Episode 7: Keyence

Kevin: Welcome to What Matters Most, Sands Capital’s podcast series in which we explore some of the trends in businesses that are propelling the pace of global innovation and changing the way we live and work today and into the future.

Today, we’ll speak with Sands Capital Senior Portfolio Manager and Research Analyst Suni Thakor and Portfolio Manager and Senior Research Analyst Danielle Menichella, who recently joined Suni as a co-portfolio manager on the International Growth strategy. Today, we’re talking about Keyence, a Japanese leader in factory automation that specializes in sensors and sensor systems.

So I want to thank you both, Suni and Danielle, for joining us today. You’re both return podcast guests. Suni, you and I discussed BioTechne, a great life sciences business, with Daniel Cheng. And Danielle, we had what I thought was a fascinating conversation talking about autonomous vehicles with Dave Levanson in our Aptiv podcast. So I would encourage listeners to check those out. I think you’d find them very interesting as well. But today, we’re diving into Keyence, a business I bet many of our listeners aren’t very familiar with, but one I think is pretty fascinating. So let’s dive right in.

Danielle, I want to start off with a little bit about you. You’ve been an investment and business analyst for many years. On our last podcast episode together on Aptiv, you talked about your history with the industrial sector and how your research has led you to gaining a deep understanding of pretty much how everything is made, which is obviously a very broad world there—so, that vast amount of knowledge on something that most people know very little about. Talk to us about how you found Keyence among all of that deep knowledge in the industrial space, and what led you to determining it was worth the deep dive?

Danielle Menichella: Well, I don’t know if I would say I’m an expert in how everything is made everywhere, but I’ve certainly been in my fair share of factories and manufacturing facilities. And when you’ve gone to enough of them, you start to notice patterns and recognize equipment. And you see things like cameras and sensors and conveyor belts and robots and cobots and safety equipment. And you start to notice where humans are in the factory, where they aren’t. What things are automated, which ones aren’t and why they might be automated.

Sometimes you see automation equipment as a result of the job that’s being done is just too hard for a human, like they have to move machinery that’s too heavy or awkward, or they might have to interact with dangerous chemicals. They might have to read an inscription that is too hard to read with their naked eyes. Sometimes it’s just a process that’s repetitive, and for quality control it makes more sense to have a machine do it over and over again with fewer mistakes.

Those are some of the reasons why you might see automation. And when you see enough of that, then you go to other factories and you could recognize where there’s room for more automation, and pretty much every factory has room for more automation. And then you also see some industries where automation is relatively underpenetrated, but there’s still this great opportunity set out there. Some of the equipment you see is really obvious. It’s like those big robots, and it’s obvious who makes them. They’re color coded according to the four big manufacturers. The problem with robot investing, though, is it’s a very capital-intensive thing to build—it’s a highly competitive industry.

It has high operating leverage, and all of that means that the bottom lines of these companies tend to be really volatile. So what I preferred to look at in terms of investment purpose was the businesses that make the sensors and the peripheral equipment: the cameras, the scanners, the safety equipment that get used either instead of—or with—robots, and one of the names that kept coming up was Keyence.

Kevin: All right. So what was so special about Keyence?

Danielle Menichella: So Keyence is an automation producer. They make sensors and other things that are used for inspection, for measurement, for placement and positioning. It’s a 50-year-old company that’s based in Japan, but they sell their sensors globally. And a lot of what Keyence does is products that are only a dollar or $2. So they’re very low cost to implement, but they provide a great service, and the service has a short payback period. It makes factory floor managers look really good quickly because they’re saving money. It is a market leader in this space. It was well-regarded by a lot of the people that we spoke to, whether it be companies or the factory floor managers themselves, integrators—integrators will use Keyence products to build equipment for customers. And they were also well-regarded by competitors and distributors, who sell other people’s equipment.

It’s a high-margin business. And that’s because it has a high software content to the sensors that they sell. They’re also fabless and fabless is important, because that means that they don’t have their own factories. They can outsource to a group of certified suppliers that they have good relationships with. And what’s great about that is, then you have no legacy equipment. You have no legacy products that you must continue to sell. You can discontinue anything that doesn’t have high demand or high profitability. And then the other thing about Keyence is that it has this very strong R&D engine. It’s the only company that has a direct sales force. The direct sales force is involved in selling, implementing, and maintaining the solutions. So they’re on that factory floor, they’re in constant conversation with the people who are using their solutions. So they’re hearing where the problems are and what else they’d like to have solved. So they go back to the R&D team and design the next products. That gives them first-mover advantage, which means higher prices and higher margins.

Kevin: Excellent. So Suni, you’ve followed along in this research as a research analyst yourself, but also as a portfolio manager, thinking about this business and how it might fit into the portfolio. Danielle just went through a lot of really interesting information that on the surface makes for a very compelling investment. What was it about Keyence that attracted you to the business? And I think also, when in that process for you did the light bulb go off?

Sunil Thakor: Well, there are a few things that struck me about the business. I remember our first real in-depth conversation about Keyence. I looked at Danielle, and I said, you had me at You also had me when you said fabless. And those two things together in the context of our criteria, scream “attractive business space” and “high margins.”

It’s an asset-light business that outsources the more commoditized capital-intensive parts of the process. And focuses solely on the high-value-added parts of its business. Then you juxtapose that with the idea that it’s opex—and not capex—that allows Keyence to sidestep one of the biggest challenges in the industrial space. And this is an area where I think Danielle and her colleagues have done an excellent job landscaping the industrial sector for us, because industrials in the minds of most investors, rightfully so, are full of capital-intensive, highly cyclical, low-margin, low-return businesses.

Keyence sidesteps that through its asset-light model, but then also selling products that are relatively low cost, high return and quick return, and point solutions, not large systems. And all of that means that the sales cycle can be much faster and is less impacted by the ebbs and flows of the broader capex cycle. When you put all of that together, you have still somewhat of a growth cyclical business, but with a much lower degree of cyclicality than would be typical in the broader industrials or even the industrial automation space.

Kevin: So that’s interesting, and let’s set a little context here. We’ve talked a little bit about this trend of global automation. Maybe you can give us an idea of how that has historically been unfolding and what you see in the near- and longer-term future. And then specifically, what’s next for Keyence and what role will that play as this unfolds?

Danielle Menichella: So automation has been around a long time. I mean, you could go back to the seventies and see the beginnings of it. Traditionally, you’ve seen automation in automotive factories and that mainly had to do with having the large robots to help move the cars around. Yet there still is a lot of room in automotive factories for further automation. The other big area where we’ve seen automation a lot over recent years has been in consumer electronics, especially as smartphones have become smaller and smaller.

And there, it’s less about the robots and more about the sensors and the machine vision, dealing with those small components and putting them together and reading ID codes and making sure they fit in the right place. And then, over the past five years, as automation solutions have become cheaper and more effective, there’s all different industries that are starting to see value in deploying them. And we’ve seen this in food and beverage, in pharmaceuticals, in medical devices, in furniture production, even things like toy production. And we expect over the coming years that automation will grow about a 10% CAGR for the next decade or so. Specifically within that, there will be areas that are going to grow faster.

Keyence will probably be a beneficiary of that growth, considering that it has lower-priced, as Suni keeps pointing out, opex not capex, high value, and fast payback periods. So that growth should be faster.

And then, Keyence’s growth specifically will come from several different areas. First of all, you have more factories being built. When factories are built, you deploy automation equipment, and Keyence is a beneficiary of that. Then you have greater penetration of automation solutions in factories, even factories like automotive. You’ll see, as we have more electric vehicles, there’s more of a need for robotics because you are dealing with a lot of dangerous chemicals that you don’t want people touching.

So you’ll have greater penetration in existing industries. You’ll have expansion into new industries. Like I said, food and beverage and medical devices. Those are relatively niche in comparison to others. Keyence will continue to introduce solutions and benefit from scale.

Kevin: You guys started looking at this business years ago and the world has, as it always does, but even more so now, clearly changed.

And we can go through the geopolitical issues, we can talk about regulatory changes, inflation, et cetera. But I think what might be interesting to hear your take on is how this company operates right in the middle of the supply chain, helping companies manufacture stuff that people want. Has their business been impacted by it? Is this a headwind or would it be a stretch to say this may even be a tailwind for what a company like Keyence does?

Danielle Menichella: So there was definitely a headwind related directly with COVID. I mean, factories closed. You couldn’t get on factory floors. You couldn’t talk to management teams or factory floor managers. You couldn’t sell your product. But we got through that relatively quickly. China closed before everybody else and then reopened. China’s a big market for Keyence, then that slowly happened in other parts of the world. So there was that initial slowdown. However, I think long term this is going to be a positive driver for automation demand.

What COVID showed companies or reiterated to companies was that we can’t rely on human labor. And that could be because, like I said, humans can’t physically go into a factory because of a pandemic. It could be because the job market has gotten so tight that they can’t fill jobs. It could be that we just don’t want people actually touching the stuff that we’re going to consume.

But for whatever the reason, I think that COVID has really shown companies that the more we can reduce reliance on human labor, the better. And this is a trend that we would expect to play out over the coming years.

Kevin: Suni, do you have any comments on the global situation and how a company like this will fare?

Sunil Thakor: So [in] my view, industrial automation is one of those inexorable trends that is affecting every industry, every product that we consume. And for that reason, it’s very hard to put a fine point on how big the opportunity is [and] over what time frame it plays out. On the other hand, it’s very easy to build a case and get your arms around the idea that the opportunity is massive, and we are very early in it. And from a portfolio construction perspective, it’s nice to own businesses that are benefiting from very long-term secular trends, even ones that are hard to measure, because that gives you a great degree of conviction around the sustainability of the above-average growth. And although it’s hard to put a fine point on the details, it’s very easy to understand the idea that the products we make are getting ever more precise, ever more complex.

And you’re trying to pull the human element out of it sometimes for profit reasons, sometimes for quality reasons. So then you zoom out, and you think about all the different types of products that we live with in our physical world, whether it’s the microphones we’re talking into right now, televisions, cars, any device that’s made, any physical device. And you think about all the individual steps of manufacturing that. It’s easy to get your arms around the idea that there is a very long-term, sustainable trend that is unlikely to reverse.

Kevin: So that’s interesting. Let’s now have you put both of your portfolio manager’s hats on. You’ve uncovered a really exciting business. You’ve done the work. Give us a little insight into your thought process as a portfolio manager. When you find a great business like this, what part of the investment process is it that allows you to gain conviction that this is not just a great business, but a business that deserves a place in the portfolio?

Sunil Thakor: So our starting point, as you mentioned, Kevin, is building conviction that this is a business we want to own and that is really rooted in our six investment criteria. Is it a leader that’s operating in an attractive business space, that has built a significant, sustainable, competitive moat around its franchise? Danielle’s laid out a very compelling case that that is true here. We think that, though, of every company we own in the portfolio.

There is no such thing as a perfect company. So from a portfolio construction perspective, the way we think about it is: What do we like about this business? What does it bring to the portfolio? What don’t we like about this business? We’ve already decided we want to own it. So we know there’s a lot more we like than what we don’t like. So we want to own it, but then find ways to mitigate the parts we don’t like.

So when we look at Keyence, as a business model, it’s among the most attractive business models in the portfolio. Whether we want to look at that from a financial perspective and returns on invested capital. If we want to look at the duration of the underlying secular trend driving the business and some of the stability around that. The one thing we don’t like is that “opex not capex” is great, but there’s still some inherent cyclicality in this business that is entirely outside of the company’s control. And there’s absolutely nothing we can do about that.

So the way to mitigate that in the portfolio is to pair it with companies where the business operates at a different cadence and is affected by different things and seek to introduce a broad diversity of growth drivers in the portfolio. From a business perspective, however, we think of Keyence as a top-10 type of a franchise in the context of our broader global portfolio construction. And then, we seek to mitigate the cyclicality of the business by owning businesses that just look very different and make money in different ways.

Kevin: Danielle, same question to you, and you have, I think, a unique position. All PMs are analysts, but you have feet squarely in each camp right now. So as you’re going through the process, are you thinking just as an analyst or are you also putting your PM hat on too and thinking, what else do I need to know beyond just, is this a great business to make that decision to add it to a portfolio?

Danielle Menichella: Well, as you pointed out, we’ve been looking at businesses like Keyence for many years. The first step in the process is purely analyst hat for me. It’s: Is this company an attractive business? Does it meet Sands’ six criteria? Is this something that I feel comfortable recommending to any strategy? And the work leading up to Keyence, the work in the automation space, the work we had done in robotics previously—that all was with my analyst hat. And then, once we do that work and we can answer that we have conviction and the strength of this business case, the strength of this business itself, the potential of growth over the next decade even—then we start thinking in terms of how does this fit into the portfolio?

And from that, I would say this is a business that proves to be more resilient than many of the other industrials businesses. It is affected by cyclical headwinds, but less so because these are smaller-priced tickets with high-value and low-payback periods that help other businesses be more profitable. So that’s how I get my arms around the comfort level there, that despite cyclical headwinds, that this is something we’d still want to own. And then we look at how the portfolio itself is built. How much do we currently have with similar growth drivers? And this is a diverse earnings driver. Keyence itself sells to many different end markets. And it is a trend that’s going to continue, and that’s how I get comfort with it.

Kevin: Excellent, so I guess it’s one of those of businesses that during difficult times for their customers, they become an even more integral part of their process. Help them make things cheaper, better, faster. And we saw that certainly in the energy space years ago.

Danielle Menichella: Yeah. Sometimes it’s not immediate, like during the financial crisis. They had weakened sales just like everybody else. But I think once the economic situation improves and those businesses have even a slight amount of money to spend on opex, they’re willing to invest quickly, because they realize that this helps them improve their profitability.

Kevin: Sure. So I imagine this is the kind of business that you want to see in action. Can you talk about, pre-lockdown, an example or two of watching this stuff work?

Danielle Menichella: Yeah. So at Sands, we do so much of our research on teams. We rarely travel alone. And we always bring people with different backgrounds. So all of us have been to many factories all over the world and all different kinds of industries. And I would say that’s really the first place that we get our background information and our background understanding for Keyence.

Secondly, we had a working group that did a deep dive a few years ago on the robotics space. So we learned about automation through that. And then when we think about the specific kinds of research activities that we do for Keyence, there are different kinds. Like I said, we go to factories. We have built up all over the world in Asia, in Europe, in the United States, these expert networks [made up of] people who are either customers or they may be salespeople or used to be salespeople for Keyence. People who work for integrators, who integrate the equipment that Keyence is selling to make robots or other things in the automation space. We speak to distributors and just experts who follow the trends. And that’s our greatest source of information and staying on the pulse of what’s happening.

Then we continue to go to vision shows and automation shows. There’s probably about three of them a year that we would normally go to in China and other places in Asia. There’s one in Japan. There’s several that we go to in Europe per year, and the United States, there’s at least two or three. And so there, you can see Keyence products in action. We can speak to Keyence salespeople, we can see the newest solutions that they’re bringing to market and compare those to what the competitors around them are providing. So that’s a great source also.

Sunil Thakor: So I think one of the hallmarks of the research process at Sands is that our portfolio managers are involved in the frontline research work with our analysts. So building the context along the way and really having more of a conversation rather than a cadence of: “Do research. Make presentation.” The flip side of that coin is that our analysts tend to be much more engaged in the decision-making process alongside the portfolio managers than is typical in the industry.

So instead of thinking of the portfolio manager and analyst relationship as a hierarchical one, I like to think of it as more of a continuum. And there are very few people in our firm that sit on one extreme of that continuum between analyst and PM. Most people—Danielle’s a perfect example—sit somewhere in the middle and are wearing different hats at different times.

That leads to much higher-context decision-making, and I think is really part of the secret sauce of how we do it in terms of linking that underlying research work to the portfolio decision-making. Because at the end of the day, they both matter a lot. It’s two different sides of the same coin.

Kevin: Yeah, that’s a good point. Thanks for sharing that. I mean, from my seat, I have never worked with a group of people more intellectually curious than Sands Capital. So it really doesn’t matter what your title or your business card says. Everybody likes to open the hood of a business and take a deep look at how it operates. And this is one of those kind of businesses that really lends itself to that.

I know I learned a lot of things, but I’ve never heard of the term “cobots” before. So I know what a robot is, but a cobot—that’s something I’ll have to probably Google after this.

Danielle Menichella: Well, I’m happy to tell you what it is.

Kevin: Quickly, what is it?

Danielle Menichella: “Collaborative robot.” It means that it’s a robot that is smaller, usually less expensive—not always. But it’s less dangerous. So most robots have to have safety equipment, preventing people from getting near them, because they’re large and they can move a lot of weight and they can cause harm if a person gets in their way. A cobot can work alongside with other humans without any sort of special security.

Kevin: Ah, it makes sense.

Sunil Thakor: It would be great if there were a cobot that could do house cleaning since we have three kids at home.

Kevin: I think it’s called a Roomba. Can’t pick up large objects though.

Danielle Menichella: I think you could actually see some of the cobots in certain bars on like cruise ships. They have a cobot bartender.

Kevin: Sure.

They’re in the mall now, I think.

Kevin: Well, we talked a lot about the company, very specifically, what they do, how they do it, that kind of thing. We talked about the industry and what its course is over the future. One thing we didn’t really touch on, though, is their approach to ESG. How do you think about that with your Sands Capital long-term investor hat on? How do you think about their environmental/social/governance profile?

Danielle Menichella: Sure. To me, with Keyence, the biggest risk is their ESG profile. They don’t do anything that’s that different than what other Japanese corporates have done, traditionally. But what we’ve seen recently is some of their competitors and some of their peers are trying to improve their ESG profile. And they’ve done this through modernizing their boards, adding women to it, increasing their disclosures, meeting more directly with international investors. One of the things that’s special to Keyence is that [it] sits on a large amount of cash and it saves that cash for a rainy day. We think that that cash would be better spent either paying special dividends or doing share buybacks. So these are the things that we would like to see Keyence do in the future. To me, the greatest risk is that they don’t follow suit with other Japanese peers, and they fall behind. But the fact that they have all of these things that they can do is a great source of opportunity that would really, I believe, help investor sentiment around the stock.

Kevin: And a big part of our approach to ESG is engagement. So have you engaged with management about that? Can you give us maybe a couple of quick anecdotes or stories about how you’ve talked to them about these issues?

Danielle Menichella: Yeah, we have approached these issues specifically with the management team at every call or meeting that we’ve done with them over the past several years. We have written to them specifically to lay out changes that we know we would like to see that we think would help them, and we continue to engage with them on that front.

Danielle Menichella: And I believe as a result of our efforts, combined with the efforts of other investors, that Keyence is starting to implement changes that are really helpful. We’ve seen more quarterly disclosures, quarterly releases of earnings. We’ve also seen them start to do something with the cash—like they recently doubled their dividend payment. And we would hope and expect to see more of these changes going forward.

Well, we again have learned a lot about this interesting space, this interesting business. I hope people listening to this podcast have learned a little bit about this as well.

So we’ll wrap up that part of the conversation and dive into the other part of the conversation that’s been fairly common on these podcasts—getting to know our guests a little bit better.

And I’ll start with you, Suni. Last time you were on What Matters Most, I asked you about career advice. What career advice would you give to a future investment professional? And you gave what I thought was a great answer, and it was to embrace uncertainty and ambiguity. So is that a fairly standard piece of Suni advice?

Sunil Thakor: It absolutely is, because I think it’s a fairly accurate description of the world we live in and it’s especially an accurate description of the industry in which we work.

In our work, we talk a lot about conviction. And conviction sometimes gets, I believe, inaccurately conflated with certainty. And conviction in my mind, does not mean certainty. It means, we believe that there is a strong probability that it is more likely that we are right than wrong and that more things will go our way. But ultimately, something that you need to get comfort with as an investor is you’re predicting the future. You’re making decisions with imperfect information, and there’s an uncomfortably large role of randomness and luck underlying every single one of our investments.

Now, the reason the process still works over time is because we believe good things tend to happen around what we believe are high quality companies. Competitive moats provide a buffer against missteps, and they make it harder for someone to come in and copy what you’re doing. Strong underlying economics or an attractive business space allow you to invest in different opportunities that can drive your growth. Even if you are imperfect in the execution, having a clear mission makes it more likely that you will execute on your objectives. So we can have quote-unquote conviction, without having uncertainty. We can have a mixture of outcomes.

Kevin: That’s a great answer. It’s very much a private equity approach as well. The likes of Peter Thiels and the rest have written a lot of books about that.

Kevin: All right. Well, thanks again to Suni and Danielle, and thank you to our listeners. We hope you enjoyed learning about Keyence as we dug into this fascinating growth story today. We invite you to join us for our next episode of What Matters Most.

Disclaimer: The views expressed are the opinion of Sands Capital and are not intended as a forecast, a guarantee of future results, investment recommendations, or an offer to buy or sell any securities. The views expressed are current as of May 1, 2022, and are subject to change. This material may contain forward-looking statements, which are subject to uncertainties outside of Sands Capital’s control. The securities identified do not represent all of the securities purchased or recommended for advisory clients. There is no assurance that any securities discussed will remain in the portfolio. You should not assume that any investment is or will be profitable. A company’s fundamentals or earnings growth is no guarantee that its share price will increase. For more information, including a full list of portfolio holdings, please visit our website at www.sandscapital.com.