DemandSupply Mismatches and Shareholder

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Demand-Supply Mismatches and Shareholder Value
The Case of Excess Inventories Vinod R.
Singhal DuPree College of Management Georgia
Institute of Technology Atlanta, GA,
30332 December 2005
2
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

3
Accenture study

• Comparison of supply chains linkage to financial
  performance of 600 global companies over two
  different time periods
• 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?

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Plan

• Review of some recent empirical work on
  inventory
• Consequences of excess inventory
• Sample
• Measurement time period
• Methods to estimate the shareholder value
  effects
• Statistical tests
• Results
• Implications

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Recent empirical work

• Overall trend in inventory behavior
• - Rajagopalan and Malhotra (2001), Chen et al.
  (2005)
• Drivers of inventory turnover/levels
• - Rouminatsev and Netessine (2005), Gaur et al.
  (2005), Cachon et al. (2005), Lai (2005)
• Inventory turnover and corporate performance
• - Chen at al. (2005), Lai (2005), Shin and Wood
  (2004)
• JIT implementation/inventory reduction and
  financial performance
• - Huson and Nanda (1995), Balakrishnan et al.
  (1996), Lieberman and Demister (1999)

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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

• On March 18, 1998 Jabil Circuits announces
  excess inventory
• 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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Average stock returns on excess inventory
announcements
of sample firms with abnormal negative returns
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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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Announcement abnormal returns over time
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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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Average stock returns over different intervals
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Pre-announcement abnormal returns

• Results are because sample has mostly poorly
  performing firms
• Have controlled for poor performance by matching
  on performance
• No evidence of poor performance after
  announcement
• Results are unaffected when firms that do not
  survive or when firms with low stock price (
  10) are excluded

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Pre-announcement abnormal returns

• Results are due to earnings management
• Inventory is not the first thing that comes mind
  to when we think of earnings management
• If sample firms successfully practiced earnings
  management, abnormal returns before the
  announcement should have been positive
• Earnings management is hard to detect and prove
• Results are unaffected on excluding firms that
  are likely to have IPO and secondary equity
  offerings where earnings management activity
  has been documented

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Pre-announcement abnormal returns

• Results are due to bad news about economy and
  industry
• Bad news about industry and economy has been
  controlled
• If industry and economy bad news is driving the
  results then the poor performance should continue
• Big bath write-offs are an attempt to clean
  balance sheet
• - Non-write-offs subsample show negative
  performance

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Pre-announcement abnormal returns

• Declining profitability/sales can explain the
  negative abnormal returns in the pre-announcement
  period
• Compare operating income and profitability over 2
  different time periods
• Year leading to the announcement three quarter
  before the announcement to the quarter of the
  announcement (YEAR0)
• Year before 7 quarters before to 4 quarters
  before the announcement quarter (YEAR-1)
• Estimated change in sales YEAR 0/YEAR -1
• Estimated change in operating income YEAR0
  YEAR-1

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Pre-announcement abnormal returns
Relative Sales On announcement Year before
the announcement 0.22 to 0.75
(n51) -3.75 -49.43 0.75 to 0.95
(n126) -6.68 -43.26
0.95 to 1.05 (n126) -3.92
-30.24 1.06 to 1.25 (n180) -5.33
-27.75 1.25 and more (n120)
-9.70 -37.09 less than
1 (n245) -5.12 -39.97
more than 1 (n 374) -6.58
-31.87
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Abnormal returns segmented by changes in
operating income
Change in On announcement Year before
the Operating income
announcement Negative
(n415) -6.32 -41.53 Positive (n 200)
-5.55 -19.88
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Summary

• Excess inventory causes significant destruction
  in shareholder value
• It does not matter where is the buildup of excess
  inventory it still hurts
• 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
• Market to some extent seems to anticipate excess
  inventory situations

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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
• Demand/supply mismatches and cost of capital
• Economic consequences of product development
  delays

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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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Pre-announcement abnormal returns

• Results are because of poor operating performance
  (past and future) due to excess inventory
• Revenue effects
• Could grow but still have excess inventory if
  firms are overoptimistic about demand
• Could drop in a growing market if firms do not
  have the right inventory
• Could drop due to soft economic conditions
  have controlled for this
• Cost effects
• Costs are generally increasing with excess
  inventory
• Opportunity costs
• Lost anticipated profits expected from holding
  inventory

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Issues on focusing on short window

• Does the market really care about excess
  inventories?
• Does excess inventory announcements convey new
  information to the market?
• Are excess inventory announcements good news or
  bad news?

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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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Announcement abnormal returns over time
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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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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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Comparison of abnormal returns for oversupply and
undersupply