Financial health of Chinese suppliers…is a concern

Don’t let what has happened in the stock markets (locally as well as globally) these past few months give you a false impression that normalcy might be returning to China manufacturing…it remains a brutal operating environment for manufacturing.

Tightening in the credit markets continue globally, declines in demand remain in most industries, and competition is becoming much more intense.  And….you can take it to the bank….the same consolidation and restructuring that is taking place elsewhere in the world will certainly happen here in China…and the pressure will be on Procurement professionals to know how to select those suppliers that will be among the survivors.

Concerns Going Forward

I believe Supplier Disruptions is likely in most industries.  BBK has a financial rating process subscribed by over 50 multinational clients and has assigned risk of financial distress for 7000+ individual suppliers globally since 2007.  With regards to Chinese manufacturers, 15% are now considered as financially distressed. This is up from 9% in 2008.  As a comparison, 40% of Korea suppliers are now financially distressed versus 27% in 2008.  

Another concern is that current economic crisis is rapidly accelerating consolidation in many industries.  There are simply too many companies operating in virtually every industry here in China.  There are 100 wheel suppliers in China with enough capacity to supply wheels for 100 million vehicles per year.  The biggest Logistics provider in China has 2% market share.  The top 10 players in the pharmaceutical industry have only 13% market share. The top 100 automotive suppliers in China have only 50% of the market share.  The list goes on.  In most every industry, the supply base will consolidate 30% to 50% as industries align to consumer demand and economies of scale are created.

Lastly, I have a grave concern that lenders are starting to take more aggressive actions to exit companies & industries in some cases…Let me share one recent example of what I am referring to.

Any of us who have worked in purchasing knows painfully well how a distressed supplier, which runs out of cash and can no longer maintain product shipments, presents some unique challenges.  Recently, one multinational OEM who was dependent on continuity of supply from a distressed Chinese supplier had to face such a situation.  The supplier’s sales were heavily dependent on export.  It had high debt levels, experienced a substantial drop in sales, and was exposed to rising raw material costs…. consequently, it generated large operating losses, violated its bank covenants and did not generate enough cash to service its debt.  The banks exercised their security interest in all of the supplier’s assets, including its inventory, and stopped all customer shipments.  The banks recognized the OEM’s dependence on the supplier and demanded “hostage” payments above the contract price to release shipments.  Although the OEM only needed a portion of the supplier’s inventory it was forced to pay premiums for shipments needed while it developed a replacement supplier.

We see lenders taking much more aggressive actions than in previous times.

Financial Health of Chinese Suppliers

Let’s start with the obvious…suppliers saw less sales growth Year over Year in 2008 versus 2007.  Significant sales growth covers up lots of operating problems or debt issues. Suppliers that are solely dependent on domestic volumes are better than the averages & those suppliers that are heavily dependent on exports are worse than the averages.
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                                         2007     2008
Sales Growth (YoY)    77%      25%
Net Income/Sales       7.6%      3.7%
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Net income as a % of sales reduced from 7.6% in 2007 to 3.7% in 2008….not surprising. An interesting point about profit margins in China is that in most of the industries we follow, the Tier 1’s/Tier 2’s have higher margins than do the OEM.
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                                      2007   2008   2009
Liabilities to Equity  1.4      2.0      1.6
Quick Ratio*               1.2      1.0      0.8
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*Current Assets less inventory / Current Liabilities

Here we are looking first at the ratio of total liabilities to equity. A slight deterioration from 1.4 in 2007 to 1.6 currently can provide an indication that Chinese firms, relative to their owner’s investment, took on more liabilities such as borrowings or extended trade payables.  This trend is important to note since it is more difficult for companies with high leverage to access additional capital which could be needed to weather a downturn. Liabilities to Equity ratio of 3.0 can usually lead to problems in accessing additional borrowings. 

The quick ratio represents a company’s current assets (such as cash, accounts receivable, but not inventory…I want to talk more about inventory in a minute) divided by its current liabilities (such as accounts payable, debt payments due within the year or tax liabilities). In 2008, the quick ratio of Chinese firms deteriorated to 1.0 from 1.2 in the prior year and is currently averaging 0.8.  It is worth noting that a ratio of less than 1.0 implies that a company does not have enough current assets to cover its near-term payment obligations.  A company who’s quick ratio declines close to this level represents a higher risk of distress since business changes, such as a customer requiring longer payment terms, suppliers demanding quicker payments, or declining sales place additional strains on a company’s liquidity. While the two financial metrics illustrated here are not sufficient to fully evaluate an individual supplier’s health, the noticeable degradation over this sampling of suppliers sends a signal that the global downturn has impacted the financial health of Chinese suppliers and could threaten their ability to maintain a reliable supply….
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                                                             2007  2008
Accounts Payable (in Days)            92    57
Accounts Receivable (in Days)       89    79
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When we look at what has happened to changes in Accounts Receivables & Accounts Payables, on average, most suppliers have been paying their suppliers quicker than previously….most likely pressured so by many of their suppliers…and is a cause for deterioration in working capital at several companies.  Purchasing organizations are requested to target matching up payment terms to suppliers with those payment terms agreed to with their customers.  You certainly don’t like paying your suppliers before you get paid by your customer.
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Supply Base            Inventory Turns*
China                           3.1
Korea                          13.7
Japan                           9.7
US/ Europe                 12.0
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*Annual Sales / Inventory

Lastly, let’s look at inventory. With the increased pressure on balance sheets and Cash Flow being more critical now than ever, we see Inventory Management as perhaps the single greatest opportunity for operational improvement and, an area where many Chinese Manufacturers should begin to immediately focus their attention!

Here we are comparing inventory turns for Chinese companies versus their counterparts elsewhere in world. Inventory turns is measured as Annual sales / Inventory (Finished, WIP & raw material). 

Chinese suppliers significantly lag the performance of its peers in other countries. Reducing inventory levels frees up cash and improves a firm’s liquidity which is most crucial in this environment.  For many firms this also reduces its need for bank borrowings and their associated interest expense.  One of the first places we look for improvement in financially distressed companies is Inventory Management

Proactive approach to supply base viability will save significant RMB in costs

As many companies rethink how to structure their Chinese operations into their overall global supply chain strategy, most are concluding that a comprehensive Supply Risk Management (SRM) process that proactively monitors and validates the financial and operational viability of a supply base is essential for identifying distressed suppliers early.  The earlier the problem is identified, the more time a supplier has to find a solution or look to a new source to protect the customer from substantial revenue loss due to production interruptions or delays. Customers need to evaluate its suppliers’ financial and operational viability both prior to awarding the contract and on a regular basis thereafter. This requires understanding aspects of the supplier’s business that they might be hesitant to share, such as profitability levels.

SRM is critical for companies with the potential for supplier problems that could affect performance and delivery and for companies who have an inability to source from another supplier to prevent disruption. This may be due to suppliers with proprietary processes, the need to move customer-owned tooling, or simply the time necessary to contract and validate with a new supplier.

For those suppliers that are deemed “high risk”, an action plan to mitigate the risk should be tailored to the specific situation.  Some risk mitigation tactics include:
• Regular monitoring of the company’s financial health
• Building safety stock inventory
• Identifying alternative suppliers
• Working with the supplier to develop and implement operational and financial improvements. 

While each distressed supplier may present unique challenges, the benefit of averting a crisis can help your firm protect its bottom line. 

About the author: Duane Bolinger, Gasgoo's columnist, is Managing Director of BBK Consulting Co., Ltd. of Asia Pacific. Prior to BBK, Bolinger's senior roles with automotive companies have included Managing Director of ASIA Pacific, Corporate Finance Director, Business Line Executive, and Director of Strategic Planning for General Motors Worldwide Purchasing and Production Control.

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