This week's Economist has a few articles on capital markets in the US. This one, "What's wrong with Wall Street", is the leader, and should be available to everyone. This one, "Down on the Street", is a special report, is longer, and requires a subscription. The articles discuss capital market efficiencies, and whether regulation is putting US capital markets at a disadvantage to London and other markets. I found the issues raised in context of the world's largest capital markets to mirror some thoughts I have about the very small capital market for funding Government of Canada (GoC) projects.
The GoC (or as the current prime minister would have it "Canada's New Government") spends about C$200B annually. Of that most is recurring expenditures, leaving about C$20B annually for new capital spending. Expenditures of over C$20M follow a formal approval process that includes the requirement for Treasury Board secretariat review, and depending on the value and other factors may require cabinet level approval, delegated to a committee of cabinet, the Treasury Board. This past June I participated in submissions to Treasury Board requesting just about C$170M in funding for various projects, funding that was approved by the Board. It was a rather depressing experience. Within the GoC bureaucracy it is an accepted fact that the GoC has, by definition, the lowest cost of capital, and therefore should fund all its own capital requirements. Put in another way, the GoC funds internal investments from its own captive, and monopolistic, capital market.
This is a classic error that many readers have likely already spotted. Within the procurement function we routinely review for "Total cost of ownership" (TCO). The TCO review I had our team look at for the cost of the capital investments for the submissions in June showed that, while the interest cost on the capital was the lower than that available from competitive capital markets, the pursuit costs and the opportunity costs seem to be substantially above those tolerated in competitive capital markets.
For an investment of C$170M the pursuit costs were approximately C$35M (which was also borne by the GoC), and it had taken the GoC approximately 5 years to work its way through to approval. The returns expected from the $170M are expected to be in the order of C$1B annually, of which the investment would enable the GoC to lock in $C200M immediately. I am not an expert on the workings of capital markets, but I suspect a competitive market would be able to fund projects with that profile at a substantially lower pursuit cost, and would have done so far more quickly, lowering the opportunity cost of the process as well.
The main arena that this debate is useful, is in the debate of whether "Public Private Partnerships" (PPPs) make sense for the governmental sector. Those opposed to PPPs will argue that the private sector cannot provide the same value as government self-performance as the government has a lower cost of capital and does not need to generate profit from its activities. I'll leave aside theoritical arguments for and against that view, and say that I am much more bullish on PPPs after closely observing how one government loads cost the private markets would not onto its own capital market.
Wednesday, November 29, 2006
Tuesday, November 28, 2006
OECD sees a "mild" slowdown - what do buyers think about?
Today's FT is reporting that the OECD is forecasting a mild economic slowdown next year driven by the cooling off of the US housing market. Economic uncertainty, whether unexpected growth or unexpected declines, offer great opportunities on the corporate buy-side. As in all cases understanding your supplier and their industry is key. In a slowing economy your supplier may be facing underutilized production and other assets leading to a desire to lock a longer-term sales agreement. The procurement team may decide that makes sense, but they should also consider that declining markets can also offer great opportunity for opportunistic spot-buying. The decision should reflect the degree to which the good or service is of strategic value to your business.
During the last housing slow-down I helped a client, one of the largest residential housing REITs in the US, to recognize that construction material costs were relatively insignificant in relation to the companies financial performance and market value. Their business is building and operating high-end residential rental communities. Their financial returns and their share values were influenced mostly by the market's assessment of their ability to construct, generate rental income, and manage operating costs at their projected levels. The market did not react nearly as much to their ablility to construct their communities at a cost per unit that was competitive to their industry. This understanding led to a strategic decision, they used the housing start slow-down to negotiate preferential access to construction labour and materials. While price was negotiated (generally using an indexed price to the spot-market) the firm chose to value preferential supply ahead of lowest cost. That strategy really paid off over the last three years as they were able to maintain an enviable record of delivering their communities on-time during a period where many of their competitors would routinely suffer construction delays due to the booming construction sector in the US.
During the last housing slow-down I helped a client, one of the largest residential housing REITs in the US, to recognize that construction material costs were relatively insignificant in relation to the companies financial performance and market value. Their business is building and operating high-end residential rental communities. Their financial returns and their share values were influenced mostly by the market's assessment of their ability to construct, generate rental income, and manage operating costs at their projected levels. The market did not react nearly as much to their ablility to construct their communities at a cost per unit that was competitive to their industry. This understanding led to a strategic decision, they used the housing start slow-down to negotiate preferential access to construction labour and materials. While price was negotiated (generally using an indexed price to the spot-market) the firm chose to value preferential supply ahead of lowest cost. That strategy really paid off over the last three years as they were able to maintain an enviable record of delivering their communities on-time during a period where many of their competitors would routinely suffer construction delays due to the booming construction sector in the US.
Monday, November 27, 2006
Mmmm Burgernomics
Free exchange, the Econmist's blog has posted a note, Weighting Game, that says Big Mac burger patties vary in size by country. This could have an impact on the Big Mac index. Should the economist decide to re-weight the index for patty weight, I suggest they balance their new weighting with an understanding that patties are only a portion of the total cost of input into a Big Mac. It would be easy to overweight the weight of the patty weight in the new index.
Ivey Purchasing Managers Index
Every month the University of Western Ontario's Richard Ivey School of Business and the Purchasing Management Association of Canada (PMAC) publish the Ivey Purchasing Managers Index. I'm not sure who uses the index, or where the value lies in the data they publish. One of the first things you'll notice is that there is huge month-to-month variance in the data, as shown in the table below, from October 2006. The FAQ for the site addresses the "jumpiness" by stating they don't adjust for seasonality, inflation, and covers the entire Canadian economy. As a buyer, I don't see how I could use this index to lower my cost of purchased goods and services. I wonder if the economists out there place value on it that I don't see.
Here's one that went wrong
The Government of Canada has apparently decided to back away from its ambitious plan to save $2.5B through reforming its creaky procurement system. I'm very familiar with this situation, and I plan to comment as this develops. Tories can't hit $2.5B savings target.
Thursday, November 23, 2006
Wednesday, November 22, 2006
More bids equals higher cost?
I don't like "Requests for". What buyer (or seller) hasn't been through innumerable "RFx" Requests for Proposals, Quotes, Interest, Information, etc. They are used by buyers to help them understand what the market can offer, and create competition amongst suppliers so the buyer can lower their procurement costs and, ideally, increase the quality of their supply chain.
Many organizations also like them as they structure their buying decisions in an "open and fair" manner. What is needed to understand a broader impact of these approaches is to understand that buyers don't act alone, they have counterparts on the sell side that are going to react to the approach. The sell side reacts with approaches and analysis such as "Bid Management", "Pursuit Costs", and "Success Rates". I'll give some brief examples of each below. The objective of the buyer should be to lower pursuit costs and improve seller's success rates up while not impairing the benefits of competition.
Bid Management
What buyers, and more rarely the sellers, sometimes fail to understand is that RFx often increase the cost and impairs the quality of the supply chain. Here's an article "To bid or not to bid ..." by Mark Whitley on the Institution of Engineering and Technology website that touches on some of these issues. Mark talks about bid management as a growing field of expertise and lays out the standard project management imperative triangle of time, cost, and quality. In his discussion of cost he advises that bidders consider more than direct bid costs such as bought-in costs and travel and also consider opportunity cost (what else could the team have done instead of bidding for a particular job).
Pursuit Costs
From a buyer's perspective I like to understand the pursuit costs and the related success rate. Pursuit costs are simply the costs that your bidders incur pursuing your business. These costs occur within and external to formal competition. In one memorable discussion with a white-box PC retailer I was told that his industry employed twice the number of sales people relative to revenue to service my account than they did on average for all their other accounts. It was an interesting discussion as the retailer viewed this as evidence of his industry demonstrating to us our importance. I viewed it as evidence that we were paying too much (sales costs on average were about 10%, but for us this rose to 20%) for our PCs.
Success Rate
It turns out that we not only bid our PC business to often, but we also invited to many bidders to each competition (and punished those who did not regularly bid by not inviting them into future bids). These actions had the impact of lowering the industry's success rate in competing for our business and success rate directly impacts a buyers cost. The success rate is the percentage of bids that result in revenue. If a seller bids for 10 jobs and wins 3 their success rate is 30%. Sales management tends to be pretty obsessed with success rates. Obviously a sales organization wants to increase its success rate, but it also simply wants to be able to forecast it. Sales teams spend a lot of effort building and managing the "sales pipeline" in order to be able to generate revenue. If you are on the buy side and can help to improve success rates while maintaining adequate competition everyone comes out ahead.
In another category of spend for a large client we were bidding several hundred millions of dollars for professional support for information technology services. Several thousand firms and individuals were qualified to bid and every offer over $25,000 was open to each and every firm. Some offers would receive hundreds of bid responses. The success rate for bidders was very low, and benchmark analysis showed that this was reflected in our price for these services to be high relative to the market.
Procurement teams that work to understand these market dynamics and then to structure their offers to increase competition while lowering pursuit costs and increasing success rates will end up with better suppliers at a lower cost.
Many organizations also like them as they structure their buying decisions in an "open and fair" manner. What is needed to understand a broader impact of these approaches is to understand that buyers don't act alone, they have counterparts on the sell side that are going to react to the approach. The sell side reacts with approaches and analysis such as "Bid Management", "Pursuit Costs", and "Success Rates". I'll give some brief examples of each below. The objective of the buyer should be to lower pursuit costs and improve seller's success rates up while not impairing the benefits of competition.
Bid Management
What buyers, and more rarely the sellers, sometimes fail to understand is that RFx often increase the cost and impairs the quality of the supply chain. Here's an article "To bid or not to bid ..." by Mark Whitley on the Institution of Engineering and Technology website that touches on some of these issues. Mark talks about bid management as a growing field of expertise and lays out the standard project management imperative triangle of time, cost, and quality. In his discussion of cost he advises that bidders consider more than direct bid costs such as bought-in costs and travel and also consider opportunity cost (what else could the team have done instead of bidding for a particular job).
Pursuit Costs
From a buyer's perspective I like to understand the pursuit costs and the related success rate. Pursuit costs are simply the costs that your bidders incur pursuing your business. These costs occur within and external to formal competition. In one memorable discussion with a white-box PC retailer I was told that his industry employed twice the number of sales people relative to revenue to service my account than they did on average for all their other accounts. It was an interesting discussion as the retailer viewed this as evidence of his industry demonstrating to us our importance. I viewed it as evidence that we were paying too much (sales costs on average were about 10%, but for us this rose to 20%) for our PCs.
Success Rate
It turns out that we not only bid our PC business to often, but we also invited to many bidders to each competition (and punished those who did not regularly bid by not inviting them into future bids). These actions had the impact of lowering the industry's success rate in competing for our business and success rate directly impacts a buyers cost. The success rate is the percentage of bids that result in revenue. If a seller bids for 10 jobs and wins 3 their success rate is 30%. Sales management tends to be pretty obsessed with success rates. Obviously a sales organization wants to increase its success rate, but it also simply wants to be able to forecast it. Sales teams spend a lot of effort building and managing the "sales pipeline" in order to be able to generate revenue. If you are on the buy side and can help to improve success rates while maintaining adequate competition everyone comes out ahead.
In another category of spend for a large client we were bidding several hundred millions of dollars for professional support for information technology services. Several thousand firms and individuals were qualified to bid and every offer over $25,000 was open to each and every firm. Some offers would receive hundreds of bid responses. The success rate for bidders was very low, and benchmark analysis showed that this was reflected in our price for these services to be high relative to the market.
Procurement teams that work to understand these market dynamics and then to structure their offers to increase competition while lowering pursuit costs and increasing success rates will end up with better suppliers at a lower cost.
Tuesday, November 21, 2006
Mean or Green?
This weeks Economist has an article, Tilting at Windmills, that discusses the boom in investing in renewable energy technology companies. There are some interesting comments, including a reasonable one that suggests $50/barrel for crude oil is the tipping point that makes alternative energy viable, we've been at that price since early 2005.
This thought process, "at what point does it make economic sense to invest in a substitute product sector?" should be a pretty common piece of analysis in the corporate procurement world.
In the spring of this year I spoke to several hundred members of a material management organization that is largely made up of government sector buyers. It was an interesting experience as they work in a sector where policy often trumps reason. The range of policy objectives and interest groups that are factored into procurement decisions include small business, green procurement, aboriginal business, regional diversity, industry lobby groups, linquistic diversity, industrial policy, safety standards, etc. I challenged the group to consider which of these policy objectives could be supported through cost/benefit or other economic analysis.
In many cases "green procurement" can and does make good procurement sense. Here are a few examples:
This thought process, "at what point does it make economic sense to invest in a substitute product sector?" should be a pretty common piece of analysis in the corporate procurement world.
In the spring of this year I spoke to several hundred members of a material management organization that is largely made up of government sector buyers. It was an interesting experience as they work in a sector where policy often trumps reason. The range of policy objectives and interest groups that are factored into procurement decisions include small business, green procurement, aboriginal business, regional diversity, industry lobby groups, linquistic diversity, industrial policy, safety standards, etc. I challenged the group to consider which of these policy objectives could be supported through cost/benefit or other economic analysis.
In many cases "green procurement" can and does make good procurement sense. Here are a few examples:
- a well-known global clothing retailer saved over 50% of their waste removal costs by removing cardboard (OCC) from the waste stream and generating revenue from recycling
- Low-rise commercial buildings can install various technologies to pre-condition air prior to it reaching the roof-top HVAC unit. Typically these are heat-exchange units that capture the thermal value of outgoing chilled or heated air (depending on the season) prior to expelling the air. Economic payback is often 3-5 years, while government subsidies often substantially shorten that period.
- including VPN capability into your secure network design adds cost, but it can enable staff to work from home, cascading into lower facility costs, and incidentally removing some carbon load from commuter traffic
- In many office environments there is little thought given to the number and capacity of the printers and copiers. A recent study I looked at for two multi-story office towers showed that there were about 30% too many printers and copiers. Not only does this mean capital and maintenance costs are higher than necessary, there is a two-order impact on energy consumption. First the surplus machines consume energy, and second they generate substantial heat that requires additional energy to cool the office environment.
Monday, November 20, 2006
Equity Office Properties acquired by Blackstone. A small procurement investment would make sense.
Today Blackstone announced they were acquiring EOP in a record setting leveraged buy-out worth $36B ($20B to shareholders and $16B in acquired debt). This story caught my eye as a few years back an e-marketplace I worked for served EOP and we also worked for a few months to convince their new VP Procurement to hire us for procurement services work. On the other side of the transaction a former client is now a Managing Director at Blackstone. I think this transaction can help illustrate my statement that few investments can rival procurement for generating returns for companies.
The sources and analysis appear below.
EOP has approximately $850M in sourceable spend, that is the cost purchasing of goods and services that typically can be negotiated. Based on my recall of discussions at EOP and similar REITs I estimate that approximately 50% of the spend could be addressed by strategic sourcing - $425M. Strategic sourcing in this industry typically yields savings, net of $4M in sourcing costs, of 8% or $34M in annual savings.
So apart from generating an incremental $34M to the bottom line, how else can we describe the impact an incremental investment of $4M in Blackstone's $36B acquisition of EOP achieve?
Current
Source: EOP Annual Report 2005
The sources and analysis appear below.
EOP has approximately $850M in sourceable spend, that is the cost purchasing of goods and services that typically can be negotiated. Based on my recall of discussions at EOP and similar REITs I estimate that approximately 50% of the spend could be addressed by strategic sourcing - $425M. Strategic sourcing in this industry typically yields savings, net of $4M in sourcing costs, of 8% or $34M in annual savings.
So apart from generating an incremental $34M to the bottom line, how else can we describe the impact an incremental investment of $4M in Blackstone's $36B acquisition of EOP achieve?
Current
- Earnings per common share of Operating Income: $2.27
- Earning per comon share of Net Income available to common shareholders: $0.02
- Earnings per common share of Operating Income: $2.35 (an incremental $0.07 per share)
- Earning per common share of Net Income available to common shareholders: $0.08 (an icremental $0.06 per share)
Source: EOP Annual Report 2005
- Revenue: $3.0B
- Operating Expenses: $2.1B
- Operating Income: $0.9B
- Net Income available to common shareholders: $8.1M
- Weighted Average Common Shares Outstanding: 403,147,751
- Earnings per common share of Operating Income: $2.27
- Earning per comon share of Net Income available to common shareholders: $0.02
- Sourceable Spend: $849M (Repairs & Maintenance $341M, Property operating $442M, Corporate and general administrative $67M)
- Addressable spend: $425M
- Cost estimate to source $425M in addressable spend: $4M
Irrationally Rational
One of the things I've observed is how difficult it is for companies to make rational investment decisions. Here's a post by Tyler Cowan linking to here that suggests many people think they make rational decisions while other people are irrational. I hope that the authors at overcoming bias continue their discussions.
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