Supply Chain Disruptions and Shareholder Value Kevin Hendricks

Supply Chain Disruptions and Shareholder Value Kevin Hendricks Richard Ivey School of Business Ontario, Canada Vinod R. Singhal DuPree College of Management Georgia Institute of Technology Atlanta, GA, 30332 February 2005 1 Some thoughts Without facts you are just another person with an opinion unless you are at a level of the organization where your opinion becomes fact When research is limited or absent, anecdotes prevail 2 Accenture study (with INSEAD and Stanford) Comparison of supply chains linkage to financial

performance of 600 global companies over two different time period Supply chain performance classified into four groups based on - Inventory turns - Return on assets - Cost of good sold/sales (1- gross margin) Financial performance - Industry adjusted shareholder return grouped into four groups 3 Supply chains and shareholder value Shareholder Value = Create - Destroy Poor supply chain performance destroys shareholder value Practices that prevent poor supply chain performance create value by avoiding value destruction 4 Issues examined Effect of disruptions on shareholder value Effect of disruptions on profitability growth in operating income, sales, cost, assets, and inventory

Effect of disruptions on risk share price volatility 5 Approach Sample Measurement time period Methods to estimate the impact of disruption on performance Statistical tests Results Implications 6 Sample 800+ announcements of supply chain disruptions (production or shipment delays) from Wall Street Journal and Dow Jones News Sun Microsystems delays shipments of workstations and servers, Dow Jones News Service, December, 14, 2000. Sony Sees Shortage of Playstation 2s for Holiday Season, The Wall Street Journal, September 28, 2000. Boeing pushing for record production, finds parts shortages, delivery delays, Wall Street Journal, June 26, 1997. Hershey will miss earnings estimate by as much as 10%

because of problems in delivering order, Wall Street Journal, September 14, 1999. 7 Distribution of sample announcements 40 36.52 35 32.41 Number of firms (%) 30 25 18.62 20 15 12.45 10

5 0 1989-1991 1992-1994 1995-1997 1998-2000 8 Sales volume of firms experiencing gltiches at the time of the gltich announcemen (% of firms) Distribution of disruptions by sales volume 40 35 30 26.48 25 20.94 18.78

20 15.01 15 11.49 10 7.29 5 0 Less than $50 million $50 million to $100 million $100 million $250 milion $500 million to $250 to $500 to $1billion million

million Over $1billion 9 Responsibility for disruptions 40 35 33.61 29.38 30 % of Firms 25 20 15 12.81 14.51

10 6.05 3.81 5 0 Internal Customer Supplier Nature and government Other combinations None provided 10 Reasons for disruptions 35

29.38 Number of firms (%) 30 25 21.64 20 15 10 8.94 8.823 8.46 4.11 5 3.26 0 Part

Ramp/rollOrder shortages out problems changes by customers Production Development problems problems Quality problems None provided 11 Measurement time period for share price changes Sony announced a disruption on September 28, 2000 Set September 28, 2000 as day 0 in event time Day -1 is the previous trading day Day 1 is the following trading date Day before the announcement Announcement

date 1st Year after Year before -251 -1 0 2nd Year after 250 500 12 Measurement time period for profitability changes Sony announced a disruption on September 28, 2000 Set the quarter ending after September 28, 2000 as quarter 0 Announcement date 9/28/2000 1st Year before

Quarter -4 1st Year after Quarter 0 2nd Year after Quarter 4 Quarter 8 13 Measurement time period for share price volatility changes Sony announced a disruption on September 28, 2000 Set September 28, 2000 as day 0 in event time Announcement date -509

2nd Year before -260 1st Year before -10 0 10 1st Year after 260 2nd Year after 510 14 Estimating stock price performance implications Compare performance of disruption experiencing firms with

portfolios of similar type of firms - Size (created 14 portfolio) - Book to market value (subdivided each of the 14 into 5 ) - Prior performance (subdivided each of the 70 into 3) 210 portfolios of firms Simulated 1000 benchmark portfolios Used the simulated distribution to test statistical significance 15 Estimating stock price performance and risk implications One to one matching - Closest in size - Closest in performance - Closest in SIC match Estimate the difference in stock price performance between the sample firm and its benchmark Estimate the difference in change in volatility of the sample firm and its benchmark 16 Methodology for estimating the profitability impacts Create benchmark samples to adjust for the effect of economy and industry

Three different benchmark samples created by matching on Sales Assets Standard Industry Classification (SIC) Codes Prior Performance 17 Average stock returns on disruption announcements Portfolio Matched Size Matched -7.18 -7.17 Performance Matched

Industry Matched Average shareholder return (%) 0 -2 -4 -6 -8 -6.81 -7.81 -10 18 Comparison with stock market reaction to other corporate events Operational events Marketing events Increase in capital expenditure 1.0% Change in firm name Increase in R&D expenditure 0.7%

1.4% Brand leveraging Effective TQM implementation 0.7% 0.3% Internal corporate restructuring Celebrity endorsement 1.0% 0.2% Decrease in capital expenditure -1.8% New product introduction Plant closing 0.7% Information technology events Financial -0.7% Affirmativeevents action awards 1.6% Delay introduction of new IT Investments Stock -5.3%splits products 1.0% 3.3% B2C e-commerce

Open market share repurchase 10.5% 3.5% B2B e-commerce Proxy contest 3.3% 4.2% IT problems Increasing financial leverage -1.7% 7.6% 19 Decreasing financial leverage -5.4% Average stock returns over different intervals Year before On announcement 1st year after 2nd year after Average shareholder return (%)

0 -1.77 -3 -6 -7.18 -9 -10.45 -12 -15 -13.68 20 Average stock returns over three years Portfolio Matched Size Matched Performance Matched

Industry Matched Average shareholder return (%) 0 -10 -20 -30 -34.77 -40 -40.66 -32.21 -38.40 -50 21 % Change in equity risk (standard deviation) Year to year changes in equity volatility 20 15.16 15

13.5 10 5 2.82 0 -1.74 -5 Two years before One year before One year after to Two years before to one year to one year after two years after to two years after before 22 Profitability impacts in the year before the disruption Performance Measures Operating Income Return on Sales Return on Assets

0 Percent change -20 -40 -42.27 -60 -32.02 -35.82 Median -80 -100 -120 Mean -92.24 -107.43 -114.67

-140 23 Profitability impacts in the year before the disruption Sales Cost Assets Inventory 20 13.88 15 Percent change 10.66 9.59 10 4.29

5 6.08 3.06 0 -2.84 -5 -10 Mean Median -6.92 -15 -20 24 Profitability impacts in the year after the disruption Operating Income Return on Sales

Return on Assets 5 0.94 0.1 Percent change 0 -5 -6.27 -6.36 -10 -4.62 Mean Median -15 -20

-18.09 25 Profitability impacts in the 2nd year after the disruption Operating Income Return on Sales Return on Assets 5 0 Percent change -5 -3.49 -10 -6.58 -8.32

-15 -20 Mean -25 Median -23.09 -25.44 -30 -35 -40 -36.19 26 Average stock returns by responsibility Internal Supplier Customer

Average shareholder return (%) 0 -10 -20 -24.93 -30 -40 -35.69 -50 -52.88 -60 27 Average stock returns by reason Part shortages Ramp/roll-out problems Order changes by customers

Production problems Average shareholder return (%) 0 -10 -20 -30 -25.48 -40 -41.67 -50 -46.59 -52.79 -60 28 Average stock returns by size Ist quintile (smallest)

2nd quintile 3rd quintile 4th quintile 5th quintile (largest) Average shareholder return (%) 0 -10 -20 -19.61 -30 -32.35 -40 -50 -46.68

-47.05 -60 -70 -64.28 29 Summary Disruptions cause significant destruction in corporate performance It does not matter who or what caused the disruption you still pay Small firms suffer more from disruptions Market always took a dim view of supply chain disruptions Firms do not quickly recover from disruptions 30 Broader perspectives S&P 500 has returned about 12% annually over the last 15 years Major disruptions are associated with 35% underperformance in stock returns One major glitch every 10 years average return of 9%

31 Why enough attention is not paid to the possibility of disruptions? Consequences are not known Low frequency events Resource shortages Requires cross-functional effort Short tenure of managers You dont get credit for fixing problems that never happened You have not experienced one 32 Are supply chains more prone to disruptions today? Globalization of supply chains Increased reliance on outsourcing and partnerships Single sourcing Little slack in the supply chain Competition 33 Dealing with disruptions

Reduce the frequency (probability) of disruptions - better forecasting - better planning - communicate, collaborate, and share Develop ability to predict disruptions (business intelligence) - select, define, and track key performance indicators - analyze disruptions to develop key leading indicators - track leading indicators - need visibility 34 Dealing with disruptions Elapsed time between the occurrence and detection of glitch - aim for zero elapsed time - real time visibility of the extended supply chain - event management systems Time it takes to resolve the glitch - quick resolution, prevent escalation and worsening - a process for dealing/responding to disruptions - developing capabilities to react and respond 35 Implications for making business case Traditional approach create shareholder value - efficiency driven (impacts on cost and capital cost)

- cost-benefits analysis (ROI) of potential solutions - ignores revenue, indirect benefits, and intangibles Augment the traditional approach - need to preserve value and avoid value destruction - value of reliable, responsive, and robust supply chains - prevention role of effective SCM - effective SCM buys insurance against value destruction 36 Future research Understand how upstream and downstream supply chain partners get affected by disruptions Examine the impact of excess inventory on shareholder value Product development delays Operation glitches and cost of capital 37 Average stock returns by industry groups Process Batch manufacturing High technology

Services and others 0 Average shareholder return (%) -10 -20 -30 -27.31 -35.84 -40 -50 -47.65 -51.12 -60 38 Profitability impacts by industry groups

Process Batch manufacturing High Technology Services and others 20 11.93 10 5.56 1.91 1.7 Percent change 0 -3.6 -10

-4.4 -3.5 -6.5 -20 -30 Operating Income -32.6 -40 Sales Costs -50 -60 -55.6 -56.7 -70

-70.3 -80 39 Consequences of disruptions Lower Revenues Higher costs Poor asset utilization Excess inventory, inventory write-offs, stockouts Higher cost of capital/borrowing Shareholder lawsuits Management and personnel turnover Loss of reputation and credibility, negative publicity 40 Estimating profitability impacts of disruptions Growth in Operating Income Sales manufacturing costs selling and general administration costs Growth in return on sales Operating income normalized by sales Growth in return on assets

Operating income normalized by total assets Growth in sales Net Revenues Growth in costs Manufacturing costs + selling and general administration cost Growth in total assets Growth in inventory Raw material + Work-in-process + Finished goods inventory 41 Median profitability impacts by responsibility Performance Measures Internal Supplier Customer 20 4.52 Percent change

10 5.82 1.25 0 -10 -1.1 -4.3 -5.6 -20 Operating Income -30 -50 -60 Sales

-29.9 -40 Costs -43.7 -55.0 -70 42 Median Profitability impacts by reason Ramping/Rollout Order changes Parts Shortage problems by customers Production problems 20 10 5.65

1.68 5.69 2.81 Percent change 0 -1.2 -10 -3.0 -2.6 -10.3 -20 -30 -40 Operating Income -31.2

Sales Costs -50 -60 -50.2 -59.0 -58.8 -70 43 Median Profitability impacts by size Performance Measures Operating Income Return on Sales Return on Assets Sales

Cost 20 2.6 Percent change 0.3 7.6 0 -7.8 -20 -40 -22.9 -25.2 -29.5 Larger firms

-60 Smaller firms -80 -100 -72.4 -66.2 -86.4 44 Why link supply chain performance and shareholder value? Attract and engage top management attention Make business case for organizational changes Make business case for investments in technology Convince our students that OM matters 45 Supply chains and shareholder value

Efficiency Reliability Responsiveness 46 Lean and efficient versus risk of disruptions in supply chains Lean and efficient supply chains - Stretched and complex supply chains - Outsourcing and dependency on third parties - Single sourcing - Low slack Above practices can increase the risk of disruptions Trade-off between lean/efficiency and the risk/expected cost of disruptions 47 Issues examined Effect of disruptions on shareholder value Effect of disruptions on profitability growth in operating income, sales, cost, assets, and inventory

Effect of disruptions on risk share price volatility - cost of capital (discount rate) - more expensive and difficult to raise capital - can affect investment/acquisition plans - increase the cost of factors of production - conflict between various stakeholders 48

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