Sourcing Innovation: Securitizing Direct Materials

Last week, a number of my blogging colleagues began posting their thoughts on sourcing innovation. This unofficial brainstorm round-robin came courtesy of Michael Lamoureux, who suggested that we all chime in, providing our thoughts and opinion on the future of sourcing. Today, I thought I would share an innovative sourcing concept that I've been kicking around for quite some time, but is probably closer to reality today than it was when I first thought of it in my early days at FreeMarkets when I tried unsuccessfully to build a business plan around it. I apologize if this post comes off as more of a ramble than my usual musings, as I want to get a fair amount down on these virtual pages in a short space. This post also assumes a bit of prior knowledge on options, futures, and capital markets to fully get the gist. So here goes:

Historically, companies have always purchased direct materials from suppliers based on a direct relationship (i.e., company A contracts with supplier B to provide parts X, Y, and Z). Reverse auctions, strategic sourcing, optimization, and one-off part capacity-based marketplace approaches (e.g., have done nothing to address the underlying problems with this model. That's because if looked at from a capital markets perspective, traditional -- or even new -- sourcing approaches are woefully inefficient. Consider that if you were a stock broker, would you contact a company to buy its shares or debt directly? No, unless you were in private equity. Rather, you would buy it on an open market, conducting a trade through a physical or electronic exchange (and quite possibly through an intermediary such as a floor trader). And because you were buying it on the open market, you would pay a true market price -- the ask price -- and if you were selling it, you could sell it at the bid price.

If you were buyer or seller, you might even trade on the company’s futures, hedging your bets or taking additional risks and possible returns by buying or selling options contracts which would give you the right -- but not the obligation -- to buy or sell the stock at a certain price on a certain date. In the financial markets, these mechanisms combine to create liquidity and tighter spreads in pricing the underlying commodity, or in this case, stock. It also allows outsiders or traders to speculate as well, creating a true market environment and enhanced liquidity. In other words, the invisible hand is not so invisible at all, in a true bid/ask market.

Now, let's take this concept and applying to the world of direct materials. Consider metals categories such as forgings, castings, and machinings. We all can agree that it would be impossible to securitize future production of actual parts on a bid/ask market given that many are built to print, or delivered in a customized fashion (e.g., JIT) which introduces too many variables to factor into a pricing equation, and that would most likely not be desirable for another party. But what if you could securitize future capacity (e.g., future machine time and the costs of the other underlying components such as materials and labor)? What if, for example, a major industrial manufacturer approached its top suppliers from a quality perspective and told them that they could guarantee them a certain amount of capacity for the next thirty-six months -- given their machinery, equipment, and labor capabilities -- but did not know exactly what they would want them to supply, but knew, exactly, the amount of time necessary for production runs of certain parts (as well as the cost breakdown elements of these parts). Then, things get interesting. Because what the company is in effect buying are not parts, but capacity, which is something which is possible to securitize and trade with other organizations. And once something is securitized, it's possible to start to trade it on the options side of the equation as well, which could benefit all parties. What if, for example, a supplier sold a put option on a certain amount of capacity for delivery over a three month period in a year's time?

Suppliers would benefit substantially from this model. For one, they could forward sell capacity and realize cash flow to fund investments in equipment, labor, etc. They would also benefit by better understanding the market price for capacity. Perhaps this type of "capacity" sell would also benefit suppliers by letting them lock-in a portion of future revenue, while letting them float the rest by letting other companies buy on contract based on specified demand. In any event, stable, predictive, operating cash flow is a major benefit of this model, at least on the supply side.

Buyers would also benefit by being able to choose to buy a balance of capacity or the actual parts themselves, and ensure they were purchasing at a true market price. And they could also take a more active role in acquiring the underlying commodities that go into finished parts from suppliers, reducing risk and variability of supply markets pricing, avoiding escalation / de-escalation clauses entirely. In addition, if they were not happy with the current market price for capacity, they could try a direct negotiation technique, or they might hedge their bets by buying a "call" on future capacity rather than the underlying contract itself. And if they know the supply market well, perhaps they might even become a trading party, buying and selling capacity for profit based on their analysis of the market. The possibilities are endless, but the potential for all parties is huge. So Frank Russo, if you're reading this, what about having consider such a model! You guys are in a far better position to attempt such an approach than anyone else out there.

Jason Busch

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