This article originally appeared in Business Insider
As we review the landscape for small and midsize manufacturing companies, we see considerable challenges. A review of some items in the February 2013 ISM Report on Business® is instructive (see report here).
Gross Margins have been an issue that we have focused on extensively at ACM Partners. The operating expenses of a company are certainly important, but in our experience understanding where gross margins might be headed and why is often a useful exercise in predicting pockets of distress in the broader economy.
The gross margin picture suggests that challenges lay ahead. In February the index of prices paid by manufacturers increased by 5 percentage points. As companies lose the ability to protect gross margins, management teams often panic and seek to address the problem by increasing sales. The pursuit of higher sales at declining margins and with less discipline over the costs of servicing new clients is a long-established recipe for taking a company from mild under-performance to deep distress.
Inventories: Up at Producers, Down Among Customers
Among small and midsize industrial companies we anticipate demand shocks as customers, now comfortable with a historically low level of inventory, respond more quickly to changes in end-market demand. The disconnect between customer inventories having been below 50 (the point at which they are considered too low) for nearly 4 years and producer inventories increasing suggests that producers are increasingly ill-equipped to address fluctuations in demand, and may be making the implicit choice to tie up cash in increased working capital rather than in capital expenditures.
These diverging trends in inventories present two serious challenges to small and midsize manufacturers:
1. From a pricing standpoint the existence of slow-moving inventory will provide for some companies a temptation to sell at reduced prices, further eating into gross margins.
2. From a financing standpoint this approach is a recipe for trouble, as asset based lenders will advance considerably less on inventory than on accounts receivable. Additionally, for troubled small and midsize industrial companies there are fewer options to get any availability on inventory, further heightening the risk of this approach.
Changing Power Dynamics
Power flows up and down the supply chain, depending on industry, quality of management, availability of financing and a multiplicity of other factors. At the moment large national and multi-national customers control the fates of their suppliers, both the small and midsize manufacturers making the products, and the similarly sized distribution companies that store those products and handle order fulfillment. As these dominant customers seek to maximize profitability and optimize their working capital, they are causing ripple effects throughout their supply chains. The dominant strategy for the small and midsize industrial companies seeking to adjust is to become indispensable by occupying high value niches or gaining scale.
Companies will continue to make and ship things, and so manufacturers and distributors will continue to have a role in the economy. But there is no guarantee that their role will be a profitable one.