You will be able to judge a company's competitive advantage and check it against its returns and margins.
Marcus asked a colleague who used to work for a chip equipment maker why customers stay with a supplier like Larkspur. The answer took ten minutes and came down to one sentence: "Nobody gets fired for keeping a qualified supplier, and qualifying a new one takes most of a year." That's the claim lesson 6.2, Business review and risk factors: what management must disclose, wrote into Larkspur's business model. This lesson asks how strong that advantage really is, and whether the numbers agree.
Figures are made up and in S$ millions unless stated.
In a 1979 Harvard Business Review article, the economist Michael Porter set out a way to judge how much profit an industry lets its companies keep. He named five forces that compete for that profit, and the framework still carries his name.
Buyers, who push prices down; suppliers, who push costs up; rivals already in the industry; new entrants who could join it; and substitutes, products from outside the industry that do the same job
The question for each force is how much bargaining power it holds against your company. Marcus scored Larkspur from 1 to 5, where 5 means the force works hard against it.
Buyers got a 5. Two customers take 62% of revenue, they're far larger than Larkspur, and one has started qualifying a second supplier. That's as much power as a buyer can hold. Suppliers got a 2, because Larkspur buys metals, components and machine time from many sources. Rivalry got a 3: several precision engineers in Singapore, Malaysia and Japan chase the same customers, though each part, once qualified, is rarely contested. New entrants got a 2, because a newcomer needs capital, a quality record and that year of qualification before it earns anything. Substitutes got a 2, since a customer could bring a part in-house or redesign it out of the machine, but rarely does.
The score says Larkspur's industry is decent, with one dangerous force. The money it keeps depends on how hard its two big customers decide to press on price.
Warren Buffett popularised the word moat for a lasting competitive advantage. Put precisely, a moat is whatever lets a company earn returns above its cost of capital for many years, when competition would normally push them down. Lesson 8.4, Return on invested capital vs cost of capital, explained why returns tend to drift back towards the cost of capital. A moat is what stops the drift.
Moats come from a short list of sources: customers who find switching costly, costs nobody else can match, a brand people pay more for, a network that grows more useful as it grows, or a licence or patent others can't get. Larkspur's claimed moat is the first, switching cost through qualification.
Claims are cheap. A moat that's real shows up in the accounts as returns that stay above the cost of capital and margins that stay steady, especially in a bad year.
Start with return on invested capital. Lesson 8.4 found Larkspur earning about 15.6% in FY5, against a cost of capital of about 9%. The harder test is the FY4 downturn, when revenue fell 15%. Return on capital fell to about 11%, still above 9%, though only by two points. A company with no moat would usually fall to or below its cost of capital in a year like that.
Then look at margins against peers. Larkspur's operating margin ran from about 11% to 16% across its cycle. The five peers from lesson 9.3, Choose a peer group that is really comparable, sit between 10% and 15% in their latest year, with a median of 13%. Larkspur isn't an outlier. Its margins look like those of a solid member of a competitive group, not a company with pricing power over its customers.
The segment note sharpens the picture. Coatings, with about S$60 million of capital including its goodwill, earned close to nothing in FY5, so its return on capital was barely above zero. Take it out, and the parts business earned operating profit of about 55 on the remaining capital of about 237. After tax at 17%, that's a return of about 19%. So the moat, such as it is, belongs entirely to the parts business. The coatings purchase diluted it, which lesson 9.5, Capital allocation: dividends, buybacks, acquisitions and reinvestment, follows up.
Marcus's verdict: the moat is real but narrow. Returns stayed above the cost of capital through one downturn, by a thin margin, and margins match the peer group rather than beating it.
Every moat changes, so the useful question is which way it's moving. Look for evidence in both directions and write it down.
Evidence of narrowing at Larkspur: one large customer is qualifying a second supplier, which is the clearest possible sign that the switching cost is being paid down. Evidence of widening: Larkspur's announcements show new parts qualified in each of the last two years, which deepens its place in the customers' machines.
Turn that into things you can check at each results announcement. The share of revenue from the top two customers, as above. The gross margin, which falls first if customers push on price. And the number of newly qualified parts, which management reports. If the top-two share stays near 62% while gross margin slips, the customers are using their power. If the share falls with no new customers replacing it, the second supplier is taking volume.
Larkspur's Five Forces score and its numbers point the same way: a decent business whose biggest risk sits with its two largest buyers. When the score and the numbers disagree, believe the numbers and go back to the reports to find out why.
For the activity, score your own company on the five forces from 1 to 5, then set its return on capital and margins, including its worst recent year, beside the score.
Score your company on the Five Forces and check whether its margins and return on capital support the score.
Junxiong-WFG Organisation is an authorised representative of AIA Financial Advisers Private Limited (Reg. No. 201715016G).