Problem Areas Credit Risk - IBISWorld

Economic Environment
Agriflation
Identifying Supply-Chain
Problem Areas
and Quantifying an
Industry’s Vulnerability to
Credit Risk

Rising prices for food commodities have ripple effects
on industries downstream. Lenders can evaluate how rising
prices affect certain industries and the resulting impact on a
firm’s credit risk.
b y Gav i n Sm i t h
Th e f i r s t a rt i c l e in this series, which appeared in the September
issue, focused on the sharp increase in the price
of agricultural goods and sought to distinguish the shortterm
factors that have pushed up prices from longer-term
fundamentals. A key underpinning of this series is that
price increases in one industry have ripple effects through
an economic supply chain—with an associated increase
in credit risk.
Monitoring and measuring the risk faced by companies
along a supply chain is essential to sound bank-lending
practices. Not all industries, or companies, are created
equal and risk is rarely spread evenly. Separating the good
risks from the bad risks is a significant challenge.
Understanding industry fundamentals and their inherent
strengths and weaknesses will offer some indication of
the robustness of companies that face a supply-chain price
rise. In this article, we create two simple agribusiness supply
chains that show the interconnectedness of industries
(and thus the means by which risk is spread) and highlight
the factors that can increase or mitigate credit risks.
The first article pinpointed corn, soybean, and wheat
farming as major areas of interest, given that the supply
chain from these three industries involves many agricultural
producers, foodstuff manufacturers and processors,
wholesalers and storage providers, as well as retailers.
This article will focus on price increases in the corn, soybean,
and wheat farming industries and the ability of industries
in the animal production and food production
supply chains to weather a supply-chain price shock. We
will highlight industry characteristics that help determine
the typical company’s vulnerability to sharply rising input
prices and offer benchmarks that lenders can use to
quantify the relative risk level faced by the sector and the
companies that operate in it.
The Supply Chain
Figures 1 and 2 each show eight key industries located
downstream of the corn, soybean, and wheat farming industries.
Figure 1 shows the animal production supply
chain. Figure 2 shows the food production supply chain.
These 16 industries rely on the goods sold by crop farmers
and therefore are susceptible to the recent rise in agricultural
input prices.
Purchase costs for animal production industries along
the crop-growing supply chain total $114.7 billion. Average
profitability along the chain is around 12.6% of
industry revenue. The value of the food production supply
chain is greater at $220.3 billion. Purchases from in-
Figure 1
Agriculture and Animal Production Supply Chain
Corn,
Soybean
& Wheat
Farming
Animal Products— Downstream Demand Turkey Production 44.0%
Material Purchase Costs (% of revenue) Animal Food Production 61.0%
Beef Cattle Production 48.8% Egg & Poultry Wholesale 83.0%
Milk Production & Dairy Cattle 51.9% Beef & Pork Wholesale 83.6%
Hog & Pig Farming 50.0% Total Purchase Costs $114.7bn
Chicken Production 52.2% Average Profit Margin 12.6%
Source: IBISWORLD, INC.
The RMA Journal October 2008 43

Figure 2
Agriculture and Food Production Supply Chain
Corn,
Soybean
& Wheat
Farming
Food Products— Downstream Demand Cookie, Cracker & Pasta Production 40.4%
Material Purchase Costs (% of revenue) Tortilla Production 43.8%
Flour Milling 73.0% Syrup & Flavoring Production 27.7%
Margarine & Cooking Oil Processing 70.2% Corn, Wheat & Soybean Wholesaling 89.3%
Cereal Production 32.4%% Total Purchase Costs $220.3bn
Bread Production 36.1% Average Profit Margin 20.4%
Source: IBISWORLD, INC.
dustries in this chain include a wider array of goods and
services from sources other than primary producers, although
this trend is not uniform. At an average of 20.4%
of total industry revenue, the average profit margin of the
food production industries is greater than that of the animal
production chain.
Evaluating and Measuring Industry Vulnerability
Below is a summary of criteria used to evaluate and measure
an industry’s vulnerability to a supply-chain price
shock. The checklists contained in Tables 1 and 2 establish
industry benchmarks used to judge the robustness of
an industry’s typical company. Key factors a lender must
consider are:
• Purchase costs as a proportion of total revenue. This
quantifies the average company’s overall exposure to
input price shocks further up the supply chain. The
bargaining dynamics of the supply chain can complicate
matters. For instance, a bulk buyer or one with
long-term supply contracts will secure a better price
than a smaller company that purchases sporadically.
Moreover, a company with an alternative supply source
(or an alternative input), including the ability to import
goods, will be able to strike a better deal to reduce risks
associated with higher input prices.
• Average industry profitability. This indicates the size
of the average firm’s short-term financial buffer against
higher variable costs. The buffer gives operators a
chance to absorb input price rises by running down
profit to avoid passing on costs to consumers (and
risk losing market share) or failing to meet loan repayments.
• Economic life-cycle stage. This is a qualitative and
quantitative assessment of an industry’s markets, products,
technology adoption, and revenue growth. A company
that operates in a growth industry may be willing
to accept higher short-term prices to stay in business
in the hope of future profits. Industries in the decline
phase provide an operator with fewer alternative business
strategies and therefore have increased credit risk.
• Average size of an industry player. This can be used to
benchmark a company’s bargaining power in the supply
chain and its ability to exploit economies of scale.
• IBISWorld Industry Health Index. This score (described
in the first article) measures the impact of external
variables on an industry, thereby putting operators
in a real-world context.
Agriculture and the Animal Production Chain
The price-shock vulnerability checklist (Table 1) shows
that a number of industries are susceptible to supply-chain
price increases. Of clear concern are industries in the decline
stage of their life cycles. Decline is characterized by
falling or static per capita consumption of the good or service
the industry produces. As such, an operator’s decision
to pass on a price increase to consumers will likely hasten
the buyer’s move away from the good. Moreover, decline
is characterized by only cosmetic industry-technology
change, meaning companies are unlikely to develop new
production processes that could increase productivity and
mitigate the full impact of rising input prices.
Of the industries in the decline stage of their life cycles,
the two wholesalers stand out as particularly vulnerable
given thin profit margins and high purchase costs. The
data shows a very low tolerance for input price rises, namely
4.8% in the egg and poultry wholesaling industry and
only 3% in the beef and pork wholesaling industry. This
means a typical operator in the beef and pork wholesaling
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October 2008 The RMA Journal

Table 1
Industry
Purchase Costs
(% of total revenue)
Profit Rate
(% of revenue)
Price-shock Vulnerability Checklist
Implied Input Price
Rise 'Buffer'
Industry Life-
Cycle Stage
Average Size of
Industry Company ($)
IBISWorld Industry
Health Index
Beef Cattle Production 48.8 15.0 30.7 Mature 73,365 106.1
Milk Production & Dairy Cattle 51.9 13.0 25.0 Mature 502,688 99.3
Hog & Pig Farming 50.0 14.0 28.0 Decline 481,334 103.7
Chicken Production 52.2 18.5 35.4 Mature 968,033 119.2
Turkey Production 44.0 14.1 32.0 Mature 1,176,110 123.6
Animal Food Production 61.0 19.6 32.1 Mature 21,721,465 110.8
Egg & Poultry Wholesale 83.0 4.0 4.8 Decline 10,859,586 79.1
Beef & Pork Wholesale 83.6 2.5 3.0 Decline 9,760,094 77.6
industry might bear a short-term increase in input costs
of only 3% before considering passing on prices or threatening
default. These pressures are likely to accelerate the
general move toward wholesale function bypass and play
to the strengths of vertically integrated agribusinesses that
grow, process, wholesale, and even retail goods.
The saving grace of the wholesale sector is the large
average size of an industry operator. Buying power is a
key pressure point along any supply chain. In comparison
to most farmers, wholesale firms have a high degree of
bargaining power in the supply chain. Firms at or larger
than the benchmarks noted can use economies of scale in
purchasing, storage, and distribution that a smaller company
would find more difficult. The discrepancy in establishment
size is a fair indication of one company’s power
compared with another.
Evidence of the way supply-chain dynamics operate
is calculable. According to the U.S. Department of Agriculture
(USDA), the retail price of beef increased 16.6%
between 2002 and 2007, and all of this occurred between
wholesalers and retailers. A comparison of the farm gate
price of beef and the wholesale price shows a fall of 6.2%
over the same period. Clearly, the discrepancy between
average farm size and average wholesaler and manufacturer
is vital.
Supply-chain credit risk is mitigated by reasonably high
average profit margins, which operators can use as a shortterm
buffer against price shocks before passing the price
to consumers (or further down the supply chain) or, in the
worst-case scenario, before credit default.
The animal food production industry is particularly
well sheltered with a significant average establishment
size (manufacturing is reliant on economies of scale that
reduce unit prices) and a profit margin touching 20%
of revenue. The buffer in this industry’s cost structure is
32.1%. Although purchase costs are reasonably high, they
are spread across crop and noncrop industries.
Moreover, the mature stage of the industry life cycle
allows the best companies to segment their product offerings.
Higher-quality goods will probably be marked up
in price at the retail level (pet food accounts for around
30% of industry revenue), while lower-end goods (such as
cattle feed) will benefit from some near-term price crosssubsidization.
The IBISWorld Industry Health Index shows an average
score across all industries in the chain of 102.4—ranging
from a very healthy 123.6 points for turkey production to
a low of 77.6 points in the beef and pork wholesale industry.
Turkey producers are aided by the fact that purchase
costs account for only 44% of total revenue (the lowest in
this supply chain). Of that total, only about 15 percentage
points come from crops (as used for feed). Further along
the turkey production supply chain, operators are helped
by the high price of turkey livestock, a low incidence of
disease, and changing consumer consumption habits favoring
white meat.
Three industries fall below the baseline 100 level, suggesting
relatively poor health. In the case of the milk production
and dairy cattle industry, problems stem from the
industry operators’ reliance on crops as feed. IBISWorld
estimates that crops account for about 20 percentage
points of purchase costs (which total 51.9% of revenue).
The industry also suffers from a weakening supply chain
of its own. Key buyers, such as the dairy product manufacturing
industry, which accounts for about 30% of total
demand, will grow only 0.6% in 2009. Another key buyer,
the ice cream manufacturing industry, will decline 0.9%.
Agriculture and the Food Production Chain
The benchmark checklist for industries in the food production
supply chain (Table 2) has two industries in the
growth stage of their life cycles: the tortilla production
industry and corn, wheat, and soybean wholesaling. On
closer inspection of the latter, we find that expansion is
concentrated in the corn segment, especially sales to producers
of ethanol and other biofuels. Expansion in this
The RMA Journal October 2008 45

Table 2
Industry
Purchase Costs
(% of total revenue)
Industries in Food Production Supply Chain
Profit Rate
(% of revenue)
Implied Input Price
Rise ’Buffer’
Industry Life-
Cycle Stage
Average Size of
Industry Company ($)
IBISWorld Industry
Health Index
Flour Milling 73.0 15.0 20.5 Mature 36,196,730 71.8
Margarine & Cooking Oil Processing 70.2 15.0 21.4 Mature 124,543,827 70.7
Cereal Production 32.4 43.5 134.3 Mature 180,525,000 114.3
Bread Production 36.1 19.0 52.6 Mature 3,931,639 100.1
Cookie, Cracker & Pasta Production 40.4 21.7 53.7 Mature 28,534,268 108.3
Tortilla Production 43.8 18.8 42.9 Growth 7,531,546 114.5
Syrup & Flavoring Production 27.7 26.1 94.2 Decline 57,388,966 105.1
Corn, Wheat & Soybean Wholesaling 89.3 5.0 5.6 Growth 37,309,661 83.2
product line has been significant enough to push up the
industry’s profit margin to 5% of revenue, which is beyond
the sliver normally associated with wholesaling.
Moreover, the industry’s average company size, $37
million, reflects strong buying power. Data from the
USDA shows that major wholesalers (and, by extension,
manufacturers to which they sell) and retailers have successfully
“out-bargained” farmers. For instance, the value
of cereal and bakery products returned to the farmer fell
from 14% in 1980 to 6% in 2006. Over the same period,
the retail cost of cereal and bakery products increased
153%. The source of power in this chain clearly is not
with farmers.
Profit margins across the whole food production supply
chain are relatively high, which provides a short-term buffer
against default. Indeed, three industries return a buffer
level greater than 50%, with a typical operator in the cereal
production industry able to bear a short-term price rise
of 134% before taking ameliorative action. Profit margins
are buoyed by the relatively low cost of labor in this chain.
Wage costs are an average of 4.8% of revenue compared
to 6.2% for those in the animal food supply chain. Wage
costs have been eroded by the extensive use of machinery
and large-scale manufacturing plants. Reasonably benign
purchase prices over the past five to 10 years have fed
directly into profit ratios, with minimal leakage into depreciable
investment spending on newer machinery.
The IBISWorld Industry Health Index scores for the
industries in the food production segment average out at
96 points, meaning the supply chain as a whole is in a
slightly riskier position than the baseline measurement
in 2005. The riskiest are the margarine and cooking oil
processing industry (with a score of 70.7 points) and the
flour milling industry (71.8 points). These two industries
have very high purchase costs at 70.2% and 73% of revenue,
respectively.
More importantly, these purchases are concentrated
in the three industries that have experienced the highest
rise in agricultural prices. On average, wheat purchases
account for around 30% of total revenue for a typical flour
miller. Meanwhile, oilseed crops account for 35% of revenue
in the margarine and cooking oil processing industry
and corn accounts for another 10%, making the rise in
agricultural prices a cause for concern.
Some Companies Are Stronger Than Others
With the purchase cost of agricultural goods high and rising,
the average profit margins of industries in a number
of supply chains are likely to be eroded. The best enterprises
will weather the storm over the short term without
threat of credit default or passing on price increases
to consumers (and dissuading people from buying the
good). Some weaker enterprises, especially those in industries
susceptible to supply-chain price shocks, will suffer.
Consequently, credit risk will increase.
A number of key indicators have been determined and
quantified in this article to help determine the robustness
of an industry as it deals with price increases from suppliers.
An industry’s life-cycle stage accounts for a number
of industry fundamentals and will prove a solid guide to
the industry’s long-term viability. In the short term, an industry’s
purchase costs, the distribution or concentration
of those costs, and the average profit margin are central
to judging changes to the credit risk environment. This
article established some benchmarks figures for 16 key
industries.
The third and final article in this series will focus on
stress-test modeling. In this way, we can hypothesize further
agricultural price rises (and falls) and other macroeconomic
shocks that help pinpoint weaknesses along the
agribusiness supply chain. v
••
Gavin Smith is a senior economic analyst at IBISWorld Inc., a Los Angeles-based
industry intelligence firm. Contact him by e-mail at gavins@ibisworld.com.
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October 2008 The RMA Journal