Why the Supply Chain Is Stronger

During yesterday's chat with Matt Sheerin, senior equity research analyst and managing director at Stifel Nicolaus & Co., readers (astutely) questioned his assertion that supply chain companies are in better shape now than they were before the recession hit in 2008-2009.

With events such as Japan's earthquake/tsunami, the wild swings in the stock market, and entire countries drowning in debt, it is hard to see how this can be the case. Here's Sheerin's take:

First, balance sheets are quite strong -- the distributors all generated a ton of free cash flow as revenue fell (they just worked down inventories and receivables) -- and many companies lowered their fixed costs dramatically -- so as revenue came back, we saw a big jump up in profits.
On [distributor inventories], yes, all of the [distributors] got ahead of themselves, but they are pretty quick to work them down, hence the pain the suppliers are enduring right now.

We didn't have the time (or typing capability) to go into too much detail yesterday, so I thought I'd supplement Sheerin's observations.

When things turned ugly in 2008, suppliers immediately cut back on staff and capacity. Usually, their response to shifts in the market mirrors the market itself -- dramatic cuts followed by dramatic rampups. That didn't happen this time. When the electronics market appeared to begin recovering in early 2010, there was not a lot of hiring, and capacity expansion was extremely cautious. Net result: Suppliers don't have a lot of overhead right now, and costs are more aligned with revenue as it begins to slow down.

Distributors also cut staff and kept a tight rein on inventory. They also built up cash reserves and focused on internal efficiency. For example, even though the market was tanking, Avnet Inc. (NYSE: AVT) went ahead with two new state-of-the-art distribution centers. Distributors recognized a while ago that everything associated with an order -- managing inventory, pulling, packaging, and delivering -- incurs costs along the way. Simplifying the process saves costs.

Arrow Electronics Inc. (NYSE: ARW) invested in reverse logistics: services that take excess or unused inventory off shelves. This helps the customer's balance sheet, and distributors often can return unused inventory to suppliers. They also can sell it to another customer. This better use of inventory helps prevent buildup within the channel.

Finally, customers have made an effort to be more transparent with their suppliers -- both component makers and distributors. Customer forecasting is at best an inexact science, but suppliers have learned to use historic purchasing trends as a reality check against recent orders. To make this work, customers have to trust their suppliers to use this information wisely (not to share it with competitors, for example). Customers also have to be receptive when a supplier flags an anomaly. Again, this type of activity helps avoid inventory buildup in the channel.

The end result is a supply chain that corrects itself more quickly than ever. In the most recent earnings period, global distributors Arrow and Avnet said their inventories began to build in anticipation of customer orders. Those orders began to slow in late June and early July. As a result, distributors are already looking at the mix of inventory they carry and are not buying a lot of additional stock. Suppliers may be feeling the pinch -- some of that stock is still sitting on their shelves -- but the channel is pretty confident inventory will correct itself within the next quarter.

The supply chain is understandably cautious going into the second half of the year, Sheerin says. "We are modeling both the Sept. and Dec. quarters to be below seasonal for component/semiconductor suppliers and distributors due to this correction, but demand will ultimate dictate how it plays out."

The supply chain still has a lot of imperfections, and EBN's readers, bloggers, and guests will continue to point them out. But most supply chain companies are not repeating the mistakes of the past, so the industry has positioned itself to weather the next market storm.