I recently had a chance to read Dr. Hermann Simon’s Hidden Champions of the Twenty-First Century: The Success Strategies of Unknown World Market Leaders, and so I have been on the hunt for future “Hidden Champions.”
As a brief background, a Hidden Champion is a company that operates under the radar of most investors but dominates its industry niche (top three worldwide or number one on its continent, by market share) and consequently is capable of earning consistently strong returns while employing below-average leverage. Dr. Simon found a number of similarities among these companies, such as a common focus on gaining market share through products that display superior value relative to performance, rather than simply offering the lowest prices (perhaps unsurprisingly, German-speaking countries are disproportionately rich in Hidden Champions).
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There are strong similarities between Hidden Champions and the Buffett/Munger approach to investing in companies with sustainable competitive advantages, or moats. For this reason, I would suggest reading Hidden Champions, if only to further reinforce the value proposition of these companies (there is much discussion on their performance over the last decade and their characteristics in the aggregate) and identify some of the key factors that contribute to their continued success. My only disappointment with the book is that it focuses on the aggregate of all Hidden Champions in Dr. Simon’s study, at the expense of individual case studies which I believe would have been invaluable in identifying common threads prior to becoming dominant players in their respective niches.
In my search for Hidden Champions (or, obscure companies with market dominance), I came across American Pacific Corporation (NASDAQ: APFC), a specialty chemicals manufacturer. A review of the company’s recent 10-K shows three operating segments, Fine Chemicals, Specialty Chemicals, and Aerospace Equipment.
This division accounts for 40 – 48% of consolidated revenues and includes four lines of business. For the largest line (Energetic and Specialty Processes, with ~37% of this segment’s revenues), the company lists that is only one of a few companies worldwide with the “experience, facilities and know-how” capable of services its customers. This is somewhat vague, but worth taking note of.
In another business line (High Containment products, with 29% of this segment’s revenues), the company suggests that it faces limited competition due to the significant capital investment required to enter this niche and the high level of expertise acquired over time (i.e. a steep learning curve). Again, not indicative of a Hidden Champion, but when aiming for Hidden Champions, you might stumble upon an industry with low competition and thus above-average returns.
The company appears to take low competition seriously, as it is actively pursuing markets where it can dominate. For example, the company recently received long-awaited approval by the FDA to manufacture Controlled Substances, which cannot be imported into the United States except in rare instances. The idea being that a lack of foreign competitors allows domestic producers to earn strong returns.
Overall, the Fine Chemicals segment provides only vague support for the idea that APFC might be a dominant player in a few niches.
This segment accounts for 32 – 35% of consolidated revenues. The largest contributor by far is the sale of Perchlorates, which accounts for around around 90% of the segment’s revenues. Here’s what the company said about these sales (emphasis added):
In March 1998, we acquired certain assets and rights of KMCC related to its production of AP. By virtue of this acquisition, we became the sole commercial producer of perchlorate chemicals in North America.
This is where I started to get excited. Not only is APFC the largest producer by market share, but it is the sole producer! Furthermore, the likelihood of new competitors is low:
We believe building a competing facility in North America is not a viable business option for a potential competitor.
Another business line in this segment is Sodium Azide. Here’s what the company says about competition:
We believe that current competing sodium azide production capacity includes at least one producer in Japan and at least two producers in India, including Alkali Metals.
So not only is the company the largest and sole producer in North America, but it is one of just four producers worldwide (it is worth noting that the bulk of demand for this product is from outside North America, so being the largest in that region is somewhat inconsequential).
A Hidden Champion?
In the segments comprising 72 – 83% of consolidated revenues, the bulk of sales are derived from industries with low competition, and the company outright dominates a few of its business lines (including the largest single source of revenues, Perchlorates). Does this make it a Hidden Champion? Unfortunately, the data suggest no.
As mentioned above, Hidden Champions are capable of translating their market dominance into strong returns. After all, there would be very little value in dominating an unprofitable niche (e.g. owning the only bowling alley in Borneo is a worthless position if there is only slight demand for this product and you remain unprofitable). A review of APFC’s financials show that the company has only a passing relationship with profitability, and that returns have been consistently quite poor.
There are a number of factors that appear to be counterbalancing the relatively low competition that APFC enjoys in its core industries. One of which should be familiar to those who have read Michael Porter’s writings on competition, which outlines the “Five Forces” common to MBA curricula: customer bargaining power. While low competition among industry players (idealized in the sole competitor industry, such as APFC and perchlorates) is often indicative of above average returns, this single factor can be outweighed by customers who have excessive bargaining power.
In the cash of APFC, all of its perchlorates go to two customers, both of which are associated with the government (by supplying space and defense rockets). Thus, the company is largely beholden to Congress in terms of funding NASA And DOD programs that require APFC’s perchlorates (which I gather are necessary for solid rocket propellants). These appear to be discretionary programs (as we have seen with NASA’s budget cuts in recent years), which means APFC has an incentive to charge reasonable prices, as the cancellation or postponement of these various projects would leading to far greater downside to APFC than the upside generated from using its dominance to price gouge.
The same issue exists in the company’s Fine Chemicals segment, which as you will recall from above the company is quite vague about its market share. While the company’s phrasing suggests low competition, it also states that only a few customers account for the bulk of revenues, which nullifies any advantage stemming from few competitors.
Furthermore, it is worth noting that in the company’s other segment, Aerospace Equipment, as well as a number of its other business lines, it is not a dominant player and faces high competition. This further contributes to counterbalancing the company’s dominance elsewhere.
It is evident that being a dominant player in a market niche is insufficient on its own in leading to persistent above-average returns. There are other factors which are also necessary that must be considered (specifically, according to Porter, we must also consider customer bargaining power, supplier bargaining power, threat of substitutes and threat of new entrants. See this chart).
Unfortunately for APFC, an inability to utilize fully its market dominance is not the end of its problems. Until May 1998, the company manufactured its Perchlorates in Henderson, Nevada. Almost a decade later, in 1997, the Southern Nevada Water Authority detected perchlorates in Lake Mead and the Las Vegas Wash, which support drinking water for Las Vegas and Southern California. After investigation, APFC was required to begin remediation processes. Initially, the company took a $26 million charge, but then a few years later was forced to take an additional $13.7 million in charges, and a few years after that another $6 million charge.
To be clear, these are not small charges relative to APFC which has a market cap of just $57.7 million and already carries a relatively high debt load ($105 million). Furthermore, given the number of new accruals required, we have no idea whether this will be sufficient coverage. Updated studies could easily show further work will be required, or even identify new sites of contamination.
Hidden Champions are worthy targets for their market dominance and relative obscurity, but should not be appreciated for their own sake; rather, it is the persistent super normal returns that are desirable. Given APFC’s historical returns and scary environmental liabilities, we see a good example of how market dominance can (and should) quickly take the back seat to more pressing concerns.