Why Did Warren Buffett Buy Lubrizol? Pricing Power ~ market folly

Friday, March 18, 2011

Why Did Warren Buffett Buy Lubrizol? Pricing Power

When Warren Buffett released his 2010 annual Berkshire Hathaway letter, much was made of the fact that the legendary value investor was on the prowl for large acquisitions. His quote, "our elephant gun has been reloaded, and my trigger finger is itchy," sent analysts scrounging for potential acquisition targets. Well, we've found the smoking gun.

While many looked for a large deal akin to Buffett's massive purchase of Burlington Northern Santa Fe, Berkshire Hathaway announced it would be buying on a slightly smaller scale, purchasing a $9b specialty chemical company, Lubrizol (LZ).

There are many takeaways from this acquisition, but the mainstream media seems to be missing one key point. While yes, emerging markets are part of the story and "America isn't going away" is also part of it, there is one main reason worth highlighting further: pricing power.

1. Lubrizol has raised its product price 18 times since 2004 as evidenced by a slideshow from its analyst day in October:

(click to enlarge)

2. In an interview with the Financial Crisis Inquiry Commission (FCIC), Buffett said, "The single most important decision in evaluating a business is pricing power. If you've got the power to raise prices without losing business to a competitor, you've got a very good business. And if you have to have a prayer session before raising the price by 10 percent, then you've got a terrible business." Lubrizol appears to fit the bill.

3. Lubrizol's ability to pass on input costs is superb due to working with customers as early in advance as they can in a collaborative manner. It also helps that their customers have also been able to successfully raise prices as well.

4. Some structural tailwinds behind automobile manufacturer BYD (another Buffett position) are aiding the Lubrizol thesis. Per a Lubrizol presentation, they say that:

"Looking at geographic expansion under plans for growth, we're very excited about this. Let me start with a few of the megatrends that are driving this business. First one is mobilization of developing countries. We have an advantaged position in many of the countries that you talk about all the times, the India's, the China's, if you will, Brazil. And we not only have capabilities in place, but we can leverage those, and we are. And I'll talk about that.

The second set of megatrends are all around changes to lubricant performance that are occurring because of increased needs for things like fuel efficiency, energy efficiency in this case. Emissions drive a lot of what happens to our OEMs and how they respond with technology. Lubricants are shaped based on that.

And so as emission regulations become more and more strict, performance requirements for lubes go up, more additive is used. And again, we benefit from that in conjunction with our customers. And then durability of equipment. If you're going to build a large diesel engine, you want to make sure it's protected with the right lubricant. And as changes occur technologically, performance requirements for lubes continue to increase."

So, while emerging market exposure and economic recovery are undoubtedly part of Buffett's rationale, it seems as though his primary thesis could be predicated on pricing power. After all, it's one of his favorite attributes of a business. To learn to invest like this legend, head to Warren Buffett's recommended reading list. And for wisdom from the man himself, check out the top 25 Buffett quotes.

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