steve bergsman

Last summer, when The Boeing Co. announced it would delay the introduction of its 787 Dreamliner, CEO Jim McNerney blamed the problem on the company's supply chain. A large product like an airplane uses thousands of individual parts, but Boeing attempted to mitigate the smaller, individual supply chain quandary by using major suppliers to construct large pieces of the plane. Parts of the wings, for example, are being assembled as far away as Japan.

McNerney reported to the press that the delays were attributed to a "slowing up in the supply chain rather than a fatal flaw in the supply chain."

Boeing's problem with its supply chain is emblematic of a challenge all U.S. companies now face: managing supply chains that are longer and more convoluted than ever before. For any given product, raw materials can be sourced in Africa, refined in India, produced in China, assembled in Mexico and finally distributed in the U.S.

Today, however, the biggest problem-faced not only by manufacturers but also by service companies like restaurants-is the rising cost of the supply chain. This is not necessarily because of the manufacturing piece of the chain, which can be performed in low-wage countries such as China, but because of the rapid rise in transport costs.

Obviously, the price of oil hovering above $90 a barrel boosts cost of production. But it also means a huge increase in the expense of transporting parts and completed goods. And the issue goes beyond energy costs. Earlier this year The Wall Street Journal reported that due to a shortage of freighters the cost of shipping goods has reached an all-time high. The paper noted the cost to carry raw materials from Brazil to China had tripled from 2006 to 2007.

Interestingly, during the years 2000 to 2004, supply chain costs (from raw materials to production to final sales outlet) declined because there was no real rise in energy costs and deregulation had eased transportation expenses, notes Thomas Freese, a principal in Freese & Associates Inc., a Chagrin Falls, Ohio-based management and logistics consulting firm. "But that trend reversed itself in the last two to three years because the rise in energy costs is now impacting transportation costs."

In 2005, when the trend line for transportation expenses started to reverse, adds Freese, logistic costs amounted to 9.6 percent of GDP, up from 8.6 percent in 2003. Some of these costs are passed along to consumers, but in many cases the market is too competitive to raise prices, so companies have to look at the total supply chain, not just manufacturing but logistics as well.

"Businesses will continue to span supply chains across the globe," avers Dan Brutto, president of UPS International. "However, rising fuel costs are driving companies to move away from a one-size-fits all'approach to transportation management and toward implementing a multi-modal strategy that reflects product value, life cycle and handling characteristics at stock-keeping unit level. The side effect is that supply chains are becoming more agile and more closely matched to strategic business plans."

Emeryville, Calif.-based Jamba Inc., owner and franchiser of the 640 Jamba Juice stores across the U.S. and one store in the Bahamas, sources fruit, "boosters" (optional additives like ginseng and wheat grass used in its smoothies), and hard products like cups from suppliers across the globe. As an example, most fruit for its drinks comes from South America, but more of the exotic fruits are now grown in Asia. Meanwhile, its boosters are mostly shipped from Europe.

Jamba takes supply chain issues so seriously that in July it lured Greg Schwartz away from Wal-Mart, where he was vice president of global procurement, to the newly created post of vice president of supply chain management at Jamba. "People, process and technology are crucial to a healthy corporate supply chain," says Paul Clayton, Jamba's president and CEO. "Our success comes from having an experienced department."

In 2007, Jamba Juice expanded significantly, opening close to 130 stores. "As the volume continues, we become a bigger and bigger user of everything from cups to fruit," says Schwartz. "You can imagine the demand we have on suppliers in other parts of the world to fulfill our needs. Our No. 1 focus has been on insuring supply."

In expense terms, the most important factor for Jamba is the cost to the store. When those expenses rise, Schwartz does a reverse diagnosis of the supply chain, scrutinizing components to understand where the increase is coming from. At the same time, it will dissect the rest of the supply chain to look for opportunities to mitigate the problem, whether the cause is fuel or labor increases.

"We do not treat fuel costs on transportation any differently than we would the cost of product," Schwartz explains. "We try to look at the total value, the total landed costs to stores. So if a case of oranges costs $10 to deliver today and $11 tomorrow, it doesn't matter if it is transportation costs or labor costs, we plan for it and try to find other ways to mitigate the increase."

Companies need to look at the supply chain "holistically," affirms Rajan Penkar, vice president of global solutions and implementation for Atlanta, Ga.-based United Parcel Service Inc. Managing the supply chain is not just about manufacturing, but the entire landed cost of the product, including transportation, distribution and inventory.

By using long-term forecasting models, Jamba minimizes surprises, including rising costs in its supply chain, and by incorporating a holistic approach mitigates potential future cost risk. "We can plan for reduced costs in other areas of the supply chain in order to keep the stores and product cost as competitive as possible," says Clayton.

Penkar recommends building flexibility into the supply chain so different modes of sourcing, manufacturing and transport can be utilized if there are breaks in the supply chains or increasing costs. Also, different parts of the supply chain need to be balanced against other parts. Manufacturing may be cheaper in Southeast Asia, but the cost to ship those goods to the U.S. can negate the savings in production.

"In areas like technology, while the cost of production has declined, the total cost of the supply chain has still risen, and that has affected the overall price of the product," says Penkar. "This is a big concern for many of our tech customers."

Part of the problem in today's global business environment is that supply chains can be 10,000 miles long. Not only does that increase the risk of something going wrong- earthquake in China, political turmoil in Indonesia, shipping accident in the Pacific, longshoreman strike in Long Beach-somewhere along those 10,000 miles, but with oil prices pushing $100 a barrel, transport expenses tumble out of control because at every mile more energy is being used.

This is a problem Glen Tellock, president and CEO of The Manitowoc Company Inc., based in Manitowoc, Wis., tries to address by moving production closer to its markets.

Among its other manufacturing sectors (i.e., ice-making machines), Manitowoc is one of world's largest suppliers of lifting equipment such as cranes for the construction industry. In July, Manitowoc acquired Shirke Construction Equipments Pvt. Ltd. In Pune, India, and followed that up with the August announcement that it will build a crane manufacturing facility in Saris, Slovakia. As Tellock notes, the company's moves were to bring manufacturing closer to the end customer.

"We try to take advantage of the markets when they are on the upswing while at the same time minimizing our fixed costs," he explains. "On the crane side of our business, we had manufacturing in China and the U.S. But if you look at low-volume, high-weight type items, they lend themselves to manufacturing closer to the end user because shipping weight is very expensive. High-volume, less-technology, easily assembled items can be manufactured anywhere in the world. We try to find centers of excellence as we expand production around the world."

When a product is big and bulky, it makes sense to move closer to endusers, if they entail a large market, notes Yossi Sheffi, director of the Massachusetts Institute of Technology's Center for Transportation and Logistics. "If you are talking automobiles, over time a lot of Japanese, German and Korean automakers have established plants in the U.S. Theyare moving closer to the market because shipping cars is expensive." Fundamentally, the goal of any company is to shorten the supply chain as much as possible. "That is the No. 1 objective," says W. Barry Gilbert, chairman, president and CEO of IEC Electronics Corp., a publicly traded, $23 million contract manufacturer based in Newark, N.Y.

Since supply chain concerns affect even small companies, IEC, in August, hired a vice president of supply chain for the first time. Veteran electronics supply chain manager Stephanie Martin came to IEC from the much larger Sparton Corp., another publicly traded electronics maker.

The reason for the hire was to improve supply chain efficiency, says Gilbert. "With original equipment manufacturers, the cost of materials will represent 35 percent of selling price, but to a contract manufacturer like IEC, that figure goes up to 65 percent," he notes.

"When you have such significant material content and the growth we've experienced, which was 80 percent this past year, you really have to pay attention to cost. Where we may have been inefficient before, the cost of those inefficiencies increased dramatically, so that no longer makes any sense."

IEC has about 500 active suppliers, principally through electronic distribution, Martin says. "We source out of Asia, Europe, Canada and the U.S." Unlike a company such as Manitowoc, IEC brings its product in by air using freight forwarders. "Transport evolved to be in my realm," Martin says. "We watch it, negotiate contracts, but primarily we are dealing with small packages. We do minimal ocean shipping."

For Martin, the bigger headaches are maintaining alternative sources, addressing demand changes and dealing with exchange rates with European manufacturers. Like Penkar, Martin says success in supply chain management is all about flexibility.

At the same time, the biggest challenge in a supply chain (which encompasses manufacturing, distribution, transportation, warehousing and ports-all the elements that come together to bring a product to market) is not the physical aspect of the product, it's the time element, notes Sheffi. In short, the time between making something and selling it.

"The main problem in supply chains is that many more things can go wrong because there are many more participants, and it takes more time to get something to market," he asserts. "Furthermore, you have to forecast the need of the consumer weeks or months ahead of the buying period, and by the time you make the stuff, ship, store, ship again, store again, get it to the store shelf, the consumer wants something else." 

In June, Avnet announced it would acquire Marshall Industries in a deal valued at$830 million. The $6.3 billion distributor of electronics parts reported that the transaction, part cash and part stock, would also include the assumption of $160 million of Marshall Industries' debt.

Now, the assumption of debt in an acquisition is nothing out of the ordinary. Among the many deals this year to include debt assumption were Cooper Tire & Rubber's $584.4 million offer for Standard Products ($173 million of assumed debt), Trenwick Group's $212 million purchase of Chartwell Re Corp. ($104 million of assumed debt) and Ogden Corp.'s $342 million deal for Volume Services America Inc. ($215 million of assumed debt).

But just because the assumption of debt is fairly commonplace doesn't mean it shouldn't be treated cautiously or that other options shouldn't be considered.

Roy Vallee, chairman and CEO of Phoenix-based Avnet, says when his company looks at an acquisition there are a number of different ways to calibrate or measure the financial ramifications of a deal. "The one I favor is the return on invested capital and in that calculation I include debt as part of the overall investment capital. Therefore, the investment that I'm making is a combination of debt and equity and then I look at what the return should be."

In Vallee's calibrations, a debt-ridden company is obviously worth less than a debt-free company and "if you just keep increasing the level of debt you get to the point where the acquisition price has to be lower and lower. Sometimes, in fact, you just have to walk away."

There is another concern, and that is the balance sheet of the company after the acquisition, especially if the rating agencies don't like the look of all that new debt. A low rating on company debt creates two problems: it increases the amount of interest to be paid and reduces the access to capital as lenders are more interested in lending to A-rated companies rather than C-rated companies.

Companies have to go through a risk analysis to determine if it makes sense economically to pay the debt back, says David Reed, managing director and group head of PaineWebber's M&A group in New York. "Often, the acquiring company has a better credit rating and therefore a lower cost of funds and it can actually enhance profitability by paying back the acquired company debt."

In any acquisition, Reed notes, one either has to assume the acquiring company would have some sort of change of control provision, which means it has to come up with cash to pay the debt as part of the acquisition, or it has to come up with an alternative financing source without actually assuming the specific debt instrument.

Another concern is that the debt instrument of the acquired company might have a change of control provision where there are prepayment penalties. "While that adds to the cost of the acquisition, it's not an impediment," says Reed, "particularly as it is usually a big company buying a smaller one."

In July, Equity Residential Properties Trust, a Chicago-based real estate investment trust, announced it would be acquiring Lexford Residential Trust in a $740 million transaction, including the assumption of about $530 million of debt. When completed, Equity Residential, the largest publicly traded apartment company in the U.S., will boast a market capitalization of $13 billion and 1,087 properties in 36 states.

The assumption of debt, says Douglas Crocker, Equity Residential's president and CEO, is a large component of its deal analysis for four important reasons:

•   Its impact on rating agencies' outlook for the combined company's rating.
• The impact of the maturity schedule of the debt being assumed.
• The interest rate on the debt relative to current market conditions.
• The cost of assuming the debt (higher interest rate, shorter maturity, more collateral or covenants and assumption fees). Can the lender call the debt?

The debt of the company being acquired can be so high that the combined company's interest and total coverage ratios could be negatively affected, says Crocker. "This would surely result in a rating downgrade, which would cost the new company each time it wanted to issue debt or preferred securities. To maintain ratings, the acquirer might be forced to issue equity at a disadvantaged price, thereby increasing the actual cost of the company being acquired."

In the end, are there ways to avoid assuming the debt of the acquired company? The buyer could structure the deal so an affiliated entity pays back the debt, or the buyer could lend money to the target company in advance of the acquisition and the target company could use the money to pay back the original lender.

Steve Bergsman is a Mesa, AZ-based freelance business writer who has written about corporate finance for Reuters, Barron's, Global Finance and Corporate Finance.