When Warren Buffet looks for shares to invest in, he looks for companies with “durable competitive advantages”. As Procurement professionals, we are also concerned with performance and stability of suppliers. So, are there lessons to be learned from Warren’s approach? Most definitely, yes.
Knowledge isn’t power, applied knowledge is power
Eric Thomas
That is true in many aspects of life, including when it comes to negotiating with suppliers. The first step in acquiring that power is to prepare. And a big part of preparing for a negotiation is to research to get relevant knowledge. Prior to investing, Warren Buffet spends “forever” doing research before making a “go” or “no-go” decision, and the sources he uses are mostly publicly available financial company accounts.
These documents can deliver powerful knowledge for the world’s most successful investor in the form of how companies perform today, and likely will perform long-term. Likewise, these financial annual reports can reveal powerful knowledge to Procurement professionals. Only difference is how we apply that knowledge. Warren invests. We assess suppliers and prepare for contract negotiations. So, we are typically not looking to make a “go/no-go” decision, but need to understand the strengths and weaknesses of the supplier better to mitigate risk and leverage that insight in a negotiation.
Here are the top 3 insights we Procurement professionals can learn from annual reports by applying a little Warren Buffet thinking:
1. How competitive is the supply market?
Take a look at the company’s gross profit. It’s an indicator of how competitive the supply market is. Gross profit is turnover minus Cost of Goods Sold (COGS). So, the money that’s left over to pay all the overheads (or “indirects” in Procurement speak). So, don’t think of gross profit as actual profit – it’s not. Actual profit is net profit.
Less than 20% gross profit indicates a fiercely competitive environment, where there is no opportunity to develop competitive advantages. So, a commoditised market, in other words. Above 40% gross profit may indicate competitive advantages, as the company is able to command a high price for its goods or services.
It can be misleading to just look at data from one year, as something unusual may have happened during that particular year. So, it’s prudent to track gross profit for 10 years to check whether gross profit is consistent and what the trend is over time.
A supplier operating in a fiercely competitive market would likely still put forward a “unique value proposition” in a negotiation. But that is to be taken with a very large pinch of salt, and you will find that you have many comparable alternatives. If their offering is so “unique” they would be able to command higher prices.
2. Is the supplier under pressure to offer long payment terms?
To find out, look at net receivables on the balance sheet. This is a snapshot of the money owed to the supplier on the day the balance sheet was prepared. What makes it net is the fact that bad debt has been deducted.
Low percentage of net receivables in relation to net sales suggest the company does not have to offer long payment terms, and they may, therefore, have competitive advantages working in their favour. Net sales are the supplier’s gross sales minus returns, allowances, and discounts. To decide what qualifies as a “low percentage”, run the net receivables/net sales ratio for a few competitors in the industry.
It may be challenging to negotiate long payment terms with a supplier with a low net receivables/net sales ratio, which is good to know in advance of the negotiation. If, on the other hand, the ratio is high and you are not offered long payment terms, you know the supplier probably has more to give.
3. Does the supplier carry too much long-term debt?
Too much debt is a risk. A risk of future insolvency, in particular. High debt (but not too much) could be an opportunity to negotiate multiyear deals that provides the supplier with more income stability, in exchange for favourable terms for the buyer.
No or low debt, on the other hand, may be an indicator of a durable competitive advantage. To find out whether this is the case, look at debt load over the past 10 years. In any given year a company should have enough net earnings to pay off all its long-term debt over a 3 to 4-year earnings period. If all other indicators are that the company has a durable competitive advantage, but it still has a lot of long-term debt, this debt may have been created by a leveraged buy-out.
The above mentioned 3 indicators are just a few of the ones Warren Buffet considers when deciding which shares to buy.
What if there are no financial reports?
If the company you are preparing to negotiate with is a current supplier you will also have access to a wealth of past performance information from stakeholders. You will know which areas the supplier is strong in and where they need to improve. This will allow you to negotiate safeguards against any future poor performance, perhaps in the forms of SLAs or liquidated damages. And there may also be opportunities to use past less than stellar performance as a bargaining chip at the negotiating table.
But what if the supplier is neither stock-exchange traded, nor a current supplier? Well, Google’s mission is to, “organize the world’s information and make it universally accessible and useful.” So, doing some Internet research is a good place to start. For UK incorporated companies, the Companies House website can provide some basic financial information. If your company subscribes to premium date sources such as Dun & Bradstreet, you will find some information there. And even though the supplier is not publicly traded you can still learn about industry dynamics by analysing annual reports of publicly listed competitors.
