This article first appeared on Advisor Perspectives.
“I’ve admired Precision Castparts’ operation for a long time. For good reasons, it is the supplier of choice for the world’s aerospace industry…” – Warren Buffett on the acquisition of Precision Castparts
“ISCAR makes money because it enables its customers to make more money. There is no better recipe for continued success.” – Warren Buffett on the acquisition of ISCAR Metalworking
In one of the earlier articles in our series, we identified six distinct sources of competitive advantages. This is the fifth article in the series and focuses on mission critical products and services as the source of a sustainable competitive advantage.
Defining mission critical products and services-based (MCPS) moats
We define MCPS moats as businesses that have built a strong reputation as a reliable provider of products/services that cater to mission-critical requirements of the customer. In our experience, many analysts struggle with the applicable analytical framework when they analyze moats of this variety. Frequently, analysts classify such moats as either economies of scale- or switching cost-based moats.
However, businesses with MCPS-based moats possess specific attributes that are distinct from plain vanilla economies of scale or switching cost-based moats. Additionally, analysts sometimes classify businesses as moats solely because they provide products/services that are mission critical even though other key characteristics that are required for such moats are absent.
Analysis framework: MCPS-based moats
For a provider of mission critical products and/or services to possess sustainable competitive advantages, each one of the following four attributes needs to be present:
- Product complexity – technologically complex products requiring specialized knowledge;
- Importance of reputation – limited ability of the customer to identify substitutes such that reliability of the supplier is of the essence;
- Low costs in relation to the total cost of the customer’s end product; and
- Criticality to the customer – product/service supplied should be a critical piece of the customer’s end product such that changing the supplier could lead to significant costs in the form of rejections/complaints by the end customer.
In the discussion below, we discuss each one of these attributes in greater detail.
- Product complexity
The key for MCPS based moats is a technologically complex product or service requiring specialized knowledge. High level of product complexity is important because it allows the business to differentiate its offerings from that of its competition. Additionally, high complexity and need for specialized knowledge serve as competitive barriers as they limit the customer’s ability to identify effective substitutes.
High product complexity limits the ability of the customer to identify substitutes such that the ability to rely on the supplier becomes of utmost important. The business needs to have built and continue to maintain its reputation as a supplier of choice.
Consider the case of Novozymes, a leader in the global enzymes market with a 48% market share. Enzymes are biological proteins based catalysts that drive chemical reactions and have applications across a number of industrial processes, including in production of washing detergents, food and beverages, ethanol, etc. The supplier customer relationships in the industry are not characterized by simple product sales. Instead, Novozymes acquires the role of a strategic partner to its customers. Often, Novozymes develops products and in certain cases, integrates its business systems with that of the customer’s. In the process it creates a revenue stream that spans over the lifecycle of the customer’s product.
- Low cost as a percentage of customer’s total costs
Another important attribute of a MCPS-based moat is that their products or services have relatively little impact on the overall cost of the end product. This is an important criteria as low overall cost impact results in much less of a willingness on the part of the customer to look for substitutes. When combined with product complexity and criticality, this attribute gives rise to competitive barriers that prove themselves to be insurmountable. The resulting unwillingness of the customer to look for substitutes gives rise to customer captivity and serves to insulate the business against competitive threats.
- Criticality to the customer
For a business to have a MCPS-based moat, it needs to provide a product or service that is mission critical to the customer. Criticality of the product or service may emanate from a variety of attributes including the impact that the product/service has on the end product’s performance and/or appearance, value placed by the end customer on the product/service supplied by the business, or cost savings and/or efficiency improvements realized by the customer.
Figure 1 summarizes the key elements of our analytical framework concerning mission critical products and services driven moats.
Figure 1: MAEG’s Analytical Framework for Mission Critical Products/Services Moats
Analysis framework: Ancillary elements
- Demand for customer’s products
As a supplier of products/services to another business, the performance of these businesses will be affected by the fortunes of their business customers. Accordingly, an important element that has a bearing on the expansion or contraction of the business’s moat is related to the demand for the customer’s end product. The analyst needs to track the end products for any signs of changing consumption behavior that could lead to product obsolescence. A business with a diversified customer base and user industry base will be able to mitigate risks related to obsolescence of the end product.
- Lifecycle cost perspective
In some cases, the analyst will need to pay attention to the impact of the business’s products/services on the overall lifetime costs of the customer. Consider the example of air compressors supplied by Atlas Copco. For most customers of Atlas Copco, compressed air is an extremely important part of their production costs as well as their overall costs. Generation of compressed air can account for upwards of 40% of a plant’s electricity consumption. The compressed air solutions provided by Atlas Copco help their customers achieve substantial energy cost savings. Indeed, the cost savings are of a large enough magnitude such that the customer recovers the cost of investment in the compressor equipment within one and a half years.
Figure 2 shows the overall lifecycle cost of the compressed air solutions provided by Atlas Copco and resultant potential cost savings.
Figure 2: Lifecycle cost of an air compressor. Source: Atlas Copco
Application of the framework: Givaudan
Givaudan is a Swiss manufacturer of fragrances and flavors (F&F) that was founded in 1895. Think of how you go about purchasing your perfumes. Apart from the value you associate with the brand and the experience, chances are that the fragrance itself is the biggest driver of your decision to buy one perfume over another. This highlights that a significant portion of a perfume’s value is driven by its fragrance. As an F&F business, Givaudan is one of the businesses that provides the most important component within a perfume: the fragrance.
The company has a dominant 25% market share within the global F&F industry; an industry estimated to be CHF 18-19 billion in size. Figure 3 shows market shares for Givaudan and its competitors within the industry. The company derives nearly 45% of its revenues from emerging markets.
We classify Givaudan as a business that possesses sustainable competitive advantages driven by mission critical products/services.
Figure 3: Global Fragrance and Flavor Industry Market Share (2016). Source: Givaudan 2016 Investor Presentation
Givaudan has a global team of 70 perfumers specializing in the design of both fine fragrances and consumer products and the company’s perfumery team is the largest in the industry. The company invests nearly 8-9% of its sales in R&D efforts as it works with its customers to develop fragrances and flavors in an effort to enrich its ingredients palette.
Figure 4: Product complexity. Source: Company data and MAEG’s calculations
Givaudan has developed long-term and highly profitable customer relationships over the course of a century. For most fragrance and flavor compositions, a change in supplier is an important decision that can affect the acceptability of the product as it is very difficult to copy an existing flavor or fragrance without a conceivable change to the taste, smell or consistency of the product concerned.
The company’s reputation as a best-in-class F&F supplier is also reflected in the behavior of its market share over the years. Figure 5 shows Givaudan’s market share between 2012 and 2016.
Figure 5: Reputation – Global Fragrance and Flavor Industry Market Share Trend. Source: Givaudan Annual Reports and Presentations
As seen in Figure 6, cost of fragrances is typically 0.5% of the customer’s total cost with fine fragrances accounting for about 4-6% of the customer’s total costs.
Figure 6: Low costs as a percentage of customer’s total costs. Source: Givaudan 2016 Investor Presentation
While F&F costs are low as a proportion of overall costs, they have a significant bearing on the end customer’s purchasing decision. As seen in Figure 7, scent is the most dominant driver in the consumer’s decision to buy a perfume, while smell and taste carry a higher weight in the consumer’s purchasing decision than the brand image.
Figure 7: Criticality to the buyer. Source: Givaudan 2016 Investor Presentation
As discussed, Givaudan has developed a strong reputation as a supplier of relatively complex products that have very significant impact on the end consumer’s purchasing decision and are consequently critical to Givaudan’s customers. Importantly, Givaudan’s products carry a small impact on the overall total cost of the customer. All these attributes combine to create substantial competitive advantages for the company and allow it to generate supernormal returns on its capital. Additionally, the company should witness continued expansion of its competitive advantage driven by increasing consumption of the end products marketed by its customers.
Not all suppliers of mission critical products and/or services enjoy durable competitive advantages. Apart from the criticality of the product and/or service, there are several other factors that need to be present for the business to have sustainable competitive advantages driven by mission criticality. When all these elements are present, a business ends up with competitive advantages that tend to be durable and makes the business a great one to own for the investor.
Other articles in this series:
- Entry and Exit Barriers
- Sources of Sustainable Competitive Advantage
- Economies of Scale
- Consumer Preference Moats
In our own analysis, the complexity and criticality of components supplied by Precision Castparts to Boeing and Airbus creates a competitive advantage because it’s difficult for plane and engine producers to switch companies without risking quality and incurring the cost and delays for certifying new parts with regulators.