Corporate deal-making is an important route to new growth and efficiency. The due diligence process is well defined and most deals meet established financial criteria. There is, however, a gap that many acquirers are beginning to pay more attention to: the supply chain uncertainty created when companies combine.

Kai Trepte

Kai Trepte Supply chain

There’s evidence that because of time constraints, deal complexity, regulatory issues, and investor pressure, scrutiny of supply chain uncertainty can be short-changed in the due diligence phase of M&A deals. The reason? Supply chain and finance functions operate in different universes. This gap becomes visible when you read articles in the business press.

Consider, for example, the current merger between the oil and gas businesses of General Electric and Baker Hughes. Assuming the deal overcomes regulatory hurdles, it could create a formidable competitor in the oilfield services business. Most of the commentary on the merger talks is about synergy and capturing future upsides when the oil and gas industry recovers. These statements ring true, and support the logic behind the merger. But there’s a perspective which may be even more compelling that hasn’t received much attention: the supply chain risk lens.

The supply chain risk lens applies standard supply chain calculations to financial statements to assess the uncertainties surrounding a company’s top-line revenue, gross margin, and inventory. The goal is to understand whether the combined entity increases uncertainty.

Analysis_Bug3The premise behind the supply chain risk lens has three elements. First, variations in demand and revenue, gross margin, and inventory represent uncertainties that companies have to deal with, and we here at the MIT Center for Transportation & Logistics use historical changes in these values as a proxy for uncertainty.

Second, we quantify the various uncertainties by measuring the year-to-year variation over the past three years and calculating an average variation. Lastly, we calculate how much added revenue would be required to offset that same amount of variation in revenue, margin, or inventory.

Let’s take, for instance, a company with a $2 million variation (or uncertainty) surrounding inventory and a 10% net margin. In order to offset a potential $2 million inventory variation, it would need to generate an additional $20 million in top-line revenue with respect to net profit. This illustrates the very high leverage that can come from assessing the variation in terms of “equivalent” revenue.

The bar graph below presents data for Baker Hughes, Halliburton, and General Electric. Applying the supply chain lens assessment sheds significant light on why Baker Hughes was an appealing target for Halliburton (a previous proposal to merge with Halliburton did not come to fruition), and is appealing now to General Electric.

In one instance, the deal offsets revenue uncertainty (General Electric), and in the other instance it offsets margin uncertainty (Halliburton). We see this when we express the uncertainty areas as percentages. Note that even though the categories add up to 100%, they do not represent all the uncertainty the companies face.

Also, the analysis doesn’t show whether total uncertainty increases or decreases – it only shows how the sources of uncertainty mix changes. But the analysis can be used as a starting point for examining whether supply chain risk increases or decreases in mergers.

uncertainty_breakout chart (1)

The three companies shown in the left three columns have different uncertainty profiles when viewed through the supply chain lens. Baker Hughes largest uncertainty is inventory uncertainty (84%); General Electric’s is revenue uncertainty (49%); and Halliburton’s is margin uncertainty (54%).

When the companies combine (shown in the right two columns) the appeal to Halliburton may stem from its ability to reduce its margin uncertainty (24%). Also, the sales of assets, proposed in the original deal would likely reduce the inventory uncertainty as well. In this case, the supply chain lens supports the financial and strategic logic behind the proposed merger.

In contrast, the appeal to General Electric may stem from its ability to reduce its revenue uncertainty to 14%. The continued separation of the two entities is likely to reduce the balance sheet effect of assets on General Electric’s balance sheet as the integration process moves forward. Once again, the supply chain lens supports the strategic and financial logic behind the merger.

The larger benefit of the supply chain lens from acquirer or investor perspectives is that it provides focus and support for added due diligence efforts.

While not the only method or rationale for assessing the compatibility of merger candidates, the application of a supply chain risk lens can help investors and acquirers understand the likely uncertainty mix when they combine organizations. And, on a broader level, such an assessment supports closer links between the supply chain and finance functions in both merger and daily operational settings.

Kai Trepte is research affiliate, MIT Center for Transportation & Logistics.

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