QUALIPORT
Beware The Highly Prized Customer!

By Maynard Paton (TMFMayn)
February 15, 2001

Carburton Street, London – Predictability is a word often bandied about within Qualiport reports. And rightly so, because it's a key investment characteristic for the long-term buy and hold philosophy. To be precise, the Qualiport is looking for companies with operating predictability. That is, companies that have a steady and stable demand for their products and services.

There are, of course, some obviously unpredictable companies, the speculative biotech firm or diamond prospector to name but two. And to a lesser extent, there are cyclical companies, whose product demand naturally oscillates over the years. When considering a cyclical, it can be difficult for the outside investor to determine whether any slowdown is "normal" or hiding something more fundamental.

The Qualiport tries to avoid those uncertain speculative or cyclical businesses by only investigating companies that possess a steady profit profile. But although a company may have a proven growth record, it's not always the case that a proven growth record equates to operating predictability.

While the future of some products are inherently more uncertain than others (e.g. fashionable clothes or children's toys), there are other "predictability" dangers that won't show up in financial statements either. Long-term investors ought to consider the customer profile of their prospective investment before committing any hard cash.

Highly prized customers

As can be expected, it's the company's customers who cause most investment heartaches for shareholders. Not enough customers coming through the door is usually the simple problem.

However, trouble can lurk even when your company appears to be firing on all cylinders. Beware the business reliant on a handful of highly prized clients. Because the fewer customers a company has, the more devastating the disappearance of just one of them will be.

Smaller firms are particularly prone to this "hidden" uncertainty. If, like the Qualiport, you've experienced investment disappointment with Marks and Spencer (LSE: MKS), then spare a thought for shareholders of Big Green's suppliers.

A 30-year relationship with M&S didn't help William Baird (LSE: BDW) last year after the clothing firm was suddenly dropped from M&S' supply chain (this ten-year chart highlights Baird's sad long-term story). Dewhurst (LSE: DEWH) and Lambert Howarth (LSE: LMBT) have also suffered badly from M&S' supply chain rationalisation. In retrospect, all three had become too dependent on M&S in years gone by. Their operational predictability was out of their own hands to a certain extent. You could say it was in the hands of M&S.

Small company squeeze

Other companies that rely on a handful of demanding customers include suppliers to supermarkets and the motor industry. In the constant battle to maintain "permanently low prices", the supermarkets constantly squeeze their smaller suppliers. Trouble is, if the supplier doesn't like the margin pressure, what's the alternative? There are only four major supermarket chains to do business with...

The ongoing consolidation in the car industry, plus the tough trading environment the motor manufacturers are experiencing at the moment, is proving to be a headache for their suppliers too. Car part suppliers like Mayflower (LSE: MFW) and Laird (LSE: LARD) have limited options if their client list consists of only giant names like Ford (NYSE: F.) and General Motors (NYSE: GM.).

And it's not just the smaller companies that can get into trouble. By the very nature of its business, defence firm BAe Systems (LSE: BA.) has a limited number of clients. Not only that, but national governments don't replace expensive jet fighters on a very regular basis. A recent profit warning from BAe relating to the order intake of such planes again shows the dangers from relying on too few customers.

And although clothing, food, car parts and defence systems are hardly areas of mega growth, the dangers of the highly prized customer do lurk in the more attractive areas for the long-term buy and hold investor.  Specialist software companies have a regular tendency to disappoint on contract news, as London Bridge (LSE: LNB), Vega (LSE: VEG) and IDS Group (LSE: IDG) have all shown in the past few weeks. While all three software firms have enjoyed large and lucrative contracts in the past, the flipside is that when one or two major customers defer their IT developments, profits collapse.

Qualiport

On the subject of specialist software houses, MMT Computing (LSE: MMT) appear to be the only Qualiport member at great risk from "customer unpredictability". MMT supplies IT services to a number of far larger and cost-conscious blue-chip firms, although customer diversity has increased over past few years. However, more of an issue is MMT's Energy division, whose market at present is limited to the handful of European electricity firms. Currently, the Energy operation generates around 25% of MMT's group profit. So a few prospective Energy customers not wanting MMT's software could severely damage the company's growth prospects.

Overall, what's the lesson? The company's historic growth record may be great, but a limited customer spread won't show up in a company's financial history. Beware of the company that relies upon just a handful of powerful, external decision-makers for its profits. For a prospective long-term buy and hold investor, the ideal company will have a myriad of smaller customers, each of whom regularly returns to do business.

Independent Insurance

Following Monday's decision to sell Independent Insurance (LSE: IIG), Tuesday saw the Qualiport dispose of 1133 Independent Insurance shares at 271p each. After costs of £15, the transaction realised £3,055.43.