From the February 2011 issue of Treasury & Risk magazine

Best Friends Forever


The flow of credit from financial institutions all but froze starting in late 2008, and although it has thawed somewhat, suppliers' financial risk remains at the top of their corporate customers' concerns. What happened in the car industry as the credit crisis struck in the fall of 2008 was a harbinger of the closer ties that now bind companies to their suppliers. Plummeting car sales had dire ramifications for parts suppliers, many of which depend on their sales to the manufacturers.

French carmakers Renault and PSA Peugot Citroen publicly promised support for their suppliers. And in 2009, BMW helped bail out Edscha, a German manufacturer of sunroofs the luxury car company uses in its Z4 convertible.

The lack of demand for their products, coupled with the financial crisis, squeezed and sometimes turned off parts suppliers' bank credit, prompting their customers to take quick action.

"We did support some companies by shortening payment terms for some period of time or accepting some temporary price increases," says Nicole Bjugger, director of supplier financial solutions at AB Volvo.

For many companies, the financial crisis became an exigent reminder of the importance of their supply chains, while revealing just how much business had changed.

Only a few years ago, finance executives were focused on the credit of their customers, leaving supply-chain risk analysis to the purchasing office. That said, purchasing departments had long monitored their suppliers' risks, aided by research firms such as Dun & Bradstreet (D&B).

What has changed, however, is that global financial upheavals, juxtaposed with regulatory changes and especially business trends, have created a toxic mix that is sending shivers up companies' supply chains. That has prompted companies to devote more resources to track a broadening array of suppliers' risks.

The financial shocks may not be over. There's the ongoing threat of sovereign defaults in Europe and their possible financial ripple effects. Rising commodity prices threaten the bottom lines of suppliers, which, locked into contracts with customers, must absorb those potentially fatal higher costs.

And the combination of the financial crisis and the Great Recession is taking its toll in the U.S. Chapter 7 bankruptcies in 2010, for example, increased 16% through the third quarter, compared to the same period in 2009, according to the Administrative Office of the U.S. Courts.

If a supplier unexpectedly declares bankruptcy and liquidates its assets, the outcome can be dire for its customers, as opposed to a more manageable Chapter 11-type reorganization. How many Z4s could BMW sell without sunroofs?

"If one of the companies that supplies you with a critical part goes down, then your whole manufacturing process can stop," says Jerry Flum, CEO of CreditRiskMonitor, a provider of corporate financial information analysis and news that competes with D&B. "We're talking about jugular-vein risk in the supply chain."

At least two business trends exacerbating supplier risk have peaked in recent years. One is companies' fervent focus on their "core competencies," which has prompted them to outsource any production that isn't directly related to the product or service they offer. That's resulted in supply chains stretching around the world.

A second trend is the push toward "just-in-time" inventories, which allow for more efficient use of capital and reduce the risk of excess inventory should demand unexpectedly drop.

Outsourcing introduces many more risk variables into the supplier equation, including transportation and political risks, while the just-in-time approach to inventories makes each of those variables much more critical to control and hedge.

"Companies have pursued these strategies to take cost out of system, but it has made supply chains more brittle and complex," says Jim Lawton, president of supply-side solutions at D&B. "The point companies have woken up to is that while before it was a supply problem, now it's a business problem."

Consequently, analyzing suppliers' credit risk is no longer the domain solely of the purchasing department, and corporate finance executives are playing an increasingly important role. Bjugger notes that as the financial crisis unfolded, the corporate finance department at Volvo's head office "requested regular reports from us and monitored crisis cases, if any, on a weekly basis. This monitoring is less intensive at present but still in place."

And now that the global economy seems to be on the mend, companies are ramping up production, presenting a new, operations-oriented risk to monitor. In addition to ongoing liquidity risk, says Bjugger, critical risks include those "linked to suppliers' production capacity to cope with the increased demand of their automotive customers like us."

That risk has emerged on the radar of customers using PrimeRevenue's supply-chain finance tool, which lets a company's suppliers view the real-time status of their receivables and potentially receive faster payments from members of PrimeRevenue's lender network. PrimeRevenue also performs a working capital analysis of its customers' top few hundred suppliers, examining the credit risk of those companies as well as their key suppliers.

"Whereas during height of credit crisis the emphasis was on supplier solvency, now we're seeing more concern about supplier response time," says Robert Kramer, vice president of working capital solutions at PrimeRevenue.

Whatever the reason for suppliers' shortfalls, they can damage the corporate customer's bottom line, so companies are wise to analyze the supply chain impact of risks in addition to credit.

Timothy G. Martin, vice president of supply chain at R.J. Reynolds Tobacco Co., the largest subsidiary of Reynolds America, says analyzing supply chain risk has always been a company priority, and suppliers' liquidity and credit shortages remain an ongoing concern.

Another recently emerging risk, he adds, has been the new powers granted to the U.S. Food and Drug Administration in June 2009 to regulate the manufacturing, marketing and sale of tobacco product. The FDA "is focused on supply-chain risk, and on our ability to assess quality risk and mitigate this risk throughout our supply chain," Martin says.

Other risks that can prompt supply-chain disruptions include law suits, violations of Environmental Protection Agency rules, or the designation of a supplier as a terrorist organization or supporter by the Office of Foreign Assets Control, and its subsequent sanctioning. Research firms monitor for such events, for a fee, but companies can do much of the monitoring on their own by subscribing to news services that enable automatic searches for key words.

Even risks that have always been present should be considered more carefully in today's environment. Dan Fulton, vice president of credit at Metl-Span, a producer of insulated metal panels that was acquired by Australia's BlueScope Steel in 2008, notes the importance of scrutinizing more closely the terms and conditions in contractual agreements between companies and their suppliers.

"Now, if a supplier is struggling and an issue comes up that could be worth thousands of dollars, the supplier is more apt to refer to its terms and conditions," Fulton says, noting that broadly written indemnity clauses could put a corporate customer on the hook for more liability than it bargained for.

"The terms may be something like, 'If we buy the steel, we're liable for any and all claims,'" he says. "That's a very general statement and probably should be excluded." Fulton adds that the company should negotiate the terms to refer to transactions only between the firm and its supplier.

An industry of research firms offers windows into supplier risk, but none covers all the bases. Credit rating agencies, for example, assess publicly issued bonds and very large bank loans, but the agencies are renowned for the tardiness of their warnings. In any case, most companies' suppliers are too small to have rated debt. Moves in the prices of credit default swaps can indicate credit problems in a more timely fashion, but only the biggest debt issues generate credit default swaps. And many suppliers are private companies, most of which rely on bank loans and private placements, rather than issuing public debt.

Firms such as D&B, CreditRiskMonitor and PrimeRevenue scrutinize a long list of risks in addition to credit risk, including operational disruptions and brand risk. They aim to be more timely than the rating agencies by scouring a vast array of data and news sources to provide predictive scores and alerts warning of potential supplier troubles.

Michael Denton, a partner in the corporate risk division of management consultancy Oliver Wyman, says companies shouldn't rely on any single source for their supply chain analysis. In a recently published report, Oliver Wyman recommends that companies develop their own predictive credit analysis frameworks. "Midsize firms, too, need to go beyond ratings agency information," Denton says.

Corporate customers have an advantage when it comes to gathering information about private suppliers. "As a buyer, I can demand a lot of things from sellers; more than sellers can from buyers," says CreditRiskMonitor's Flum. His firm recently launched a service enabling companies to upload financial information they request from private suppliers and compare it against other companies.

Denton recommends that companies compare not only financial data but also more qualitative information, such as management changes, M&A activity and other major events that often require follow-up phone calls to the supplier to determine the impact. He also points to late deliveries, requests for early payments, and variations in quality as early warning indicators that may foreshadow future supply problems.

The challenge then, Denton notes, is turning qualitative information into numbers that allow a meaningful comparison between suppliers.

"It ultimately comes down to creating a framework with a defined set of questions," he says. "For each of your responses, you attach a number that when weighted properly can be compared against other suppliers."

While companies should already be keeping careful tabs on their most vital suppliers, and perhaps those suppliers' suppliers, they may be unaware of firms further down their supply chain, where an unexpected bankruptcy could have a damaging domino effect.

The extensive databases of companies like D&B offer insight up customers' supply chains, while other vendors, such as Revere Data, offer the ability to explore those relationships.

Revere maps connections between companies, including supply chain relationships, and has been working with Ashbury Heights Capital to apply algorithms that rank companies' importance in the overall economy as well as in specific supply chains. That service is currently available, but Revere and Ashbury are working on a more user-friendly version that will facilitate information searches, much like Google did for Internet searches, says Kevin O'Brien, CEO of Revere.

Eric McGill, managing director at Ashbury Heights, says looking at the supplier matrix in early 2008 shows General Motors ranked very high in economic importance in the U.S. "You may quibble about whether GM should have been bailed out," says McGill, "but from a theoretical standpoint, yes, it was a very important company."

Today, Revere mostly sells to Wall Street firms, as well as some corporate customers in industries such as technology and healthcare that use its service for business intelligence. Such a service could be valuable from a supplier-risk perspective as well, enabling companies to spot bottlenecks up the supply chain--critical suppliers several links away.

"If a firm identifies a critical dependence on a supplier, it could purchase the company or innovate around it by finding another supplier or developing that part on its own, so it's not so dependent," says McGill.

The company could discover that it's one of a supplier's few customers, giving the purchaser greater pricing power. It could also view supply chain risk from a competitive standpoint, McGill says. "Here is my supply chain risk, and how does it stack up against my five closest competitors'."

To read more about supply chain risk, see A Lifeline for Suppliers.

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