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Grahamites
Grahamites
Articles (329) 

The 'Bribing the Purchasing Agent Model' – Part II

How to apply Charlie Munger's model

In my last article, I wrote about the conditions to which the “Bribing the Purchasing Agent Model” applies:

  • The existence of information asymmetry – the customers are ignorant about the technicality and quality measurement standards of the product or the service, whereas the providers and the intermediary possess in-depth knowledge that cannot be easily learned.
  • The end customer is not involved directly in the purchasing decision.
  • Higher price benefits both the provider and the intermediary so that there is powerful incentive for them to form an alliance.
  • The existence of monopoly, duopoly or oligopoly in the market. Again, the incentive bias is favorable – fewer dominant players will help keep price rational.
  • High barrier to enter due to brand name association, technological uniqueness, patent, regulatory burden, etc.
  • The existence of a price-insensitive payer for the products.

Let me clarify that not all of the above conditions have to be met for the model to apply. The hearing aids industry is one such example where five of the six conditions are present. The market is dominated by only six players – William Demant (WDH), GN Store Nord (GN), Sonova (SOON), Amplifon (MIL:AMP), Siemens (SIEMENS) and Widex. There’s tremendous barrier to entry due to technological expertise, patents and the oligopoly market. In the high-end hearing aid market, the customers are often not price-sensitive. Higher price benefits both the hearing aids manufacturers as well as the agent – the audiologists, who are keen to sell high-end products that have higher profit margins. High-end hearing aids can cost more than $1,000 and sometimes more than $2,000 with another charge of customized fitting, which can cost as much as the high-end device itself.

As a result, the “Bribing the Purchasing Agent Model” has been working quite well. For instance, since 2002, William Demant has experienced annual compounded revenue growth of 8% and earnings growth of 10%. The stock price tracked the fundamental growth nicely with a CAGR since 2002 also about 10%.

At the end of my last article, I wrote that we have to watch any disruptions in technology as well as the distribution channel. Any change in technology, payment model or the relationship among the supplier, the agent and the end customer may break the model.

One recent trend in the high-end hearing aids distribution system should be monitored by investors as a potential disruptor of the model. In 2014, Sonova decided to sell a premium Phonak product in Costco (NASDAQ:COST). While most manufacturers already sell through the Coscto channel, they mainly sell the low-end and mid-tier hearing aids, not the high-end ones. Sonova’s decision to sell its premium Phonak Brio created a riot in the independent channel. Here the traditional link between the manufacturers and the agent is disrupted by the new link between the manufacturers and the big box wholesale chain. Suddenly the audiologists are losing clients and high-profit businesses to Costco.

The impact of this development on the long-term margin profile and profitability of high-end hearing aids manufacturers remains to be seen. Wholesalers such as Costco make the product more affordable, which can increase penetration. At the same time the margins are considerably lower than the independent channel.

Another example of disruption is developing in the medical device market in the form of gradual payment model change. As health care shifts from fee-for-service payment model to value-based-payment model, the way the hospitals are paid have changed and the change will be more dramatic in the future.

Without going into the details, I just want to point out that the days that the hospitals can spend as much money as they want to purchase super expensive equipment such as Varian’s linear accelerators have gone. It will be increasingly difficult to justify big ticket purchases. While Varian (NYSE:VAR) and Intuitive Surgical (NASDAQ:ISRG) still make the best products that many physicians can’t live without, they may face challenges getting the hospitals to upgrade to the newer and more costly models.

Disclosure: No position in any of the stocks mentioned in the article.

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About the author:

Grahamites
A global value investor constantly seeking to acquire worldly wisdom. My investment philosophy has been inspired by Warren Buffett, Charlie Munger, Howard Marks, Chuck Akre, Li Lu, Zhang Lei and Peter Lynch.

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Comments

Grahamites
Grahamites - 3 years ago    Report SPAM

Fung9815 - Thanks for the comments. You are right that a strong model often leads to complacency both on the manufactuer side and the agent side. The example I provided in the article illustrates this point. I do think there's a difference between some of the names you mentioned and the companies that subject to this model. For instance, the customers of Nokia, Blackberry products are price sensitive and there's very little information asymmetry between the users and the manufactuers. I agree that we need to watch out for the more frequent disruptions though.

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