Berkshire Buys Lubrizol

So Berkshire has announced its latest acquisition—Lubrizol (LZ).

In its latest 10-K, Lubrizol describes its primary business—lubricant additives (primarily for engine and driveline lubricants):

“We believe we are the market leader in lubricant additives, and we intend to remain the leader by continuing to invest in this business. Our Lubrizol Additives segment’s growth strategy is to continue to optimize our product mix while closely aligning production capacity with product demand. Challenging market forces and conditions continue to influence the Lubrizol Additives segment. A key factor is the low long-term global growth rate for this market, which we believe is in the range of approximately 1% to 2% per year.”

Pre-tax operating income in 2010 was $1B, on $5.4B in revenues—both records for the company. At an estimated purchase price of $9.7B (which assumes $0.7 net long-term debt), Berkshire is paying 10x pre-tax OI. And almost 4x shareholder equity.

Lubrizol’s gross profit percentage for 2010 was 33.1%, which also appears to be an all-time high. (2008 marked the five year low, at 22.3%; 2006 saw 24.6%.)

Lubrizol has earned very good returns on shareholder capital (excluding special items) in recent years. Its average return on shareholder equity for 2010 was 34.4%, also an all-time high.

I will not extend the theme, but the drift is clear: this purchase price is not a bargain for Berkshire, given Lubrizol’s results over the last five years. Any margin of safety then must lie solely in expected (and highly likely, one would presume) future performance. At minimum, I would think, Berkshire must expect revenues and margins to remain close to their 2010 performance, for at least the majority of the next decade.

Berkshire was not willing to offer LZ shareholders the option of Berkshire stock (as in the Burlington deal), so that should indicate Buffett’s thoughts on each’s relative value.

Longer term, LZ’s future revenues and earnings may face risks—if, e.g., 1) improved engine design increases drain intervals, 2) new vehicle purchases slow and stagnant, or 3) input costs (particularly petroleum) increase faster than expected.

Clearly, I’m missing some important piece of this puzzle.

Disclosure: I hold shares of Berkshire Hathaway.

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3 responses to “Berkshire Buys Lubrizol

  1. I did some work on Lubrizol today and came to a similar conclusion regarding margins. If you consider average net margins over the past five years to be “normalized”, then the deal is quite expensive – over 22 x normalized earnings. However, if margins are sustainable going forward (as management insists and Buffett clearly believes), then it could be quite cheap particularly given the very rapid growth in emerging markets and Lubrizol’s growing presence in China (where much of the planned capex for the next few years is dedicated). Also, Buffett could stop hedging currency and gain exposure to significant foreign currency revenues as a hedge against the dollar.

    Obviously Buffett believes margins will hold. Having only started looking at the company today, I can’t form a definitive conclusion but the trends clearly are favorable and the company’s performance through the recession are obviously impressive. We shall see.

  2. I don’t think you realize it but your post was very insightful. I was wandering what did Buffett see in Lubrizol and you gave me the answer. Vehicle and engine production and purchase are low and many predict that it will remain so for a few years. Much like certain purchases in the past Buffett sees this as an opportunity to buy an excellent business that remained profitable through the economic crisis and is operating in a field that is certain to grow and recuperate in the long run at a fair price. The price he paid is high relative to 08’-09’ earnings but is fair relative to 11’ and does not account for any growth beyond that since no one predicts substantial growth for the near future. This is, as you’ve described, the low tide in the business cycle for Lubrizol, therefore Buffett was able to follow he’s own advice. Instead of buying a mediocre business at a great price, he’s buying, at a fair price, an excellent business that is virtually certain to substantially increase earnings ten and twenty years from now.

  3. This is a late reply, but any idea what stops others from competing with Lubrizol? If the returns were this attractive, and no one else has competed with them, then there must be something that forms a moat – I’m just not sure what it is yet.

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