A few quarters ago, the idea of switching costs was introduced in my investment commentary as a powerful type of moat. CRH Medical and Intuit (owner of Quickbooks), though very different from each other, were cited as specific examples of this phenomenon. Having captive customers, or those who would experience difficulty in switching suppliers, translates into pricing power and typically a high return on tangible capital. The more I reflect on switching costs, the more I desire to find companies embedded with them. It is just so beneficial for an investor’s quality of sleep to own revenue streams that are sticky as crazy glue.
About 50% of the Starvine flagship strategy is invested in B2B (business-to-business) firms, which tend to be a natural breeding ground for switching costs. It is not difficult to see why: most businesses must outsource functions because they involve skills in which the company has limited competency. It happens that these functions are often mission critical.
A key Starvine holding that is abundant in switching costs is Platform Specialty Products. Created by Martin Franklin (of Jarden fame) through a series of acquisitions, this company produces specialty chemicals for a wide range of industrial end-markets (automotive, energy, and consumer electronics) and crop protection.
Platform Specialty Products
Specifications: The Holy Grail
On the industrial side, most products are mission critical for customers, to the point where production lines would shut down without the company’s specialized chemistry. Since the chemicals represent a minute portion of their customers’ overall cost base, there is little incentive to invest significant time to find alternative suppliers. For example, Platform’s products represent only ~$0.90 per unit for a smartphone manufacturer’s costs. The same dynamic exists with its OEM (Original Equipment Manufacturer) clients in the auto industry, where Platform’s chemicals comprise only ~$30-50 per unit for a higher end car. Completing the lock-in of business is the high level of integration with customers. I had the pleasure of speaking with Dan Leever, former Platform CEO, at the annual investor day in New York in September 2016. Leever intimated about the longevity of clients, some of which have remained with the company for decades. At the core of the bond are specifications that Platform must satisfy with the OEMs. These specifications – referred to as ‘the holy grail’ by management – require intense collaboration with clients, who then become dependent on the company’s technical service.
The combination of the dynamics above serves to entrench customers. In summary, switching to another supplier would:
These realities are all conducive to deep sleep for the long term investor.
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