About the author: James H. Gellert is chairman and CEO of RapidRatings, a financial health data and analytics company.
Those expecting a quick end to the supply-chain crisis are going to be sorely disappointed.
Port back-ups, trucker shortages, factory closures, and shortages of raw materials are huge contributors to this current wave of the crisis. But a second wave looms on the horizon. This wave will be harder to identify, and too many companies are focused on just the current crisis without appreciating the risks of what’s coming next.
Viewed broadly, public and private companies across the globe reduced short-term risk during the pandemic by adding cash, and debt, to their balance sheets. Despite taking this step, many took on more risk from a long-term perspective. How does this happen? In these cases, companies’ underlying businesses might improve while the cash lasts, but if they don’t, they must get more liquidity to buy more time. If companies can’t resolve their debt problems, they either fail or begin to cut corners that create unseen problems for their customers.
Financial failure of a supplier is never good, but at least it’s often clear-cut. A supplier’s degradation can be more insidious, creating risks that are harder to see, but that are costly and potentially critically damaging to its customers.
Wave two of the supply-chain crisis will come from suppliers that are profoundly degraded by the challenges of the past 20 months, where operational, reputational, and financial risks are being introduced to their customers downstream. It will happen when companies cease being able to Band-Aid over problems with cheap and historically easy to access capital.
Here’s how it will play out.
A supplier that cuts corners in IT spend may create cybersecurity risks for its customers. One that delays products or reduces R&D spending is less innovative and responsive to a customer’s own product development and agility. A supplier that cuts corners in health, safety, or manufacturing-equipment upgrades introduces sustainability, quality-control and delivery-timing problems, which lead to challenges with reputational risk, business continuity, revenue disruption, inventory management, and working-capital efficiency.
Since March 2020, we’ve seen companies across industries raise capital to stave off business failure or to address operational damage caused by Covid-19 and the first wave of the supply-chain crisis.
While government interventions such as the Paycheck Protection Program helped, the environment of liquidity and low rates sustained by the Federal Reserve Bank since the 2007-2009 financial crisis has created a market dynamic where almost all companies can raise debt capital. As a result, pension funds and other asset managers have spent the last 12 years searching for yield in this low-rate environment, stretching down the credit spectrum to buy exposure to riskier companies in order to hit their benchmark returns. At the same time, more providers of debt capital have emerged, creating a largely unregulated and untested asset class of alternative credit providers. These two forces have propped up companies and provided affordable capital all the way down to the smallest of private companies in a typical supply chain.
Companies across industries—from autos to leisure to retail—have borrowed more, increased cash to current liabilities and bridged themselves through an incredibly hard operating environment. In the meantime, many subsegments within these industries have become increasingly risky, but for the temporary boost of capital.
There are signs of stress even in industries that have done well operationally, such as semiconductors and microelectronics, which have had tremendous pricing power through wave one of the crisis. RapidRatings’ Core Health Score measures companies’ longer-term strengths and weaknesses. Among companies at or under $50 million in revenue in the semiconductor industry, the average score now sits at 40 on our 0-100 point scale, one point above our high-risk category. Over 90% of companies that have failed in the past 20 years were rated at 40 or below. All that said, this subcategory of companies has an average Financial Health Rating—which measures short-term default risk—of almost 60, giving it the largest delta between short-term default risk and long-term core quality in the industry.
In our experience rating public and private companies from 150 countries, regardless of industry, private companies make up 75% of the average Fortune 1000 company’s supply chain. As private companies’ access to capital goes, so does the resilience of the chain.
Bottom line: At some point in the not-too-distant future, these and other companies that are facing a mountain of debt will need financing (or refinancing, as the case may be), and many will be unable to raise liquidity at affordable rates, if at all.
Cracks in the credit market are already starting to emerge. The distress of Chinese property developer Evergrande is sending shockwaves around Asia. The Fed’s decision to begin tapering has put bond market investors on edge. Those issues add to a lengthy list of concerns: PPP funding has long since run out. Inflation now appears sustained rather than transitory. There is significant volatility in risk assets, including High Yield Bond Index cash outflows, cryptocurrency swings, and quick shifts in more equity markets. All that plus unease about the Omicron variant means a perfect storm will catch many suppliers that have been underperforming materially, if not failing outright.
Fortunately, one of the biggest trends in supply-chain risk has been supplier collaboration. Private-company suppliers recognize the commercial value in transparency and are more open to disclosing financials; intellectual property; information security; environmental, social, and governance initiatives; and other sensitive material. Supply-chain risk professionals who engage with those suppliers to understand their financial health are best positioned to help mitigate problems and build the most resilient supply chains possible—creating value for both customer and supplier, and helping the investor-relations professionals and chief financial officers of the world communicate trustworthy narratives hinged on true resiliency.
Despite all this, there is more work to be done. Many of these professionals will need more support and resources. In 2022, there will be intense scrutiny from shareholders on those controlling the narrative of their companies’ supply-chain risk-management strategies. That magnifying glass will also focus heavily on how they are preparing for the next set of risks. While risks, in and of themselves, can’t be eliminated—they can be managed. Especially as a second wave approaches, knowing what these risks are is key. To be clear, the sky isn’t falling today. That said, supply chain risk managers need to be looking upwards.
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