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- June 3, 2011 -

 
     
 

Supply Chain Graphic of the Week: Impact of Inventory Reduction on Share Price

 

If You Think Supply Chain Improvements Impact Shareholder Value Through Operational Savings and Company Earnings Alone, Think Again

 
     
 

By SCDigest Editorial Staff

 
 

 

SCDigest editor discusses some supply chain finance 101 concepts in this week's First Thoughts column, trying to sort through the often confusing areas of working capital, cash flow, inventory carrying costs and more (See A Little Supply Chain Finance 101).

 

There, he referenced a chart developed a number of years ago in an SCDigest white paper, done in collaboration with Gerry Marsh of High-Tech Analyst Group, and shown below.

Here, we just want to focus on one thing - the impact of inventory reduction on a fictitious company, Action Apparel (which was a composite model of several athletic apparel companies, based on public financial data).

Through various improvements in its global supply chain, Action Apparel was going to reduce its costs and improve its earnings signficantly, which wll impact its share price, all things being equal (e.g., not considering overall market fluctuations, other company developments, etc.).

But notice the data in the red box in the graphic - the improvement in inventory turns from 6 to 7 per year will reduce inventory levels such that the present value of Action Apparel's future cash flows increases by $104 million, including both the drop in inventory investment directly and the operational savings that also come with the lower inventory levels (using a total inventory carrying cost of 19%).

These inventory improvements will increase Action Apparel's market capitalization by 13%, or more than half of the 22% of the total increase in shareholder value that is expected from a series of global supply chain initiatives in this fictious case study. Besides inventory, improvements were projected in cost of goods sold (COGS) and overhead (SG&A), as seen in the graphic.

In all cases, the improvements are in discounted (present value) cash flows Action Apparel will generate in the future.

 

 

 

How can this be? Marsh notes that "buy side" analysts rely heavily on cash flow based models to estimate a company's value, and that if a company that makes permament changes in the amount of cash it can throw off per dollar of revenue, that will have a powerful effect on those financial models and thus what the analysts believe the company is worth.

Very few companies well understand this.

Agree or disagree? What is your perspective? Let us know your thoughts at the Feedback button below.

 
 
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Feedback
2011-06-06

Thanks for writing. Below is Gerry Marsh’s response.  
 
“Wim is correct but only under the very restrictive assumption that there is no revenue growth or 0% CAGR in perpetuity. If that`s the case, then inventory is the least of his problems!
 
The single biggest deficiency of the "Carrying Cost" Model is that it is a static model which completely ignores the compounding effect of revenue growth on working capital investment. If a business is only growing at 2% - 3% per the year the underestimation is not very large. However, once the growth rate pushes up to 5%/year and beyond the impact becomes very substantial. Growth creates both additional expense reduction benefits and additional capital investment reduction benefits in future years.”
 
Gerry
 

NOTE FROM EDITOR: 
I will give you my layman’s explanation, which I think was on this page, but basically it assumes the ability to run the business on lower inventories will continue. It therefore has a more powerful cash flow business model, which goes directly into the buy side valuation models about what the company is worth out into perpetuity, which is how they do it.
 
 
Dan Gilmore


A reduction in inventories translates into an equivalent improvement in cash flow, but only once – not annually (the savings in COGS are ‘perpetual’, the balance sheet effect isn’t). Future cash flows are largely unaffected by a present reduction in inventories - the company continues to generate cash from operations much in the same way as today. We don’t have the base data for the Action Apparel example, but it is unlikely that a company valuation based on the present value of future cash flows should be that sensitive to inventory positions.
 
Wim Van de Velde
Senior Business Analyst
Brussels - Belgium

 


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