Geoff Gannon July 17, 2017

How to Judge a Company’s Bargaining Power With its Customers and Suppliers

A Focused Compounding member asked me this question:

“…what are the factors we should be thinking about when assessing the bargaining power of a given business relative to its customers and suppliers?”

In an earlier memo, I talked about “market power”. My definition of market power is the ability of a company to make demands of its customers or suppliers without fearing that such demands will end their relationship. Why would a supplier or customer agree to demands without considering ending the relationship?


Recently, it was reported that Wal-Mart will start fining suppliers for delivering early as well as delivering late. Wal-Mart wants to manage inventory in their stores. So, they want to make sure that orders arrive on-time and in-full. Many suppliers to a retailer like Wal-Mart don’t have a good track record when it comes to making sure 100% of the order is there on the scheduled day. This causes problems for retailers. For example, I was at Costco last week and picked up the very last box of Eggo waffles available in that store. A few days later, there were several dozen boxes of Eggos – all containing 72 waffles each – stacked sky high. Everyone who came to Costco after I did was either looking for their usual supplier of frozen waffles and didn’t get them – or they have no idea Costco even sells Eggo products. Getting a supplier to deliver on time and in full sounds like a small thing, but a business model like Wal-Mart depends on keeping inventory at the right level. Wide selection in store is Wal-Mart’s main advantage. In most of the towns Wal-Mart is in it’s the offline “everything store” that Amazon aspires to be online. It is the only place to make a true one-stop shopping trip. If shelves are bare of any items at all – shoppers go away disappointed. Too much inventory obviously causes problems for shareholders – it ties up more capital and lowers free cash flow for the year – but it’s also a problem for employees. Because of the way Wal-Marts are run, employees spend a lot of time in areas shoppers don’t see. Sometimes, those areas aren’t the most pleasant places to work. When they are overcrowded with inventory, they became very unpleasant places to work.

Wal-Mart has a lot of bargaining power with some suppliers. Mostly, these seem to be suppliers that have gradually become dependent on Wal-Mart over time. This could happen for a few reasons. One of the most common reasons you see is chasing high growth in slow growth industries. So, if a company was in the soda business or the cereal business and Wal-Mart was quickly expanding around the nation during the 1970s, 1980s, 1990s, and early 2000s – such a company might have tried to grow faster than its category by selling a greater share of its product to faster growing retailers like Wal-Mart. This sounds like a good idea at the time. It allows the company to grow faster than its competitors and faster than its product category. But, there’s a problem here. A faster growing retailer will become a retailer with greater scale than the slower growing retailers. Is it really a good idea to sell through Amazon, Wal-Mart, Costco, and Home Depot? Or, is it a better idea to sell to smaller chains, regional chains, and slower growing chains?

The other reason a supplier might become dependent on a certain customer is that the customer controls access to a desirable demographic group. Wal-Mart has a fine position across the country. In certain categories and certain states – the company’s position isn’t really that impressive. For example, I wrote a report about a supermarket in New Jersey called Village (VLGEA) that operates Shop-Rites. If you are selling perishables like fruit, vegetables, meat, seafood, and fresh bread – you can ignore Wal-Mart if your focus is New Jersey. Wal-Mart isn’t a leader in those categories in that state. Likewise, if you are interested in selling food in Florida – you shouldn’t focus on Wal-Mart, you should focus on Publix. In Texas, you shouldn’t focus on Wal-Mart – you should focus on H-E-B. But, if you are interested in selling to certain groups of people (lower income) and certain parts of the country (rural) – you would need to sell to Wal-Mart to reach those groups. For example, I was recently in a very rural part of Oklahoma. In a place like Northern New Jersey (where most of Village’s Shop-Rite stores are located) there will often be 2-4 good food store choices within 5-15 minutes. Out in the part of Oklahoma I was in, there’s 1-2 food store choices within a 20-30 minute drive. None of Wal-Mart’s competitors in the area (they’re all local) really offer anything in food that Wal-Mart doesn’t. And then Wal-Mart offers you the option of buying everything else at the same time. When driving to any store of any kind takes 20-30 minutes instead of more like 5-15 as in highly populated areas – that’s a real advantage. Also, the difference in income levels between where Village is in Northern New Jersey and where I was in rural Oklahoma is big. I’d guess people average an income level about 65% lower in the part of Oklahoma where I was relative to the part of Northern New Jersey where I grew up (and where Village’s stores are). So, serving a customer like Wal-Mart can be the only good way to sell to very poor and very rural areas. The companywide figures often don’t illustrate this well. Wal-Mart is everywhere in the United States now and it sells to some wealthier and more suburban customers. But, there is a part of the company’s store base – think the 20% of the chain that is in the most rural locations – that serves a customer base you really can’t reach without becoming dependent on Wal-Mart.

If you imagine the difficulty of reaching different demographic groups, you can see why a supplier would become dependent on retailers like Amazon or Costco. Also, all of these companies – like all popular retail concepts – had a very fast growth period where selling to them would drive faster than industry growth for your company.

So, asking whether a supplier gets a large portion of its sales from a single customer (the percentage of sales – if more than 10% – is included in the 10-K) is a good first check. A second question to ask is whether this percentage is bigger than the supplier’s competitor’s sales to the same company. For example, if Hanes gets 20% of its total sales from Wal-Mart – does Fruit of the Loom get 10%, 20%, or 30% of its sales from Wal-Mart. If the answer is that they get the same amount of sales, this lowers the concern of insufficient bargaining power. If the answer is that the supplier you are looking at gets more of its sales from a single customer than competitors usually do, that’s a possible red flag.

The next step is to look at the flipside, how much of its purchases within a category does a buyer allocate to this supplier. This is – in rough terms – very easy to check in retail. One Wal-Mart is pretty much like any other Wal-Mart. So, if you want to know how much of its underwear needs Wal-Mart buys from Hanes, Fruit of the Loom, etc. you just go to a Wal-Mart and check it out. If a battery maker says they get 20% of sales from Wal-Mart, but you see 50% of shelf-space for batteries dedicated to this company’s brand – then is Wal-Mart more dependent on the supplier or is the supplier more dependent on Wal-Mart? There’s a tendency for investors to worry a lot about investing in a supplier who gets a lot of sales from a certain customer. I see this all the time in write-ups on blogs and by analysts, etc. What I don’t see enough is a discussion of depending too much on a single supplier.

This can happen to any company. Even a very big company can – if it’s not careful about how it fulfills its needs – become dependent on a single supplier. For example, Wal-Mart allowed itself to become dependent on Cott for its private label beverage needs. Wal-Mart wanted to sell more private label beverages. That’s fine. But, Wal-Mart is big and its national. And, honestly, there just aren’t that many companies in the U.S. and Canada who could supply you with things like soda who aren’t themselves owners of big brands like Coke, Pepsi, or Dr. Pepper. So, if you want to get away from just selling Coke, Pepsi, and Dr. Pepper products – you’re very likely going to end up dependent on a single supplier like Cott. If it was easy to get private label soda on store shelves – everyone would do it. The big manufacturers don’t just have the brands customers want most – they also have the best distribution and lowest unit costs due to their big scale and very long histories in each region. To match that kind of scale and get good prices on private label stuff – you’re often going to have to commit a lot to private label, focus on giving all your private label business in a category to just one supplier, and sometimes even guarantee buying a certain amount or buying exclusively from a certain supplier for a number of years. When Wal-Mart buys a ton of underwear from Fruit of the Loom or Hanes – it doesn’t have to do any of that. It buys whatever it needs whenever it needs it.

So, that’s one example. Wal-Mart became dependent on Cott. Years ago, I read a lot of posts about how dangerous this situation was for Cott. I didn’t read much of anything saying that Wal-Mart had become dependent on Cott, because its private label needs had far outgrown what other suppliers in North America could hope to meet. The scale of what they needed to buy and where they needed it (everywhere) had grown too big to smoothly find another supplier.

This actually happens a lot. Really big customers can find themselves in situations where they need a really, really big supplier – and there usually aren’t many. I own shares of BWX Technologies. BWXT supplies very nearly all of the critical components needed for a shipboard nuclear reactor. The U.S. Navy uses BWXT exclusively for all its reactor needs for aircraft carriers and submarines. The U.S. Navy has long been 100% nuclear powered for its carriers and subs. So, as long as the U.S. Navy feels it needs to buy carriers and subs and that they have to be nuclear powered – the U.S. Navy is dependent on BWX Technologies. Of course, BWXT is completely dependent on the U.S. Navy. I feel there would be no BWXT without a U.S. nuclear powered navy and there’d be no U.S. nuclear powered navy without BWXT. There is a tendency to pay a lot of attention to the risk that the U.S. Navy could put BWX Technologies out of business without paying enough attention to the risk that the U.S. Navy couldn’t have nuclear powered ships without getting the reactors from BWXT.

In these kind of bargaining situations, you’ll often find that the best position is to bet on the side of the table which cares most about the price/cost and which has more at stake. Usually, you want to look for situations like BWXT where reactors are an important part of the Navy budget, but they’re only part of a few very key projects for the Navy. And, most importantly, the Navy’s priorities aren’t really to spend less on ships in total. The U.S. Navy isn’t a for-profit business. It likes having more ships and better ships and higher budgets every 5-10 years. Yes, it wants to economize. But, it often wants to economize by spending less on this ship so it buy some other ship. As I’ve written before, I think the Navy would be about as excited by the prospect of buying a run of 11 subs for the price of 10 subs rather than 10 subs at 10% less per sub than it originally expected to pay. In other words, the Navy is open to getting 10% more ship for the same price rather than the same ship for 10% less money. That’s not how a for-profit business works. Many for profit companies have a specific need and want to buy that quantity at the lowest cost to save money they will then convert into profit or use somewhere else in the industry.

The strongest bargaining power is when the firm on the other side of the table won’t seriously consider terminating the relationship. This is always the most powerful bargaining chip. So, any business where customers are afraid of serious disruption if they dump the current provider is in a good position. For example, households are reluctant to switch banks, brokers, etc. And banks, brokers, etc. are reluctant to switch any sort of custodial relationship.

Some industries have nearly perfect client retention. The best example of this is advertising agencies. Very big brands almost never switch ad agencies. Over time, the various marketing functions of the client and a lot of different specialties inside the agency become entwined in all aspects of positioning a brand, creating campaigns, researching customers, etc. Consumer brand companies do replace their agencies. But, they don’t really replace their agencies more frequently then they make desperate shifts in corporate strategy like firing the CEO or selling the entire corporation to a competitor, private equity owner, etc. Each of those events is as likely as firing the ad agency.

Bargaining power for a supplier is often good when:

  1. Customer buys all or most of its needs in a category from a single supplier
  2. Customer can’t vet possible alternative suppliers ahead of time without causing problems
  3. There is a large gap between the “price” the supplier charges and the “cost” as the customer calculates it
  4. The buyer can serve as a middleman that puts the supplier and customer on the same side versus the end consumer

A good example of #4 would be Apple. In a sense, Apple – and other device makers – depend a lot on wireless carriers getting end customers to buy the product in a certain way. If the average phone user bought Apple products using cash from their own pocket, paid instantly, in a Wal-Mart type setting next to other competing models – Apple wouldn’t be such a good business. But, a lot of people who have iPhones aren’t even sure exactly how much they are really paying for the phone as opposed to the plan. This works well for both a company like Verizon and a company like Apple though. They are both in a position of trying to maximize the lifetime value of customers by getting phone users to pay a lot more for a lot longer than they otherwise would. They both benefit from making pricing very opaque.

I would say that #3 is usually the most important. Whenever you are looking for a business you think has bargaining power, you want to find a company where the price it receives is not what the customer considers the cost to be. For example, a customer that already owns original equipment and now is going to buy replacement parts and maintenance services (a “razor and blade” business) is a good customer not just because they are locked into buying parts and services. They are a good customer, because their “cost” is – in their eyes – usually calculated as downtime rather than the price of the parts and services. The cost of grounding a helicopter in your search and rescue fleet, shutting down an escalator in your department store, delaying a construction project, etc. because of missing parts and services is not usually calculated in terms of the purchase price at all.

Finally, I should talk a little about “switching costs”. All economists and some value investors talk about “switching costs” as being the explanation to many “moats”. I think the term “switching costs” is misleading. The cost in switching banks is really not that high. I researched a dominant company – Breeze-Eastern – in the helicopter rescue hoist industry. It was explained to me time and time again that engineering the necessary changes to make a helicopter work with a competitor’s hoist is neither expensive nor difficult to do. Yet, it’s something that’s very rarely done. That’s the only part that matters to investors. If switching is “very rarely done” – that’s all we need to know. We don’t need to seek a rational explanation for this behavior. If someone thinks Coke and Pepsi taste basically the same, cost basically the same, and are available at basically all the same places – there is still a “moat” around Pepsi if that customer always buys Pepsi without checking the price of Coke. What matters is that someone is loyal enough to buy one brand without checking the other. And, in fact, what I just described is fairly typical behavior. A lot of soda drinkers will substitute Coke for Pepsi or vice versa when that is what a waiter tells them they must do. However, that same customer will always buy their preferred brand in the store without checking the price on the competing product. That’s all that matters. Does the customer do any “comparison shopping”? You always want to look for situations where the customer won’t comparison shop. They just never start the process. That’s almost always how banks keep their depositors. Depositors – once they’ve been with a bank or a few years – simply never again compare different banks. That’s always what you want to look for – customers who never enter “search mode”. If they aren’t looking at the alternatives – you’ve got them for life.

I give the example of phone makers and wireless carriers being an industry where two businesses often have interests that align to their benefit at the expense of the end user. Often, especially in retail, the interests of the supplier are different from those of both the buyer and end user. For example, I do very close to 100% of all my shopping at just two places: Amazon and Costco. Those are good places for households who buy there. I’m not sure they are good places for suppliers who sell to them. If I was running a business, I wouldn’t be looking to sell a lot at Amazon or Costco. I’d avoid customers like Home Depot too. Some of the best positioned companies do just that.

Focused Compounding members can read my report on Hunter Douglas. That company had not – until it made an acquisition recently – really sold anything through stores like Home Depot and Lowe’s. And yet it’s by far the leader in blinds and curtains in the U.S. Sherwin-Williams is the leading paint brand in the U.S. It’s also been one of the best performing true “buy and hold” investments you’ll ever find (SHW stock has returned 16% a year for 40 years). And yet, Sherwin-Williams mostly sells through about 4,000 company owned paint stores. In the long-run, having the kind of market power that Sherwin-Williams and Hunter Douglas have will often get better results for the stock than selling more and more to a fast growing customer who you come to depend on.

The best example of a company deliberately growing its market power over time is Luxottica. As a member, you can read that report in the Focused Compounding “library” as well. The merged Luxottica-Essilor will have even more market power because it combines the world leader in eyeglass and sunglass frames with the world leader in eyeglass lenses. If you want to learn about market power, I’d suggest you study the history of Luxottica under Leonardo Del Vecchio from the time it was founded till the merger with Essilor.

Really digging into Luxottica’s corporate evolution will teach you so much more about bargaining power than I ever could in this one memo.