Jason Stipp: I am Jason Stipp for Morningstar. The 2011 Berkshire Hathaway meeting is in the rearview mirror, but with six-plus hours of Q&A commentary to pore over, we're still finding some interesting points.
So I am sitting down today with Pat Dorsey. You may remember Pat as our former director of equity research. He's now at Sanibel Captiva Trust, but he is still a great friend of Morningstar.
I'm sitting down with him to compare some "moat notes" from the Q&A of Berkshire.
Thanks for joining me, Pat.
Pat Dorsey: Thanks for having me, Jason.
Stipp: So one of the things I think that's really interesting to study about Berkshire Hathaway is their acquisitions and some of the reasoning behind the acquisitions. The Lubrizol acquisition had, unfortunately, some negative news surrounding it. We've already talked about that enough.
Dorsey: Thank you. Thank you. I've heard enough about it.
Stipp: So I'd like to talk a little bit about some of the operations of Lubrizol, and why it might have been attractive to Berkshire within the framework of economic moats.
So, we have four major types of economic moat criteria here at Morningstar, but there's some interesting incremental moat insights…
Dorsey: There are some subtleties to it, and this really came out in one of the questions ... when [Buffett] was asked, "so what do you find attractive about Lubrizol? Initially Sokol pitched it to you, and you said, 'eh,' and then you looked into it a little bit more, and you said, 'oh, there might be something here.'"
And I think, it's a really interesting lesson. One of them is that it's a fairly small market. Buffett quoted the market for the kind of lubricants Lubrizol sells as about $10 billion overall, not chump change, but not huge.
And we find frequently that companies that dominate niche markets, and Lubrizol I think does have the number one share in this particular market, can have very good pricing power and good moats around themselves because what you find is that the profit pool in that small industry is not large enough to support a ton of players, and that's a barrier to entry. It's harder for someone else who wants to come into that industry to say, "if I come in there, and now there are five players instead of four, maybe the aggregate amount of profits goes down so much that it's not worth me coming in." So niche companies can often be more profitable than you think.
Stipp: I think something interesting, and a little bit hard to understand at first, is that lubricants seem like commodities, they are formed from commodities, they are commodity-based. How do you get pricing power out of such a product?
Dorsey: Yes, that's interesting because the thing there is, you think about the value that a lubricant adds versus its cost, and you think about owning a big Cat bulldozer--the oil you stick in there, the lubricants, the industrial lubricants, not just oil in the engine, but all the lubricants in all the different moving parts, it's not a big cost of running the tractor, right? But if they're not working, if the hydraulics cease up, if the engine ceases up, you are not a real happy camper. And so it's very important to the overall functionality of it, and it's a pretty small amount of the cost, and so again you can get a little bit more pricing power.
You see this also with companies like Ecolab, for example, which sells basically solutions for keeping kitchens sanitary. They used to just sell industrial dishwashers. And they positioned themselves as, "we are the guys who help keep all the cooks and people in your kitchen in compliance with food safety rules," and at the end of the day, food safety is a cost for a restaurant. It's a fairly small cost--buying dishwashing liquid and making sure people wash their hands--it's a very small cost in terms of what it costs to deliver a $20 entrée, but you get it wrong, someone gets salmonella, life is not so good for the restaurant.
Stipp: Small cost, but very important cost.
Dorsey: Exactly. So that's the thing. So you have this small cost relative to a big benefit for the eventual good or service that gets produced--the provider of that can get a little bit of pricing power.
Stipp: So a smaller cost, but some interesting points on pricing power. We also learned about a third incremental moat of the company, potentially, on some of the value-add that they bring to the table. What did we find out there?
Dorsey: Munger specifically referred to Lubrizol's fanatical service, their "fanaticism in service," I think, is specifically what he said. And I've seen frequently, that when you bundle service with a product, you get stickier customers. If you just sell them a thing, they can go buy another thing from somebody else, but if you sell them a thing plus a service contract on the thing, suddenly you have an ongoing relationship with them, a maintenance contract, much higher ticket item than lubricants, but you see this with Otis Elevators, Rolls-Royce, and GE jet engines--where often the company makes far more money off the service than it does off the good itself.
A small German company called Burckhardt Compressor does the same thing; so these compressors that are very, very critical to a lot of chemical applications, making industrial chemicals, and a compressor is a compressor, but you add a service contract on to that, suddenly you get a higher-margin revenue stream, more predictability, stickier customers, really good things for shareholders.
Stipp: Well, Pat, I'm glad, there's a really interesting investment angle to this Lubrizol story. Thanks for coming in and sharing that with us today.
Dorsey: Anytime, Jason.
Stipp: For Morningstar, I'm Jason Stipp. Thanks for watching.