Are suppliers too profitable? (Insight).

Should an automaker make better profits than its suppliers? Poor profit margins and abysmal returns on invested capital among some automakers have prompted a few top executives to ask exactly that.

A DaimlerChrysler (DCX) executive, for example, recently remarked that "Johnson-Controls [JCI] is a great company; its only problem is that it makes too much money." This statement is somewhat curious in that during the most recently reported accounting period, DCX out earned JCI. For the first nine months of JCI's fiscal year ending in June 2002, the company's operating earnings equaled 5.2% of sales. DCX's operating earnings for the first six months of calendar 2002 ending in June totaled 5.7% of sales.

Whether or not the facts support the contention, there is a perception that some suppliers are "excessively profitable." In spite of the widespread financial distress among their ranks, there are indeed a few examples of suppliers with exceptional financial performance. The superbly managed American Axle 8 Manufacturing's return on equity of 22.5% and an operating profit margin of 12%, for example, far exceeded the results of Ford and GM. Others with above average returns include Wescast, Superior Industries International, and Gentex.

To determine a "reasonable" level of profit for a given company, we need to look at both the sources of profitability and forces that affect the risk of the profit stream. Sources of profit are both external and internal to the firm.

External Forces Affecting Profitability Harvard economist Michael Porter identified the five external forces that best explain the ability of an industry to generate profits in his book Competitive Strategy (1980). According to Porter's model, an industry's profits thrive when:

* There are barriers to entry against new competitors

* Supplier pricing power is weak

* Buyers have little bargaining power

* The threat of substitute products is low

* There is weak rivalry among competitors

Automakers' profit picture benefits from three of the above: (1) barriers to entry, (2) weak supplier power, and (3) the threat of substitute products is low. (At least in the U.S., substitutes like public transportation have little chance of replacing private passenger autos anytime soon.) Much, if not most, of the advantage, however, is offset by the strong rivalry among competitors and the strong bargaining power of consumers. On balance, automakers in North America (or most of the rest of the world for that matter) are not operating in an environment conducive to making strong profits.

The market situation for suppliers is worse. Suppliers lose on all five counts. Because less than 10 automakers worldwide dominate the industry, suppliers have little opportunity to broadly diversify their customer base. Economists refer to this as an oligopsony: a market with few buyers. In this situation, the power over pricing easily gravitates to the buyers.

Tough To Compare Internal Sources The internal sources of profit are derived from the quality of management, the effective and efficient use of assets (both physical and intellectual), and the formulation and execution of a sound corporate strategy. There is no way to fairly compare the automakers as a group versus suppliers on these criteria. We can, however, evaluate the inherent risk of each.

Financial theory and practice have long held that the greater the risk, the greater the return. A number of factors have served to increase the risk of suppliers vis-a-vis their customers during the past 20 years. One example is the industry-wide transfer of fixed investment from the automakers to the suppliers. Another factor is access to capital.

A substantial portion of risk borne by any manufacturer derives from operating leverage: that is, the use of fixed cost investment to lower variable costs. The upside is that once a manufacturer reaches breakeven in sales, the point at which fixed costs are covered, profits accrue very quickly because of the relatively low variable cost per unit produced. The downside comes when manufacturers over invest and cannot attain production and sales levels sufficient to cover fixed investment cost.

Building cars and trucks is by nature a high fixed cost business. Carmakers, in order to reduce operating leverage risk, have been systematically pushing off capital investment requirements to their suppliers. According to the most recent data available from the U.S. Department of Commerce, the percentage of total capital investment in the U.S. auto industry made by suppliers versus OEMs rose steadily from 63.7% in 1997 to 68.5% in 2000. Anecdotal evidence indicates suppliers' share is still increasing.

Couple this with the huge amount of borrowing many suppliers undertook during the late 1990s to fund expansion, and the risk is compounded.

Automakers have an edge in their ability to attract lower-cost capital. Much of this benefit clerives from their larger size, name recognition in both the product and financial markets, and from the fact their equity is nearly always publicly traded. The majority of suppliers' equity, on the other hand, is privately held.

Due to both their size and private ownership, suppliers pay an illiquidity premium, raising their cost of capital and thereby increasing the requirement to make higher profits in order to continue to fund their growth.

If innovative companies with sound market strategies, low-cost manufacturing positions, substantial investment in intellectual capital, and resulting superior products make financial returns only as good as the poorly performing North American automakers, sources of new capital for the industry will remain as dried up as they have during the last two years.

There is no clear-cut answer as to who should make a higher profit, the customer or the supplier. It is clear that in our highly successful economic system, investment capital flows to firms demonstrating the ability to make financial returns in excess of their cost of capital. Because of the multitude of factors determining profitability, both external and internal to the firm, there are obviously going to be many suppliers making better returns than their customers. Automakers should view this as a good thing.