More bad news for the banking sector this week as five of the largest US financial institutions (Wachovia, SunTrust, Fifth Third, Regions Financial and Washington Mutual) announced a total of $11 billion in quarterly losses.  Just when you think the worst is over, the financial services industry finds a way to deliver more surprises.  But believe it or not, there are other interesting things happening in the banking industry in addition to the subprime mortgage crisis.  In my last post I talked about the Single European Payments Area (SEPA) launched earlier this year, which I believe will have as big of an impact on banking going forward as the subprime fallout.  One of the other trends that I find interesting is the changing dynamics between corporations and their banking partners. 

During the past 18 months I have spent a lot of time visiting with both corporates and financial institutions throughout North America, Europe and Asia.  In total I have probably met with 75 companies during the past year and half.  One of the conclusions that I have reached is that almost every major multi-national corporation of $5 billion or larger has a major transformation project occurring in their back office.  What are they changing?  A better question is what is not changing?  Multi-national corporations are reorganizing their treasury and accounting functions; re-evaluating their approach to payment processing; renegotiating agreements with key banking partners and re-architecting their financial information systems. 

I have spent some time in recent months analyzing the underlying forces driving these dramatic changes with a goal of understanding the market dynamics better.  Some forces are obvious such as the desire to reduce costs and operate more efficiently.   The other forces are more specific to financial processes including changing regulations, disruptive technologies and increasing globalization.  I compiled a list of the top 5 forces that I think are driving the transformation projects at multi-national corporations.  The first five are business oriented forces:

1.       Conversion from Checks to EFT – The past 10 years has seen a migration away from paper based check instruments to electronic funds transfer.  The most significant transition is occurring in the US, which historically utilized checks as the primary B2B and B2C payment instrument.

2.       Payment Factories – Multi-national corporations are rethinking the organizational structures for their Accounts Payable (A/P) groups.  Corporations are moving from country-centric A/P organizations towards shared service centers operating on a regional or global basis.

3.       Centralized Treasury – In addition to creating shared service centers for A/P, corporations are centralizing treasury functions as well.  Centralization enables a number of efficiencies in the areas of cash forecasting, foreign exchange and cross-border payments.

4.       In-House Bank – Corporations are establishing their own in-house banks to complement centralized treasury functions.  The in-house entities operate much like a commercial bank by offering payment processing, cash management and collections functions to the various subsidiaries.

5.       Consolidation of Banking Relationships – Along with centralization of internal functions, multi-national corporations are also rationalizing the number of banking relationships they maintain.  In many cases, corporates are reducing banking providers from over 100 to 2-3 global relationships.

Some multi-national corprorations are in the early phases of these transformation projects while others have nearly completed them.  It will take another five years for the transformation to fully occur.  However, once complete the dynamics of corporate banking will have changed forever…

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.

One of the industry associations GXS has been working with recently is the Global Supply Chain Forum sponsored by Stanford University.  The forum is comprised of representatives from many of the world’s largest manufacturing companies as well as some of Stanford’s leading faculty such as supply chain thought leader Dr. Hau Lee.  Dr. Lee has introduced a number of revolutionary ideas over the past few years, but there is one particular insight that stands out in my mind:

“Instead of company to company competition, we are now in an era of supply chain to supply chain competition.”

This is a concept that I think becomes more and more critical every day that goes by.  To illustrate my point, let us examine the high tech industry as an example.   More specifically, consider the sub-sector of high tech that manufactures computers and related peripherals.  This is a relatively young sector that was first started back in the 1960s and 1970s.  However, during its short history the supply chain model has undergone a radical transformation. 

Mainframe Value Chain 

When the first mainframes were introduced a single vendor often functioned as the sole source for all computing needs.  OEMs such as IBM and Honeywell manufactured not only the finished mainframe product, but most of the components as well including the memory, storage (DASD) and processors.  The operating system, database and even some applications were developed by the same vendor who manufactured the hardware.  If the mainframe broke or needed an upgrade, the hardware OEM provided the repair and service. 

2008 PC Value Chain 

Contrast the mainframe model to the complex, multi-tiered value chain in today’s computer industry.  I work on an “IBM Thinkpad.”  However, while the logo on my laptop says IBM, the manufacturer of the machine is actually a Chinese company – Lenovo.  Although Lenovo is the OEM, it only contributes a small fraction of the content of the laptop.  The components inside the laptop are sourced from third party suppliers (Kingston for memory; Seagate for storage; Intel for microprocessors).  Also noteworthy is the fact that Lenovo does not typically sell the machine directly to end users.  My laptop was purchased through our company’s preferred distributor – CDW.  The software on the machine is made by another group of specialized companies.  Microsoft publishes the Windows operating system and Office application suite.  Other software vendors such as Adobe, Symantec and Apple provide other applications such as document viewing, desktop security and digital music.  And when my laptop breaks, who do I call?  Not Lenovo, but a 3^rd party such as a high tech distributor, 3^rd party logistics provider or a contract manufacturer for warranty support and repair. 

The point here is that the computer industry has migrated from a vertically integrated model to a highly specialized, heavily outsourced model.  This type of highly outsourced model in which OEMs outsource much of the manufacturing and supply chain management to suppliers is growing more common in all discrete manufacturing sectors.  Examples can be found not only in high tech, but also aerospace, automotive, consumer products and industrial equipment.

Supply Chain versus Supply Chain 

The key take-away from the discussion above is that OEM manufacturers are increasingly dependent upon a community of outsourcing partners to achieve success.  Factors that can go wrong (and do go wrong) are, in many cases, completely out of the control of the OEM.  In these new value chain models, companies are actually not competing with other companies, but instead their supply chains are competing with other supply chains.  This crucial concept, first introduced by Dr. Lee, is critical for channel masters in today’s supply chain to understand.  However, while it may seem obvious, the majority of today’s leading retailers and manufacturers continue to structure models that prioritize the near-term financial performance of their own company above the overall long-term competitiveness of their supply chains.  The term “partner” continues to be utilized ever more frequently to describe suppliers in a value chain.  However, the approach of most channel masters remains more adversarial than collaborative.   The largest exception is, of course, the Japanese manufacturing community which has structured itself around kereitsu relationships between OEMs and key suppliers. 

Consider the following “company centric” paradigms that are becoming more commonplace in today’s supply chains.

• Performance Scorecards and Penalties – Retailers and manufacturing OEMs have instituted elaborate chargeback mechanisms that penalize suppliers for problems arising during routine order fulfillment.   Not only are these penalties designed with the goal of optimizing the buyer’s business processes, but each retailer and manufacturer has different measurement criteria.  As a result, suppliers are forced to comply with terms such as delivering during tightly monitored 2-hour receiving windows and labeling of pallets with customer-specific serialized barcodes and text.  While these processes simplify receiving for the buyer, they add cost and complexity for the supplier and friction to the overall relationship.
• Open Account – Large buyers are moving from their traditional letter of credit processes with overseas suppliers towards open account models.  The goal of the migration is to reduce banking fees for the buyer, but in many cases the side-effects to suppliers are significant.  Without a bank-guaranteed letter of credit to use as collateral for short term financing, suppliers struggle to fund raw materials purchases, manufacturing plant payrolls and other operating expenses.
• Extended Payment Terms - In an effort to hold on to cash longer, buyers are extending payment terms with suppliers to periods of 60 or 90 days.   Extended terms create a cash flow issue for suppliers who must now seek out short term loans to fund their operations.  For smaller suppliers with lower credit ratings, these expensive short term loans compromise profit margins and increase the overall cost of goods sold.
• Vendor Managed Inventory – More and more customers are looking for their suppliers (or a 3^rd party) to hold title for inventory until the point of consumption or sale to the end-customer.    Buyers prefer these types of models as they shift the inventory carrying costs to the supplier’s balance sheet along with the risk of product obsolescence and retail shrinkage.  For high volume channels, large suppliers can benefit from the added demand visibility and end-customer insights available through a VMI program.  However, for many buyer-supplier relationships the risks and costs are heavily unbalanced in favor of the customer.

What do suppliers as valued partners in the relationship receive in exchange for these terms?  Buyers will offer appealing terms to suppliers willing to engage in customer centric business processes:

• Greater share of a customer’s wallet as the supplier becomes the preferred vendor for a particular product line
  Broader scope of services that may include many value added services that increase the average revenue per unit sold

Suppliers must weigh the pros and cons of such arrangements to determine their best strategy.  Often the tradeoff is a choice between revenues and profitability. 

What are the EDInomics of supply chain to supply chain competition?   B2B integration technology can be the key to unlocking the potential of collaborative relationships in a value chain.  B2B can be used to enable a variety of strategies such as multi-echelon demand visibility, collaborative product development and third party supply chain finance.   But the technology is rendered ineffective unless the channel master in a relationship has a long-term, supply-chain wide perspective on their activities.   Unhealthy suppliers introduce performance drag, cost overhead and higher risks to the overall supply chain.  While these factors may not be visible in the buyer’s next quarterly income statement, they will most certainly define the long term success of the buyer.  After all, as Dr. Lee states “The weakest link in the supply chain defines the supply chain.”

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.