Emerging Mega-Bankruptcies Threaten Supply Chains
During the global lockdown one of the critical issues discussed was the vulnerability of the global supply chain particularly the ability to transport foodstuffs. Fortunately the logistics were adequately to deliver foodstuffs already in inventory to avoid starvation specific to the pandemic.
With the re-openings and ability of farm workers (albeit in lower numbers than normal) to enter the countries for harvesting, the food supply chain has recovered sufficiently to operate at safe levels. However counter-intuitively various other supply chains are entering a precarious phase just there are progressive re-openings worldwide.
Corporations are still assessing how to move forward in a post-pandemic, pre-vaccine world particularly since customers, many of whom have been laid off or furloughed and for this reason are reluctant to send on non-essentials.
Furthermore in a collaborative agreement between corporations and their employees remote working will continue strongly for months while there will be a skeleton staff on corporation premises. This on-going shortfall may just be enough to tip the scales and force many businesses into the red and possibly declare bankruptcy if they carry too much debt.
Supply chains are complex, a delicate global lattice of business and relationships which makes accurate risk assessments far more challenging than one can imagine.
Even with the best intentions, major firms were not able to reassess their supply chains and vulnerabilities during the worldwide lockdown in which on-site inspections and in person visitations are key to determining the level of risk.
According to the New York Times article 18 June 2020 A Tidal Wave of Bankruptcies is Coming, looming on the horizon with the next 3-60 days may be a spate of mega-bankruptcies (over $1 billion) and large bankruptcies (over $100 million). The Federal Reserve of St. Louis stated that corporate debt in the US reached $10.5 trillion in 1Q2020, the highest since WW II. The article specifically mentions publicly traded companies such as Hertz [NYSE: HTZ], J. Crew [NYSE: JCG] and Neiman Marcus [NYSE: NMG.A] as those who entered leverage buyouts just after the Great Recession who are struggling under massive debt.
The industries which are the most vulnerable to bankruptcies include retail such as JC Penney [OTCMKTS: JCPNQ], including the luxury market, which I forecast in a previously published article dated 8 April 2020 entitled The Luxury Market’s Brutal Restructuring, travel & leisure encompassing airlines and hospitality sectors, manufacturing and extraction industries specifically the shale oil industry such as firms Whiting Petroleum [NYSE: WLL] and Chesapeake Energy [NYSE: CHK].
Though not often publicly traded the restaurant business is a bellwether industry that is highly dependent on the business from white to blue collar employees and hosting corporate events, tourists in commercial districts. The vulnerability of the present-day recession and continued voluntary remote working is shown on the following chart entitled Restaurant Industry Collapses in Major US Cities provided by OpenTable, an online restaurant reservation service, and presented by Statista, an online statistical firm.
Although suppliers have the products readily available for shipment and have re-established reliable logistics, if their clients are financially constrained because of looming or on-going bankruptcy procedures and can only purchase a limited amount of product, then the shortfall of cash flow will hurt the supplier.
For several years prior to the pandemic big corporations have ruthlessly financially “squeezed” suppliers with providing more favorable prices on raw materials, just-in-time and faster delivery demands. With margins whittled to low levels, suppliers are far more vulnerable to closing shop during an economic shock or a buyer’s financial difficulties.
The same financial constraints hold true if a supplier is unable to manufacture goods to a cash-rich importing company. The risk increases if the products are manufactured to a client’s custom specifications and elevated even further if the supplier is sole source.
Should both the supplier and buyer encounter severe financial issues that could result in bankruptcy filings, then both parties would try to negotiate from weakness in which neither supplier nor buyer has leverage over the other.
Even profitable companies with robust supply chains are vulnerable. The downfall of a major competitor does not equate to increased market share, increased cash flow or profitability. Rather in their expanded market share they indirectly inherit their former competitor’s unique supply chain issues.
Quantitatively the investor’s determination with respect to which companies are financially stressed is straight forward. Qualitatively determining whether a cash-rich company has supplier finance problems is a more difficult matter because often the company themselves aren’t fully aware of the risk. It behooves the supplier to downplay their predicament to buy time so as not to lose out to the competition.
A Quantitative Tool to Measure Financial Risk
One quantitative useful tool for the intrepid investor to determine the financial stability of a firm for a bullish or bearish play, is the utilization of the Edward Altman Z-score. Altman’s Z-score measures the likelihood of bankruptcy; the accompanying video in the link provides a detailed explanation and its shortcomings
Altman’s Z score = 1.2A + 1.4B + 3.3C + 0.6D + 1.0E
A = working capital / total assets
B = retained earnings / total assets
C = earnings before interest and tax / total assets
D = market value of equity / total liabilities
E = sales / total assets
Once again the hidden and unknown financial terms mandated by bankruptcy courts affecting suppliers and buyers is the final determining factor how and whether these firms will emerge intact as a going concern.
Legal Eagles Follow Black Swans
Legal eagles, by necessity, follow black swans for the purposes of damage control and to fill the gaps in the contractual agreements so that the firm can continue operations as seamlessly as possible without additional risk.
Internally many departments believe that the legal department interferes in the business of profits when in reality it’s their responsibility is to protect the firm from itself. Upper management might engage is legal, ethic and morally proper behavior to continue or complete business deals, however because after a global economic earthquake the firm becomes increasingly vulnerable to legal action from everyone (government, competitors, shareholders, customers) because the “business as usual” model no longer applies in a black swan environment.
Merely the discussion of considering filing for bankruptcy impacts the firm’s contracts and business relationships. Depending on the jurisdiction the bankruptcy court’s interpretation during a pandemic may not fully fall automatically under the contractual force majeure clause.
Force majeure or similar contractual clause and insurance coverage address epidemics and pandemics causality and non-performance which are sometimes difficult to determine or define, contingent on jurisdiction, interpretation (narrow or broad-based), civil vs common law even if the clause is identically worded.
Corporate Restructurings & Politics
Companies and industries are undergoing profound restructurings in operations and personnel seeking to lower fixed costs to compensate for the projected short to medium term shortfall in business and adjusting to a new post-pandemic environment.
Politically there’s also the “wait & see” attitude with respect to the upcoming presidential elections and, assuming Biden wins, to what extent the Democrats will be business friendly enough with economic support and legal guidance to provide stability and predictability to raise business confidence.
As the re-openings are progressively underway worldwide many medium to big corporations face the possibility of filing for bankruptcy as a result of huge debts incurred from post-Great Recession leveraged buyouts compounded by little business during the pandemic lockdown. This financial dilemma will impact their suppliers who are also under severe financial strain. Successful emergence from bankruptcy does not guarantee financial solvency for the supplier; insolvency and subsequent court ordered liquidation of assets by the corporation will vaporize not only their suppliers but possibly other suppliers in that industry.
[Originally published 24 June 2020]
Copyright 2020 Cerulean Council LLC
The Cerulean Council is a NYC-based think-tank that provides prescient, beyond-the-horizon, contrarian perspectives and risk assessments on geopolitical dynamics and global urban security.