Last week I had the privilege of delivering a presentation at the CFO Rising conference in Orlando, Florida on the topic of Supply Chain Finance.  I was fortunate to be presenting jointly with Neal Harm who is the Chief Administrative Officer of BB&T’s Commercial Finance group.  BB&T was a key exhibitor at the show, promoting their new integrated financial supply chain product - Supply Chain 360 (http://www.bbt.com/bbt/business/products/supplychainsolutions/supplychain360.html).  Working with the BB&T team on their product launch activities has been a rewarding experience for me as I have found their Commercial Finance team to have some of the most visionary thinking in the industry.  We were fortunate to draw a crowd of over 40 CFOs and senior level finance executives, who were all very actively interested in this hot topic.

Why such a crowd?  Because, supply chain finance promises to enable radical new efficiencies for managing working capital in the value chain.  Supply Chain Finance is a multi-faceted concept.  Some of these concepts can be leveraged today while others are more visionary at this point.  Without question the most widely embraced aspect of supply chain finance today is the idea of post-export supplier financing.   The term is intimidating to those not familiar with trade finance, but the principles are actually quite simple and familiar to anyone who has used a credit card. 

Comparison to the Credit Card 

We are all familiar with how a credit card model works, but I will recap a few of the more relevant points that help to illustrate the analogy to supplier finance.  Let’s suppose that you are a sports fan that has decided to invest in a high definition plasma television to enhance your viewing experience.  Perhaps, if you are in the US you may wish to buy a new HDTV in time for this month’s NCAA basketball tournament.  So after evaluating the various brands and product options you make a visit to your favorite consumer electronics retailer to purchase the TV.  The easiest way to purchase a high value item such as a TV is probably not to carry cash, but instead to use a credit card.  Using a credit card, you can purchase the HDTV on credit, taking possession immediately without having to present any cash to the merchant (electronics retailer).  The merchant assumes little risk as the bank who issued you the credit card guarantees payment in all but a few scenarios.  And the merchant is paid quickly.   Within just a few days of uploading their point-of-sale transactions to their bank, the merchant is reimbursed for the value of your purchase.  However, you (the consumer) do not have to remit any payment for at least 30 days when your next monthly statement arrives.  At this point you can decide to pay the balance in for your monthly purchases (including the TV) full or defer payment until later.  Or you might pay only a percentage, financing the remainder of the balance. 

The credit card model has become the most popular means of retail payment due the benefits it offers to both consumers and merchants.  Consumers can purchase goods and services on credit, deferring payment until a later date that enables them to optimize their cash flows.   The merchant offers a simple, hassle-free approach for consumers to make payment, but also benefits from the relatively fast inward cash flows that the credit card system offers.  Both the issuing bank and the merchant’s bank also benefit by charging a processing fee to the merchant for facilitating the settlement process.  The issuing bank that provides the consumer the credit card also enjoys significant upside, in that, the consumer may elect to defer payment of the balance.  The issuing bank then enjoys an additional income stream as interest accrues on the consumer’s balance.

Supply Chain Finance – A Credit Card for International Trade 

Supply Chain Finance operates under similar principles as the credit card model except that the transaction is business-to-business rather than business-to-consumer.  Suppose, for example, a large UK-based department store is purchasing a line of apparel products from a third party contract manufacturer in Vietnam.  After reviewing samples and finalizing on a sales forecast, the retailer places a bulk order for the clothing with the manufacturer.  The manufacturer acquires the fabric materials, performs the sewing process and then ships the product to the retailer’s distribution center outside of London.   Concurrently, an invoice is sent from the manufacturer to the retailer’s accounts payable department.   The retailer performs a series of validations and matches on the invoice to ensure consistency with the quantities, colors and sizes specified on the original purchase order.  The invoice is then approved to pay.  In a traditional buyer-supplier relationship, the retailer may withhold payment of the invoice until its maturity which could be another 30 or 60 days after receipt of the goods.  Why?  Because, most buyers prefer to hold onto their cash as long as possible so that they can put it to use in other ways.  However, in the supply chain finance model, a different sequence of events occurs – very similar to the consumer credit card example described earlier. 

In the supply chain finance model the retailer will instead notify the bank of their intention to pay the supplier at term.  The bank will then approach the supplier asking if they would like to be paid immediately.  Most suppliers, especially smaller ones in emerging markets such as Vietnam, are cash constrained.  As a result, the early payment option is appealing to them.  Upon confirmation from the supplier, the bank immediately transfers the appropriate funds to the supplier’s account.  The supplier has now collected its revenues from the products it manufactured.  And the bank has assumed responsibility for collecting the payment from the retailer.  30 or 60 days pass until the date the original invoice is due is reached.  Now the bank will collect the appropriate funds from the retailer.  At this point, the retailer may elect to settle the transaction in full with the bank.  Or they may request to extend the payable to a future date based upon their cash flow situation. 

Let us compare the retailer B2B example to the earlier B2C HDTV purchase example.  In both scenarios, the suppliers (the apparel manufacturer and the electronics retailer) are compensated shortly after delivery of the goods.  In both scenarios, the buyer (the department store chain and the sports enthusiast consumer) has the option to settle their transaction balance within the original purchase terms or to extend terms with an interest-based financing approach.  In both scenarios, the banking system provides short term financing to bridge the time-span between when the buyer takes possession of the goods and the buyer makes payment.  The most important concept is the value created to all three parties in the transaction.  The timing of the supplier’s inbound cash flow is accelerated.  The timing of the buyer’s outbound cash flow is maintained or extended.  The financial institution generates income from the processing and financing of the transaction.

Given the analogy above, you might ask why the credit card companies are not participating in the supply chain finance market today.  The answer is that they plan to.  Facilitating B2B payment transactions and short term financing arrangements are a natural extension of the value proposition and capabilities credit card processing networks offer today.  Of course, the funding sources for the short term financing will be the actual banks.  There is an interesting study in contrasts when one compares the situation in the banking sector to the major credit card brands.  MasterCard and Discover have both enjoyed tremendous success with their IPOs.  The Visa public offering scheduled for this week promises to be one of the largest in history.  By contrast, the banks are struggling to keep afloat as the credit crisis continues to worsen.  With the collapse of Bear Stearns over the weekend and the recent turmoil in the financial markets, one might question whether adequate liquidity and credit facilities will exist to support supply chain finance…

Steve Keifer 

© Copyright 2007 GXS, Inc.  All Rights Reserved.

The US Automotive Market in 2008 

It seems like every day more and more people are talking about a probable US recession in 2008.  As a result businesses in every industry are exploring the potential repercussions of an economic slowdown.  The automotive industry is one sector that will certainly not be immune to a downturn in consumer spending.  However, the industry may be better prepared than other sectors due to its recent history.  Over the past 5 years many of the US manufacturers have been reengineering their business models to account for the rebalancing of market share that has occurred between domestic and foreign brands.   Many believe that the worst of the transition is over, but the market dynamics are poised to shift once again.  Throughout the past few weeks a number of noteworthy equity analysts at major securities firms have lowered their 2008 forecasts for US auto sales.  Sales projections have been revised downward from bullish estimates of 17 million new vehicles down to lower forecasts closer to 15 million new units.   When times get tough in the automotive industry, much of the attention focuses on the Big 3 OEMs and their Tier 1 suppliers.  But the retail dealerships who sell the vehicles to end consumers struggle as well.

The Dealer Challenge 

There are several key challenges for auto dealers in recessionary periods.  First, dealers must compete for a smaller number of overall sales.  Furthermore, dealers are challenged to win business from Internet-savvy consumers who are much better educated on the true vehicle costs, financing options and aftermarket accessories than ever before.   Another significant challenge for dealers is sales forecasting.  To win consumer sales, dealers must be able to offer the right car at the right place at the right time for the right price.  Consequently, a dealer must be able to estimate the exact product mix they need on their lot weeks, if not months, in advance.  If dealers underestimate demand for popular makes and models they risk missing sales opportunities.  If dealers overestimate demand then they will be stuck with excess inventory which they may need to hold on their books for long periods of time.  Ultimately the dealer may be forced to offer incentives or discounts to sell excess inventory.  The challenge of how dealers can forecast consumer demand for vehicles is one of the most complex issues in the automotive supply chain.  I will defer that discussion for a later post.  Instead, I would like to explore the financial implications of overestimating consumer demand.

One of the challenges with excess capacity is the risk of obsolescence and depreciation.   Vehicles which remain in inventory for extended periods of time may decline in value.  The risk is higher for units acquired during the summer months preceding the new model introductions in the fall.  It is not uncommon for vehicles to remain in a dealer’s inventory for 90-120 before purchase.  However, during a recessionary period of low sales, some vehicles might remain in inventory for periods of up to 9 months. 

Another challenge with excess capacity is financing the inventory.  At any point in time a dealer may have a few hundred (or thousand) vehicles in stock each of which ranges in value from $15,000 to over $50,000.  If you do the math, you quickly begin to understand the financial challenges associated with holding inventory.  A dealer with 500 units each valued at an average of $20,000 is holding $10,000,000 in inventory at that point in time.  How do small businesses such as dealers afford this?   

Note that there is an increasing trend towards consolidation in the US dealer market as chains such as AutoNation, UnitedAuto Group, Sonic Automotive and Group 1 Automotive continue to purchase smaller franchises.  However, the majority of dealers by numbers are small or midsize companies.

Dealer Floorplan Financing 

Instead of leveraging their own working capital for inventory, dealers rely upon specialized short-term lending programs from their banking partners.  The financial institutions offer a line of credit upon which dealers can draw from to fund “floorplan” inventory.  Floorplan in this context refers to vehicles both in the dealer showroom and on their lots or extended storage facilities.  Lenders assess interest and various fees in exchange for the financing services. 

Floorplan Financing - How it works

1.       The dealer places an order with the automotive manufacturer OEM.

2.       The manufacturer ships the vehicles to the dealer location.

3.       The invoice for the shipment is sent to the dealer’s preferred floorplan lender.

4.       The lender transfers funds to the manufacturer under the terms of sale.

5.       The cost of the vehicle is applied to the dealer’s line of credit.  Interest is assessed for the duration of the vehicle’s presence on the showroom floor (or outside lot).

6.       Once the vehicle is sold, the dealer pays the lender for the amount financed.

The steps above are an oversimplification of the process.   A much more complex set of loan servicing, technical integration and relationship management activities occur behind the scenes.

Technology Complexity 

For example, a significant challenge in the floorplaning process is tracking the inventory of vehicles and the associated financing activities.  A complex set of information flows between the automotive OEM, dealer and financial institution must be orchestrated to track and finance each individual vehicle.  To reduce the costs of financing fees, all parties are incented to automate workflows using technology.  Ideally, the process works as follows:

1.       Electronic invoices are extracted from the manufacturer’s accounts payable system and transmitted to both the dealer and financial institution.

2.       After processing the invoice, the lender transfers funds to the manufacturer using an automated clearinghouse transaction.  Associated remittance data detailing the payment transaction is routed from the lender to the manufacturer.

3.       Once the vehicle is sold to a consumer, the dealer pays off the floorplan loan to the lender.  A payment instruction is routed to the dealer’s bank transferring funds into the lender’s account.

4.       Throughout the process, all three parties – manufacturer, lender and dealer – can view the status of financing activities and the location of inventory through a common web-based portal.

Of course, the key to success for automation of the workflows is B2B e-commerce technology.  Without integration and digital document exchange between dealers, manufacturers and lenders, the process would be significantly more complex and risky.  This is yet another powerful example of EDInomics at work.  Visibility to inventory and financing activities becomes even more critical during recessionary periods.  Financing is typically arranged for a few months for each vehicle.  Once a pre-determined threshold of days has passed, the lender will begin curtailing their risk, by asking the dealer to pay a percentage of the inventory value. The payment reduces exposure for the lender in the event of vehicle obsolescence.  Both dealers and lenders will closely monitor their risk exposure for long-term inventory vehicles.  We can expect the scrutiny applied by banks will be even stricter in the coming years in the wake of the subprime mortgage crisis.

I will offer one final thought.  This is less relevant to EDInomics, but an interesting aspect of the dealer floorplan market.  It has to do with the relationship dynamics between lenders and dealers.  Lenders collect interest income and administrative fees from the financing offered to dealers.  However, the end goal for the banks is not the interest revenues from the floorplan financing.  The margins on these types of commercial financing are relatively low.  The real reason that lenders offer floorplan financing to dealer chains is to capture lead referrals for consumer auto loans.  75% of consumers financing vehicle purchases use the dealer’s recommended lending institution.  As a result, the dealer segment, collectively, has an incredible influence on the consumer auto loan market.  Traditionally, the captive financing divisions of major OEMs (e.g. GMAC, Ford Motor Credit, Toyota Motor Credit) have dominated the consumer auto loan market.  However, in recent years traditional financial institutions have aggressively targeted the fast growing auto lending sector.  With outstanding loan balances for auto financing are forecasted to reach $1 Trillion in the coming years we can expect competition to increase.  Retail consolidation is affecting the market as well.  Larger chains which sell multi-brand product portfolios have lessened dealer dependence on specific OEMs and captive finance institutions.

Steve Keifer

© Copyright 2007 GXS, Inc.  All Rights Reserved.

Part 1 

Last week GXS announced that it was selected by BB&T to power the financial institution’s new “Integrated Supply Chain Finance” solution.  And since then our phone has been ringing off the hook with calls from other banks, analysts and partners interested in learning more about this topic of Supply Chain Finance.  This is a fascinating area and one that I have been studying for about 24 months now, so I thought I would offer my perspective on the topic.

Supply Chain Finance is part of a broader trend in the market, which involves the convergence of the physical and financial supply chains.  There is much more to be shared on this topic than I can offer in just one post so let’s start with the topic of supply chain finance as it relates to international trade.  

History 

Historically, many of the international trade transactions between large buyers (based in the US or Europe) and small suppliers in emerging markets (China, India, Southeast Asia, Latin America) have been conducted using a letter of credit.  When a dispute arises in trade between two parties located in different countries with different legal systems, resolution can be timely, complex and expensive.

This is where a letter of credit can provide significant value by simplifying international trade terms and providing risk mitigation against default by the buyer.  The letter of credit offers a guarantee to the supplier that they will be paid for goods delivered to a buyer if they meet all of the terms and conditions outlined in the purchasing agreement.  The guarantee is made from the buyer’s bank to the supplier’s bank, both of whom facilitate the transaction on behalf of the buyer and supplier.  The commitment in a letter of credit is very strong.  In fact, with most letters of credit the buyer’s bank will make payment even if the buyer goes bankrupt or is for some other reason unable (or unwilling) to pay. 

While letters of credit provide strong risk mitigation for the seller, they are viewed by many buyers as costly, slow and inefficient.  As a result, many large US and European buyers are moving their international sourcing relationships away from letter of credit towards “open account” terms.  With open account there are no bank guarantees.  Payment terms are negotiated directly between buyer and supplier.  Critical to such an arrangement is the assumption of trust between both parties. 

Cash Rules! 

In addition to changing to open account, buyers are also extending their payment terms with international suppliers.  Buyers want to hold onto cash as long as possible.  As a result, they would prefer to defer payment to suppliers for 60 to 90 days so they can put their cash to use in other ways.  Other uses of cash might include 1) short term investments to generate interest income or 2) cash outlays for capital projects requiring immediate funding.  On the other hand, suppliers want to be paid as quickly as possible for the goods and services they provide to their customers. 

Suppliers must purchase raw materials and to pay their labor force to manufacture the products.  In international trade, the time between when a purchase order is first issued and payment is received may be 120-150 days.  Extended payment cycles with customers force suppliers to seek out financing from third parties to keep their business operating.  These competing priorities of buyers and suppliers are a growing source of tension in the supply chain.

Source of the Tension 

Some of you may be wondering, why is this tension around payment terms a new phenomenon?  International trade scenarios such as the example above have been common for decades.  This is true.  But, the migration towards open account and the extension of payment terms have combined to exacerbate the working capital challenges of exporting suppliers.  Why?  Because, historically, exporters in emerging markets had the security of a letter of credit, which could be used as the basis for a working capital loan to fund their manufacturing activities.  A letter of credit backed by a major financial institution (and buyer) in the US or Western Europe was viewed very favorably (less risky) by banks in emerging markets.  As a result, exporters in these countries could receive a cash advance against the value of the purchase order from their local bank.  The cash could be applied to purchasing, payroll or other operational activity until the payment from the buyer was received.

In an open account world, the supplier in the emerging market only has a purchase order.  A PO is relatively easy to counterfeit.  And even legitimate POs lack any firm payment guarantee from the buyer.  As a result, open account transactions are viewed as having a higher risk by banks in the exporter’s home country.  Financing is therefore more difficult to obtain.  When financing is available to a supplier, it is often for substantially less than the full purchase order value.  Even more problematic is that financing is offered with relatively high, credit card level interest rates.

A Lose-Lose Situation 

Few buyers have considered the full implications of the new terms of trade they are negotiating with suppliers.  Extending Days Payable Outstanding (DPO) and reducing banking fees may seem like a winning proposition to the buyer.  However, the overall cost and risk introduced into the supply chain may offset the other benefits.  By having to borrow money at a higher interest rate to fund manufacturing operations, the supplier’s cost structure has now effectively increased.  These higher costs will undoubtedly be passed onto the buyer in the form of higher prices.  Furthermore, suppliers who are not able to obtain timely financing, may be at risk of financial insolvency.  Others may be forced to cut costs resulting in unexpected manufacturing delays or lower quality products. 

Dr. Hau Lee of Stanford University has recently introduced a new theory that I think is very insightful articulation of today’s international supply chains.  He stated:  “Instead of company to company competition, we are now in an era of supply chain to supply chain competition.”  If companies are going to compete on the strength of their supply chains, buyers must find a more supplier-friendly approach to international trade. 

So what is the solution? 

An innovative new concept called Supply Chain Finance, which is a topic I will explain further in an upcoming post.

Steve Keifer

© Copyright 2007 GXS, Inc.  All Rights Reserved.

I first learned about ISO 20022 some 18 months ago.  I remember first thinking about the name.  I said to myself this new payment standard must be intended to replace the 20021 different formats the global financial community uses today for payments.  Unfortunately, while perhaps very fitting, that is not the origin of the name.  However, that is the intention.  While there probably are not 20,000+ standards yet, it is not an understatement to say that there are hundreds if not over a thousand in use today.

Why are there so many payment standards? 

Banking, like most service sector segments, has historically been a business that focused on local markets.  It is only within the past 20 years, that regulations changed so that banks could easily operate within more than one US state or that banks could economically operate in multiple countries within the EU.  As a result, when electronic funds transfer and payment technologies were introduced in the 1980s, each country created their own technology standards in isolation.   Message formats were standardized based upon the central clearing and settlement systems operated by each country’s central banks.  For example, in the US, Federal Reserve’s ACH and FedWire; in the UK, BACS and CHAPS; in France, SIT and so on.  Today, not only do we have different payment message structures for each country, but each country also has different file formats for each payment type (e.g. check, automated clearinghouse (ACH) and wire transfer).  And it doesn’t stop there.  It is not only the message structure that differs between payment files, but the content as well.  For example, a payment in one country may require a complete street address, city name and postal code, the same type of payment in another country may only require the postal code.   To complicate matters even further, the non-bank corporations tend to utilize a different set of standards (e.g. ANSI X.12 , EDIFACT, OAGi) to exchange payment information with their banking partners. 

Numerous organizations including OAGi, RosettaNet and TWIST have each made an attempt to standardize payment message formats at varying levels.  ISO 20022 is the most promising effort yet towards a common payment information standard. 

What is ISO 20022? 

ISO 20022 is also known as UNIFI (UNIversal Financial Industry message scheme).  The official definition from www.iso20022.org is “UNIFI provides the financial industry with a common platform for the development of messages in a standardized XML syntax, using:·         A  modelling methodology (based on UML) to capture in a syntax-independent way financial business areas, business transactions and associated message flows;·         A set of XML design rules to convert the messages described in UML into XML schemas.”  Although, the discussion above describes ISO 20022 in the context of payments, the standard has ambitions which extend far beyond that domain.  The scope of ISO 20022 is all financial messages including Payments, Foreign Exchange, Trade Finance and Securities.  And the standard is beginning to gain widespread adoption as organizations such as TWIST, OAGi, RosettaNet and SWIFT have begun to embrace it.Who is using ISO 20022? ·         SWIFT – SWIFT is embracing ISO 20022 as the preferred XML format for messages exchanged on the SWIFTNet service used by over 8,000 financial institutions in over 200 countries to exchange financial transactions.·         SEPA - ISO 20022 is one of the key unifying standards that will harmonize payment technologies and standards throughout the European Union with the Single European Payments Area (SEPA).  For example, ISO 20022 will be a foundational standard for TARGET 2 (Trans-European Automated Real-time Gross Settlement Express Transfer System), the next generation, real time settlement system for Pan-European payments.