Combining Logistics with Financing for Enhanced Profitability

Because few companies have a clear idea of this "total" cost, they tend to target the more tangible elements of logistics costs, such as transportation and warehousing. As with every service, however, there is a point at which costs can no longer be reduced without affecting service quality. Many feel that if the transportation industry isn't there now, it's close. Meanwhile, while many conclude that the reduction in inventory carrying costs over the last several years ­ from about 5.4% of GDP in 1990 to just over 4% last year ­ is due to great strides in reducing inventory levels, the facts show that a marked reduction in interest rates over the same time frame has driven the majority of the benefit. In short, cost reducers, or logistics companies seeking new sources of revenue, need a new, more tangible target. When one considers the total dollar value of goods shipped through third party providers, the value created by reducing the financing cost by even a few basis points is far greater than any cost savings possible from traditional transportation and warehousing targets.

Current Situation
Three phenomena, none of which are likely to go away anytime soon, are driving this cost reduction opportunity. The first two, the failure of supply chain information owners to share and coordinate shipment status and product availability data with financiers, drives financing costs artificially higher; the third, the relentless pressure on suppliers in virtually every industry to accept longer and longer trade terms to enhance their customers' return on invested capital (ROIC) and return on assets (ROA) comes from Wall Street pressure: when managing ROA, if you can't up the "R," cut the "A". In short, own the inventory for the shortest time possible.

Lack of Information Sharing
Could owners of supply chain information, if that information were shared, influence the costs to finance inventory? Consider the components of an interest rate; In addition to the cost to fund, embedded in any financier's rate is the risk premium associated with credit and the costs to service, e.g. the costs to audit and inspect inventory. In effect, financiers seek out the same information that logistics providers require to provide service to their customers, and/or that customers gather directly, as financiers rely on asset tracking as a means to verify collateral levels and location to establish borrowing bases from which they extend credit. This alone provides a revenue opportunity in that real-time information on inventory levels and status has value to financiers because certainty of asset location and control of physical movement and possession results in a reduction in risk that can be reflected in the cost of credit. Put another way, the risk premium and servicing cost components of the interest rate are artificially high because financiers gather supply chain information independently and far less accurately than logistics providers, increasing risk and cost, resulting in an artificially higher rate. In short, reliable supply chain information is credit-enhancing. Owners of this information have a great asset, but they fail to maximize its value.

Poor Coordination
At the same time, each supply chain participant typically arranges financing separately. Suppliers establish lines of credit with financial service providers to acquire equipment to produce their products, to provide financing to build inventory and to support the extension of trade credit. Manufacturers, distributors and value added re-sellers follow the same practice (see Figure1). In so doing, each participant typically utilizes different financial service providers, each with its own terms and conditions, pricing hurdles, risk parameters, credit capacity and industry/product knowledge. Objective coordination with information exchange and physical movement through the supply chain to support the financing of inventory as it passes from one participant to the next is rare. As a result, process duplication occurs between suppliers utilizing a variety of different finance and logistics providers. In short, supply chain partners rarely talk about financing as part of their vendor negotiations, and as a result all pay more.

Figure 1.	Current State

Elongated payment terms
Countless suppliers are in effect financing their customers, as "net 30" becomes net 60 or worse. Most supplier discounts ­ e.g. 2% 10 days/net 30 ­ are either not taken or abused. Again, the Fortune 1000's relentless focus on ROA is the culprit; in effect, suppliers who do not want to lose an important account pay the price.

As a result, a gross inefficiency exists in most supply chains as higher cost of capital suppliers finance lower cost of capital manufacturers, assemblers, retailers or distributors. Almost regardless of industry ­ computer PCs, automotive and retail to name a few ­ the little guys are financing the big guys, creating a significant revenue opportunity for supply chain information owners to share their data on product movement and, working in conjunction with financiers, to manipulate the resulting arbitrage opportunity while earning a slice of the financing revenue in return.

CREDIT SUISSE FIRST BOSTON'S SOLUTION
Partnerships
Progress to date in achieving the supply chain goals of suppliers, manufacturers and retailers has focused on forming closer relationships or "partnerships" with one another. In theory, by working more closely together, all parties should achieve their ultimate goal of exceeding customer expectations at a lower cost with more seamless delivery. The overuse of the term "partnerships" and mixed results to date notwithstanding, we believe that to achieve real value, these partnerships must not be confined to traditional supply chain participants, but extend to financial service providers. To realize value, we utilize the following well-structured approach ­ one that demonstrates the fundamental improvement opportunities and is articulated to the CEO, CFO and senior logistics management.

Figure 2.	CSFB Model

Solution Model
CSFB's solution model is the creation of a structure whereby logistics providers jointly market their core products in conjunction with financial services designed to support customer solutions, or customers using third parties direct their provider(s) to offer these more comprehensive services to their vendor base. As a result, logistics vendors include financial and insurance services in conjunction with their core offering (see Figure 2). The objective is to establish service groups composed of finance and insurance companies that work in unison with supply chain participants to facilitate the movement of products while altering the current method of logistics and financing interaction to lower costs. As part of this equation, the use of asset securitization is key to further reduce the financing costs of product distribution. Note that this "single source solution model" is not the creation of a new product, but rather a re-alignment of existing processes to realize yet-untapped cost reduction opportunities.

Mechanics
In its most basic format, the logistics service provider and/or customer leverages its information capabilities and physical movement controls in a cooperative venture with the appropriate financial providers to capture excess charges between trading partners for financing and insurance. In most in-bound cases, this takes the form of accelerated payments for goods in-transit and the introduction of a Product Transit (insurance) Policy to cover insurable risk. In those situations where the supplier has a higher cost of capital than does the customer and the customer's actual payment practice has created extended payment situations (45 + days), the economics of accelerating payment can be substantial. Since the payments are made by a party unrelated to the customer, there is no increase in the customer's liabilities, while transaction costs are covered by the discount captured by accelerated payment of the suppliers' invoice. That is, we use the prompt payment discount ­ often 2% or more ­ to fund the program. To enhance the potential margin, the funding source needs to be more highly rated than is the customer and have the ability to tap the securitization markets. Revenue flows to the participants in the form of fees for sharing product status information and asset management services, including continued responsibility for accounts payable management. Note that this continued responsibility for accounts payable management allows the customer to maintain vendor contact while benefiting from the arbitrage opportunity with its suppliers. Meanwhile, the use of the Product Transit Policy consolidates the placement of insurance coverage, replacing the current process of independent and uncoordinated coverage placement. The net result is a lowering of costs to insure for all parties involved in the product's movement.

Clearly, participant selection is key to program performance, as each customer's trading situation is unique and each financing/logistics solution is tailored to the specific requirements of the customer's trading practices.

Value Creation
When a supplier ships products to a customer utilizing a logistics provider offering this single source solution, the supplier is able to receive an immediate payment for the sale, subject to the terms and conditions under which it has sold its products, instead of having to book a receivable and fund it on the company's own balance sheet. Note that if the supplier wants to transfer ownership of the receivable or title to the goods, it will be able to do so. As a result, the supplier has a new source of financing geared to the credit quality of the customers it sells to rather than to its own balance sheet. As a result, larger credit exposures can be taken with customers than would otherwise be possible, while financing costs generally fall because the interest rate is associated with the customer's credit rating, not the supplier's. At the same time, both the customer and the logistics provider share in a potentially significant revenue stream (or viewed another way, lower costs), while the logistics provider has a new, differentiated service vis-a-vis the competition with no balance sheet encumbrance.

More generally, value creation arises from the coordinated utilization of existing processes inherent in logistics services and financing. The difference between what is charged currently under a poorly coordinated set of services versus the savings that can be generated by delivering these services in a revised format results in reduced costs. In addition to the cost savings, there is the opportunity for reduced recourse and off-balance sheet treatment that may accrue to the suppliers and manufacturers serviced under these programs.

Figure 3.	Example: Computers

This solution is fairly straightforward. The logistics competitor continues to control inbound product movement and provides product status information to the special purpose company (SPC) set up to make and receive payments. The invoice servicer supporting the SPC provides electronic payment to each supplier at point of control by the logistics competitor, less the 2.5% trade discount. The servicer also provides cash management and risk underwriting. Note that the SPC now "owns" the inventory, not the logistics provider. Meanwhile, the computer assembler pays the full value of each invoice to the SPC under its normal payment practice.

This program generates $3.3 million in free cash flow per year. What is the key to success here? We use the trade discount and a bona fide receivable from an investment grade credit (the computer assembler) to cover the costs to fund, service, risk underwrite and insure. The free cash flow is split among CSFB, the logistics provider and the computer assembler.

Figure 4.	Prioritizing Opportunities

Generalizations
We are often asked to generalize the set of circumstances that make for the best opportunities. While such generalizations are difficult because each customer situation/solution is customized, we can make a few summary statements (see Figure 4). First and most simply, higher value products offer larger cost improvement opportunities because there is more to finance for any given volume of product and level of inventory turns. Likewise, faster turn products generally mean more potential for cost improvement for any given product value and trade terms. Next, trade terms that are offered but not taken ­ e.g. "2% 10 days/net 30" ­ accompanied by an elongated or abused payment cycle make for extremely low hanging fruit. These opportunities are especially lucrative when the supplier has a higher cost of capital than the customer to whom it ships. Sound familiar?

CONCLUSION
We believe that the proper definition of logistics embraces three flows: physical movement, information and financial; any solution that addresses only information and physical movement is not a complete solution, only a transitional one. The service providers that can articulate this new definition to customer decision makers and deliver a single source solution ­ or customers progressive enough to direct their logistics providers to offer an integrated service ­ will add significant economic value to their customers' businesses and enhanced revenue to their own bottom line. As we look out over the business landscape, we see major outsourcing projects under consideration in industries where global growth requires new supply chain solutions, all of them requiring financing.

About The Authors
Jon M. Africk
Managing Director, Co-Head of the Global Transportation and Logistics Group.

Jon Africk is a Managing Director in the Investment Banking Division of Credit Suisse First Boston, responsible for co-leading its investment banking activities in the Transportation and Logistics sectors. Prior to joining CSFB, Mr. Africk co-founded the logistics investment banking practice at Deutsche Morgan Grenfell, and spent seven years with A.T. Kearney, where he was a partner in the Transportation Practice. Leading the firm's work with global logistics companies, Jon Africk was A.T. Kearney's link between its carrier strategy practice and supply chain integration team. He has more than ten years experience in the industry.

Jon Africk received his MBA from Northwestern University's Kellogg Graduate School of Management where he is now a guest lecturer and member of the Transportation Center's Business Advisory Committee. Jon Africk earned his bachelor's degree in economics, magna cum laude, from UCLA.

Richard P. Palmieri
Managing Director, Co-Head of the Global Transportation and Logistics Group.

Rich Palmieri is a Managing Director in Credit Suisse First Boston's Investment Banking practice, and responsible for co-leading the Transportation and Logistics Group. Prior to joining CSFB, Mr. Palmieri was Managing Director of Logistics and Supply Chain Financing for Deutsche Morgan Grenfell where he co-founded the logistics investment banking practice. Mr. Palmieri was Executive Vice President of Marketing and Corporate Development for Deutsche Financial Services, the Asset Based Financing subsidiary of Deutsche Bank and President of Deutsche Credit Helicopter Finance.

Before joining Deutsche Bank, Mr. Palmieri was President of Whirlpool Financial Corporation, Chairman of Whirlpool Financial Aerospace, Ltd. and Chairman of Whirlpool Finance Spain.

Mr. Palmieri is an Officer of the Commercial Finance Association and a member of the Expert Advisory Panel to the United Nations Commission on International Trade Law. Mr. Palmieri has over 25 years experience in the Distribution Finance Industry.