Holding a qualified supplier: capacity, concentration and exit

The division holds four specialty materials positions, all of them suppliers into regulated manufacturing processes: elastomeric closures, coated glass, filtration media and a single-use polymer used in bioprocessing. The barrier in each case is the customer qualification file, and the advisory side of this firm has written about that barrier before. The question an owner asks is a different one. An owner has to decide what the qualification is worth across a five-year hold, what will erode it, and what must be spent each year to extend it. Those three questions have numbers attached, and the numbers are the subject here.

We call the measure specification lock, and we calculate it as the share of revenue derived from parts named in a customer registration or validated process. In the four positions the figure runs from 44 to 81 per cent. That range is the difference between a business that can raise prices with input costs and a business that negotiates annually against three competitors. In the position with 81 per cent, list prices rose 9.4 per cent last year against input cost inflation of 11 per cent, with the balance recovered in the following quarter. In the position with 44 per cent, price recovery was 3 per cent and the margin absorbed the rest.

The calendar is the second half of the measurement. Requalification of a closure in a sterile product runs to between 11 and 18 months in the jurisdictions our customers sell into, including stability testing that cannot be compressed. The customer must also carry the risk that the new material behaves differently at the end of shelf life. Purchasing departments understand the cost. Quality departments understand the risk. Where those two functions report separately, the specification holds. Where a customer has combined them under a cost mandate, we have observed genuine switching, and we discount the lock accordingly.

The exposure that lock creates runs both ways. A supplier named in a filing rises and falls with the product it is named in. Our filtration position derived 38 per cent of revenue from a single customer product line, and when that line lost volume to a competitor therapy the revenue fell with it, on the same timetable, with no purchasing decision involved. We now cap single-product exposure at 25 per cent at entry and require a named plan for qualification into at least two new customer processes a year. Qualification is the growth engine in this sector, and it is slow, which is why the businesses are cheap relative to their durability.

Capacity discipline separates the good operators. A qualified line running at 90 per cent leaves no room to take a new qualification, and a customer that cannot be supplied during validation goes elsewhere. The best of our four holds 25 per cent of qualified capacity in reserve and prices it into the plan. The weakest sold every hour of capacity and then declined two qualification requests, which cost it a decade of revenue it will not recover. That decision was made by a plant manager on a monthly utilisation target, which is a governance failure rather than an operating one.

These positions are held for a long time and sold to a specific buyer. Trade buyers pay for qualified capacity and for the customer filings that name it. Financial buyers pay for the margin and discount the concentration. The realisation of the coated glass position in the fourth quarter cleared to a trade buyer at 11.2 times operating earnings, against a financial bid of 8.4 times, and the proceeds have been reallocated to information infrastructure. The rule holds across the firm: originate where entry is hard, convert on a documented timetable, and move the capital to where the next return is strongest.

Published 2023-01-24 by the Private Equity division. Research is prepared for eligible counterparties and does not constitute advice.