DemandSupply Mismatches and Shareholder

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Demand-Supply Mismatches and Shareholder Value
The Case of Excess Inventories Kevin
Hendricks Richard Ivey School of
Business Ontario, Canada Vinod R.
Singhal DuPree College of Management Georgia
Institute of Technology Atlanta, GA,
30332 September 2005
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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

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Accenture study

• 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

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Supply chain performance and shareholder value

• Shareholder Value Create - Destroy
• Poor supply chain performance destroys
  shareholder value
• Demand-supply mismatches are examples of poor
  supply chain performance
• Practices that prevent demand-supply mismatches
  create value by avoiding value destruction

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Issues examined

• Effect of demand/supply mismatches on shareholder
  value
• Supply is less than demand (undersupply)
• Supply is greater than demand (oversupply)
• Focus on excess inventory

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Issues examined

• What are the shareholder value effects of excess
  inventory?
• How does the shareholder value effects of excess
  inventory vary by firm characteristics?
• Do firms recover quickly from the negative
  effects of excess inventory?
• Compare the shareholder value effects of
  oversupply versus undersupply

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Plan

• Consequences of excess inventory
• Sample
• Measurement time period
• Methods to estimate the shareholder value
  effects
• Statistical tests
• Results
• Implications

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Consequences of excess inventories

• Higher inventory holding costs
• Drop in component prices
• Price protection
• Product returns
• Cost of curtailing production/temporary shutting
  of facilities
• Write-offs and associated disposal costs
• Limited pricing power
• Hamper ability to introduce new and innovative
  products
• Management credibility
• Shareholder lawsuits

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Sample

• 900 announcements of excess inventory
  situations from Wall Street Journal and Dow Jones
  News
• Jabil circuits announces that customers are
  reducing inventories, Dow Jones News Service
  March 18, 1998
• Champion International plans to curtail
  production to reduce its office-paper inventory,
  The Wall Street Journal, August 4, 1998.
• Eastman Kodak cutting prices 15 to 20 to
  liquidate inventory, Wall Street Journal,
  September 30, 1997.
• Intel to write down inventories of components,
  Dow Jones News Service March 16, 1996
• Announcements dates provide a reference point for
  measuring performance

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Distribution of sample announcements
Recessions July 1990 to March 1991 (19
announcements) and March 2001 to November 2001
(97 announcements)
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Distribution of sample firms by equity value
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Where is the excess inventory?
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Reasons for excess inventory
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Dealing with excess inventories
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Measurement time periods

• Jabil Circuits announces excess inventory on
  March 18, 1998
• Set March 18, 1998 as day 0 in event time
• Day -1 is the previous trading day
• Day 1 is the following trading date

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Estimating abnormal returns

• Abnormal performance Actual performance of a
  sample firm minus the performance of benchmark
• Use portfolio of firms as benchmarks (portfolio
  matching)
• Size (create 14 portfolio)
• Book to market value (subdivided each of the 14
  into 5 )
• Prior performance (subdivided each of the 70 into
  3)
• Create 210 portfolios
• One-to-one matching
• Similar in size
• Similar in terms of industry (SIC code)

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Testing statistical significance of abnormal
returns

• Statistical tests when mean abnormal returns are
  independent
• Standard t-tests
• Statistical tests when mean abnormal return are
  not independent
• p-value from boot strapping
• Median abnormal return
• - Wilcoxon sign-rank test
• of abnormal returns that are negative
• - Binomial sign test

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Average stock returns on excess inventory
announcements
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Comparison with stock market reaction to other
corporate events
Marketing events Change in firm
name 0.7 Brand leveraging
0.3 Celebrity endorsement 0.2 New
product introduction 0.7 Affirmative
action awards 1.6 Delay introduction
of new -5.3 products
Operational events Increase in capital
expenditure 1.0 Increase in RD
expenditure 1.4 Effective TQM
implementation 0.7 Internal corporate
restructuring 1.0 Decrease in capital
expenditure -1.8 Plant closing
-0.7 Undersupply (shortfalls)
-7.2
Financial events Stock splits
3.3 Open market share repurchase 3.5 Proxy
contest 4.2 Increasing
financial leverage 7.6 Decreasing financial
leverage -5.4 Seasoned equity offerings
-3.0
Information technology events IT
Investments 1.0 B2C
e-commerce 10.5 B2B
e-commerce 3.3 IT
problems -1.7
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Average stock returns over different intervals
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Average stock returns over three years
For the year before announcement through
announcement median abnormal return is -27.03
and 72 of the firms had negative abnormal returns
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Compounding and abnormal returns

• Year 0
• You invest 100 in a stock
• I invest 100 in a stock
• Year 1
• Your investment gave 100 return (You have 200)
• My investment gave 0 return (I have
  100)
• First year abnormal return is -100.
• Year 2
• Your investment gave 100 return (You have 400)
• My investment also gave 100 return (I have 200)
• 2nd year abnormal return is 0
• Two-year abnormal return is -200 (100 - 300)

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Sensitivity analyses of abnormal returns year
before through announcement period
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Sensitivity analyses of abnormal returns year
before through announcement period
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Are abnormal returns due to periods of low sales?
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Are abnormal returns due to periods of low sales?
Non Recessionary periods - 779
announcements Recessionary periods - 114
announcements
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Are abnormal returns due to periods of low sales?
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Comparison of abnormal returns for oversupply and
undersupply
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Average abnormal returns by who holds the excess
inventory
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Average abnormal returns by actions taken to
reduce inventories
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Average abnormal returns by various industry
groups
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Average abnormal returns by size
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Summary

• Excess inventory causes significant destruction
  in shareholder value
• It does not matter where is the buildup of excess
  inventory you still pay
• The effect of excess inventory is negative
  irrespective of size, industry, and calendar time
• High technology and retail industry do worse than
  process and batch manufacturing industries
• Firms do not recover quickly from excess
  inventory situations
• Market seems to anticipate excess inventory
  situations

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Broader perspectives

• SP 500 has returned about 12 annually over the
  last 15 years
• Excess inventory situations are associated with
  35 underperformance in stock returns
• One major excess inventory situation every 10
  years average return of 9

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Some concluding thoughts

• From an operational perspectives we know of many
  factors that could lead to excess inventory
• Earnings management can also cause excess
  inventory
• We seem to know many strategies that firms can
  adopt to reduce the chances of excess inventory
• Adoption and implementation of these strategies
  is not as widespread as one would like given
  their widely touted potential and promises

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Why enough attention is not paid to the
possibility of demand-supply mismatches?

• 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

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Future research

• Understand how upstream and downstream supply
  chain partners get affected by supply/demand
  mismatches
• Examine how other forms of oversupply such as
  excess capacity affects shareholder value
• Demand/supply mismatches and cost of capital
• Economic consequences of product development
  delays