]

Mike: Yes, they're connected in dotted lines and many interesting ways. The next one connects everything in some sense. But the last trend that we wanted to talk about was- well, it's titled "Supply Chains: Flexibility versus Efficiency." But I think what you mean is that everybody has become much more aware of their supply chain and sensitive to it being interrupted because of various macro factors. How do you see what happened as a trend that influences other things?

[00:24:39]

Andrew: You nailed it. What is interesting is that a lot of this comes from the corporate boardrooms. Over the past 15 or 20 years, corporates have focused on costs. But at the same time, what it did, was it disregarded risk as the supply chain got longer and longer and became more concentrated. Also, longer lead times, people don't think about it, and a lot more working capital gets tied up. Now, it didn't get tied up at the corporate level; you outsource it. But throughout the supply chain, elongated supply chains and longer lead times do mean more working capital being tied up. There is a lot of talk about rising costs as we shatter these global supply chains.

This argument makes a lot more sense in some cases, like semiconductors. The reason we're doing it is for national security considerations. But boards have also rationally decided that volatility and uncertainty are the costs of doing business with these extended global supply chains, and there is no focus on minimizing the tail risk. That's what we're trying to talk about, flexibility versus efficiency. It turned out what we thought was efficient. Under stress turned out not to be as efficient, and there's this desire for flexibility to improve the resiliency of the supply chains.

[00:26:20]

Ken: Almost a cyclic equation going between centralized and decentralized, much like many corporate reorgs I've been at, but certainly applicable to the global supply chain. We heard aligned perspectives at the World Economic Forum in Davos this year with discussions of resilience, reshoring, and renewables. Tempered, of course, with discussions of trade wars, deglobalization, the global response to the US IRA or Inflation Reduction Act, etc. One of the day one session captured the sentiment with its title, "The Future of Industrial Policy." One of the panelists said, "Who would have thought even a couple of years ago that we'd be on the stage at Davos talking about industrial policy?" To what degree do such industrial policy may affect your forecasts?

[00:27:12]

Andrew: It's a key driver. This is a great question. Here are the big drivers. First, semiconductor investment would not have happened without concerns about national security. This is one sector that, if you look at these global supply chains at scale, brought a lot of efficiencies. You start looking at it from a national security angle, and maybe you have very different considerations. As I said, semiconductor, in our view, the near term at least, is the single largest driver of investment in the US and, to some degree, in Europe as well. Then, of course, you have the Inflation Reduction Act, and what we have written is that the way to think about it is the US is trying to build a world-leading decarbonization industry. The view is that the US missed the boat on solar and battery storage after the world financial crisis. If you look at the technologies, you look at the manufacturing capacity; it's all outside the US. A lot of it is in China.

Having missed that, I think what the administration is trying to do is to focus on hydrogen, carbon capture, and storage. What's interesting about it, if you think about it, the companies that are engaged in these activities- both the technology providers and consumers, a lot of these old economy companies- and I think there is very much a desire there to use the existing scale to build out world-leading decarbonization capability. Frankly, if you look at the headlines, there was concern in Europe about this. I think the Europeans have figured out that this is the US trying to build the decarbonization industry at scale. Because as I said, the technology providers are existing companies, and because the consumers of the technology need to consume it because of the ESG requirements, existing companies in the US- you put it together, and you have scale and government support. There's a lot of focus on buildings and energy efficiency.

To us, the trend that impacts more traditional industrial companies- and I think you're going to see more read across on the software side is this desire to have a world-leading decarbonization industry, and there's no reason the US will not succeed. I'll use another example, biopharma. I had a very interesting conversation in Barcelona. It's about the fact that during COVID, we've discovered that we no longer manufacture some very basic drugs or components. There's just a need to double-source. Once again, it's not about efficiency. In the ideal world, this works, but COVID has shown some countries, for example, restricting the exports of basic drugs because their people needed those drugs. You can completely understand that. I think these are three areas: semiconductors, the decarbonization industry built out through IRA, and biopharma. These three very interesting examples are driven by post-COVID industrial policy.

[00:30:40]

Mike: That's great. Thanks, Andrew. Just popping up to a macro level. My final question refers to some conversations we heard swirling around Davos. In general, there's a lot of concern over the global economy fragment. Many things are in flux, creating redundancies in manufacturing and supply chains in many countries, not just the US. Of course, that's one of our big concerns. But many countries seek to create more local and resilient sourcing. Do you share that concern? Do you see the industrial companies that you follow able to play that trend?

[00:31:25]

Andrew: I think I have alluded to that before, and you guys said it is part of this corporate cycle. I think it's a complicated answer. In the case of semiconductors- what do you do with the national security concern? How do you address that, short of what's being done? Another example I'll give you post-COVID; we can't make cars. The automotive industry is a huge source of employment in the US and Europe. The auto industry is all gummed up because the supply chain cracked under pressure. It worked great pre-COVID but didn't work so well after COVID. There is a lot of political rhetoric here. But part of it also rationally addresses the tail risk of disruption that we didn't know about COVID. As I said, the world is changing, and we're back to thinking about national security concerns, and it's part of it. Also, I wouldn't underestimate the hype there is about it because these supply chains are efficient in places where they create value, and they will continue to create value. It's more of a mixed, complex picture. I don't think it's as simplistic as what we had was great, and what we're having now is more negative. Look, the real world is quite a bit more complex than that.

[00:32:55]

Mike: No doubt, no doubt. Thank you.

[00:32:58]

Ken: In some sense, it goes back to the well, maybe a macro feeder for the whole conversation that is the duplication of supply chains and manufacturing efforts under reshoring movements are naturally going to create more investment, more industrial policy, and thus result in an uptick in the overall industry. The CEO of BlackRock talked about the decade-long trend- what did he call it? He called it the deflationary dividend in the sense that globalization created, effectively, deflation. Now, as deglobalization takes place in part or whole, you're seeing inflation being driven up because costs will be higher because of more infrastructure spending. It does make sense as a meta-cycle if you want to think about it in terms of that. Look, one final question. I know we were all together in Barcelona, and of course, we kicked off the Industry 5.0 fund. We had Sean O'Reagain from the EU Commission talking about Industry 5.0 in the keynote. What's your general perspective when you think of Industry 4.0, Industry 5.0, and their impact as a guiding hand to everything we're talking about?

[00:34:10]

Andrew: You guys were on stage, and you were talking about doing well by doing good, and I completely buy into that because of the investments in automation software and efficiency- the harder you sweat the acids, the less electricity you consume. You emit less CO2. Making the world a more efficient place is compatible with the goals of- more efficiency and being greener go hand in hand. I remember I had a bunch in California, it was a founder of a company that targets the oil and gas industry, and the guy brought up this fact; he said- I was shocked. He was talking about fracking. He was saying- if you look at how much good has come out of fracking in terms of lower energy costs, efficiency, and how much thought the industry has put into it- and yet, the industry cannot explain it. In a way, they cannot explain that these more efficient ways of lifting oil out of the ground are good for the environment. It was very different. I never thought about it, but you have people stuck with this view that this is good, and this is bad. As we look at it, companies in the petrochemical industry as we look at it they can be the greenest companies in the world as we go to net zero, reducing carbon emissions. Why? Because they can do the most, and if you think about how companies are measured on ESG, it's not where you are but where you're coming from and where you're going. What's interesting is it's the traditional industries that offer the most opportunity for saving; a lot of this opportunity comes from being more efficient and embracing modern technology. I think there are a lot of ironies there, and I think both sides should see better eye to eye because there's much more room for cooperation and arriving at a win-win outcome where we have a more efficient industry and a much greener environment, and everybody's happier. That's my answer.

[00:36:38]

Ken: Well said, Andrew. I'm impressed; I should have had you on the stage. Thank you for joining us today for this milestone episode that we've done. Any closing thoughts, Andrew?

[00:36:51]

Andrew: Well, it's always a pleasure to talk to you. I learn a lot from the folks at Momenta; I'm a huge fan of your podcast series. Thank you so much for having me on. It's always a pleasure.

[00:37:03]

Mike: Thanks, Andrew. Thanks very much.

[00:37:04]

Ken: Yes, and thank you, Mike. This has been Andrew Obin, Senior Multi-industry Analyst, BofA Securities Equity Research. Thank you for listening, and please join us for the next episode of our Digital Thread podcast series. Thank you, and have a great day. You've been listening to the Momenta Digital Thread podcast series. We hope you've enjoyed the discussion, and as always, we welcome your comments and suggestions. Please check our website at momenta.one for archived versions of podcasts, as well as resources to help with your digital industry journey. Thank you for listening.

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