Analyzing Industrial Companies: Backlog, Pricing Power & Cycles

Industrial companies make the machines, components, and infrastructure that keep the global economy running. They range from boring and predictable to wildly cyclical. Learning to tell the difference is one of the most valuable skills in quality investing.

The Two Types of Industrials

Industrial businesses fall into two broad categories. The first sells products that customers must buy repeatedly: replacement parts, filters, bearings, maintenance supplies. These are recurring revenue businesses with predictable demand. Their customers do not stop maintaining factories during a recession — things break regardless.

The second category sells large, expensive equipment: turbines, trains, construction machinery. These purchases can be delayed. When the economy slows, companies stop buying new equipment. This makes these industrials highly cyclical. Revenue can drop 30-50% in a downturn.

Backlog: The Crystal Ball

The most important number for any industrial company is its backlog — the value of orders received but not yet delivered. A growing backlog means demand is strong and future revenue is secured. A shrinking backlog warns that customers are holding back.

Backlog quality matters too. A backlog of standardized products with fixed prices is less valuable than one with escalation clauses that pass cost increases to customers. The best industrials have multi-year backlogs with pricing protection built in.

Pricing Power in Manufacturing

Not all industrials can raise prices. Companies making commodity parts compete on cost and have zero pricing power. Companies making specialized components with few alternatives can raise prices every year. The difference shows up in gross margins.

A company with gross margins above 40% usually has some pricing power. Below 25%, it is likely a price taker. The best quality industrials combine gross margins above 40% with EBIT margins above 15% — a rare but powerful combination.

The Replacement Cycle Advantage

Many industrial companies benefit from an installed base effect. Once a factory installs your equipment, buying replacement parts and service from a different supplier is expensive and risky. This creates switching costs that generate recurring revenue for decades.

Companies like this — specialized industrial firms with high switching costs and essential aftermarket parts — are the closest thing to compounders in the industrial sector. They combine moderate growth with high returns on capital and exceptional predictability.