A Small Business CEO’s Guide to Uncertainty
On January 30th, 2020 in The Wall Street Journal, the economic update lede read: “The U.S. economy headed into 2020 on a solid footing, with growth settling back to the roughly 2% pace that has prevailed during the decade-old economic expansion.” By mid-March, most business operators found the foundational elements of operations upended as politicians pleaded with the public to stay home, physical stores shut down, overseas production stalled, and shipping containers remained at sea. Not even a full year later and, as the saying goes, hindsight is 2020.
While the initial shock has subsided, the landscape for operators has shifted, leaving big questions as we collectively race for a new year and what we hope is a fresh start. Studies and data sets examining where value chains broke down this year are being released, accompanied by major corporate response plans and announcements.
Responses from industry giants will differ in scale and scope from those of smaller companies, but the core questions are similar. As a small company operator, you must still make decisions about key areas like contract terms, inventory, CAPEX, suppliers, product materials and design, distribution, pricing, and intended rate of growth as you look to 2021 and beyond.
While overused this year, “never waste a good crisis” rings true. Our aim below is to help break down what the research and data highlight, examples of corporate response, and frame a discussion that may be useful in making decisions about your small business’s future.
AN UNWELCOME EDUCATION
Force majeure is one of those contract terms that historically makes non-legal eyes glaze over. Acts of God feel like an abstract or obsolete risk when there’s a deal to strike. COVID-19’s legal status as an Act of God will likely be argued several thousand times over in the coming years, but the act itself was material to operations in almost every country around the world, creating a uniquely universal scenario.
Following decades of globalization, that universality exposed how interdependent our value chains are and the extent to which, when a certain geography or industry is hit by a catastrophe, the second order effects may spread. You likely experienced it, if not in your work then in the hunt for toilet paper.
The McKinsey Global Institute began a study in 2019 on value chain disruptions that led to the October 2020 release of “Risk, resilience, and rebalancing in global value chains.” Within a matrix, researchers separated types of disruptive events based on the estimated cost of such a shock (catastrophe vs. disruption) and the ability to anticipate said shock. As an illustrative example of magnitude, the most extreme unanticipated catastrophes are a meteoroid strike and a solar storm. Not exactly things in everyday risk calculus.
While the research origins were seeded in other recent past disruptions, such as the dozens of 2019 weather disasters with damages in excess of $1 billion each, this year’s global pandemic offered a broad real-time case study.
The McKinsey report outlines industry-specific variabilities and vulnerabilities, but focuses on the universal truths. The researchers found that, “averaging across industries, companies can now expect supply chain disruptions lasting a month or longer to occur every 3.7 years.” Simulating for various conditions, they also found that a 100-day disruption in only production “would wipe out between 30 and 50 percent of one year’s EBITDA for companies in most industries.” To put it simply, while the COVID-19 pandemic is certainly a catastrophe, other disruptions and catastrophes have happened before and will happen in the future. We all know this, but risk calculus tends to shift with personal experience.
INCONSISTENT INDICATORS
2020 played out the catastrophic scenario, and, as of October, the economic indicators are good, bad, and ugly all at the same time. The IMF is projecting a 4.4% contraction globally for the year, “a less severe contraction than forecast in June…” The FRED noted, “Economic activity began to increase in May or June, and most forecasters currently expect that output will increase in the second half of 2020 unless the pandemic resurges to the point of necessitating widespread business closures.”
The general spring lockdown period revealed dramatic drops. Domestically, each state’s GDP declined by 7.1% to 13.9% between Q4 2019 and Q2 2020. The states’ net job losses from February to August 2020 range from 16.8% (Hawaii) to 1.8% (Idaho). The Index of Industrial Production recorded a historic drop as, “The February-to-April decline in IP was the largest two-month decline in the history of the index, which begins in 1919. The cumulative declines in IP during the first four months of the Depression and the 2020 recession were similar.” As an industry-specific example, between April and June, the U.S. imported 49% less year-over-year in apparel. And there have been many reports on the supply shortages of everything from paper towels to canning supplies to refrigerators.
Especially following the spring lockdowns, some of the indicators and industries trending positively started to do so in equally dramatic fashion. E-commerce sales have reached heights forecast for 2022, expected to top “$794.50 billion this year, up 32.4% year-over-year.” U.S. civilian agency spending for Fiscal Year 2020 was up 17% year over year, with $59.4 billion going to small businesses (~26% of total spend). Beer, Wine, and Liquor Stores are also experiencing all-time highs in revenue.
These positive developments, particularly in distribution, have their costs. Shipping and warehousing, in particular, are estimated to be an ongoing challenge. The September survey by the Logistics Managers’ Index (LMI) found that the “transportation capacity reading was the lowest level ever.” FedEx Chief Marketing Officer Brie Carare warned, “There will be days within the holiday season where the industry will be over capacity.” At a local level, as one bakery owner described, “[Packaging] is the bane of my existence… It really drives our business in a way, because I've had to make some choices from a menu perspective based on the packaging that I have."
SHORT-TERM SHOCK SOLUTIONS
Bottlenecks popped up early and often for many firms. Companies like Fiat Chrysler importing from China had early warning signs based on the swift downshift in Chinese exports in January, resulting in significant constraints downstream. As ports and plants closed, having relatively strong control over product production or existing stockpiles of inventory became a powerful commercial advantage. But with no end in sight, those stockpiles would only last so long.
Companies large and small got scrappy in the spring. As outlined in the Financial Times, “Jaguar Land Rover admitted to flying parts over in suitcases from China to keep its production lines in Britain running. At one point, the company was building one key fob for the car, rather than the standard two, to fulfil orders.”
At skincare company HoliFrog, they doubled component orders and got creative about Plan B options:
One unanticipated consequence of the beauty industry’s vigorous jump into hand sanitizers and hand washes is that it caused a shortage of bottle pumps… Should the brand face a direct shortage from its partners, it will tap into a reserve pile of 50,000 pumps held at its Kentucky warehouse. This stockpile was not intentional, but actually the result of a change in a bottle design that resulted in a surplus of pumps. The pumps, which are white and were ordered in Dec. 2018 prior to the brand’s launch, were before Parr and Hemmat decided they needed color-coded pumps to align with the final bottle design. At the time, she and Hemmat were “kicking ourselves over this mishap” she said, but now she anticipates that some bottles may need to use them if there is a second Covid-19 wave.
But these examples do not offer sustainable solutions. They were short-term fixes in a crisis situation.
Nike demonstrates an example of a more sustainable solution, albeit extremely costly and dependent on their scaled supply chain. As discussed in a podcast, “Nike is a company that had invested in really understanding where goods were in its supply chain, through a digital platform linked to its contract manufacturers. And when COVID hit in January, it was able to see what products it had, reroute goods that were headed toward the brick-and-mortar stores that were shut down now, toward e-commerce fulfillment centers.” As outlined in McKinsey’s report, “Nike used predictive analytics to selectively mark down goods and reduce production early on to minimize impact.”
DURABLE OFFENSE
When faced with a future disruptive event, why can’t we all be like Nike or Proctor & Gamble, using predictive analytics to redirect orders between hundreds of suppliers (or 50,000, in the case of P&G) and distribution channels? Because not many businesses have those kinds of resources.
As a small business operator, your network and influence are comparatively limited. Most small companies have at most a handful of close supplier relationships, very little access to outside data, and are capital-constrained.
These realities make it all the more imperative that you develop defensive strategies to remain durable against future shocks. That said, the current pandemic is ongoing and so acting intentionally now may benefit your company in the short-term as well as the long-term.
Each company’s solutions will differ based on your industry, risk appetite, balance sheet, relationships, and offerings. But the themes below should prompt worthwhile discussions among any leadership team:
SUPPLY CHAIN
“If the emphasis for a long time was on creating lean, efficient supply chains, there is now a fresh focus on “short” supply chains to reduce the risks of disruption between countries, according to Prashant Yadav, affiliate professor of technology and operations management at Insead.” - Financial Times
“Freight forwarding is a relay race… many players to get cargo from exporter to importer… and it’s run in a black box… that black box has become brittle this year.” - Ryan Petersen, Flexport
“Jim Adler, who run’s Toyota’s AI Ventures… told an FT conference last week that the pandemic had brought the “fragility” of the cross-border set-up into “stark relief”. Supply lines “were focused, in many cases towards China, and the resiliency of those supply chains was traded away because it was so efficient and so cost-effective…”” - Financial Times
“The intermediate-term backlash against globalization and urban living seems unlikely to persist past 2024, since the economic benefits of those long-term trends are so compelling.” - WSJ
“No longer able to rely on pre-existing steady-state models, businesses are increasingly making decisions using real-time information and comprehensive analysis.” - Supply & Demand Chain Executive
What strengths and weaknesses did we discover this year in our supply chain? What was most unpredictable?
What, if any, early warning signs were visible ahead of any bottlenecks? How well are we tracking associated indicators? What, if any, preemptive measures should we have taken?
Where is there the potential for redundancies or optionality? What are the tradeoffs in creating redundancies/optionality?
What has been the maximum delay experienced to date? Root causes? How resilient is our supply chain to such delays?
In a future crisis, how responsive/adaptive is our supply chain? What are the tradeoffs in making it more responsive/adaptive?
How well were we treated within the supply chain (i.e. AP aging, shipment prioritization)? How well did we treat others? What, if any, are the mid- and long-term implications?
PRODUCT OFFERING
“Despite having been historically regarded as more costly than overseas sourcing, domestic sourcing has always maintained an advantage in quality. This advantage in quality and reliability combined with an inherent circumvention of rising tariffs, lockdown-related shipping delays, excessive logistics costs, freight expenses, and geopolitical disagreements that can upend supply chains with little to no warning, have all brought domestic material sourcing into pricing parity or better with overseas suppliers while offering substantially less risk.” - Supply & Demand Chain Executive
Are all of our products dependent on the same supply chain? If so, was that concentration an issue this year?
If one part of our supply chain suffers, how quickly could we shift our offerings to a mix of products that come from a more reliable part of the chain?
Is it time to “upgrade” our products to components that come from a more resilient value chain?
Are there alternative supplier options with whom we should start a relationship before another crisis hits (e.g. onshore supplier)?
Can we offer additional services to our customers that make them want to do more business with us as a supplier?
INVENTORY
“It’s not just about government-mandated shut downs… If people aren’t confident, they won’t return to their shopping habits.” - Phil Levy, Flexport
“Before the pandemic, the emphasis was on “just-in-time” production, with parts being delivered just when they were needed in the manufacturing process. In the post-pandemic period, the emphasis could shift to some extent to “just-in-case” supply chains, emphasizing proximity and certainty of delivery.” - WSJ
“If history is a guide, it seems likely that consumption will come back with a vengeance. Periods of plague-driven austerity have often been followed by periods of liberal spending.” - WSJ
Have we shifted our quantities or timelines around inventory as a result of this year? At what cost? How do we intend to optimize if this is the “new normal”?
On a go-forward basis (and tied to our predictions on growth), how confident are we in demand? Do we expect to make early buys as a result? If so, at what scale?
On what necessary materials or goods did we experience shortages or shipping delays this year? How are we modifying our procurement, if at all?
What are our best options for managing any excess inventory?
DISTRIBUTION
See the FRED’s sales data on Nonstore Retailers, Discount Department Stores, Warehouse Clubs and Superstores, and General Merchandise Stores.
See Klaviyo’s monthly data on Global Ecommerce Orders.
“Online shopping is so strong that it will more than offset the 3.2% decline in brick-and-mortar spending this year, which will drop to $4.711 trillion. As a result, total retail sales in the US will remain essentially flat.” - eCommerce
“From January through mid-August, retailers had announced they would close a total of more than 10,000 stores in the U.S… Retailers are likely to decide to close as many as 25,000 U.S. stores in 2020.” - WSJ
“If most e-commerce companies have been pulled 1–3 years into the future in terms of their revenue, then the e-commerce businesses of most category leading brick and mortar retailers have been pulled 5–10 years into the future… Wal-Mart’s digital revenue in Q2 was an annualized $42 billion, growing 94% — faster than Amazon. Best Buy’s digital revenue in Q2 was an annualized $19.4 billion, growing 242% — faster than Amazon.” - Gavin Baker
How have our methods of distribution shifted this year? What resulting investment(s) is necessary (i.e. if increasing D2C e-commerce, may need increased associated infrastructure and/or 3PL capacity)?
What, if any, distributors proved to be poor partners this year (e.g. cancelled orders, unpaid invoices, returned inventory)? How are we responding?
What trends do we notice in customer satisfaction by distribution channel? How much control do we have in the outcome?
What about our offering is difficult to appreciate without in-person sales? How are we working to translate for remote purchase decision-making? Are we betting on in-person sales in the long-term?
PRICING
“There was a reason people went across the ocean in the first place… it wasn’t easier. There was a significant pricing difference.. somewhat mitigated by tariffs now… but, as an economist, I believe people will do the economic calculus...” - Phil Levy, Flexport
“While unit prices for apparel tend to decline modestly year over year… the decline in 2020 over 2019 is vastly larger than normal and is driven by the industry’s response to the pandemic… the only means through which the reductions in unit price apparent in the data could have been achieved is the imposition by brands and retailers of retroactive discounts—below the agreed contract price for the goods in question.” - Sourcing Journal
How did our margins and cost structure shift this year? What controls, if any, were we able to exercise?
Should we adjust our pricing (up or down)? If so, why, and at what cost in terms of customer roster and competitive position?
Are there particular cost centers (e.g. raw materials, shipping type, labor type) that contributed an outsized amount of cost this year? If so, what other options do we have?
CONTRACTS
“Look past force majeure into such areas of jurisdiction, warranty, inspection, indemnification and title of goods…” - Supply Chain Dive
What contract weaknesses did we discover this year? How do we intend to update our own? How do we expect such changes to be received?
Are there suppliers hurting for business that might give us long-term price breaks in exchange for a longer commitment?
What do we need to pay particular attention to in reviewing contracts on a go-forward basis?
GROWTH & INVESTMENT
See the FRED’s graph of Sales Revenue Growth Uncertainty and Sales Revenue Growth Expectation for illustrations on how peer confidence has shifted.
“Following the contraction in 2020 and recovery in 2021, the level of global GDP in 2021 is expected to be a modest 0.6 percent above that of 2019…” The U.S. grew 2.2% in GDP in 2019, is expected to contract 4.3% in 2020, and then rebound 3.9% in 2021. - IMF
“A vaccine will probably not be widely deployed before the U.S. achieves herd immunity—a level of infection in a population, roughly 40% for SARS-CoV-2, that limits the further epidemic potential of a pathogen. We are likely to reach that point by 2022 no matter what we do… Either way, with a good vaccine or without one, Americans will live in an acutely changed world until 2022—wearing masks, avoiding crowded places and limiting travel, at least if they wish to avoid getting or spreading the virus.” - WSJ
Federal contract spending has grown significantly amidst the pandemic, according to Bloomberg Government senior defense analyst Rob Levinson.
Are we on offense or defense right now? What risk tolerance do we have? How have government interventions positively and/or negatively interfered with our operations?
At the beginning of the year, what were our growth-oriented priorities? How has 2020 shifted related expectations or standings?
Is our peer set shifting? Are there opportunities to gain market share? If so, at what cost?
What is our cash position? What kind of cash cushion do we want to have as we continue through this disruption? If there’s excess cash, what is the best use?
What are our most significant growth constraints? What, if anything, can we do about them?
RESILIENCE
It’s hard to say how things will play out, and there are no obviously right answers to the questions listed above. Permanent Equity was founded in 2007, which gave us a front-row seat following the Great Recession to review how companies fared, restructured, and, frankly, survived. Luck played a role, but proactive resourcefulness, investment, and consistent communication were regular themes among those that built themselves into stronger organizations through and following that event. While 2020 presents a unique set of challenges, use the opportunity. May your best days be ahead.