The economic impact of COVID-related plant shutdowns and the war in Ukraine has disrupted the global supply chain. Raw materials prices and supplier input costs have surged at rates faster than any time since 1974 and should be a key focus of near-term M&A due diligence.
For instance, the World Bank’s global metals and minerals price index has jumped by 12.4 percent between the end of last year and February, while the same index shows a 90 percent leap since COVID hit in March 2020. Much of this is due to a spike in metals pricing. But while supplier input costs rise quickly, output prices tend to move more slowly: The producer price index of U.S. manufacturers rose by a relatively small 4.6 percent in the same period. Would-be acquirers should therefore scrutinize the target company’s input and output prices for evidence of squeezed margins and the likelihood of this occurring in the future.
Acquirers must determine whether target companies’ output price changes have kept pace with the cost of inputs. If not, one way to reduce the gap is by adjusting the price of every SKU on a monthly, weekly, or even daily basis. An example of this approach is the use of supply-aware dynamic pricing that adapts quickly to volatile changes in the supply chain. There are other ways to deal with the challenge. For example, an automotive supplier developed a win-loss predictive algorithm that forecasts the outcome of supplier quotes.
Investors should use caution with cost-indexing agreements, however, as they are often less insulated than acquiring companies imagine. Acquirers can find themselves negotiating deals that prevent repricing or involve Most Favored Nation clauses, onerous certification requirements, and vaguely worded good-faith price-dispute clauses.
Among the questions acquirers should ask regarding the target company’s supply chain:
- Is the procurement strategy helping to control costs? Is the strategy and commercial pricing strategy synchronized?
- Is the target company conducting regular pricing and margin reviews and examining the pricing clauses of supply contracts?
- Is sales compensation designed to preserve margins and take advantage of temporary opportunities for higher-margin sales?
- Are the sales contracts drafted broadly, to cover as many eventualities as possible?
- Is the procurement strategy transparently communicated, and tailored to suppliers and customers?
We are seeing tremendous volatility in supply chains and prices. If acquirers fail to perform due diligence regarding input costs, they may end up taking ownership of a company that is highly vulnerable to price instability—with dire effects on the bottom line.