Managing Through Supply Chain Disruptions
We recently sat down with three of our research analysts to discuss supply chain disruptions, their impact on pricing in various industries, and whether the disruptions would abate in the short or long term.
Blake Haxton: There is no doubt, the supply chain, especially the international supply chain for everything from bulk commodities to consumer packaged goods, remains snarled. If you break down transportation, mode by mode–rail, water, truck–across the board there are short-run headwinds. On the labor side of the supply chain, there are ongoing capacity restraints. As investors, we ask ourselves if these issues are short or long term, and then how do they impact the long-term earnings capacity on a company-by-company basis.
A factor exacerbating these issues is a high level of volume–that doesn’t appear to be transitory. It will likely take a few quarters to sort out the current problems, but in the long run, we are already seeing efforts to invest in solutions for the existing inefficiencies.
Chris Piel: Blake calls out an important point. A global and interconnected supply chain running smoothly doesn’t garner much attention from anyone, apart from those of us who analyze companies for a living. But amid a period of disruption, it takes only one part of that supply chain breaking down to cause broader havoc, leading to inflationary costs across the global system, which is what we have experienced lately.
In the consumer and technology space, where I spend a lot of my time, for decades we’ve seen companies investing toward a global supply chain, outsourcing parts of their process in pursuit of cost savings. However, companies are starting to realize there are also downsides to an interconnected system–an inability to source a critical part can have cascading cost effects.
Take a company like our holding Assa Abloy, an innovative designer and manufacturer of locks and door opening solutions for commercial and residential spaces globally. We’ve all read about the semiconductor shortage causing issues in the auto sector. But semiconductors are also among the biggest input costs for Assa Abloy’s digital lock business. To combat shortages, the company has been flying in parts itself. However, increased demand for fuel has added to costs. Then, because of delays, lead times are compressed and factories are having to work overtime to stay on schedule which negatively impacts labor costs.
Helping offset this is Assa’s strong competitive position–as the scale leader in the space, it has significant pricing power. We anticipate it will be able to pass on increased costs through price and other efficiencies over the coming quarters. It has also experienced a strong demand increase thanks to growing renovation and upgrade projects in both the commercial and residential spaces, spurred by COVID-related safety and security needs, as well as ongoing ESG-related green initiatives.
Even before the pandemic, we were seeing some companies start to rethink their approach to a fully connected supply chain. We saw it in the run-up to the Brexit vote and then in the aftermath as the UK worked toward implementation. The heightened China-US trade war rhetoric in recent years was another impetus. Some companies are starting to realize there is value in controlling more of their supply chain which may offset the additional costs.
Harsh Acharya: When we look at diversified industrial companies, which is my area of coverage, they are generally set up to meet local demand from locally manufactured products using locally sourced raw materials. This structure helps minimize supply-chain issues, among other things. The ongoing pandemic has nonetheless highlighted a certain degree of fragility within this construct.
Running lean operations with just the right amount of investment in working capital, including inventories, is an indicator of management’s effectiveness–a dynamic turned on its head by the pandemic. Companies have struggled to meet a strong consumer-demand recovery while supply has fallen short due to personnel inefficiencies and pandemic-related absenteeism.
We’ve also seen varying degrees of time lag in diversified industrial companies passing through input cost inflation to customers. Whether the resulting margin compression is transient or structural depends mainly on whether the products are technologically differentiated and mission-critical to the end processes. The length of the time lag is partly driven by sales channels used by the companies, whether prices are set in the spot market or are contractually driven, and the frequency of customary prices increases in their respective end-markets.
We view both–the supply chain issues as well as margin compression due to input cost inflation–as largely transient for our holdings.
We are seeing companies coping with supply-chain challenges by reshoring production to a limited degree, dual sourcing important raw materials, and modifying long-term supply agreements with key vendors, among other actions. For example, tier 1 aerospace suppliers are providing unprecedent transparency to tier 2 and 3 suppliers into the manufacturing schedules of key aerospace majors such as Boeing and Airbus to allow for largely seamless production ramps.
In terms of passing through input cost inflation, a vast majority of the product portfolios of our holdings are technologically differentiated and mission critical. So long as consumer spending remains healthy, we believe our holdings would be able to pass through cost inflation to customers, albeit with varying degrees of time lag. As such, intervening margin compression could be transient in our view, not causing a material impact to our estimate of intrinsic value, all else being equal.
As of 31 Dec 2021, Diamond Hill owned shares of Assa Abloy.
The views expressed are those of the authors as of January 2022 and are subject to change without notice. These opinions are not intended to be a forecast of future events, a guarantee of future results, or investment advice. Investing involves risk, including the possible loss of principal. Past performance is not a guarantee of future results.