Whenever supply and demand get massively out of balance, there's an inevitable impact further down the line: The Bullwhip Effect.
CIPS: The bullwhip effect is the demand distortion that travels upstream in the supply chain. Upstream in the supply chain consists of the retailer through to the wholesaler and manufacture. The distortion is created by the variance of orders which may be larger than sales.
Yeah, but what is it in English bruv?
We've had the perfect demonstration over the past couple of years. A sudden increase in demand that supply can't easily meet is a signal to ramp up production.
But nobody knows how long that increase in demand is going to last, so retailers just keep ordering, and producers just keep producing until the opposite signal feeds back through the chain (which takes time)...
Everyone locked in at home was the first signal and this was later reinforced by the continuing trend towards work-from-home...
People needed a load of electronic goods, all at once. Essentially, we all pulled forward our demand for those goods by a couple of years and compressed those purchases into a shorter period. Now, we don't need as many.
Which means even the giants might not escape the Bullwhip effect... 👇
...according to BofA Securities’ analysis, about 41.8 million excess iPads were sold in 2020 to 2022, partly due to new demand but also because customers replaced their devices faster as they worked and took classes from home.
“In our view, a quarter of the incremental sales are linked to quicker replacements, which we expect to result in year over year declines in iPad units shipped in 2022 and 2023,” Mohan wrote. But “if post-pandemic work/study trends result in an inherent change in customer behavior and increase replacement levels, there could be upside to our iPad outlook for 2024.”
“Although the device continues to attract a high proportion of new users (about 50% of purchasers in any quarter even pre-pandemic were new to the device), replacement rates remain muted,” Mohan wrote in a research note Monday. “We see this as a function of the category being in structural decline.”
Companies produce goods to meet the current level of demand, and nobody's any good at predicting when it'll end so they inevitably just keep on producing.
It seems like a problem that should be easy to solve, but it's hard to imagine a business trying to call the production 'top'. The penalty for getting it wrong and under-producing would be severe.
Think of all those missed profits! Heads would roll...
Which makes the Bullwhip effect inevitable. Morgan Stanley have been taking stock (puntastic) of the situation, adding some extra colour and charts to our thoughts here... 👇
The key takeaways?
- The problem with inventory is twofold - supply chain bottlenecks are clearing while demand, especially demand for goods, is slowing.
- Faced with a glut of inventory, companies will need to decide whether they want to accept high costs to continue holding inventory, destroy inventory, keep prices high and take a hit on the number of units sold, or slash prices to stimulate demand.
- We believe many will turn to aggressive discounting to solve their inventory problem which is likely to spark a “race to the bottom” as companies attempt to cut prices faster than peers and move out as much inventory as possible. This dynamic will weigh heavily on margins and fuel the earnings slowdown we are predicting.
Although the effect is different across industries, and even within industries, the trend is clear.
This chart and snippet on semiconductors sums it up well (emphasis added) 👇
The supply chain shortages - driven by a variety of idiosyncratic disruptions to production, most notably from China trade tensions and Covid lockdowns - remain the driving factor here; purchasing managers across most semiconductor consuming markets report a preference for keeping buffer inventories high.
But for the markets where semiconductors make up the majority of the bill of materials - PCs, smartphones, servers - inventories exceeded the tolerance of the customers, and we are starting to see reductions that are fairly severe, in some cases.
While those inventories are down from 3 months ago, they are still flat with 6 months ago, and much higher than the historical norm.
Even within those customers, we see different behavior for different types of components. We saw customers in the smartphone space where builds are otherwise quite strong cancelling memory backlog as early as July; as it became obvious that producers have plenty of inventory of such commodity parts, there is simply no need to maintain a high reserve of such inventory - especially when prices started falling 20%+.
Especially when this is happening...👇
Behavior is very different in markets where semiconductors make up less than 10% of the bill of materials - including automotive, industrial, infrastructure, and some enterprise markets. The lost revenue for those companies due to the ongoing semiconductor shortage is material and painful.
Anecdotally, we hear of an almost unlimited desire to purchase every available component, without respect to how much of that inventory is on hand.
Semiconductor shortages have been a big problem for automakers especially, and the recent trend of growing auto (and parts) exports from South Korea even as overall exports decline is one to monitor. 👇
And if you fancy some Nike gear on the cheap Morgan Stanley thinks you might be in luck... 👇
While wholesalers are likely to see less dramatic gross margin declines, we worry investors may be underestimating margin risk for branded apparel players. NKE’s 1Q23 report highlighted
1) currently elevated & misaligned apparel inventories in the US,
2) still-heightened apparel inventory deliveries given early ordering & elongated lead times, &
3) the need for deep discounts to clear through excess
Good news for consumers, bad news for company profits. Bullwhip Thanos clicks his fingers, the race to the bottom starts and half of those profit margins disappear...
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