Supply Chain Crisis: Shipping, Evergrande & More

If you want to watch the full video where we break down current conditions, Evergrande, outlook, etc. check out the above. For the shorter, actionable version just keep reading out.

COVID and bad boating has brought the topic of “global supply chains” to the forefront of the news over the past year. Today we’re going to take a look at just how complex global supply chains are and how this tangled web affects you as a consumer.

Take a look at the smartphone. If you were asked, where are iPhones made? Your answer would probably be China. While it is assembled in China by Foxconn, all of the parts that go into an iPhone are manufactured across 43 different countries before they end up on store shelves. The lithium in the batteries are mined in Brazil, semiconductors are printed in Taiwan, and the iPhone boxes are manufactured in the Czech Republic to name a few.

Now here’s an important realization -> If any critical part of this supply chain is disrupted or delayed, the entire product is disrupted or delayed! This is the push and pull of managing a global supply chain where a company has to juggle between lowering costs and resiliency so delays and disruptions don’t become showstoppers.

Why are global supply chains so complex?

A company like Apple sells the iPhone, but they don’t manufacture a single component themselves. Every single piece is subcontracted out to specialists and the final product is assembled by Foxconn. This supply chain complexity is typical in most products that you see today in every single vertical from the hamburger you have at McDonalds all the way to the COVID vaccine from Moderna.

So let’s talk about why this happens:

• Minimizing Costs
• Taxes
• Lobbying

Minimizing costs is the easiest to understand. Companies are built to maximize shareholder value so reducing the cost to produce their products is often one of the biggest focuses within a company. Raw materials aren’t available everywhere in the world so different components need to be sourced from where they can be mined or harvested from. For example, lithium is an essential component in all modern batteries. Australia is the largest producer of the world’s lithium at 52.9% while Chile has the largest reserve of lithium in the world at 55.5%. The lithium has to be mined and then transported to a facility that produces batteries, then shipped out to the country where the product is assembled and then out to where it’ll be finally sold. Depending on the costs within a country and the current cost of shipping, it may make sense to weave what seems like an enormously complex web and at the end of the day, have the cheapest product at the right quality.

Now to make this even more complex, let’s add in lobbying and taxes.

APN311 is one of the leading drugs to treat high-risk neuroblastoma. This, as well as many other essential drug components, is produced out of Austria, one of the most expensive places on earth to produce something. It’s made here because the government has invested in an incredibly robust Research and Development infrastructure for drug research within Austria with the tradeoff being any breakthrough drug developed in the state-sponsored facilities is required to be produced in Austria. This is seen as a win-win because the pharmaceutical companies are able to access a wealth of medical research and the residents of Austria get access to a large number of high-paying pharmaceutical manufacturing jobs.

Now that we’ve established that Austria produces one of the essential ingredients for APN311, why is it that China is the main manufacturer? This comes down to taxes. Countries have certain trade deals that dramatically influence how this supply chain web looks. Import taxes can oftentimes be steep, which can heavily influence the final price of the product.

On the other hand, countries that have special trade relations offer enormous tax savings if the supply chain is routed through them appropriately. Austria is part of the European Union, which means products can be traded freely between Austria and Ireland. Ireland is home to a specific duty-free zone that can export goods to China without any tariffs to be packaged and then all of a sudden, APN311 is a product of china with a component from Austria. As a Chinese product, it can now be exported into any country that has made trade deals with China which is quite a few countries.

This is a fairly simplified supply chain to demonstrate what factors may influence the supply chain and add to the complexity. Most companies never disclose their entire supply chain so oftentimes a consumer won’t know why certain products are delayed or discontinued. One of the important things to pay attention to when looking at any company that produces a physical product, especially a complex product, is its reliance on single-source suppliers. When Tesla first began ramping up their production in the fiscal year of 2013, they were sourcing 2,000+ parts from 300 suppliers where most of them were single-source suppliers. This means that if any one of the single-source providers were delayed and Tesla ran out of that product in the production line, all production would have been halted until that part arrived at the production line.

Hedging Against Supply Chain Risks:

But now flash forward to 2018 and Tesla now has many partners to source their components and has reduced its reliance on single-source suppliers to minimize risk. And as of late they've moved more and more to a vertical integrated model.

This is where it gets interesting!

While it is very expensive to become vertically integrated, once integrated, you're able to start raising margins and hedge out most supply chain risks - because you're the entire chain. If one component of your output gets delayed or a factory goes out of business, you need not worry because everything is done in house! While this model is hard to recreate, looking out for companies that are able to do this or are on their way there is a sign of mastery that shouldn't be ignored. While it is hard to quantify this in traditional analysis, a mark of this is paramount to a strong forward looking business model. The biggest benefits in addition to this are, lower transportation costs and turnaround times, reduced disruptions and quality problems from suppliers and improved profitability.

So with that context, here are three strong companies who are working in the right direction.

1. Shell (RDS.A): Remember this recent post on Shell?  Shell has exploration divisions that seek new sources of oil and subsidiaries that are devoted to extracting and refining it. Their transportation divisions transport the finished product. Their retail divisions operate the gas stations that deliver their product. From start to finish, Shell is a part of the exploration process all the way to end sales with the user themselves. The output is extraordinary and is the reason Shell is a top pick for us in the energy sector. True vertical integration is hard to achieve and Shell is a model citizen for how to do it!

2. Netflix (NFLX): Netflix's path to vertical integration has been a long ride. Once they realized they could improve margins by producing some of their own original content, they moved from a DVD distributor to a vertically integrated player. Today, Netflix uses its distribution model to promote its original content alongside programming licensed from studios and should be a force for years to come. We have and continue to be long the company! 

3. Peloton (PTON): Don't think Peloton is vertically integrated? They're sneakily more-so then you would think. For example, rather than using someone else's bike, they designed and manufacturer their own bike from the ground up with its own hardware and software. Rather than outsource classes and instructors they do everything in-house. Rather than put these instructors in pre-built studios, they stood up their own and bought their own store front. In addition they stood up their own retail stores rather than going through a third party. At every turn Peloton optimized for vertical integration even though that meant a longer and more expensive go to market. While the stock has been hit hard YTD due to a return to gym culture, we think the business should bounce back in the long term. Its a high risk pick but the valuation is finally starting to come in check!

Bonus: Tesla (TSLA):

• We know we said three but Tesla is an obvious choice for this as well. So let's count this as a bonus. But with news of them moving large parts of their operations to Texas, Tesla is the model citizen for vertical integration! As we've been mentioning for the last few years, this is a buy and hold stock to keep over the next decade!