For nearly all of your existing suppliers, the answer is clearly “no”. But, for some, if it means saving them from an inevitable bankruptcy or from being acquired by a competitor, saying “yes” may well be your best alternative. In these challenging times, losing a strategic partner could have a disastrous impact on your own survival.
The evidence suggests that the current crisis will have deep and lasting consequences. After having warned that customers and suppliers were having difficulty obtaining financing, Jorma Ollila, chairman of Nokia and Royal Dutch Shell, told the Financial Times: “Five months on and nothing has improved despite all the government measures. The credit crunch is still here.” Credit rating agency Moody’s predicted a larger proportion of companies would go bankrupt in the coming years than during the Great Depression in the US. By January 2010, it forecasts the default rate could reach 16.4 per cent globally and even 19.6 per cent in Europe.
Here we examine why so many key suppliers, in all sectors, are in such a desperate cash position and how CPOs can read the signs of cash distress. Once alerted to potential crises, we investigate how they can cost-effectively support and strengthen existing business relationships.
As sales of industrial products freefall in the three leading world economies, exports from developing countries are collapsing even harder. The bullwhip effect – a problem in forecast-driven supply chains where variations in demand amplify through the chain – is expressing itself throughout. Each player faces a greater drop in demand as we move upstream. Faltering consumer demand therefore quickly results in a complete halt in production for suppliers.
Consequently, companies are destocking at a frenetic pace and suppliers are under increasing pressure to drop their prices drastically – to almost marginal cost levels – to get rid of unsold products. Profits are vanishing as volumes drop and prices are reduced. For many companies, the earnings of Q4 2008 showed the first drop after years of positive quarterly results progression. Although balance sheets and profit-and-loss accounts haven’t yet integrated all the bad news, the critical cash flow statements are feeling the pain. Some managers have rediscovered, almost overnight, the impossibility of having negative free cash flow for too long and the absolute impossibility of having a negative net cash position. More than ever, cash is king.
The supply chain effect
From heavy industry, the credit crunch epidemic has spread to all other industries. The small and medium-sized enterprises – especially those that are highly leveraged because of recent acquisitions or major investment programmes to support the stellar growth of their big customers – are being hit particularly hard. For example, in the Chinese Pearl River Delta, centre of global toy production, the local government announced in early March that more than 3,900 manufacturers had gone out of business, representing a staggering 53 per cent of the local industry.
In its recent edition entitled “All you need is cash,” The Economist described the “desperate scramble, of even the most solid companies, to find money to meet such basic obligations as paying their staff”. All of a sudden, companies were becoming cash desperate. Acquisition plans, share buy-back programmes and dividend payouts have been suspended, capital expenditure projects have been reduced or postponed and operating expenses and working capital cut.
Many large companies have made huge efforts over the past couple of years to optimise net working capital. They have successfully used their commercial muscle to negotiate better terms with customers and suppliers. The latest example is the letter from international brewer Anheuser Bush InBev to all suppliers imposing an increase of its payment terms from 30 days to 120 days. As a result, company specific-programmes to improve cash flow have transferred billions of euros of cash from the balance sheets of SMEs to those of the large multinationals. The name of the game was, and still is, to have the shortest possible CCC (cash conversion cycle); a metric that expresses the length of time, in days, a company takes to turn cash outlays into cash flows.
When a company acquires inventory on credit and sells its products on credit, cash is not involved until the company collects the accounts receivable and pays the accounts payable. The shorter the cycle, the less time capital is tied up in the business process, and thus the company’s cash flow is better off. The company can use this excess cash for its own benefit. From a purely financial point of view, a negative CCC is the ultimate objective.
These days, customers buy less. They pay less. And they pay later. The problem is that those companies directly or indirectly affected by this exceptional situation probably exist throughout your own supply chain.
Banks and financial institutions are, of course, continuing to lend money, but not all companies are equal. If you are lucky enough to work for a multinational with a market capitalisation of several billion euros you can still go to the market and issue new shares, even if they are priced at least 50 per cent lower than they were 12 months ago.
Your company can also issue convertible bonds and obtain fresh cash. Warren Buffett’s recent cash injections into the likes of Goldman Sachs, General Electrics, Harley Davidson and Swiss Re are a good illustration of the importance of size and reputation. Naturally, the Sage of Omaha is expecting a high annual yield (10-15 per cent) in return for his favour.
If your company has several thousand employees, it will also receive a certain level of government support to maintain a minimum socioeconomic stability. Rating agencies will be more flexible in their analysis of your capacity to reimburse your short and long-term debts.
However, if you are working for an smaller business, you should consider yourself lucky to find a bank prepared to lend you money. You would quickly realise that they have increased their margin calls considerably against base-lending rates. Indeed, although central bank interest rates have never been so low, banks are lending capital at up to 300 basis points (3 per cent) more than a year ago. This is an additional €300,000 on a €10 million loan.
Numerous highly leveraged companies are nowadays in breach of their bank covenant (the terms according to which the borrower must comply if they don’t want to be considered in default and therefore at risk of the lender demanding payment of the debt in full). They are, therefore, very vulnerable to their creditors. The only grounds for moderate optimism are that the problem is so widespread that it is a major issue for the banks themselves and for governments around the world.
Identifying your key suppliers
The first step every company should take is to identify those suppliers it cannot do without or the ones that will have the greatest impact on its business if they go bankrupt. Land Rover, for example, decided it couldn’t do without the supplier that produced the chassis for its Land Rover Discovery, so it was forced to take the supplier’s £15 million debt on to its own balance sheet so production could continue.
Last year, GM had a similar experience when it agreed to pay $10.6 billion to Delphi to speed up the key auto-parts supplier’s emergence from bankruptcy. Suppliers that are single sources and deliver specific products or materials are a big risk for your company. Switching from such a company to another could easily take months, assuming you are lucky enough to find an alternative, which is not always possible.
As mentioned earlier, some suppliers are unable to refinance at a reasonable cost to invest for future growth. This has generated a multitude of direct bankruptcies within the supply chain or indirect bankruptcies from suppliers’ suppliers. Although some of these collapses were foreseeable, many were not, mainly because of the incredible volatility of the past few months and the fact that you probably don’t have the appropriate early-warning signals on your radar screen.
The sudden extreme fluctuation of currencies increased the risk of doing business for many suppliers. For those in Central and Eastern Europe, a 90-day time gap between the delivery of goods to their western-based customers and the actual collection of cash could mean a 20 per cent depreciation of their currency against the euro. Most SMEs don’t have the finance organisation or the expertise to hedge against such big swings.
There is, therefore, an urgent need to monitor your supply chain for early warning signs. This implies that procurement and finance specialists have a thorough understanding of the macroeconomic environment, solid financial backgrounds and inquisitive, independent minds. Although profitability, liquidity, debt and efficiency ratios may all indicate eventual financial distress when referring to last year’s consolidated accounts, they do not help to show the prevailing situation.
There are a host of early warning signals that suggest a business partner is in financial difficulty. Some of the most important ones are listed below:
Review analyses and reports produced by Horbis, Dun & Bradstreet and rating agencies, and government agencies such as the French credit insurer Coface. These reports are usually quite old as they are only produced every quarter, but they show you the trend over several quarters or even years.
Peruse their quarterly financial reports as well as analysts’ reports produced by financial institutions to identify financially vulnerable companies.
Search for news and rumours in the market. For example, major closures and/or relocation of businesses, key employee movements, strikes and redundancies.
Beware of companies that are:
asking for pre-payment, price increases and contractual relationships to show to their banks;
changing factoring habits upwards and/or delaying tax payments and VAT returns;
substantially increasing their CCC over a short period of time;
announcing “temporary redundancies”, cutting or freezing travel expenses, or both;
suspending capital expenditure programmes;
no longer paying a dividend or buying back shares;
cutting bonus payments on a large scale.
Irrespective of the signal, direct communication should be intensified with key suppliers and more questions asked about their capacity to meet short-term liquidity issues. A refusal to reply to your questions, especially concerning receivables and payables, should set alarm bells ringing.
Regularly monitoring your suppliers (including critical tier two and three suppliers on occasion) will allow you to keep an eye on your risk. The vulnerability dashboard (see figure 2,) is today part of the quarterly management report of many companies. Once the biggest eminent risks (the red square) and the next potential risk (the yellow area) have been identified, it is time for action. We found several companies that have successfully implemented a commando-type approach for suppliers falling in the red and yellow areas, which we have labelled the 4-A approach:
1.
Ask questions to collect as much relevant information as possible (CCC evolution, for example).
2.
Analyse all of the information and data thoroughly (prepare your own key performance indicators on an Excel spreadsheet).
3.
Anticipate the likelihood and consequences of different scenarios (contingency planning).
4.
Act swiftly before it is too late (before the competition).
How to help a distressed key supplier
If you have decided to help a supplier, you must determine what type of rescue package you will offer. The CFO and CPO must work together to develop this. Your company should be prepared to rescue critical, cash-strapped partners quickly so that the end-to-end supply chain is not interrupted. This solution could take the form of the following actions, starting with the simplest to implement, and ending with actions that would require shareholder approval:
Pay invoices on time.
Pay invoices on delivery of the goods.
Make advance payment.
Buy the raw materials directly from a tier two supplier and pay only a conversion fee to the tier one supplier.
Provide or support financing.
Take an equity stake (directly or through a fund).
Merger or acquisition.
Bankrolling a business partner is not a new idea. In the aircraft industry, Boeing and Airbus have helped airlines to secure funding from banks for decades. Some companies, such as automotive, help their customers to secure better conditions than they could have obtained on their own. For example, in August 2008, Volkswagen lent £1 billion to small and medium-sized UK fleet companies for the purchase of about 70,000 of its vehicles.
These solutions could significantly increase the complexity and risk profile of your company, which raises the question of whether it has the skill and competencies to conduct a proper due diligence and counter-party risk analysis. Acknowledging the extent of the problem and setting up a dedicated taskforce is the first step. This team should review not only tier one but also critical tier two and three suppliers. Groups such as Daimler and EADS have put dedicated crisis teams in place to follow their key suppliers’ cash positions (often supported by government funds).
Banks used to be the solution for managing cash. Now they are, unfortunately, part of the problem. In the US car industry, a large proportion of the cars are sold on bank loans. The challenge for Chrysler and GM is that finance companies do not approve consumers for loans so they cannot buy cars. Both Chrysler and GM separated their finance and car-making businesses. Vehicle dealers now claim that they cannot sell cars because consumers are denied financing for the cars. On the other hand, Ford is able to sell more cars than its competitors because the finance arm of Ford is still managed within the Ford umbrella.
To make matters worse, many experts ascertain that customers have lost trust in banks and that the banks don’t trust each other, given that they are reluctant to lend money to one another. This is one reason why quite a few companies prefer to raise capital by issuing bonds rather than ask banks for loans. People appear to have more trust in industrial blue-chip companies.
Market revival
Électricité de France (EDF) is even reported to be working on a project to revive the historic market in bonds held by individuals. While in the past companies would have only tapped into the money pool of pension funds and institutional investors, under this plan to issue bonds in smaller denominations, they would be able to tap into a new, and potentially huge, pool of liquidity: the savings of Mr and Mrs Smith.
Bankers claim that they have superior knowledge when it comes to evaluating business risk; their tools and financial models allowing them to make a more comprehensive assessment. A basic assumption for most of these models is that banks don’t take unnecessary investment risks given their access to information and liquidity. This supposition has been shot down in flames through a litany of bankruptcies that has further undermined the necessity to rethink how the supply base should be financed.
The belief in bankers’ superior knowledge has been so strong that one of the critical questions for years from financial experts has been: “Why is it efficient for non-financial corporations in a well-developed market system to act as financial intermediaries when a financial sector that specialises in the provision of capital already exists?” In other words, financial experts believe that you should not give credit to your customers or be given credit by your suppliers when an efficient banking system is in place.
But if there is no efficient banking system in place, should companies take the flow of money away from financial institutions? We know that independent decision-making in supply chains leads to suboptimal decisions. Thus, linking finance and risk chains to goods and information chains looks like the logical decision to obtain more efficient solutions. This is the new business opportunity called supply chain finance where buyers and suppliers share invoice data to allow suppliers to gain cheap credit from lenders based on the buyer’s company payables or its risk. This means a supplier can receive payment within a few days but the buyer can pay the financier on day 90, with neither company’s cash flow affected.
Many more victims
The current economic and cash crisis will claim many more victims and will not be a “quick win” for anyone. There is no panacea. The latest vulnerability dashboard produced during one of our consulting assignment indicates that supplier financial problems are actually increasing (see column “Q2 2009” in figure 2), especially when we consider the interdependency between tier one, two and three suppliers, sometimes spread over four continents. The Baltic Dry Freight Index, global stock markets, real estate and a multitude of key economic indicators will take a long time to recover.
Although the banking sector is showing signs of improvement, a wealth of toxic assets remains and there is little evidence to suggest increasing financial support for tier two and three suppliers. Governments are trying to help, providing cash to a variety of distressed suppliers through, to name but two, the Auto Supplier Support Program of the US Department of Treasury or the Strategic Investment Fund of the French Government.
However, your capacity to resist and to grow in future months will be determined by your ability to adjust your commercial relationship with your (and their) key suppliers. This means dedicating resources to understanding your level of exposure and the cost to your business. You will need courage to convince your peers internally of the need to increase the number of suppliers on your respective radar screens. You will need to anticipate future risks and determine the degree of financial support to be given to selected suppliers. This ongoing crisis has once again thrown procurement into the spotlight and the ever-increasing complexity of the role will make life difficult for both CPOs and their judges (CFOs, CEOs and ultimately board members) alike. They now have every incentive to work even more closely together.
The issue of tomorrow will be how to effectively optimise capacity and supply, given the current lack of investment from suppliers. Bottlenecks will occur, supply of certain materials will be limited, prices will rise and inflation will return with a vengeance. This will happen against a backdrop of currency fluctuation and interest rate increases. Ignore these risks at your peril. For some leading CPOs, 2010 and 2011 already gives more cause for concern than 2009.
What cpos should do
Self-assess: Consider you own company’s cash flow first. If cash is tight, think carefully about how far you can go to
support suppliers.
Sort: Segment your supply base in terms of the potential impact in case they go bankrupt. Evaluate the cash-distress level of all your tier one, two and even tier three suppliers.
Keep tabs: Monitor the situation of your most cash-vulnerable key suppliers. Are you in full adherence to contractual terms and conditions? For example, can you improve their cash flow by not stretching payment terms?
Finance: Can you provide some breathing space to your suppliers by changing your payment terms to cash-on-delivery? Can you even make advance payments? Can you free up some cash for your supplier by taking some of its inventory, equipment or even debt on your own balance sheet?
Lend: Consider using your business relationship with your supplier as a guarantee to help it negotiate extra financing
with government funds and bankers. Use your knowledge of
the industry to evaluate the risks associated with your supplier, and then act as its banker, lending the company money directly for a given interest.
Integrate: Take an equity stake, directly or through a fund you have set up, in your supplier to provide it with cash and reassure their lenders. Take full ownership of your strategic supplier before it files for bankruptcy and you start losing control.
Fighting fund
One European firm that has already stepped in to act as a banker to its key suppliers is Safran, a French aerospace and defence company.
In July 2008, Safran took the lead to set up, with Airbus and the French government, Aerofund, an equity fund worth €75 million dedicated to providing capital and funding to struggling small and medium-sized aerospace enterprises. In late 2008, the CPO of Safran also put in place a taskforce to closely monitor the financial situation of its most strategic suppliers.
Aerofund’s first undertaking was in March when it stepped in to support Daher, a French supplier of components to the aerospace, automobile and nuclear industries. In January, Daher purchased a 70 per cent stake of EADS subsidiary Socata, to become a major tier one aerospace supplier.
But the financial crisis had threatened future growth. Aerofund and the French strategic investment fund (SIF) – a €20 billion state fund set up to help French companies hit by the credit crisis – together injected €85 million into Daher, taking 3 per cent and 17 per cent equity respectively.
Later that month, Mecachrome, a French supplier of aircraft and automobile parts, received a €20 million cash injection in the form of debtor-in-possession from Aerofund, in addition to a €7 million new credit facility from banks and €2 million financial support
from Safran.
