While on vacation in Southern California this week, we came across an interesting little article in the LA Times. The article tells the tale of closely held Katzkin Leather and its new Lectra Versalis cutter. Katzkin, based in Montebello, California, is an aftermarket automobile upholsterer. They provide leather upholstery to car buyers who do not want to upgrade their automobile model (like EX over LX for Honda models) but want leather interior. According to the article, Katzkin has 400 employees and hopes to do $73 million in sales this year.
What struck us about the article is that management is falling for the same fallacy that Warren Buffett described in his 1985 letter to shareholders. Like many companies (including Berkshire Hathaway in its original incarnation), Katzkin is losing business to cheap competition from abroad. To cut costs and compete with the foreign competitors, Katzkin went out and purchased the Lectra Versalis machine for $300,000. The machine is faster, more energy efficient and wastes less leather than older models. The company believes that the new machine will boost productivity and dramatically increase sales.
That all might be true, but will any of it fall to the bottomline? Does this new machine really create a moat that will make Katzkin the low cost producer for a meaningful period of time? We find it extremely unlikely.
In the 1985 letter, Buffett describes running into exactly the same phenomenon in the textiles industry. He states that over the years he had the option of making capital expenditures like the Lectra Versalis. Each individual purchase would have allowed Berkshire to reduce variable costs and each purchase made sense when a standard ROI calculation was done in isolation. “But,” Buffett cautions, “the promised benefits . . . were illusory.” The problem was that all of Berkshire’s competitors were able to make the same investments. Similarly, what will stop Katzkin’s foreign competitors from purchasing the Lectra Versalis? Buffett goes on to sum up the results of such investments in an industry with no moats: “Viewed individually, each company’s capital investment decision appeared cost effective and rational; viewed collectively, the decisions neutralized each other and were irrational (just as happens when each person watching a parade decides he can see a little better if he stands on tiptoes). After each round of investment, all the players had more money in the game and returns remained anemic.”
We fear that no-moat Katzkin faces much the same outcome.
Punch Card Investing 
I’m actually not sure if capital expenditures are as futile in this situation as you make them out to be. According to the article, these interiors are usually shipped by express air freight, which is obviously more expensive from a more distant destination than from a closer one.
Thus, the machines Katkin buys don’t need to make the company’s products cheaper to make than those of its competitors in absolute terms. They just need to make those products cheaper after the increased cost of shipping from farther away.
You see this, incidentally, in the return of some manufacturing to the US–the products are probably still cheaper in China, but they’re more expensive after shipping (or once you take into account the hassles of outsourcing).
This is somewhat different, I think, from the Berkshire situation, given that cloth is probably less time sensitive and has fewer outsourcing issues than (semi)-customized leather interiors.
Also, customers might be willing to pay more to receive their interiors sooner, which might give Katkin an advantage relative to more distant suppliers if the company is only slight more expensive than its competitors.
Charles,
You make a great point. These interiors need to get to the dealer quickly – an issue Berkshire did not run into. Transportation costs are certainly a major consideration here. But surely any US-based or even North America- based competitor could simply buy the same machine. I don’t see this acquisition creating a durable competitive advantage.