A Looming Recession: Will it Drive up Supply Risk?

Yesterday, I posited that the chance of a worldwide economic slowdown or recession had a moderate to strong degree of probability based on Caterpillar's 2007 revenue warnings, as well as a number of other economic indicators that together signal a downturn (e.g., falling housing prices, inverse debt yield curves, declining automotive sales). We can all agree that a recessionary environment presents a great opportunity to drive price concessions from suppliers (in many cases, without sacrificing their margin, since falling commodity prices will often buoy a supplier's bottom line). In addition, as capacity opens up in such constrained markets as specialty metals, memory, and even giant tires, the likelihood of suppliers negotiating more favorable terms and pricing to simply keep busy increases as well, especially when a supply base has made significant investments to bring new capacity online in recent years. But despite the favorable sourcing and Spend Management environment an economic downturn brings, it also introduces the very strong possibility of material increases in supply risk as well -- both locally and globally.

On the Western front (North America and Europe) the probability of suppliers going bankrupt in such challenged markets as automotive will certainly increase in a down market. Earlier this year Alix Partners, a consultancy, suggested in a report that "Thirty-eight percent of North American and 24% of global [automotive] suppliers face possible insolvency." But even in less risky vertical markets, a lack of ready access to capital as banks make obtaining loans more challenging will increase operational risk as suppliers are forced to operate on shoe-string budgets. This point reminds me a of a story I heard last week from a tier one A&D provider who visited a metals supplier and found out that their price concession demands so cut into their supplier's margin, that their supplier was forced to buy direct materials COD. In this case, the supplier was not set up to operate in a lean environment! It was dieting because it had to. But in my book, there's no doubt that famine and starvation are quite different ballgames. And this type of behavior suggests that a recessionary environment might bring even more supplier quality and operational risks than those pertaining to just financial viability.

But perhaps the greatest area of supply risk in a recession or market downturn comes from global suppliers. Because Chinese suppliers, especially, are extremely constrained by access to capital, and many are constantly about as leveraged as one can be without closing the doors. Without access to lines of credit or capital through other means, changing demand signals could wreck havoc with their ability to support ongoing operations. I will say, however, that a recessionary-driven shake-out in global suppliers is far overdue, as far too many companies have been competing on low-cost labor alone. But I would not want to be the one waiting on a container from a low-cost labor supplier when the shake-out actually happens!

Later this week, I will examine what investments procurement and operations organizations can make to take full advantage of a downswing in the market -- as well as those which they will need to make to prevent downside risk.

Jason Busch

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