QUALIPORT
The Worst Suppliers For Your Shares

By Maynard Paton (TMFMayn)
August 3, 2004

Corporate guru Michael Porter outlines five industry 'forces' in his seminal book Competitive Strategy: the threat of new entrants, the power of customers, the power of suppliers, pressure from substitute products and existing industry rivalry.

Of the five forces, the power of suppliers is probably the one most overlooked by investors. Yet the actions of suppliers can often lead to shareholder grief. Porter comments: "Suppliers can exert bargaining power over participants in an industry by threatening to raise prices or reduce the quality of purchased goods or services. Powerful suppliers can thereby squeeze profitability out of an industry unable to recover cost increases in its own prices."

The conditions that make suppliers powerful tend to mirror those that make buyers powerful. Porter notes that a supplier group is strong -- and therefore bad for investors -- if one of the following six factors apply:

1. The supplier group is dominated by a few companies and is more concentrated than the industry it sells to.

Suppliers selling to more fragmented buyers will usually be able to exert considerable influence over price and quality. For example, suppliers of advertising space -- be it newspaper, radio or television -- tend to be dominated by a handful of big players. Smaller companies dependent on regular mass marketing, of which there are many, are rarely in a position to negotiate over their media presence.

In addition, planning restrictions have limited the number of major shopping centres in operation. Such controls give suppliers of prime retail space, like Liberty International (LSE: LII), a strong bargaining position when dealing with the country's multitude of retailers.

2. The supplier group is not obliged to contend with other substitute products for sale to the industry.

The power of even large, powerful suppliers can be reduced if they compete frequently with substitutes. Although no company exists without the threat of replacement products or services, those firms running airports and seaports probably get the closest to considering themselves substitute-free. Airlines and shipping companies have little choice when it comes to finding suitable suppliers of runway slots and deep-sea docks. No wonder operating margins at BAA (LSE: BAA) and Associated British Ports (LSE: ABP) are over 30%.

3. The industry is not an important customer of the supplier group.

When suppliers can make money from a number of industries and a particular industry does not represent a significant proportion of sales, suppliers are much more prone to exert power.

Royalties from computer games aren't a significant financial aspect of Hollywood film groups and major sports stars, yet the computer gaming industry continues to be heavily dependent on such high-profile third-party content. With strongly positioned but somewhat indifferent suppliers, it's not surprising to note games companies have consistently registered terrible returns. Even David Beckham couldn't save Rage from the receivers.

4. The supplier groups' products are an important input to the buyer's business.

'Inputs' important to a company's manufacturing process or product quality raises the supplier's power. This is especially true if the input in question is not storable, thus enabling the buyer to build up stocks.

There have been few more important 'inputs' of late than the latest Harry Potter book. Good news for Potter supplier Bloomsbury Publishing (LSE: BMY), bad news for retailers prepared to cut their own throats and sell the tome at breakeven.

Other companies supplying market-leading products include Renishaw (LSE: RSW) and First Technology (LSE: FRS). The notoriously tight-fisted motor industry is a customer of both firms, yet the two can produce superior margins because their high-precision measuring probes and sophisticated crash test dummies are key features of vehicle development.

5. The supplier group's products are differentiated or it has built up switching costs.

Differentiation or switching costs facing buyers stops them playing one supplier off against another.

Those businesses that supply long-term service contracts tend to have inherent switching costs. Capita (LSE: CPI) for instance has many of its clients locked in on multi-year deals; when it comes to renewals, experience of the work involved and being a known quantity play into the outsourcer's hands.

Developing parts integral to a buyer's product can also give suppliers a firm trading position. Thus if you're manufacturing mobile phones that use ARM Holdings (LSE: ARM) microchips or aeroplanes that use Rolls-Royce (LSE: RR.) engines, suddenly switching to a rival supplier's component can be a very costly and time-consuming exercise.

6. The supplier group poses a credible threat of forward integration.

The threat of forward integration reduces the industry's ability to improve the terms on which it purchases. Retailers are particularly prone to this supplier hazard, since the sector possesses very low barriers to entry and suppliers can easily cut out the high street middleman.

Among those shopkeepers with powerful suppliers is JJB Sports (LSE: JJB). Not only does it have to deal with Nike (NYSE: NKE) on a supply basis, JJB now has to compete with the US group on a direct basis. Another retailer in danger perhaps is music chain HMV (LSE: HMV). Its CDs could easily be sold direct by the record publishers in electronic form in future.

More on Porter: Competitive Industries To Avoid | Substitutes For Your Shares | Great Barriers To Entry | The Best Customers For Your Shares

Maynard owns shares in Associated British Ports

A version of this article was first published in August 2003.

Portfolio value

Holding	Number of shares	Closing price 02/08/04 (p)	Value (£)
Associated British Ports	681	402	2,737.62
Emap	372	724.5	2,695.14
Halma	1,920	148	2,841.60
Johnston Press	1,608	526	8,458.08
London Stock Exchange	1,669	359.25	5,995.88
Cash			61.31
Total			22,789.64