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“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 Castparts1

“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:

  1. Product complexity – technologically complex products requiring specialized knowledge;
  2. Importance of reputation – limited ability of the customer to identify substitutes such that reliability of the supplier is of the essence;
  3. Low costs in relation to the total cost of the customer’s end product; and
  4. 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.

  1. 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.

  1. Reputation

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.

Figure 1: MAEG’s Analytical Framework for Mission Critical Products/Services Moats

MCPS

By Baijnath Ramraika, Prashant K. Trivedi and Siddhi Gujar - Read the full article here.