TECHNICAL TRENDS

How Agile Is Your Solution?

by L. Bryant Underwood

Reverse Logistics Magazine, Edition 16

My life is built around a very long commute to work. On the way in I use this time to visit with various leaders in the RL business to better understand the consensus on the up and coming market trends. To a person, all anyone has wanted to discuss in the last few months is the financial confusion that is now dominating the world economy. After talking with quite a few of these leaders it is clear that the confusion involves not just our politicians and talking heads on the news but also managers and directors that are just trying to understand basic things, like the inventory risk of a business opportunity. I'm a simple guy, let me share with you in simple terms the elements that I understand and thoughts on how to react and plan for success.

Background:

There are several of areas of finance that have a lot of institutional secrecy. Two good examples are oil supplies and hedge funds. We are all familiar with the oil cycle in the late summer of '08 when oil got to ~$5.00 USD per gallon, and then out of nowhere the market crashed and gas was selling at 1/3 the price in just a few months. How did this happen? Secrecy. The public data for oil supplies and reserves is notorious for being wrong. So wrong in fact that there are several companies that do very good business manually tracking the inventory. How manual? They have 'spies' track the inventory with pencils and binoculars. Their employees will watch tankers at various ports worldwide, write down the dates, times, registry numbers of the vessels and how low the ship sat in the water when it arrived and left port. This data is fed into a data base and the inventory of oil movement begins to become much clearer. This is how a number of analysts were able to predict the gas price bust before it happened in '08. They knew how many tankers were just being paid to park oil out at sea because there were no buyers. More supply + less demand always = lower price.

For hedge funds, secrecy is also a normal attribute. People look at the recent hedge fund scandals and shake their heads in amazement. It seems impossible that anyone would invest when the return was reported to 18%-25%+ and believe it was real. The fact is that the median for hedge funds from 1990 on has been in the 15% range and some funds generated returns that were much higher.

Although secrecy abounds the general strategies are well known. One such strategy is the famed Credit Default Swap. These are very exotic financial instruments to be sure but in simple terms they are really just insurance policies. At first they were sold as a form of insurance to spread risk in connection with securitized real estate instruments. But since the policies were a stand-alone offering you could buy as many policies as you could pay the premium. Later someone figured out the economic cycle was switching (as it regularly does) and if they bet on the default with multiple policies, the profits would be huge. Guess what happened in late 2008? Some people made better bets than others and a feeding frenzy ensued to help perpetuate the downward trends, drive higher defaults and for some, there was a solid payday from the tactics. This is why the insurance companies and investment banks have been so central to the economic unraveling. Today the total CDS market is estimated to have ~$25T in contracts with ~$14T held in the US. Still a lot of risk out there that is yet to flush out of the economy.

Effects and Tactics

The first phases of the effects were seen in the spread between the interest charged in LIBOR (London inter bank) and from the US Fed (TED Spread). Shortly thereafter the velocity of money just froze. Take a look at the chart below from the St. Louis Federal Reserve Bank.

The net change in turns was ~62% in just ~100 days, a giant change compared to any other period in recent history. That along with all the other data like the producer price index, unemployment and prime interest rate all point to a deflationary cycle. In a stable or deflationary cycle, you want to compress your supply chain as much as possible. This allows you to drive value for two reasons;

• The future cost will be lower
• Delay of payment/terms extension promotes improved cashflow and better ROIC All good practice and tactics to take-today.

Tomorrow may be a different story. Right now capital constriction in the world economy is crystal clear. However, this is also certain to change. One very interesting measure of things to come is automobile fleet-turnover. Transportation is always a leading indicator of economic future and helpful to untangle what is really going on. Fleet-turnover rate reflects how long the current auto supply will stay in consumers' hands before they decide to replace their current car with a new one. The NY Times reported in February of this year on this trend. In the article, they reported the projected rate of US vehicle sales for 2009 was ~9.2M units. If we divide this by the total number of vehicles registered in the US, 247.3M in 2008 we end up with a fleet turnover rate of ~26.8 years. Are you planning on keeping your car for a quarter century before replacement? Me neither. So you can be sure that credit will ease and growth for consumer products will then follow once transportation begins moving, but will it stop there?

Not likely. From the news reports, we all hear over and over million/billion/trillion-it's hard to know when a number is big enough to really care about. The chart below will help you get your mind wrapped around just what a historic time we are in. In just a little over a single quarter we grew the US monetary base by over 100%.

So, just when the pressure from pent up demand for transportation and consumer products hits, it will be matched with an epic spike in the supply of available dollars. There is little doubt inflation will be at least one very negative outcome.

If a tight supply chain is desirable in stable/deflationary cycles, what is the right strategy once inflation starts? The answer depends on if the inflation is just from currency or if there is some underlying growth driving some part of business and commodities in addition to how price sensitive the market is to the products being sold. In broad general terms, opportunities from an inflationary cycle come by the management of holding inventory to avoid production disruption from shortage risks and cost escalations from future price changes. If we re-kindle stag-flation (stagnant growth + inflation) then you will probably want a hybrid supply chain model because there will be a mix of commodity price declines in some market segments and price increases in others. This is rare and usually driven from some outside influence. The catalyst in the 70s was from the oil embargo. The energy prices rose way out of proportion to the rest of the economy and some commodities even declined.

Summary:

Recall from above that there have been several massive market changes that have erased ~35% of the world wealth in just a few months. Almost everyone that relied on standard new and information sources was at least a step behind how fast the world was moving. Information is critical for success. We all must better leverage all our sources and keep in better contact with our worldwide supplier base.

By the way, this is a great reason why it makes sense to keep carving out time to attend trade shows. Good communication is invaluable. Direct contact is the most reliable and valuable. Reduce your current risk by validating your suppliers and knowing their financial health. In addition, structure your business offerings to be as agile as possible. The ability to respond to market changes will give your company more value to offer? your Clients in addition to a strong measure of protection. Oh, one last item-hold ON!

L. Bryant Underwood is Director, Supply Chain for Elbit Systems of America, a leading provider of high performance products and system solutions focusing on the defense, homeland security, commercial aviation and medical instrumentation markets.