March 2, 2020

Mitigating the Economic Impacts Coronavirus

Prepared by Meadowlark Advisors

J. Cooper Crouse & Dillon Zwick

03.02.20 Update

Introduction

The purpose of this document is to provide an overview of the risks presented by the Coronavirus to global markets, international supply chains and the companies relying on those markets and supply chains to do business.

As of this update, China is, for the most part, not open for business. Its major businesses are shutdown, its ports are effectively closed, its work force is at home and no one is traveling in or out of China.

The largest worldwide exporter and one of the largest importers is closed.

Additionally, Coronavirus continues to cross national borders. It is not an official pandemic, but more people are getting sick in more countries. More people will die. More businesses outside of China are being affected. It is likely that the economic disruptions will also spread and intensify, beyond China, potentially globally.

There is a potential for months of widespread disruption in markets and supply chains, just from the current Chinese epidemic.

If not already started, companies should immediately focus on assessing their risks and developing mitigation plans to reduce the impacts to those enterprises.

Aspects of the Coronavirus are addressed in this document due to the unique characteristics of the illness, the rapidly changing information being publicly provided and the wide differences in opinion of the worldwide health and business risks.

Like the victims of the Coronavirus, weaker businesses will be at higher risks than healthier businesses in facing these challenges.

And also like the Coronavirus, carrying on assuming that this is “life/business as usual” exposes others to risk with each passing day and each interaction. Businesses need to assess their current exposure now and take action now. Waiting for a diagnosis after the symptoms are obvious is not an effective strategy at a personal or business level.

You may have been sick for weeks.

Influenza and Novel Coronavirus (COVID19)

The last major global pandemic was a century ago when the Spanish flu, an avian influenza strain (H1N1) infected 500 million peoples, approximately one third of the world’s population. 50 million of those infected died between 1918 and 1919. (WHO)
In recent years, anywhere from 20,000 to 60,000 die globally from the flu and resulting complications. So far in 2020, there have been 14,000 flu fatalities. (CDC)
Generic Coronavirus is a flu that occurs in humans and animals. It is associated with the common cold, as well as MERS and SARS (hence the most recent name change). (WHO)
Novel Coronavirus (COVID19), is a new strain of Coronavirus first detected in Wuhan, China on December 31, 2019, weeks before the start of Chinese New Year. (WHO)
The virus continues to spread across China with the peak of the illness projected to occur in March 2020.
There are conflicting reports from epidemiologists on whether Coronavirus will become a global pandemic; however:
- Once a person is exhibiting any flu symptoms, differentiating Coronavirus from other flu viruses is estimated to be 50% reliable.
- Unlike other flu strains, where an infected person is contagious for typically one day before symptoms and 6 days after, COVID-19 infected people can be asymptomatic, but contagious for up to 14 days, thus increasing the odds of additional exposure.
- It is widely believed, and unofficially discussed by experts, that the worldwide reported cases are underreported, possibly by an order of magnitude.
Coronavirus continues to spread on a global scale with updates nearly hourly of revised statistics, additional countries reporting cases and new impacts to businesses and commerce.
As an illustration of the rapid dynamics of the situation, Coronavirus has been renamed three times: COVID19, 2019-nCoV and, most recently, SARS-CoV-2 as epidemiologists learn more about the virus.

Chinese Economic Impacts

There have already been significant impacts to the Chinese economy and foreign businesses with interests in China.

The first identified case occurred in December 2019, just before the Chinese New Year national shutdown (~2 weeks).
The Chinese New Year shutdown is typically planned for by companies worldwide who add additional capacity, build inventory stocks and utilize second source suppliers to support their requirements.
To date, the areas of China impacted by Coronavirus contribute ~80% of the Chinese GDP and ~90% of Chinese exports.
Most of the businesses in these areas have ceased operations until mid March, with workers advised to stay home in self quarantine.
In response to the health risks, major US corporations have ceased Chinese retail and manufacturing operations and are predicting losses in Q1 2020.
Chinese ports have curtailed operations to the point where goods are stranded inbound and outbound with no workers available to move products.
Thus far, economists have predicted a decline in the annual Chinese GDP, from the projected growth of ~6% down to ~4%, with no growth predicted for Q1 2020.
Chinese small businesses, making up 60% of GDP, are particularly at risk. If the outbreak continues through March, it is estimated that 80% of them may be forced to close – representing roughly ½ of China’s GDP.
If China’s GDP drops below 4.15%, the bad loan ratio at China’s largest banks would increase five fold potentially extending the economic stress while balance sheets are restructured.

Impacts Beyond China

COVID-19: Outside China, new reports of cases and updated statistics are occurring almost hourly as the disease continues to spread rapidly, sometimes without any direct links to China.

Source:https://www.bloomberg.com/graphics/2020-wuhan-novel-coronavirus-outbreak/

Beth Ann Bovino, U.S. chief economist at S&P Global predicts U.S. GDP growth to be 1% for Q1, with a possible small increase in Q2 and then rebound in the second half of the year.
Singapore, Japan, Thailand, and New Zealand have all revised down their GDP forecasts this year due to trade and tourism implications from COVID-19, with Japan now projecting a recession and Singapore forecasting a contraction.
Worldwide, there are increasing reports of businesses suffering from supply chain disruptions and businesses outside of China shutting down operations due to health concerns.
The potential impacts on companies delivering goods to China (also a major import market) is becoming an increasing concern with decreased Chinese demand, Chinese port capacities reduced and shipping lines forced to discontinue shipping.

Potential Sector Risks

Energy

Oil and Gas consumption is closely tied to economic activity. The high volumes and fixed storage capacities make the consumption (not necessarily the price) a potential early indicator of the economic momentum. For example, China’s largest importer of LNG has declared force majeure and is rejecting deliveries and driving down prices. North Asian Liquid natural gas prices are down 30% this year. While oil demand is expected to fall 435K barrels a day for the rest of the first quarter.

Travel and Tourism

Chinese tourism has stopped, both into and out of China. According to the UN World Tourism Organization, China is the largest contributor to global outbound tourism, spending $277 Billion in 2018. In San Francisco, alone, Chinese tourists spent 1.3 Billion in 2019 (San Francisco Chronicle).

All cruise liners have cancelled plans to sail to ports in China, Thailand, Vietnam and the Philippines.

American, United, and Delta have suspended flights to China and Hong Kong with lucrative air cargo services also under restrictions. Air France warned of a possible $216 MM hit to earnings by April.

Large conferences or events that draw participants from China or Asia have already cancelled or at risk or cancellation. As Coronavirus spreads to other countries, more and more events will face that decision. COVID-19 has led to the cancellation or postponement of 24 conferences worldwide.

List of Canceled Events

Formula One’s Chinese Grand Prix that was to take place in Shanghai on April 19th.
The 2020 Mobile World Congress in Barcelona.
Facebook’s annual marketing conference in San Francisco.
Venice Carnival, a 100,000 person event.

Tech

The most visible area of economic impact is in manufacturing supporting the tech industry. In 2015, China launched Made in China 2025, an ambitious national plan to make China a technological manufacturing powerhouse. Chinese investment in this initiative, foreign investment in facilities based in China and the continued success of multinational supply chains have created a critical dependence on Chinese production across most consumer and industrial sectors.

In advance of Chinese New Year, manufacturers increase inventory buffers to 15-20 days, and drain those levels back down to keep in line with Just-in-Time and Lean manufacturing principles.

The impacts of China’s shutdown will have big impacts on the bottom lines of tech based manufacturers and retailers. Shutdowns in Zhengzhou and Shenzhen will reduce Apple’s shipments of iPhones by 5-10% this quarter and Nvidia is projecting a $100 MM hit from the virus. Even manufacturers outside of China and mandatory quarantine are experiencing parts outages stopping production.

Automotive

Wuhan is known as China’s ‘motor city’ Containing factories for Nissan, GM, Renault, Honda, and Peugeot. The shutdowns are spilling over into neighboring countries as Nissan said they are experiencing supply parts shortages in their Kyushu plant in Japan. Hyundai suspended operations of it’s Korean plant due to lack of parts. GM halted production at that South Korean plant for the same reason. Fiat Chrysler halted operations at a Serbian plant, the first european shutdown due to the virus. Jaguar said it could run out of car parts at its British factories by 2/23 if parts didn’t arrive soon.

While, GM is closely monitoring supply chains and fears US production could be disrupted due to lack of parts if things don’t turn around. Typically automotive manufacturing only carries a supply buffer of 30-40 days and plants have been closed for 6 weeks. Toyota and BMW are also heavily affected.

124 out of 183 factories in China that manufacture complete cars are still shuttered as of Wednesday 2/12. Auto sales in China plunged 18% YoY in January and are down 92% for the first 2 weeks in February.

Pharmaceuticals

The head of a large Indian pharmaceutical group warned of serious disruptions to drugmakers if the lockdowns continue and they are unable to obtain essential chinese-made ingredients. Umang Vohra, global chief executive of India’s largest drugmaker Cipla says,”supplies for most companies would start running out by the end of this month unless China resumed production”

India is the world’s biggest exporter of generic drugs and depends on China for 70% of its raw pharmaceutical materials. While western pharmaceutical companies have expressed little concern about the short term, holding 3-6 months of inventory, it would be difficult for them so switch suppliers due to required approval by regulators.

Textiles

China is the world’s largest textile exporter at 38% of global share. Even as producers try shifting production off-shore, they are still dependent on China for raw materials. Wells Fargo Analyst predicts out-of-stock at US shelves by mid-April if production doesn’t resume soon. Steve Madden has the largest exposure at 65% production in China. Followed by Skechers at 48% and Nike at 26%.

Consumer Products

CPG supplier Procter & Gamble, is not only having issues getting products exported out of China, but also delivering products to their chinese consumer that represents their second largest market.

Transportation

International shipping has been disrupted as Chinese ports, unable to staff operations, effectively ceased receiving or shipping goods. Portside LNG and oil storage facilities are at capacity with the reduction in industrial and consumer consumption and are curtailing inbound products. Shipping lines have reduced and / or rescheduled routes. This will ripple through the world import and export transport markets and eventually hit US domestic shippers. One $2 billion freight forwarding company reported that their schedules have evaporated.

Commodities

Iron ore shipments are being delayed to china in order to avoid a 14 day quarantine before being able to reload. Copper, nickel, aluminum all face a similar fate as China is the largest consumer of raw materials. So far this year Iron is down 10%, Copper & nickel 8%, and zinc & aluminum are down 5%.

Construction

Shortages of Chinese sourced materials may create delays in construction projects. One large urban multi family development in Texas reported that their Chinese sourced toilets would not be delivered, and there was no estimate of the future quantity or timing provided. For commercial contractors relying on progress payments, these delays will create liquidity issues as they wait on predecessor contractors to procure parts and materials in order to complete their work.

What should companies do now?

Do not assume that you are a spectator.

Look out for your employees and treat this as an immediate health risk

Engage leadership and HR departments to protect the employee base.
Educate management and employees on the disease.
Reinforce basic physical prevention tactics.
Make these practices and compliance discussable.
Communicate to your employees what you know, frequently.

Treat this as a business crisis

Leadership engagement is required. Their experience will be critical in evaluating potential risks, developing mitigation plans and leading immediate corrective actions.
Change the metrics. In a crisis, focus needs to shift to real time, operational data where the information reflects current state and the impacts of corrective actions can be evaluated.
Creative and critical thinking is required, and needs to be supported from the top down.
Engage supply partners, creditors and customers in the discussion so that they can assist in risk assessment and supporting corrective actions across the supply chain.

Reforecast sales and take aggressive actions accordingly

Assess the Customer base risks and their impact to sales and forecasts?
- What is the percent of sales and gross margin contribution from customers potentially at risk?
- If the enterprise is a second tier or third tier supplier, what the exposure exists in the next steps to the final customer?
- Have there been any changes in order backlog across all customers?
- Contact customers to discuss the situation and report back to management.
- Based on all those considerations, what adjustments to the sales forecasts and gross margin contribution are reasonable?
- Are there sufficient margin dollars to support the business?
  - If not, what steps can be taken now to reduce costs and improve viability?
- Review contractual obligations and rights on each side of agreements.

Monitor real time order and backlog metrics
- Determine the exposure to Chinese (potentially all Asian) customers by reviewing current, year over year and trends in:
  - Current order backlog, including recent changes, deferrals and cancellations of orders
  - Internally generated forecasts by customer
  - Customer provided forecasts
- For potentially at risk customers, increase the frequency of communications to know if, and when, those customers take actions that will impact the company

Assess the supply base risk to shipments

Percent of spend on suppliers directly at risk?
- For direct suppliers at risk, are there viable second and third sources identified and contracted with? What is their delivery capacity?
For assembled parts or sub assemblies, what percent of that provided content comes from impacted regions?
- For those suppliers, what is their risk mitigation plan?
- Do they have second sources ready to support production?
- Do these suppliers have sufficient capacities to provide materials?
Review contractual obligations and rights on each side of the agreement

Monitor purchases, material receipts and quality

Obtain and review purchase order (PO) history
- Open POs by supplier
- Changes to PO quantities or delivery dates
Are actual material receipts slipping past the promised dates?
Intensify quality inspections on in bound products. As Chinese suppliers respond and ramp production activity, they are facing new HR challenges. The usual post-Chinese New Year 20% attrition rate could expand to 50% as workers rethink returning to Wuhan Province. The retraining of potentially ½ of the workforce will create a slower ramp and potentially increase quality issues. to Ensure in bound quality inspections are completed and corrective actions are immediate. As suppliers respond to the situation with new solutions, the risk to quality increases.

Conclusion

It’s been about 60 days since the first case of Coronavirus and there is still a tremendous amount that we don’t know about the virus, the worldwide health risks and its global economic impacts. RIght now, we know:

It’s not over,
It’s going to get worse,
A lot of people will die from the virus,
The widespread impact on global business is only starting to be seen, discussed and assessed.

Jim Collins, probably best known for From Good to Great, asserts that distress is preceded by deterioration in gross margins, current ratios and debt-to-equity ratios. While companies that thrive during times of crisis have high cash to total assets ratio & cash to current liabilities, and optimally low short term debt to equity.

In other words, “dry powder” in the forms of cash, convertible assets and untapped liquidity provide companies the time, management capacity to maneuver and resources to capitalize on future opportunities that the crisis created. The companies that don’t have the dry powder will end up battling on two fronts – an unpredictable, expanding market and supply crisis and an internal liquidity crisis. This is a daunting task rarely survived.

In that scenario, the three key survival assets are cash, time and talent to execute quickly. Companies can buy time by identifying the risks and taking immediate actions to get ahead of the impacts. They may be able to increase liquidity and generate cash from working capital. They must engage the entire management team to develop solutions.

For companies exposed to the markets and supply chains that are at risk, this should be the only priority for the next 60 days.

With focus, companies can buy time. The time to allow the northern hemisphere to transition to spring, complete the Coronavirus’ natural demise and participate in the recovery from what may be a worldwide health and economic crisis.

Learn more at: https://meadowlarkadvisors.com/

Additional Resources

Mitigating the Economic Impacts Coronavirus

Chinese Economic Impacts