Berkshire Beyond Buffett(54)

Lubrizol was created in 1928 by a group of former Dow Chemical Co. employees, including three sons of Albert W. Smith, a chemistry professor who had cofounded Dow in 1897.25 They formed the Graphite Oil Products Company, a chemical concern providing solutions for the emerging automotive and petroleum industries. For instance, they created a product—involving the arcane feat of suspending graphite in oil—to prevent squeaks and creaks in car suspension springs. In the 1930s, they conquered a problem that often deterred people from buying cars entirely, overheating engines, by creating a chlorine-containing additive to cool running engines. This lubricant additive explains the company’s name today: Lubri-zol. In 1935, General Motors and other automakers endorsed Lubrizol (the hyphen was dropped in 1943) for use in their engines.

The founders perfected Lubrizol’s business model and moat. The marketing team works closely with customers, manufacturers, and regulators to identify problems. This team explains any problems to Lubrizol’s scientists, who research solutions. In additives, for example, Lubrizol works with manufacturers—makers of vehicles, marine diesel engines, power plant generators—who want lubricants like motor oil or transmission fluid to enhance operation and longevity. Lubrizol buys base oil and other petrochemicals and develops additives to create products that will do so, which it sells to lubricant makers. These customers, in turn, want their products approved for use in manufacturers’ equipment, and Lubrizol provides the performance-tested certifications. As the intellectual and research link in the value chain, Lubrizol charges a premium for its expertise and validation, branding what would otherwise be commodity products.

By the late 1980s, Lubrizol was a global leader in producing petroleum additives. Yet the industry was now mature, with limited growth prospects. For example, in 1987, Lubrizol’s annual revenues crossed the $1 billion mark, producing income of $81 million; in 2003, sixteen years later, net income was $91 million.26 At this time, however, a young veteran chemical engineer who had joined Lubrizol in the 1970s at the age of eighteen rose to become president in 2002 and CEO in 2004.27

This employee, James Hambrick, had been a keen observer of Lubrizol’s corporate development activities for a long time. Hambrick stressed that the nominal growth in revenues and tiny growth in income meant that Lubrizol was shrinking. It had survived on its additive business but was not prospering. Hambrick wanted to send a message to employees and customers that the only businesses that warrant reinvestment are those that earn high rates of return on capital and expertise.

Hambrick thought it would be disingenuous to ask Lubrizol’s research scientists to invent Lubrizol into prosperity.28 Instead, he proposed to translate core competencies into new product lines. Lubrizol’s core competencies involved putting specialty chemicals on the most difficult surfaces, such as internal combustion engines running at high speeds for long periods. The strategic vision was to expand outward, putting specialty chemicals on every surface imaginable, from items as diverse as hair and paint to money.

In April 2003, Hambrick asked Lubrizol’s board to authorize management to seek a big acquisition to expand beyond its traditional business. It took a year, but in early 2004, Lubrizol acquired Noveon International, Inc., a specialty chemical firm once part of The B. F. Goodrich Company, owned since 2001 by private equity firms. The businesses were complementary: Lubrizol led in fluid technologies for the transportation industry, whereas Noveon created personal consumer products and specialty coatings, polyvinyl, polyurethane, and liquid polymers. In technical terms, Noveon excelled in polymer chemistry, a complement to the traditional monomer chemistry underlying Lubrizol’s additives businesses.

Paying $1.84 billion ($920 million in cash plus assuming $920 million in debt), Noveon had revenues of $1.2 billion, and Lubrizol had revenues of $2 billion. Buying a scientific business from private equity owners was a shrewd move. For one, such firms sometimes skimp on research and development vital to the prosperity of companies like Lubrizol and Noveon, revealing to a chemical engineer like Hambrick value propositions less visible to private equity investors.29 In addition, private equity firms run short-lived funds that can result in pressure to sell, giving buyers an edge in price negotiations.

Lubrizol’s acquisition of Noveon has proven pivotal. In personal care, Lubrizol became involved in making coatings for skin and hair products made by companies like Avon, Estee Lauder, and Procter & Gamble, against competitors like Dow Chemical’s Rohm & Haas. Surface technologies encompass a range of industrial coatings, where customers might be Benjamin Moore, Sherwin-Williams, or Valspar, and competitors include BASF.30 Lubrizol is poised to exploit specific niche applications of the future, including, for example, coatings for currency, as monetary authorities shift from using paper for money to various plastics.31 Looking back on the Noveon deal, Hambrick explained: